Industrial Structures and the Development of Small and Medium Enterprise Linkages: Examples from East Asia (Edi Seminar Series)

al Structures and the Development of Small and Medium Enterpri

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Industrial Structures and the Development of Small and Medium Enterprise Linkages Examples from East Asia Edited by Saha Dhevan Meyanathan

© 1994 The International Bank for Reconstruction and Development / THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing October 1994 The Economic Development Institute (EDI) was established by the World Bank in 1955 to train officials concerned with development planning, policymaking, investment analysis, and project implementation in member developing countries. At present the substance of the EDI's work emphasizes macroeconomic and sectoral economic policy analysis. Through a variety of courses, seminars, and workshops, most of which are given overseas in cooperation with local institutions, the EDI seeks to sharpen analytical skills used in policy analysis and to broaden understanding of the experience of individual countries with economic development. Although the EDI's publications are designed to support its training activities, many are of interest to a much broader audience. EDI materials, including any findings, interpretations, and conclusions, are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Because of the informality of this series and to make the publication available with the least possible delay, the manuscript has not been edited as fully as would be the case with a more formal document, and the World Bank accepts no responsibility for errors. Some sources cited in this paper may be informal documents that are not readily available. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Distribution Unit, Office of the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or from Publications, Banque mondiale, 66, avenue d'Iéna, 75116 Paris, France. Industrial Structures and the Development of Small and Medium Enterprise Linkages

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Industrial Structures and the Development of Small and Medium Enterprise Linkages Saha Dhevan Meyanathan is senior industrial economist in the Finance and Private Sector Development Division of the World Bank's Economic Development Institute. Library of Congress Cataloging−in−Publication Data Industrial structures and the development of small and medium enterprise linkages: examples from East Asia / edited by Saha Dhevan Meyanathan. p. cm.—(EDI seminar series, ISSN 1013−2015 "Chapters . . . used in a number of seminars conducted by the Economic Development Institute in collaboration with the Asian Development Bank"—Foreword. Includes bibliographical references. ISBN 0−8213−2876−X 1. Small business—Asia, Southeastern—Case studies. 2. Asia. Southeastern—Economic conditions—Case studies. I. Meyanathan, Saha Dhevan, 1948−. II. Series. HD2346.A75153 1994 338.6'42'0959—dc20 94−20988 CIP

Contents Foreword

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1. Industrial Structures and the Development of Small and Medium Enterprise Linkages: An Overview

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Saha Dhevan Meyanathan and Roger Munter 2. Malaysia

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Saha Dhevan Meyanathan and Ismail Muhd. Salleh 3. Singapore Soon

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Teck Wong 4. Indonesia

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Thee Kian Wie 5. Thailand

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Nattapong Thongpakde, Wisarn Puppahavesa, Bunluasak Pussarangsri Bibliography

Contents

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Industrial Structures and the Development of Small and Medium Enterprise Linkages

Foreword The industrial sector program of the Economic Development Institute's (EDI's) Finance and Private Sector Development Division focuses on the process of industrial change (adjustment, restructuring) and its role in economic development. The training curriculum is presented within a framework that allows discussion of the role of the state in facilitating this change, and organizes the subject into modules that can then be grouped according to the needs of the participants. The modules review the effect on industrial performance of financial, fiscal, trade, regulatory, and specific industrial policies; how changes in the global economy can affect sector or subsector performance and how a country may in turn adapt its policies; the required institutional framework and infrastructure, including supporting infrastructure such as entrepreneurship, management capabilities, and technology; and the social dimensions of industrial change. Specialized training activities draw from the framework and include the role of the financial sector in facilitating industrial change, subsector and enterprise restructuring, public enterprise reform, privatization, industrial pollution abatement, and the effect of market structure on competition and on small enterprise development. The framework as applied to small and medium enterprise development and industrial structure is presented in chapter 1 of this volume. The program is articulated around cycles of regional and worldwide roundtables and seminars. Policymakers, mid−level civil servants, chief executive officers, and trainers are brought together to discuss agendas of specific issues and problems, often identified beforehand by the participants themselves. The chapters in this book have been used in a number of seminars conducted by the Economic Development Institute in collaboration with the Asian Development Bank. The division would like to acknowledge the contribution of Roger C. Munter in editorial assistance and James E. Quigley in production assistance in the publication of this volume. The views expressed herein are entirely those of the authors and do not necessarily reflect the views of EDI and the World Bank. XAVIER SIMON DIVISION CHIEF FINANCE AND PRIVATE SECTOR DEVELOPMENT DIVISION ECONOMIC DEVELOPMENT INSTITUTE

1— Industrial Structures and the Development of Small and Medium Enterprise Linkages: An Overview Saha Dhevan Meyanathan and Roger Munter Small and medium enterprises (SMEs) are playing an ever increasing role in the industrial structures of developing countries around the world. Recent trends in technology, management techniques, firm sizes, and global investment have (among other factors) led to significant changes in industrial structure. The chapters in this volume analyze the importance of SME development—in the context of interfirm linkages (particularly interfirm linkages, see box 1.1: Interfirm Linkage and Subcontracting: Definitions)—and demonstrate how recent changes in industrial structure are providing opportunities for this type of development in four East Asian countries (Malaysia, Singapore, Indonesia, and Thailand). The bulk of this volume (chapters 2−5) will describe the efforts being made by each of the four countries to develop greater interfirm linkages and analyze the relative success of Foreword

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Industrial Structures and the Development of Small and Medium Enterprise Linkages their efforts. First we would like to lay out a brief overview of the nature of industrial structure, why industrial structure is changing, and what these changes mean to SMEs in the developing Asian nations (or, how can these nations exploit changes in industrial structure to develop greater interfirm linkages). Ultimately, it is our aim to show how developing linkages between large firms and SMEs can lead to broader and deeper economies that are better able to sustain long−term growth. I— What is Industrial Structure? There is no one accepted definition of what industrial structure is; the definitions tend to change depending upon what one is looking for. Industrial structure can be defined strictly by the size scale of firms (Scherer and Ross 1990). This definition of an industry tends to distinguish large, vertically integrated firms, and focuses on such industry aspects as: capital intensive versus labor intensive, light versus heavy industry, formal versus informal legalities, and structures that relate to levels of output, employment, and value added. Another potential definition focuses on an industry's competitive

structure (Porter 1990). This definition highlights plant concentration ratios, vertical integration, firm conglomeration, and economies of scale and scope. Still again, we can define industrial structure in terms of foreign versus domestic ownership, or in terms of regional (spatial) structures. Box 1.1: Interfirm Linkage and Subcontracting: Definitions Interfirm Linkage: The term interfirm linkage refers to all possible forms of economic relationships between firms operating within an economy. However, the term is usually meant to imply a continual relationship with repeated transactions, as opposed to individual contacts. Interfirm linkages can be divided into different forms of contractual arrangements according to the degree of control which one party has over the other. The classification runs from complete internal organizational control to complete dependence on the market ("hierarchy" versus "market" control). A typical classification is as follows: outright equity control (parent 100 percent) joint venture (majority, 50−50, or minority) industrial cooperation agreement licensing and franchising "arm's length" market relationship − "spot" market transaction − "longer−term" recurrent contractual supplier−buyer relationship Subcontracting: Subcontracting is one type of interfirm linkage. Essentially, it is a back−end linkage relationship involving arm's length market transactions between a large buyer and an SME supplier. Some writers use the term subcontracting to define the more narrow interfirm linkage relationship in which an SME supplier provides labor services in processing raw materials given out by the buyer firm. However, as we are attempting to show in this chapter, advances in technology are

I— What is Industrial Structure?

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Industrial Structures and the Development of Small and Medium Enterprise Linkages moving SMEs beyond the labor−intensive stage, and consequently we are interested in subcontracting in its broader sense, encompassing the entire range of interfirm linkages. Indeed, we focus on the most technical and specialized subcontracting relationships because of their greater potential for developing broad based industrial structures. Source: Wong (1991). This volume focuses on the definition of industrial structure, which relates to interfirm linkages between large and small firms. In the present changing global economy, an industry's vitality depends upon low levels of market friction and a high degree of flexibility. It is our belief that a broad based industrial structure with strong interfirm linkages achieves both of these objectives. Market frictions are lowered as repeated interactions between firms lower the transaction costs of obtaining and acting upon information, while standardizing market norms. Higher flexibility is realized as dependable subcontracting relationships allow firms to meet production needs as they occur without having to maintain high levels of inventory. Finally, the largest benefit of interfirm linkages is also the largest constraint to its development: the increased absorptive capabilities of SMEs. Interfirm linkages are most beneficial when they supply technology−intensive (as opposed to labor−intensive) products. As such subcontracting relationships are repeated, SMEs receive a valuable skills upgrade. However, until this upgrade takes place, the generally low skills level of SME workers (including

management skills) often leads to poor quality or late arrivals and, consequently, discourages further subcontracting usage. As noted above, current trends in trade, technology, and investment— changing the nature of industrial structure around the globe—are creating opportunities for this type of development. To understand why this is so we look at how and why industrial structures are changing. II— How and why are Industrial Structures Changing? The most extensive and important trend in industrial structure today is the breakup of large enterprises. Decentralization, deverticalization, and downsizing are evident on an increasing scale globally. Where half a generation ago, the continued growth and increasing verticalization of multinational enterprises (MNEs) appeared to be inevitable, today vertical disintegration and international subcontracting have led at least one major periodical to see "the incredible shrinking firm" as the wave of the future (Economist 1990). In the United States, the "make−or−buy" issue has expanded to managerial decisionmaking functions, so that some firms subcontract product development as well as marketing, and even hire consulting firms to do their bidding (Washington Post 1991). Clearly this trend brings with it many inherent organizational changes. While subcontracting has traditionally belonged to the manufacture of less differentiated or labor−intensive products, which can be subcontracted cheaply without losing quality, the rules on this appear to be changing. New technologies are permitting more differentiated products at lower costs. Niche marketing, shorter product cycles, and just−in−time (JIT) inventory management techniques are cutting down on organizational waste. The potential value of linkages between large enterprises (LEs) and SMEs in creating a broad and sustainable industrial structure is significant in the face of these trends. Before a country can take advantage of this, however, the appropriate human resource infrastructure must be in place in order to facilitate efficient skills transfer. Cheap II— How and why are Industrial Structures Changing?

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Industrial Structures and the Development of Small and Medium Enterprise Linkages and unskilled labor with low absorptive capabilities has a very limited value in today's fast−changing global economy. As organizational changes are occurring on an inter and intrafirm level, increasing attention is being paid to Porter's (1990) value chain (see figure 1.1 for an example of the value chain). As the chain, from supplier to buyer has expanded across national borders, the structure of international trade and investment has also changed. Some see foreign direct investment (FDI) as having replaced international trade in importance (UNIDO 1991). Large firms (at the global level) are now following fragmentation strategies, focusing on product differentiation; this has created an opportunity for middle income developing nations to create interfirm linkages through subcontracting, particularly with the advent of niche marketing that can allow SMEs to specialize production without incurring heavy overhead expenses. The reasons for these trends are not difficult to see. Essentially, there are three main factors that have led to the downsizing of LEs: (a) need for cost reduction; (b) advancing technologies; and (c) management innovations. Large firms are challenged by significant increases in costs of production and labor. In

the need to combat these costs, subcontracting has become an attractive alternative. Cost factors have also affected corporate strategies. With increased competition, firms are looking for ways to increase their flexibility and broaden their consumer markets; the need for product differentiation has led to new agile manufacturing concepts (for instance, computer numerically controlled [CNC] machines, which allow a high degree of variation in product runs and product specialization), which, in turn, have lowered barriers to entry for SMEs. This, too, has made inter firm linkages more desirable for large firms.

Figure 1.1: The Value Chain in Practice Note: Mill gate price = 100; values at international markets. Source: Pepper and Bhattacharaya (1994). A burgeoning field in economics—transaction costs—helps explain these factors and their role in determining a firm's decision to use subcontracting. The concept of transaction costs has become a significant factor for those interested in institutional economics and industrial organization. Transaction costs are the economic equivalent of friction in physical systems. Transaction costs economics adopts a contractual approach to the study of economic II— How and why are Industrial Structures Changing?

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Industrial Structures and the Development of Small and Medium Enterprise Linkages organization. In transaction costs economics, the business firm is regarded as a governance structure, rather than a production entity, and a greater weight is placed on the institutions of contract and contracting. Transaction costs are the most observable dimension of the institutional framework highlighting constraints to exchange. Transaction costs directly influence the organization of economic activity. Early writers believed that transactional considerations were decisive in determining which mode of organization would be enacted. Coarse

(1937) explained the issue of economic organization in terms of institutions, expanding the boundaries of firms: firms and markets could be considered as alternative means of economic organizations, rather than two fundamentally different entities. Whether transactions were organized within a firm (hierarchically/vertically integrated) or between firms (across a market) was merely a decision variable, based upon the transaction costs attendant upon each option. Recently, however, writers have increasingly emphasized the roles of technological advance and new organizational forms as determining factors in the evolution of transaction costs (North 1990).1 Transaction costs economics assumes that human beings are subject to bounded rationality (that is, uncertainty and information failure are prevalent) and are given to opportunism. Transactions are further affected by the specific nature of assets in production—the degree to which durable transaction−specific investments are incurred. Transactions are therefore characterized by uncertainty, post−contract opportunism, and transactional dependence due to asset specificity. These human and environmental factors impede exchanges between firms (particularly where markets are not well developed). Large informal sectors with personalized exchange systems tend to perpetuate underdevelopment. Firms develop short−term horizons, acting only on the most profitable activity—in trade, for example. Transaction costs consist of measuring the legal and physical attributes of a transaction (for example, the costs of gathering information and then policing and enforcing an agreement, along with a measure of uncertainty). They are partly market costs (and therefore direct and measurable): legal and other direct fees; and the various costs involved in organizational supervision, coordination, monitoring, and metering quality. Some, however, are indirect and less easy to measure: the opportunity costs of time spent acquiring information, queuing, satisfying bureaucratic requirements, making unofficial payments, and, of course, incurring losses due to imperfect monitoring and enforcement. To the degree that we can measure these indirect costs, we can more accurately measure the degree to which institutions facilitate or constrain market development (Dobler, Burt, and Lee, Jr. 1990). In addition, these transactions must have proper governance structures. Property rights must be defined and protected, and agreements enforced. Transactions benefit from a strong legal framework and, since formal rules cannot be complete in all respects, informal rules usually exist as well (for example, a firm's reputation, standards of conduct, and the bonds that emerge from repeated interactions). Institutions can help or hinder this kind of market development; they can raise or lower transaction costs across a market. Transaction costs are integral to our discussion of SMEs and interfirm linkages, because they play such a determining role in the organization of economic activities. Clearly, the "make−or−buy" decision is linked to transaction costs and an industry's level of market development. In less developed markets, firms will often tend to choose in−house production in order to avoid the high transaction costs related to poor market development. Their unfamiliarity with potential suppliers raises the costs of gathering information and coordinating transactions with suppliers. Therefore, a firm may regard vertical integration as a way to avoid potential supplier problems (for example, transportation strikes, late delivery, or poor product quality)

that could lead to a production shutdown. Information costs aside, these fears are often well−founded in a poorly developed market environment. Suppliers' skill levels and management capabilities may well be low (especially in SMEs), and in developing countries this can often lead to quality problems and high rejection rates, which, in II— How and why are Industrial Structures Changing?

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Industrial Structures and the Development of Small and Medium Enterprise Linkages turn, can lead a firm to choose in−house production in future transactions. As constraints to market development are overcome, markets become more integrated and demand becomes more diversified. This creates opportunities for product differentiation and specialization by manufacturing establishments of different sizes. With market development, transactions become standardized and, in highly competitive markets, continuously self−policing. Mature market development results in several factors that make subcontracting a desirable option for a firm. Agglomerations and industrial clusters lead to an improved flow of information between firms (both between LEs and LEs, and between LEs and SMEs). As institutional and personal relations develop, buyer−supplier relationships are encouraged. As product differentiation increases in value (Porter 1990), suppliers with specialized knowledge and research make subcontracting highly attractive. SMEs can move into goods with high income elasticity and supply goods and services to large firms, developing a complementary relationship between small and large firms such as Porter (1990) noted in the Italian leather footwear industry, or as is evidenced in Singapore's electroplating industry. Unfortunately, this is often not the case in developing countries. Failing this, such factors as small volume requirements, long setup time, or mass production of standardized items can all favor buying from a supplier, as they can make in−house production more expensive in terms of costs and work hours than the product itself is worth. The challenge for many developing countries is to turn these kinds of subcontracting relationships into opportunities for skills upgrade. As noted above, advancing technologies have played a significant role in these changes. The phenomenal march of technology over the last twenty years has led to radically new economies of scale and scope. Process innovations have flowered. Small batch production and JIT techniques (among others) are made possible by increased efficiency of manufacturing processes. Technological breakthroughs have led to modular designs and the increased interchangeability of parts in sophisticated products (for example, the computer and electronics industries). Again, these innovations have worked to lower barriers to entry and resulted in the burgeoning electrical components and engineering industry (much of which can be subcontracted to SMEs). As the trend toward product differentiation makes products more complex, a significant range of know−how becomes necessary to maintain vertical integration. Many large firms concentrate on core activities and subcontract related activities out to specialist firms. The more suppliers a firm has, the more easily diversified the final product can be when manufactured in short runs from several common components. This increased flexibility, along with such innovations as JIT inventory management, and niche marketing, together with the growing cost of materials and labor relations, have made subcontracting increasingly attractive to large firms. It must be noted, however, that these advantages can only be taken advantage of through ''know−how." Quality management must exist to turn

technological advances into cost reductions. One of the strongest lessons found in this volume's case studies is that countries lacking skilled management and absorptive capabilities cannot turn these global trends into national advantage. Opportunities for growth and learning by enterprises exist in today's environment. The trends toward globalization and deverticalization can allow developing countries to play a vital part in global restructuring while obtaining the benefit of deepening their industrial structure through interfirm linkages. One key to taking advantage of this development lies in a thorough examination of policies focusing on SMEs, which encourage a broadening of the industrial structure (through greater entry of firms) and provide opportunities for organizational learning and technology transfers.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages III— How Can the State Use these Changes to Encourage Interfirm Linkages? Given that changes in industrial structure have created opportunities for increasing interfirm linkages, and given that increased interfirm linkages are beneficial to a nation's economic development, the question becomes: How best can the state facilitate these linkages? Clearly, policymakers have three general choices: (a) allow market forces to create linkages; (b) use "market friendly" incentives; and (c) force linkages through state intervention (for example, local content requirements).2 In the conclusion of this chapter we will speak more directly to the decisionmaking process; for now, however, suffice it to say that a whole host of interrelated policy and nonpolicy factors must be considered before choosing which option will be most effective: What is the state of a country's market development and how can this be enhanced? How have previous policies created the requisite physical technological, and human infrastructure? What is the skills level of a country's work force? What political realities exist that induce the development of SMEs? What cultural endowments may be used to the country's economic benefit (Biggs and Levy 1991)? What attractions does a country's industrial structure have to offer domestic, regional, and global investors? All of these factors will affect the state's ability to implement its chosen policy and must be thoroughly considered. Although this decisionmaking process is clearly a complex one, specific policies have been initiated to enhance SME linkage development in a number of East Asian countries. Although the countries discussed in this volume differ (sometimes greatly) in their degree of state intervention, we see several specific policies that are being used in varying forms across the region. These include: Tax Incentives. Malaysia has instituted tax incentives to promote subcontracting between MNEs and local SMEs. Singapore has also established tax incentives to promote subcontracting, and uses the International Procurement Office of MNEs to facilitate this. Specific Institutional Arrangements. Malaysia uses an "umbrella strategy" in which one large "umbrella" company, possessing the necessary financial resources and expertise, helps to coordinate production and marketing for SMEs. The SMEs receive valuable skills

and management training, while the umbrella firm is offered inducements (in one case the SMEs' products are marketed under the umbrella firm's name, in another the umbrella firm is offered government contracts without competitive bidding). A very similar initiative is the "foster−father" plan in Indonesia. Singapore promotes interfirm linkages between MNEs and local SMEs through the Local Industry Upgrading Program (LIUP), which encourages MNEs to "adopt" local enterprises and work to upgrade their technical and management capabilities. LIUP is managed on a rotating basis by experienced engineers from MNEs (whose salary is paid by the Economic Development Board [EDB]) who identify areas for focused assistance. This system uses market forces as an incentive, as the expertise which is transferred to the SMEs will, in turn, make them more effective supplier/partners for the MNEs. In Taiwan (China), where local industry is largely made up of SMEs, the Center−Satellite Factory System (CSFS) was established to help coordinate linkages between individual SMEs that perform complementary functions, but are not big enough to overcome the transactions costs of seeking out and coordinating efforts by themselves. Vendor Development Schemes. These are closely related to the programs attempting to establish interfirm linkages above. Vendor development schemes induce LEs to give focused assistance to local SMEs. In Malaysia, this is done by INTEL and the Malaysian car producer, PROTON. The case of Hyundai in the Republic of Korea has been a notable success.3 Local Content Requirements. Except for Singapore, all the countries examined in this volume have used local content requirements to try to promote interfirm linkages. Results from such policies have been mixed from III— How Can the State Use these Changes to Encourage Interfirm Linkages?

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Industrial Structures and the Development of Small and Medium Enterprise Linkages country to country, but, in general, these requirements have not produced the expected results. A related policy is to levy procurement requirements on MNEs. This has been used most notably (and successfully) in Taiwan (China). Information Provision and Exchange. Similar to CSFS in Taiwan (China), these programs are designed to enhance the flow of information to SMEs who are too small to effectively obtain it themselves. In Malaysia, the Subcontracting Exchange Scheme (SCX) acts as a computer clearinghouse, linking component−producing SMEs with component−using MNEs. A similar program is the Board of Investment Unit for Industrial Linkage Development in Thailand, which targets parent companies to contact complementary subcontractors. Cluster Creation. Singapore has taken the lead decisively in the creation of industrial clusters. Their success in clustering complementary enterprises has allowed them to use market forces effectively as incentives for many of their other schemes mentioned here. Malaysia has relocated related SMEs in order to create clusters. In Indonesia, the Small−Scale Industries Development Program (BIPIK) uses clusters in order to enhance technical assistance to SMEs. This scheme actually dates back to the 1950s when the Indonesian government established Industrial Centers to provide technical assistance to the indigenous

weaving industry (insufficient funding and a lack of willingness on the part of managers led to the failure of this early program). The most successful of these strategies tend to be those in which incentives are used to increase the absorptive capabilities of SMEs in order to make them more attractive to LEs and to encourage them to export their goods. Korea, Taiwan (China), and Singapore have been particularly successful with these types of programs, and Malaysia is now starting to focus its attention on specific technical assistance schemes. Indonesia has been less successful in its attempts to create interfirm linkages, and this is in part due to the fact that they have lagged behind in technical assistance schemes; what promotion policies they have initiated have yet to be felt. Other schemes (such as selling shares of LEs to SMEs) have not proved effective. As Singapore's example shows, long−term thinking, focusing on a sound market strategy, which convinces MNEs that technical assistance to local SMEs is in their own best future interests, can prove highly successful. Where schemes have failed, the problems often revolve around ineffective implementation of policies. Taiwan (China), Korea, and Singapore all have the institutional capacity in place for providing focused assistance, and this has shown in their results. Institutions in Malaysia, Indonesia, and Thailand, meanwhile, have been plagued by communication problems. While Taiwan (China), Korea, and Singapore all have strong coordinating agencies in place (the Investment Development Bureau in Taiwan (China); the Ministry of International Trade and Industries in Korea; and the Economic Development Board in Singapore), the other countries have used multi−agency approaches that have failed to produce the desired results for a number of reasons: (a) lack of private sector involvement; (b) inconsistencies in implementation; (c) lack of communication between agencies; (d) unfair regulatory burdens placed on SMEs; and (e) lack of managerial accountability. Indonesia has had particular troubles in these regards. Thailand, as noted above, has made little effort to induce SME development. In Malaysia, linkages due to market developments have been slow to emerge, although recent policies have begun to show positive results. In the next section we will summarize the individual country cases provided in chapters 2−5. Although this volume does not include case studies on Korea and Taiwan (China), we feel that they cannot be ignored and, therefore, include short summaries in the following section for comparative purposes. We then move on to Malaysia, due to the extensive policy intervention found there, and follow with Singapore, Indonesia, and Thailand.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages IV— Country Case Summaries: Industrial Policy, Changing Industrial Structure, and Interfirm Linkages A. Republic of Korea

This section is based on Lee (1992), and Leipziger and Petri (1993). Korean industrial policy can be seen as having undergone three distinct phases. First, in the mid−1960s, policies favored exports in general, without a sectoral bias, with credit allocations favoring exporters, rewarding size and growth with access to what were then scarce capital resources. This set the stage for the

formation of large family owned firms (chaebols) and the future trend toward concentration in Korean industry. The second phase, in the mid−1970s, was characterized by intense, selective intervention favoring heavy and chemical industry (steel, machinery, chemicals, and shipbuilding were seen as strategic industries) and assisting their growth through directed, subsidized credit, selective protection, and regulations affecting industrial entry. This strategy aimed at expanding scale as quickly as possible, and larger corporations received priority. Intercompany shareholding was permitted, leading to a further concentration of ownership. As of 1991, the top 10 chaebols owned half of the largest 100 firms and accounted for 62 percent of the value of manufacturing shipments. Industrial structure became concentrated as a result of these policies. A monopolistic market structure of organizations developed in the 1970s and 1980s, whereby a command of the scarce materials and financial resources by a few conglomerates satisfied the driving desire for economic growth. Once these conglomerates were established they were able to: (a) introduce mass production techniques from abroad into the small domestic market at an early stage of economic development gaining a monopolistic, or at least highly concentrated oligopolistic position in the market; and (b) retain comparatively superior human and physical resources. They were protected by institutional barriers erected to limit new entry into the market, while they easily entered new markets and diversified their operations, thanks to the same institutional protection. Trade associations generally behaved like cartels. The final phase began when Korea abandoned the heavy chemical industrialization preferences during the adjustment period of 1979−81 due to problems in labor−intensive sectors of the economy and a balance of payments crisis created by the second oil shock. This period also saw the functional thrust of the new industrial policy toward research and development. Despite the Small and Medium Industries Law of 1966, which aimed to promote SMEs, the importance of SMEs actually fell during the 1970s. Only in the late 1980s did it begin to rise again (in the late 1960s and 1970s the share of SMEs in manufacturing work force and its contribution to total value added declined; only between 1981−87 did the sector begin to recover with 14.7 percent growth, 40 percent value added, and 60 percent of employment in manufacturing). SMEs became a significant presence in textiles and footwear, as well as in parts and components manufacture. Although laws have been on the books since the 1960s, only recently has effective public action been taken to reinvigorate SMEs and provide greater assistance in financing, modernizing research and development (R&D), and training. SME development has recently become politically attractive. The general policy has shifted against concentration with the Small and Medium Industry Products Procurement Act of 1981 and the Small and Medium Industry Start−up Promotion Act of 1986. These are supported through credit guarantees, significant measures of directed credit through financial institutions, and eight separate government funds. As in Singapore, a well−coordinated joint effort approach has been engaged, with the Ministry of International Trade and Industry (MITI) acting as the overall coordinator, supported by the Korean Federation of Small Business (KFSB), a nongovernmental organization (NGO) that is effective in training, productivity improvement, screening inter firm contracts, and promoting entry into

IV— Country Case Summaries: Industrial Policy, Changing Industrial Structure, and Interfirm Linkages 11

Industrial Structures and the Development of Small and Medium Enterprise Linkages international markets. The development of subcontracting has been slow due to the historical trend toward strong vertical integration and horizontal conglomeration by the chaebols (particularly in electronics—Samsung, Daewoo, Lucky−Goldstar, and so forth). Almost everything was produced in−house. Recently, explicit policies have aimed at expanding the scope, efficiency, and equity of subcontracting, and at regulating excessive competition between small and large business in the same product line. Unlike Taiwan (China), the transactional dependence by small suppliers on a single customer is very high; the customer (large firm) is in a strong position to dictate contract terms. The government has acted in various ways to address these issues, but vague provisions and poor implementation of laws and regulations limited the impact. In 1984 the Act on Fair Transactions in Subcontracting was passed, extending the government's supervisory authority to monitor contracts. By 1987, the Ministry of Trade and Industry had designated (through regulatory directive) 337 large enterprises as primary contractors and 2,188 SMEs as subcontractors in 41 industrial subsectors. Selected industrial subsectors were reserved for exclusive development by SMEs. In 1985, the Linkage Guarantee System was established and extended preferential guarantee service to those firms subcontracting for primary contractors. As a result, subcontracting has grown rapidly, accounting for 42 percent of the value of the manufacturing sector by 1986, and over 70 percent of electric machinery and transport equipment. Hyundai now subcontracts over 60 percent of its production costs, or 80 percent of its materials costs from 437 vendors, most of which are SMEs that have benefited from Hyundai's financial, managerial, and technical support. As incentives, financial and fiscal support are available to SMEs involved in subcontracting, as well as the necessary funds for process and product development. Subcontractors are exempt from stamp taxes, and a tax deduction is given for a preset percentages of investments in laboratory and inspection equipment. Expenses incurred for technical guidance by the parent firm is treated as a loss. The Korean Federation of Small Business has built up considerable expertise in subcontracting, and plays a mediating role in subcontracting problems. B. Taiwan (China)

This section is based on Dahlman and Sananikone (1991), Biggs and Levy (1991), and Wade (1990). During the 1960s, Taiwan's (China's) industrial policies focused on light industries. They were primarily concerned with export promotion. In the 1970s capital− and technology−intensive industries were highlighted, and in the 1980s the focus shifted to high technology. Foreign direct investment (FDI) has always played an important role, with tax incentives and export processing zones (EPZs) used to lure MNEs to Taiwan (China). These have mostly been Japanese and American. FDI requirements have generally imposed subcontracting upon most MNEs. SMEs have traditionally been the backbone of Taiwan's (China's) economic life. They hold a dominant position in Taiwan's (China's) economy, accounting for 98 percent of all enterprises, 62 percent of all manufacturing enterprises, 70 percent of the employed population, 55 percent of the gross national product (GNP), and 48 percent of output value in the late 1980s. In the commercial sector

99 percent of all firms are SMEs (defined as having less than 300 employees). Further, micro industries (fewer than 50 employees) accounted for more than 91 percent of all registered firms. Culturally, there seems to be a strong preference in Taiwan (China) to "be one's own boss." Business success is a source of great family pride. Initially, this cultural preference merged with typically limited access to capital; the formal credit market was tight with lending, and consequently many borrowed small amounts informally. Political uncertainties caused many businessmen to shy away from long−term investments. Then, during the import substitution phase of Taiwan's (China's) development, the government promoted labor−intensive industries, and large MNEs spawned small−scale enterprises as subcontractors. The small size structure has been highly viable. SMEs focus on specialization has made them highly flexible, as has niche marketing, short production runs, and JIT techniques. Computer Numerically Controlled (CNC) machines have allowed a high variation of production runs and specialization. As small firms entered and expanded as subcontractors, suppliers, and traders, they B. Taiwan (China)

12

Industrial Structures and the Development of Small and Medium Enterprise Linkages continuously created external effects, which tended to improve the transactional efficiency of markets. This, in turn, led to a decline in search costs and an increase in the flow of information on norms and standards that reduced the costs of contract negotiations and monitoring and post−contract opportunism. All of this lowered transaction costs; the incentives were there to go to market and market boundaries expanded. Government policies have typically aimed at increasing the capabilities of SMEs, and improving financial, management, accounting, technology, and marketing assistance. The Center−Satellite Factory System (CSFS) is the coordinating institution that aims to upgrade product quality, improve product specialization, and accelerate industrial development through improved cooperation between complementary enterprises. Technical assistance and quality management programs aimed at improving capabilities, making SMEs more attractive as potential vendors, have been highly successful. Local content requirements, on the other hand, have generally not provided the expected results. Taiwan (China) has a well established and extensive network of public and private institutions cooperating together to provide focused assistance on management, financial, and technical support to SMEs. This has proven to be necessary, as the downside of their traditional small−scale structure is the difficulty in acquiring technology and undertaking R&D activities. The government has invested in disseminating technological information through various institutions, and has tried to promote technology transfer within the subcontracting relationships with foreign MNEs. On the macro level, Taiwan (China) has pursued export promotion policies in an attempt to create a sound business environment that encourages investment from both foreign and domestic sources. The role of trading companies has been very significant in this regard. In Taiwan (China) all small companies tend to compete for subcontracting offers. Long−term relationships are rare, and transactional dependence is consequently lower than in countries such as Korea (or Japan). In general, then, government efforts have tended to be indirect, buttressing rather than dictating market forces. Those government efforts that have been direct, for instance, local content, have not been very important or

effective. Technological upgrading through subcontracting has, however, been significant. C. Malaysia

As Meyanathan and Salleh assert in chapter 2, Malaysia's economic story has, in general, been a successful one. Over the past three decades the country has moved from a primary commodity−dependent economy to one in which the manufacturing sector accounts for 60 percent of exports. The overall growth of the economy has been about 7 percent per year (from 1987−92). The country has developed through three definable phases: (a) in the late 1950s and throughout the 1960s Malaysia focused on import substitution; (b) during the 1970s and early 1980s, Malaysia became more export oriented, using free trade zones (FTZs) to entice MNEs and other large enterprises. At the same time, the government pushed industrial deepening through the promotion of heavy industries (HICOM) and used a massive buildup of public initiatives to promote the equity goals of the New Economic Policy (NEP) of 1971; and (c) following the economic crisis of the mid−1980s (leading to a −1 percent growth year in 1985) the state has been less interventionist, using a mix of policy and market forces to guide the economy. Due to social imperatives, Malaysia has expended more effort than other countries in the region to develop SMEs; this effort has, however, met with mixed results. A plethora of policy instruments covering finance, training, marketing, technological assistance and the provision of infrastructure have created only limited impact on developing the capabilities of SMEs. As a result, Malaysia still lacks a vibrant SME sector. There is a strong need for rationalizing the institutional support system, and for the involvement of the private sector and attention to cost recovery. C. Malaysia

13

Industrial Structures and the Development of Small and Medium Enterprise Linkages Although concern over indigenous (Bumiputera) SMEs has existed since the 1950s (due to the political desire to build a Bumiputera Industrial and Commercial class), this did not translate into a widespread policy toward developing SMEs and creating greater inter firm linkages. Indeed, until the mid−1980s, a policy bias existed toward large enterprises and MNEs. This was so both in Malaysia's early development phase, which focused on import substitution, and in its push toward industrial deepening and an export oriented economy. Only in its most recent phase has policy considered the development of SMEs a priority issue. This historical bias toward LEs shows up clearly in the manufacturing sector. The manufacturing sector is narrowly based and concentrated mainly in electrical and electronics products, and is located mostly in the FTZs. Although the industrial sector is made up of a large number of SMEs (over 80 percent), they account for only a modest proportion of total manufacturing employment and value added, while LEs (mainly foreign owned) have been expanding rapidly in terms of employment, output, and value added. It is also significant that the two subsectors with the largest foreign ownership are the electronics/electrical and the machinery engineering subsectors (both important in Malaysia's export sector) while SMEs have traditionally concentrated in such subsectors as food processing, wood products, light engineering, and paper and printing.

There is now, however, a growing trend toward greater interfirm linkages in the industrial sector. This is particularly the case in the electrical/electronics, telecoms, furniture, and automotive subsectors. Typical subcontracting activities include tool and die−mold making, metal stamping, plastic injection molding, engineering plastics and application software. The reasons for this trend include gradual market development, MNE · relocation, and state policies. MNEs' cost−reduction and globalization strategies (for instance, Intel and Matsushita) have combined with a rise in domestic skill levels (particularly in engineering) to spur a new wave of foreign investment in ancillary industries. At the same time, specific policies have encouraged subcontracting. As noted in section HI, these policies have included vendor development schemes (by the private sector and the state), the "umbrella" marketing scheme, the establishment of the Subcontracting Exchange Scheme, government procurement, and fiscal incentives for subcontracting. The most significant of these policies aim at increasing the absorptive capabilities of SMEs (in terms of quality and productivity). AS in other countries discussed in this volume, however, there have been problems with poor quality, late deliveries, and a lack of competitive pricing in some subcontracting relationships. Also, a lack of investment funds for newer technologies also plagues Malaysia's SMEs. In summary, Malaysia has put more effort into broadening its industrial base through the development of SMEs than any of the other countries discussed in this volume. SMEs have always had a place in Malaysia's attempt to reduce ethnic inequity, but this concern has been translated into a widespread focus on SMEs in general only since 1986. As opposed to Singapore, where state policies tend to follow market forces, Malaysia has used policy initiatives to prod and direct market development. So far, Malaysia's schemes have not been as effective or as efficient as have Singapore's, but they are slowly and steadily showing success. D. Singapore

In chapter 3, Soon Teck Wong traces how Singapore has transformed itself from a resource−poor maritime center into a dynamic, industrialized economy with the modern service sector accounting for a larger share than manufacturing. Singapore has maintained a high growth rate, with real GDP growth averaging 8.2 percent from 1960 to 1990. Singapore's development has been characterized by its stability (both economic and political), the continuing importance of trade and investment, and the strong role of the government in development. Stable macroeconomic policies have built a conducive environment for private enterprise. The public sector, meanwhile, has invested heavily in building up the country's human capital and infrastructure resources. D. Singapore

14

Industrial Structures and the Development of Small and Medium Enterprise Linkages As Soon Teck Wong notes, Singapore's industrialization has been driven largely by foreign direct investment (notably from large MNEs). AS a result, Singapore found itself in a position similar to Malaysia: small establishments account for 35 percent of all manufacturing companies, but only 1.1 percent of total value added and less than 1 percent of output. In addition, SMEs in the manufacturing sectors tend to be very small, with 75 percent employing fewer than ten workers. SMEs do have a greater presence in the commerce and service

sectors. As in other countries, Singapore's SMEs face the following constraints: a lack of financial resources, insufficient demand, insufficient skilled manpower, and insufficient management expertise. While the Singapore government had been providing an array of financial and nonfinancial assistance schemes for SME manufacturing establishments since about 1962, these schemes were not the product of a focused strategy, and tended to be rather inefficient. During the 1980s, however, Singapore did begin to focus on SME development as a policy priority. This culminated in 1989 with the SME Masterplan. The Masterplan comprehensively reviewed SME issues, and consolidated former policies. Finally, it identified seven target areas which, when implemented, would form a comprehensive self−help package: (a) tax incentives and financial assistance; (b) technology adoption, automation, product development, and innovation; (c) information technology exploitation; (d) business development; (e) improved productivity and training; (f) international marketing and design; and (g) the Local Industry Upgrading Program (LIUP). In addition, in conjunction with the Economic Development Board, a multi−agency network concept was endorsed to support SMEs. This network involved public sector organizations (including the National Computer Board, the National Productivity Board, the Standards and Industrial Research Institute, as well as universities and polytechnics) working with private sector organizations, chambers of commerce, and, finally, financial institutions. The strong coordinating role of the EDB was added to make things work. Again the influence of market development was the major factor in this plan. Cost reduction globalization strategies on the part of MNEs have had a major impact in Singapore. Some MN have shown commitments to developing long−term supplier relationships (mostly Japanese and American firms). These market developments were combined with policies that aimed at improving technological and managerial absorptive capabilities in SMEs (for example, the Skills Development Fund). Singapore has also made great use of policies that promote clusters of supporting, or ancillary industries (such as fabricated metal products and machinery). The result has been a growing trend toward the use of subcontractors. This has been so in the electronics, consumer electronics, computer manufacture, and semi−conductor subsectors, which involve more standardized than specialized products. Subcontracting activities that have particularly increased include paper packaging, aluminum and plastic name plating, metal stamping, precision engineering, electroplating, and precision tooling. In conclusion, interfirm linkages have expanded in Singapore due to the combination of market developments and the active role of the government. Singapore has combined effective general policies that have created a desirable business environment (especially in its interface with MNEs; Singapore is exceptionally foreign investment−friendly) with specific institutional arrangements that facilitate subcontracting. In so doing, it has effectively upgraded the absorptive capabilities of its SMEs through policies that have been generally well conceived and coordinated.

E. Indonesia

As Thee Klan Wie notes in chapter 4, Indonesia has performed well in terms of growth. Between 1965−90, the average GDP growth has been almost 7 percent. This has been accomplished despite a rapid structural change, which has seen Indonesia change from an oil− and gas−dependent economy to one in which non−oil manufactured exports have grown rapidly. Much of this was due to a series of policy reforms in the middle to late E. Indonesia

15

Industrial Structures and the Development of Small and Medium Enterprise Linkages 1980s that moved the country away from its strategy of import substitution through a reduction in the anti−export bias, deregulation, and exchange rate adjustments. Indonesia's industrial structure has been characterized as ''upstream socialism and downstream capitalism." Government ownership in basic and intermediate products (for example, metals, non−metallic minerals, chemicals, oil and gas processing, iron and steel, aircraft, cement, and so on) was boosted by the oil boom revenues of the 1970s. Meanwhile, the private sector has been concentrated mainly in labor−intensive products. Although the structural change noted above has resulted in a strong response from SMEs in non−oil manufactured exports, the role of SMEs in general in Indonesia is declining. Cottage and small enterprises predominate in terms of numbers, but contribute very little in terms of value added. Furthermore, between 1985 and 1990, the share of small and medium enterprises in total manufacturing value added declined significantly, while the share of very large enterprises was on the rise, indicating an emerging "hollow middle" in the size distribution of enterprises (see figure 1.2). The rise of the very large enterprises and conglomerates is partly due to problems in the capital markets and suggests a lack of concomitant development in market agents and legal infrastructure. In terms of our discussion in section II, Indonesia's slow market development has led to high transaction costs. Unlike other countries, Indonesia's promotional policies for SMEs have largely concentrated on small and cottage enterprises. Starting somewhat late (in the 1970s), credit and technical assistance programs were instituted, but with mixed results. Again the problem was one of poor implementation. In addition, Indonesia has had a notable lack of private sector involvement in its SME development policies, and has shown little success in cost recovery. Other policy instruments have included the establishment of small industrial estates (or clusters of small enterprises), and directed credit for small enterprises. Also, state enterprises are obligated to allocate 5 percent of their net profits to help the financial, managerial, and production capabilities of small enterprises (a policy which, again, points out the lack of organization in Indonesia's private sector in increasing the absorptive capabilities of SMEs). Three distinct strategies have been created in Indonesia for fostering interfirm linkages: The "foster−father" linkage and partnership program, in which large companies market the products of small enterprises, and help SEs overcome production and financing problems. Although thousands of large enterprises have become foster fathers, the effect has yet to be seen in terms of upgrading skills. The numbers of large enterprises involved in this program may reflect political pressures being exerted by the state, rather than a willingness on the part of large enterprises

to help SMEs. This is also partly the fault of poor coordination: often the LEs are matched with SMEs from unrelated industries; The sale of shares of large enterprises to small enterprises (including cooperatives). This, again, is imposed upon large enterprises, and does not indicate their willing participation; Localization policies and local content requirements. These include deletion programs. for engineering and electronics, and automotives.

E. Indonesia

16

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Figure 1.2: Changing Industrial Structure in Indonesia Source: World Bank (1993). Although localization policies have been quite successful in the motorcycle subsector, most others have suffered from a quality problem. Also, localization policies have forged more linkages among large enterprises than between large and small. In conclusion, while Indonesia has successfully transformed into a non−oil manufactured export economy, it still concentrates predominantly on labor−intensive products. And, while cottage and small enterprises, which are crucial to labor absorption in Indonesia, have grown in numbers, they have declined significantly in terms of value added. Clearly, these facts are cause for concern.

Unfortunately, policies promoting SME development have not met encouraging results. Indonesia has so far not succeeded in creating a policy environment that would encourage SME growth. Unlike Singapore, Indonesia has not been able to persuade LEs in the private sector of the potential benefits of interfirm linkages. Interfirm linkages and subcontracting have largely been the result of specific localization requirements, but the linkages that have formed have mainly occurred between large enterprises. Market development has been slow, skill levels of SMEs are still low, and foreign investment policies have not been conducive for MNEs to subcontract. F. Thailand

In chapter 5, Thongpakde, Puppahavesa, and Pussarangsri note that Thailand's economy has displayed rapid growth, over 9 percent between 1985 and 1990, and has successfully undergone industrial transformation (with the manufacturing sector contributing 26 percent of GDP in 1990). The government has emphasized effective general policies with fiscal prudence, a stable financial system, and competitive exchange rates all combining to create an atmosphere attractive to foreign investment. Until recently, however, large enterprises have been favored through a policy of infant industry protection, a policy bias that negatively affected SMEs. F. Thailand

17

Industrial Structures and the Development of Small and Medium Enterprise Linkages In general, Thailand shows the same disproportionate influence of large enterprises as we have seen in Malaysia, Singapore, and Indonesia. Small enterprises (with fewer than 50 employees) accounted for 92 percent of the total number of factories in 1990; however, large enterprises accounted for over 40 percent of employment. Thailand also suffers from a large regional disparity, with a predominance of firms concentrated in the Bangkok metropolitan area (particularly large enterprises). SMEs in Thailand face many of the same constraints we have seen in other countries. SME products are largely resource−based and labor−intensive, and lack quality standards. SME employees generally lack technical skills and capabilities; this includes poor management skills. SMEs have very little access to finances (due largely to problems with collateral), and are focused predominantly on domestic markets, rather than export−oriented products. Finally, interest rate ceilings have resulted in credit rationing, crowding SMEs out of loans. Unlike the other countries discussed in this volume, however, these problems have been exacerbated by a lack of policy initiatives designed to combat them. Instead, the government of Thailand has preferred to let market forces stimulate the use of subcontracting and interfirm linkages. Those subsectors where subcontracting is notable include machinery, metal, electric and electronics, transport equipment, textiles, wood and furniture, and engineering. Subcontracting linkages tend to develop through networking with personal contacts and former employees. Relationships develop based on the subcontractors ability to meet delivery schedules at agreed prices and quality levels. However, the skills of SME employees tend to be poor and uneven, and management skills are equally low. Consequently, as we have seen in Indonesia, Thailand's subcontracting tends to take place among LEs, rather than between

LEs and SMEs. To combat the lack of information on available contractors, a new institution has been created—BUILD—which works to match LEs and SMEs. However, institutions created to help SMEs strengthen their absorptive capabilities have been weak and ineffective. Many subcontracts have been terminated due to a lack of quality and/or late delivery. Where large enterprises do seek out subcontracting relationships, we see the effect of the same global trends noted earlier: the need to reduce costs; and the desire to avoid labor problems. From the subcontractor's point of view, these linkages have increased their production capacity, and decreased their marketing costs. In conclusion, Thailand needs to review its approach to SMEs. Apart from local content requirements, specific policies to encourage interfirm linkages have been noticeably absent. The changeover to a value added tax system (VAT) in Thailand is expected to encourage subcontracting. However, based on our discussion of market development and subsequent transaction costs, market forces in Thailand do not currently favor subcontracting and, consequently, will probably not lead to SME development and skills upgrade by themselves; some state involvement is most likely necessary. V— Concluding Remarks This overview, along with the accompanying four chapters, captures a complex process of industrial change—change in the size−structure and the nature of interfirm linkages. This change in industrial structure (and the accompanying interfirm linkages, in the form of subcontracting that may result from it) needs to be examined against the recent technological and organizational changes taking place at the global level (see section II). The challenge for a number of middle−income developing countries is not only how to broaden the industrial structure by increasing the number and effectiveness of small and medium enterprises, but also how to increase subcontracting linkages between smaller and larger domestic and multi−national enterprises. V— Concluding Remarks

18

Industrial Structures and the Development of Small and Medium Enterprise Linkages To successfully manage this, four clusters of factors must be taken into account, not as isolated influences but as interlinking fields of influence (see figure 1.3): A convenient starting point is the analysis of global changes and trends. These take place mainly within large enterprises and MNEs. Here policymakers must understand all of the push factors (inducing large enterprises toward subcontracting): global subcontracting; strategic alliances; shifts in global trade; investment and marketing; intrafirm developments (involving the need for flexibility and cost control); changing technologies (for example, the trend toward modular designs); and organizational and management changes (for example, JIT inventory management). These push factors must be learned in order to modify local conditions so as to maximize benefits from foreign investments; SME development policies need to be reexamined so as to increase SMEs' absorptive capabilities and maximize the pull factors that will bring LEs voluntarily into linkages with SMEs. Support measures should include improving infrastructure (physical, finance, and human resources development) and export financing. These should focus on increasing

capabilities, improving firm infrastructures, and arranging institutional skills training, particularly focusing on technology skills. Those measures that have most often proved effective include: self−help programs; multi−agency networks (with a strong coordinating agency); user−fee charges; and cooperation with nongovernment organizations. No policy will work effectively, however, without skillful coordination and communications between the relevant public and private institutions; Specific linkage creation policies could be designed so as to enhance the pull factors and encourage the push factors by lowering transaction costs. As we have seen, the countries discussed in this volume have used a variety of similar initiatives: subcontracting exchanges; incentives; agencies; venture capital schemes; local content requirements; regulations; market reservations; and targeting former MNE employees as subcontractors through financing schemes. The cases suggest that incentives for technological upgrading are the key to creating linkages. Lacking this, other potentially effective policies may be severely constrained; Finally, a government must not lose sight of fostering general market development. Their macro−policies, regulatory structure, and physical and human infrastructure must create a stable business environment, attractive to foreign investment. They must create credible institutions (legal, educational, informational, and market agents), and their governance of contractual relations should promote confidence for business relationships. Informal networks should be allowed to flourish; business services should be available and efficient. And, as we saw in section I, added to all this a government must always keep in mind their political needs. Stable growth is impossible in a turbulent society. We should note that none of these factors are ever static. The challenge to policymakers is always one of understanding all of these sets of factors not as isolated, but as codependent. Industrial strategy influences industrial structure, and industrial structure influences the efficiency with which any strategy can be implemented. The two affect each other, so that, in effect, industrial structure must not be seen as a defined monolithic entity, but as a dynamic system over time. Clearly, what is being presented in this volume is not an easy "how to" solution. Rather, it is a complex and pragmatic challenge: how can strategy successfully manage all four components concurrently and (to a practical degree) harmoniously. These four disparate sets of factors function as one system, and only by viewing them as such can a country hope to manage SME and interfirm linkage development in a successful and sustainable manner.

V— Concluding Remarks

19

Industrial Structures and the Development of Small and Medium Enterprise Linkages The challenge for these countries is to adapt workable policies and institutional arrangements from elsewhere rather than adopting them wholesale. Singapore's success, so far, in developing interfirm linkages suggests that its government has clone an admirable job of orchestrating these influences. They have created an environment that is attractive to potential investors, with a strong infrastructure that increases the effectiveness of both market forces and state initiatives in trying to create a broader industrial structure. Malaysia also appears to be waging a successful battle. Indonesia has done a

successful job of managing the macro environment, but it has yet to show any real commitment to broadening its industrial base. Thailand needs to rethink its strategy toward SME development. While suffering from the same constraints that we see in all three of the other countries, the state has undertaken no substantial efforts to overcome them.

Figure 1.3: Industrial Structure and SME Development: Major Links Successful policies will work to reduce market frictions. In order for this to occur, governments must have effective "feedback" channels at the national, industry, and subsector levels (which take into account economic and political factors), and they must be willing to adjust accordingly to this feedback. Contrary to traditional philosophies, which assumed frictionless markets and

omniscient agents, economists are now beginning to explore the roles that externalities and transaction costs play in an economy. Policymakers must be able to factor transaction costs, externalities, and organizational learning V— Concluding Remarks

20

Industrial Structures and the Development of Small and Medium Enterprise Linkages into their prescriptions in order to devise successful strategies. The ability to adjust to all of the above named factors to create a strategy that fits is probably the most important attribute of government policy. Endnotes

1. See also Coarse (1937), Levy (1992), Porter (1990), Thorelli (1986), and Williamson (1986).

2. See World Bank (1991) for details on market−friendly incentives.

3. This was actually the result of political and economic necessity rather than a policy strategy.

2— Malaysia Saha Dhevan Meyanathan and Ismail Muhd. Salleh From the time of independence in 1957, the industrialization drive in Malaysia was promoted through the establishment of larger enterprises with fiscal incentives, tariff protection, and free trade zones (FTZs). Tariff protection however, was low compared to other developing countries. With local capital largely concentrated in trade, finance, real estate, commodity production, and processing, industrial expansion was largely left to foreign enterprises. Concern over small and medium enterprise (SME) development by the government in the 1950s and 1960s was limited to entrepreneurship development, provision of small loans, advisory services and infrastructural support in rural areas by agencies such as the Council of Trust for the Development of Indigenous People (MARA) and the Rural Industrial Development Authority (RIDA). Greater concern over the development of small enterprises was shown only in the early 1970s with the introduction of the New Economic Policy (NEP), in 1971, which aimed at reducing poverty and restructuring ethnic economic imbalances in a multiethnic nation. This concern, however, covered only the development of indigenous Malay SMEs rather than SMEs as a whole. Despite the proliferation of SME promotion programs after the NEP, their development was essentially peripheral to the buoyant, export−led, foreign−investment−dominated manufacturing sector. It was only after the recession of the mid−1980s that a concerted effort was made to refocus policy on SMEs by reducing the size bias of fiscal incentives and encouraging linkages between SMEs and large enterprises (LEs). This chapter examines the role and development of SMEs within the Malaysian industrial structure. It focuses on the wide−ranging promotional policies of the Malaysian government in encouraging the establishment and growth of SMEs and in the development of their capabilities. Industrial deepening and interfirm linkages, a recent concern, is analyzed in the second part of the chapter. Specifically, the chapter addresses: (a) the reasons for SME development; (b) the measures, mechanism and institutions for SME development and interfirm linkages; and (c) the lessons of such developments for Malaysia and other developing countries. Section I of the chapter deals with the Malaysian industrial structure and the role of SMEs. In sections II and III, the SME promotion policies and the lessons of broadening the industrial base are analyzed. Section IV then takes the discussion to the deepening of the industrial structure and draws some lessons in

section V. We end the chapter with some concluding remarks and challenges facing Malaysia in section VI.

Endnotes

21

Industrial Structures and the Development of Small and Medium Enterprise Linkages I— Industrial Structure Over the past three decades, Malaysia has moved from a primary−commodity−dependent economy to one in which the manufacturing sector accounted for about 60 percent of total exports, 27 percent of GDP, and 18 percent of employment by the early 1990s. The overall annual growth of the economy has been in the region of 7 percent per annum between 1987−92, largely propelled by the manufacturing sector. Despite the impressive performance of the manufacturing sector, there are several structural weaknesses, as pointed out in the Malaysian Industrial Policy Studies and Industrial Master Plan.1 These include: the narrowly based industrial structure; a low level of industrial linkages, research and development, and export diversification; insufficient manpower training; and the lack of a vibrant SME sector. In the sections that follow, we provide an overview of the industrial structure in terms of size, output, ownership, spatial distribution, and interfirm linkages.2 We start by reviewing the role, characteristics, and contributions of SMEs. A. Definition of SMEs, Characteristics, and Contribution

There is no legal, or single, clear−cut definition of what constitutes small and medium enterprises in Malaysia. Various government agencies have, in the past, tended to use different definitions. Recently, however, a broad consensus appears to have emerged within official circles on what comprises small, medium, and large enterprises. The Small−Scale Enterprises Division (SSED) in the Ministry of International Trade and Industries (MITI) now classifies small enterprises (SEs) as having shareholders' funds or net assets not exceeding M$500,000 (US$200,000); and medium enterprises (MEs) as having shareholders' funds or net assets between M$0.5 million and M$2.5 million (US$1 million). The usage of these particular definitions of small and medium enterprises has gained wider currency in Malaysia, especially among the central agencies responsible for policy, regulation, and administration affecting SMEs. The classification of the size structure of manufacturing establishments, in terms of the paid−up capital or fixed assets, causes difficulties due to problems of measurement and poor data. The measure that is much more commonly used in most developing and industrialized countries is the number of persons employed. Considering Malaysia's level of economic development and the classification used by the Industrial Master Plan, this chapter adopts the following definitions: that SEs are industries employing fewer than fifty employees. This definition of SEs includes the cottage enterprises (CEs), which usually employ fewer than five workers. Medium enterprises (MEs) are those employing 50 to 199 employees; and large enterprises (LEs) are those employing 200 employees and more. Small and medium enterprises, which comprise the first three categories of enterprises, accounted for about 98 percent of the manufacturing establishments in 1981 according to the latest available Industrial Census.3 Despite their

numerical preponderance, SMEs accounted for a relatively small proportion of total employment and value added of all manufacturing establishments. Nevertheless, in pursuit of rapid growth of the industrial sector, greater emphasis is being given to the development of SMEs. Table 2.1 presents the comparison of the three categories of SMEs in terms of their employment absorption and contribution to value added and labor productivity. Labor productivity is defined as value added per worker. The 1981 Census of Manufacturing Establishments by the Department of Statistics indicates that out of the total 20,429 manufacturing establishments, 8,817 (43.1 percent) were CEs and 9,469 (46.3 percent) were SEs. These two groups alone constituted 89.4 percent of the total manufacturing establishments. In addition, there were also 1,680 MEs representing 8.2 percent of the total number of establishments. The remaining 464 establishments or 2.3 percent were LEs, mainly foreign owned.

I— Industrial Structure

22

Industrial Structures and the Development of Small and Medium Enterprise Linkages Table 2.1: Structure of Malaysian SMEs, 1981 Enterprise size (workers) Number

Percent

Employment

Percent

Value added (M$ millions) Percent

Cottage < 5

8,817

43.1

9,745

1.8

356.0

1.0

36,530

Small 5−49

9,469

46.3

131,884

23.7

5,120.5

13.4

38,830

Medium 50−199

1,680

8.2

159,390

28.7

13,783.5

36.1

86,470

Large 200 >

464

2.4

255,395

45.8

18,876.4

49.5

73,910

Total

20,430

100.0

556,414

100.0

38,136.4

100.0

235,740

Value added/ employment

Source: Government of Malaysia (1981). Collectively, SMEs accounted for 54.1 percent of the total employment and 50.5 percent of the total value added in all 20,429 manufacturing establishments surveyed in 1981. SEs absorbed 23.7 percent of the labor force and contributed 13.4 percent to value added. MEs, while comprising 8.2 percent of the total manufacturing establishments, absorbed 28.7 percent of the labor force and contributed 36.1 percent of value added. CEs, on the other hand, absorbed only 1.8 percent of the labor force and contributed 1 percent of the value added. This suggests that the CEs, although consisting of nearly half of the manufacturing establishments, have an insignificant role in their contribution to value added and employment generation. Appendix 2.1 presents the sectoral structure and value added contribution of SMEs in Malaysia. Traditionally, SMEs have concentrated in product areas more amenable to small−scale production requiring less capital and catering to local market demands. Consequently, the SMEs in Malaysia have tended to concentrate on food processing, wood products, and light engineering; the latter in support of mining and estate operations. The 1981 census of manufacturing establishments indicated that five product groups dominated more than 80

percent of all SMEs: these being food, wood, textiles, fabricated metal and machinery. The latter two accounted for 14 percent and 8.4 percent of establishments, respectively. The distribution of products by the three categories (that is, CEs, SEs, and MEs) shows different concentrations of products. More than 80 percent of CEs are concentrated in six product groups. Food products accounted for 20 percent of CEs, of which 80 percent were in noodles, bakeries, and biscuits. Small rice mills also constituted a large proportion of this product group. Textiles constituted 21 percent of CEs, of which more than 60 percent were small apparel makers. Wood products accounted for 16 percent of CEs, the bulk of which were in furniture making. A large number of CEs were in foundries and hardware as well as machinery and equipment, but their contribution to value added was low. Cottage enterprises also produce industrial rubber goods, latex products, and ceramic products. The SEs seem to have the same product distribution pattern as CEs, with more than 80 percent of them in four product groups. Food accounted for 19 percent, textiles/apparel 18 percent, paper and printing 18 percent, and fabricated metals 15 percent. It is notable that in fabricated metal and machinery, SEs' contribution to value added is very significant. SEs contributed 25 percent of value added in the machinery subsector and 21 percent in the fabricated metals subsector, which would suggest that in these subsectors SEs have a definite niche. MEs make up the dominant share of food and wood and provide an even more significant contribution to value added in chemical and rubber products despite their smaller numbers. MEs' contribution to value added in each of these subsectors was more than 20 percent. The distribution in terms of value added seems to suggest that SEs have I— Industrial Structure

23

Industrial Structures and the Development of Small and Medium Enterprise Linkages their niche in light engineering, while MEs concentrate in chemical and rubber products. After the NEP in 1971, Bumiputera SMEs were specially targeted for promotion, mainly in the food, batik, handicrafts, and furniture subsectors.4 These sectors were the focus of public policies, as discussed in section II. How have Malaysian SMEs performed? We examine this issue next. B. Trends and Performance of SMEs

The analysis of trends of SMEs in Malaysia is constrained by the lack of data and the absence of a common definition. Time−series data on SMEs can only be obtained from the annual industrial surveys carried out by the Department of Statistics. But these surveys exclude the smallest of the firms in their coverage, hence these figures tend to underestimate the role of SMEs in industrial development. Appendix 2.2 presents the characteristics and the performance of SMEs and LEs in terms of output, employment absorption, and contribution to value added for the periods 1979, 1984, and 1988. Collectively, SMEs accounted for 41.43 percent of the total employment and 36.23 percent of the total value added in manufacturing establishments surveyed in 1988. The corresponding figures for 1979 were 45.80 percent and 43.75 percent, respectively. In 1988, SEs absorbed 11.66 percent of the labor force and contributed 7.06 percent to the value added. MEs, while comprising 30.75 percent of the total manufacturing establishments, absorbed 29.77 percent of labor and contributed 28.07 percent of value added for the same year.

Appendix 2.2 also indicates that there seemed to be a general decline in the relative significance of SEs during the 1979−88 period in terms of their share of establishments, contribution to output and value added, labor absorption, and fixed assets. The LEs, on the other hand, have been expanding most rapidly, not only in terms of employment but also in terms of output and value added. The performance indicators of enterprises according to size is given in appendix 2.3. Value added per worker has risen in all industry sizes between 1979 and 1988. Likewise, fixed assets per worker have also increased irrespective of industry size. These figures also show that the larger the firms, the higher the value added per worker. This, however, does not necessarily imply that smaller firms are less efficient, since fixed assets per worker have also risen with the size of the establishment, but more so than value added per worker. For instance, in 1988, value added per worker in LEs was 83 percent higher than in SEs and 17 percent higher than in MEs; but capital per worker in these large firms was 121 percent higher than in SEs and 49 percent higher than in MEs. As for labor productivity, there is no consistent pattern of change over time. Nonetheless, value added per worker, measured in constant prices, was higher in enterprises with a higher capital−labor ratio, implying that capital injection did play an important role in labor productivity gains. We next review the structure of industries in terms of ownership and spatial structure, characteristics of entrepreneurs, financing of SMEs, and interfirm linkages. C. Ownership Structure of Industries

Table 2.2 shows the ownership structure of industries in Malaysia. A number of observations can be made from the table. First, the foreign share of equity has declined on an overall basis with the exception of the machinery/engineering subsector. Second, the chemical and petroleum, electronic/electrical, iron and steel, textiles and apparel, and machinery/engineering subsectors exhibit foreign ownership in excess of 30 percent. Finally, the two subsectors with the largest foreign ownership are the electronic/electrical and the machinery/engineering subsectors. Appendix 2.3 indicates that the foreign share of value added in these subsectors has been over 80 percent. Government ownership in industries, a feature of the 1980s, has been gradually reduced through privatization in such areas as iron and steel, automobile, cement, and agro−processing. B. Trends and Performance of SMEs

24

Industrial Structures and the Development of Small and Medium Enterprise Linkages The share of Bumiputera directly and indirectly owned enterprises and corporations increased from 2 percent in 1970 to 20 percent in 1990 due to policies pursued to encourage Bumiputera participation in the formal sectors. D. Spatial Distribution

The pattern of growth of the Malaysian economy has had important implications on industrial location and agglomeration. The development of the export−oriented industrial structure, narrowly based on electronics and textiles, has meant that much of the industrial development has been concentrated in the free trade zones (FTZs) and industrial estates of Penang, Klang Valley,

Melaka, and Johor. The availability of infrastructure and agglomeration economies has contributed to the increased polarization of industrial development in the ''Principal Growth Areas" of Klang Valley, Penang, and Johor Baru, and in the West Coast States of Peninsular Malaysia. Over the past decade there has been some geographical clustering and deepening in the industrial structure as more industries producing parts and components for the principal industries (transportation equipment, electronics, and so forth) prefer to locate close to the principal industries, which are mainly found in the Klang Valley and other major industrial centers such as Penang and Johor. This factor strengthens further the process of agglomeration of the major industrial centers. Despite the encouragement of industrial dispersal through the Locational Incentive, there has not been much success.5 Table 2.2: Ownership of Equity Share Capital (Companies Incorporated in Malaysia) (In M$ millions) 1981

1988

Subsector

Percent s hare by Malaysians

Total equity share Percent capital Percent share by (M$ share by non− residents a millions) Malaysians

Total equity share Percent capital share by (M$ non− residents a millions)

Rubber products

78.7

21.3

372,656

79.1

20.9

586,064

Palm oil products

80.6

19.4

404,644

83.9

16.1

640,863

Food processing

68.8

31.2

765,541

73.7

26.3

1,204,462

Wood based

89.3

10.7

417,711

92.4

7.6

512,053

Chemical and petrochemicals

43.3

56.7

448,015

66.6

33.4

1,956,569

Nonferrous metal

100.0

0.0

11,241

100.0

0.0

18,981

Nonmetallic mineral

72.5

27.5

575,549

73.5

26.5

1,486,759

Electronic/electrical

32.9

67.1

323,187

37.8

62.2

1,070,884

Transport equipment

69.0

31.0

313,222

75.6

24.4

782,483

Iron and steel

59.8

40.2

149,149

69.5

30.5

691,406

Textiles and apparel

50.2

49.8

475,020

62.8

37.2

941,577

Machinery/engineering

59.2

40.8

99,893

51.8

48.2

236,849

D. Spatial Distribution

25

Industrial Structures and the Development of Small and Medium Enterprise Linkages Total

65.4

34.6

4,355,828 68.8

31.2

10,128,950

a . Includes companies having annual revenue of M$5 million and above and foreign−controlled. Source: Malaysian Industrial Development Authority. E. Entrepreneurs' Background

According to the 1986 University of Malaya/Institute of Developing Economies (UM/IDE) Survey, over 86 percent of the sample of firms surveyed were started by the present owners, for firms established for over five years. Most of the entrepreneurs started their manufacturing activities as they realized the economic potential and viability of their projects, as well as to satisfy their

\self−actualization needs. About 18 percent of the entrepreneurs started their businesses due to acquaintance with business partners and received advice from them. Only 10 percent of the present owners inherited their enterprises from their fathers. Most of the entrepreneurs were relatively young, less than forty−nine years old, and fairly well educated. Forty−two percent of them had a senior high school education with another 11.4 percent achieving tertiary level education (appendix 2.4). Many of them (46 percent) had previous job experience as employees in the same sectors as their present firms (Fong 1990). Table 2.3: Comparison of Sources of Funds for Initial Year and 1985 among SMEs Initial year of operation (percentage of firms)

1985 (percentage of firms)

Less than 50%

27.1

36.3

50% or more

72.9

63.6

Subtotal

(151)

(162)

100.0

100.0

Less than 50%

96.0

99.4

50% or more

4.0

0.6

Subtotal

(151)

(162)

100.0

100.0

Less than 50%

96.7

100.0

50% or more

3.3

n.a.

Subtotal

(151)

(162)

100.0

100.0

Funding sources as percentage of total requirements

Own funds:

Parents and relatives:

Friends and acquaintances:

Nonbank institutions and government

E. Entrepreneurs' Background

26

Industrial Structures and the Development of Small and Medium Enterprise Linkages agencies: Less than 50%

98.7

99.4

50% or more

1.3

0.6

Subtotal

(151)

(162)

100.0

100.0

Less than 50%

88.7

75.3

50% or more

11.3

24.2

Subtotal

(151)

(162)

100.0

100.0

Commercial banks:

n.a. Not applicable. Source: Fong (1990). F. Financing of SMEs

The majority of firms (72 percent) in the UM survey used their own funds to provide 50 percent or more of the capital required to start their business. About 7 percent of the firms received help from their friends or relatives in providing more than 50 percent of their capital required for the start−up. Only 11.3 percent received similar assistance from commercial banks and 1.3 percent from nonbank financial institutions and government agencies. By 1985, although the proportion of self−financing was about 63 percent, commercial banks accounted for 24 percent of the capital required compared to 11 percent at the start of the

business (table 2.3). SMEs, therefore, launch their businesses mainly using their own funds, but by the seventh year funding by commercial banks tends to increase (Fong 1990). This trend was also confirmed by an earlier survey by Chee (1975) where internally generated funds for enterprise start−up accounted for about 77 percent of small enterprises and 55 percent of medium enterprises (more than fifty employees). Chee also found the same trend for medium− and long−term capital financing. Surveys conducted by the Central Bank on manufacturing companies between 1986−90 indicated that internally generated funds accounted for about 69 percent of total financing of enterprises. (Yusuf and others 1992). Larger companies have more accessibility to external sources of funds, compared to small and medium companies, due to their track record and reputation and the less stringent requirements imposed on them by financial institutions. Larger companies benefited more than small and medium size companies in terms of the average cost of funds. These conclusions were derived from analysis of data collected by the Central Information Collection Unit of the Permodalan Nasional Malaysia (National Equity Center) (Yusuf and others 1992). G. Interfirm Linkages

Electrical and electronic products and textile products accounted for about 63 percent of total manufactured exports in 1988, with electronics contributing about 50 percent of total exports. In addition, the free trade zones (FTZs), which were established in 1971 to spearhead the export−oriented industrialization strategy, have largely remained as industrial enclaves until recently. While these zones were responsible for the rapid development of export industries concomitant with enhanced employment opportunities, linkages to the rest of the economy have been slow to emerge. Firms in the FTZs, until the late 1980s, had low demand for local intermediate products and were not active in subcontracting, resulting in low technology transfer, adaptation and diffusion to local F. Financing of SMEs

27

Industrial Structures and the Development of Small and Medium Enterprise Linkages enterprises. Two recent studies indicate that there has been a growing trend toward back−end linkage between a number of multinational electronics firms and the local suppliers of parts and components (Wong 1991; Lim 1992). Section IV elaborates on these issues. II— Small and Medium Enterprise Promotion Policies A. Background

Public policy concern over SME development in Malaysia has undergone three phases. In the first phase, during the 1950s and 1960s, there was the promotion of Bumiputera entrepreneurs through the provision of small loans, advisory services, and infrastructural support in rural areas by agencies such as MARA and RIDA. Concern over the development of SMEs increased in the 1970s with the introduction of the NEP in 1971. But this concern was over the development of indigenous Malay SMEs, rather than SMEs as a whole. Despite the proliferation of SME promotion programs and institutions after the NEP, the development of SMEs was essentially peripheral to the buoyant, export−led foreign−investment−dominated manufacturing sector. The aim of policy during

this period was to develop local entrepreneurship (especially Bumiputera entrepreneurs), productivity and incomes of small entrepreneurs, and in the process exploit the potential of sectors such as food processing, wood−based products, light engineering, plastics, and ceramics (Fong 1990). It was only after the recession of the mid−1980s that a concerted effort was made to refocus policy on SMEs by reducing the size bias of fiscal incentives and encouraging linkages between SMEs and large enterprises. An overview of the three phases of policy are discussed below. Phase 1 (1957−70)

At the time of independence in 1957, due to British colonial policies, economic function was identified with the three ethnic groups in Malaysia. Non−plantation agriculture was the preserve of the Malays while foreign interests dominated the plantation and mining sectors. The Chinese dominated small−scale manufacturing and mining in addition to being active in the wholesale and retail trades. The Indians were predominantly employed in the plantations and technical services. To counter this racial stratification, RIDA was established in 1951 as a general development corporation to promote small Malay enterprises and carry out rural development. RIDA provided loans during the 1950s and 1960s to rural cooperatives and small Malay producers in rice growing areas, for rural infrastructure, and marketed agricultural producers. MARA and RIDA also established rural industries, and provided loans to contractors, taxi and transport operators. Preference was given to Bumiputeras in the issuance of taxi licenses. In the early 1960s, RIDA began to implement training schemes for Malays with emphasis on commerce and industry. This, however, was not very effective due to poor organization. RIDA suffered heavy financial losses as a result of inexperience, lack of planning, and excessive political interference; consequently, it was reorganized as MARA (Council of Trust for the Development of Indigenous People) in 1966 (Gale 1981). The objectives of MARA were to motivate, guide, train, and assist Bumiputeras in order to enable them to become actively involved in commercial and industrial activities in an effort to create a Bumiputera commercial and business community. MARA has been preoccupied with helping small entrepreneurs and enterprises through the provision of credit facilities and consultancy services to Malay businessmen. It has also built shophouses for rent, and it has provided entrepreneurial training and loans for the purchase of taxis and other transport vehicles. It also provides support for the construction sector and helps educate Bumiputeras. As a statutory body it is wholly owned by the state and has a separate legal entity. It is independently financed and generally exempted from regulations applying to the expenditure of public funds, and it has its own organizational form.

II— Small and Medium Enterprise Promotion Policies

28

Industrial Structures and the Development of Small and Medium Enterprise Linkages The Malaysian Industrial Development Finance (MIDF) was set up in 1960 to provide long−term industrial finance for industrial development. Loans to the Bumiputera community and SMEs, however, were marginal. Phase 2 (1971−85)

With the onset of the NEP in 1971, the development of SMEs took on a more determined role in terms of Bumiputera employment, asset ownership, and the creation of a Bumiputera Commercial and Industrial Community (BCIC). The focus of public policies was on the development of

indigenous, that is, Bumiputera entrepreneurs through a plethora of public agencies engaged in the promotion of SMEs and entrepreneurial development that was recognized as crucial under the societal restructuring objectives of the NEP. The strategy adopted to promote SMEs, and particularly SEs, was for the government to provide a wide range of public support services. In addition to MARA, twenty−nine other agencies under thirteen ministries were set up to develop SMEs (see appendix 2.5). With the functions of many of these agencies overlapping, their efficiency and outreach were largely circumscribed. The measures were to be part of a comprehensive package encompassing improvement of production capabilities, provision of support services (such as finance), export finance, management, technological, and marketing assistance, physical infrastructure support, and entrepreneurial development. In 1974 the Central Bank issued guidelines for priority sector lending, including lending to small−scale enterprises from financial institutions. This phase also saw the enactment of the Industrial Coordination Act in 1973, which sought to enforce Bumiputera employment and equity ownership in all industrial enterprises. The Act was subsequently loosened due to the negative impact it had on industrial investment. Phase 3 (1986−90)

Since the recession in the mid−1980s, ending with an overall growth of −1 percent in 1985, recognition has been given to a more outward looking, export−oriented development of SMEs. This new outlook was focused on the need for the expansion and modernization of SMEs through the provision of financial assistance; improvement of the fiscal incentive system to reduce the size bias; promotion of research and development activities; and the strengthening of the institutional delivery system responsible for SMEs. The strategy of subcontracting and franchising was also adopted to increase the capabilities of SMEs to supply inputs to larger enterprises and to penetrate export markets. This phase also emphasized the development of all SMEs— Bumiputera and non−Bumiputera. Fiscal incentives that were the preserve of larger enterprises (with paid−up capital of more than M$25 million or that employ more than 500 employees) have now been extended to SMEs. The 1989 budget introduced special incentives for SMEs, including pioneer status for promoted activities or products, investment tax allowances, abatement of adjusted income (especially for large enterprises that subcontract from SMEs), and a reinvestment allowance for small, medium, and large enterprises to expand. Also, the product development and design scheme and the quality and productivity improvement scheme were introduced. In addition, export, training, and research and development incentives were also extended to SMEs. Further, the 1989 budget exempted SMEs from import duties on their raw materials. Renewed efforts were also made to increase the pool of new entrepreneurs through financial schemes in the late 1980s.6 While the policies of the previous development phases were aimed at broadening the industrial structure through export−oriented industries and the creation of SMEs, the policies of the third period have aimed at simultaneously broadening and deepening the industrial structure. In the sections below, we provide an analysis of the promotion policies that cover finance; training, technological, and marketing assistance; and infrastructure provision.

B. Effects of SME Promotion Policies

Phase 2 (1971−85)

29

Industrial Structures and the Development of Small and Medium Enterprise Linkages Financial Assistance Policies

The most commonly cited problems confronting SMEs are the inadequacy and difficulty of obtaining finance due to the small size of firms, their lack of collateral, and the conservative lending policies of financial institutions. As revealed in the 1986 UM/IDE survey of SMEs, 50 percent of entrepreneurs ranked inadequacy of financial resource as their most crucial business difficulty, while 28 percent ranked it as their second major business difficulty.7 This inadequacy arises from the small size of their businesses, which are traditionally family owned, with capital mainly sourced from personal savings or loans from friends and relatives. Eighty percent of the firms surveyed listed their own funds as their major source of financing. The inability of SMEs to provide adequate collateral for loans from the banking system has also restricted access to commercial bank credit in most cases, resulting in a shortage of working capital. Chee (1986) estimated in his study that only about 6 percent of these loans came from the banking sector. Rather than the cost of credit, access to credit, particularly for non−Bumiputera enterprises, is a major constraint facing Malaysian SMEs. From the perspective of the commercial banks, however, loans to small industries are often unprofitable for several reasons: a low interest rate ceiling imposed by the Central Bank's (Bank Negara) priority lending guidelines (discussed below); the higher administrative costs involved in processing and screening small loans; the high costs involved in providing extension/consulting services and in monitoring the business operations of small clients; and the high incidence of nonperforming loans due to higher risks of failure. Small enterprises are, also, not as competent in financial management as are LEs. In a study of small Bumiputera entrepreneurs in Malaysia, it was found that most of the small firms did not keep detailed accounts, prepared no regular financial statements, and were unable to present a profit and loss account or a balance sheet. There was no breakdown of the various costs involved in the business, and no financial budgets were prepared for the different business activities (Chee 1992). Because of such problems, commercial banks have tended to reject a high proportion of loan applications from small businesses that also lack adequate collateral (ADB 1990). In the following section, the lessons of SME financing in Malaysia are reviewed. The section will address the issues of financing of small enterprises by MARA; the Credit Guarantee Schemes for SMEs; the SME lending guidelines for banks and finance companies issued by the Central Bank; lending by development banks; and the export credit refinancing schemes. Mara

Between 1966 and 1980 MARA provided credit facilities close to M$0.5 billion to about 94,000 persons, constructed business premises to the value of M$198 million, and spent M$20 million on entrepreneurial training. MARA is a large organization with a staff of 4,300 persons at its headquarters in Kuala Lampur and has an extensive regional network of 14 state offices and 54 district offices. Most of the entrepreneurs assisted by MARA are petty traders who establish tiny family businesses, small retail outlets, mini markets, sundry shops, or engage in small handicraft manufacturing, food processing (soy sauce, coffee, bakeries), construction work, and furniture making; they run motor

workshops, tailoring shops, restaurants, car dealerships, and the like. By the early 1970s MARA was also engaged in directly setting up small business projects in trade and industry with the hope of selling them to Malays after they became viable. In later years, these functions were to overlap with other agencies such as the Urban Development Authority (UDA) and the National Corporation (PERNAS), as well as various State Economic Development Corporations. Due to the lack of sufficient managerial control and accountability, MARA companies have lost money, as sociopolitical criteria guided the management of the subsidiaries. As required by credit laws of the country, all loans were secured by land, buildings, shares and personal guarantees. The loan rates were 2 to 3 percent lower Financial Assistance Policies

30

Industrial Structures and the Development of Small and Medium Enterprise Linkages than bank rates, and in later years guarantors for loans below M$2,000 were abolished. By the late 1970s, loans over M$1 million were written off as borrowers had gone bankrupt or were difficult to trace. Despite court action, unsettled debts had risen to M$3.5 million by the late 1970s and only half of the repayments were made. The beneficiaries of the loans were lower class hawkers and traders. Over 80 percent of the loans did not exceed M$5,000. MARA was also inflicted with informal patron−client relationships, fraud, and middlemen who used their knowledge of the system to skim off payments from loan recipients. MARA was confronted with the problem of creating Bumiputera entrepreneurs, many of whom, new to the "market culture," thought that loans were favors for which repayment was not seriously expected (Gale 1981). Most of the successful businessmen helped by MARA were the ones who had skills in the trades they were involved in, knew the market, and had a good sense of management and thrift. During the third phase of development, after 1986, greater efforts at screening, monitoring of loans, and increasing accountability on the part of the management have been enforced by central planners, while the MARA Council has been revamped and a more aggressive stance toward the collection of loans has been pursued.8 Credit Guarantee Corporation

As part of its overall thrust of adopting a more activist development approach under the New Economic Policy, the government set up the Credit Guarantee Corporation in 1972 and followed this up with specific guidelines requiring commercial banks and finance companies to channel a prescribed proportion of their total outstanding loans to priority sectors including small enterprises. Limits were also enforced on the interest rates that could be charged to certain types of priority borrowers. Three development banks were also established to provide medium−and long−term capital on concessionary terms to the industrial and agricultural sectors. Recognizing the financial constraints facing SEs, especially their lack of collateral, and to encourage commercial banks to lend to SEs, the government established the Credit Guarantee Corporation (CGC) with a paid−up capital of M$2.5 million in which 20 percent equity was held by the Central Bank and the rest by the commercial banks. The main objective of CGC was to assist SEs to obtain credit facilities at reasonable terms from the banks by providing credit guarantee facilities. It was felt that the development of the SEs would be sped up, given the extensive branch network of the banks. To reduce risks of lending to SEs, the guarantee schemes were aimed at sharing credit risks with the

lending banks in cases of default by borrowers. Banks are responsible for processing and evaluating the loan application. Once approved, the bank submits the application to the CGC for further evaluation. The CGC introduced its first guarantee scheme, the General Guarantee Scheme (GGS), in 1973. This was followed in 1981 by a second scheme called the Special Loan Scheme (SLS) to complement the GGS.9 The SLS, while not replacing the GGS, offered better guarantee cover for small businesses so that they could gain access to bank credit—up to M$200,000 for Bumiputera and M$100,000 for non−Bumiputera borrowers. Under the GGS and SLS the corporation guaranteed 60 percent of the amount of any loan in default, in return for a guarantee fee equivalent to 0.5 percent of the value of the approved loans outstanding. At the time of establishment, the interest rate charged was 1 percent below the base lending rate (BLR) of the commercial banks. Interest rates under these schemes generally ranged from 7.5 to 9 percent. From 1988, the interest rate charged on loans granted under the SLS was subject to a ceiling rate of either 9 percent per annum or .75 percentage points above the average base lending rate of the two leading domestic banks, whichever being lower. Throughout the 1980s, credit under the GGS was channeled mainly to small firms in the services sector; the manufacturing sector accounted for 10 percent of the total loans approved under the scheme. Since the GGS and the SLS were introduced, some 149,000 small businesses were guaranteed by the CGC, involving M$2.8 billion loans. The CGC had received about 2,700 claims from commercial banks, for a value of approximately M$17 million, up to July 1988 (ADB 1990).

Credit Guarantee Corporation

31

Industrial Structures and the Development of Small and Medium Enterprise Linkages The partnership between the CGC and the banking system has not worked well. From the perspective of the commercial banks, claims procedures under the CGC guarantee cover take several years, and the rejection rate of claims is high. Lending to SMEs continues to be risky. At the end of 1988, outstanding loans reported as nonperforming by the banks amounted to M$240 million or 41 percent of the outstanding loans guaranteed by the CGC. Between 1980−87, the percentage of total commercial bank loans guaranteed under the CGC compared to total loans by the commercial banks was between 1.2 and 1.7 percent, and as a percentage of total small loans it ranged from 12 and 20 percent. Although loans may be made without security, in practice many banks have obtained additional security against their loans. A number of problems were associated with the implementation of the scheme: CGC's guarantee, which reduced the bank's risk, had also reduced the incentives for the banks to properly evaluate, supervise, and collect loans. Consequently, banks often treated the guaranteed loans with less prudence than their normal loans. This resulted in more loan failures. Due to a high rate of default, banks, over time, became doubtful of the guarantee cover provided by the CGC. Banks are essentially profit motivated and as such were not concerned with the attainment of social objectives. Participating in the scheme was viewed by the banks as a "social cost," and they were, therefore, reluctant to push lending beyond the required minimum. Banks continued to have the perception that lending to SE is risky business, unprofitable, and involves high administrative costs. This is compounded by the fact

that SEs are new, lack a good track record, lack managerial experience, and have a high failure rate. CGC's total reliance on commercial banks has resulted in a failure to market the scheme. Bank clients knew little about the CGC schemes. CGC made inadequate provisions for handling claims. Five years after the Central Bank guidelines for CGC loans were introduced, the CGC's capital fund (including provisions for claims) amounted to only 4.4 percent of its guarantee obligations. The scheme was grossly underfunded (Levitsky and Prasad 1987). Due to such problems the CGC restructured the schemes and implemented the Principal Guarantee Scheme (PGS) in 1989 to replace the two earlier schemes.10 The new scheme was structured to encourage the commercial banks to lend to SEs in compliance with the lending directive of the Central Bank. Under the PGS the lending ceiling has been raised from a limit of M$200,000 to M$500,000, and the coverage expanded from term loans and overdrafts to include letters of credit, trust receipts, bills purchased, export credit financing, and so on. It also guaranteed 70 percent of the loan (Mohd. Isa 1992). Under the PGS, the issuance of guarantee cover is no longer assured as it was under the previous schemes. Instead, the commercial banks will carry out a desk appraisal on every application, and the guarantee cover will only be given once the lending banks have carried out a proper loan evaluation; this should eliminate some of the previous problems. Also, secured loans granted by banks that fall within the bank's normal margin of finance will not be guaranteed by the Corporation. The guarantee cover will no longer overlap with the security already taken by the banks. By 1991, the PGS guaranteed loans were more than the combined total loans approved under the previous two schemes from 1985 to 1989. The interest rate under the PGS loans was pegged at 1.5 percent above the BLR in order to give an adequate return to the banks (Mohd. Isa 1992). Central Bank Guidelines for Priority Sector Lending

The activist role taken by the Central Bank during the second phase also saw the introduction of specific guidelines for priority sector lending in 1974. The guidelines have been reviewed each year, specifying the Central Bank Guidelines for Priority Sector Lending

32

Industrial Structures and the Development of Small and Medium Enterprise Linkages required level of lending to four priority groups: the Bumiputera community; small−scale enterprises; farmers and enterprises engaged in agricultural food production; and loans for low cost owner−occupied houses.11 The Central Bank also imposed penalties for failure to comply with the guidelines. Banks and finance companies that did not meet the targets were required to place deposits in the Central Bank equal to their respective shortfalls for a period of one year at zero percent interest. The funds so deposited were on−lent to those banks and finance companies that exceeded their targets. In 1989 commercial banks were required to extend a total of at least M$600 million in new loans to small businesses. Under the priority lending guidelines the maximum interest rate that can be charged by commercial banks is pegged at either 1.75 percentage points above the average BLR of the two leading banks or 9 percent per year, whichever is lower.12 In line with the reduction in the BLR of these banks, the maximum interest rate for priority sector loans was lowered to 8.5 percent per year, effective July 1, 1988.

During the third phase of development, the Central Bank reduced the number of priority sectors as well as the proportion of total loans covered by the guidelines. In 1991 only two targets were set: the Bumiputera community and small enterprises. In the case of finance companies, only loans to Bumiputeras were targeted. Between 1980 and 1990, commercial bank lending to the Bumiputera community always exceeded (in excess of 25 percent) the lending guidelines prescribed by the Central Bank. The guideline has varied from 50 percent in 1975 to 20 percent from 1984 onward. In the case of lending to small enterprises, the targets were more than met (with the exception of the recession years of 1983 to 1985). The guideline for small−scale enterprise lending has shifted from a proportion of lending to quantitative targets. The finance companies have performed better at complying with the Bumiputera lending guideline, with their total loans to Bumiputeras accounting for over 57 percent, compared to the target of 20 percent during the 1980s. From 1989 onward, the ceiling rates were removed from a large proportion of loans to the priority sectors, with the exception of loans made for the purchase of low cost houses and for loans made to small enterprises under the Principal Guarantee Scheme. Although directed lending has imposed a cost to banks and finance companies (which is made up in other forms of lending), the flexible management of the schemes has kept the functioning of financial system sufficiently robust. Development Finance Institutions

To provide overall term financing to the industrial sector, the Malaysian Industrial Development Finance (MIDF) was established in 1960 with equity participation from the government, the commercial banks, insurance companies, and the Commonwealth Development Corporation to provide medium− and long−term financing for industrial enterprises through loans and direct equity participation. Interest rates for term loans in the early 1980s were between 11 and 12 percent for the purchase of fixed assets including land. MIDF also made factory mortgage finance available to firms. Its subsidiary, Malaysian Industrial Estates Limited (MIEL) builds standard factory units in selected locations for sale to small and medium enterprises through rental, credit financing, and more recently through its lease and purchase scheme. MIDF also makes available the hire purchase financing of machinery, and could take an equity position in the enterprise. Security on loans is normally through a first charge on the type of loan (that is, fixed assets of the enterprises). The average size of its loans was M$800,000 in 1988. Loans and leases to small enterprises in 1988 were 18 percent of the total number of loans and 9.1 percent of the total value. Loans to Bumiputeras were concentrated in the small−scale sector (food processing and beverages). As of 1987 MIDF experienced an arrears of 10 percent of loans and leases outstanding. Development Bank of Malaysia

Realizing the low level of investment by Bumiputeras in the corporate sector and the need to achieve targets established by the NEP, the government established the Development Bank of Malaysia (Bank Pembangunan Malaysia (BPM)) to develop and accelerate Bumiputera participation in the industrial and commercial sectors. The Bank lends only to Bumiputera Malaysians and has focused its lending in the

Development Finance Institutions

33

Industrial Structures and the Development of Small and Medium Enterprise Linkages manufacturing, tourism, and mining (excluding tin mining) sectors. With thirteen branches covering all states, BPM provides term loans, plant hire, leasing facilities, and entrepreneurial and advisory services. The Bank also undertakes equity investment in high technology manufacturing enterprises for later divestment to individuals once the enterprises are successfully operational. For small−scale lending, the Bank has operated on a narrow margin of 2.75 percent, while the needed margin has been about 5 percent (ADB 1990). BPM and the MIDF participated in the World Bank assisted program for the development of SEs between 1985−88. The World Bank program was originally restricted to Bumiputera entrepreneurs but was extended to other Malaysians as there were insufficient viable projects from potential small−scale Bumiputera entrepreneurs. The Bank has instituted a supervisory services scheme to identify potential business problems among SE borrowers at an early stage in order to allow sufficient time for corrective measures to be implemented through quarterly visits to clients and by countersigning all checks; nevertheless, it has experienced a failure rate of 30 percent among SEs. Another 20 percent of SEs have experienced severe financial difficulties (ADB 1990). SEs have not paid sufficient attention to detailed feasibility studies and business plans and often propose ventures in sectors saturated with competitors, where profitability is low. BPM provides loans for working capital fixed assets, and buildings. The Bank has an active clientele of about 1,000 enterprises, most of which are small enterprises that were established in the late 1980s. In 1985, BPM established the Nursery Factory Scheme (NFS) to provide new factory units for rental, at subsidized rates, by new Bumiputera firms receiving financial assistance from the Bank. Support services are provided to assist firms in the first three to five years of manufacturing after which they are supposed to move out of the nursery complex. The scheme offers close supervision by the NFS management that reduces the likelihood of business failure. Economies of scale are achieved in terms of the provision of support services. Five complexes are now available in Penang, Terengganu, Kelantan, Kedah, and Johor. Most of the firms in these clusters produce food products, leather products, handicraft items, and packaging materials. This has been an encouraging experience (ADB 1990; Salleh and Rahim 1992). Agricultural Bank of Malaysia and the Industrial Bank of Malaysia

The Agricultural Development Bank was established in 1969 to mobilize resources for agricultural development and provide agribusiness loans (loans for the operation of small enterprises involved in agricultural processing and marketing activities). The interest rates charged vary according to the clients' capacity to pay. Projects directed at low income farmers are charged an interest rate of 4 percent for loans below M$50,000. Larger loans carry a higher interest rate at 9 percent (ADB 1990). The Industrial Development Bank (Bank Industri) was set up in 1979 to stimulate the development of export−oriented, high technology industries through: the provision of long−term loans; financing of domestic and international trade; and financing and assisting the expansion and modernization of manufacturing enterprises. Although its financing has been targeted at medium and large enterprises, it has also granted loans to

smaller engineering firms. Bank Industri only lends to financially viable projects, and in most cases it is jointly involved in the financial management of the client companies. It often requires the operation of joint banking accounts with the clients, countersigns all checks for payment of expenses, and monitors the performance of its clients. Financial management advice and assistance is provided, together with frequent visits, to the clients' business locations. Its research staff play a key role in identifying and evaluating new areas for it to penetrate and, unlike other development financial institutions, it has an unusually low level of client financial problems. This has been achieved with an interest margin of 1.5 to 3.0 percent.

Agricultural Bank of Malaysia and the Industrial Bank of Malaysia

34

Industrial Structures and the Development of Small and Medium Enterprise Linkages Export Credit Refinancing

In 1977, the Central Bank introduced the export credit refinancing facility (ECR) to promote the exports of manufactured and approved agricultural products. Exporters of goods manufactured in Malaysia, with sufficient value added and local content, could qualify for pre−and post−shipment credit at preferential rates of interest through commercial banks. The scheme was revamped in 1986 resulting in: (a) a wider range of eligible products as well as financial limits; (b) a shift in emphasis from post−shipment to preshipment financing; and (c) an extension of the scheme to a wider range of indirect exporters. The ECR interest rate has ranged from 5 percent in 1983 to 4 percent in late 1988, and then back up to 5 percent in 1991, Table 2.4: Total Value of Loans under Export Credit Refinancing Facilities, by Subsector, 1979−89 (M$ millions) Subsector

1979

1983

1986

1989

1980−89

Machinery, mechanical appliances and electrical equipment

476.7

168.3

185.0

1,078.2

3,361.0

Oil and fats (mainly palm oil products)

248.8

268.9

342.4

807.3

3,123.4

Textiles and textile products

131.7

144.1

162.1

155.9

1,569.7

Food, beverages and tobacco products

55.5

65.2

138.7

218.2

1,086.1

Rubber and plastic products

39.3

122.7

178.7

940.0

2,750.7

Wood products

34.6

84.2

88.4

271.0

1,116.3

Chemical products

40.3

27.6

53.1

123.3

530.1

Other manufacturers

67.6

99.1

228.5

736.1

2,363.3

Subtotal

1,094.5

980.1

1,376.9

4,330.0

15,900.6

Machinery, mechanical appliances and electrical equipment

—

0.3

45.7

889.8

1,567.8

Oil and fats (mainly palm oil products)

—

230.6

594.2

1,331.8

4,527.7

Textiles and textile products

73.7

126.1

253.1

653.8

2,252.4

Food, beverages and tobacco products

1.5

126.1

253.1

653.8

582.8

Rubber and plastic products

—

4.8

39.6

1,043.1

2,457.3

Wood products

5.2

66.9

129.7

603.0

1,530.2

Chemical products

—

—

11.9

8.4

35.3

Other manufacturers

3.3

27.7

76.8

436.8

954.2

Subtotal

83.7

582.5

1,404.1

5,620.5

13,907.7

Postshipment

Preshipment

Export Credit Refinancing

35

Industrial Structures and the Development of Small and Medium Enterprise Linkages — Not available. Source: Bank Negara Malaysia.

moving with the overall interest rate structure. The period of refinancing is four months for preshipment and six months for postshipment. Eligibility of goods for refinancing is determined through a ''negative list" concept, whereby products not on the negative list are eligible for refinancing, provided they satisfy the 20 percent value added and 30 percent local content criteria.13 The minimum amount of ECR financing is M$10,000 and the minimum drawdown is M$2,000. As a reflection of the popularity of the scheme among exporters, annual utilization of the scheme has risen from M$140 million in 1977 to M$9.9 billion in 1989. The scheme has been beneficial to indirect, small and new exporters, without the exporter's collateral presently demanded by commercial banks. Food, beverages and tobacco products, rubber, and plastic products have experienced particularly strong increases in exports under this scheme (table 2.4). C. Training, Technological and Marketing Assistance

Two categories of training are currently offered for the development of SMEs: entrepreneurial development and business management training; and technical skills training (including marketing). There has also been an expansion of private sector involvement in skills training since the mid−1980s. We provide an analysis of the training schemes below. Entrepreneurial and Business Management Training

Three institutions specialize in providing entrepreneurial training for potential entrepreneurs. The Malaysian Entrepreneurial Development Center, established in 1975, provides training to potential Bumiputera entrepreneurs in the start−up of new businesses.14 Its main program, the Entrepreneurial Development Program (EDP), is conducted on a full−time basis over six weeks, and consists of four modules: (a) entrepreneurial motivation; (b) project selection; (c) management; and (d) the formation of companies.15 Participants, who usually have a secondary−level education, are required to have a business proposal and an interest in, and basic knowledge of, technical and business concerns. Graduates of the course receive certificates that are recognized by banks and may assist them in gaining loans for business start−up. Two other courses target government employees and graduates. The course for government staff is conducted over a four−month period including a one−month attachment to a company or factory. For university graduates, an eight week, part−time course is conducted in the evenings. About one in five of those trained usually go into business after completion of the program. (ADB 1990). MARA conducts three types of entrepreneurial courses: (a) precreation programs (on challenges and risks of starting a business); (b) creation programs (on developing business proposals); and (c) entrepreneurial advancement programs. Sectoral focus of the courses includes transport, food, tourism, and construction. Usually about 10 to 15 percent of the participants go on to establish new businesses. The National Productivity Corporation has a Bumiputera services division that provides entrepreneurial training in auto mechanics, food processing, and transport. The Small Business Development Center of Agricultural University (UPM), established in 1981, provides training and extension to small businesses through short courses for a three−month period

with individualized attention and attachment to firms for on the job training. While successful, the UPM program is too limiting in terms of numbers.

C. Training, Technological and Marketing Assistance

36

Industrial Structures and the Development of Small and Medium Enterprise Linkages Technical Skills Training/Extension Services

A survey of 762 firms, undertaken by Universiti Pertanian Malaysia (UPM) and the International Development Research Center (IDRC), Canada (1988), on SMEs in four subsectors (food, wood, light engineering, and construction materials) revealed that the majority of SMEs (72 to 82 percent) were still at a low state of technology utilization. Only 14 to 19 percent of the firms surveyed utilized higher−end technology, and these tended to be the medium−scale enterprises. In terms of manufacturing management techniques, most SMEs observed in the UPM/IDRC study did not use statistical quality control. Inspection was carried out by sampling or when troubleshooting a technical problem. Most SMEs also applied their own quality standards, with only 18 percent applying international standards. Fifteen percent of the SMEs undertook maintenance of machinery only when breakdown occurred. Decisions on quality control, product design and development, plant maintenance, and production planning and control were primarily made by the manufacturing manager/owner of the firm. The UPM/IDRC study also showed that only 13 percent of small firms surveyed employed a Malaysian National Standard, while an insignificant 3 percent employed an International Standard for quality control purposes. However, both standards were commonly used by the medium−scale firms covered in the survey. At present, three institutions provide technology oriented training, combined with consulting services to assist SMEs in improving supply−side capabilities in productivity, quality, product design, and manufacturing techniques. These services are provided by the industrial extension unit of SIRIM (Standards and Industrial Research Institute of Malaysia), the small−scale industry section of the Forest Research Institute (in the case of the wood−based industry), and the Food Technology Division (FTD) of MARDI (Malaysian Agricultural Research and Development Institute). Among the three, the FTD of MARDI has an adoption scheme that involves providing selected firms with a three−year program of technology training, together with a comprehensive review and upgrading of the firm's production process, quality management, packaging, and product line. While effective, and done on a cost recovery basis, the outreach of these institutions is limited compared to the demand for such services by SMEs. Technical skills training is provided by several government institutions, in addition to the above three agencies. These include: the Center for Instructor and Advanced Skill Training (CIAST); ten Industrial Training Institutes that conduct craftsman training programs of one to three years' duration; thirteen MARA Vocational Institutes that offer two−year programs; fifteen MARA skill training institutes that offer basic skills training to the needs of local communities; and the four Youth Training Centers of the Ministry of Youth and Sport that offer two−year programs that include job attachments.16 A number of problems remain in the provision of training and extension services by government agencies. These include: (a) limited institutional impact due to staff and resource constraints; (b) limited use of hands−on practical training, and, when it is provided, it tends to be outdated; (c) little

involvement by the private sector in directing training needs and in responding to market demand; (d) insufficient flexibility in the management of training institutions due to public sector regulations and procedures; (e) lack of quality trainers with business experience; (f) suboptimal utilization of training facilities; (g) outdated courses and curricula; (h) concentration of agencies in the federal capital, limiting their regional outreach; and (i) lack of coordination among agencies providing such services.17 At present, only a small number of SMEs participate in the training offered. Many SMEs are also not aware of the training and services provided by agencies. Banks and financial institutions have not paid enough attention to management advisory services such as those provided by the development finance institutes. Banks and financial institutions lack the necessary professional staff who understand the problems and attributes of SMEs. Agencies that are successful at providing such services focus on particular subsectors, seek flexibility in organizational structures, aim at cost recovery, reach out for private sector involvement, and have highly motivated senior Technical Skills Training/Extension Services

37

Industrial Structures and the Development of Small and Medium Enterprise Linkages management teams. Examples include the FTD of MARDI, SIRIM (see box 2.1), UPM's adoption scheme, FRIM, Bank Industri, and the Penang Skills Development Center (see box 2.2). Box 2.1: Standards and Industrial Research Institute of Malaysia (SIRIM) SIRIM's facilities are at the vanguard of Malaysia's push to advanced technology. They have recently signed an agreement with Hewlett Packard Sales (Malaysia) to establish the SIRIM−HP CIM laboratory to train local industries in computer integrated manufacturing. SIRIM has been targeted by the government as a leader in developing advanced materials, advanced manufacturing technologies, design, instruments and biotechnology. Their research projects on sago starch bioconversion, biodegradable plastics, and their process design for the development of a vinegar−bioreactor for the commercial production of sago vinegar have all attracted interest in the private sector. At the same time these projects are part of SIRIM s emphasis on environmentally responsible research and development. One of their contract projects now is the study of industrial pollution and treating various types of wastewaters. In early 1991, an allocation of M$44.7 million was formally approved for SIRIM to embark on a concerted Human Resource Development Program (HRD) for 1991−95. Through this program, an estimated 365 places will be provided for post−graduate training over this period in addition to provisions for short−term fellowships and training attachments. As environmental concerns, HRD, and advanced technologies all have a prominent place in Vision 2020 (of becoming a developed nation), it is clear that the government of Malaysia holds SIRIM's capabilities in high regard. The government is not alone, however, as SIRIM has attracted a good deal of attention in the private sector, both for the technology that they develop and for their vast information dissemination capabilities. Recently, SIRIM has engaged in an outreach program toward the private sector. From a tightly centralized organization, they have developed into branch networks. Since 1990, SIRIM has increasingly engaged in a dialogue with the private sector. More of their research contracts are being conducted with local firms, and they are increasingly presenting themselves as a service to be used by the private sector (their new publication is one example of this). As a result, SIRIM has a great potential for profitability themselves, and the 1991 Corporate Plan has dictated a direction for taking SIRIM into the private sector. This plan transformed the institute into a contract−only research organization in 1993, with the possibility of its corporatization in 1996. Source: SIRIM annual reports. SIRIM was established in 1975 as a resource for furthering Malaysia's push toward industrialization. Its functions were: (a) to promote and undertake industrial research with the objectives of improving technical processes and methods, adopting and adapting technology developed in other countries for use in Malaysia, and applying the results of such research; (b) to promote

industrial efficiency and development; (c) to provide technology transfer and consultancy services to assist industry; (d) to promulgate standards and to promote standardization and quality assurance for greater quality competitiveness; and (e) to promote public and industrial welfare, health, and safety. SIRIM undertakes research projects (collaborative or contractual) with universities, government departments, other research institutions (both Technical Skills Training/Extension Services

38

Industrial Structures and the Development of Small and Medium Enterprise Linkages local and abroad), and even local firms. One of the major reasons for SIRIM's undeniable success is their emphasis of quality standards and standardization. SIRIM studied the methods and results of other research and development institutions, particularly Singapore's, as a model for their own. As the institute has grown and succeeded, they have continued to search for other models of efficiency to learn from. Many of their staff have trained in Germany under the aegis of SIRIM−TUV/GTZ Germany in order to increase their own efficiency. This program has led to the institute's increased services to the metal and metalworking industry, which has resulted in an impressive income. In their efforts to promote national and international quality standards, SIRIM has entered into several mutual recognition programs, signing memoranda of understanding with the British Standards Institution (BSI), Canadian Standards Association (CSA), Hong Kong Standards and Testing Centre, Ltd., and KEMA of the Netherlands. SIRIM has been a leader in pushing for ISO 9000. In addition, in order to convince Malaysian companies of the need to compete on the basis of quality, rather than just price, SIRIM has recently inaugurated publication of a magazine entitled Design in Malaysia. In order to help small− and medium−scale industries that are unable to meet the standards of ISO 9000 and similar quality systems, SIRIM has introduced the Quality Improvement Practice program, which includes an umbrella concept, whereby large corporations would help small industries meet quality standards. SIRIM has also advanced testing services for new products. SIRIM's technical services is backed by a depository of seven million technical documents containing technology information on patents, standards specifications, R&D results, and technological data. Box 2.2: From Concept to Reality: Penang Skills Development Center (PSDC) in Malaysia PSDC is a public/private sector joint venture. Its membership includes industries, the Penang state government, the state−run Universiti Sains Malaysia, and the Standards and Industrial Research Institute of Malaysia (SIRIM). Their members will embark on a series of training programs to cater to the needs of industry. In 1992, it had 37 corporate members with a work force of 51,676, or 37 percent of the total work force in the four Free Trade Zones and four Industrial Estates in Penang. The administration is run by an executive director and three full−time staff under the direction of its management council made up of eleven industry and four government representatives. PSDC was given tax exempt status in 1991 and provides training, not only to its members, but also to the entire manufacturing sector; members receive special treatment. Starting from 32 courses offered in 1989−90, it increased the number of conducted courses to 156, involving 2,137 participants and trainers in 1991−92 including part−time, full−time, and weekend courses. Trainers from around the world are hired on the basis of courses offered. It has forged alliances with other training institutes in Malaysia to minimize duplication of courses and at the same time maximize use of available resources with institutions within and outside the country. It has accreditation with Australian, British, and U.S. institutes. Three types of courses are offered—technical skills courses, manufacturing processes, and management courses—but is heaviest on the technical side. It has twinned with other institutes and will offer degree and post−graduate programs. (continued)

(table continued from previous page)

Technical Skills Training/Extension Services

39

Industrial Structures and the Development of Small and Medium Enterprise Linkages The equipment in its training labs and workshop are either donated by industry or leased with the aim of keeping up with the latest developments in the technological area. Apart from on−site training it provides training needs analysis for companies, culminating in corporate training plans and customized curriculum for in−house training. Such training can benefit from the 1992 Human Resources Development Fund.a Companies can also rent the Center's premises to conduct their own training. Training courses are demand−driven. The Center conducts a biennial survey of training needs for members and non−members. Companies are required to indicate courses that they "must have," are "good to have,' and are nice to have within a two−week period. Based on this, courses are offered and companies "buy into" the program and make the necessary payments. The Center's approach to course offerings is to "conduct 20 percent of the required courses that are demanded by 80 percent of the companies' to ensure that there is a "critical mass for training offered. The Center adds a 30 percent margin on costs of programs in order to break even. Member companies receive a rebate on training fees compared to non−members, and small companies pay a lower fee. In the short period that it has existed, its gross income has exceeded M$1.6 million per year. a . This fund (similar to Singapore's Skill Development Fund) requires firms to contribute one percent of their monthly payroll for training purposes. Initially, large− and medium−sized firms in the manufacturing and tourism sectors will participate. The contribution will be used to finance training undertaken by the contributing firms. The fund would be managed by the Human Resources Development Council. Its membership comprises two−thirds private sector representation and one−third public representation. Source: PSDC annual report and presentation by PSDC executive director (1992). The PDSC was a concept that arose from discussions between the American Business Council, representing multinational enterprises (MNEs) involved mainly in electronics, and the Penang state government in Malaysia. Realizing that the future of the state of Penang would be closely linked to the training and development of its work force, the concept of industry, government, and academia sharing resources to achieve common goals was set in motion in the late 1980s. It became a reality in 1989 as the first industry−led training institution in Malaysia. Since its establishment as a nonprofit organization, it has emerged as one of the leading training institutes in the country, making it a model for other states to follow. The Center has been financed by both the private sector and the state government. The state government has provided the premises and a grant for the first eight years of its operations. Its corporate members have supported the Center with seed money and donations in the form of money, time, and equipment. The Chairman of the PSDC is a member of the Penang Human Resources Development Council, ensuring close coordination of the Center with the state apparatus. With the approval of the Double Deduction Training Incentive (in institutions approved by the government) in 1991, and the setting up of the Human Resources Development Fund by the government in 1992, PSDC is expecting to play an active role in skills development in Malaysia. Marketing

Poor marketing has long been recognized as a crucial problem faced by SMEs. The UPM/IDRC survey found that the most common marketing problem perceived by SMEs is their inability to generate adequate sales at high enough margins. About 60 percent of firms surveyed identified "not enough sales," and roughly 55 percent identified "low margins" as their major problems. The study also showed that, in general, SMEs do not have the capacity to undertake marketing functions in an organized manner. They do not Marketing

40

Industrial Structures and the Development of Small and Medium Enterprise Linkages have the expertise nor the resources to conduct any form of market research, sales forecasting, or sales force training. Even for the medium−size firms, only about one−haft of those in the sample reported using modern marketing approaches. The inability of the SMEs to penetrate world markets was caused by unattractive packaging and labeling of products and inefficient promotion and advertising campaigns. Only 13 percent of SMEs in the UPM/IDRC survey were able to export their goods overseas. Many small firms lack knowledge of export procedures and overseas market opportunities and requirements for their products. This deters them from commencing export activities and forces them to remain heavily dependent on the domestic market. There are a few government agencies in Malaysia which provide free or subsidized consulting services in the marketing field. These include the Malaysian Council of Trust for the Development of Indigenous People (MARA), Malaysian Entrepreneurship Development Center (MEDEC), and the Development Finance Institutions (DFIs). However, their capacity is limited and often the consultants provided are more proficient in general management principles than in specialized marketing skills. They have the capacity to provide general advice on marketing, but are not normally able to provide SMEs with advice on the day to day marketing activities that need to be undertaken at the level of the individual firm (ADB 1990). SMEs, for their part, have been reluctant to employ consultants for such purposes, not realizing the potential improvements in productivity; instead, they view consultant services as providing little value for the money (Kassim 1992). In the next section we discuss the provision of infrastructure for SMEs. Infrastructure Provision

While land and infrastructure for large−scale enterprises were provided at subsidized costs, through industrial estates developed by government agencies as part `of the industrialization drive, similar efforts for SMEs were lacking. Small factories grew haphazardly around residential areas, as "backyard factories," or in the urban fringes. The machinery and engineering small enterprises were particularly vulnerable to penalties for contravening zoning regulations (Fong 1990). Costs and affordability, rather than the supply of industrial land, have been factors affecting SME relocation. As land matters rest with state governments under the Constitution, relocation of factories in many instances has taken place with the assistance of state economic development corporations. For Bumiputera entrepreneurs, MARA, as part of its comprehensive package of assistance, undertakes construction of office complexes, arcades, shop houses, bazaars, and stalls, mainly in the rural areas. Priority for renting premises is normally given to entrepreneurs who have already started their businesses in the area. Buildings are rented out at subsidized fees. Apart from MARA, the Urban Development Authority (UDA) was established in 1971 under the restructuring goals of the NEP, to assist Malay traders in expanding their business premises in strategic locations within Chinese dominated urban commercial areas (Gale 1981). Under the UDA Act, the authority could declare any area to be an Urban Development Area, enabling it to become the ultimate planning authority in that area, irrespective of other laws to the contrary, and permitting it to acquire land for "public purposes." However, it has rarely used these powers. It builds business premises for hire−purchase and for rent.

Financial assistance was also provided for the purchase of equipment, fixtures, and renovation to those renting or buying premises from UDA. UDA also acquired business premises to be sold or leased later to Malay businessmen. Like the agency PERNAS, UDA, in its early years, began acquiring shares in relevant companies for the development of new premises through the direct business purchase of equity in non−Bumiputera companies. The companies were chosen on the basis of their potential employment of Bumiputeras and their planned training of Malays as potential entrepreneurs.18 UDA faced a number of problems in the 1970s including the reluctance of the Chinese community to cooperate and participate in joint−ventures. As in the case of MARA, but unlike PERNAS, patron−client problems emerged Infrastructure Provision

41

Industrial Structures and the Development of Small and Medium Enterprise Linkages in its operations, and in the late 1970s it was facing financial difficulties. Malay businessmen were reluctant to repay loans and this, combined with administrative malpractices, had cost the authority millions of dollars. UDA did not present its annual report until 1977. By 1977, bad debts had risen to $M10 million and the accumulated deficit was over $M40 million (Gale 1981). Organizational changes were instituted in the late 1970s to prevent further loss of funds, and its role had to be redefined in relation to MARA and PERNAS.19 Besides MARA and UDA, the Malaysian Industrial Estates Limited (MIEL, a subsidiary of MIDF) has also assisted Bumiputera manufacturers, who have taken up 35 percent of UDA's factory space. This is facilitated through rental, credit financing through its factory mortgage loan scheme, or through its lease and purchase scheme. MIEL has participated in the relocation of SMEs in seven towns in collaboration with the state economic development corporations.20 The state governments are also providing land for the creation of foundry and engineering parks to be located near urban centers and larger industrial estates, benefiting the relocation of SMEs in the respective subsectors. In the next section we provide key lessons of broadening the industrial base through SME promotion. III— Lessons of Broadening the Industrial Base Malaysia, more than the other countries in the Association of South East Asian Nations (ASEAN) region, has employed a comprehensive set of measures, instruments, and institutions to encourage the development of SMEs. This effort was guided by two main concerns: (a) to break the stratification of ethnic groups within economic functions and geographical areas; and (b) to broaden the industrial base that has been propelled by foreign−based MNEs located in the FTZs. What were the lessons of the SME promotion? We summarize below the three main lessons in terms of finance for SMEs, support institutions, and entrepreneurship development. A. Finance

On the question of finance, a number of conclusions from the Malaysian experience of financing SMEs can be noted. First, while finance remains a constraint, it is the access to finance rather than the cost of finance that constrains the SMEs.21 This is not too surprising given the relatively good macroeconomic management: inflation has not been a major problem in

Malaysia and swings in interest rates have not been wide. The problem, however, is that financial institutions are not generally geared toward lending to small enterprises as they lack the necessary expertise in dealing with the small enterprise sector. Financial institutions must separate lending instruments for cottage or microenterprises from those for small and medium enterprises or a separate institution for micro lending must be devised. As demonstrated by the success of the ADEMI, an NGO in the Dominican Republic, lending to micro−enterprises can be profitable if enough effort can be expanded in understanding the functioning of the microenterprise.22 We also note that in the case of certain institutions, such as Bank Industri, its low default rate is partly due to its role in the "governance" of the enterprise through financial management and monitoring of client companies. It has also built up capability by specializing in certain subsectors (such as engineering). Second, the collection problems faced by MARA indicate that borrowers should be inculcated with a "repayment culture" from the outset; loans should not be viewed as entitlements. Third, as discussed in the next section, the practice of subcontracting among SMEs should be encouraged as it tends to alleviate their financing problems. Banks are favorably disposed to firms that subcontract, placing emphasis on project based lending rather than on collateral. Fourth, export financing has provided a boost for SMEs that export; the restructuring of the scheme to meet the needs of SMEs was crucial. Fifth, the Credit Guarantee Corporation has not been very successful in increasing the access of SMEs to credit. To be effective and useful, such schemes must be properly structured and funded, and the screening of loans by banks and the corporation must be ensured to avoid "moral hazard" problems—the extension of risky loans due to implicit guarantees. Sixth, directed credit to SMEs in terms of quantity and interest III— Lessons of Broadening the Industrial Base

42

Industrial Structures and the Development of Small and Medium Enterprise Linkages rate guidelines may not unduly distort the workings of the financial system, if flexibly implemented, as shown by the Malaysian experience. B. Support Institutions

As noted above, there has been a proliferation of agencies (thirty) and ministries (thirteen) involved with the development of SMEs. Two conclusions can be derived from this intervention. First, due to the strong role played by the state during the second phase of development, institutional effectiveness and accountability were accorded a secondary role. Duplication of functions across the various levels of government was a normal occurrence. Little attention was paid to the fit of objectives of organizations to their structure, strategy, and the needed skills to achieve the objectives; as a corollary to this problem, a complete overhaul of the institutional delivery mechanism has to be undertaken through a comprehensive and integrated SME development plan— with the phasing out of, and the rationalization of, certain agencies. The rationalization should compel agencies to specialize by key functions with regional branches. In addition, a central coordinating authority for SMEs is essential. Second, in the provision of services, certain agencies (such as SIRIM, FRIM) have been more successful in their outreach and delivery than others. Their success factors should be studied for replication by other agencies. It is worth repeating these: (a) they focus their services on particular subsectors; (b) they seek flexibility in their organizational structures; (c) they aim at cost

recovery; (d) they reach out for private sector involvement; and (e) they have highly motivated senior management teams who are held accountable. C. Entrepreneurial Development: Bumiputera Entrepreneurs

After more than twenty years of credit provision, training, advisory services, quotas and price allowances in supply and works contracts, the issuance of licenses in local authority areas, the allocation of shares in new companies, and the provision of buildings, the government still laments at the lack of a vibrant Bumiputera entrepreneurial class—a class that can venture out without political crutches.23 There is, however, a vibrant class of Bumiputera salaried managers and corporate entrepreneurs (accountants and lawyers) who are involved in acquiring and turning around companies, aided by employment policies and activities of trust agencies such as PERNAS and PNB.24 We provide six observations on the entrepreneurial issue. First, as noted in the recent exhortations by the government, which have aimed at inculcating a modem work ethic, entrepreneurial development must ultimately grapple with the new culture of self−reliance, productivity, and risk taking. Second, despite the existence of a Bumiputera managerial class, it has not learned from the bottom up, a process that builds up management and industrial skills along the way. While this is a concern, ways of broadening the skills of this class can only be done through market incentives and job rotation. Third, separate support of entrepreneurial activities by ethnic groups has not been very successful. Recent efforts at increasing the cadre of Bumiputera entrepreneurs have included the establishment of joint ventures between Bumiputeras and non−Bumiputeras, and also between previously successful and new Bumiputeras. Fourth, the government has realized that ultimately it is training and education that will make the difference and the New Entrepreneurs Fund was set up in 1989 in the hope of attracting new (and educated) entrepreneurs into the market.25 Fifth, very little is known about the effect of entrepreneurial training apart from the fact that between 10 and 20 percent of those who receive training actually start businesses. Of these, fewer still succeed. General management training appears to make a difference, particularly with those who do have higher education levels or who have had formal sector experience (ADB 1990). Finally, it must be realized that entrepreneurs are a special breed who are willing to take risks and are creative; financial assistance alone is not sufficient for their success. More generally, entrepreneurship is a matter of skills, not cultural inheritance. Education and effective training promote it. In the next section we provide an analysis of the Malaysian experience of broadening the industrial base through interfirm linkages (subcontracting).

B. Support Institutions

43

Industrial Structures and the Development of Small and Medium Enterprise Linkages IV— Deepening of the Industrial Structure A. Interfirm Linkage Development

Several factors have influenced the development of interfirm linkages within the Malaysian context: (a) acquiring of ownership of non−Bumiputera and foreign companies by Bumiputera trust agencies such as PERNAS, PNB (National Equity Corporation), MARA, and UDA; (b) franchising of well−known products (especially in the food subsector); (c) market arrangements

involving buyer−supplier relationships between MNEs and local suppliers; and (d) fostering of interfirm linkages by the government since 1986. This section will discuss the latter two developments.26 Direct vertical back−end linkages (buyer induced) have been the more prevalent form of interfirm linkage in Malaysia. Table 2.5: Reasons for Not Offering Subcontracting to Small Firms Reasons

Larg e firms (71)

Joint ventures (56)

Delay in delivery

2.8

n.a.

Lack of quality

16.9

18.5

Shortage of qualified small firms

2.8

11.1

Instability in management of the small firms

2.8

3.7

Sufficient self−production capacity

25.4

n.a.

Others

8.5

33.3

Total

100.0

100.0

n.a. Not applicable. Source: Fong (1990). The University of Malaya survey on SMEs in 1986 revealed that about 14 percent of the 167 firms surveyed had fostered some kind of linkage with other large and foreign joint−venture firms in terms of subcontracting and business transactions (Fong 1990). The survey indicated that the main problem faced by SMEs in terms of subcontracting was the poor quality of their products (table 2.5). By the early 1990s, more local firms were involved in subcontracting for internationally renowned brand names in the electronics and electrical consumer products and the garments subsectors.27 A study conducted by Rasiah (1990) indicated that domestic sourcing in electronics and electrical machinery production increased in the 1980s. Electrical, consumer electronics and computer peripheral MNEs in the sample reported that they sourced between 10 and 70 percent of their inputs domestically. However, between 5 and 40 percent of these requirements are supplied either by their own subsidiaries or other foreign subsidiaries in Malaysia. As for semiconductor and telecommunications components, domestic sourcing has increased from 0.5 to 2 percent in the early 1970s to between 6 and 20 percent in 1990. Between 3 to 10 percent of these items (lead frames, machinery, and so forth) were supplied by their own subsidiaries or foreign firms operating in free trade zones and licensed manufacturing warehouses (LMWs).

IV— Deepening of the Industrial Structure

44

Industrial Structures and the Development of Small and Medium Enterprise Linkages As fabricated wafers and, to a lesser extent, lead frames were the chief inputs used, domestic sourcing by semiconductor firms may not grow very much unless greater efforts are made to draw these stages of production into Malaysia. Foreign firms are unlikely to purchase fabricated wafers from other firms. This is because wafer fabrication is the main technological element that distinguishes semiconductor producers. There is, however, a recent trend in the manufacturing of some "front−end" wafer fabrication in the country.28 The rising trend in domestic sourcing offers considerable opportunity for local firms,

especially the small− and medium−scale ones, to strengthen linkages with electronics and electrical transnationals. Indeed, sales of the local firms linked to electronics and electrical firms in Rasiah's survey almost doubled every year since 1985. The largest sales recorded by one firm rose from M$4.5 million in 1987 to M$17.5 million in 1990 (at 1985 prices). The items sourced include tool and die mould making, metal stamping, plastic injection molding, electroplating/surface finishing, printed circuit board (PCB) manufacturing, packaging and printing, prototyping/automation equipment, engineering plastics, and application software (Wong 1991). There are several cases of SMEs (such as Eng Hardware in Penang—see box 2.3) that started off as small ''backyard" enterprises before growing to become key supporting industries, especially to the semiconductor industry, spawning new companies, which have become their subcontractors in turn (Lim 1992). Box 2.3: The Rapid Rise of ENG In 1974, physician Teh Ah Ba set up ENG hardware engineering with only M$500 ($200). Nearly 20 years later, ENG now finds itself listed on the Kuala Lumpur Stock Exchange with a market capitalization of roughly M$120 million. ENG represents a typical local company in Malaysia that has thrived in the wake of the multinationals found throughout the country. In the early 1970s, multinational semiconductor producers began arriving in Malaysia, thus providing a market for local producers of necessary materials. With strong government encouragement, ENG started out by servicing the multinationals' needs for engineered spares and parts. Quickly it developed into a vendor to the semiconductor industry, with a concentration on robotic automated systems, as well as high−tech strong carbine tooling and machining. In the mid−1980s, 30 percent of ENG s sales revenue was coming from direct exports to Korea, Singapore, Thailand, and the United States. ENG then, moved into disk drive production, stating that "a move from jobbing to manufacturing was necessary. Since its initial entry into the disk drive market with Maxtor (an American disk drive producer), ENG has gone on to become Malaysia's largest producer of E blocks for disk drives and is now one of the top ten suppliers to the world s multinational disk drive manufacturers. ENG s growth in the last five years has been remarkable. Turnover of M$6.035 million in 1988 reached M$17.736 million in 1992. ENG also retains a "pioneer" status with the Malaysian government, which exempts the company from corporate tax. ENG went public for two main reasons. First, as a capital−intensive industry, it was necessary to acquire investment capital in order to develop as a local equivalent of a multinational. Second, as a Chinese−owned company, it was politically prudent for ENG to structure the company to ensure that some of its profits are distributed among the local Malays.

IV— Deepening of the Industrial Structure

45

Industrial Structures and the Development of Small and Medium Enterprise Linkages At present, ENG is contending with a labor shortage, which has required a renewed commitment to training. ENG recruits twenty graduates a year as apprentice technicians and then offers long−term contracts as a way of retaining staff. ENG, although it has been primarily a vendor to the electronics industry, is planning to branch out into the aerospace, automotive, and telecommunications industries. ENG has been increasing its involvement in initiating the development of products for its customers, and has long−term goals of attracting more professionals so that it can move into the higher technology end of the market. Source: The Financial Times (1993). The best example of subcontracting in Malaysia by the private sector is the case of Intel (Malaysia). Another example is the Proton car vendor development scheme for Bumiputeras. These, the "umbrella" subcontracting schemes, and the policy initiatives on subcontracting are discussed below.

B. The Case of Intel (Malaysia): Private Sector Initiative

Intel (Malaysia), a subsidiary of Intel (United States), was established as an offshore plant in the Penang free trade zone in the early 1970s. The company's operation has steadily increased over the years and is now the major production platform for the company's leading microprocessor chips. The capability of the plant has advanced from simple labor−intensive assembly operations to highly automated processes, and the plant has expanded its operations to cover testing, marketing, and technical support (Wong 1991). The company realized that in order to develop greater linkages between LEs and SMEs, it would have to assist SMEs all the way. First, a staff cooperative (Shinca) was established to invest in a company to provide subcontracting services (largely assembly) to the consumer electronics MNEs in Penang.29 Second, Intel also encouraged its engineers to set up their own subcontracting businesses. Third, a supplier partnership program was established to develop long−term relationships with suppliers.30 In all cases, subcontractors had the benefit of receiving management technology transfer from Intel, and it appears that this has been a key factor in their success. In the case of the company spawned by Intel, Shinca, Intel personnel are seconded to run the operations. Intel also targets its key managers/engineers who have the technical know−how and backs them to break out on their own. These new entrepreneurs thus have the benefit, not only of industrial experience, but also the management know−how for the business. Likewise, in its sourcing for local supplies/inputs, Intel's policy has been to target a few reliable suppliers and continuously help them upgrade their quality to meet international standards. Clearly, the attitude of top management in Intel was instrumental in making its collaborative ventures a success. C. The Case of the Malaysian Car: Proton Vendor Development Scheme31

To increase the local content of the Malaysian automotive (assembly) industry, established in 1967, the government introduced the Mandatory Deletion Program for passenger cars and commercial vehicles in 1980. Over thirty components were localized under this program. However, the proliferation of models and makes of cars resulted in a small and fragmented volume of production of each model, preventing mass production of parts. As a means of rationalizing the automotive assembly and parts industry, the Heavy Industries Corporation of Malaysia (HICOM), the Mitsubishi Motors Corporation, and the Mitsubishi Corporation of Japan established a national car company, Proton, in 1982 and commenced production in 1985. The appreciation of the yen and the desire to meet the Generalized System of Preferences' (GSP) local content requirement for the export market led to a concerted effort by Proton to develop the components industry through the attraction of foreign car component makers (such as Robert Bosch) and the development of local vendors. B. The Case of Intel (Malaysia): Private Sector Initiative

46

Industrial Structures and the Development of Small and Medium Enterprise Linkages About 115 vendors were supplying components to Proton in 1992, 52 of them SMEs, involved in the production of small plastic injection and metal stamped parts. The local content of Proton increased steadily over the years from about 18 percent, or 14 component parts, since its inception in 1985, to 40 percent in 1987. By 1989, its local content had risen to 70 percent, well in excess of the 60 percent required for export under the GSP to the

United Kingdom. About 15 percent of Proton's production has been exported. Table 2.6 shows the local content items achieved by Proton. During 1989 it localized 190 parts, in addition to 174 new components stamped in−house. Of the 190 parts, 57 were from plastic and rubber, 39 from metal, and 46 from electrical sectors. Proton prefers single sourcing of suppliers located within 100 miles of the Proton plant to meet just−in−time (JIT) production requirements. The criteria for selection of local vendors include Bumiputera participation, commitment to quality improvement, long−term commitment to grow with and support the company, and a willingness to continuously invest profits in technological upgrading (Hussain 1992). Table 2.6: Local Content Items Achieved by Proton Local content items

1985

1986

1987

1988

1989

Total

In−house stamped parts for body shell

176

47

14

108

174

519

Plastic and rubber

10

23

7

10

57

107

Metal

5

4

29

7

39

84

Electrical

9

16

10

2

46

83

Others

28

7

13

—

48

96

— Not available. Source: Proton. In implementing its local vendor program, Proton encountered a number of problems and has sought to overcome them in the following ways: Low level of technology in Malaysia, compared to the demands of the modem automotive industry. Proton's own research and development department assists subcontractors in raising their level of technology and, in some cases, training is arranged in Japan through Proton's private sector shareholder, Mitsubishi Motor Corporation. Low quality and a poor appreciation of the need for quality improvement. Most smaller manufacturers do not own testing equipment, and there is only one fully equipped public testing facility in the country (at SIRIM, although the universities will also do some kinds of testing for private clients). Proton subjects its suppliers to rigorous testing and rejects those which fail to meet specifications. However, their policy is to identify problems and help suppliers to improve their performance, rather than to penalize them; no supply contract has yet been terminated. Little research and development effort and a tendency to do things according to experience and "feel." A symptom of this is a general failure to make things from drawings. Proton uses its own research and development facilities and seeks to educate its suppliers to introduce more formal methods and to look for ways to improve their practices and their products.

B. The Case of Intel (Malaysia): Private Sector Initiative

47

Industrial Structures and the Development of Small and Medium Enterprise Linkages Undercapitalization with respect to both fixed capital investment and working capital. A fund has been set up by the Ministry of International Trade and Industry (MITI) to help Bumiputera suppliers

to Proton, from which several million Ringgit have been disbursed, so far, for the development of new components for Proton's new model. Commercial banks tend to respond favorably to loan or overdraft requests that are backed up by orders from Proton. Raw materials present two kinds of problems. First, the automotive industry (and other industries making high−tech products) requires materials with very precise specifications (for example, specialized steel and plastics and heat−resistant synthetic rubbers). These are not widely available, especially outside the Klang Valley. Second, when they are available, suppliers are often unwilling to sell in the small quantities that may be required by a subcontractor making a specialized part. Imprecise pricing by subcontractors, who tend to either underestimate overheads or set prices arbitrarily with a very high margin. Proton makes its own cost analysis as a basis for negotiations with suppliers and encourages them to undertake detailed costing exercises. D. The Case of "Umbrella" Subcontracting Schemes

The "umbrella" concept, in the Malaysian context, is a means for linking small SMEs to large marketing intermediaries. The umbrella company possesses the necessary financial resources and expertise to assist the SMEs in areas such as production, design, quality control, and marketing. The umbrella company coordinates production and marketing of these SMEs, enabling them to produce at the right quality and quantity, and making the products available to the market at the right time. Two umbrella companies that are presently providing services to SMEs are Guthrie Furniture Sdn. Bhd. and Besta Distributors Sdn. Bhd. Guthrie Furniture Sdn. Bhd.'s umbrella concept allows medium−sized Bumiputera firms to participate in government supply contracts. Guthrie acts as a marketing agent in return for a 5 percent commission; the government supports the scheme by giving Guthrie contracts without competitive tendering. Guthrie's services to its sevety−two subcontractors include product design and specifications, negotiations with customers, quality management and upgrading (with the assistance of FRIM and SIRIM), credit assistance, raw material supply on credit, and training. Efforts have been made to subcontract widely throughout Peninsular Malaysia. But there is a strong west coast orientation. In 1991, Guthrie entered the export market with plans to build a M$5 million finishing plant around Port Klang. Domestically the company reached out beyond the public sector, where it had been protected from competition, into the corporate/hotel market. When the umbrella concept is firmly established in the furniture industry, it is likely to be extended by Guthrie to other products in the food, plastics, electronics, automotive, and computer sectors. Besta, a subsidiary of the Development Bank of Malaysia, buys food products from contracted manufacturers, many of them in rural areas, and markets them under its own brand name. Besta's products are largely high volume items, for which production technology is relatively simple, and for which they enjoy a ready domestic market (for example, beehoon, chili sauce, tomato sauce, curry powder, and so on). The Besta brand competes against many

others in a market where product differentiation is minimal. Annual sales for the company exceed M$15 million. There is a government subsidy in the form of television advertising for these products.

D. The Case of "Umbrella" Subcontracting Schemes

48

Industrial Structures and the Development of Small and Medium Enterprise Linkages E. Policy Initiatives on Subcontracting

Apart from the preference in government procurement and the advertising subsidy, the government established a Subcontracting Exchange Scheme (SCX), within the Ministry of International Trade and Industry, to support subcontracting arrangements. In addition, the private sector operates its own registry for subcontracting.32 The SCX was established in September 1986, following recommendations by the Industrial Master Plan to promote the growth of local supporting industries by facilitating their linkages with large−scale manufacturers. The SCX is a computerized clearinghouse, linking component−producing companies with component−using ones. The SCX provides a link between the buyers' requirements and the vendors' capacity to supply. Companies that register with the SCX are expected to provide detailed information on their products and production capacities. The services of SCX are provided free of charge. Under the SCX, large enterprises can be awarded a 5 percent Abatement of Adjusted Income (AAI) for purchasing components from SEs under a registered government program. The abatement is calculated at either 5 percent of the total amount purchased or 5 percent of the adjusted income, whichever is lower. For the year 1991, two companies, an electric products company and an automotive components manufacturer, were given the incentive. Based on data from the SCX in 1990, 2,289 firms were registered for subcontracting work. Because of the government's emphasis on the development of engineering subcontracting networks, most of the firms registered at the SCX are engineering firms. Other subsectors emphasized are automotive, electrical, electronics, rubber, and plastics. Light engineering is the most subscribed subsector at 65 percent, followed by rubber (8 percent), electrical (6 percent), electronics (4 percent), and plastics (4 percent). By 1991, however, the actual linkage established through SCX was negligible; only eighteen firms had made inquiries about subcontracting through the Exchange. The main difficulties encountered in the implementation of the SCX scheme include: (a) limited number of SMEs with production capabilities that meet international standards, particularly with regard to quality standards and reliability in meeting delivery schedules; (b) higher than international prices quoted by SME producers due to the lack of scale economies and the high cost of imported materials; (c) inaccurate information fed by SMEs into the database on the capabilities, specialization, and production facilities, resulting in inaccurate selection of vendors; and (d) slow development of component sourcing by MNEs. In the next section, we provide the main lessons of deepening the industrial base through interfirm linkages. V— Lessons of Deepening the Industrial Base The emphasis on industrial deepening started during the heavy industries strategy in the early 1980s with establishment of the Heavy Industries

Corporation of Malaysia (HICOM), but the interest in interfirm linkages, the concern of this chapter, began only in the mid−1980s. Inter firm linkage, that is, subcontracting, has taken root in the industrial sector, particularly since the policy reforms of 1986 in a number of subsectors such as electronics and telecommunications, packaging and printing, engineering plastics and low−entry barrier subsectors such as furniture and food. Although the subcontracting practice is an emerging one, we make four observations about the experience to date. First, while there are fewer cases of supplier−induced subcontracting, most of the cases are buyer−induced. In the Malaysian case there has been a need for an active push by buyers to create subcontracting arrangements; the positive attitude by top management of the MNEs (such as Intel and Matsushita) has been important in this regard. Second, the key element that forces subcontracting between the buyer and supplier firms is the technological capability of the supplier firm in terms of meeting quality and delivery standards. This can be progressively increased by augmenting the absorptive capabilities of SMEs, that is, the technological learning capacity of the firm, which is largely a function of human resource capabilities and the willingness by supplier E. Policy Initiatives on Subcontracting

49

Industrial Structures and the Development of Small and Medium Enterprise Linkages firms to invest in technological upgrading. Third, explicit policies to encourage subcontracting have thus far only played a small role. The incentives for subcontracting, product development, export, training, and research and development (discussed below) have only been recently introduced; and government procurement and the SCX have had only marginal impacts. Fourth, general policies, in contrast, have played a far more important role in creating the environment for subcontracting. The policies affecting foreign investment, licensing, exchange rate management, and skills development have, in combination with the capital surpluses and currency appreciation of the East Asian economies, attracted a new wave of ancillary and support industries to be set up in the country.33 VI— Concluding Remarks While the first and second phases of Malaysia's development saw the promotion of SMEs, the need to increase their capabilities for subcontracting became an important concern during the third phase. Five new policy initiatives begun during this phase are discussed below. Incentive for private sector training. To stimulate private sector training, especially to support the introduction of new technology or new products, a double deduction incentive scheme was introduced in 1987. To obtain this incentive, manufacturing firms are required to demonstrate that their training programs are necessary to upgrade skills to manufacture products or to improve manufacturing processes that support the adoption of new technology. This double deduction scheme has targeted critical areas for support, such as upgrading craft skills, training foremen and supervisors, and providing training in advanced technical skills for professionals, engineers, and technicians. The Human Resources Development Fund. This fund, set up in 1992 and funded by the private sector, also aims at encouraging industrial training.

Cabinet Committee on Training. Realizing the importance of skills training in a national context, a Cabinet Committee on Training was formed in 1991 and has recommended the following policies: (a) improving the responsiveness of public training institutes to market demand; (b) expanding the role of the private sector in training; and (c) strengthening the linkages between training and technological change (Government of Malaysia 1991a). Many of the training institutions are to be corporatized, and a number of specialist training centers are also to be established (a construction academy, foundry centers, a textile and fashion design center, and a wood based training center). Industrial Technical Assistance Fund (ITAF). In 1990 the ITAF was established to encourage SMEs to upgrade and modernize their operations. It provides a subsidy in the form of a matching grant in four areas: product development; quality improvement; feasibility studies; and marketing. The ITAF is available to manufacturing firms that have at least 70 percent equity held by Malaysians, and a shareholders' value of under M$2.5 million. The scheme, administered by the Ministry of Trade and Industry, is managed by specialized agencies. It provides for the use of consultants in improving the production and marketing capabilities of SMEs. As of 1992, 100 applications had been approved, out of 231 applicants, with a total project cost reaching M$4.5 million (Kassim 1992). Tables 2.7 and 2.8 provide the breakdown of the grants approved. Infrastructure and Cluster Creation. Infrastructure provision for industrial development has generally concentrated on the larger export−oriented enterprises. Similar initiatives for SMEs, largely neglected in the past, have only recently become a concern. The role of MIEL and the state governments are key in this regard to further facilitate the relocation of SMEs. The relocation and the creation of foundry and engineering parks near urban centers and larger industrial estates would strengthen the formation of clusters needed for agglomeration and interfirm linkages.

VI— Concluding Remarks

50

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Table 2.7: Industrial Technical Assistance Fund, 1992 Type of scheme

Applications approved

Grant approved

Feasibility study

18

M$

Product development

42

2,683,000

Quality and productivity improvement scheme

28

1,605,150

Market development

12

160,871

Total

100

M$

116,500

4,565,521

Source: SIRIM.

Table 2.8: Industrial Technical Assistance Fund, 1992 Industry

Number of firms

Chemical and pharmaceutical

7

Plastic

10

Textile

8

Iron and steel

17

Food

9

Wood

7

Rubber

6

Electrical and electronic

16

Automotive

14

Nonferrous metal

6

Total

100

Source: SIRIM. Despite the above, we conclude this chapter with four challenges for the Malaysian economy as a whole and the development of SMEs in particular. First is the need to restructure the education and training system to meet the needs of a modern society. As we have noted elsewhere (Salleh and Meyanathan 1993), Malaysia has been spending more on education than other countries in the region and getting progressively less out of it. While we recognize that this will not be easy in a plural society, a sound educational structure and system is crucial for Malaysia's next transition. Second, the general policies affecting trade, investment, and macroeconomic management that were put into place in 1986 should be pursued fully. Third, while a proper balance of foreign and domestic enterprises is needed, the emerging schism between foreign and domestic enterprises should be resolved through strategic alliances that would benefit both concerns. Fourth, the collection problems faced by MARA and Bank Bumiputera demonstrate the need to delink the association between politics and finance progressively within the Malaysian context.

VI— Concluding Remarks

51

Industrial Structures and the Development of Small and Medium Enterprise Linkages Appendix 2.1 Malaysia Distribution of Firms by Size of Employment and by Industry, 1981 Employment < 20

Employment 20−49

Employment 50−90

Industry

No. of firms V/A share

No. of firms

V/A share

No. of firms V/A share

Food products

2,578 (80.6) 6.9

328 (9.3)

8.4

119 (3.7)

14.0

Beverages and tobacco

116 (39.2)

0.9

98 (33.1)

2.1

37 (19.2)

4.2

Textile

2,123 (35.3) 8.0

192 (7.7)

7.2

67 (2.7)

5.9

Wood products

2,097 (73.9) 11.6

384 (13.5)

16.5

204 (7.2)

23.1

Paper and pulp printing and publishing

638 (66.0)

10.1

203 (21.0)

15.4

73 (7.6)

16.4

Chemical products

718 (65.4)

8.6

213 (19.4)

12.6

84 (7.6)

15.7

Petroleum products

6 (40.0)

0.1

6 (40.0)

1.0

1 (6.7)

0.0

Rubber products

334 (61.1)

2.4

67 (12.2)

6.3

61 (11.2)

18.1

Non−metallic

467 (60.1)

4.9

191 (24.6)

11.7

67 (8.6)

9.5

Base metal

316 (74.9)

10.0

61 (14.4)

10.1

18 (4.3)

9.2

Fabricated metal

2,080 (86.9) 21.8

183 (7.7)

15.8

80 (3.3)

16.3

Machinery

1,190 (82.4) 25.1

193 (13.3)

24.0

35 (2.4)

9.6

Electrical/electronic 123 (39.4)

0.7

57 (18.3)

1.8

36 (11.3)

3.3

Transport equipment

224 (66.7)

4.9

55 (16.4)

4.9

25 (7.4)

2.1

Other manufacturing

540 (83.5)

10.8

52 (8.0)

5.3

25 (3.9)

12.7

6.9

2,28 (12.9) 8.7

952 (5.3)

10.9

Employment 100−199

Employment 200+

Total

Industry

No. of firms V/A share

No. of firms

V/A share

No. of firms V/A share

Food products

117 (3.6)

23.8

56 (1.8)

46.9

3,198 (100) 100

Beverages and tobacco

32 (12.1)

2.7

13 (4.4)

90.1

296 (100)

Textiles

38 (1.5)

3.4

70 (2.8)

75.5

2,490 (100) 100

Wood products

99 (3.5)

18.0

53 (1.9)

30.8

2,837 (100) 100

Paper and pulp printing and

25 (2.6)

9.2

27 (2.8)

48.9

966 (100)

Total manufacturing 13,550 (76.2)

Appendix 2.1

100

100

52

Industrial Structures and the Development of Small and Medium Enterprise Linkages publishing Chemical products

60 (5.5)

21.9

23 (2.1)

41.2

1,098 (100) 100

Petroleum products

1 (6.7)

0.0

1 (6.7)

98.9

15 (100)

100

Rubber products

48 (8.8)

21.9

37 (6.7)

51.3

547 (100)

100

Non−metallic

28 (3.6)

13.4

24 (3.1)

60.5

777 (100)

100

Base metal

18 (4.3)

3.6

9 (2.1)

67.1

422 (100)

100

Fabricated metal

41 (1.7)

9.4

10 (0.4)

36.7

2,394 (100) 100

Machinery

17 (1.2)

11.1

10 (0.7)

30.2

1,445 (100) 100

Electrical/electronic 28 (9.0)

4.5

68 (21.8)

89.5

312 (100)

100

Transport equipment

13 (3.9)

8.1

19 (5.6)

80.0

336 (100)

100

Other manufacturing

10 (1.5)

0.0

20 (3.1)

71.2

647 (100)

100

12.2

437 (2.5)

61.3

1,778 (100) 100

Total manufacturing 555 (3.1)

Source: Government of Malaysia (1981). Appendix 2.2 Principal Statistics of Manufacturing Industries by Employment Size Group, Selected Years (percentage) Employment size group

Number of Gross establishment value of output

Value added

Total employment

and wages paid

Salaries Fixed assets

66.11

12.51

11.97

17.44

14.19

11.23

50−99

16.48

13.72

13.96

13.71

13.01

13.79

100−199

9.06

20.90

17.82

14.65

15.33

17.88

200−499

5.84

27.92

27.80

20.92

22.75

26.73

500 +

2.51

24.94

28.46

33.28

34.72

30.37

64.80

9.05

9.50

16.18

13.09

7.92

1979 SSEs below 49 MSEs

LEs

1984 SSEs below 49 MSEs

Appendix 2.2

53

Industrial Structures and the Development of Small and Medium Enterprise Linkages 50−99

16.96

12.78

10.60

14.50

13.15

9.85

100−199

10.41

21.22

16.27

17.17

16.95

16.16

200−499

5.30

23.65

20.19

19.85

20.35

20.36

500 +

2.53

33.31

43.44

32.30

36.46

45.71

58.80

9.81

7.07

11.66

9.36

6.30

50−99

17.17

11.80

9.99

11.75

11.71

9.02

100−199

13.58

22.66

18.08

18.02

17.94

14.86

200−499

6.92

22.98

24.50

20.05

21.01

29.30

500 +

3.53

32.74

40.36

38.51

39.98

40.52

LEs

1988 SSEs below 49 MSEs

LEs

Source: Government of Malaysia (1984a, 1988). Appendix 2.3 Principal Statistics of Manufacturing Industries by Employment Size Group, 1979, 1988 Employment size group

Employment Value per added establishment per worker

Wages per worker

Fixed assets per worker

Value added per fixed asset

Wages per value added

Employment value added elasticity 1979−84

Total

84

16,129

4.032

14,292

1.13

0.25

0.23

22

11,068

3,281

9,200

1.20

0.30

0.24

50−99

70

16,430

3,825

14,380

1.14

0.23

0.68

100−199

136

19,614

4,219

17,440

1.12

0.22

0.60

200−499

301

21,428

4,384

18,258

1.17

0.20

0.41

500 +

1,113

13,792

4,207

13,044

1.06

0.30

0.09

Employment size group

Employment Value per added establishment per

Wages per worker

Fixed assets per

Value added per

Wages per value

Employment value added elasticity

1979 SSEs below 49 MSEs

LEs

Appendix 2.3

54

Industrial Structures and the Development of Small and Medium Enterprise Linkages worker Total

worker

fixed asset

added

1984−88

103.52

27,162

7,394

41,351

0.66

0.27

0.62

20.53

16,455

5,935

22,353

0.74

0.36

7.98

50−99

70.86

23,091

7,365

31,721

0.73

0.32

−0.11

100−199

137.38

27,257

7,361

34,104

0.80

0.27

0.55

200−499

300.06

33,189

7,749

60,425

0.55

0.23

0.35

500 +

1,130

28,465

7,675

43,504

0.65

0.27

1.89

1988 SSEs below 49 MSEs

LEs

Source: Government of Malaysia (1984a, 1988). Appendix 2.4 Profile of Small Entrepreneurs, 1985 Characteristics

Number

Percentage

Yes

144

86.2

No

23

13.8

Realize business potential and 24 want self−actualization

74.3

Acquaintance with business partner and advice

31

18.6

Inheritance

18

10.8

Others

5

3.0

< 5 years

33

19.8

> 5 years

134

80.2

Tertiary education

19

11.4

Senior high school

21

42.5

Junior high school

50

29.9

Elementary school

21

12.6

Started own firm

Reason for starting own firms

Years of operation

Education level

Appendix 2.4

55

Industrial Structures and the Development of Small and Medium Enterprise Linkages No formal education

6

3.6

Started the business immediately after graduation/school

10

6.0

17

10.2

Merchant/trader

8

4.8

Owner of another firm

77

46.1

Employee from same firm

28

16.8

Employee from different industry

1

8.6

18−39

56

33.5

40−49

63

37.7

50−59

31

18.6

60 and above

17

10.2

Previous job experience

Current age

Source: Fong (1990). Appendix 2.5

Appendix 2.5

56

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Appendix 2.5

57

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Endnotes

1. The Industrial Master Plan, unveiled in 1986, was an indicative plan for the achievement of rapid manufacturing growth.

2. Recent studies of the Malaysian industrial structure show that concentration is high. The four−firm concentration ratio (CR4) showed that industries in Malaysia are highly oligopolistic in nature. About 30 percent of industries are controlled by four or fewer firms which supply at least 70 percent of total industrial output. Soap manufacturing, primary iron and steel manufacturing, and dyed fabric are highly concentrated industries. Those that are moderately concentrated include paints, varnishes, and cables. The industries with low concentration include plywood, biscuit, and rubber glove manufacturing (Government of Malaysia 1993).

3. The Industrial Census was carried out for the years 1959, 1968, and 1981. Conducted more frequently are the Industrial Surveys, which do not generally capture the smaller, cottage enterprises.

Endnotes

58

Industrial Structures and the Development of Small and Medium Enterprise Linkages 4. The term Bumiputera denotes ethnic Malays of Muslim religion and indigenous people of East and West Malaysia.

5. The incentive is in the form of a 15 percent investment tax allowance for enterprises located in promoted areas.

6. The New Entrepreneurs Fund, or Tabung Usahawan Baru (TUB), was launched in December 1989 to help small and medium Bumiputera enterprises. Loans under the scheme were funded by the Central Bank at a concessionary rate of 5 percent. The original fund of M$250 million was increased to M$350 million in 1990, and the maximum loan for each borrower was M$1 million. Participating banks could obtain the Credit Guarantee Corporation's guarantee of up to 50 percent of the unsecured NIF loans.

7. The survey was conducted on 167 enterprises in the country.

8. By the late 1980s, MARA also began extending loans for fixed assets and working capital. Loans to the manufacturing sector had risen to about 60 percent of total loans by 1990 (Salleh and Rahim 1992). In early 1993, the new MARA Council was faced with the daunting task of collecting M$945 million of unpaid business and study loans (New Straits Times, May 31, 1993).

9. These schemes were formulated along the principles adopted by the Credit Guarantee System in India (Mohd. Isa 1992).

10. The new PGS, however, does not include the Hawkers and Petty Traders Loan Scheme, which continued to operate under its own terms and conditions. This scheme sought the involvement of business associations to market the scheme.

11. Other sectors were included at various stages, such as the manufacturing sector, agriculture, fishing, forestry, and so forth.

12. Bank Bumiputera Malaysia and Malayan Banking Berhad.

13. The eligible amount of preshipment facility is 80 percent of the value of the export order or 70 percent of the value of exports for the preceding 12 months. For the postshipment facility, the eligible amount of financing is 100 percent of the invoice value.

14. At the MARA Institute of Technology.

15. This module incorporates topics such as small business management, production management, bookkeeping, financial management, costing, credit control, distribution and retailing, price setting, marketing strategy, salesmanship, taxation, cash control, and business communication.

Endnotes

59

Industrial Structures and the Development of Small and Medium Enterprise Linkages 16. MARA vocational schools are known as Pusat Giat MARA. In addition, school−based technical and vocational education is provided by the Ministry of Education.

17. There are a few agencies with regional branches, such as SIRIM, MARA, and the Development Bank of Malaysia (DBM).

18. Usually the authority held majority shareholding but sometimes agreed to 30 percent. The UDA was also involved in comprehensive urban renewal, acquiring land in strategic locations for future development (Gale 1981).

19. The UDA also faces the problem of Bumiputeras selling premises to non−Bumiputeras for quick profits. The agency was brought into greater control by central planners through the Ministry of Public Enterprises in the late 1970s.

20. Segamat, Johor, Kuda Ibai, Gong Badak, Kuala Terengganu, Jakar, and Kemaman.

21. Sometimes the finance constraint can be a symptom of deeper management problems.

22. See P. J. Jiménez, ''Credit for Microenterprises—The Informal Sector," mimeo February 1993.

23. A 10 percent price preference is given to Bumiputera suppliers.

24. Many Bumiputera enterprises fell into financial difficulties during the recession years in the mid−1980s; the government later set up a fund to help out the most viable of them.

25. Based on an ongoing study of emerging entrepreneurs by SIRIM, the breed of small entrepreneurs who are involved in the technology−based products (electronics and so forth) are usually professionals with college degrees in technical subjects. Many of them have worked for multinationals, or are the college−educated sons of trading families.

26. See Chee (1993) for details on franchising.

27. Subcontracting is also known to take place among local furniture makers and in the food industry.

28. In this stage, the circuitry of the integrated circuit is etch−printed onto a wafer of silicon.

29. Shinca currently operates from three sites—two in Penang and one in Jitra. Its customers include Bosch, Sony, Sanyo, Acer, and Action. It even Endnotes

60

Industrial Structures and the Development of Small and Medium Enterprise Linkages supplies components to LEs in Taiwan (China). With the success of its first cooperative, Intel is setting up another company to do subcontracting of computers and computer peripherals.

30. Under the program, the company provides subcontractors with profitable orders, rolling twelve−month forecasts, and technical assistance. In return, the company expects competitive pricing from suppliers, priority to the company's work orders, adherence to quality and delivery schedules, and a willingness to reinvest profit in technological upgrading to grow with the company.

31. Two other companies also involved in vendor development are Sharp (in electrical and electronics products) and Sapura (in telecommunications products).

32. The Federation of Malaysian Manufacturers operates a Registry of Sub−Contracting. About eighty companies are listed, and the Registry is updated on an annual basis. Its main function is to disseminate information regarding subcontracting possibilities. Dissemination is done both locally and in foreign countries.

33. Sixty−six percent of Taiwanese (Chinese) investors between 1989−90 in Penang were subcontractors (Lim 1992).

3— Singapore Soon Teck Wong While Singapore's industrialization process has largely been driven by direct foreign investment, notably from the large multinational enterprises (MNEs), small and medium enterprises (SMEs) have contributed significantly to this process, accounting for a large share of the economy (Lim Chong−Yah 1988). Chew (1988) examines the contribution of SMEs to the industrial development of Singapore and attempts to assess their role in the manufacturing sector. He observes that SMEs have flourished in the promising industries of the 1980s—electrical/electronic products, transport equipment, machinery, and fabricated metal products, and that SMEs have played an important role in the manufacturing sector in the late 1970s and early 1980s. He concludes that industrial complementarity among different sizes of firms is very strong, and that SMEs are expected to continue to play an important role in the Singapore economy. This chapter presents an analytical evaluation of the SME sector in Singapore and its place within the industrial structure of Singapore. Section I provides an overview of Singapore's changing economic structure as a result of its rapid industrialization during the last three decades. While it is shown that SMEs have a greater presence in the commerce and services sectors, section II reviews briefly the evolution and performance of SMEs in the manufacturing sector. This emphasis on the manufacturing sector is due to the desire to relate SME development to the industrial sector as well as the greater availability of data on establishments in the manufacturing sector. Section III reviews the efforts, policy measures, and initiatives undertaken by the Singapore government to promote SMEs. These measures and initiatives were consolidated under the SME Master Plan (or the Enterprise Development Plan) presented by the Economic Development Board (EDB) in 1989. The philosophy and thrusts of the SME Master Plan are discussed in the section. A summary of the SME Master Plan is provided in appendix 3.1. Section IV attempts an assessment of the vast array of incentives and assistance available to SMEs. Section V examines the Local Industry Upgrading Program (LIUP), which is designed as a "partnership" strategy to promote 3— Singapore

61

Industrial Structures and the Development of Small and Medium Enterprise Linkages back−end linkage from the large MNEs to the SMEs. An attempt is made to evaluate LIUP's effectiveness in the technological upgrading of SMEs. Section VI draws some lessons and implications from the Singapore experience. Section VII concludes with a discussion of the prospects and challenges facing the Singapore economy in general, and the SME sector in particular.

I— Industrial Structure and SMEs The transformation of the Singapore economy from a largely entrepôt−based economy to a newly industrializing economy (NIE) has been well documented. In the course of this transformation, the relative contribution of the manufacturing sector has increased substantially as may be seen from table 3.1, which also shows that the relative contribution of the financial and business services sector has increased significantly. The relative contribution of SMEs (defined in terms of equity and fixed assets) in the various sectors of the economy is shown in table 3.2.1 In 1987, SMEs constituted 90 percent of the total number of establishments, 44 percent of employment, 24 percent of value added, and 16 percent of direct exports. They have an overwhelming presence in the commerce sector. However, when compared to their foreign counterparts, that is, SMEs with foreign ownership, operating in Singapore, they lagged behind in productivity, management skills, marketing, and technology. In manufacturing, they were 23 percent less productive; in commerce, 68 percent; and in services, 72 percent. There is therefore an urgent need for SMEs to improve their performance. Table 3.1: Industrial Structure by Percentage of GDP, Selected Years Sector

1960

1970

1980

1990

Agriculture and fishing

3.5

2.3

1.3

0.3

Quarrying

0.3

0.3

0.3

0.1

Manufacturing

11.4

20.0

29.1

29.1

Utilities

2.3

2.6

2.2

2.0

Construction

3.4

6.8

6.4

5.6

Commerce

32.1

27.1

21.7

17.3

Transport and communications

13.3

10.6

14.0

13.1

Financial and business services

14.0

16.4

19.7

32.8

Other services

17.0

12.7

9.1

10.1

Less: imputed bank charge

1.5

1.9

5.6

11.4

Plus: import duties

4.3

3.0

1.7

1.0

Total

100.0

100.0

100.0

100.0

Source: Government of Singapore (1990).

I— Industrial Structure and SMEs

62

Industrial Structures and the Development of Small and Medium Enterprise Linkages Table 32: Relative Contribution of SMEs by Economic Sector, 1987 Sector

Value Establishments Employment added

Direct exports

Manufacturing

79.7

35.9

17.8

9.3

Commerce

93.9

64.4

46.9

33.5

Services

85.1

34.1

23.3

3.6

Percentage of total

90.0

44.0

24.4

15.9

Source: Adapted from SME Master Plan, EDB (1989).

Of the approximately 65,000 SMEs in Singapore, nearly 50,000, or more than 90 percent, are in the commerce and services sector. Thus, the presence of SMEs in the manufacturing sector is relatively modest. However, their contribution is significant without which Singapore's industrialization process would have been somewhat less impressive. For example, the presence of large MNEs in the disk drive industry depends on the availability of high quality ancillary supporting services that are provided by SMEs in the precision engineering industries. II— SMEs in the Manufacturing Sector Statistics on SMEs are collected in the annual Census of Industrial Production (CIP), which was conducted by the Department of Statistics from 1959 to 1987, when it was handed over to the EDB. Since the report of the CIP provides the principal manufacturing statistics only for establishments with five or more workers, we shall, in the first instance, consider those establishments with between five and fifty workers.2 For ease of exposition, we shall refer to such establishments as small and medium establishments. The number of small and medium establishments in the various groups for selected years during the last three decades are shown in table 3.3. In the 1960s, small establishments were found predominantly in the food manufacturing, textiles, apparel, footwear, and the printing and publishing industries. While these two industries (food manufacturing; textiles, apparel, footwear) continued to have a significant number of small establishments, the 1970s showed a dramatic increase in their number in the textiles, apparel and footwear industry, and machinery and fabricated metal products industries, a consequence of Singapore's success in attracting substantial amount of direct foreign investment, initially in labor−intensive industries. While the number of small establishments in these industries increased in the 1980s, substantial increases were experienced in plastic products, electrical and electronic products, and transport equipment. It may be inferred that with the successful attraction of MNEs to Singapore, new opportunities were made available for small, local businesses to be established to provide the ancillary support services and subcontracting work required by the MNEs. Although data pertaining to SMEs are not available in the Census of Industrial Production Report, the SME Master Plan (EDB 1989) does provide specific data on SMEs. SMEs in the manufacturing sector are usually small, with 75 percent employing fewer than ten workers (table 3.4). Performance data reproduced from the SME Master Plan (table 3.5) shows that SMEs in the manufacturing sector have performed reasonably well. In terms of net fixed assets per worker, investments by SMEs increased by an average of about 8 percent between 1980 and 1987, which compared favorably with the average of about 12 percent for the manufacturing sector. Value added per worker (or productivity) increased by an average of over 5 percent per year, while direct exports rose by 2 percent per year. Statistics published in the Census of Industrial Production allow us to analyze various characteristics of small II— SMEs in the Manufacturing Sector

63

Industrial Structures and the Development of Small and Medium Enterprise Linkages establishments (that is, those with less than ten workers). As 75 percent of SMEs in the manufacturing sector are small establishments, it is worth comparing their characteristics with those of larger establishments.

Table 3.3: Number of Small and Medium Establishments by Industry Groups, 1963−88 Industry

1963

1973

1983

1988

Food manufacturing

250

354

510

465

Textiles, apparel, footwear

181

606

1,012

838

Wood products (excluding furniture)

99

174

130

108

Furniture and fixtures

40

90

278

295

Paper products

39

71

93

75

Printing and publishing

141

246

435

451

Chemicals and chemical products

45

114

123

140

Petroleum and petroleum products

—

3

2

5

Rubber products

27

26

24

21

Plastic products

—

93

224

254

Non−metallic products

35

20

33

34

Basic metals

6

19

25

12

Fabricated metal products

132

277

556

568

Machinery

99

247

541

589

Electrical/electronic products

34

51

177

200

Transport equipment

106

102

316

229

Instrumentation equipment

—

18

31

31

Other manufacturing

85

188

256

269

All industry groups

1,319

2,699

4,766

4,584

— Not applicable. Source: Government of Singapore, Department of Statistics, various years. Table 3.4: SME Establishments by Size in the Manufacturing Sector Number of employees

Number of SMEs

Percentage of SMEs

Fewer than 10 workers

8,300

75

More than 10 workers

2,732

25

Total

11,032

100

II— SMEs in the Manufacturing Sector

64

Industrial Structures and the Development of Small and Medium Enterprise Linkages Source: Economic Development Board (1989). Table 3.6 shows that while small establishments account for 35.2 percent of the establishments in the manufacturing sector, they account for only 1.1 percent of the total value added and less than 1 percent of the output of the manufacturing sector. In terms of productivity, they are much less productive than the larger establishments. Value added per worker for small establishments is only about S$17,000 (US$10,400) when compared to about S$55,000 (US$33,700) for the larger establishments.3 Small establishments export only 4.0 percent of their output, which is very low compared to the 66.9 percent exported by the larger establishments.

Table 3.5: SME Performance in the Manufacturing Sector Economic variables

1980

1987

Average growth (%)

Number of establishments ('000)

2.7

2.7

0.2

Number of employees ('000)

114.5

99.1

−1.9

Value added (V/A) (S$ bn)

2.1

2.6

3.1

Direct exports (S$ bn)

2.5

2.8

1.7

Productivity (S$ '000)

18.3

25.7

5.8

Net fixed assets per worker (S$'000)

12.3

19.1

7.8

Source: Economic Development Board (1989). Table 3.6: Comparative Performance of Small and Larger Establishments in the Manufacturing Sector, 1988 Economic variables

Small establishments

Larger All establishments establishments

Establishments

1,970

3,624

5,594

Workers

11,176

324,713

335,889

Output (S$ mn)

524

56,470

56,994

Value added (V/A) (S$ mn)

193

17,918

18,111

Output per worker

46,886

173,908

V/A per worker

17,279

55,182

Direct export to output (percentage)

4

67

Source: Government of Singapore, Department of Statistics (1988). Table 3.7 shows that the industries with a substantial number of small establishments are food, textiles and wearing apparel, printing and publishing, fabricated metal products, and machinery. Of these five industries, the first two are highly labor intensive, low value added industries that the EDB wants to relocate to neighboring countries. Printing and publishing is an industry that has a high export potential. Fabricated metal products and machinery form an essential core group of supporting industries and are therefore encouraged and promoted actively by the EDB.

II— SMEs in the Manufacturing Sector

65

Industrial Structures and the Development of Small and Medium Enterprise Linkages

Table 3.7: Principal Statistics of Small Establishments Industry

Establishments Workers

Value added (S$ mn)

Value added per worker (S$)

Food

230

1,342

19.3

14,401.6

Beverage

5

32

05

16,343.8

Textiles

28

175

3.2

18,497.1

Wearing apparel

357

2,012

24.4

12,107.9

Leather

24

126

15

11,706.3

Footwear

70

366

4.4

12,082.0

Sawn timber and wood

37

208

4.3

20,726.0

Furniture

166

862

13.0

15,091.6

Paper products

18

102

1.4

14,058.8

Printing and publishing

183

1,046

20.9

20,017.2

Industrial chemicals

5

33

0.6

19,212.1

Paints, pharmeceuticals and other 31 chemicals

180

3.9

21,444.4

Petroleum products

4

23

0.3

15,173.9

Plastic products

43

233

4.3

18,270.4

Glass products

11

58

1.0

17,982.8

Structural cement

5

25

0.4

14,280.0

Non−metallic mineral products

15

92

2.0

21,543.5

Iron and non−ferrous metal

4

28

0.4

14,357.1

Fabricated metal products

244

1,377

25.7

18,651.4

Machinery except electrical

277

1,551

35.9

23,163.8

Electrical machinery

29

171

4.4

25,830.4

Electronic products and components

20

162

2.7

16,709.9

Transport equipment

72

407

9.4

23,132.7

Instrumentation equipment

8

49

1.0

20,816.3

Other manufacturing

84

516

7.9

15,337.2

Total

1,970

11,176

193.0

17,269.5

Source: Government of Singapore, Department of Statistics (1988).

II— SMEs in the Manufacturing Sector

66

Industrial Structures and the Development of Small and Medium Enterprise Linkages III— SME Promotion: Measures and Initiatives The first government assistance to SMEs took place in 1962 when the Light Industry Services (LIS) Unit of the EDB attempted to help small manufacturing establishments modernize and expand with funds provided by the United Nations Development Program (UNDP) for machinery and equipment. The US was fairly active in its assistance. In 1964, it received 522 requests for assistance. These included 241 requests for assistance in site location, 140 requests for loans for equipment and working capital, 109 requests for technological advice on machinery, process and plant layout, and 32 requests for marketing, accounting, and management services. In its 1968 annual report the EDB estimated that the assistance extended by the LIS was responsible for the creation of 1,000 jobs and of

an additional output of S$10 million (US$6.1 million). Despite this, the LIS ceased operations in 1973, and its functions were assumed by other units within the EDB. The Local Operations Section (LOS) within the Investment Services Division was established in 1973 with the objective of promoting the expansion, upgrading, and diversification of SMEs through various means, including the encouragement of joint ventures with foreign or local partners, which could provide higher levels of skills and technology or new markets, either in existing or new product lines. Thus, in establishing the LOS, the EDB recognized the need for SMEs to participate in joint ventures that could increase their access to financial resources, technology, markets, and management resources. Such an approach recognizes implicitly that SMEs generally face resource constraints in four major areas as follows: Insufficient financial resources or lack of capital; Insufficient demand for their products or services, that is, lack of access to markets; Insufficient skilled manpower; Insufficient management expertise. In recognition of the above, the Bureau for Joint Ventures was established in 1975 under the LOS to promote industrial joint ventures and to provide any necessary assistance in monitoring and expediting the implementation of joint venture projects. Several financial assistance schemes were also established in the 1970s. These included the following: The Capital Assistance Scheme (CAS), which was established in 1974 to provide equity capital and loan financing at attractive terms to assist SMEs in the setting up of high technology industries; The Investment Allowance Scheme (IAS), to enable firms with at least 30 percent local ownership to make tax deductions ranging from 10 to 50 percent of approved new fixed investments; The Product Development Assistance Scheme (PDAS), which provides grants of up to 50 percent of the direct development costs of a project. By far, the most significant financial assistance scheme was the Small Industries Finance Scheme (SIFS), which was established in 1976 by the EDB in collaboration with the Development Bank of Singapore (DBS). The objective of the SIFS was to encourage the further development and technical upgrading of the operations of SMEs. An applicant to the SIFS, together with the loan being applied for, should not have more than S$1 million III— SME Promotion: Measures and Initiatives

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Industrial Structures and the Development of Small and Medium Enterprise Linkages (US$0.6 million) in fixed productive assets, the latter being defined as factory buildings, machinery, equipment, and tools. Apart from these schemes, minimal government support was provided to SMEs, which grew in a haphazard manner in response to sheer market initiatives. With the growing significance of the electronics industry, the shortage of skilled craftsmen, particularly in precision engineering, and the inadequacy of the local supporting industries became major concerns. Such concerns led the EDB to initiate discussions with large MNEs to establish joint industrial training centers. These included the Tata−Government Training Center (TGTC), Rollei−Government Training Center (RGTC), and the Philips−Government Training Center (PGTC). Some of the more enterprising trainees from these centers were able to set up their

own firms to provide supporting services to the MNEs. Further, with the failure of Rollei in Germany and the closure of its Singapore subsidiary, some of the retrenched craftsmen in precision and instrumentation engineering set up their own businesses. Their subsequent successes laid the foundations for the high quality of the supporting services now available in Singapore. Thus, despite the absence at the time of a stated policy in developing SMEs, the joint training centers contributed to the establishment of SMEs that became successful and graduated out of the SME status. The onset of the 1985 economic recession, which resulted in a significantly large number of business failures, brought about strong expressions of concern for SMEs. To help local firms acquire capital resources through low interest loans and copartnerships, a S$100 million (US$61 million) Venture Capital Fund was set up by the EDB. Local firms that required venture capital investment would be able to obtain loans from the EDB at concessionary interest rates. The EDB itself would coinvest with Singapore partners in new technology firms, both in Singapore and overseas, and share the business risk involved in such ventures. Despite the varied efforts of the EDB in assisting SMEs, several complaints were raised during the 1985 economic recession that the EDB was too preoccupied with the large MNEs to care about the welfare of the SMEs. Partly in response to such complaints, but also in recognition of the importance of the SME sector, the EDB established the Small Enterprise Bureau (SEB) in January 1986 to act as a one−stop consultancy agency for SMEs. The SEB consisted of three departments: the General Assistance Department, the Loans and Grants Department, and the Planning and Coordination Department. The General Assistance Department provided general assistance to SMEs. The Loans and Grants Department provided advice on the types of loans that SMEs could arrange with banks, and on the types of grants available from the EDB. The Planning and Coordination Department coordinated the work of other government agencies such as the Singapore Institute of Standards and Industrial Research (SISIR), the Trade Development Board (TDB), the National Productivity Board (NPB), and the Skills Development Fund (SDF). SMEs would be able to obtain advice from the Bureau on the upgrading of their management skills and on technical matters. The SEB was to be supervised by the Committee on Small Enterprises Policy, which was formed in 1985. The committee, which comprised representatives from various ministries and statutory boards, was to coordinate government efforts to help SMEs (The Straits Times, January 25, 1986). Three groups of SMEs were targeted for assistance by the SEB: SMEs that exported their products and services, and those with the potential to do so; SMEs in the supporting services industries; Traditional businesses that could be upgraded and modernized.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages Recognizing the need to help SMEs to upgrade technologically, the SEB initiated the Local Industries Upgrading Program that basically involved the adoption by participating MNEs of SMEs, which are their subcontractors and suppliers. Grants would be provided to the MNEs for training the SMEs in areas such as management, quality control, production process, technology, and equipment. Up to 90 percent of the training costs incurred by the MNEs (which include workshops, training, consultancy services, and factory visits) would be reimbursed. SMEs would bear the balance of the training costs.

The EDB has also initiated joint schemes with the universities, the National Computer Board (NCB), and Telecommunications Authority of Singapore (Telecoms) to help SMEs. A Small Business Consultancy Unit has been set up by the National University of Singapore (NUS) under the auspices of the EDB. Management audit services from the School of Accountancy in the Nanyang Technological University (NTU) became available to SMEs at a highly subsidized fee. The NCB has launched a scheme, called the Small Enterprise Computerized Accounting Program (SECAP), to enable SMEs to computerize their accounting systems quickly and at low cost, with 70 percent of the cost of computerization paid by a grant from the EDB under the Small Industries Technical Assistance Scheme (SITAS). In 1987 the various schemes initiated earlier, as well as some new schemes, were brought together under an umbrella scheme, the Economic Development Assistance Scheme (EDAS), which would be allocated S$847 million (US$519 million) for the 1988−91 period (The Straits Times, February 11, 1987). The eight major schemes included under the EDAS, whose primary objective was the assistance of SMEs, are: The Small Industries Finance Scheme (SIFS); The Capital Assistance Scheme (CAS); The Product Development Assistance Scheme (PDAS); The Small Industries Technical Assistance Scheme (SITAS), which provides grants to enable SMEs to seek external expertise to upgrade their operations; The Venture Capital Scheme, which invests in venture fund and high technology projects to encourage the transfer of technology and to foster the local venture capital industry; The Initiatives in New Technology program (INTECH), which provides grants to both manufacturing and service sectors for the development of new capabilities and for selected training programs; The Robot Leasing Scheme (RLS), which provides soft loans for the acquisition of robots and other industrial automation equipment; The Business Development Scheme, which provides grants to SMEs to explore overseas marketing and technology tie−up opportunities. Three of these eight schemes have since been taken over by the SDF, that is, SITAS, INTECH, and RLS. Besides the EDB, several other government agencies also provide assistance to SMEs. These include the Singapore Institute of Standards and Industrial Research (SISIR), an autonomous technical and consultant agency of the EDB. Established in 1969, SISIR initially provided testing facilities for local firms. Since then, however, its activities have been extended to include quality management, standardization, improvement in the design of products and processes, and development of new products. Since 1986, SISIR has embarked on a new role of providing industrial research technology to SMEs. Further, to help SMEs improve their export performance, SISIR provides information on overseas technical requirements and helps SMEs to meet these requirements by III— SME Promotion: Measures and Initiatives

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Industrial Structures and the Development of Small and Medium Enterprise Linkages inspecting and testing their products. The National Productivity Board (NPB), which was established in 1972 to formulate and organize programs to improve work attitudes, productivity, and labor−management relations, has set up a Management Guidance Center in 1986

to help boost the performance and efficiency of small firms. SMEs receive advisory, diagnostic, and consultancy services in four ways: Diagnosis and review of management problems; Analysis of training requirements and training programs to solve efficiency problems; Planning schemes or mechanisms to help solve specific productivity problems; Assistance in making full use of the resources available from various government agencies and private consultants. The Skills Development Fund, as noted earlier, is responsible for various financial assistance schemes to help SMEs finance their training needs and to upgrade and modernize their operations. In addition to SITAS, RLS, and INTECH, in 1981 the SDF also introduced the Development Consultancy Scheme (DCS), which was designed to provide grants to SMEs in need of external assistance for short−term assignments in the areas of business operations, technical know−how, management, and manpower training. Despite the wide range of incentives and assistance provided to SMEs, there still was a general perception that insufficient attention had been given to the problems of SMEs. To address this perception, in 1987 the EDB initiated a multi−agency effort to draft a Master Plan for SME development. Under the umbrella of the SME Committee, the six government agencies that provide assistance to SMEs—the National Computer Board, National Productivity Board, SISIR, Singapore Tourist Promotion Board (STPB), Trade Development Board (TDB), and the EDB—examined the issues involved and considered the methods by which a vibrant and resilient local business sector could be developed. EDB also brought the private and public sectors together in a national forum. Seven work groups, comprising over 300 representatives from local businesses (mainly SMEs), chambers of commerce and industry and trade associations, financial institutions, tertiary institutions and government agencies, were formed. Over a period of five months, these work groups examined the development issues facing SMEs in the areas of finance, technology, business development, productivity, and human resource management. Their reports were presented on May 4, 1988, at the SME Development Plan Workshop. The workshop concluded with a consensus on the following: SMEs had a greater role to play in Singapore's future economic growth; Full collaboration between the private and public sectors was required to ensure success; The Economic Development Assistance Scheme was reviewed and found to be comprehensive and well−structured; The multi−agency network adopted by the EDB was endorsed; SMEs should take full advantage of the EDAS and other development assistance programs.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages However, the workshop also called for an intensification of promotion efforts, a strengthening of the academia−industry link, and the setting up of a task force to look into helping local chambers and associations expand their role. A major outcome of the workshop was the SME Master Plan, which integrated the developmental measures of all the relevant public and private sector organizations providing assistance to SMEs. Further, to remove the stigma

attached to the ''SME" label and to recognize the potential for SMEs to grow, the EDB's Small Enterprise Bureau was subsequently reorganized as the Enterprise Development Division. Thus, the SME Master Plan (subsequently referred to as the Enterprise Development Plan) could be seen as a blueprint for the development of local enterprises (which are mostly small) and a counter to the general perception that the EDB was interested only in the large MNEs. The Enterprise Development Plan was based on three strategies (SME Master Plan, p. 29): Creating a more conducive and pro−enterprise environment; Providing help for self−help; Accelerating the pace of growth with incentives. The most innovative of these three strategies was that of "providing help for self−help." The promotion of a conducive and pro−enterprise business environment has always been a fundamental tenet of Singapore's economic policy. Central to this are, of course, the following: an enterprise culture, good infrastructure, strong business and education link, ease of access to information about new methods and opportunities, and an efficient market. With respect to the use of fiscal incentives and financial assistance to accelerate the pace of growth of SMEs, the SME Master Plan reviews and consolidates the wide range of fiscal incentives and financial assistance schemes introduced earlier to promote higher value added and new business activities, operational upgrading and innovation. In view of the above, the SME Master Plan can be viewed as providing the basis of a comprehensive self−help package (figure 3.1). The plan is implemented through a wide network of government agencies and private sector organizations that seek to put SMEs in touch with bankers, investors, experts, and relevant government agencies, so as to help them gain a competitive edge. The network is coordinated by the EDB and includes the other leading government agencies involved in the assistance of SMEs (SISIR, NCB, NPB, TDB, and SDF). These agencies are supplemented by the universities, polytechnics, vocational and technical institutes, and the EDB training institutions. For example, the Enterprise Development Center (ENDEC) of the Nanyang Technological Institute provides financial diagnosis services to SMEs. The other key public sector agencies in the network include: The National Science and Technology Board (NSTB), which administers the Research and Development Assistance Scheme; The Construction Industry Development Board (CIDB), which assists SMEs in the construction industry; The Primary Production Department (PPD), which promotes agrotechnology; The Housing and Development Board (HDB), which helps retailers in public housing estates; The Jurong Town Corporation (JTC), Public Utilities Board (PUB), and Telecoms in infrastructure development.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages The private sector partners in the network include the four main local business bodies—the Chinese Chamber of Commerce and Industry, Malay Chamber of Commerce, Indian Chamber of Commerce, and the Singapore Manufacturers' Association—as well as the other trade and business associations such as the Singapore Retail Merchants Association, Singapore Textile and Garment

Manufacturers' Association, Singapore Precision Engineering and Tooling Association, Singapore Federation of the Computer Industry, Association of Small and Medium Enterprises, and Association of Management Consultants. Besides these associations, several other private sector partners are also in the network. These include banks and financial institutions participating in the Small Industries Financing Scheme (SIFS) such as Overseas Union Bank, DBS Finance and SAL Leasing, MNE partners in the Local Industry Upgrading Program such as Philips, Hewlett Packard, and Matsushita, and management consultant firms such as Deloitte Haskins and Sells, KPMG Peat Marwick, Arthur Anderson, and Coopers and Lybrand. A schematic diagram of the multi−agency network is shown in figure 3.2.

Figure 3.1: A Comprehensive Self−Help Package for Enterprises Source: SME Master Plan, EDB (1989).

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Industrial Structures and the Development of Small and Medium Enterprise Linkages

Figure 3.2: The Multi−Agency Network Source: SME Master Plan, EDB (1989). To initiate the self−help approach, the EDB seeded the formation of the Enterprise Promotion Centers (EPC) Pte. Ltd., whose mission was to promote, encourage, and foster the development of local enterprises by identifying and

responding to their needs. The shareholders of this nonprofit organization would be the various chambers of commerce and trade associations such as the Singapore Manufacturers' Association, Singapore Precision Engineering and Tooling Association, and the Textile and Garment Manufacturers' Association of Singapore. The EDB contributed a S$5 million (US$3.1 million) grant while the shareholders provided office space and support facilities at their premises as well as additional capital funds. Thus, the self−help approach was reinforced by involving the chambers of commerce and trade associations in the EPC. Further, with the recognition for the need to promote entrepreneurship, the Nanyang Technological Institute established an Entrepreneurial Development Center to provide clinical consultations to local entrepreneurs. This academic center and the EPC would work together to change the mindset of local entrepreneurs to become more self−reliant. Dissemination of information III— SME Promotion: Measures and Initiatives

73

Industrial Structures and the Development of Small and Medium Enterprise Linkages and exchange of views would be facilitated through publications such as the SME newsletter, a joint publication of EDB, NCB, NPB, TDB, STPB, and SISIR, and the Singapore Enterprise, which is published by the same agencies jointly with the EPC. Finally, to champion the development of local enterprises (mainly SMEs), a sixteen−member Enterprise Development Council was formed in May 1990. The objective of the council, comprising members of Parliament, prominent local entrepreneurs, chief executive officers of MNEs, and academicians, was to provide ideas and recommendations on enterprise development. IV— SME Development: assessment of Assistance In assessing the assistance provided to SMEs, the easiest approach would be to consider the amount of financial assistance. In doing so, it is worth reiterating that financial assistance is not the only form of assistance provided to SMEs. Indeed, we have already noted that SMEs require assistance in several areas, that is, financial, marketing, technical, training, and managerial expertise. While the various measures and initiatives discussed in section III are intended to provide assistance in all these areas, except for financial assistance, their direct evaluation is difficult. Financial assistance is also regarded by many SMEs to be the most crucial form of assistance they required, and is provided to help SMEs meet and overcome their problems in various ways. Thus, if financial incentives and assistance were linked to the provision of technical support, training, and upgrading programs, consideration of financial assistance is both useful and meaningful. Financial incentives and assistance have been provided to SMEs since the establishment of the Small Industries Finance Scheme in 1976. Of the 40,034 cases involving S$1.5 billion (US$920 million) approved under the various schemes between 1976 and 1988, those approved during the period 1976 to 1980 were negligible, amounting to less than 1 percent of the total number of cases and 5.5 percent of the total amount. While the financial assistance provided during the early 1980s increased, it was only after the 1985 economic recession that a substantial amount of financial assistance was provided to SMEs. In 1988, the year in which the SME workshop was held, 10,884 SMEs were provided financial assistance amounting to S$322.5 million (US$197.8 million), or nearly S$30,000 (US$18,400) per SME. Of all the schemes, those provided through the Skills Development Fund assisted the largest number of SMEs (73.4 percent),

but the largest amount of funds were provided through the SIFS (88.0 percent) over the period 1976 to 1988 (table 3.8). Table 3.8: Financial Assistance Provided to SMEs, 1976−88 Scheme

Number of cases

Amount (S$ million)

Investment allowances

1,120

67.0

Pioneer status

16

n.a.

Double taxation deduction

1,849

36.6

5,441

1,295.3

Tax incentives

Loans Small Industries Financing Scheme (SIFS)

IV— SME Development: assessment of Assistance

74

Industrial Structures and the Development of Small and Medium Enterprise Linkages Grants Small Industries Technical Assistance Scheme (SITAS)

1,178

8.0

Business Development Scheme (BDS)

126

0.4

Product Development Assistance Scheme (PDAS)

80

6.8

Market Development Assistance Scheme (MDAS)

752

5.7

Research Development Assistance Scheme (RDAS)

4

1.7

Software Development Assistance Scheme (SDAS)

9

0.8

Skills Development Fund (SDF)

29,499

48.6

Total

40,034

1,472.6

n.a. Not available. Source: Economic Development Board (1989). The comprehensiveness and effectiveness of the vast array of financial incentives and assistance provided to SMEs may be illustrated by the case study of Univac Precision Engineering Pte Ltd, a company dealing in the fabrication of precision steel molds for plastic injection established in 1980 (this case study was reported in The Straits Times, January 8, 1991). Univac was encouraged by the SIFS and given the Investment Allowance tax incentive to purchase state−of−the−art computerized manufacturing equipment such as the Computerized Numerical Control (CNC) milling machines, which were purchased with soft loans under the SIFS. By switching over to CNC machines, Univac was able to increase its productivity by about 30 percent. Further, Univac was able to send its workers for retraining not only in Singapore but also in Japan, with the help of grants from the SDF. This case study demonstrates that financial assistance provided as part of an integrated package is effective in promoting the development of SMEs. V— Technological Upgrading and Subcontracting Development SMEs in Singapore do not appear to have as much problems with the awareness and acquisition of technology and other technical expertise as those in other developing countries. In this regard, we can offer two plausible explanations. The first is the increasing pool of local entrepreneurs, who are better educated and trained to exploit technological developments in their businesses. Many of them are, in fact, former employees of the MNEs who have received training from the various EDB training institutions or the polytechnics. The experience gained from

working in MNEs have given them the confidence and contacts to set up their own businesses. The second, and more important explanation, is the Local Industry Upgrading Program (LIUP), which was initiated to assist SMEs to compete in international markets and to build up their capacity to innovate and grow. LIUP was designed to forge close business development ties between SMEs and participating MNEs, and in the process foster their mutual growth. Through LIUP, MNEs have been able to assist their suppliers and subcontractors to increase their technological skills and operational efficiency. LIUP has been assessed to be an V— Technological Upgrading and Subcontracting Development

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Industrial Structures and the Development of Small and Medium Enterprise Linkages effective scheme because the benefits are mutual and because market forces, rather than administrative compulsion, motivate the acquisition of technical skills and the transfer of technology from the MNEs to the SMEs. A substantial proportion of the costs incurred by the MNEs in training the SMEs are reimbursed by grants from the SDF. LIUP was conceived in 1986 essentially as a "partnership" among the EDB, participating MNEs, and their subcontractor SMEs. The program was designed to enable SMEs in the supporting services industry to tap the management and technical expertise of MNEs to upgrade their capabilities in order to supply more competitive high quality parts, components, and services not only to the partner MNEs, but eventually to reach a standard enabling them to compete in the international market. Under the program, an experienced engineer from the MNE is identified and seconded to EDB to assume the responsibility of the LIUP manager. During the period of secondment, usually two to three years, the remuneration of the LIUP manager is fully paid for by the EDB. His responsibility is to identify areas for focused assistance for the SMEs. With the recommendations of the LIUP manager and the support of the EDB, the participating SMEs gain ready access to the various financial incentives discussed above: Small Industries Finance Scheme, Small Industries Technical Assistance Scheme, Product Development Assistance Scheme, Business Development Scheme, and Investment Allowance Scheme. The conceptual framework underlying LIUP is shown in figure 3.3. LIUP is perhaps the most significant of all the policy measures and institutional arrangements through which the EDB promotes back−end linkages. Under the program, MNEs are encouraged to "adopt" SMEs that are their subcontractors with the view of assisting them to improve their operational efficiency. The program is expected to be effective in upgrading the technological capability of SMEs because the benefits are mutual, and market forces rather than administrative exhortation or compulsion motivate the transfer of technology from the MNEs to the SMEs. Recognizing the importance of having a core of competent ancillary services and supporting industries tied to MNEs (Porter 1990), the EDB has placed the highest priority on this program. The EDB envisaged the LIUP to be implemented in three phases: Phase 1—improvement of overall operational efficiency of the SMEs (for example, production planning, inventory control plant layout, financial control, and so on); Phase 2—introduction and transfer of new products or processes to the SMEs; Phase 3—joint product or process research and development with the partners.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages

Figure 3.3: Local Industry Upgrading Program Concept Source: Economic Development Board. By the end of 1990, 27 MNEs and 116 SMEs had joined the program (Ministry of Trade and Industry 1990), the majority of which were still in Phase 1. As of the end of 1990, only sixteen SMEs had progressed to Phase 2. In assessing the effectiveness of LIUP and, more importantly, the reasons underlying its effectiveness, we draw upon the case studies undertaken by Wong (1991) to develop an understanding of the process of technological transfer to, and upgrading of, SMEs in Singapore through subcontracting linkages with MNEs, that is, the form of vertical back−end linkages promoted by LIUP. His case studies covered eight MNEs in the electronics sector and sixteen of their SME suppliers (two per MNE). The eight MNEs were selected to represent different nationalities of ownership (three from the United States, three from Japan, and two from Europe) as well as different subsectors within the electronics sector (four consumer electronics, two computers and peripherals, and two semiconductors). They were among the largest global electronics corporations in the world, and

each of them had established operations in Singapore for at least eight years. The sixteen SMEs were similarly selected to reflect a representative cross−section of the supporting industries in terms of technologies involved (four in precision engineering/metal stamping, three in automation equipment, two in paper/plastic packaging, two in printed circuit boards assembly, and two in injection moldings, one in printing, one in electroplating, one in plastic lenses, and one in fasteners). In evaluating LIUP, it is instructive to discuss the notion of technology absorption, which stresses the active efforts of the recipient party (SME) to use the technology received, and to subsequently improve upon it. Whereas technology transfer focuses on the flow of technology, the stress on technology absorption suggests that the success of the SMEs in upgrading their technological capability depends critically on their characteristics and V— Technological Upgrading and Subcontracting Development

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Industrial Structures and the Development of Small and Medium Enterprise Linkages their efforts. SMEs that are more pro−active in seeking out new technological opportunities and that have a higher technological absorption capacity are more likely to benefit from the MNE−SME linkages developed through LIUP. Factors that affect the technological absorption capacity include the financial resources available to the SMEs, the pre−existing level of technical competence of the workers employed by the SMEs, the level of technical and middle management expertise and experience, and the corporate culture of the SMEs. The following salient characteristics of the subcontracting relationships in the case studies were noted: Most of the MNEs appeared to place considerable commitment to maintaining a long−term relationship even for several of the standardized items. Out of the sixteen subcontracted items, ten could be characterized as standardized while only six could be regarded as somewhat specialized. There appeared to be very few subcontracted items where the MNE had substantial in−house knowledge; this was true even in cases where the technology was considered to be "specialized." A review of the literature by Wong suggests that the rate of technology absorption depends less on the direct efforts of the MNEs in transferring their technology (direct know−how transfer effect) than on the feedback provided by the stringent quality/performance assurance control system imposed by the MNEs on the output of the SMEs (learning facilitation effect). Further, SMEs with a high technology absorption capacity are more likely to be able to improve their technological capability through access or exposure to information resources provided by the MNEs as a result of the subcontracting arrangement (spillover effect). Finally, the existence of a stable subcontracting relationship may induce the SME suppliers to commit to technological investments that would otherwise not be made in the absence of such a relationship (inducement effect). The case studies confirmed the above, that is, direct transfer of technology was less important than indirect transfer. In particular, learning facilitation through quality testing and diagnostics feedback, spillover transfer in the form of "information disclosure" through product design specification, and exposure to general "good manufacturing practices" within the MNE environment appeared to rank high in terms of perceived importance to the SME suppliers. The only form of direct transfer of moderate importance was advice/training on quality management systems and other ''good manufacturing practices."

On the basis of his case studies, Wong concluded that the dominant type of technology know−how acquisition by SMEs through subcontracting was in the area of quality assurance achieved largely through learning facilitation. He also observed that acquisition of operational know−how or process technologies also appeared to be significant in many of the cases, but these were also acquired through learning facilitation and inducement and not through direct transfer. In several cases, an important form of learning facilitation was the MNEs' introduction of the SMEs to subcontractors who had the expertise and technology that the MNEs themselves did not. The case studies also revealed that the extent of technology absorption correlated strongly with the technology absorption capacity of the firm. Of the four cases where technology absorption was found to be low, two of them could be accounted for by the fact that the technology absorption capacity of the SMEs concerned were low. Of these, one was due mainly to the lack of willingness of the entrepreneurs to invest in technological diversification, while the other was due mainly to poor management and organization style, which resulted in high turnover of staff. The third case involved standardized items where the MNE had no in−house expertise. In the fourth case, the SME did not want to be confined to metal stamping but was actively seeking to diversify to other technological activities that it saw as more profitable. Thus, it was unwilling to commit significant resources to further upgrade its metal stamping technology.

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Industrial Structures and the Development of Small and Medium Enterprise Linkages In the light of the case studies, we can conclude tentatively that LIUP was effective in capitalizing on the presence of a large number of world class MNEs in Singapore, particularly in the electronics industry. These MNEs have brought with them their highly developed supplier management systems from their home nation environments. The stringent quality and delivery performance requirements of these MNEs have exposed the SME subcontractors to internationally competitive market environments. Thus, despite the short period of Singapore's industrialization, the supporting services industry in Singapore is more extensive than that of the Republic of Korea where subcontracting is confined to large national firms. Programs such as LIUP appear to be effective in helping Singapore SMEs attain the high level of technical competence required to eventually export their products and services. While it is perhaps too early to make a conclusive assessment of LIUP, it can be said that a fair degree of success has been achieved, and, that with the passage of time, more of the SMEs would proceed to Phase 2 and eventually to Phase 3 when they would undertake joint product development between the SMEs and the MNEs. A major factor for this success appears to be the involvement of the EDB, which is highly regarded by the MNEs. EDB's involvement and commitment to LIUP would ensure the commitment of the participating MNEs. Further, the several financial incentives made available to the SMEs as well as the services provided by other government agencies such as SISIR and NPB meant that the constraints in implementing the recommendations of the LIUP manager could be easily overcome. It is worthwhile to note that a precondition for LIUP's success must be the technological absorption capacity of the SMEs. With many of the SME entrepreneurs having received technical training from EDB's training institutions and the polytechnics, their receptivity to technological innovations and upgrading is generally high.

VI— Lessons and Implications Before attempting to elicit some lessons and implications from the Singapore experience, it is worthwhile reiterating the fundamental tenets of Singapore economic policy. Singapore policymakers have repeatedly stressed the importance of not straying from these fundamentals which include: Good government Efficient infrastructure Free enterprise Flexibility High savings Conducive business environment Fiscal prudence.4 These fundamentals are well documented and discussed at great length in several publications, notably by Lim Chong−Yah (1988). Needless to say, while policies based on them may be interventionist, they are "market friendly" (World Bank 1991). Further, the very openness of the Singapore economy, the smallness of its domestic market, and its dependence on direct foreign investment imply that businesses operating in Singapore must be able to compete in the international market. Such considerations mean that all enterprises (whether small or large, domestic or foreign) in Singapore have to be competitive. Thus, while assistance and incentives can be provided to the SMEs in the short term, in the medium and longer term they must ultimately be able to compete on their VI— Lessons and Implications

79

Industrial Structures and the Development of Small and Medium Enterprise Linkages own accord. In drawing lessons and implications from the Singapore experience, we must be conscious of the above considerations. For example, it would be extremely difficult to graft the Singapore system on a large developing country with a substantial rural population. Despite the unique circumstances of Singapore, we nevertheless believe that the Singapore experience does contain useful lessons and implications for policymakers in the developing countries. What are these lessons and implications? First, the fundamentals are necessary. Without a conducive business environment and efficient infrastructure, no amount of government assistance would enable the SMEs to improve their performance. With the fundamentals in place, SMEs would grow and develop in response to market forces and initiatives, as they did in the early phases of Singapore's industrialization. However, without financial and other assistance, it would be difficult for them to grow and achieve the level of performance required to compete with their foreign counterparts. With Singapore's industrialization based largely on direct foreign investment by MNEs, it was not surprising that its economy has become overwhelmingly dependent on the MNEs. Hence, a conscious effort has to be made to promote SME development, and more importantly, to assist the more promising SMEs to grow into home−based MNEs. Second, human resource development is crucial. In reviewing the case studies undertaken by Wong (1991), we noted that the entrepreneurs in the more successful SMEs were receptive to technological upgrading, and had a higher technology absorption capacity as a consequence of having

received technical training from the EDB training institutions or the polytechnics. The importance of human resource development in developing Singapore's technological capability is discussed at length in Soon (1992). Moreover, human resource development and training has to be undertaken continuously, and not only during the period of formal education. Singapore has established several training schemes in collaboration with the various EDB training institutions, NPB, polytechnics, and the universities. Financial assistance to these training schemes are provided under various programs administered by the SDF, particularly the Small Industries Technical Assistance Scheme, which has assisted the largest number of SMEs. Finally, in fostering human resource development, efforts should be made to involve industry (mainly the MNEs) in addition to the efforts of the government and formal training institutions. Third, while the vast range of incentives and initiatives have been introduced on an ad hoc basis and in response to market needs, it is necessary to review, consolidate, and integrate them as in Singapore's SME Master Plan. With the increasing complexity of the economy and the changing nature of the problems faced by SMEs, a periodical review of the various incentives and initiatives available to SMEs must be undertaken. Such a review will not only ensure the availability of a comprehensive range of assistance schemes available to SMEs, but will also increase public awareness of these schemes and help counter the view that the "government is not doing enough." As there will always be SMEs that do not perform well, the government can never "do enough." Fourth, the efforts of the various agencies must be coordinated if they are to be effective. The forms of assistance available to SMEs are many and vary greatly in nature, ranging from technical assistance and training to financial assistance. In Singapore, the various agencies providing assistance to SMEs are drawn together and coordinated by the EDB under the auspices of the SME Committee. Such a multi−agency approach has a far greater chance of success than that of several agencies providing various forms of assistance in an uncoordinated manner. For example, SMEs that receive financial assistance from the Small Industries Finance Scheme to purchase machines may require assistance from the Small Industries Technical Assistance Scheme to train theft workers to use the new machines. Further, they may also require management advice following the acquisition of the new machines. The coordinating agency should be the agency with the greatest knowledge of and contacts with industry. Thus, in VI— Lessons and Implications

80

Industrial Structures and the Development of Small and Medium Enterprise Linkages Singapore, despite the accusation that "the EDB only favors the big MNEs" and suggestions for establishing an independent statutory board to look after SMEs, the government decided that the EDB should remain the coordinating agency for SMEs.5 Fifth, efforts should be made to draw upon the expertise and research capability of the various training institutions, research organizations, and tertiary institutions in the country. Since the promulgation of the SME Master Plan, various centers have been established in the training, research, and tertiary institutions to provide various forms of assistance to the SMEs, including an Entrepreneurial Development Center.

Academicians have also been invited to serve on the Enterprise Promotion Council. Sixth, to develop a strong and vibrant supporting services industry, a partnership should be forged with large industrial firms. In the case of Singapore, the Local Industry Upgrading Program has facilitated the forging of a stable subcontracting relationship between the MNEs and the SMEs, with the EDB acting as a facilitator, or a go−between. The commitment of the EDB and the priority it accorded to LIUP is critical. Further, with the involvement of the EDB, the vast array of incentives and initiatives became readily available to the participating SMEs. Seventh, SMEs themselves must want to succeed and priority should be accorded to promising SMEs who want to succeed and grow. With the limited resources available, it is not possible to assist all SMEs to the same extent. Assistance should be provided to those that are able to make use of the assistance. Otherwise, the efforts and resources that go into the provision of the assistance will be wasted. Eighth, an attitude of self−help must be promoted among the SMEs. Chambers of commerce and trade associations should be strengthened so that they can provide assistance to their members. The EDB has initiated the idea of self−help through the seeding of the Enterprise Promotion Centers Pte. Ltd. Self−help provided through the chambers of commerce and the trade associations is more likely to be effective than direct government assistance, because the trade associations have a greater awareness of the nature of the problems facing their members. VII— Concluding Remarks While Singapore's economic success has been widely acclaimed, it should be stressed that the Singapore economy, as indeed all economies, faces several problems and challenges. In retrospect, despite having established a comprehensive and well−structured array of incentives and initiatives to assist SMEs, the local business sector is relatively underdeveloped, with the economy being overwhelmingly dominated by MNEs. The presence of many world class MNEs is, however, advantageous in that they can assist the development of a core of strong and competent supporting services in the industrial sector. Some measure of success has been achieved in this respect, particularly through the Local Industry Upgrading Program discussed above. Although the supporting service industrial sector is proceeding satisfactorily, SMEs within that sector face the same problems as the rest of the economy, that is, an increasing shortage of labor, which causes the constant need for technological upgrading. Further, with the manufacturing sector dominated by MNEs, there is a need to increase the Singapore−based operations of the MNEs. Thus, the EDB has sought to promote the establishment of their regional headquarters (or Operational Headquarters) in Singapore. In this respect, the strategy appears to be one of increasing the Singapore−based character of the operations of the MNEs. For such an approach to succeed, the technological capability and competence of the local supporting industries must not only be strong but also internationally competitive, which explains the importance and priority placed upon LIUP.

VII— Concluding Remarks

81

Industrial Structures and the Development of Small and Medium Enterprise Linkages Even while national strategies are formulated and presented, the EDB has recognized that industries do not operate in isolation. The overall competitiveness

of a particular industry depends on the various vertical and horizontal linkages to suppliers and customers. Such a group of industries is generally referred to as a cluster. For example, the strength of the electronics cluster in Singapore may be attributed to the presence of a fairly strong core of supporting services industry. The structure of the electronics cluster is shown in figure 3.4. By considering clusters the EDB has been able to identify the core capabilities needed to maintain the competitiveness of its industries.6 Within each of the clusters, the EDB seeks to identify and promote a core group of local businesses able to provide the required products/services.

Figure 3.4: The Electronics Cluster Source: Economic Planning Committee (1991).

Despite the tentative success of LIUP, it should be emphasized that vast numbers of SMEs in the domestic industries/services sectors are still performing very poorly with low value added. While assistance could be provided to these SMEs, they have to adjust to realities, and some would eventually fail or be phased out. For example, small retailers in Singapore's housing estates face two major problems. First, their popularity as neighborhood stores has declined sharply as a result of growing affluence and changing consumer preference. This has resulted in the diversion of their customer base to supermarkets and shopping complexes. Second, the rental costs of their retail spaces have been increasing sharply. Given that most of the SMEs are in the domestic sector, the Singapore government has indicated in its Strategic Economic Plan (which it presented on October 14, VII— Concluding Remarks

82

Industrial Structures and the Development of Small and Medium Enterprise Linkages 1991, at a National Business Forum) a proposal to re−develop the domestic sector. One aspect of this proposal is to provide the training and human resource development to enable uncompetitive retailers to move out of the sector. It is worth noting that the self−help initiated by the EDB has begun to bear fruit, for soon after the plight of the retailers was highlighted at the forum, the Federation of Merchants Association (FMA) announced its proposals to assist the small retailers.7 While the FMA has called for the government to include shopkeepers under the SIFS to enable them to buy their own shops, it has also proposed the formation of management corporations to jointly promote their activities, and to form chain stores to compete with major retailers. Acknowledging the likelihood that some of the businesses of its members might fail, the FMA stated that with the implementation of its proposals, its members would at least have a "fighting chance." The economic redevelopment of the domestic sector is a challenge for the Singapore government in general, and the EDB in particular. It is likely that the EDB would, as in the SME Master Plan, mount a multi−agency approach in assisting this sector. However, even with all its good intentions, it is unlikely that the EDB would contemplate measures to subsidize the sector merely to ensure the survival of all the SMEs. With the economy facing a labor shortage and the insistence of the EDB on allowing market forces to prevail, it is likely that the less competitive SMEs in the sector would be allowed to fail, thereby allowing the entrepreneurs concerned, as well as their workers, to move into other, possibly more productive sectors.

Appendix 3.1— Outline of SME Master Plan Adapted From the Executive Summary of the SME Master Plan (a) Rationale

The task of promoting local enterprise development in Singapore is an important and urgent one. In particular, the rapidly changing business environment has caused many adjustment problems for local SMEs. Priority has therefore been given to promoting SME development as the first phase of the overall effort to promote world class enterprises. (b) Target Group

Innovative start−ups and local enterprises, which have the critical mass, capacity, capability, and commitment to innovate and grow, are the target group for government development assistance. (c) Objective

The objective of the SME Master Plan is to help local SMEs that possess the necessary factors for success to emerge and grow by adding value to their people, products, and capital. The Plan seeks to: Continue to improve and provide a conducive business environment that promotes entrepreneurship and innovation; Increase market efficiency by encouraging information exchange and improving the provision of information about new methods and opportunities; Promote best practices in business through easy access to consultancy, technology adoption, and training; Encourage local enterprises to grow and go international.

Appendix 3.1— Outline of SME Master Plan

83

Industrial Structures and the Development of Small and Medium Enterprise Linkages (d) A Framework for Action

Our strategy is to stimulate local enterprises by creating a more pro−enterprise environment, providing help for self−help, and accelerating the pace of growth with incentives. The role of the government is to guide and assist enterprises by setting the direction, improving the business environment, and building up a supportive infrastructure. In order to fully integrate the development of local SMEs into our overall economic development, a multi−agency approach coordinated by EDB has been adopted. Private sector organizations are also key players. They should do their part and actively participate in the multi−agency effort to help local enterprises realize their full potential. In particular, local chambers of commerce and industry and trade associations are urged to expand their role. Business and education need to work closely at all levels. By participating in the education system, businesses can help to shape local attitudes toward industry and commerce, assist young people to acquire useful skills, and develop an enterprise culture. Local firms should also

tap the expertise of and collaborate actively with universities, polytechnics, and other tertiary institutions. (e) Development Mindset

A new orientation is necessary. Our SMEs need to adopt a developmental mindset. They must look ahead, plan carefully, build up their capacity and capability, and venture forward boldly. (f) The SME Initiative

The SME Initiative is a comprehensive package to accelerate the physical transformation of local SMEs. Implemented through a multi−agency network of government agencies, tertiary institutions, and private sector organizations, it puts our SMEs in touch with bankers, investors, experts, and administrators, thereby giving them the extra muscles to gain a competitive edge. The following incentives and development assistance are made available through the SME Initiative: Fiscal incentives and access to financial assistance; Technical problem solving and help in technology adoption, automation, innovation, and product development; Exploitation of information technology; Expert help in productivity improvement and training; Practical advice on business development and help in establishing business partnerships; Assistance in international marketing and design; A Local Industry Upgrading Program (LIUP) to build up the supporting industry.

Endnotes

1. The definition of an SME follows the eligibility criteria used by the Singapore Economic Development Board (EDB) to qualify firms for assistance. Under these criteria, an SME is a company with at least 30 percent local equity and not more than S$8 million (US$4.9 million) net fixed asset investment if it is in manufacturing, or employs not more than fifty workers if it is in commerce or services.

(d) A Framework for Action

84

Industrial Structures and the Development of Small and Medium Enterprise Linkages 2. The number of such establishments overestimates the number of SMEs, because they would include those firms with fifty or fewer workers but whose net investment assets exceed S$8 million (US$4.9 million). Such firms are not eligible for assistance by the EDB and therefore are not regarded as SMEs by the EDB.

3. Converted at the rate of I US$ = 1.6305 S$, the exchange rate between the U.S. dollar and the Singapore dollar as at the end of 1991. However, all monetary values in the tables are denominated in Singapore dollars.

4. These fundamentals have been reiterated at the National Business Forum held on October 14, 1991 to discuss the Strategic Economic Plan formulated by Singapore's Economic Planning Committee (1991).

5. This was told to the author by an EDB officer who argued that the unique advantage of the EDB in coordinating the efforts to assist SMEs lies in its ability to draw on the resources of the MNEs, if required.

6. In the Strategic Economic Plan, fourteen clusters were identified as follows: commodity trading, shipping, precision engineering, electronics, information technology, petroleum and petrochemical, construction, heavy engineering, finance, insurance, general supporting industries, tourism, international hub, and domestic industries/services.

7. The Federation of Merchants Association comprises 29 affiliate associations representing about 4,000 retailers, or about 20 percent of the SMEs in Singapore; The Straits Times, October 16, 1991.

4— Indonesia Thee Kian Wie During the past two decades Indonesia's manufacturing sector has experienced very rapid growth, averaging 12.0 percent annually during the period 1965−80 and 12.7 percent during the period 1980−89 (World Bank 1991). This industrial growth has propelled Indonesia into the front ranks among the developing countries in terms of the manufacturing sector. While in 1970 Indonesia was the least industrialized country among the ASEAN (Association of South East Asian Nations) countries, by 1988 it already had the eighth largest manufacturing sector (in terms of value added) among all the developing countries, after China, Brazil, the Republic of Korea, Mexico, India, Argentina, and Turkey (World Bank 1991). Although Indonesia is not yet a newly industrialized economy (NIE) by both Organization for Economic Cooperation and Development (OECD) standards as well as the standards set by Professor Bela Balassa (Ezaki 1991), it is well on its way to becoming a ''near−NIE," with its manufacturing sector contributing slightly more than 20 percent to Indonesia's GDP in 1992, and accounting for a steadily rising, though still very small, share of world manufacturing value added and world manufactured exports. This chapter reviews Indonesia's efforts at broadening and deepening its industrial structure through SME (Small and Medium Enterprise) promotion and efforts at creating intra and interindustry linkages. Section I of this chapter discusses the industrial structure while section II reviews SME promotion policies. Section III discusses issues of industrial deepening and section IV examines efforts at balancing industrial widening and deepening. Section V concludes with lessons and implications.

4— Indonesia

85

Industrial Structures and the Development of Small and Medium Enterprise Linkages I— Industrial Structure The 1986 economic census (Government of Indonesia 1986) has yielded valuable and comprehensive data on Indonesia's manufacturing sector that were hitherto unavailable, and that enabled researchers to draw up a fairly comprehensive picture of Indonesia's industrial structure. In addition to the findings of the census, the reestimation of the industrial database for the period 1975−86, and the inclusion of the large oil and natural gas processing industries, has made a more comprehensive analysis of Indonesia's industrial development during the period since the mid−1960s possible. (Hill 1990). The 1986 census was the third industrial census since Indonesia's independence, the first having been conducted in 1963 and the second one during 1974−75. The first industrial census of 1964, however, was undertaken during a period of political unrest and economic upheaval, and its findings are therefore suspect. Hence, in analyzing Indonesia's industrial

development, the time frame used in this chapter will encompass the period 1974−75 through the late 1980s. One of the most recent and most comprehensive analyses of Indonesia's industrial structure has been provided by Hal Hill who, unlike other researchers in previous estimates, has included both the large oil and gas processing industries, as well as the small enterprises in his analysis (Hill 1990). Hence, Hill's analysis includes the large, medium, and small enterprises, but excludes the cottage enterprises as reliable information on this subsector is very difficult to obtain. Moreover, despite the very large number of cottage enterprises all over the country, their overall contribution to total manufacturing value added is quite small because of their low productivity. A comprehensive picture of Indonesia's industrial structure is presented in appendix 4.1, which includes data on the relative contributions to total manufacturing value added, as well as relative employment shares in all the large, medium, and small enterprises. Appendix 4.1 also shows the relative importance in terms of value added and employment of the various manufacturing industries, if the important oil and gas processing industries are included and when they are not. The data in column 2 of appendix 4.1 show that the oil and gas processing industries (ISIC 353/4) are, in terms of manufacturing value added (MVA), by far the most important manufacturing industries, accounting for 28 percent of the total MVA (26 percent if the small value added of the small enterprises is included). The only non−oil and gas industry with value added in excess of 10 percent of total MVA is the tobacco industry, which includes the very large clove cigarette industries. The relative importance of the various non−oil and gas industries becomes more apparent in column 1, which indicates that the most important non−oil industries (in terms of MVA) are the tobacco industry (17 percent), the textile industry (12 percent), and the wood products industry (10 percent), while the other industries contribute less than 10 percent of non−oil and gas MVA. The industries contributing between 5 and 10 percent of non−oil and gas MVA include the food products (8 percent), basic metals (8.5 percent), and transport equipment (6 percent) industries. Considering manufacturing employment, the data in column 4 show that the largest employers are the textile (18 percent), food products (13 percent), and tobacco products (12 percent) industries. These industries are still the largest employers even if employment in the small enterprises is included (column 5), although the relative importance of the textile industry is slightly lower (14 percent). While the manufacturing sector contributed almost 20 percent to Indonesia's gross domestic product (GDP) in 1990, it employed a much smaller proportion of the total labor force compared to its Asian neighbors, such as Malaysia and Thailand. Despite rapid industrial growth during the past two decades, this sector has not been an important source of additional employment, providing only 14 percent of the increase in total employment during the 1970s, and an even lower 10 percent during the first half of the 1980s (Jones and Manning 1992).

I— Industrial Structure

86

Industrial Structures and the Development of Small and Medium Enterprise Linkages Moreover, the structure of manufacturing employment also differs from that of the industrially more advanced Asian developing countries, including Thailand and Malaysia, in that the bulk of the workers are employed in the small and particularly in the myriad of cottage enterprises. It is estimated that these

industries account for two−thirds of the industrial labor force, with the remaining one−third in the large and medium enterprises (Jones and Manning 1992). This obviously implies that there is a wide disparity in labor productivity between the large and medium enterprises (LEs, MEs), on the one hand; and the small and cottage enterprises (SEs, CEs) on the other. This is clearly evident from the data presented in table 4.1. Table 4.1: The Relative Importance of Small Enterprises in Indonesian Manufacturing, 1986 Establishments

Employment

Percent

Value added at market prices Million rupiah

Percent

Enterprise size Number

Percent

Number

Large and medium enterprises

12,765

0.8

1,691,435 32.7

9,348,483

82.2

Small enterprises

94,534

6.2

770,144

775,304

6.8

Cottage enterprises

1,416,935 93.0

2,714,264 52.4

1,234,419

11.0

Total

1,523,935 100.0

5,175,843 100.0

11,378,206

100.0

14.9

Source: Biro Pusat Statistik (1991). The data in table 4.1 indicate that in 1986 the average value added per worker in LMEs exceeded that of small enterprises by a factor of 5.5 and that of the cottage enterprises by a factor of 12. The data in table 4.1 also indicate that while large and medium manufacturing establishments accounted for only 0.8 percent of all the manufacturing establishments in the country, they produced no less than 82 percent of total manufacturing value added. On the other hand, while cottage establishments accounted for 93 percent of the total number of manufacturing establishments in the country, they produce only 11 percent of total manufacturing value added. The data in table 4.2 indicate that the large majority of small manufacturing establishments are to be found in the food, textile, wood, and non−metallic minerals industries. The small manufacturing establishments operating in the non−metallic minerals industries produce mainly cement and lime products, bricks, and tiles (Wymenga 1991). As Hill (1990) notes, a range of "industrial economics" factors impinge on these subsectors. These are relatively low skill, labor−intensive industrial subsectors in which scale economies are less important. They may also have a comparative advantage when flexibility (in terms of operations or adaptation to consumer preferences) is required.

I— Industrial Structure

87

Industrial Structures and the Development of Small and Medium Enterprise Linkages Table 4.2: Industrial Composition of Small Enterprises in Indonesia, 1986 (percent) ISIC

Industry

1986

31

Food and beverages, tobacco

37.1

32

Textiles and leather

17.0

33

Wood and wood products

14.3

34

Paper and paper products

6.2

35

Chemicals

6.7

36

Non−metallic minerals

9.3

37

Basic metals

0.0

38

Metal products

6.7

39

Other

2.7

Total

100.0

Source: Wymenga (1991). In terms of the spatial distribution of the manufacturing industries, Hill (1990) estimated that, excluding the oil and gas industries, the large and medium enterprises on Java accounted for 75 percent of total MVA (52 percent if the former enterprises are included). These figures indicate that the oil and gas processing establishments are located outside of Java (for example, the oil refineries in the provinces of Riau and South Sumatra, and in Kalimantan; and the liquid natural gas [LNG] plants in Aceh province on Sumatra and in East Kalimantan). Including the oil refinery in Cilacap, Central Java, the large and medium enterprises on Java account for 78 percent of total manufacturing employment in the large and medium manufacturing subsector (Hill 1990). Hence, both in terms of value added and employment, Indonesia's manufacturing sector is largely located in Java (which accounts for 60 percent of Indonesia's total population in 1990 [Hull 1991], but only 6 percent of Indonesia's total land area). This concentration in Java is not only limited to the large and medium enterprises, but also encompasses the small and cottage enterprises (Jones and Manning 1990). Rapid industrial growth during the 1970s and 1980s has also led to a rapid change and diversification of Indonesia's industrial structure, particularly in the non−oil and gas manufacturing industries, as indicated in appendix 4.2. The data in appendix 4.2 clearly indicate that both in terms of the relative contributions to output and the relative shares of manufacturing employment, a significant structural change took place in Indonesia's manufacturing sector. During the period 1975−1986 the relative importance of the traditional, more labor−intensive industries related to the agricultural sector, such as the food, beverages, tobacco, and rubber products industries, declined from 53 percent of total MVA in 1975 to 33 percent in 1986 (Hill 1990). On the other hand, the relative importance of the more capital−intensive basic metals industries (ISIC 37) increased from a minuscule 0.3 percent in 1975 to 8 percent during the same period, largely as a result of the establishment of the iron and steel complex in Cilegon, West Java, and the Asahan aluminum smelter in North Sumatra. Similarly, the relative contribution of the wood products industry increased from 3.1 percent to 9.8 percent as the ban on the export of logs led to the establishment of a large number of wood processing industries, notably plywood mills. Recent data from the BPS

suggests that between 1985 and 1990, the share of small (5−19 workers) and medium enterprises (20−99 workers) in total manufacturing value added declined respectively from 16 to 8 percent and from 34 to 27 percent. The share of very large enterprises (over 100 workers) increased from 35 to 49 percent, indicating a "hollow middle" in the size distribution of enterprises. I— Industrial Structure

88

Industrial Structures and the Development of Small and Medium Enterprise Linkages The data in appendix 4.2 also show that the change in the employment structure has been less striking than in the output structure, mainly because the industries that grew fastest during this period, such as the basic metals industries, also happened to be the most capital−intensive industries (Hill 1990). Moreover, the high proportion of manufacturing employment in small and cottage enterprises is another factor hampering the rapid growth of manufacturing employment. Even high rates of employment growth in the large and medium enterprises will not have a considerable impact on overall manufacturing employment in view of the slower growth of the small and cottage enterprises. Admittedly, this subsector has shown greater potential for rapid growth since the shift to an export promoting strategy in 1986, as indicated by the rapid growth in manufactured exports produced by the small and cottage enterprises in recent years (appendix 4.2). The data in table 4.3 indicate that SMEs have been equally capable as the LEs in responding swiftly, perhaps even more so, to the export opportunities opened up by the shift from the import substituting industrial strategy of the 1970s and early 1980s to the export−promoting strategy since the mid−1980s. In fact, the data in table 4.3 indicate that whereas total manufactured exports during the period 1983−90 increased by 370 percent, the manufactured exports of the SMEs increased by 950 percent, more than double the increase in total manufactured exports. Table 4.3: Manufactured Exports of Indonesian Small Enterprises, 1983−90 (millions of US$) Type of industry

1983

1984

1985

1986

1987

1988

1989 a

1990

1. Food industries

11.6

10.0

9.2

9.8

69.9

100.9

117.9

157.1

2. Textile and leather industries

55.5

122.9 156.4

180.3

192.8

254.4

385.7

617.0

3. Chemicals and construction materials industries

28.5

41.0

37.6

38.4

60.8

96.8

56.8

79.6

4. Handicraft and general industries

41.2

40.4

44.3

93.6

349.4

503.9

459.6

302.3

Total SE exports

136.6

214.4 247.5

322.1

672.9

956.0

1,020.0 1,156.0

Percentage of total manufactured exports

4

5

7

10

10

9

6

10

a . Preliminary figures. Source: Government of Indonesia (1991); Biro Pusat Statistik (1991); Departemen Perindustrian (1991).

While it may still be true that rapid growth of some of the LEs has led to a decline in some labor−intensive, low technology SMEs, producing goods similar but inferior to those produced by the LEs (for example, woven clothes, soft drinks, and the like), as was the case in the 1970s, and thus worsened overall manufacturing employment (McCawley 1979), it also seems quite likely that the rapid growth of manufactured exports in recent years has opened up new employment opportunities in export−oriented SMEs. In view of the scarce information on this issue, further research would be needed to find out whether or not the employment creating effects of steadily rising manufactured exports generated by SMEs have been able to offset the employment displacing effects of the rapid growth of the capital−intensive, modern LEs on the more traditional, labor−intensive, low technology SMEs. I— Industrial Structure

89

Industrial Structures and the Development of Small and Medium Enterprise Linkages What is the structure of ownership and concentration in Indonesian industry? Three main ownership categories dominate Indonesian non−oil manufacturing: private firms (domestic); joint ventures involving government; and private−foreign ventures and state−owned enterprises. Private firms employ the largest work force and are the most numerous. But they are much smaller than other groups in terms of output per firm. By subsector, the government's presence is found in basic metals, non−metallic minerals, chemicals and plastics (table 4.4). As described by Thee and Yoshihara (1987) Indonesia's industrial structure is one of "upstream socialism, downstream capitalism." The government's strategic objectives of industrial deepening and controlling the commanding heights of industry, aided by the oil boom of the 1970s, explain much of the pattern of ownership in Indonesian industry (Hill 1990). The deepening that has taken place has been mainly due to the strategy of import substitution largely in the intermediate products, resource based processing, and the engineering sector. Apart from this, the industrial structure is shallow, with little depth and diversification, dominated by traditional activities. Table 4.4: Major Ownership Groups, 1989 (percentage of value added) Industrial subsector

G

JV

P

CR

Food, beverages, and tobacco

10.1

6.7

83.2

57.0

Textiles

2.9

1.9

95.2

24.0

Wood and wood products

1.3

1.9

96.8

16.0

Paper and paper products

16.6

0.3

83.1

49.0

Chemicals and plastics

27.8

2.6

69.6

50.0

Non−metallic minerals

30.6

6.0

63.4

56.0

Basic metals

62.1

20.7

17.2

81.0

Metal products

6.3

12.4

81.3

58.0

Other

0.1

0.0

99.9

58.0

Note: G = Government; JV = Joint Venture (government and private); P = Private; CR = Four−firm concentration ratio. Source: World Bank (1992a). As shown in table 4.4, the four firm concentration ratio is high in a number of subsectors: basic metals; non−metallic minerals; paper and paper products; food,

beverages, and tobacco; chemicals; and metal products. The market power of firms in these subsectors is due to the past trade regime, regulatory barriers (that have also encouraged the rise of conglomerates), government ownership, and "industrial economics" factors such as minimum efficient scale, access to capital and technology, and so forth. Low concentration industries are labor−intensive industries, less affected by government regulatory barriers (textiles and garments, and wood and wood products). The next section provides an analysis of the promotional programs for SMEs. II— Small and Medium Enterprise Development

II— Small and Medium Enterprise Development

90

Industrial Structures and the Development of Small and Medium Enterprise Linkages A. Definitions of Small Enterprises

In discussing the promotional policies of small and medium enterprises (SMEs) in Indonesia, one has to bear in mind that these policies are directed at promoting small enterprises (SEs) rather than SMEs. Moreover, in Indonesia different agencies have different definitions of what constitutes small enterprises. As noted in appendix 4.1, the Central Bureau of Statistics (BPS) defines large enterprises (LEs) as those establishments that employ more than one hundred workers, medium enterprises (MEs) as employing twenty to ninety−nine workers, small enterprises as employing five to nineteen workers; and cottage enterprises (CEs) as employing fewer than five workers, including unpaid family workers. The Indonesian Ministry of Industry and the Capital Investment Coordinating Board (BKPM), on the other hand, define small enterprises as those enterprises whose capital investment in machinery, equipment, and buildings (excluding land) is less than Rp 600 million (or approximately US$ 300,000) at the prevailing exchange rate of US$1 = Rp 2,000. The Central Bank (Bank Indonesia) also defines an enterprise as small if its assets are less than Rp 600 million (US$300,000) (Suhartono 1988). These different definitions imply that what is considered as a small enterprise by the Ministry of Industry may well be a medium or even large enterprise under the definition of the BPS. These different definitions have also to be taken into account when reviewing the various SE promotion programs carried out by the various government agencies. B. Current Promotional Policies

The official stated policy of promoting small enterprises (SEs) by the Directorate−General of Small Industry, Ministry of Industry, is spelled out in Direktorat Jendral Industri Kecil (1992). In trying to foster the development of SEs, the Directorate−General of Small Industry's guidance has focused on: Assisting SEs in overcoming their marketing problems by the Foster Father−Business Partner (Bapak Angkat−Mitra Usaha ) linkage scheme; Assisting SEs in their production and financing problems; Assisting SEs in their institutional development by encouraging them to form clusters of SEs operating in the same field, which could then be encouraged further to form cooperatives or limited liability companies. In implementing the policy of developing SEs, the establishment of linkages and partnerships (sistem keterkaitan dan kemitraan ) has recently been officially launched as a "national movement" (Gerakan Nasional ).

The establishment of linkages between the Foster Father (that is, a large firm) and its Business Partner (that is, a small firm) is to be a cooperative arrangement between the large firm and the small firm, which should be based on the principles of mutual need, mutual reinforcement, and mutual benefit. Other steps to achieve a more balanced development of large and small enterprises include: The sale of shares of large enterprises (up to 25 percent) to cooperatives, including the cooperatives of SEs. The obligation of state−owned enterprises (BUMN) to reserve up to 5 percent of their net profits to help promote small enterprises. The requirement that banks in Indonesia will have to allocate 20 percent of their credit portfolio to small enterprises, including SEs (Small Enterprises Credit (KUK) scheme).

A. Definitions of Small Enterprises

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Industrial Structures and the Development of Small and Medium Enterprise Linkages C. The Major Promotion Programs for SEs

The major (current) promotion programs for SEs in Indonesia can be classified according to two major categories, namely, Subsidized Credit Programs and Technical Assistance Programs. These are analyzed below. Subsidized Credit Programs

The Small Enterprises Development Program (KIK/KMKP) Until it was converted into the unsubsidized Small Enterprises Credit Scheme (Kredit Usaha Kecil or KUK) in January 1990, the Small Enterprises Development Program or Credit for Small Investment/Permanent Working Capital Scheme (KIK/KMKP), launched in 1973, was the major nationwide subsidized credit scheme aimed at helping small, indigenous enterprises, including small and cottage enterprises, to obtain subsidized credit for investment and working capital purposes. Eligibility for KIK and KMKP credits was restricted to small firms where at least 75 percent of the capital was owned by indigenous, or pribumi Indonesians, or at least 50 percent if the majority of the board of management of the small enterprise consisted of pribumi Indonesians (Bolnick 1982). The bulk of the funds for the KIK/KMKP scheme was provided by the Bank of Indonesia, which also coordinated the implementation of this scheme. In addition to the Bank of Indonesia, the World Bank also provided financial support for this credit scheme, while the European Economic Community provided support in the form of training, staff development, and other forms of technical assistance. In terms of the volume of credit, the KIK/KMKP credit scheme was by far the most important of subsidized credit schemes to promote the development of indigenous small enterprises. The actual provision of credit was handled by Indonesia's five state−owned commercial banks, the Indonesian Development Bank (BAPINDO ), all Regional Development Banks (Bank Pembangunan Daerah ), and fourteen private, national banks, which around the mid−1980s had altogether more than 1,000 branch offices throughout Indonesia. The KIK and KMKP credits were not only provided to indigenous small manufacturing enterprises, but also to small enterprises operating in other sectors, including agriculture, mining and quarrying, construction, transport, commerce, and other services (Netherlands Economic Institute 1986).

Since the introduction of the KIK/KMKP scheme in 1973, the volume of KIK credits grew from Rp 74 billion in 1977 to Rp 870 billion in late 1985, while during the same period the KMKP credits grew from Rp 85 billion to Rp 2 trillion. Of the above amount, small manufacturing enterprises received 13 percent of KIK credits and 11 percent of KMKP credits, respectively (Poot, Kuyvenhoven, and Jansen 1990a). A study conducted by a team of Dutch consultants from the Netherlands Economic Institute on the effectiveness of the KIK/KMKP scheme estimated that in 1983 small firms operating in the food industry had received the largest amount of KIK loans (28 percent), followed by SEs in the non−metallic minerals industry (20 percent), and in the textile and wood products industries (15 percent each). During the same year, the largest amount of KMKP credit was received by small firms in the textile industry (24 percent), followed by those firms operating in the food and wood products industries (21 percent each) (Poot, Kuyvenhoven, and Jansen 1990a). The major target of the KIK/KMKP scheme in the manufacturing sector was the small manufacturing enterprises, estimated to number around 113,000 in 1979. Although the cottage enterprises also qualified for the KIK/KMKP credits, their capital requirements were often too low to enable them to absorb KIK or KMKP credits. It was stipulated, however, that cottage enterprises that employed paid workers (in addition to unpaid family workers) could be included in the target group of KIK/KMKP credits. Including these cottage enterprises, it was estimated that in 1983 around 280,000 small and cottage enterprises qualified as a target group for KIM/KMKP credits. The number of small and cottage manufacturing enterprises that actually received KIK/KMKP credits in 1983 C. The Major Promotion Programs for SEs

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Industrial Structures and the Development of Small and Medium Enterprise Linkages numbered around 100,000. Reducing this number by 35 percent to correct for the fact that several firms had received more than one loan or that several enterprises had received both KIK and KMKP credits, we get a number of around 65,000 small and cottage manufacturing enterprises that had received KIK and KMKP loans in 1983. Comparing this number with the target group of 280,000 enterprises, we get a number of around 23 percent of the target enterprises that actually had received KIK and KMKP credits in that year (Poot, Kuyvenhoven, and Jansen 1990a). Although this percentage appears rather low, one might also argue that the above coverage was adequate in view of the many problems involved in providing the KIK and KMKP credits. Findings of the Netherlands Institute study indicated that the KIK/KMKP subsidized credit scheme has generally yielded favorable results for small enterprises, particularly for those operating in the manufacturing sector. The study attempted to estimate the incremental impact of KIK/KMKP credits on employment, investment, and value added of small enterprises in the various economic sectors of the economy. The findings of the above study on the relative impact on each major economic sector indicated that KIK/KMKP credits had the largest impact on the small enterprises in the manufacturing sector, in terms of investment, value added, and employment (Poor, Kuyvenhoven, and Jansen 1990a). Using indicators, such as the incremental capital−labor ratio and the incremental−capital−output ratio, the findings of the Netherlands Institute study confirmed the generally favorable impact of the KIK/KMKP scheme. The study also indicated that the economic rate of return (ERR) of incremental investment

made possible by the KMKP loans was quite high, amounting to more than 50 percent (Poot, Kuyvenhoven, and Jansen 1990a). The findings of the Netherlands Institute study tended to suggest that a continuation and expansion of the KIK/KMKP scheme was desirable. This recommendation, however, had to be qualified, as the subsectors covered by this study represented only a relatively small part of all manufacturing subsectors that had received KIK/KMKP credits. While the Netherlands Institute's assessment of the effectiveness of the KIK/KMKP scheme was generally favorable, another assessment made by an American economist, Steve Grizzell, was much more negative. Grizzell argued that despite the successes referred to in the Netherlands Institute study, a major objective of the KIK/KMKP scheme, namely the generation of a sustainable alternative source of credit for small enterprises, including small manufacturers, had probably failed, because arrears and collection problems had driven the default rate to around 27 percent. Grizzell argued that this high default rate was endangering the self−sustainability of this scheme (Grizzell 1988). Grizzell attributed the high default rate and serious collection problems to inadequate staff training, unofficial payments, mismanagement of the funds, and inadequate penalties for default or incentives for the bank staff to make the collections. To remedy these problems, Grizzell recommended that the skills of the bank staff, particularly in management and accounting skills, needed to be raised to make them more able to appraise loans. Grizzell also recommended a simplification of the approval and collection systems and adequate incentives for bank staff to collect the loans to reduce the high default rate (Grizzell 1988). The KUPEDES Program The KUPEDES program is a general rural savings program aimed, like the KIK/KMKP scheme, at promoting small business development, including SEs. Unlike the subsidized KIK/KMKP credit scheme, however, KUPEDES credits were offered not at the annualized interest rate of 12 percent a year, but at a much higher rate of 32 percent. Like the KIK/KMKP program, the KUPEDES program is being administered by one of the state−owned commercial banks, Bank Rakyat Indonesia or BRI (Indonesia People's Bank). While the KIK/KMKP C. The Major Promotion Programs for SEs

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Industrial Structures and the Development of Small and Medium Enterprise Linkages scheme has been plagued by a high default rate (27 percent), the KUPEDES scheme has been much more successful in the collection of loan repayments, as indicated by a very low default rate of only 2 to 3 percent, despite its much higher interest rate (Grizzell 1988). The better performance of the KUPEDES scheme in collecting loan repayments can most likely be attributed to the more appropriate system of incentives of this program. Unlike the KIK/KMKP scheme, which was administered by the BRI branches at local government levels higher than the subdistricts (Kecamatan ), the KUPEDES credits are being handled by BRI branches at the subdistrict and the village (Unit Desa ) level. Although the BRI staff at these lower−level branches are generally less skilled and experienced, they receive a 10 percent bonus on profits, which may to some extent account for the greater success of the KUPEDES scheme. Similarly, the system of penalties under the KUPEDES scheme may be another factor accounting for the greater success of this scheme, as the subdistrict or village branches of the BRI are required to pay off bad loans. In comparison, under the KIK/KMKP scheme, 75 percent of a loan was covered by a state−owned credit insurance company, namely P.T. ASKRINDO (Indonesian Credit Insurance

Ltd.), which was established in 1971 to promote bank lending to small enterprises with insufficient collateral leading to moral hazard problems (Ministry of Industry 1980). Another important difference between the KUPEDES and the KIK/KMKP schemes concerns the average amount of loans. Under the KUPEDES scheme, the average amount of a KUPEDES loan was Rp 540,000 at the subdistrict (Kecamatan ) level and Rp 40,000 at the village (Desa ) level, while under the KIK/KMKP scheme, the average amount of a loan was much larger and advanced for a much longer time, with the possibility of reaching an average amount of Rp 10 million for both KIK and KMKP credits with a maximum maturity of three years for KMKP loans (Ministry of Industry 1980). While the small manufacturing enterprises made use of the KIK/KMKP credits on a wide scale, these enterprises generally did not make much use of the KUPEDES credits. According to a government official familiar with credit schemes to small enterprises, the reason for the lower participation of SEs in the KUPEDES scheme is that loans to SEs carry a higher risk and yield lower profits. It also requires more technical knowledge to appraise the loan applications of SEs than the applications of small traders and other small enterprises operating in the services sector. It also appeared that small manufacturing enterprises were more likely to apply for KIK/KMKP credits, in view of the larger size and the longer maturity of the average KIK/KMKP loan (Grizzell 1988). Technical Assistance Programs

The Small Industries Development (BIPIK) Program The most important program providing training and extension services to small enterprises is the Small Industries Development Program (Program Pembinaan dan Pengembangan Industri Kecil, or BIPIK), initiated and carried out by the Directorate General of Small Industry, Ministry of Industry. The BIPIK is a coordinated program of input provision for SEs, under which technical assistance is provided to dusters of SEs. This concept of clusters of SEs is a major element of the BIPIK scheme, which actually dates back to the 1950s when the Indonesian government established ''Industrial Centers" (Induk Industri ) to provide technical assistance, particularly to the indigenous weaving industry. However, insufficient funding and reluctance on the part of the small entrepreneurs to utilize the facilities offered accounted for the lack of success of this early promotion program (Grizzell 1988). The inadequate funding for this scheme can be attributed to the fact that the Indonesian government in the 1950s was much more concerned with the problems of political consolidation and nation building than with the problems of economic development, including the promotion of SEs. It must be pointed out that the BIPIK program is aimed at assisting small enterprises.

Technical Assistance Programs

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Industrial Structures and the Development of Small and Medium Enterprise Linkages Despite these early failures, the BIPIK scheme has again stressed the development of industrial clusters or centers of small enterprises (Sentra Industri Kecil ), which generally consist of fifty to one hundred small manufacturing establishments, including cottage establishments. These clusters of SEs are being supported by technical Service Centers (Unit Pelayanan Teknis, or UPT), which provide extension services and technical services to the SEs. Sometimes these Service Centers also provide raw materials to these SEs. These UPT are staffed by Extension Field Officers (Tenaga Penyuluh Lapangan, or TPL) who, having received

special training, provide extension services as well as conduct simple training courses (Departemen Perindustrian 1982). The BIPIK scheme is mainly carried out by the provincial governments, as well as the provincial offices of the Ministry of Industry, particularly in fostering the industrial clusters and the technical service centers. Most of the SEs in the industrial clusters consist of the following industries: Food processing industries Textile and leather industries Chemicals and building materials industries Metal goods industries Handicraft industries. In view of the above concentration of SEs, the BIPIK scheme has focused its efforts on the five clusters of SEs known as Kelompok Industri Kecil (Departemen Perindustrian 1985). Since the late 1970s, Small Industry Estates (Lingkungan Industri Kecil, or LIK) have been established in some regions with a relatively large concentration of SEs in regions where specific skills appropriate to SEs are available. The two major facilities available to SEs in these LIK are facilities for education and training and facilities for improving the quality of the products (Departemen Perindustrian 1982). These Technical Service Centers (UPT) and Small Industry Estates (LIK) have not been very successful, as indicated by the low occupancy of these facilities and the low productivity of the SEs in these facilities. The reason for this is that the field extension officers have generally little or no technical and business experience. The training and subsidized inputs in these facilities are provided according to a schedule determined by central planners rather than by the needs of the existing and potential small entrepreneurs (Grizzell 1988). The "Foster Father−Business Partner Linkage" Program Within the BIPIK program a "Foster Father−Business Partner" partnership and linkage program (Program Kemitraan dan Keterkaitan Bapak Angkat−Mitra Usaha ) has also been introduced to foster the development of SMEs. The "Foster Father" (Bapak Angkat ) is a large enterprise, which, because of its access to domestic and/or export markets, is in a good position to assist SMEs in marketing their products. A Ministry of Finance decree in November 1989 stated that state−owned enterprises could put aside 1 to 5 percent of their net profits to assist small enterprises. Under this scheme, the foster fathers are also expected to guide the SMEs by raising their capability in management, process technology, financing to purchase raw materials, and marketing; and acting as a guarantor of SMEs in their loan applications (Suhardi 1992a). The Foster Father−Business Partner concept was extended into a national movement on February 14, 1991. This implied that the Indonesian government henceforth would make this "linkage program" the major thrust in Technical Assistance Programs

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Industrial Structures and the Development of Small and Medium Enterprise Linkages promoting SMEs; and for this purpose would expect all the large firms, including both the private as well as the state−owned (BUMN) firms, to participate in this program by forming "linkages" (keterkaitan ), that is, by becoming foster fathers to their small "business partners" (mitra usaha ).

Undoubtedly, the pressure exerted on both large private, and particularly state−owned, firms by the official proclamation of the linkage program as a "national movement" (gerakan nasional ) has resulted in a rash of cooperation agreements being signed by the foster fathers and a large number of their business partners. In fact, by the end of 1991 cooperation agreements had been signed by 4,698 large foster father firms with 21,983 SE business partners in 22 of Indonesia's 27 provinces. It is hoped that by the end of the Fifth Five Year Development Plan on March 31, 1994, not less than 10,000 foster fathers will have established linkages with SEs (Suhardi 1992b). In the case of the state−owned P.T. Pusri, it has assisted thirty−seven enterprises in subsectors such as textiles, precious stones, embroidery, lacquer ware, and ceramics. This successfully managed state enterprise provided management assistance, technical assistance to increase production skills, marketing assistance, and also advanced working capital to small firms. The often cited successful "adopted" enterprise is a ceramics firm that has met with success and is repaying P.T. Pusri 25 percent of its turnover until the loan advanced is paid off. As yet, it is too early to make an assessment of the impact of the linkage program and its sustainability. While there have been various instances where this program has been successful, notably in which the foster fathers have successfully marketed the products through their own marketing channels in the domestic as well as export markets, there has also been some skepticism about the effectiveness as well as sustainability of this linkage program, as "forced marriages" or "forced partnerships" are unlikely to be viable, particularly if one of the partners, specifically the large firm, gets little or no benefit from this partnership. III— Deepening of the Industrial Structure A. Industrial Policy Since the Late 1960s

Indonesia has experienced rapid industrial development since the late 1960s. Like many other developing countries in their early stages of industrialization, Indonesia during the 1970s and early 1980s pursued an import substituting strategy of industrialization. Buoyed by the huge revenues of the two oil booms of the 1970s, and concerned to maintain the pace of industrial development once the limits of the "easy" import substituting phase had been reached by the mid−1970s, the Indonesian government in the late 1970s decided to push industrial development into the secondary phase of import substitution. There was at that time a perceived need to rectify an imbalance in Indonesia's industrial structure, which as a result of the import substituting industrialization during the First and Second Five Year Development Plans had "led to a widening, rather than a deepening, of the industrial structure" (Soehoed 1981). To satisfy this need, industrial policymakers decided to "deepen" Indonesia's industrial structure through the development of upstream industries, including basic industries, as well as intermediate goods industries. Instead of continuing to extract and export minerals and expand light industries, Indonesia's industrial progress would involve the establishment of basic industries that would process Indonesia's. natural resources into intermediate inputs, for further processing by the downstream industries. Some of these basic and intermediate industries had

already been initiated by the end of the Second Five Year Development Plan (Repelita II) in the late 1970s, including iron and steel, cement, aluminum, fertilizer, artificial fibers and pulp, rubber, and basic chemicals. As most of the natural resources, envisaged to be processed in Indonesia, were located in the islands outside of densely populated Java (Outer Islands), the establishment of a wide range of resource processing basic industries in these regions was also considered to be an effective way of redressing the regional imbalance under which Java had thus far received a disproportionate share of capital investment (Gray 1982). Most, if not all, of the basic III— Deepening of the Industrial Structure

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Industrial Structures and the Development of Small and Medium Enterprise Linkages industries were to be initiated by state−owned enterprises, in view of the fact that the private sector was unlikely to take an interest in industrial projects that required huge funds and involved a long gestation period. Arguing that during Repelita I and II "industries had expanded and grown more or less independently, and perhaps in some cases even in competition with each other," and that "inter−industrial linkages, both backward and forward, were generally not very strong" (Soehoed 1981), the Ministry of Industry emphasized natural resource−based heavy industries and the need for inter−industry linkages between upstream and downstream industries. The Indonesian Ministry of Industry's approach was referred to as the "structuralist" approach to industrialization in the early 1980s at a national seminar held in December 1981 to discuss Indonesia's long−term industrial development (CSIS 1982). With the end of the oil boom era in 1982, however, the Indonesian government was forced to engage in a thorough reappraisal of its import substituting industrial strategy, and gradually had to shift to a more export−oriented strategy with a view toward expanding non−oil exports rapidly, particularly manufactured exports, in the face of declining foreign exchange earnings from oil exports. To achieve this goal, the Indonesian government, beginning in the mid−1980s, embarked on a series of structural reforms to reduce the "anti−export bias" of its highly protectionist trade regime, as well as a series of deregulation measures to stimulate increased private domestic and foreign investment in export−oriented activities. This shift in industrial strategy was clearly reflected in the Fifth Five Year Development Plan (Repelita V) for 1989/90−1993/94 that, while setting the same industrial policy objectives as Repelita IV (see appendix 4.3), had changed the ranking of priorities in that the promotion of manufactured exports was now given priority over the deepening of the industrial structure, as the development of manufactured exports was now viewed as the major engine to accelerate the growth of the manufacturing sector (Republik Indonesia 1989). Clearly, this reordering of priorities for Indonesia's industrial development indicated the determination of the Indonesian government to promote the development of an internationally competitive manufacturing sector. However, while manufactured exports are now given top priority, industrial policymakers have certainly not abandoned the objective of deepening and strengthening the industry structure. This is expected to be accomplished through the establishment of linkages with other sectors, particularly the primary sector, including agriculture, forestry, and mining; through the establishment of mutually supportive and profitable interindustry linkages between large, medium, and small enterprises; and through the establishment of linkages between upstream and downstream industries (Menteri Perindustrian 1991).

B. Implementation of Industrial Deepening

The plans to establish a wide range of state−owned natural resource processing basic and intermediate industries had to be put off with the end of the oil boom era in 1982. At that time, the Indonesian government made the painful, but widely acclaimed, decision to defer the implementation of a great number of planned, large public sector projects, such as the proposed olefin plant, aromatics plant, polymer center, methanol plant, and hydrocracker (see appendix 4.4). With the revival of the economy in the late 1980s, a number of these upstream industries were again initiated with state−owned enterprises (BUMN) and private sector participation, and largely financed with credits from state−owned banks and offshore loans. However, with the worsening of Indonesia's current account deficit in the course of 1991, the Indonesian government in September 1991 was again forced to effect a rescheduling of the implementation of a number of large projects in which state−owned enterprises were involved by introducing a list of these projects ranked according to priority and by imposing a limit to the amount of offshore borrowing that these projects were allowed to obtain in the next few years. As part of the drive to foster the growth of intermediate industries, in the late 1970s and early 1980s, the Ministry of Industry started introducing "localization" or "deletion programs" to promote the development of local supplier industries that could manufacture parts and components for the various assembling industries, particularly the motor vehicle industry, and specifically commercial vehicles (for example, buses and trucks) and motorcycles, the heavy equipment (for example, tractors) industry, the diesel engine industry, other engineering goods industries, B. Implementation of Industrial Deepening

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Industrial Structures and the Development of Small and Medium Enterprise Linkages and the electronics industry. Under the deletion program, a deletion schedule was drawn up on an item by item basis, under which local assembling firms were required to use progressively more and more locally manufactured parts and components in the assembly of final goods as specified by the deletion schedule for that particular industry (Thee 1984). For instance, the deletion program for the motor vehicle industry was initiated in 1976 when the Minister of Industry issued a Ministerial Decree (No. 307) in which a schedule was set for the gradual deletion of specified components from the imported CKD (completely−knocked−down) kits and their replacement by locally made components for the assembly of commercial vehicles, that is, trucks and buses. In the following years, more decrees were issued, specifying in further detail the components that had to be made locally (Thee 1984). In pursuing the localization program for the commercial vehicle industry, the establishment of local supplier industries, especially small and medium enterprises (SMEs), was hampered by market fragmentation, caused by the large number of commercial vehicle assemblers, proliferation of models, and the concomitant lack of standardization within the context of a relatively small domestic market.1 Such a situation obviously results in small orders for local component suppliers, which, in turn, can prevent them from growing into viable supplier industries, particularly those producing components involving significant economies of scale. The Indonesian government was quite aware of the problem of market fragmentation facing Indonesia's commercial vehicle industry, and of the urgent need for rationalizing the commercial vehicle industry and the need for greater standardization among the assemblers, if there was to be any reasonable chance of

building up viable, local component supplier industries. Hence, in 1979, the Minister of Industry issued another Ministerial Decree (No. 168), which contained some provisions designed to reduce the number of makes of commercial vehicles that could be assembled. To this end, the decree stipulated that for each make only one type for each category of commercial vehicle could be manufactured (Thee 1984). In general, the implementation of the deletion program for the commercial vehicle industry has thus far proceeded quite satisfactorily, even though the deletion program was rescheduled when the industry faced serious difficulties during the economic slowdown of the mid−1980s. Like the commercial vehicle industry, the motorcycle assembling industry also had to carry out a deletion program, beginning in 1977 when the Minister of Industry issued a Ministerial Decree (No. 08) requiring the assemblers of two−wheeled motor vehicles, including motorcycles and scooters, to use a specified number of locally made components (Thee 1984). Unlike the commercial vehicle industry, market fragmentation and its attendant problems have not been such a serious problem for the motorcycle industry. Hence, the lack of standardization, so evident with Indonesia's automobile assemblers, has been a less serious problem for the motorcycle industry. Since the annual output of motorcycles has also been larger than the output of commercial vehicles, the scope for achieving economies of scale in the motorcycle industry has also been greater than in the commercial vehicle industry. Moreover, to achieve further rationalization of the motorcycle industry, another Ministerial Decree (No. 651 of 1981) stipulated that each approved motorcycle assembling firm was only allowed to assemble a maximum of five models for every make of which it had the sole agency. The clause also stipulated that in the case where less than five models of a certain make were being assembled, no increase in the number of models would be permitted, thus effectively forestalling model proliferation, which has plagued the automobile industry (Thee 1984). A feature of Ministerial Decree No. 651 of 1981, which has not been evident in the various decrees on the commercial vehicle industry, has been a clause that recommended that components for two−wheeled motor vehicles be manufactured outside by subcontractors as much as possible, and that the subcontracting program be speeded up. However, the above decree did not stipulate that "outside" manufacturers of components will have to be small or medium supplier firms (Thee 1984). The outcome of the deletion programs for the various B. Implementation of Industrial Deepening

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Industrial Structures and the Development of Small and Medium Enterprise Linkages engineering goods industries, including the commercial vehicle and motorcycle industries, has resulted over time in an increased number of parts and components for the assembly of these engineering goods, which were hitherto imported as part of the CKD kits. In fact, in some cases, notably in the motorcycle industry, full manufacturing has been achieved in the sense that even the most intricate components, particularly the engine, are now being made locally. However, the mandatory deletion programs have either led to in−house manufacture of the major components (which has therefore led to the vertical integration of assembly firms and the newly established local supplier firm) or, if manufactured outside, the local manufacture of the components is carried out by large supplier firms, often affiliated with large multinational enterprises (MNEs) overseas.

To the extent that some linkages have been established with small subcontractors, these linkages are still weak, and often only established after some prodding by senior government officials (Thee 1984). The reluctance of the large assembly firms to establish vertical linkages with small, weak subcontractors may be attributed to the fact that these assembly firms are often quite reluctant to sacrifice efficiency levels in their operations and product quality to assist small, technologically inferior subcontractors, which they feel is not really their duty. For instance, a study on small subcontractors supplying a Japanese−Indonesian diesel engine plant indicated that the average reject ratio of parts and components supplied by 29 subcontractors in 1982 was 9.8 percent, 8.6 percent in 1983, and 9.0 percent in the first 8 months of 1984 (Hamid 1985). Even though over the years there has been a slight decline in the rejection rates of the components supplied by small subcontractors, these high rates indicate that product quality is often a problem with small subcontractors. Late delivery is yet another problem. Where subcontracting has worked, the parent companies sought out the subcontractors from past dealings. The criteria for the selection of subcontractors were based on the availability of technicians, production capacity, quality assurance system, and the availability of appropriate tools. While these were necessary, the subcontractors also had to produce acceptable samples within specified costs before being appointed. This highlights that fact that it is not the quantity of local content, but quality that matters. IV— Balancing Industrial Widening and Deepening The relative lack of success in promoting the development of SMEs through mandatory deletion programs raises the question whether these deletion programs are an appropriate way of promoting SMEs or whether there is a better way. While there is general agreement that the Indonesian government has an important role to play in promoting SMEs, pushing the establishment of subcontracting relationships with local SMEs, which are often technologically unsophisticated, may not be the best way of establishing viable subcontracting networks patterned after the Japanese model. After all, in Japan the large assembly firms rely on the technological capability of their supplier firms, and therefore do not have to provide all kinds of assistance to their subcontractors. In Indonesia, on the other hand, most SMEs require the large assembly firms to provide all kinds of assistance. Not surprisingly, the large assembly firms often turn to large, technologically sophisticated supplier firms, often themselves affiliated with foreign MNEs, for the sourcing of components. While the deletion programs have over time led to an increase in the number of small subcontractors supplying locally made parts and components to the large assembly firms, one cannot say at the moment that there exists strong linkages between the large assembly firms and local small supplier firms. The economic costs of linkage creation between large assembly firms and small local supplier firms may be quite high because of the initial inefficiencies arising from the mandatory deletion programs. For instance, the implementation of the deletion program, as we have seen, has often encouraged assembling firms to set up captive component plants supplying specific components. This has prevented the emergence of viable component suppliers capable of supplying a wide range of assemblers. This inefficiency is sometimes exacerbated if production levels are

IV— Balancing Industrial Widening and Deepening

99

Industrial Structures and the Development of Small and Medium Enterprise Linkages low because of the relatively small size of the Indonesian market, and therefore costs increase (World Bank 1985). Production levels can, of course, increase if part of the output is exported, but in order for such an increase to happen, product quality must be sufficiently high. The forced pace of the deletion programs also raises costs of production as more and more complex components have to be produced locally (World Bank 1985). Hence, the Indonesian government would do well not to pursue policies that force the pace of local subcontracting beyond the technological and managerial capabilities of SMEs. Instead, the Indonesian government should only encourage the creation of linkages between the large assembly firms and SMEs in those fields that are within the technological and managerial capability of these SMEs. Aside from this, the government would do well to lay the basis of establishing viable local supplier firms by effecting a rationalization of those assembly industries where market fragmentation is a problem. As long as the assembly industries are operating on a small scale for the domestic market, industry fragmentation is a serious problem. However, with Indonesia's shift to an export−oriented path of industrialization, industry rationalization and the attendant problems of small, uneconomical output are likely to become less important, if the Indonesian government continues to stick to export promotion policies by eliminating any remaining measure that in the past gave rise to the strong "anti−export bias." V— Lessons and Implications A. Promotion Programs for Small and Medium Enterprises (SMEs) Credit Programs for SMEs

As indicated earlier, the Indonesian government, like the other ASEAN governments, has introduced several promotion programs to foster the development of small and medium enterprises (SMEs) in Indonesia, notably subsidized credit and technical assistance programs. The fact that the major subsidized credit program, the KIK/KMKP program, was abolished in January 1990 due to high default rates and serious collection problems, while the smaller, unsubsidized rural credit program, the KUPEDES scheme, turned out to be more successful, may indicate that access to low interest loans is a less important problem to SMEs than the limited access to appropriate credit institutions at the local level. We have also seen that the problem facing SMEs in obtaining bank credit is that banks in general prefer to provide loans to traders, because it is more profitable for them to do so (Grizzell 1988). Moreover, SMEs in rural areas sometimes have little or no access to credit institutions simply because these institutions are not there. Hence, increasing the number of active credit institutions in the rural areas would go a long way in overcoming the problem of access to credit faced by SMEs. However, the contrasting experiences of the KIK/KMKP scheme and the KUPEDES scheme also indicate that high default rates and serious collection problems can be remedied by introducing an appropriate system of incentives and disincentives for the local credit institutions and their staff. For instance, by offering the local staff of the banks a bonus based on a certain percentage of profits, while at the same time requiring the local (subdistrict and village) branches of the lending institutions to pay off bad loans, instead of being covered

by credit insurance companies, banks will certainly make a greater effort to appraise loan applications and to collect loan repayments. For these tasks to be performed well, however, the skills of the staff of the local bank branches, particularly in basic management and accounting, would need to be raised in order to make them better able to appraise the loan applications. In addition, the rather cumbersome approval and collection system would need to be simplified to make it easier both for the bank staff to do their job well and for small entrepreneurs to comprehend the loan application procedures. V— Lessons and Implications

100

Industrial Structures and the Development of Small and Medium Enterprise Linkages The abolition of the KIK/KMKP subsidized credit scheme in early 1990 also indicates that providing subsidized credits to SMEs, a large part of which defaulted, eventually became too costly for the Indonesian government. The experience of other ASEAN countries, such as Thailand, indicates that low cost funds for SMEs will in any case be inadequate. Moreover, allocating limited amounts of low cost credits to a large number of SMEs may also lead to unofficial payment practices that are harmful to these SMEs. We have also seen that in recent years SMEs have played an important role in raising manufactured exports. A case might therefore be made to provide these SMEs with export credit to cover their need for working capital, particularly as the present financing scheme for the exports of SMEs is quite weak. A case might therefore be made for an export promotion program that caters to the specific needs of SMEs, including their need for export credits (Simandjuntak, Pangestu, and Thahir 1990; Zainuddin, Nasution, and Bari 1990). Thus far, the Small Enterprise Credit Program (KUK), which was introduced in January 1990 to replace the KIK/KMKP scheme, has not been successful either, as banks have either found it too difficult or been rather reluctant to allocate 20 percent of their loan portfolio to small entrepreneurs. This is partly due to the high transaction costs for small credits—as much as 20 percent according to Feekes (1993). In view of the difficulties experienced by the banks in implementing the KUK scheme, the Indonesian government recently called for a thorough review of the implementation of the KUK scheme with a view to improving its implementation. The experience in the other ASEAN countries, such as Malaysia, also indicates that reliance on commercial banks to provide loans to SMEs conflicts with the conservative lending policies of commercial banks, which prevents them from providing loans to these SMEs. Moreover, these banks often lack staff with the skills and experience to appraise the loan applications of SMEs. Hence, building up a small staff acquainted with the problems faced by SMEs would help to solve the problem faced by commercial banks in appraising the loan applications of SMEs. Feekes (1993) provides two additional suggestions: promote low cost financial institutions according to regional need for credit and promote interest differentiation by banks. Technical Assistance Programs

As in other ASEAN countries, the Indonesian government introduced a major technical assistance program to help SMEs to raise their managerial and technical capabilities to increase their production process and raise the quality of their products. We have seen that the BIPIK program, Indonesia's official technical assistance scheme for SMEs, has not been very successful, as reflected by the low occupancy rates and limited use of the Technical Service Centers (UPT) and the Small Industry Estates (LIK), and the

low productivity of the SMEs in these facilities. The reason for this is that the extension workers have little or no business and technical experience. Moreover, the training and subsidized inputs tended to be scheduled by central planners rather than by the needs of the small entrepreneurs and local conditions. Not having met with much success in providing direct technical assistance to SMEs, the Directorate−General of Small Industry, Ministry of Industry, under the aegis of the BIPIK program, has introduced a "Foster Father−Business Partner Linkage" scheme, which is now being pushed as a major way to assist the SMEs in overcoming their production, financing, and in particular their marketing problems. Despite some success that some large state−owned firms (BUMN) have had in marketing some products of SMEs, such as the "belinjo" chips, in domestic and export markets, there is some ground for skepticism about the viability of this program.2 This is due to the fact that political pressure has been required to persuade the large firms, particularly the state−owned firms, to act as foster fathers to often unrelated SMEs, as there is little or no economic benefit that these large firms obtain from these "partnerships" or "linkages," except some political goodwill.

Technical Assistance Programs

101

Industrial Structures and the Development of Small and Medium Enterprise Linkages To be sure, large firms with access to export markets could render some valuable help to export−oriented SMEs in selling their products in overseas markets, as these SMEs have, as we have seen, for the past few years generated quite an important share (9.7 percent in 1990) of Indonesia's total manufactured exports. In this endeavor, government marketing agencies, such as the National Agency for Export Development (Badan Pengembangan Ekspor Nasional, or BPEN) could also play an important supporting role to SMEs by providing them with valuable information on export markets and on the type of products for which there would be good demand in export markets. This agency could also assist the SMEs in their sales promotion efforts in overseas markets (Poot, Kuyvenhoven, and Jansen 1990a). Such agencies must, however, be effective; Indonesian sectoral institutions are plagued by low incentives, inconsistent objectives and have been long accustomed to industry regulation rather than facilitation. A recent preliminary assessment made by the Directorate−General of Small Industry, Ministry of Industry, about the results of the drive to establish "Foster Father−Business Partner" linkages revealed that since this scheme was launched as a "national movement" in February 1991, thousands of these "linkages" have been established between large enterprises and SMEs all over the country (Suhardi 1992b). Obviously, official ''persuasion" has led to the proliferation of these schemes. Whether or not this scheme will prove viable, however, remains to be seen, as "forced marriages" often founder, especially when the partnership is not mutually beneficial. B. 'Increasing the Absorptive Capabilities of SMEs

As part of the drive to foster the industrial deepening of Indonesia's manufacturing sector, the Indonesian government introduced deletion or localization programs to promote the development of local supplier industries that would manufacture various parts and components to the engineering and electronics industries. While the localization programs in Indonesia, Malaysia, and the Philippines have over time led to an increased number of parts and

components being made locally, these parts and components have, as we have seen, been largely made in−house or if made outside, made by other large firms, often affiliated with large MNEs overseas rather than by local SMEs. Hence, the localization programs have not led to the expected viable subcontracting relationships between the large assembly industries and small and medium local supplier industries as has been the case in Japan. As the deletion programs in Indonesia have often been introduced without much regard to the technological capabilities of the SMEs, the Indonesian government should first concentrate on encouraging linkage creation between the large firms and SMEs in those fields that lie within the technological and managerial capability of these SMEs. As the small subcontractors, through the process of learning by doing, acquire greater technological capability, they will, with the technical assistance and training provided by the large firms, be able to make more intricate parts and components. The growth of subcontracting arrangements in Thailand indicate that one favorable factor facilitating the establishment of direct linkages with local supplier firms was the familiarity of the large parent firm with its subcontractors, several of whom had been former employees of the large firm (Thongpakde, Puppahavesa, and Pussarangsri, chapter 5, this volume). Over time, when the subcontractors were able to gradually raise their technical capabilities, orders for more technically intricate parts and components followed. Hence, the experience of Singapore and Thailand indicates that a more gradual, rather than a forced, pace of localization will be more conducive to the establishment of more viable subcontracting relationships between large firms and SMEs. The reason for this is that if it is in their interest to procure locally made parts and components, the large assembly firms will provide the necessary technical, managerial, financial, and marketing assistance to their local supplier firms to ensure that these latter firms produce the parts and components according to the product specifications of the former. However, if the establishment of localization programs (to foster industrial deepening) takes precedence over the promotion of SMEs (that is, industrial broadening), then the inevitable result will be that the B. 'Increasing the Absorptive Capabilities of SMEs

102

Industrial Structures and the Development of Small and Medium Enterprise Linkages large assembly firms will not procure the parts and components, stipulated in the deletion programs, from the SMEs, as these enterprises, in general, do not yet possess the required technical skills to produce these parts and components according to the strict product specifications. C. General Policies

The economic policies, including trade and industrial policies, pursued by the Indonesian government, as well as the governments of the other ASEAN countries, do not intentionally discriminate against SMEs. In fact, several promotion programs for SMEs have been introduced and implemented to foster a faster development of these SMEs. In practice, however, several policies and regulations have resulted in unintentional discrimination against SMEs. For instance, in Indonesia the highly protectionist trade regime pursued by the Indonesian government from the 1970s through the early 1980s tended to favor large, capital−intensive industries rather than the smaller−scale, labor−intensive SMEs, as the highest rate of effective protection was enjoyed by the former group of industries. Fiscal incentives offered to domestic as well as foreign investors,

such as the reduction or exemption of import duties on the imports of machinery and capital equipment, also favored the large, capital−intensive industries. We have also seen that many SMEs in Indonesia, particularly in the rural areas, have had little access to appropriate credit institutions. This contrasts quite sharply with the large firms that, during the 1970s and early 1980s, were able to obtain large amounts of relatively low interest credits (liquidity credits). In fact, the remarkable rise of large conglomerates in Indonesia has been attributed to the advantage they received from their easy access to large credits provided by the large state−owned banks. In the past, the cumbersome industrial licensing system in Indonesia also favored the large firms in view of their greater resources, which they could deploy to acquire the various licenses needed for operating their business. The series of deregulation measures that the Indonesian government introduced since the mid−1980s to reduce Indonesia's dependence on oil revenues include: reduction in the high effective protection accorded to large, capital−intensive industries; simplification of the industrial licensing system; and elimination of liquidity credits to the large industrial groups as well as the various fiscal incentives formerly enjoyed by the large industries. As a result, the bias contained in the various economic policies and regulations against SMEs has been reduced, though not quite eliminated. However, even with the shift in industrial policy from an import substituting to an export promoting pattern since the mid−1980s, large firms have continued to benefit more from government policies and regulations than SMEs, as the former have continued to enjoy easier access to the various export incentives, such as export credits. There has been an attempt recently to bring the SMEs explicitly into the policy focus, for example, by allocating to them 10 percent of the Multi−Fibre Arrangement quota. SMEs, however, still face licensing barriers and this is compounded by a weak legal framework, which results in unofficial payments, increasing SMEs' compliance costs. In a recent study by the Center for Policy Implementation Studies (CPIS), it was estimated that the costs to small enterprises due to regulatory compliance was in the range of Rp 15 to 24 billion (CPIS 1993). D. Challenges for Indonesia

The important challenge facing Indonesia, as well as the other ASEAN countries, is how to strengthen their industrial structure through industrial deepening, while at the same time ensuring that this goal is achieved by industrial widening through a wider participation of SMEs in their industrialization process, without raising the costs of transactions. As the process of industrial deepening in Indonesia has, until recently, been given greater emphasis than the process of industrial widening, it has therefore not been surprising that industrial deepening has mostly taken place through vertical integration between the large assembly firms and their affiliated local supplier firms or through outside manufacture by other large supplier firms that were often affiliated with foreign MNEs. C. General Policies

103

Industrial Structures and the Development of Small and Medium Enterprise Linkages To forestall this process, the Indonesian government has pushed the foster father−business partner linkage program as a major way to foster the development of SMEs. However, in order to make these partnerships viable and sustainable, these relationships should indeed be based on the principles outlined by the Indonesian government itself, namely: (a) the principle of mutual need; (b) the

principle of mutually strengthening each other; and (c) the principle of being mutually beneficial (Suhardi 1992b). Right now, it is doubtful that these partnerships and linkages are generally needed and beneficial to the large firms, at least in the short run. Realizing, however, that widening economic disparities between the large industries and SMEs might adversely affect the business climate if these disparities lead to political and social tensions, most large firms are committed to participating in the foster father−business partner linkage programs. As these large firms are still groping to find an effective mechanism under which these partnerships and linkages can become operational, there have been several attempts by both the government and the private sector to explore feasible ways in which the government can effectively and fruitfully collaborate with private institutions, private businesses, and nongovernmental organizations (NGOs) to promote the SMEs. That this partnership and linkage program is now being taken seriously by many large firms is evident from a series of concrete proposals and suggestions put forward by several large business representatives at a seminar in January 1992 sponsored by the Indonesia Forum Foundation (IFF). The IFF is a foundation set up by the Association of Indonesian Economists (ISEI), with the support of private business executives and senior government officials, to discuss and study the various economic and social problems faced by the country and possible solutions to these problems. One important proposal put forward by the seminar is to establish a National Center for the promotion of SMEs, which would be sponsored by the national government in cooperation with private business. Such a Center, if realized, would be a suitable institution in which the public sector could cooperate with private business and NGOs to foster the development of SMEs in such a way that these SMEs would become viable operations, which could play an important role in the industrial deepening and industrial broadening of the country. There are yet other challenges facing Indonesia in creating a viable and sustainable industrial structure that would provide employment for the 2.5 million entrants into the labor force each year. These include forging greater linkages between MNEs and local enterprises, reforming the dated legal framework, improving the incentive structure of the civil service including civil service reform, reining in the conglomerates, exempting SEs from licensing requirements, refocusing industrial technology infrastructure toward small and medium enterprises and broadening the industrial base outside Java through the use of incentives and provision of infrastructure.

Appendix 4.1 The Structure of Manufacturing, 1986 (percentage of total) Output a

Employment

L+M b

L+M

excluding

including

oil and gas oil and gas

Appendix 4.1

L+M+S b

L+M

L+M+S

including oil and gas

104

Industrial Structures and the Development of Small and Medium Enterprise Linkages ISIC

Industry

(1)

(2)

(3)

(4)

(5)

311

Food products

8.2

6.0

6.9

12.9

13.3

312

Food products

3.3

2.4

2.9

5.3

7.9

313

Beverages

1.3

1.0

1.0

0.7

0.7

314

Tobacco

16.8

12.1

11.7

11.7

12.0

321

Textiles

11.6

8.4

8.1

18.0

14−3

322

Garment

1.7

1.2

1.7

3.7

5.1

323

Leather products

0.3

0.2

0.3

0.2

0.4

324

Footwear

0.5

0.3

0.5

0.5

1.0

331

Wood products

10.0

7.2

7.2

9.9

9.1

332

Furniture

0.3

0.2

0.6

0.8

2.5

341

Paper products

1.3

1.0

1.0

1.5

1.1

342

Printing & publishing

2.0

1.4

1.6

2.2

2.3

351

Basic chemical

5.3

3.8

3.6

2.1

1.6

352

Other chemicals

5.0

3.6

3.6

3.9

3.0

353/4 Oil and gas processinga

0.0

27.6

25.9

1.3

0.9

355

Rubber products

3.1

2.2

2.1

5.3

3.8

356

Plastics

1.4

1.0

1.0

2.9

2.3

361

Pottery and china

0.4

0.3

0.3

0.7

0.5

362

Glass products

1.3

0.9

0.9

0.6

0.4

363

Cement

3.0

2.2

2.3

1.7

2.7

364

Structural clay products

0.2

0.2

0.4

1.3

3.5

369

Other non−metallic minerals

0.3

0.2

0.2

0.4

0.4

370

Basic metals

8.5

6.1

5.8

1.0

0.7

381

Metal products

3.9

2.8

2.9

3.5

3.5

382

Non−electric machinery

0.8

0.6

0.6

0.9

0.8

383

Electrical equipment

3.0

2.2

2.1

2.2

1.7

384

Transport equipment

6.1

4.4

42

3.8

2.9

385

Professional equipment

neg.

neg.

neg.

0.1

0.1

390

Miscellaneous

0.4

0.3

0.5

0.8

1.4

Total

100.0

100.0

100.0

100.0

100.0

1,869.0

2,709.5

Value added in Rp billion; employment in thousands: Excluding oil and gas Including oil and gas

Appendix 4.1

10,197.3

11,097.7 14,081.2

14,981.0

105

Industrial Structures and the Development of Small and Medium Enterprise Linkages neg. = negligible, that is, the share is less than 0.1 percent. a . Output refers to value added; data on the value added of the oil and gas processing industries were obtained from the Indonesia's national accounts of 1986. b . According to the Central Bureau of Statistics (BPS): L = large enterprises (that is, establishments employing more than one hundred workers); M = medium enterprises (that is, establishments employing between twenty to ninety−nine workers); S = small enterprises (that is, establishments employing five to nineteen workers). (Cottage enterprises include establishments employing less than five workers, including unpaid family workers.) Source: Hill (1990). Appendix 4.2 Structural Change In Indonesian Manufacturing, 1975−86a Output (value added)

Employment

ISIC

Industry

1975

1986

1975

1986

311

Food products

17.4

9.3

21.1

135

312

Food products

6.2

4.0

9.8

8.0

313

Beverages

2.0

1.3

0.6

0.7

314

Tobacco

15.4

15.7

11.2

12.1

321

Textiles

11.2

11.0

18.2

14.4

322

Garments

0.3

2.2

0.8

5.2

323

Leather products

0.2

0.4

0.2

0.4

324

Footwear

1.0

0.6

0.6

1.0

331

Wood products

3.1

9.8

4.4

9.2

332

Furniture

0.5

0.8

1.8

2.6

341

Paper products

1.1

1.4

0.7

1.1

342

Printing and publishing

2.2

2.2

2.1

2.3

351

Basic chemicals

4.0

4.9

0.9

1.6

352

Other chemicals

4.4

4.9

2.9

3.0

355

Rubber products

11.7

2.9

8.0

3.9

356

Plastics

0.8

1.4

1.2

2.4

361

Pottery and china

0.1

0.3

0.3

05

362

Glass products

0.4

1.2

0.5

0.4

363

Cement

2.9

3.2

2.4

2.8

364

Structural clay products

0.4

0.5

3.0

3.5

369

Other non−metallic minerals

0.1

0.3

0.2

0.4

Appendix 4.2

106

Industrial Structures and the Development of Small and Medium Enterprise Linkages 370

Basic metals

0.3

7.8

0.2

0.7

381

Metal products

3.7

3.9

3.7

3.5

382

Non−electric machinery

1.1

0.8

0.8

0.8

383

Electrical equipment

3.6

2.8

1.4

1.7

384

Transport equipment

5.7

5.7

2.3

2.9

385

Professional equipment

0.1

0.1

0.1

0.1

390

Miscellaneous

0.4

0.6

0.7

1.4

Total

100.0

100.0

100.0

100.0

(1,468.5)

(2,685.3)

(Employment in thousands) Shares (percentage of total)b − light industry

72.1

62.2c

80.6

77.0

− heavy processing

13.7

24−5c

11.1

14.0

− heavy engineering

14.2

13.3c

8.3

9.0

a . Includes firms with a work force of at least five persons in 1975 and 1986, that is, includes data on small enterprises.. b . Defined as follows: light industry−ISIC 31, 32, 33, 342, 355, 356, 39; heavy processing industry−ISIC 341, 351, 353, 353/4, 36, 37; heavy engineering industry−ISIC 38. c . These shares alter dramatically if oil and gas are included, namely: 46.2 (light), 44.0 (heavy processing), and 9.8 (heavy engineering). Source: Hill (1990). Appendix 4.3— Industrial Sector Objectives in Development Plans The Fourth Five Year Development Plan (Repelita IV) for 1984/85−1988/89 emphasized achieving the following objectives for the manufacturing sector: 1. The deepening and strengthening of the structure of the manufacturing sector, which should be linked as much as possible with other economic sectors; 2. The development of the machinery and electrons industries; 3. The development of small industries, in which priority would be given to solving the major problems they face, namely marketing, technical, and financial problems; 4. The development of manufactured exports, which is considered of strategic importance; 5. The development of technological capability in industrial design and engineering. In Repelita V (1989/90−1993/94) the same policy objectives as in Repelita IV were set, although there was a change in the order of priorities in that the promotion of exports was now given priority over "the deepening of the industrial structure." Thus, the policy objectives of Repelita V were as follows:

Appendix 4.3— Industrial Sector Objectives in Development Plans

107

Industrial Structures and the Development of Small and Medium Enterprise Linkages 1. The development of manufactured exports as the major engine to accelerate the growth of the manufacturing sector; 2. The strengthening of the industrial structure to increase manufacturing value added and strengthen interindustry linkages and linkages between the manufacturing sector and other sectors of the Indonesian economy; 3. The development of small industries to expand business and economic opportunities; 4. The upgrading of research and design industrial design and engineering capabilities aimed at acquiring technological and innovative capabilities, the improvement of industrial efficiency and productivity, and the capability of making machinery and plant equipment and, eventually, of establishing plants; 5. The development of entrepreneurship and professional skills of technical experts and others employed in the manufacturing sector (Menteri Perindustrian 1989) (author's translation).

Appendix 4.4— Institutions Affecting Industrial Broadening and Deepening in Indonesia I. Institutions Affecting Industrial Broadening (SME Promotion) 1. Major Government Agencies In Charge Of SME Promotion Policies

a. Directorate−General of Small−Scale Industry, Ministry of Industry: in charge of the BIPIK technical assistance program to SMEs. b. Bank of Indonesia: Overseeing the implementation of the KUK (Small Enterprise Credit) program by the various state, private, and development banks. 2. Other Government Agencies Concerned with SME Promotion

a. Ministry of Manpower (training programs for small entrepreneurs) b. Ministry of Cooperatives (overseeing cooperatives of SMEs) c. Ministry of Social Affairs d. Ministry of the Interior e. National Agency for Export Development (BPEN ), Ministry of Trade (assisting SMEs in marketing products overseas) 3. Private Institutions

a. Small−Scale Industry Section, Indonesian Chamber of Commerce & Industry b. Institute of Management Education and Development (IPPM ) (training programs for small entrepreneurs) 4. Selected NGOs

a. Association for the Promotion of Small Enterprises (PUPUK )

Appendix 4.4— Institutions Affecting Industrial Broadening and Deepening in Indonesia

108

Industrial Structures and the Development of Small and Medium Enterprise Linkages b. Bina Swadaya c. Maha Bhoga Marga d. Institute for Economic and Social Research, Education and Information (LPES ) e. Mandiri Foundation f. Pekerti Foundation g. Dharma Bakti Astra Foundation II. Institutions Affecting Industrial Deepening 1. Major Government Agency Overseeing the Implementation of Deletion Programs

Directorate−General of Metal Goods and Electron Industries, Ministry of Industry 2. Other Government Agency Concerned with Industrial Deepening

Capital Investment Coordinating Board (BKPM )

Endnotes

1. This is quite evident from the following figures: In 1983 the total number of commercial vehicles assembled in Indonesia amounted to only 119,369 being produced by 11 assembling firms. Among these 11, 3 assemblers were assembling fewer than 300 units a year, while a few unnamed assemblers were assembling even fewer (Wibisono 1984).

2. A tree bearing edible seeds from which the famous "emping" chips are made.

5— Thailand Nattapong Thongpakde Wisarn Puppahavesa Bunluasak Pussarangsri Small and medium enterprises (SMEs) constituted about 98 percent of the firms in the Thai manufacturing sector in 1990. However, rapid growth and structural change in many developing countries like Thailand are induced mainly by large enterprises (LEs), especially those with foreign direct investment. SMEs have yet to be well integrated into the dynamics of the economy. The development of SMEs can deepen the manufacturing sector and foster competitiveness. Furthermore, if SMEs are not developed, the benefits of economic growth will not be distributed evenly among people in society and problems associated with income distribution will be exacerbated. The development of SMEs is justified on the grounds of both efficiency and distribution of wealth.

II. Institutions Affecting Industrial Deepening

109

Industrial Structures and the Development of Small and Medium Enterprise Linkages This chapter will sketch the structure of the Thai manufacturing sector. It will also discuss government measures to promote SMEs and lessons learned from Thailand's experiences. The chapter is divided into four sections. Section I explains the industrial transformation of Thailand, characteristics of SMEs in Thailand, and constraints to the development of SMEs. Section II discusses the promotional measures for SMEs, including both financial and nonfinancial assistance. Then, in section III, specific issues concerning the deepening of the industrial structure are examined, for example, subcontracting and local content requirements. The chapter ends with a conclusion and an assessment of the government measures affecting SMEs. I— Thailand's Industrial Structure A. Industrial Transformation Growth of GDP and Change in Structure Of Production

It is widely recognized that Thailand has experienced high and sustained growth for over a decade. The growth rates of real GDP were more than satisfactory, averaging 5.1 percent per year during 1980−85 and 9.89 percent from 1985 to 1990. The structure of production has changed remarkably since the country began industrializing in 1960s. The share of the manufacturing sector in the gross domestic product (GDP) has risen, and in 1980 it surpassed that of the agricultural sector. At present, the manufacturing sector is the leading sector. It accounted for about 26.1 percent of GDP in 1990, while the share of the agricultural sector was only 12.4 percent. The average growth rate of value

added in the manufacturing sector during 1985−90 was 13.9 percent per year, higher than the average GDP growth rate (table 5.1). Table 5.1: Gross Domestic Product by Industrial Origin (1990) Average growth rate

Sector

Value added 1990 prices $1,000 million

Share in GDP

(1972 prices) 1985−90

Agriculture

9.9

12.4

2.9

Mining and quarrying

2.8

3.5

12.8

Manufacturing

20.9

26.1

13.8

Construction

5.7

7.1

14.7

Electricity and water supply

1.8

2.3

14.0

Transportation and communication

5.4

6.7

9.8

Wholesale and retail trade

12.2

15.2

11.6

Banking, insurance, and real estate

4.8

6.0

23.3

Ownership of dwellings

2.5

3.1

5.5

Public administration and defense

2.9

3.6

2.4

Services

10.9

13.5

7.1

I— Thailand's Industrial Structure

110

Industrial Structures and the Development of Small and Medium Enterprise Linkages Gross domestic product

80.2

100.0

9.8

Source: National Economic and Social Development Board, National Income Accounts (1990). Within the manufacturing sector, the leading subsectors with regard to their share in GDP, are food processing, textiles, garments, beverages, and transport equipment. The sectors that have grown most rapidly in recent years include machinery, electrical machinery, leather, and miscellaneous goods, which include jewelry and rubber products. These are products that also exhibit high rates of export growth. The manufacturing sector has been diversified from agricultural based industries with a few dominant subsectors toward more labor−intensive industries with a broader production base. Although the manufacturing sector is the leading sector with respect to its share of GDP, its share of the employed work force is relatively small. In 1989 the agricultural sector engaged about 60 percent of total employment, while the share of the manufacturing sector was only 12 percent. The service and commerce sectors together accounted for about 23 percent of total employment. The growth rate of employment in the manufacturing sector has not been commensurate with the rate of growth of this sector's production. As a consequence of the low employment absorptive capacity of this sector, the employment structure of the Thai economy has yet to be transformed into that of an industrializing nation.

Exports and Imports

The growth rate of Thailand's export sector has been very high, especially during the second half of the 1980s. It averaged 12 percent per annum during 1980—85, and 25 percent per year during 1985−88. The contribution of exports to GDP growth, as presented in table 5.2, increased during most of the period; the only exception being 1980−85. The table also shows that the economic transformation has not reduced import dependency. The contribution of the import substitution effect has been negative, which means the ratio of imports to real GDP has risen. Table 5.2: Sources of Growth in Thailand, 1960−88 Growth rate

Source of growth

(Percent distribution)

Period

Real GDP (percent per year)

Domestic demand

Import substitution

Export demand

1960−70

7.8

89.1

−0.6

11.4

1970−75

5.6

87.9

−6.0

18.0

1975−80

7.9

87.6

−11.4

23.8

1980−85

5.6

74.0

7.6

18.4

1985−88

7.9

78.1

−23.4

45.3

Note: The contributions to economic growth are calculated using the formula: Yt − Yt−1 = a (Dt − Dt−1 ) + (a − at−1 ) St + a (Xt − Xt−1 ) in which Y = GDP; D = domestic demand, defined as Y+M−X (GDP plus imports, minus exports); S = total supply, defined as Y+M (GDP plus imports); a = Y/S; and t = time.

Exports and Imports

111

Industrial Structures and the Development of Small and Medium Enterprise Linkages The first term on the right−hand side reflects the contribution of domestic demand to growth, the second term the contribution of import substitution, and the third term the contribution of export growth. A negative sign for the second term, that is, negative import substitution, implies that with economic growth the import dependency increased. Source: Jansen (1989). The structure of exports has also changed consistent with the change in the production structure. In the 1960s about half of all exports consisted of food and processed food products. In the 1970s, the share of primary product exports declined, but the share of processed food increased. The share of manufacturing products, that is, textiles, garments, and footwear rose to about 24 percent of total exports. In the middle of the 1980s, the share of all manufacturing exports was over 75 percent of total exports. High growth export items include traditional exports such as textiles, garments, and canned foods, and nontraditional products such as electronics, machinery parts, toys, jewelry, and plastic products. Wattananukit and Bhongmakapat (1989) calculated the ratio of imports in total demand using the 1985 Input−Output Table of Thailand. The sectors with high ratios of import dependency—greater than 50 percent—were machinery (81.7 percent), transport equipment (61.2 percent), and electrical machinery and appliances (50.1 percent). The sectors with ratios between 25 and 50 percent were paper and paper products (47.6 percent), fabricated metals (45 percent), basic

chemicals (31.8 percent), chemical products (31.5 percent), and petroleum products (30.0 percent). The sectors with low import dependency ratios were labor−intensive or natural resource−based industries such as food, textiles, leather, beverages, and plastics. Although export growth and diversification have been more than satisfactory, Thailand still faces a chronic balance of trade deficit due to rapidly growing imports. The composition of imports has changed from mostly consumer products to raw materials and capital goods. As mentioned above, import dependency has not been reduced; industrialization in Thailand has broadened the manufacturing sector but has yet to deepen it. The integration of SMEs into the economy can therefore deepen the manufacturing sector. Regional Distribution of Industry

Factories are primarily concentrated in the Bangkok Metropolitan Region (BMR−Bangkok and the surrounding provinces) because of the adequate infrastructure in terms of both quantity and quality, and the proximity of transport facilities (port), and markets. Of the total value added of the manufacturing sector, before over 75 percent was generated in this region. More than 50 percent of factories are in the BMR. The per capita income in Bangkok is much higher than in the provinces indicating that the gains from development have been uneven. Although there is a trend of industries dispersing to rural areas (Thongpakde, Puppahavesa, and Pussarangsri 1991), the process has been slow and is not reaching areas away from Bangkok. B. Characteristics of SMEs Definitions

There is no accepted definition of SMEs in Thailand. Different institutions working with SMEs and different studies tend to use their own definitions. The Industrial Finance Corporation of Thailand (IFCT) and the Small Industry Finance Office (SIFO) use net fixed assets for their criterion; a small enterprise is one with fixed assets less than bhat 10 million (US$0.39 million). A medium enterprise is defined as having between bhat 10 and 50 million (US$0.39−1.9 million) in net fixed assets. The Bank of Thailand (BOT) employs both net fixed assets and Regional Distribution of Industry

112

Industrial Structures and the Development of Small and Medium Enterprise Linkages number of employees for their criteria. An enterprise that employs fewer than 50 people is classified as small; a medium enterprise has 50 to 299 employees, while a large enterprise has more than 300 persons. Most academic studies in Thailand use the number of employees as a primary criterion because it is easy to observe. The drawback of this method is that it is difficult to distinguish between capital−intensive and labor−intensive industries unless other indicators are used. Kuroda and Kasajima (1987) reviewed the definitions of SMEs in Thailand and some other Asian countries and recommended the use of both net fixed assets and the number of employees as relevant criteria. The categories they suggest for Thailand are given in table 5.3.

Table 5.3: Enterprise Size Criteria, Thailand Type of industry

Number of employees

Cotttage industry

1−9

up to bhat 1 million

Small enterprise

10−49

bhat 1−10 million ($0.4 million)

Medium enterprise

50−199

bhat 10−50 million ($0.4 −1.9 million)

Large enterprise

200 and over

over bhat 10 million ($1.9 million)

or

Net fixed assets

Source: Kuroda and Kajisama (1987). While we agree that this definition is appropriate for Thailand, due to data constraints we use the number of employees as our criterion in this chapter. Small enterprises, cottage enterprises included, are those that employ fewer than fifty persons. An SME, therefore, employs fewer than 200 persons, and an LSE has at least 200 employees. It should also be mentioned that Kuroda and Kasajima found that the investment and employment criteria are highly correlated. Number and Distribution of SMEs

The data on employment used in this chapter and in most studies in Thailand cover only registered firms. Therefore many of the unregistered microenterprises with fewer than seven employees do not appear in the figures. Despite the fact that the share of SMEs in the manufacturing sector with regard to number of factories is undoubtedly underestimated, it remains significant. SMEs accounted for 98.3 percent in 1984 and 99.4 percent in 1987. Small size enterprises with fewer than 50 employees accounted for about 92 percent of the total number of factories in 1990. Large−scale enterprises contributed to about 40 percent of total employment in the manufacturing sector in 1984. This share rose to 43 percent in 1987. The SMEs' share of employment, however, is significant since more than half of the labor in manufacturing is in SMEs. This share would be much larger if data was available for unregistered firms. Figure 5.1 shows the regional distribution of manufacturing firms classified by size. More than half of the factories are located in Bangkok and the five surrounding provinces (BMR). The share is as high as 72 percent for LEs. It is obvious that the dispersion of manufacturing firms to other provinces has been limited. In relative terms, there is a greater concentration of smaller firms in the provinces than larger firms; in 1987, 44 percent of the firms employing fewer than 10 persons were located in the provinces. In the same year only 28 percent of the LEs were Number and Distribution of SMEs

113

Industrial Structures and the Development of Small and Medium Enterprise Linkages in the provinces.

Figure 5.1: Regional Distribution of Manufacturing Firms, 1987 *BMR: Bangkok Metropolitan Region. Source: Ministry of Industry. When we examine the structure of firm size within the regions, we find that small firms dominate in both Bangkok and in the provinces (figure 5.2). About 91 percent of total factories in Bangkok and surrounding provinces are small enterprises, while the share of small enterprises in the provinces is about 94 percent. The percentage of medium− and large−scale enterprises established in Greater Bangkok is higher than in the provinces.

Figure 5.2: Distribution of Firm Size, 1987 *BMR: Bangkok Metropolitan Region. Source: Ministry of Industry.

Types of Industry Subsectors

Appendices 5.1 and 5.2 illustrate the breakdown of factories by industry type. This is shown as percentages of all factories within each industry. In these two periods—1984 and 1987—SMEs comprised more than 90 percent of all industries, with the exception of glass and petroleum. There is a relatively higher share of LEs in intermediate products. These industries include textiles, chemicals, petroleum, glass, and basic metals. The appendices show that industries with a relatively high share of small firms—fewer than fifty employees—are resource based and labor intensive, engaged in food, printing and publishing, leather products, furniture, and Types of Industry Subsectors

114

Industrial Structures and the Development of Small and Medium Enterprise Linkages plastics production. Appendices 5.3 and 5.4 show that SMEs are concentrated in food processing, general machinery, metal products, wood and wood products, printing and publishing, plastic products, non−metal products, and garments. As discussed in Kuroda and Kasajima (1987), the machinery industry in Thailand consists of small firms producing simple parts and components of low quality. And the primary use for products of the metal industry are for construction and household utensils; not for industrial purposes. Therefore, in spite of the large number of factories, the contribution of these industries is not very significant in terms of the overall development of the economy. We can conclude, therefore, that the industrial structure of SMEs is resource based or material based and labor intensive. SMEs are much less important in the production of intermediate products than LEs. Characteristics of Entrepreneurs

It is assumed that entrepreneurs involved in SMEs are not very well educated and rely on family−type management styles. They do not want outsiders to operate their businesses, as has been the case in Taiwan (China). A survey by the Thailand Development Research Institute (TDRI) in 1987 confirms this hypothesis (TDRI 1990). It was found that only 12 percent of the sample of small enterprise owners hold bachelor degrees or higher. This figure was up to 40 percent for owners of medium firms and 56 percent for owners of large enterprises. About half of the entrepreneurs involved in small enterprises received no higher than a primary education. The survey also indicates that the small enterprises have not been operating on the basis of entrepreneurs' experiences and modern management techniques. Information on markets and technology have been passed on by word of mouth, not by formal sources. We cannot definitely say with certainty that these styles of management are wrong because such firms are still surviving, but it is certain that these characteristics do not facilitate the further development of SMEs. Kuroda and Kasajima (1987) also make an interesting observation that SME owners tend to adopt trading practices. They start in business as merchants before they manufacture products. Therefore, manufacturing production knowledge is lacking. This commercial business strategy emphasizes the production of goods that are currently most marketable with potential for high turnover ratios. Efforts to improve product quality and production efficiency are neglected, undermining the benefits of long−term growth.

C. Constraints on SMEs

Before discussing government promotion measures in the next section, it is useful to examine the constraints on the development of SMEs so that the significance of the promotion measures will be more apparent. We adopt Porter's ''diamond" to identify the competitive disadvantage of SMEs (Porter 1990). Four conditions affect SMEs: factor conditions, demand, firm strategy and structure, and the role of the government. Although mentioned by Porter, we have omitted the related and supporting industries factor, because it is not clear whether this factor affects SMEs exclusively. Factor Conditions

The resource based and labor−intensive nature of the majority of the SMEs, as illustrated above, is consistent with the structure or comparative advantage of the Thai economy. Firms in the provinces should have an advantage over firms in Bangkok because of their access to natural resources and a cheap labor pool. However, Porter (1990) suggests that firms employing natural resources may lack incentives to improve product quality and to Characteristics of Entrepreneurs

115

Industrial Structures and the Development of Small and Medium Enterprise Linkages innovate in order to be on the competitive edge. Therefore, they are not well equipped to function within a dynamic environment. SMEs lack the human resources, knowledge, and infrastructure available to LEs. LEs can provide these resources because they can invest in supporting facilities and engage qualified personnel. SMEs also lack financial resources because access to formal financial institutions is difficult. They tend to rely on informal financial sources and are forced to pay higher rates of interest. Empirical studies have shown that investment opportunities are limited for SMEs, because most of the funding of these enterprises derives from internal sources such as retained earnings and borrowing from relatives. Demand Conditions

Chintayarangsan (1990) found that the share of SMEs' total sales in the domestic market was greater than that of the LEs. He also found that SMEs in the provinces sell products to regional markets while large enterprises sell to Bangkok or export their products. It is believed that demand in Bangkok and in the export market is more dynamic, and consumers are more sophisticated than in the regional markets. Thus, these demand conditions appear to reinforce the static tendencies of SMEs. The market is also quite narrow for SMEs, especially in the provinces, because the growth of regional demand is slow. Gross regional product in Bangkok is much greater than in the provinces. It is clear, then, that the market is one major constraint for SMEs. Firm Strategy and Structure

The SMEs are at a disadvantage because of the characteristics of the entrepreneurs and management. Because of shortcomings caused by low levels of education, management by experience, family−type business, domestic market orientation, and a lack of commitment to improve product quality and productivity, the development of enterprises has been retarded. However, since the new generation of SME entrepreneurs are better educated, these conditions are changing. They are beginning to operate their businesses using modem management techniques. Furthermore, the openness of the Thai economy and the dynamics of the export market make the external market more attractive to both large and small enterprises.

Government Policy

The government's attempt to promote SMEs has been clearly stated in the Economic and Social Development Plans and the many promotion measures that have been pursued will be discussed later. Despite the micro level promotion efforts, some policy biases against SMEs exist at the macro level. These include, among others, the incentive regime and the control of the interest rate. Thailand started its industrialization process in the 1960s with an import substitution strategy. High tariff rates on imports were employed to protect industries and to provide government revenue. Although a policy based on export promotion has since been promoted, tariff protection remains high. Wiboonchutikula, Chintayarangsan, and Thongpakde (1989) found that protection is high for intermediate products and raw materials. The tariff rates on capital goods were also high until the recent tariff reductions (in 1990) took effect. Now they are moderate. These high tariff rates, while protecting domestic industry from import competition, hurt nonimport and export industries. The latter are faced with high costs for machinery, materials and parts. The Board of Investment (BOI) has made efforts to offset this bias by providing firms with investment incentives such as tax exemptions on the purchase of raw materials and machinery. The BOI generally promotes export and strategic industries so they can compete internationally. This BOI scheme to some extent offsets the distortions inherent in the high tariff and tax rates. However, large firms have received the lion's share of the benefits; only 17 percent of the promoted firms in 1988 were small Demand Conditions

116

Industrial Structures and the Development of Small and Medium Enterprise Linkages enterprises. Minimum investment requirements for BOI promotion eligibility have only exacerbated the problem. Most small enterprises, therefore, are subject to high taxes without any recourse for exemptions or reductions. The recent liberalization policy (1990−91) has helped alleviate this problem. The Thai government reduced tariff rates on machinery from 40 percent to 5 percent. Tariff rates on computers and parts, and automobiles have also been reduced significantly. This will help the manufacturing sector in general and the SMEs that have been unable to receive tariff exemptions. The liberalization process will continue to cover more items, such as machinery and raw materials whose tariff rates should be reduced. Another bias against SMEs is the interest rate policy. The Bank of Thailand (BOT) sets interest rate ceilings to avoid instability and excessive competition in the banking system. The ceiling has generally been set below market levels. The result has been credit rationing since the demand for loans exceeds supply. Commercial banks tend to be risk averse and lend only to customers with sufficient collateral and good reputation with the banks. This limits access to formal financial markets for SMEs. This was confirmed by Aungsumalin's study (1990), which indicates that SMEs have a problem getting loans from commercial banks because of insufficient collateral. They are thus forced to depend on informal financial markets. If interest rates are allowed to float according to market forces, SMEs will have greater access to loans from commercial banks because their greater risk of default can be covered by higher interest rates.

The BOT is now in the process of liberalizing financial controls so that the market mechanism will determine interest rates. It is expected that SMEs will gain more access to commercial bank loans. II— Small and Medium Enterprise Promotional Measures A. Financial Assistance

The government is well aware of the financial problems encountered by SMEs. Special institutions have been established and measures taken to cope with these problems. The following is a discussion of the nature and activities of these institutions and their shortcomings. Small Industry Finance Office (SIFO)

SIFO was established in 1964 for the exclusive purpose of providing credit to small enterprises. It is a government agency under the Department of Industrial Promotion. Most of SIFO's loans were given to the smaller of the small enterprises. About 85 percent of SIFO's customers employ no more than 20 workers. Compared to the total number of small enterprises, however, loans provided by SIFO are not significant. During the period 1979−83, SIFO approved a total of 58 projects amounting to bhat 26.54 million (US$1.2 million). During 1984−88, the number of approved projects rose to 463 with a loan total of bhat 102.67 million (US$4.06 million). This is still far less than the demand for loans by SMEs. There are two types of loans offered by SIFO. They are either provided directly to enterprises or jointly with the Krung Thai Bank (KTB). The latter type of loan is larger than the former. SIFO is responsible for appraising the feasibility of joint loans, while the Krung Thai Bank is responsible for evaluating the collateral and administration of the loan. Conflicts have arisen, however, between these two institutions. The Krung Thai Bank has encountered a large number of bad loans from this scheme and has accused SIFO of negligent loan appraisal. On the other hand, SIFO has charged the Krung Thai Bank with keeping all of the good projects for itself. The result has been a decline in joint lending. To compensate for this decline, SIFO has increased its direct lending, but the amount has been small. II— Small and Medium Enterprise Promotional Measures

117

Industrial Structures and the Development of Small and Medium Enterprise Linkages Besides difficulties with the Krung Thai Bank, SIFO also faces other problems. It is not a financial institution so it is unable to mobilize funds. It has to rely on budget appropriations, which obviously limits the funds available for SMEs, as well as for personnel improvement and operations within SIFO. Because SIFO does not have provincial branches, its services to provincial industries are restricted. furthermore, it is doubtful that SIFO can expand its operations because of its limited budget. Aungsumalin (1990) also found that the loan approval process tends to be quite lengthy. It takes about five months for direct loans and over six months for joint loans to be approved. With these shortcomings in the structure of SIFO, it is not an effective agency to provide funds to SMEs. Industrial Finance Corporation of Thailand (IFCT)

The IFCT was set up in 1962 as a finance institution devoted to promoting the development of industry. Its shareholders are the Ministry of Finance and private financial

institutions. Its major sources of funds for lending are multilateral organizations such as the World Bank and international commercial financial institutions. The main task of the IFCT in support of industrial development is to provide long−term, fixed−rate loans determined on a project financing basis, rather than on collateral alone. Moreover, the government has pressured the IFCT into providing loans with interest below market rates. Although most of the IFCT's lending is to large enterprises, the share of small firms has been increasing in recent years. During the period 1978—82, loans extended to small enterprises accounted for about 3 percent of the total loan amount, and about 24 percent in terms of the number of projects. During 1984—87, loans provided to small enterprises represented 12 percent of total loans, and 60 percent of the total number of projects. The IFCT has six regional branches so it can more effectively extend loans to provincial industries. The concessionary interest rates offered, however, may limit the access of SMEs to IFCT loans, because the upward immobility of interest rates gives incentives to provide loans to LEs due to lower risk and lower lending costs. The IFCT also faces the problem of foreign exchange risk, because the major sources of funds are international financial institutions. Nevertheless, the IFCT has the potential to be effective in providing loans to SMEs, because it has regional branches and qualified personnel who are familiar with project appraisals. The Small Industry Credit Guarantee Fund (SICGF)

One of the problems encountered by SMEs is that they lack the collateral needed to borrow funds from commercial banks. To alleviate this problem the government established the Small Industry Credit Guarantee Fund (SICGF) in 1985 under management of the IFCT. The SICGF was established with a total fund of bhat 200 million (US$8 million). This fund provides services to small enterprises with net fixed assets not exceeding bhat 10 million (US$0.4 million), and loan sizes range from a minimum of bhat 200,000 (US$7,822) to a maximum of bhat 5 million (US$0.2 million). Those eligible for promotion include manufacturing, handicrafts, service, and agro−based industries. In 1987, the SICGF received additional support from USAID in the amount of US$8 million. The conditions of this USAID fund are more restrictive. Small enterprises eligible for the promotion must have net fixed assets not exceeding bhat 5 million (US$0.2 million), and the loan size cannot exceed bhat 2.5 million (US$97,235). The industries must also be located outside Bangkok and the five surrounding provinces.

Industrial Finance Corporation of Thailand (IFCT)

118

Industrial Structures and the Development of Small and Medium Enterprise Linkages The SICGF guarantees the loan portion that is unsecured by collateral, and it is limited to 80 percent of the unsecured loan. In return, borrowers have to pay an annual fee of 1.5 percent of the guaranteed loan amount. The activities of this fund have expanded rapidly. In 1986 there were only 16 projects with the guaranteed amount of bhat 8.4 million (US$0.3 million) under the fund. The number of projects increased to 126 projects by 1988 with a guaranteed amount equal to bhat 107.1 million (US$4.2 million). The services of the SICGF remain quite limited, however. Greater cooperation with commercial banks needs to be pursued since applications must first be processed through the banks' head offices before they can be forwarded

to the SICGF. It is fair to say that commercial banks do not pay much attention to this service. There are complaints that the information required by the fund puts an undue burden on the banks and its customers. The banks have to absorb additional expenses due to this service. Another problem is the constraint on personnel. If the service is to be expanded, more SICGF staff are needed to appraise project loans. Bank of Thailand's Rediscount Facilities

These rediscount facilities were established in 1956 with the rice trading rediscount facility. At present, these facilities have been extended to exports, industries, and small enterprises. Under this scheme, the Bank of Thailand (BOT) provides cheap credit to selected sectors through commercial banks, which are allowed to charge their customers on the re−lent funds. The rediscount facilities for small industries in the provincial areas began in 1978. Initially, the interest rate charged was fixed at 5 percent for commercial banks while the banks charged their customers 7 percent. The rates were changed twice in 1986. In 1987, to induce commercial banks to lend further, the rates were revised to 3 and 7 percent, respectively, giving commercial banks a larger margin. Small enterprises eligible for this scheme are firms with fixed assets not exceeding bhat 5 million (US$0.2 million), and each firm is allowed a maximum credit of bhat 1 million (US$35,114) per year. The rediscount facilities for small enterprises have only been marginally utilized. About 90 percent of rediscount facilities are for exports. This export scheme assists large−scale enterprises rather than SMEs. About 55 percent of rediscount facilities under the export scheme were utilized by 122 large exporters. The remainder were used by medium and small exporters. Of the rediscount facilities provided for industries, large enterprises made up 57 percent of the total, while 15 percent went to small enterprises (Aungsumalin 1990). The shortcoming of this package is that these BOT loans are made through commercial banks, which are not interested in using the facilities for small enterprises. Loans to SMEs still have relatively high risks and high costs. Moreover, many SMEs are not aware of these services. In October 1988, in an effort to alleviate these problems, major changes were made to the system. The BOT now provides credit of up to 50 percent of the face value of a commercial bill with commercial banks matching the rest. The interest rate charged by the BOT is 5 percent while the maximum interest rate commercial banks are permitted to charge their customers is 10 percent. Now the commercial banks obtain a wider interest margin for handling refinancing transactions. Although the share of credit allocated to small and medium exporters has been rising since the adjustment of rediscount scheme, the rediscount facilities for industry and SMEs remain small (Akrasanee, Wiboomchutikula, Wahawisan, and Chontanawat 1990). B. Technical Assistance and Skill Development

Both the government and private institutions provide assistance for industrial development. The services they provide generally are not exclusive to small industries. Nevertheless, most recipients of the services are SMEs. Bank of Thailand's Rediscount Facilities

119

Industrial Structures and the Development of Small and Medium Enterprise Linkages The Department of Industrial Promotion (DIP), under the Ministry of Industry, is the major government agency providing technical assistance. Organizations under DIP that provide the services are as follows: Industrial Service Division (ISD), which offers extension and advisory services, training courses, product testing and certification; Metalworking and Machinery Industries Development Institute (MIDI), which emphasizes the development of the metal−working and machinery industry; Regional Industrial Promotion Centers (RIP), which coordinate training, and provide advisory services and technology specific to the region; and Thailand Management Development and Productivity Center (TMDPC), which offers consultancy services on production and quality control, and assists new investors in identifying and developing projects. Other divisions that provide services to specific industries are the Textile Industry Division, the Thai Handicraft Promotion Division, and the Cottage Industry Division. The National Institute for Development of Skilled Labour under the Department of Labor (Ministry of the Interior) provides training for skill improvement of industrial workers and issues skill certifications. It has regional offices in various regions helping provincial workers. Private organizations that supply these services are the Institute for Management Education for Thailand Foundation (IMET), the Small Industries Association, and the Federation of Thai Industries (FTI). They organize training courses and seminars. The FTI also arranges factory visits for its members. C. Management and Marketing Assistance

The divisions of DIP that provide technical assistance also offer management and marketing assistance, especially the TMDPC. The activities of these groups include organizing training courses and seminars to develop entrepreneurial skills, and providing consultancy services on modem management and on investment opportunities. The Thai Handicraft Promotion Division also operates a showroom and a buyer−seller forum for handicrafts. Aside from the DIP, the Department of Export Promotion (DEP) under the Ministry of Commerce also actively assists entrepreneurs in marketing, especially for exports. The activities of the DEP for export promotion include the organization of trade fairs, both in Thailand and abroad, the arrangement of trade missions abroad, and the provision of training courses on export activities. The DEP also has commercial centers abroad identifying buyers for Thai exporters. The Institute for Management Education for Thailand Foundation, the Federation of Thai Industries, and the Small Industries Association are all private organizations supporting marketing activities. The IMET, with the collaboration of regional universities, organizes seminars, training courses, and provides consultancy services. The Small Industries Association and the FTI promote the sale of members' goods through trade fairs and provide advisory services with regard to business problems. D. Dissemination of Information

The Department of Industrial Promotion (DIP) disseminates information on technology, production techniques, marketing, management, finance and

investment opportunities. Various agencies in the DIP and the Ministry of Industry provide information for provincial entrepreneurs. The Thailand Industrial Standard Institute (TISI) provides information on national and international standardization. BOI regional offices offer information on investment opportunities through studies, seminars, and meetings. They also act as a matchmaker for joint−venture partners. The Department of Export Promotion provides information C. Management and Marketing Assistance

120

Industrial Structures and the Development of Small and Medium Enterprise Linkages on the world markets, trade opportunities, and export regulations. The FTI and the Thai Chamber of Commerce (TCC) disseminate information on trade and industries. An evaluation of the above measures is provided in section IV. We next discuss the issues relating to the deepening of the Thai industrial structure. III— Deepening of the Industrial Structure A. Subcontracting Linkage: Thailand's Experience Background

Despite a certain policy bias in favor of large integrated firms in Thailand, subcontracting and other forms of interfirm linkage have taken place under private sector initiatives. These interfirm linkages emerged on an individual basis independent of any organizational or institutional effort. Indeed, to the best of our knowledge, no organized private sector initiatives have been made to formally promote any form of interfirm linkage. While there are several types of interfirm linkages classified by form of contractual arrangement (Wong 1991), the following discussion focuses only on subcontracting, which is largely market oriented in nature but characterized by long−term, stable relationships. Subcontracting also creates linkages between large, medium, and small firms. Subcontracting is a recent phenomenon in Thailand, though it is not known when the first subcontracting arrangement took place. A survey of small and medium enterprises (Tambunlertchai 1989) found that just a few firms were engaged in subcontracting prior to 1966. Most of those involved in subcontractual arrangements—twenty−one out of twenty−eight firms subcontracting out (hereafter referred to as parent firms) and fifty−eight out of sixty−seven subcontractors covered by the survey—began the practice after 1972. Although the practice of subcontracting in Thailand remains limited in scope, it has recently begun to grow rapidly. A 1986 survey of 200 firms across 10 industrial sectors (Tambunlertchai 1989) found that 14 percent were parent firms, while 33.5 percent were subcontractors. With respect to the types of subsectors involved, machinery accounted for the largest share of parent firms in the survey (30 percent). The other subsectors include chemicals, electrical and electronic products, and transport equipment (20 percent each); textiles, wood product and furniture (15 percent each); and metal products (10 percent). Among the subcontractors, there was a higher ratio in wood products and furniture (70 percent) relative to textiles (55 percent), chemicals (45 percent), machinery (35 percent), metal products, transport equipment (30 percent each), food and non−metal products (15 percent each), and electrical and electronic products (10 percent).

A more recent survey (Chulalongkorn University 1990) found that 81 firms or 11.8 percent of the sample of 688 firms in the engineering, metal, electrical and electronic products, and other metal products industries, were hired as subcontractors. The same study also reported that thirteen electrical and electronic product parent firms had subcontracted out for the production of parts and components from eighty−four subcontractors. Another study covering four motorcycle assembly firms, three diesel engine firms, and nine refrigerator manufacturing firms, found all of them made use of a total of thirty−three subcontractors; sixteen in motorcycle parts and components, twelve in diesel engine parts, and five in refrigerator parts industries (Kanjanavirojkul 1987). These surveys suggest that opportunities exist for subcontracting in modern, high technology and high skill manufacturing sectors such as machinery, electrical and electronics products, and transport equipment. The shares III— Deepening of the Industrial Structure

121

Industrial Structures and the Development of Small and Medium Enterprise Linkages of firms engaged in subcontracting in these industries are high indeed. These industries usually subcontract out for several reasons. The finished product usually consists of various parts and components. The costs of establishing separate manufacturing capabilities for some of these components do not always justify themselves. Thus, it is sometimes more desirable for firms to establish subcontracting agreements when the cost savings exceed the transaction costs of such arrangements. Second, the production of these industries is usually in the mature stage of their respective product cycle. Therefore, there is no critical or strategic technology involved in the production of these parts and components. Finally, since these industries are modern and involve high technology, entrepreneurs in these industries are relatively well educated compared to others. They know how to manage the subcontracting arrangement. Furthermore, since these industries are rather competitive, subcontracting agreements to reduce costs sometimes become a necessity. The reasons for engaging in subcontracting arrangements vary among firms. The most frequently cited reasons for parent firms are production flexibility, subcontractor's specialization, local content requirements, and avoidance of labor management problems. Reasons given by subcontractors include greater use of production capacities, assistance from parent firms, and reduction of marketing costs. The initiation of most subcontracts were reportedly based on the reputations of the subcontractors, though they were not necessarily in the same lines of production. In−depth interviews with several subcontractors by the authors revealed a common feature among most of the firms: there exists a degree of familiarity between the subcontractor and the parent firm upon which the reliability of the subcontractor is appraised. Interestingly, many new subcontractors are former employees of parent firms. In many cases subcontracting arrangements were initiated in small quantities for products with simple production processes. The quantity ordered and the sophistication of the products subcontracted have generally risen as subcontractors have proven their dependability and capability. The most important consideration of the parent firms is the ability of the subcontractor to meet delivery schedules. The quality and price of the products and technological capability of the subcontractors are also important. Subcontractors, however, have tended to overlook the importance of on time

deliveries, thinking that product quality and price are the parent firms' main priorities. Subcontracting Performance

Product quality management has generally been the responsibility of the subcontractors. Parent firms conduct occasional checks. Thongpakde, Puppahavesa, and Pussarangsri (1991) found that parent firms rated the quality of products supplied by subcontractors as being fair or good. The major problem was the shortage of raw materials and poor production plans that hindered the ability of subcontractors to deliver products on time. This was the case mostly in the wood product, textile, and chemical subsectors. Some subcontractors also have problems with high rates of product defects. Many subcontracts were reported to have been cancelled. About half of the cancellations were in the machinery, electrical and electronic product subsectors. Almost all of the terminated contracts were a result of poor product quality. The subcontractors in the survey expressed their desire for various forms of outside assistance. Most important, calls were made for easier access to raw materials—specially wood and chemicals—at reasonable prices. Training and financial assistance were also requested for most subsectors. Subcontractors in the machinery and metal product industries particularly emphasized technological assistance.

Subcontracting Performance

122

Industrial Structures and the Development of Small and Medium Enterprise Linkages In conclusion, while subcontracting activities are still new in Thailand, the demand for subcontractors is growing. Most parent firms intend to increase the value of the processes they subcontract out and to find more subcontractors. The incentives of these activities are market oriented, that is, the potential of greater production efficiency stimulates such practices. B. BOI Unit for Industrial Linkage Development (BUILD)

To create back−end linkages in the industrial sector the Board of Investment (BOI) established the BOI Unit for Industrial Linkage Development (BUILD) in 1990. The main tasks of this unit are to match parent firms and subcontractors, and to develop the production capabilities of subcontractors. Initially, BUILD created a pilot project to match firms by inviting six BOI−promoted companies to participate in the project. These companies, which produce electrical appliances and electronic goods, were asked to increase the share of domestic content in the inputs they use, and to help subcontractors develop their production capabilities. BUILD identified capable subcontractors and matched them with parent firms. Subcontracting activities were pursued when the two parties made an agreement. No BOI privileges were granted nor were the contracts enforced by BOI. According to a BUILD official, the project has progressed smoothly. Working relationships have been established between parent firms and subcontractors. Parent firms have also assisted subcontractors in improving their production and management technologies. Companies have reported increases of domestic content in value terms of 10 to 20 percent after becoming involved in the project. To strengthen the information system, BUILD set up a computerized database of supporting industries. There are about 800 companies believed to be capable of producing parts for parent firms listed in the database. The BOI has also

published the Directory of Supporting Industries in Thailand 1991, which includes a variety of industries, most of which are involved in electronics and metal working. The directory helps companies find local firms that can produce parts or other products for them. The BOI also collaborates with other government agencies such as DIP, and private firms such as the FTI to organize training sessions and workshops for subcontractors. It is believed that development of entrepreneurship is crucial for the promotion of subcontracting. The BOI is planning to expand this unit since the creation of industrial linkages is now a high priority item in the government. More BOI units and personnel will be involved in these activities. More companies are also expected to participate in the project. Since BUILD was set up, fifteen companies have requested information on local firms. The BOI also intends to identify supporting industries that are capable of producing competitively so they may be developed in the future. C. Local Content Requirements

Local content requirements are nontariff measures often used to protect domestic industries, but which can also be utilized to deepen the manufacturing sector. The measures entail setting requirements for the minimum share of locally produced parts used in a particular product. The most important objective of the policy is to create industrial linkages in the economy. Local content requirements directly force certain industries to use minimum amounts of domestically produced parts for the final production of their goods. This is expected to create and strengthen supporting industries.

B. BOI Unit for Industrial Linkage Development (BUILD)

123

Industrial Structures and the Development of Small and Medium Enterprise Linkages In the automotive industry, for example, local parts must make up a minimum percentage of total input requirement. Since not all parts are comparable in terms of domestic value added, each part is given a "score." The scores, in turn, are used to calculate the proportion of a given part to the total input requirement. For example, the local content requirement for motorcycles is 70 percent. This implies that at least 70 percent of the parts used in the production of motorcycles must come from domestic producers based on the score of each part and not on the quantity of parts. The industries subject to local content requirements in Thailand can be classified into three groups: vehicles, machinery, and others. The automotive industry includes all types of vehicles: passenger cars, pick−up trucks, other trucks and buses, and motorcycles. Currently, the local content requirements for these industries are 54 percent, 67 percent, 45 percent, and 70 percent, respectively. The local content requirements for those included in the second group—machinery—were originally limited to small engines used for agricultural purposes. Currently, however, the restrictions include a wide range of machine types. It is difficult to generalize about the last group because it includes a broad variety of industries including milk products, steel wire and rods, copper wire, and so forth. As would be expected, this policy has both positive and negative effects. It has created new industries, especially in the auto parts sector, which is very important for the development of the automobile industry. It also creates demand for supporting and peripheral industries. In the long run, the country can

also gain from the technologies used in these industries. Some of the industries that began by supplying parts to domestic producers have also become exporters. Such industries include the battery and radiator subsectors. The negative effects stem from the fact that the policy also provides protection to the parts, supporting, and peripheral industries affected by the local content requirements. Similar to other forms of protection, the local content requirement unintentionally allows these industries to become inefficient by eliminating a certain degree of competition from foreign rivals. These industries are at times less developed in terms of technology and human resources. Some domestic suppliers, such as auto part firms, have high import content themselves. Thus foreign currency savings have not been at the level initially expected. This industry also depends on technology and investment from foreign countries, especially from Japan. The other drawback is that Thailand also loses substantial amounts of tariff revenue from products that otherwise will be imported. These products are domestically produced to substitute imports. They are used as inputs or parts of outputs of industries that are required to use a minimum proportion of domestically produced parts, such as auto parts. Further research is needed to quantify the impact of this local content requirement measure, if we want to precisely evaluate the program. IV— Lessons and Implications A. Promotional Program for SMEs

The Thai government initiated specific measures to promote SMEs. There are various agencies, both private and public, which assist SMEs in technical, managerial, marketing and information matters, as discussed in section II. Na Ronong (1990), however, shows that entrepreneurs are not aware of the services. On average only 37 percent of the survey sample knew of the agencies that provide services, and only 33 percent utilized the services. The most popular agencies are the Provincial Office of Industry and the Provincial Office of Commerce. Since these two agencies are also market regulators and affect enterprise behavior, firms already know of them. Firms seem to know regulatory agencies more than supporting ones.

IV— Lessons and Implications

124

Industrial Structures and the Development of Small and Medium Enterprise Linkages Evidence suggests that the scope of government coverage is quite limited. The training and other services provided are limited mostly to Bangkok and a few other cities. Only a minority of Thai entrepreneurs know of the services, although those who have received them have expressed satisfaction. The major problem associated with technical, managerial, and marketing assistance is the lack of publicity of the services. Budgetary constraints and shortages of qualified personnel have seriously affected government support facilities (Na Ronong 1990). Biggs, Brimble, and Snodgrass (1990) also found that the coordination has been weak among agencies providing services. Some entrepreneurs have complained that the services are not tailored to the needs of specific industries and regions. Furthermore, some have expressed their frustrations that ''experts" have insufficient knowledge of specific industries. To mitigate the shortcomings of the promotional measures, the following suggestions are offered:

The government should actively promote and advertise its services so that entrepreneurs are aware of them. Services should be in demand and meet high standards; Since the government has to provide services and information to satisfy the needs of industries, greater cooperation should be pursued between public and private agencies, such as the Federation of Thai Industries, the Provincial Chambers of Commerce, and the Association of Small Enterprises. Private agencies can provide information on the specific assistance they need; To expand the scope of their activities, government agencies should charge rates that are high enough to cover costs. Charging market prices also confirms the need for the services. The government may also want to tailor services to the needs of entrepreneurs in specific industries who exhibit the potential of improving their industrial capabilities; To alleviate the burden on the government, efforts should be made to facilitate the involvement of universities and other academic institutions in providing training and consultancy services to SMEs. On the financial issue, the financial schemes of the Small Industry Finance Office (SIFO), the Bank of Thailand (BOT), and the Small Industry Credit Guarantee Fund (SICGF) should be developed in cooperation with commercial banks. Since the commercial banks have few incentives to actively involve themselves in these assistance programs, funds for SMEs have been limited. The SIFO also has limitations on its ability to mobilize funds and to find qualified personnel because of its status as a government agency. Some of these problems have been solved. In December 1991 SIFO was abolished and its assets, personnel, and duties were transferred to the newly established Small Industrial Finance Corporation of Thailand (SIFCT). Although its board consists of representatives from Finance and Industry ministries, it is a juridical agency independent of the government and operates as a private enterprise, which allows it to mobilize funds from the public. It is too early to assess the performance of this new organization. Nevertheless, it is expected to be more efficient and should be able to provide more funds to SMEs. Concessionary interest rates charged to SMEs also cause the special financial institutions to lose money that could be used to further provide funds for SMEs. The burden on the firms receiving loans may be lightened due to the low interest rate. However, loans have become less accessible to smaller enterprises. Interest rate ceiling therefore restraints the accessibility of loans for SMEs. B. Challenges for Thailand

B. Challenges for Thailand

125

Industrial Structures and the Development of Small and Medium Enterprise Linkages Balancing Deepening and Widening

During the period of industrial expansion, the development of LEs and the inflow of foreign direct investment have created substantial industrial widening for the Thai manufacturing sector. Exports and production have diversified and Thai exports of non−conventional products such as electronics and automobile parts have risen significantly since the second half of the 1980s. However, significant industrial deepening has not been created. The industrial sector is still dependent on imports, and sectoral linkage is weak. To

create interfirm production linkages, the measures usually employed include the promotion of large−scale industries producing basic raw material for other sectors (for example, petrochemical and steel industries) and the promotion of subcontracting. To develop the upstream industries, such as the case of petrochemicals in Thailand, sometimes protection from import is needed. The government usually protects these industries with high tariffs or import quotas. This adversely affects SMEs becayse they are charged higher prices for their raw materials. The protection policy conflicts with the objective of industrial widening and SMEs promotion. To lessen the conflict, the government must make its decision on the basis of efficiency. The government must clearly specify the period of protection. The justification of the protection is that these industries need time to mature so they can compete with imports later. The time frame of the protection, therefore, must be limited in order to force the protected enterprise to improve efficiency. The government must stop the protection if the industries cannot fulfill their promises. Under this guideline of protection, SMEs will suffer in the short run, but in the long run SMEs could get cheaper and more reliable materials that are produced domestically. On the issue of subcontracting, one hopes to see small subcontractors provide locally made parts and components to large assembly firms. However, this linkage is also weak and we see more of the linkages between large enterprises. The transaction cost between LEs and SMEs is still significantly high and the cost of developing suppliers is paid totally by LEs (Pussarangsri 1993). Thus, there is a lack of incentive for LEs to provide more assistance to SMEs. Perhaps an incentive could be provided for LEs that subcontract (such as tax exemption). The experience of the BUILD program in Thailand is too short to make any evaluation. However, its direction to facilitate the market mechanism to create the linkages should be encouraged. Increasing Absorptive Capability of SMEs

Increasing the industrial capability of SMEs is crucial to the development of SMEs; especially for their subcontracting linkages. It could significantly reduce the transaction cost of interfirm linkages. The improvement of capability requires human resource development. Entrepreneurs and workers with good education are receptive to technological upgrading and have higher technology absorptive capacity. In Thailand the study by TDRI (1991) indicates that there is an imbalance between the education and training system, and the needs of the manufacturing sector. The study finds that enrollment in secondary education are low, and the vocational school graduates usually do not have the skills that their prospective employers need. Furthermore, the university system does not produce an adequate number of graduates demanded by the public. The study suggests the need for significant reform of the education system of the country. Balancing Deepening and Widening

126

Industrial Structures and the Development of Small and Medium Enterprise Linkages With the current manpower situation, it is obvious that the absorptive capability of SMEs is limited. In the long run, the significant and continuous reform of the education system is needed. However, in the short run, the training and other assistance from government and LEs are required to improve performance of SMEs. Private organizations should participate more in

organizing training courses. The role of government agencies should be improved. For example, BUILD should not only participate as a matchmaker between LEs and SMEs, but it should also participate as an organizer of appropriate training for subcontracting. Financial assistance should be provided to LEs when they train SMEs for linkage creation. It is important that human resource development be undertaken continuously after formal education. For this to happen, the right incentives must be in place. General and Specific Policies

It is important for policymakers to set the fundamental general policies that create a conducive environment for firms to be competitive. These policies include, among others, a stable financial system, fiscal prudence, efficient infrastructure provision, and competitive exchange rates. These will foster a conducive business environment and sustain economic growth with stability. It should be mentioned that during the period of the 1980s, when the world economy was in recession with high inflation, Thailand maintained respectable growth rates and a relatively low inflation rate by pursuing prudent fiscal policy and appropriate exchange rate management. The adjustment of the general macroeconomic policy is necessary to keep up with the dynamics of the world economy. Without the appropriate general policies, business, regardless of its size, would be unable to improve its performance and competitiveness. While the Thai government has maintained appropriate macroeconomic management, some of their general measures have had adverse impacts on SMEs. Tariff rates of Thailand are relatively high by international standards; they are among the highest of the ASEAN countries. This is due to the protectionist policy of the past. This increases the costs of raw materials, machinery and equipment, making SMEs less competitive with LEs. LEs are also eligible for investment promotion privileges, which provide tax and tariff exemption. This is clear if one looks at the statistics of promoted firms. The large enterprises (200 employees or more) represent about 40 percent of the promoted firms, while the small enterprises (1 to 49 employees) represent only 17 percent. Moreover, LEs are in a better position to lobby for protection of their market. Recent developments in Thailand alleviates the bias against SMEs; import tariff rates on various machinery and components were reduced from around 40 percent to 5 percent in 1991, reducing the disadvantage of firms that are not qualified for tariff exemption. (The trade policy in Thailand will be liberalized further by reducing tariff and nontariff barriers.) This will greatly help SMEs. In 1992 Thailand adopted a value added tax system in place of business tax. The objective is to remove the cascading effect of the business tax system. Under the business tax system, the cascading effect can be reduced by vertically integrating production, which is not possible for SMEs. The value added system also encourages subcontracting. The interest rate ceiling is also biased against SMEs, because it causes credit rationing among SMEs. The Bank of Thailand has lifted the interest rate ceilings successively from saving deposits to time deposits and finally on lending rates. This is expected to raise the SMEs' access to commercial bank loans,

because the higher risk and transaction cost to the banks can be compensated for by higher interest rates.

General and Specific Policies

127

Industrial Structures and the Development of Small and Medium Enterprise Linkages The changes in tax, tariff, and interest rate policy are not aimed directly to assist SMEs. The major reason of this liberalization policy is to increase Thailand's international competitiveness. The export−oriented strategy requires businesses to be competitive in external markets. The barriers that cause inefficiency have to be removed. Such measures benefit SMEs by reducing the bias against them. While the general policy provides a conducive business environment and reduces the bias against SMEs, it is necessary for policymakers to initiate specific policies to promote SMEs and encourage subcontracting. The measures include, as mentioned before, financial and technical assistance, local content requirement, and subcontracting promotion. The success of these measures depend on the credibility of principal agencies and coordination of the agencies involved. The success of the Singapore case can be attributed to the strength of the Economic Development Board, which coordinates SME development measures (Soon, chapter 3, this volume). In Thailand, each agency has its own objectives and measures, the coordination among departments is weak (see chart 5.1 for institutions involved in the promotion of SMEs). This must be corrected to make the specific measures to promote SMEs effective.

Chart 5.1: Institutional Arrangements for SME Development, Thailand

Appendix 5.1 Number of Factories by Industry Type and Employment Size, 1984 (percentage)

Industry size (workers)

Appendix 5.1

Cottage

SEs

MEs

SMEs

LEa

(1−9)

(10−49)

(50−99)

(100−199) Total

(>= 200)

59.5

33.5

3.3

1.8

1.9

98.1

Total

100.0 128

Industrial Structures and the Development of Small and Medium Enterprise Linkages Consumer products Food

65.2

29.5

2.5

1.4

98.6

1.4

100.0

Beverage

40.6

32.3

4.7

12.5

90.1

9.9

100.0

Tobacco

19.3

52.3

10.9

6.6

89.1

10.9

100.0

Wearing apparel

14.4

67.7

9.5

4.6

96.2

3.8

100.0

Leather and products

57.9

34.9

2.5

2.2

97.5

2.5

100.0

Footwear

48.7

42.7

2.7

1.8

95.9

4.1

100.0

Furniture

60.3

34.7

3.4

0.8

99.2

0.8

100.0

Printing and publishing

77.3

20.3

1.2

0.6

99.4

0.6

100.0

Intermediate products

50.7

37.5

6.2

3.0

97.4

2.6

100.0

Textile

25.2

51.2

8.9

5.9

91.2

8.8

100.0

Wood and products

58.2

33.3

6.0

1.9

99.4

0.6

100.0

Paper and products

61.8

26.1

5.1

3.5

96.5

3.5

100.0

Chemical and products

41.5

43.7

8.4

3.8

97.4

2.6

100.0

Petroleum and products

34.6

31.0

17.2

3.4

86.2

13.8

100.0

Rubber and products

52.5

32.5

6.5

5.2

96.7

3.3

100.0

Plastic products

64.0

31.8

2.4

1.2

99.4

0.6

100.0

Ceramics

24.5

54.4

12.7

4.3

95.8

4.2

100.0

Glass and products 8.9

48.9

20.0

8.9

86.7

13.3

100.0

Non−metal mineral

53.5

38.3

4.8

2.2

98.8

1.2

100.0

Capital products

76.3

19.7

2..1

1.0

99.1

0.9

100.0

Basic metal

16.6

53.1

14.9

10.3

94.9

5.1

100.0

Non−ferrous metal 62.2

32.7

2.2

1.6

98.7

1.3

100.0

Metal products

77.5

19.4

1.7

0.8

99.4

0.6

100.0

General machinery

83.1

15.3

1.1

0.3

99.8

0.2

100.0

Electric machinery 57.9

31.3

5.4

2.9

97.5

2.5

100.0

73.6

20.7

2.6

1.4

98.3

1.7

100.0

Appendix 5.1

129

Industrial Structures and the Development of Small and Medium Enterprise Linkages Transport machinery Scientific equipment

44.3

40.0

5.7

4.3

94.3

5.7

100.0

Other type products

73.8

22.8

2.2

0.7

99.5

0.5

100.0

Total

64.0

29.1

3.5

1.8

98.4

1.6

100.0

Notes: 1. Excludes rice mill factories. 2. Automobile repair shops (2,182 factories are grouped in "other type products"). Source: Government of Thailand (1985). Appendix 5.2 Distribution of Factories by Subsector and Employment Size, 1987 (percent) Subsector

1−9

10−49

50−199

> = 200

Total

Food and beverage and 12.3 tobacco

20.9

16.3

50.5

100.0

Textile and garments

1.9

17.6

18.1

62.4

100.0

Wood and wood products

16.7

33.0

33.4

16.9

100.0

Paper and printing

20.9

25.8

18.1

35.2

100.0

Chemicals

5.2

23.8

27.7

43.3

100.0

Rubber and plastic

12.8

29.5

31.0

26.7

100.0

Non−metallic

9.6

25.3

23.0

42.1

100.0

Basic metal

7.2

21.5

30.3

41.0

100.0

Metal products

30.2

28.0

17.6

24.2

100.0

Machinery

36.0

29.0

13.6

21.4

100.0

Electrical products

8.5

22.2

21.1

48.2

100.0

Transport equipment

13.8

17.8

19.2

49.2

100.0

Miscellaneous

23.4

32.8

22.2

21.6

100.0

Source: Government of Thailand, Ministry of Industry (1988). Appendix 5.3

Appendix 5.2

130

Industrial Structures and the Development of Small and Medium Enterprise Linkages Distribution of Factories by Industry Type and Employment Size, 1984 (percent) Cottage

SSEs

MSEs

SMEs

(1−9)

(10−49)

(50−99)

(100−199) Total

(>= 200)

Consumer products

32.3

40.0

32.7

35.9

34.6

40.7

34.8

Food

20.9

20.7

14.3

15.5

20.4

17.7

20.4

Beverage

0.3

0.5

0.6

3.1

0.8

5.6

0.8

Tobacco

0.3

1.5

2.6

3.1

0.8

5.6

0.8

Wearing apparel

0.8

8.6

9.8

9.5

3.6

8.6

3.7

Leather and products

0.6

0.8

0.5

0.8

0.7

1.1

0.7

Footwear

0.4

0.8

0.4

0.6

0.5

1.4

0.6

Furniture

2.7

3.5

2.8

1.3

2.9

1.4

2.9

Printing and publishing

6.3

3.6

1.7

1.7

5.3

1.9

5.2

Intermediate products

19.6

31.8

43.2

41.9

24.5

39.0

24.7

Textile

1.3

6.0

8.6

11.4

3.2

18.6

3.4

Wood and products

7.0

8.8

13.1

8.3

7.7

2.9

7.7

Paper and products

1.1

1.0

1.6

2.3

1.1

2.5

1.1

Chemical and products

1.6

3.6

5.7

5.1

2.4

3.9

2.4

Petroleum and products

0.0

0.1

0.4

0.1

0.1

0.6

0.1

Rubber and products

1.6

2.2

3.6

5.7

1.9

3.9

1.9

Plastic products

3.7

4.0

2.5

2.5

3.7

1.4

3.7

Ceramics

0.2

1.1

2.1

1.4

0.6

1.6

0.6

Glass and products 0.0

0.2

0.6

0.6

0.1

0.9

0.1

Non−metal mineral

3.1

4.8

5.0

4.5

3.7

2.7

3.7

Capital products

40.6

23.1

20.1

19.8

34.3

18.1

34.0

Basic metal

0.1

0.8

1.9

2.5

0.4

1.4

0.4

Non−ferrous metal 0.8

0.9

0.5

0.7

0.8

0.6

0.8

Industry size (workers)

Appendix 5.2

LEs

Total

131

Industrial Structures and the Development of Small and Medium Enterprise Linkages Metal products

14.4

7.9

5.7

5.7

12.0

4.7

11.9

General machinery

16.6

6.8

4.1

2.4

13.0

1.4

12.8

Electric machinery 2.1

2.5

3.5

3.7

2.3

3.6

2.3

Transport machinery

6.5

4.0

4.1

4.4

5.6

5.8

5.6

Scientific equipment

0.1

0.2

0.3

0.4

0.2

0.6

0.2

Other type products

7.5

5.1

4.0

2.4

6.6

2.2

6.5

Total

100.0

100.0

100.0

100.0

99.9

100.0

100.0

Notes: 1. Excludes rice mill factories. 2. Automobile repair shops (2,182 factories are grouped in "other type products"). Source: Government of Thailand (1985). Appendix 5.4 Distribution of Factories by Employment Size and Industry Type, 1987 (percent) Industry type

1−9

10−49

50−199

> = 200

Food and beverage and tobacco

19.6

18.2

16.2

24.0

Textile and garments

3.8

19.1

22.4

37.1

Wood and wood products

9.8

10.6

12.3

3.0

Paper and printing

5.6

3.8

3.0

2.8

Chemical

1.6

4.0

5.4

4.0

Rubber and plastic

5.2

6.5

7.8

3.2

Non−metallic

4.0

5.8

6.0

5.3

Basic metal

1.0

1.7

2.7

1.8

Metal products

16.4

8.4

6.0

3.9

Machinery

13.5

6.0

3.2

2.4

Electrical products

2.0

2.8

3.1

3.4

Transport equipment

5.5

3.9

4.7

5.8

Micellaneous

12.0

9.2

7.2

3.3

Total

100.0

100.0

100.0

100.0

Appendix 5.4

132

Industrial Structures and the Development of Small and Medium Enterprise Linkages Source: Government of Thailand (1988).

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