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Best Practices in Investment for Development - Case Studies in FDI (Malaysia and Singapore)

Case study by UNCTAD, 2011

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This case study outlines the best practices used by Singapore and Malaysia in using Foreign direct investment (FDI) to enhance local SME development, focusing principally on the linkages between foreign affiliates and domestic SMEs.

UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT







BEST PRACTICES IN
INVESTMENT FOR


DEVELOPMENT


CASE STUDIES IN FDI




How to Create and Benefit from
FDI-SME Linkages



Lessons from Malaysia and Singapore







UNITED NATIONS


New York and Geneva, 2011




ii How to Create and Benefit from FDI-SME Linkages







UNCTAD Investment Advisory Series B


NOTE


As the focal point in the United Nations system for
investment within its mandate on trade and development, and
building on three and a half decades of experience in this area,
UNCTAD, through the Division on Investment and Enterprise
(DIAE), promotes understanding of key issues related to foreign
direct investment (FDI) and enterprise development. DIAE also
assists developing countries in enhancing their productive capacities
and international competitiveness through the integrated treatment
of investment and enterprise development.



The term “country” as used in this publication also refers, as


appropriate, to territories or areas. The designations employed and
the presentation of the material do not imply the expression of any
opinion whatsoever on the part of the Secretariat of the United
Nations concerning the legal status of any country, territory, city or
area, or of its authorities, or concerning the delimitation of its
frontiers or boundaries. In addition, the designations of country
groups are intended solely for statistical or analytical convenience
and do not necessarily express a judgement about the stage of
development reached by a particular country or area in the
development process.



The following symbols have been used in the tables:

Two dots (..) indicate that data are not available or not
separately reported. Rows in tables have been omitted in
those cases where no data are available for any of the
elements in the row.
A dash (-) indicates that the item is equal to zero or its value
is negligible.
A blank in a table indicates that the item is not applicable.




iii








UNCTAD Investment Advisory Series B


A slash (/) between dates representing years – for example,
2004/05, indicates a financial year.
Use of a dash (–) between dates representing years – for
example 2004–2005 signifies the full period involved,
including the beginning and end years.
Reference to “dollars” ($) means United States dollars,
unless otherwise indicated.
Annual rates of growth or change, unless otherwise stated,
refer to annual compound rates.
Details and percentages in tables do not necessarily add to
totals because of rounding.

The material contained in this publication may be freely


quoted or reprinted with appropriate acknowledgement. A copy of
the publication containing the quotation or reprint should be sent by
post to the Head, Investment Policies Branch, DIAE, UNCTAD,
Palais des Nations, Room E-10084, CH-1211 Geneva, Switzerland;
by fax to 41 22 917 0197; or by e-mail to diae@unctad.org.
Publications are available on the UNCTAD website at
http://www.unctad.org.



UNCTAD/DIAE/PCB/2009/18



UNITED NATIONS PUBLICATION


Sales No. E.10.II.D.12
ISBN 978-92-1-112794-2



Copyright © United Nations, 2011


All rights reserved
Printed in Switzerland













PREFACE


The Investment Advisory Series provides practical advice
and case studies of best policy practice for attracting and benefiting
from foreign direct investment (FDI), in line with national
development strategies. The series draws on the experiences gained
in, and lessons learned through, UNCTAD’s capacity-building and
institution-building work in developing countries and countries with
economies in transition.


Series A deals with issues related to investment promotion
and facilitation and to the work of investment promotion agencies
(IPAs) and other institutions that promote FDI and provide
information and services to investors. The publications are intended
to be pragmatic, with a how-to focus, and they include toolkits and
handbooks. The prime target audience for series A is practitioners in
the field of investment promotion and facilitation, mainly in IPAs.


Series B focuses on case studies of best practices in policy
and strategic matters related to FDI and development arising from
existing and emerging challenges. The primary target audience for
series B is policymakers in the field of investment. Other target
audiences include civil society, the private sector and international
organizations. Series B was launched in response to a call at the
2007 Heiligendamm G-8 Summit for UNCTAD and other
international organizations to undertake case studies in making FDI
work for development. It analyses practices adopted in selected
countries in which investment has contributed to development, with
the aim of disseminating best practice experiences to developing
countries and countries with economies in transition. The analysis
forms the basis of a new technical assistance work programme
aimed at helping countries to adopt and adapt best practices in the
area of investment policies.



For Series B, UNCTAD’s approach is to undertake case


studies of a pair of developed and developing or transitional




vi How to Create and Benefit from FDI-SME Linkages







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economies that exhibit elements of best practices in a selected issue.
Country selection follows a standard methodology, based primarily
on the significant presence of FDI and resulting positive outcomes.



The Investment Advisory Series is prepared by a team of


UNCTAD staff and consultants in the Investment Policies Branch,
under the guidance of James Zhan. This study of the Series B was
prepared by John Kline, Edmund Terence Gomez and Shandre
Thangavelu. A fact-finding mission was undertaken in Malaysia in
July 2009, while the case of Singapore was prepared based on desk
research. The report was finalized by Ioanna Liouka and Cam
Vidler. Contributions and comments were received from Chantal
Dupasquier, Quentin Dupriez, Fulvia Farinelli, Ralf Krueger,
Fiorina Mugione, Joerg Weber and Stephen Young. The report has
also benefited from views of current and former government
officials, the domestic and foreign private sector and academics.
Financial support was received from the Asia-Pacific Economic
Cooperation forum (APEC) under the APEC-UNCTAD Joint
Capacity Building Project for Addressing Knowledge Gaps in the
Use of Foreign Direct Investment. The programme has also received
financial support from the Government of Germany.





Geneva, June 2011




Introduction vii







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CONTENTS
NOTE................................................................................................ ii


PREFACE ....................................................................................... iii


ABBREVIATIONS......................................................................... ix


TABLE OF FACTS ....................................................................... vii


I. INTRODUCTION.................................................................... 1
A. FDI-SME linkages.........................................................2
B. The role of government policy........................................3
C. The case studies ............................................................4


II. CASE ANALYSIS: MALAYSIA .......................................... .5
A. Country profile and policy context..................................5
B. Development model and role of FDI...............................6
C. SME sector: policies and programmes ..........................13
D. FDI-SME linkages: policies and programmes................21
E. Conclusion..................................................................32


III. CASE ANALYSIS: SINGAPORE......................................... 35
A. Country profile and policy context................................35
B. Development model and role of FDI.............................36
C. SME sector: policies and programmes ..........................39
D. FDI-SME linkages: policies and programmes................47
E. Conclusion..................................................................51


IV. “BEST PRACTICES” LESSONS FOR CREATING
BENEFICIAL FDI-SME LINKAGES................................. 53
A. Ensure a favourable business climate for SMEs and


TNCs..........................................................................54
B. Strengthen the SME sector ...........................................56
C. Attract linkage-prone foreign investors .........................67
D. Foster and develop linkages .........................................71


V. CONCLUSION ........................................................................ 77




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REFERENCES .............................................................................. 79


SELECTED UNCTAD PUBLICATIONS ON TRANS-
NATIONAL CORPORATION AND FOREIGN DIRECT
INVESTMENT ..............................................................................83


QUESTIONAIRRE .......................................................................93


Boxes


Box II.1. Regional development strategies....................................... 9
Box II.2. Sectoral strategy and new GLCs ..................................... 11
Box II.3. The Malaysian car project and the vendor system .......... 23
Box II.4. The ILP and SME-TNC linkages .................................... 26
Box II.5. The Pengang Skills Development Centre........................ 28
Box II.6. The case of Globetronics Technology Berhad ................ 30
Box III.1. Enhancing SME innovation capabilities ........................ 44
Box III.2. Local SME expansion into global electronics ............... 47
Box III.3: Early LIUP participants ................................................. 49
Box III.4. Honeywell Aerospace joins LIUP ................................. 51



Table



Table II.1. Definition of SMEs....................................................... 14
Table II.2. The Vendor Development Programme (VDP) ............. 22
Table II.3. Industrial Linkage Programme (ILP)............................ 25
Table II.4. Global Supplier Programme (GSP) .............................. 27
Table III.1. Share of SMEs and large enterprises in Singapore ..... 41
Table III.2. The Local Industry Upgrading Programme................. 49



Figures



Figure II.1. FDI inflows in Malaysia ..............................................7
Figure III.1 FDI inflows in Singapore ..........................................38




Introduction ix







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ABBREVIATIONS


APEC Asia Pacific Economic Cooperation
ASEAN Association of Southeast Asian Nations
A*STAR Agency for Science, Technology and Research


(Singapore)
CCS Competition Commission Singapore
CPI Corruption Perceptions Index
DFI development finance institution
EDF Economic Development Board
EOI export-oriented industrialization
FDI foreign direct investment
FTZ free trade zone
GDP gross domestic product
CGC Credit Guarantee Corporation Malaysia Berhad
GLC government-linked company
GSP Global Supplier Programme
HDC Halal Industry Development Corporation
HICOM Heavy Industries Corporation of Malaysia Berhad
HRDB Human Resource Development Board
HRDF Human Resource Development Fund
ICT information and communications technology
ILP Industrial Linkage Programme
IMP Industrial Master Plan
ISI import-substituting industrialization
LIUP Local Industry Upgrading Programme
MBC Malaysian Biotechnology Corporation Berhad
MDeC Multimedia Development Corporation
MIDA Malaysian Industrial Development Authority
MIDF Malaysian Industrial Development Finance
MITI Ministry of International Trade and Industry (Malaysia)
MSC Multimedia Super Corridor
NEP New Economic Policy
NSDC National SME Development Council




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PDC Penang Development Corporation
PFI participating financial institution
PLE promising local enterprise
PSDC Penang Skills Development Centre
R&D research and development
SME small and medium enterprise
SME Corp Small and Medium Enterprise Corporation Malaysia
SMIDEC Small and Medium Industries Development Corporation
SPRING Standards, Productivity and Innovation Board
SSIC Selangor State Investment Centre
TAF Technology Acquisition Fund
TIP Technology Innovation Programme
TNC transational corporation
VDP Vendor Development Programme
WTO World Trade Organization




Introduction xi







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MALAYSIA SINGAPORE








KEY FACTS TABLE
Malaysia Singapore


1981-1990 1991-2000 2001-2010 1981-1990 1991-2000 2001-2010
Population (million)* 18.1 23.3 28.3 3.0 4.0 5.1
Annual GDP growth (%) 4.9 6.1 9.8 6.3 7.3 9.6
GDP per capita ($)* 2525 4029 8348 12233 23073 42383
GDP by sector (%)


Services 42 48 48 63 65 70
Manufacturing 21 27 28 27 24 24
Agriculture 19 12 9 1 0.1 0.05


FDI inflows (annual
average) ($ million) 1132 4933 4728 2341 9567 19880


FDI outflows (annual
average) ($ million) 230 1692 6224 409 5030 13647


FDI inflows ( % of GDP) 3 6 3.8 10 12 17.9
FDI inflows (% gross fixed
capital formation) 10.6 17.8 21.3 28.3 35.1 50.9


Exports of goods and
services (% GDP) 57.5 92.7 84.1 175.8 177.3 297


Imports of goods and
services (% GDP) 55.1 86.8 69.5 175.2 163.6 258


Source: UNCTAD, FDI/TNC database and GlobStat database.
Note: Simple annual averages over time period
* Data are for 1990, 2000 and 2010 only.









I. INTRODUCTION


Promoting the growth of domestic small and medium-sized
enterprises (SMEs) represents an important development objective
in most countries for both economic and socio-political reasons.
Domestic SME development can increase employment, create local
value-added, improve domestic innovation and entrepreneurial
capabilities and generate economic growth. Although there are
obvious benefits from SME growth, many developing countries lack
the resource base or a sufficient market size to foster further internal
expansion.



Some specific obstacles to SME growth in these situations


may also include the following: First, limited access to fund and
credit. SME funding is essential not only to cover the start-up,
expansion and working capital requirements of SMEs, but also for
research and development purposes, as SMEs too often lack
assistance for developing new ideas and turning them into
marketable products. Yet, the cost of capital is often high-priced for
SMEs, particularly in times of economic uncertainty, when lenders
tend to be more risk averse. Second, deficiencies in human capital
and difficulties in establishing the required programmes, both in
terms of the overall education system and on-the-job training. For
instance, universities and vocational institutions may face challenges
to supplying the managerial and technical training programmes
needed to support local business operations. Third, weak
infrastructure with respect to information and communication
technologies, transportation and energy, can limit access to markets
and erode business revenues. Evidence shows that such constraints,
including the digital divide, present particular challenges for SMEs
across many business sectors. Fourth, limited access to information
on prospective markets and clients. Many SMEs have little
experience, particularly in becoming suppliers to foreign affiliates or
exporting to foreign markets. Fifth, the extent of government
regulation and compliance costs. These cover many issues ranging
from taxation and reporting requirements to laws that promote




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occupational health and safety. The cost of complying with national
and international standards can be very expensive for SMEs.
Finally, SMEs are often most vulnerable to economic slowdowns
due to higher risk of business failure.

A. FDI-SME linkages


Foreign direct investment (FDI) can enhance local SME
development through linkages between foreign affiliates and
domestic SMEs. These linkages can take several forms, including
backward, forward or horizontal. Backward linkages exist when
foreign affiliates acquire goods or services from domestic firms, and
forward linkages when foreign affiliates sell goods or services to
domestic firms. Horizontal linkages involve interactions between
foreign affiliates and domestic firms engaged in competing or
complementary activities. This report focuses primarily on
backward or linkages.



Linkages offer benefits to foreign affiliates and domestic


SMEs as well as to the economy in which they are occurring
(Blomström et al., 2000). For affiliates of transnational corporations
(TNCs), such benefits may include lowering transaction costs,
providing greater flexibility, spurring local adaptations and fostering
corporate social responsibility. For local SMEs, potential gains
relate to increased local market opportunities, upgraded
management skills, benefiting from new technology, facilitating
their access to capital and increased possibility of internationalizing
their business. For the host economy as a whole, linkages can
stimulate economic activity through substituting local inputs for
imported ones. The strengthening of domestic firms can in turn lead
to spillovers to the rest of the host economy.



Linkage-related benefits to domestic firms and the local


economy are not automatic. The ability of a host country to fully




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benefit from linkage-related spillovers (i.e. the economy’s
“absorptive capacity”) is determined to a great extent by the
technological and managerial capabilities of existing domestic firms.
Few spillover benefits will be captured if large "capability gaps"
exist. When domestic firms are characterized by weaker capabilities,
foreign affiliates often decide to use preferred foreign suppliers
within or outside the host country.



B. The role of government policy


Although foreign affiliates may have an interest in creating
and strengthening local linkages, their willingness to do so is
influenced and reinforced by government policies addressing market
failures at different levels of the linkage formation process. In this
regard, a multi-faceted and comprehensive approach to building and
deepening linkages needs to bring together the public and private
sectors in creating linkage opportunities and ensuring their effective
implementation. Two major policy areas are relevant for building
FDI-SME linkages (UNCTAD, 2006a).



First, the creation of beneficial FDI-SME linkages depends


on the capacity to attract a substantial quantity and quality of FDI
for the host country. In this regard, the national strategy to promote
FDI-SME linkages should be consistent with and supported by all
relevant policies to attract higher FDI inflows taking into account
the specificity of each country, including factors such as human
capital and technological capacity.



Second, strengthening the absorptive capacity of domestic


firms is vital to establish linkages and to assimilate efficiently the
technology and knowledge that these linkages may provide. Studies
have shown that firm-level absorptive capacity depends on the
firm’s environment. Such an environment is generally characterized
by the availability of educated persons with management and
engineering skills or the quality of basic (e.g. roads, electricity) and




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advanced infrastructure (universities, specialized vocational training
centres, diversified financial sector, etc.). Consequently,
programmes aimed at developing SME capabilities by supporting
technology and innovation, building SME human capital and
fostering internationalization capacities, are important.



C. The case studies


This report on “best practices” of how to create and benefit
from foreign affiliate – domestic SME linkages assesses both public
and private sector factors, including the manner in which they
interrelate. Within the context of host country conditions to attract
FDI, government objectives, policies and programmes constitute the
main public sector elements. International or regional factors as well
as actions by the FDI home-country or third countries also play a
role. The primary private sector actors are the foreign affiliates
themselves and their TNC network along with domestic SMEs.
Other significant actors include business associations, universities,
research centres and mixed private-public partnerships that can
facilitate linkages.



By analyzing the interactive effects of both government and


private sector factors in Malaysia and Singapore, useful insights can
be derived regarding the circumstances under which different policy
and programmatic options can yield the best results. This report
identifies strategic policy choices for government and business
which could generate the most effective outcomes to benefit
domestic SMEs, TNCs, and the host country economy.







II. CASE ANALYSIS: MALAYSIA


A. Country profile and policy context


Malaysia’s economic objectives and policies have been
shaped by the country’s political and social context. Malaysia is a
constitutional monarchy with a system of federalism where power is
divided between a central government and 13 state governments.
However, the distribution of power overwhelmingly favours the
federal government, thereby providing scope for centralized
economic planning. Of Malaysia’s almost 27.7 million multi-ethnic
inhabitants in 2008, Bumiputeras1 accounted for 65 per cent, while
Chinese constituted about 26 and Indians 8 per cent, with additional
minor ethnic groups. This multi-ethnic context is important to
understand the history of Malaysia's economic development policy.



Despite achieving steady, relatively high economic growth


with low inflation for over a decade following independence in
1957, income inequality in Malaysia increased and half the
population lived in poverty in 1970. Bumiputeras remained
disproportionately poor, living largely outside modern urban and
corporate sectors. With relatively few entrepreneurs, they were
concentrated in low-productivity peasant agriculture and the public
sector. These social factors, along with the inequalities in corporate
equity distribution among ethnic groups, contributed to riots in May
1969. The resulting New Economic Policy (NEP) of affirmative
action, a social and economic response to this crisis, subsequently
informed all public policies involving investment in the Malaysian
economy, including FDI. One key aspect of the NEP was for
Bumiputeras to own 30 per cent of corporate equity by 1990. To
meet this objective, the government increased state intervention and
public sector expenditures. In the corporate sector, the NEP
involved targeting a selected group as recipients of government-
created concessions to promote the rise of Bumiputera-owned
conglomerates. Despite positive outcomes in terms of poverty




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reduction, the policy was criticized as undermining inter-ethnic
social cohesion, contributing to new intra-Bumiputera inequalities
and inhibiting genuine entrepreneurial capacity, including in the
SME sector.



Bumiputera participation in manufacturing projects grew


between 1975 and 1985, with equity participation always above 40
per cent (Yasuda, 1991). Yet, this proportion subsequently declined
after the government introduced liberalization and deregulation
initiatives to address the mid-1980’s recession. Although affirmative
action policies were reinstated in the early 1990s, pressures
associated with the 2009 recession saw the Malaysian Government
liberalize the regime once again. Bumiputera equity requirements
were removed or reduced in 27 service sub-sectors as well as for
foreign companies listed on Malaysian stock exchanges.

B. Development model and role of FDI



Although Malaysia's specific development model has


changed over time, FDI has always played a central role. Foreign
manufacturing enterprises, especially British concerns, were
dominant in the colonial and immediate post-colonial periods. While
domestic Chinese investors were also significant over this period,
their share of ownership and control of corporate equity was small
relative to foreign capital. By 1970, Chinese ownership of
manufacturing companies amounted to 22.5 per cent, while foreign
enterprises accounted for nearly 75 per cent of the remaining equity.
However, by the mid-1980s, the share of equity in Malaysian
companies owned by foreigners had fallen significantly, largely due
to the expansion of local Chinese businesses. Nonetheless, FDI
inflows have grown substantially since the late 1970s (figure II.1).






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In the immediate post-colonial period, import-substituting
industrialization (ISI) was encouraged through a combination of
infrastructure investments and fiscal incentives administered by the
Ministry of Commerce and Industry (renamed Ministry of
International Trade and Industry - MITI - in 1990), which has since
been at the centre of Malaysia’s industrial policy. Foreign investors
were important beneficiaries of these policies. In the 1960s, FDI
made up 50 per cent of total investment in the manufacturing sector.
Significant public expenditures were made in the transport, power
and communications sectors, often through the creation of industrial
estates.



The most important incentive for FDI was tariff protection


offered through the 1958 Pioneer Industries Ordinance, which also
provided tax allowances to pioneer firms based on the size of their
investment. However, despite the promotion of large, capital-
intensive industries, most foreign companies participating in ISI
merely established subsidiaries for assembling, finishing and
packaging goods produced with imported materials for profitable
sale within the protected domestic market. The development of
indigenous industries remained limited, mainly due to the
government’s reliance on FDI.



Recognizing the problems associated with ISI in the mid-


1960s, the government changed policy direction and began to pursue
an export-oriented industrialization (EOI) strategy. Fortuitously,
TNCs were beginning to relocate labour-intensive production
processes abroad to reduce production costs. A variety of measures
relating to tax and export incentives were put in place to reorient the
economy and encourage domestic and foreign investment in these
industries, while promoting Bumiputera business activities.



One particularly important piece of legislation at the


beginning of the EOI period was the Free Trade Zone (FTZ) Act of




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1971 (replaced by the Free Zones Act in 1990). It provided
companies with pioneer status, involving tax holidays and tariff
exemptions to encourage FDI inflows in export-oriented
manufacturing. Where FTZs were not established, firms could use
licensed manufacturing warehouses with similar privileges,
allowing greater flexibility in locating export-oriented factories.



Also important in the early EOI period was the


establishment of the Malaysian Industrial Development Authority
(MIDA) in 1967, with the aim of encouraging industrial investment,
in part by providing incentives and infrastructure to attract FDI.
Reporting to the MITI, MIDA has functioned since then as a
comprehensive and autonomous investment promotion agency.
Regional governments were also active in FDI promotion through
the provision of subsidized land, water, electricity and other
physical and institutional infrastructure (box II.1).





Box II.1. Regional development strategies


In Malaysia, regional strategies contributed significantly to the
attraction of export-oriented manufacturing FDI. This is particularly the
case in the electronics and electrical sector promoted by the State of
Penang. The Penang Development Corporation (PDC), created in 1969,
was effective at creating infrastructure and incentives tailored to particular
TNCs. The State also acquired a strong reputation among investors for
efficient institutions and effective government leadership. Penang currently
houses the offshore operations of TNCs such as Intel, AMD, Motorola,
Sony, Agilent Technologies, Seagate and NEC. The PDC and other
regional development corporations, such as Selangor State Investment
Centre (SSIC), continue to offer a variety of infrastructure, incentives, skill
development and research and development (R&D) promotional services.


More recently, Malaysia established five economic growth
corridors in various regions of the country, with each corridor designed to


/…




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Box II.1 (concluded)

draw on regional strengths. These include Iskandar Development Region,
Northern Corridor Economic Region, East Coast Economic Region,
Sarawak Corridor of Renewable Energy and Sabah Development Corridor.

The growth corridors, administered by regional development authorities
which provide investment incentives as well as infrastructure, were seen as
a way to reduce the drop in FDI inflows due to the Asian financial crisis in
1997, but also hope to replicate the success of decentralized industrial
policy as in the case of Penang.





Although Malaysia has generally followed an EOI strategy


since the early 1970s, tariff protection was temporarily reintroduced
in the early 1980s. To further encourage the development of key
heavy industries, the Malaysian Government encouraged the
formation of conglomerates involving TNCs and government-linked
companies (GLCs). 2 For example, state-owned Heavy Industries
Corporation of Malaysia Berhad (HICOM) collaborated with
foreign, mostly Japanese, TNCs in industries ranging from steel and
cement production, to the manufacture of a local car, the Proton.
However, these efforts were largely unsuccessful, with only the
indigenous car industry still under domestic control. With the
reduction of tariffs and other import restrictions, the country had
reverted to its EOI strategy by the early 1990s.



The EOI strategy was largely successful, as Malaysia


experienced significant industrialization and internationalization
over this period. By 1993, the manufacturing sector had doubled in
size to 30 per cent of GDP (from 13 per cent in 1970), while exports
grew from $1.7 billion in 1970 to $13.6 billion in 1986.



Since the early 1990s, the service sector has grown


significantly in relative terms, with further expansion anticipated in




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key sub-sectors relating to Islamic financial products, outsourcing
and shared services, and information and communications
technology (ICT). In 2003, new importance was placed on
commercializing agriculture, recognizing the growing local and
foreign demand for foodstuff and the need to increase income in
rural areas where poverty remains a serious issue.



A key component of Malaysian economic policy in the


1990s and 2000s has been the use of specialized GLCs to promote
sector-level development. As opposed to GLCs involved in direct
ownership of enterprises, such as HICOM, these specialized GLCs
have been typically focused on servicing the private sector with
infrastructure, sector-based incentives, as well as various relevant
training and R&D activities (box II.2).


Box II.2. Sectoral strategy and new GLCs


Over the past two decades, there has been a proliferation of GLCs
with industry-specific policies and programmes. While owned by the
government, these institutions are staffed by industry experts and other
specialized private sector professionals. Similar to regional GLCs (e.g.
PDC), these institutions typically offer infrastructure, financial incentives,
skills and R&D incentives and services as well as administrative and
coordinating services to domestic and foreign investors. In addition, these
GLCs may engage in technology acquisition in order to distribute it to local
firms. They work in cooperation with private sector bodies, public research
institutions, and other programmes and objectives set by the MITI and
other relevant ministries. Examples include the Malaysian Biotechnology
Corporation Berhad (MBC), which aims to maximize returns from the
agricultural sector by ensuring value-added in downstream activities, as
well as the Halal Industry Development Corporation (HDC), created in
2006, which seeks to make Malaysia a global leader in the production of
Halal products.


Perhaps the most significant initiative by a GLC has been the
Multimedia SuperCorridor (MSC), which is managed by the Multimedia


/…




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Box II.2 (concluded)


Development Corporation (MDeC). Created in 1996 to help develop the
ICT sector, the MSC is a zone encompassing Kuala Lumpur and including
five “Cybercities”. The MSC offers an exceptional package of incentives
including a zero corporate tax regime, 100 per cent exemption from taxable
statutory income, 100 per cent Investment Tax Allowance, and eligibility
for R&D grants. Telecom and utility services come with performance
guarantees.



TNCs have commended these and other infrastructure incentives


and the Corridor has become a dynamic ICT hub, hosting over 1,200 TNCs
and domestic companies that focus on multimedia and communications
products, solutions, services and R&D. For example, Dell which had been
operating a manufacturing plant in Penang, established an office in
Cyberjaya in 2008, occupying a building paid for by the government. This
central location in the MSC enables Dell to access MDeC’s services easily
and facilitates an “e-supply chain” for managing its branches and suppliers.




Malaysia continues to provide an environment favourable to
FDI attraction. The country was ranked by UNCTAD’s World
Investment Prospects Survey (2007-2009) among the top 20 most
attractive countries for FDI. A key factor that has drawn FDI to
Malaysia is the country’s high literacy rates at about 94 per cent,
while individuals leaving school to enter the job market have at least
11 years of basic education.


Nevertheless, some constraints remain. A shortage of skilled
workers was identified by the World Bank as one of two major
challenges for Malaysia’s economy. The second challenge was the
regulatory burden on business. For example, an array of government
agencies is allowed to exercise broad discretionary powers in
approving specific FDI projects. The process has given foreign
investors an opportunity to negotiate for attractive conditions, but
the complex web of policies and regulations also present time-




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consuming obstacles for prospective investors. Malaysia recognized
these difficulties and established a high-level committee in 2008,
with some recommendations already implemented on matters such
as clearing customs and processing expatriate work visas.


C. SME sector: policies and programmes


According to the 2005 census of the corporate sector, SMEs
constitute approximately 99.2 per cent of business establishments in
Malaysia. The Government has adopted a common definition of
SMEs to facilitate identification of such firms in the various sectors
and to aid the formulation of policies and programmes to nurture
entrepreneurial SMEs. Table II.1 provides the Malaysian
Government’s SME definition of micro-, small- and medium-sized
enterprises, classified by economic sector, based on annual sales
turnover or number of full-time employees. Almost 80 per cent of
SMEs can be classified as micro-enterprises. A large majority (87
per cent) are in the services sector, compared to 7.2 per cent in
manufacturing and 6.2 per cent in agriculture. Nearly 70 per cent of
SMEs in the services sector are in wholesale, retail or restaurants.
Yet around 26 per cent of SMEs export their products abroad. SMEs
employ more than 5.6 million workers and contribute about 32 per
cent of real GDP.



Policies related to SMEs have existed throughout


Malaysia’s development. However, they have traditionally been
introduced as components of broader development initiatives, with
limited independent attention to specific SME challenges. SME
initiatives in the 1980s and early 1990s, for example, focused
narrowly on linking local suppliers to foreign affiliates within
broader industrial policies.






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Table II.1. Definition of SMEs


Micro-enterprise Small enterprise Medium enterprise
Manufacturing,
manufacturing-
related services
and agro-based
industries


Sales<RM250,000
or


Employees<5


RM250,000<Sales
< RM10 million


or
5<Employees<50


RM10 million
<Sales<RM25 million


or
51<Employees<150


Services, primary
agriculture and
ICT


Sales<RM200,000
or


Employees<5


RM200,000<Sales
< RM1 million or
5<Employees<19


RM1 million<
Sales<RM5 million or


20<Employees<50
Source: www.smidec.gov.my



It was not until the late 1990s that broad-based SME


promotion started to become one of the government’s top priorities.
In 1996, the Small and Medium Industries Development
Corporation (SMIDEC) was created as a specialized agency under
the auspices of MITI. In addition to traditional goals of fostering
linkages between local and foreign enterprises, SMIDEC was tasked
with coordinating the provision of infrastructure facilities, financial
assistance, advisory services, market access and other support
programmes to SMEs. The SME sector was further prioritized with
the creation of the high-level National SME Development Council
(NSDC) in 2004, and by its inclusion as a targeted growth area in
Malaysia's Third Industrial Master Plan (2006-2020). Most recently,
in 2009, SMIDEC was officially transformed into Small and
Medium Enterprise Corporation Malaysia (SME Corp). It continues
to play SMIDEC's role as coordinator of SME programmes across
all related ministries and agencies.


Although it was not always the case, programme eligibility
for SMEs is now often determined by a rigorous assessment of their
strengths and weaknesses. A streamlined methodology called the
SME Competitiveness Rating for Enhancement (SCORE) was
developed in Malaysia specifically for this purpose. The system




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assigns anywhere from zero to five "stars" to SMEs based on criteria
across a range of different capabilities.



Heightened policy attention in more recent years has had a


positive effect on the development of the SME sector (NSDC, 2010:
22-28). Until the early 2000s, annual value added growth of SMEs
tended be lower than overall GDP growth. From 2004 to 2008,
however, SME output grew at a significantly higher rate than the
economy as a whole. This has helped increase the relative role of
SMEs in the economy, although by most measures, Malaysia still
has a long way to go. For example, Malaysia's SME sector made up
only 31 per cent of GDP in 2009, compared to 49 per cent in Korea
and Singapore.

General SME financing


Although private capital is available to Malaysian SMEs,
the government has made additional efforts to expand financing
opportunities. Traditionally, government policy has pressured
domestic banks to lend to local SMEs, and certain agencies were
created to facilitate the flow of credit. Partly as a result, financing
has been relatively affordable. For example, interest rates for SMEs
hovered below five per cent from 1998-2005. Current government
initiatives seeking to improve access to finance, many of which have
emerged since the late 1990s and early 2000s, continue to rely on or
complement the domestic banking system. Bank loans make up 90
per cent of total recorded SME financing, and the share of SMEs in
total business lending by banks rose from 27 per cent in 1998 to 40
per cent in 2009.



An early example of government cooperation with private


banks to finance SMEs is the Credit Guarantee Corporation
Malaysia Berhad (CGC), founded in 1972. In 1973, the CGC
introduced the Small Loans Guarantee Scheme, which guarantees
loans from private financial institutions to small businesses in order




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to reduce barriers associated with their lack of collateral. The loans
can be used for working capital or capital assets. The CGC has also
become involved in other financial products, including SME loans
securitization and equity financing. Throughout its existence, the
CGC has played a leading role in securing access to finance for local
companies. Another new initiative which similarly facilitates access
for SMEs to bank loans is the SME Credit Bureau, established in
2008, which acts as a credit databank, providing financial
institutions and trade creditors with information about an SME’s
financial track record to facilitate its access to loans.



Malaysia has also directly provided capital to SMEs through


development finance institutions (DFIs), such as Malaysian
Industrial Development Finance (MIDF), which manages nine
financing initiatives. In 2005, the Government facilitated the
creation of SME Bank, which distributes the standard financial
services offered by commercial banks, but specializes in SMEs in
particular.



Increasingly, government financing of SMEs in Malaysia is


being accompanied by advisory services that focus on improving the
firm's financial knowledge and strategies. In 2003, Bank Negara,
which has played a role in a number of financing schemes, including
the CGC and some of the initiatives under MIDF, created the SME
Special Unit to provide a central location for SMEs to explore
financing options, complete loan applications, and to address
problems faced by SMEs without access to finance. Dedicated
advisory services are also available on important financial issues.
Similarly, the SME Bank has gone beyond its basic bank functions
to act as a one-stop shop for SME financial services, including
specialized business advisory services to facilitate loan approvals.



Following the onset of the global financial crisis in 2008-


2009, the government introduced further financial initiatives to




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assist SMEs, including programmes targeted at working capital
needs, financing for restructuring, and financing for micro
enterprises.



Building SME capabilities


Malaysia has developed a number of policies and
programmes to help improve the resources and capabilities of local
SMEs. These initiatives relate to building entrepreneurship and
human capital, as well as R&D, technological, and product
development capabilities. They are offered by a range of
government ministries, public agencies and GLCs, and are often
related to broader industrial policies. Many are universal, although
others are oriented specifically towards promoting capabilities
among Bumiputera-owned SMEs.



Entrepreneurship is increasingly encouraged through formal


training programmes. For general training, the National Institute for
Entrepreneurship operated 449 programmes in 2007, involving some
69,200 participants. Other entrepreneurship or start-up training is
targeted at specific industries or SME sectors. For example, MBC’s
Ignite Programme with Cambridge University employs experts to
provide a free “boot camp” for applicants in the biotechnology field
to help them refine their business ideas.



Beyond the start-up phase, human capital accumulation in


SMEs is encouraged through a variety of on-the-job training and
skills development programmes. For example, manufacturing and
service SMEs above a certain size can finance staff training from
eligible providers through a general Human Resource Development
Fund, which levies fees from employers. As many as 28 government
ministries and agencies operate training programmes registered
through a Human Resources Development Portal. Programmes may
focus on technical aspects of certain products or sectors, such as
tourism services, or more general skills, such as those related to




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exporting. SME Corp also provides grants through the Skills
Upgrading Programme to send SME employees to registered
regional skill development centres throughout the country, such as
the renowned Penang Skill Development Centre (PSDC). These
centres provide employee training at the technical and managerial
level. In 2007, 2,050 SME employees participated in the Skills
Upgrading Programme.



In addition to entrepreneurship and skill development, the


Malaysian Government has taken steps to support SMEs with new
technologies, innovation, and improvements to firm products and
processes. Often, SMEs benefit from broader policy initiatives in
these areas, such as MITI’s Commercialization of Research and
Development Fund, which provides partial grants of up to 50 to 70
per cent of R&D expenditures, including market research, product
design and development, standard and regulatory compliance,
intellectual property concerns, and demonstration costs. Similarly,
SMEs have access to the Technology Acquisition Fund, which
provides grants of up to 70 per cent to purchase technology licenses
and patent rights.



Targeted regional and sector development initiatives have


also helped develop the technological capabilities of SMEs. For
example, the city of Cyberjaha within the Multimedia Super
Corridor (MSC) has provided a growth environment for Malaysian
ICT SMEs, although it is primarily targeted at larger firms and
major TNCs. By 2005, only a decade after the MCS was proposed,
nearly 74 per cent of the 3,500 SMEs in the ICT sector had achieved
MSC-programme-status, which provides access to infrastructure, as
well as financial and R&D incentives. By the end of 2008, 444 of
the 474 companies located Cyberjaya were Malaysian firms with
MSC-status. Nevertheless, the MSC is seen by some SMEs as
infrastructure meant primarily for TNCs and large firms, with
inadequate provisions for SMEs. For example, SMEs cannot buy




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land in the MSC nor is it offered to them, while such privileges are
accorded to TNCs.



For SMEs in particular, SME Corp provides matching


grants to improve product quality and production processes,
including packaging techniques, management and quality
certifications, and the development and promotion of halal products,
one of Malaysia's identified export targets. In 2007, several hundred
SMEs received these grants. Complementing the grants, SME Corp
also offers an SME Expert Advisory Panel, which includes over 70
industry experts providing technical assistance to enhance
production capabilities.

Promoting SME market expansion


Several government agencies are involved in programmes
that assist promising SMEs to enter foreign markets or expand
foreign sales. Some assistance simply provides a platform to display
and promote SME products. Examples include SMIDEX, an annual
trade show for SMEs, as well as more general MITI-sponsored trade
shows and foreign trade missions. Other trade shows focus on more
targeted areas, such as the Malaysian International Halal Showcase.
Public export-financing schemes are also important tools to
encourage SMEs to sell internationally. Aside from standard trade
finance offered to most Malaysian firms, MATRADE disperses a
series of grants that SMEs can use to develop their export markets.


Franchising provides another avenue for SMEs to expand
their markets, and Malaysian government has provided increasingly
strong support in this area. This mechanism involves, on the one
hand, foreign franchises held by Malaysian firms and, on the other,
domestic franchising by Malaysian firms that have established
successful ventures abroad. In 1992, the Government established a
Franchise Development Division in the Prime Minister’s
Department, and introduced a long-term plan with related legislation




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to regulate the sector. In more recent years, SME Corp and SME
Bank have provided direct financial support for franchising through
a system of grants. By 2009, 373 franchise systems were registered
with the Government, of which two-thirds were homegrown while
one-third were foreign franchises.



The retail sector has had particular success within this


policy framework. Some 26 homegrown retail franchises already
have business ventures in 50 countries. Among the best known
franchises are Royal Selangor, a family business founded in 1885 to
produce and sell pewter ware. A more recent SME success is Secret
Recipe, established in 1997 as a cafe serving fine quality cakes and
fusion food, which expanded into outlets throughout Southeast Asia,
China, Pakistan and New Zealand.

Programme coordination



Given the Malaysian Government’s recent policy emphasis


on promoting SMEs, the level and breadth of programmatic activity,
only sampled above, is impressive yet concerning. A wide array of
government institutions, agencies and enterprises exercise authority,
assume responsibilities, and operate SME promotion programmes in
the economic sector they serve. In 2007 alone, there were 189 SME-
specific programmes implemented by a combination of 14 ministries
and 60 agencies, and benefiting 286,755 SMEs. With too many
agencies sponsoring an expansive range of SME programmes, there
is little coordination between them regarding the services provided.
Not only does this result in wasteful overlap and conflicting
objectives, it poses significant administrative barriers to SMEs using
these services. For instance, a 2006 survey of more than one
hundred SMEs in Selangor found that government policies, and
bureaucratic issues in particular, were perceived to be the most
significant barriers to SME growth (Saleh et al., 2006).





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The Government has recognized the need to create a more
efficient and coordinated strategy that will focus resources on
prioritized goals, while reducing overlap, red tape, and bureaucratic
delays. Part of their response has included establishing specialized
agencies to help deliver services more efficiently (e.g. SMIDEC and
SME Corp), as well as the creation of SMEinfo, a "one-stop"
information portal on SME programmes. The creation of the high-
level NSDC has had some success in coordinating the proliferation
of programmes within the government.



D. FDI-SME linkages: policies and programmes


Even before general SME development was prioritized in
late 1990s, the government had some experience with policy
measures to link foreign affiliates with local suppliers. Early
initiatives such as the Vendor Development Programme (VDP) had
limited success, primarily due to the limited capacity of the selected
local SMEs to meet the needs of TNCs. Subsequent linkage
programmes have yielded better results, as they have sought to give
TNCs more of a role in supplier selection, and have provided
complementary support for SMEs to access finance, build their
capabilities, and expand to new markets. Beyond specific linkage
programmes, MIDA and SME Corp also maintain databases of
domestic SMEs that are made available to foreign investors looking
for local partners.



Specific linkage programmes



By the late 1980s, the government began targeting export-


oriented manufacturing FDI by employing a combination of
restrictions and incentives to promote the creation and expansion of
indigenous conglomerates and local firms, particularly those owned
or managed by Bumiputera.





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Table II.2. The Vendor Development Programme (VDP)


Objective  Provide opportunities for SMEs to participate in
subcontracting arrangements and other joint-venture
related activities


 Develop and strengthen SME performance as
manufacturers and suppliers of components, input
materials, machinery, parts and supporting services to
large corporations and TNCs


How it
works


 Vendors supply components and spare parts to the anchor
companies - the large local corporations or TNCs
operating in Malaysia


 In return, the anchor companies are directly involved in
the development of the SME, particularly through
technology transfer and by providing a stable market


 This long-term contract will enable the vendors to grow
into large corporations and also penetrate the international
market


Incentives
for SMEs


 The anchor company provides a market for the SME
products and technical facilities to the vendors, such as in
the area of training and quality improvement


 The government provides soft loans and other types of
financial support


Incentives
for TNCs


 Anchors do not receive financial assistance under this
programme


Source: Masayuki (1999)


A major element of the government's industrial strategy was
the Vendor Development Programme (VDP), introduced in 1988 to
help local companies emerge as TNC suppliers of industrial
components, machinery and equipment (table II.2).3 The automotive
sector was the first to be involved in the VDP. As the programme
developed, it broadened its approach to other sectors. For example, a
scheme for the electronics industry was introduced under the VDP
in 1992. The programme also became less restrictive. Originally
exclusive to Bumiputera-owned suppliers, by the mid-1990s, the




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program had been extended to all Malaysian firms. With some
adjustments to its original structure, the VDP remains an important
tool to encourage linkages in Malaysia. In 2005, for instance, the
VDP developed 75 vendor companies based on the appointment of
three anchor companies.




The most prominent project associated with the VDP was
that of the Proton car. Under the VDP, Bumiputera firms were given
preferential rights to supply Proton with locally-produced goods.
This mechanism proved problematic when the supplied material
revealed quality and pricing problems, threatening to undermine the
success of the entire car project (box II.3). The vendor system might
have produced different results had contracts been issued to
companies with the capacity to produce high-quality products at a
reasonable price. In fact, since loosening the restrictions on non-
Bumiputera companies in the mid-1990s, several Chinese-owned
suppliers have experienced success under the VDP. Programmes
that specifically target business development policies should ensure
that recipients of government concessions can sustain themselves in
a competitive environment.




Box II.3. The Malaysian car project and the vendor system


In the early 1980s, state-owned Heavy Industries Corporation of
Malaysia Berhad (HICOM) chose Mitsubishi as its initial foreign joint-
venture partner in the domestic car project, Proton. The vendor system was
introduced in December 1988 as part of the government’s attempt to
promote Bumiputera involvement in manufacturing. Proton was to serve as
an “anchor firm” responsible for cultivating SMEs by using them to supply
component parts for the car project. To promote Bumiputera enterprises,
these firms were preferentially accorded the rights to supply Proton with
locally-produced goods. The vendor system proved unsuccessful in
nurturing Bumiputera firms in the automobile industry. However, there is


/…




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Box II.3 (concluded)


some evidence that non-Bumiputera companies fared better.


In general, SMEs tied to Proton showed little capacity to enhance
their technological skills or develop the ability to serve other companies.
Most of these SMEs did not improve the range and quality of their
products.



Proton’s concern about the quality of products it was receiving


from vendors led the company to reduce the volume of goods acquired
from favoured SMEs and seek out other suppliers. Inevitably, Proton’s
original SME vendors found it difficult to grow, given the appreciable
increase of component suppliers in the automobile sector. More
significantly, the poor quality of goods provided by SME vendors helped
saddle Proton model cars whose lower quality image undermined the car
project’s viability as well as the SMEs’ prospects (Shunji, 1998; Leutert
and Sudhoff, 1999; Rashid, Lall and Tatsuo, 2008).



The vendor system might have produced different results had


contracts been issued on broader merit to companies with better capacity to
produce high quality products at a reasonable price. This point is illustrated
by the success of local Chinese-owned SME autoparts suppliers to Proton.
For example, incorporated in 2000 after the removal of ethnic ownership
restrictions, Proreka (M) Sdn Bhd commenced business as a prototype
builder and supplier of small plastic automotive parts. The company has
since grown into a firm specializing in the design of car components, with
total sales of RM50 million in 2007.



Since the mid-1990s, Malaysia has designed other linkage


programmes that incorporate more merit-based selection
mechanisms, as well as more support for SME capacity-building,
often incorporating certain programmes introduced in the previous
section. These newer linkage initiatives, notably the Industrial
Linkage Programme (ILP) and the Global Supplier Program (GSP),
have helped contribute to several examples of successful SME
development.




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Created in 1996 under the predecessor of SME Corp, the
ILP originally promoted selected manufacturing activities, although
it is now moving into service industries as well. The programme
seeks to build TNC-SME linkages by offering tax incentives to
SMEs producing eligible products, as well as to foreign affiliates
who incur costs by helping to improve SME capabilities (table II.3).
As of 2007, 906 SMEs were registered under the ILP, of which 128
were linked to TNCs and other large companies. One of the ILPs
recent successes is the increased sourcing of local food processing
SMEs by TNC hypermarkets such as Tesco (box II.4).


Table II.3. Industrial Linkage Programme (ILP)


Objective  To develop domestic SMEs into competitive
manufacturers and suppliers of parts and components and
related services to TNCs and large companies


How it
works


 Matching services supported and enhanced by SMIDEC’s
existing financial schemes and developmental
programmes


Incentives
for SMEs


 Pioneer Status with tax exemption of 100 per cent on
statutory income for 5 years and Investment Tax
Allowance of 60 per cent on qualifying capital
expenditure incurred within a period of 5 years are
provided to eligible SMEs


 To become qualified for the incentives, SMEs must
manufacture products or undertake activities in the List of
Promoted Activities and Products in an ILP. They should
also be supplying to TNCs or large companies


Incentives
for TNCs


 Expenses incurred in developing SMEs such as training,
product development and testing, factory auditing and
technical assistance to ensure the quality of vendors’
products will be allowed as deduction in the computation
of income tax


Source: SME Information and Advisory Centre




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Box II.4. The ILP and SME-TNC linkages in food processing


The ILP has been part of the government's efforts to link local
food processing SMEs to foreign-owned retailers. These efforts support the
government's objective to promote value-added activities in agriculture and
agro-business after years of prioritizing industrialization in more heavy and
technology-intensive industries. The sourcing of local food products is
particularly important considering that many small retail outlets, most of
which were supplied by local SMEs, began to lose significant market share
when foreign ownership restrictions in the distributive trade sector were
relaxed during the mid-1980s. Tesco and Carrefour now account for 60 per
cent of retail sales and the survival of food processing SMEs has depended
on being able to supply these TNCs.


So far, a number of local food processors have become successful
suppliers to these retail TNCs. Tesco, for instance, now relies on Malaysian
food processing SMEs for its 31 locations within Malaysia, as well as
many located in other countries. As of 2009, over 70 per cent of Tesco
Malaysia's 60,000 products are produced locally, and 60 per cent of the
company's suppliers are Malaysian SMEs. Once SMEs are taken on as
suppliers by Tesco, they benefit from the TNC’s targeted efforts to help
them meet global standards by producing consistent and quality goods. In
addition, Tesco often takes top firms abroad, helping to open markets for
them in Europe and the United States.


SME Corp has agreed with Tesco on strict assessment criteria
under the ILP, which has helped ensure that linkages are mutually
beneficial. In this arrangement, only SMEs that receive three "stars" or
above according to their SCORE rating are eligible to become lLP
suppliers to Tesco. By late 2009, 49 suppliers had been selected through
this system, several of which have become successful house brands.
Source: SME Corp.





The GSP funds training and skill development for SMEs in


order to make them more effective participants in global supply
chains (table II.4). Originally created in 2000 as an initiative by the




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regional Penang Skills Development Centre, the GSP was quickly
expanded at the country-level by SMIDEC (now SME Corp). Under
the GSP, subsidies are provided to SMEs for training programmes at
a variety of regional centres and institutes. The key element of the
GSP in terms of linkage creation is that TNCs representatives design
the content of the training programmes and participants are selected
based on TNC criteria. Within its first year, the GSP had already
trained 813 employees from 225 SMEs, with the involvement of 23
TNCs or large domestic companies. Intel, for instance, has made
significant use of the PSDC and the GSP (box II.5).




Table II.4. Global Supplier Programme (GSP)


Objective  To develop SMEs into competitive suppliers of parts
and components, not only to TNCs in Malaysia, but
also their worldwide operations through the mentoring
activities and the linkage initiative of the GSP


How it
works


 Involves training in critical skills with TNC input into
curriculum, and SME selection criteria


Incentives


 The training initiative is implemented in collaboration
with local Skills Development Centers (SME Corp has
appointed 42 training providers to undertake skill
training for SMEs: e.g. Penang Skills Development
Centre


 SMEs that send their employees for courses at any of
the training providers will be eligible for 80 per cent
training grant from SMIDEC. Remaining costs may be
claimed through the Human Resource Development
Fund


Source: SME Information and Advisory Centre.





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Box II.5. The Penang Skills Development Centre and Intel


Penang has received some of the highest levels of manufacturing
FDI in the country, particularly in the electronics and electrical sector. FDI
has been used to develop the indigenous industry and SMEs, primarily
through providing a market for local machine tool and contract electronics
manufacturers. The share of TNC procurement from local sources rose
from 10 per cent in the early 1980s to 46 per cent in 1996. By 2007, there
were over 3,000 SMEs in Penang.



A widely successful initiative by the State Government and PDC


to encourage the development of local suppliers has been the PSDC.
Founded in 1989, the Centre brings together TNCs and SMEs in joint-
training activities. It is managed by the industry and includes
representatives

from TNCs and local SMEs. Membership rose from 25 TNCs and six local
supplier firms in 1989 to 56 TNCs and 52 supplier firms in 2005. The close
involvement of TNCs in the initial selection of SME suppliers and the
design of skill development programmes created specialized SME
capacities and facilitated long-term linkages. The Centre’s contributions to
supplier development inspired the federal-level GSP, which also supported
customized SME training based on TNC criteria (and used the Centre as
one of its registered training centres).


Intel, present in Penang since 1974, has used these training
services, tax incentives and financial support to develop its network of
Malaysian suppliers. Notably, Intel created a supplier initiative called the
“Smart Approach,” based on developing supplier capabilities and
competencies and providing business opportunities for SMEs. The
company promoted local supplier development through a five-step process:
(1) select promising suppliers on the basis of systematic analysis; (2)
provide initial training and TNC engagement; (3) allocate business
according to capabilities; (4) raise capabilities by technical assistance and
training; and (5) help suppliers diversify and develop into global suppliers.


/…




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Box II.5 (concluded)

Intel considered that these initiatives benefited TNCs as well as


SMEs by shifting the production of low-level components to dependable
local firms, allowing the TNCs to concentrate on upgrading and developing
new technologies. Intel has helped develop a number of successful
Malaysian SMEs, such as LKT Engineering, Eng Teknology, Polytool,
Rapid Synergy, Metfab, Prodelcon, Choon Engineering and Globetronics.


Source: UNCTAD (2006b).

TNC initiatives and employee spin-offs


Many instances of successful linkage creation in Malaysia
have occurred outside official policy initiatives. While TNCs
typically contact MIDA and SME Corp, where they can receive a
list of companies in compatible areas of business, most TNCs also
conduct independent research before entering the market, since they
often want to identify and choose their local partners. This research
is often done based on feasibility studies from consultants to help
identify supply chains that can be created with SMEs. Once they
have identified partners, TNCs often use internal programmes to
help build SME capabilities. Various private business associations
and chambers of commerce may also play a role in helping match
TNCs with Malaysian firms. These include organizations
representing domestic firms and others created along regional and
country lines, such as the American Chamber of Commerce, the EU-
Malaysia Chamber of Commerce and Industry, and the Japan
External Trade Organization.



Another way FDI-SME linkages have been created in the


Malaysian context is through the establishment of supplier firms by
former TNC employees. Often, their former employer will be their
first customer. Unico Holdings Berhad, Eng Teknologi Holdings
Berhad and Globetronics Technology Berhad are among the SMEs




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owned by ex-employees of TNCs that used such linkages to emerge
as major enterprises in the electronics and electrical sector. As
illustrated in the case of Globetronics (box II.6), which was formed
by ex-Intel employee, TNCs may encourage staff to form new
supplier firms and help nurture the company throughout its
development and subsequent expansion. However, a potential
constraint on former TNC employees serving as a principal FDI-
SME link stems from reported differences among TNC management
and technology practices. Malaysians can generally hold senior
managerial positions in affiliates of TNCs from North America and
Europe, gaining valuable operational experience and strategic
perspective. By contrast, senior positions in the management
hierarchy of firms from Japan are often held exclusively by Japanese
managers, limiting the scope of knowledge transfer to local
employees. Similarly, TNCs from Europe and North America
appear more willing to share and transfer technology with local
suppliers (up to a point), than firms from East Asia.


Box II.6 The case of Globetronics Technology Berhad


The case of Globetronics provides insights into how a domestic
SME developed out of its primary links to one TNC. Globetronics was
established in 1991 by two former employees of Intel. Together, the
founding members had 30 years of experience with Intel. When they
established Globetronics, Intel offered them the opportunity to serve as a
subcontractor. Intel provided their ex-employees with equipment and
facilities to begin their enterprise to ensure that their initial capital outlay
would not be too high. Intel also transferred a component of its
manufacturing system to Globetronics. Intel ensured, however, that their
copyright over this system was not infringed. Another important area of
support that Globetronics obtained from Intel was the TNC’s certification
of quality for their products that were to enter the supply chain network.
With Intel’s backing, foreign and local firms were willing to work with
Globetronics.


/…




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Box II.6 (continued)


The new Malaysian firm had little trouble securing financing from banks as
Globetronics’ business model involved working with Intel.


After developing its capabilities, Globetronics built on this initial
support from Intel by diversifying its operations. Globetronics’ owners saw
this step as a second stage in the firm’s expansion. From a single product
line, Globetronics used value-added engineering to develop and offer
multiple product lines that served a range of customers, including other
TNCs. The firm’s eventual customers included AMD, Agilent, STM,
CREE, Epson, Toshiba and Spansion. Globetronics was aided in
broadening its client base by its history of strong links with Intel.


In the company’s third stage of growth, Globetronics began to
develop unique local capabilities. Globetronics was aware that, while
TNCs were willing to teach SMEs certain production methods, there were
restrictions on the level and volume of knowledge that would be passed on.
Globetronics conceived and executed joint development work with their
customers. They shared risks but also had capabilities and core
competencies that helped to drive growth. Co-developed products were
shared. This practice allowed Globetronics to move up the production and
development value chain. In this stage of development, Globetronics
assessed that their links with TNCs were more diverse but still crucial, as
they were a co-developer of a product with a customer. For this reason,
Globetronics focused additional attention on R&D to develop new
technologies that will help the firm emerge with a global presence in
supplying components for personal computers.


Some facts should be noted from this brief history of Globetronics
links with TNCs. Intel outsourced just one item to Globetronics when the
latter started operations. It was cheaper for Intel to outsource this item than
to continue producing it on its own. Since what Intel outsourced was not
new technology, the TNC ran minimal risk in its initial dealing with
Globetronics. Intel wanted to focus internal resources on higher value-
added production, so transferring low-end manufacturing jobs helped fulfill
this goal. Assisting a new SME to become a reliable local supplier of
quality components also served Intel’s interests.


/…




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Box II.6 (concluded)


As Globetronics developed more capabilities and found new customers, the
firm loosened its initially tight dependence on Intel’s own interests.


The owners of Globetronics acquired the capacity to use and adapt
technology when first employed by a TNC and managed to use their
knowledge, connections and entrepreneurial talents to nurture a start-up
firm in the electronics and electrical sector. This example shows how
employment with a TNC can be an important avenue for entrepreneurs who
wish to create new SMEs with the capacity to innovate. TNCs such as Intel
see mutual benefits arising from contracting out to ex-employees, as
opposed to taking on risks with unknown firms. Globetronics’ history also
shows that new SMEs can develop internal capabilities and eventually
expand their customer base beyond solely producing component goods for
a former TNC employer.
Source: Interviews with Globetronics, July 2009.

E. Conclusion


Malaysia’s industrial policy acknowledged early on the
potential economic benefits of linkages between local SMEs and
foreign affiliates. In fact, early measures like the VDP in the 1980s,
which sought to link SMEs to foreign companies, preceded more
general policy efforts to promote SMEs as a self-standing category
of activity. By the late 1990s, SME linkage policies broadened and
began to emphasize the importance of SME capacity-building and
cooperation between local firms, TNCs and public institutions,
particularly in the area of skill development. These principles were
reflected in the ILP and GSP, as well as the efforts of SME Corp
and its predecessor over the past decade. Although Malaysia’s
hands-on policy approach provides many examples of successful
SME development through linkages with TNCs, its experience also
shows limits to policy efforts as well.




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Notes

1 Bumiputera, which means ‘sons of the soil’, is the term used in reference to


ethnic Malays and other indigenous peoples.
2 A government-linked company (GLC) is a corporate entity that may be private


or public and to which the government is a stakeholder.
3 The VDP complemented the Sub-contractor Exchange Scheme, a database of


local companies initiated in 1986 to match local producers with foreign
investors according to capabilities and needs.












III. CASE ANALYSIS: SINGAPORE

A. Country profile and policy context




Singapore is an independent city-state that operates under a
parliamentary system of government. Originally a British Crown
colony that became self-governing in 1959, Singapore joined the
federation of Malaysia in 1963, but left in August 1965 to establish
a sovereign republic. One of the most densely populated countries in
the world, the country reflects a varied linguistic, cultural and
religious heritage, although nearly three-fourths of residents are
Chinese. Singapore has a unicameral Parliament headed by a
President, but political authority is exercised by a Prime Minister
who leads the majority party and a Cabinet appointed by the
President on the Prime Minister’s advice. The People’s Action Party
(PAP) has dominated Singapore’s politics since the first general
election in 1959.


Singapore’s rapid growth from a modest trading post to a
developed nation is one of the more notable stories of successful
growth and development in the second half of the 20th century. The
Singapore economy experienced one of the highest rates of growth
in the world over the past three decades, with GDP growing at an
annual rate of about 7.6 percent during the period 1970-2005. The
result in turn propelled Singapore’s average real per capita income
from $512 in 1965 to over $26,982 by 2005, which surpassed the
level of many developed countries.


However, long-term averages can hide the vulnerability of
the city state to external shocks. Singapore experienced an acute
economic contraction in 2001, following the sharp downturn in the
global electronics industry and sluggish regional and global growth.
A confluence of negative factors exacerbated the recession,
including September 11, 2001, Bird flu and SARS, Tsunami,
Middle-East war, oil-shocks and the dot.com bubble crash. With
manufacturing and services as “twin” engines of the economy,
Singapore regained its robustness over the next few years. The most




36 How to Create and Benefit from FDI-SME Linkages






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recent global recession dealt another blow to Singapore’s economy.
This crisis again raised concerns about the challenges facing
Singapore’s open, trade-oriented policies and how best to manage
the country's essential interdependence with other economies.



B. Development model and role of FDI



The Singapore Government actively encouraged FDI


inflows from early on. The Economic Development Board (EDB)
was established in 1961 by the Ministry of Trade and Industry
(MTI) as a one-stop agency to lead Singapore's industrialization
drive. EDB worked closely with various ministries and other
government bodies to facilitate the entry of export-oriented FDI in
strategic industries. Over the 1980s, FDI played a central role in
Singapore’s development, representing up to 30 per cent of gross
domestic investment, more than double the share seen in other
regional economies. The country's skilled workforce and efficient
business infrastructure, combined with stable and largely corruption-
free institutions, drew FDI from over 7,000 TNCs that now account
for over two-thirds of Singapore’s manufacturing output and direct
export sales. Levels of FDI inflows have generally followed an
increasing trend (figure III.1), yet the vulnerability of the economy
to external shocks has created large spikes, particularly in years
around major global crises.



Despite an initial focus on labour-intensive manufacturing,


Singapore's focus shifted to encouraging FDI inflows in higher
value-added areas and skill-intensive activities. The EDB targeted
industries such as chemicals and electronics. More recently,
emphasis has been on product development, biomedical research,
educational and health care services. International businesses are
also encouraged to establish R&D facilities in the country, and to
use it as a location for international or regional headquarters.





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Singapore does not impose any restrictions on foreign
ownership in manufacturing activities but maintains restrictions on
strategic sectors for security reasons and on certain service sector
activities. However, since the late 1990s, the Government has been
relaxing foreign ownership restrictions in key service industries, for
instance, lifting the 40 per cent limit on foreign ownership of local
banks in 1999. A 70 per cent limit on foreign ownership of the Stock
Exchange of Singapore, as well as all ownership restrictions in
telecommunication services were removed in 2002. Restrictions
remain in specific professional services such as air transport, law
and media (newspaper publishing).



Overall, the Singapore Government neither screens FDI


inflows nor maintains policies on performance requirements.
Singapore largely complies with World Trade Organization (WTO)
Trade-Related Investment Measures obligations and has signed
investment agreements with its Association of Southeast Asian
Nations (ASEAN) members, as well as a number of other countries.
Many trade pacts also offer some form of investor protection. In any
event, the Singapore Government has not expropriated foreign
investments in the past.




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Singapore's FDI climate benefits from strong institutions,
plentiful infrastructure, generous investment incentives, and a
facilitative environment for R&D activities. The country has a
strong reputation for fair and transparent government decisions,
ranking fourth in Transparency International’s corruption index.
Singapore also ranked as the number one country in the World
Bank’s Doing Business report. The Government provides world-
class infrastructure for foreign investors, as well as competitive
direct and indirect incentives for FDI in key sectors. Incentives
normally include concessionary corporate tax rates of between 5 to
15 per cent or corporate income tax exemptions. Non-tax incentives
including grants can be offered for particular high-value-added
sectors, training and R&D. Among the Government’s support for
R&D-related businesses, Singapore Science Park provides modern
infrastructure in its three different locations. The Agency for
Science, Technology and Research (A*Star) also fosters scientific
research through, among other initiatives, large infrastructure
projects such as Fusionopolis (for information and media industries)
and Biopolis (for the biomedical sciences industry). Singapore
offers a good policy environment for knowledge-intensive TNCs,
including strong Intellectual Property Rights protection. To resolve
disputes in a new frontier such as e-commerce, Singapore
Subordinate Courts offer Alternative Dispute Resolution.

C. SME sector: policies and programmes



Over the years, Singapore has employed several definitions


of SMEs in examining the growth and development of the SME
sector. The definitions also determined the eligibility of firms to
government funds and assistance designated to support SME
development. In 1960s, EDB defined a small company as one that
employed less than 40 workers with fixed capital assets not
exceeding S$2 million in order to be eligible for financial assistance
under the Small Industries Finance Scheme. Under the 1988 SME
Master Plan, an SME was defined as “a company with at least 30




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percent local equity and not more than S$8 million in net fixed asset
investment if it is in manufacturing, or employs not more than 50
workers if it is in commerce or services.” More recently, domestic
SMEs were defined as companies with at least 30 percent local
equity and fixed productive assets (i.e. net book value of building,
machinery and equipment) of not more than S$15 million and
employing not more than 200 workers for the services sector (SME
21 Report). As there is a lack of data for this definition, employment
size of less than 200 employees has been often used to survey
SMEs.


Table III.1 illustrates the relative SME share of business
establishments, employment and value added for the manufacturing
and services sectors. The table shows clearly that SMEs have a large
presence in the manufacturing sector, employing nearly 41 percent
of workers and contributing about one-third of the sector’s value
added. An even stronger presence is evident in the services sector
where SMEs account for two-thirds of total employment and nearly
60 percent of value added. It should be noted, however, that SMEs
tend to experience lower labour productivity (value added per
worker) and also tend to pay lower average wages compared to
larger firms in both sectors.



Although Singapore’s early industrial strategy mainly


focused on attracting TNCs, SME promotion gained increasing
emphasis in the 1980s. The 1987 SME Master Plan outlined a goal
to develop indigenous global enterprises by strengthening the
capabilities of domestic SMEs. The Singapore Competitiveness
Report in 1998 further strengthened the country’s focus on
developing a strong local SME sector. More recently, the 2000 SME
21 Report set a ten-year strategic plan to create vibrant and resilient
SMEs in Singapore. The report set targets to increase the number of
SMEs with significant sales, improve productivity, and pursue
ecommerce. Several broad-based, sector-level, and enterprise-level
strategy initiatives were created to achieve these goals.




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A number of public institutions and agencies have been
charged with formulating and implementing SME-related
programmes over the years. In 1986, the EDB created the Small
Enterprise Bureau to coordinate a number of programmes to support
SMEs and encourage them to work with TNCs. However, today,
most SME initiatives are managed by the EDB, the Standards,
Productivity and Innovation Board (SPRING Singapore) and
International Enterprise Singapore (IE Singapore), all of which fall
under the MTI. Singapore's small size allows a concentration of
administrative responsibilities and resources. This in turn facilitates
a strategy of coordinated targeting for FDI and SME promotion,
including the potential to encourage supplier linkages.



The Government of Singapore also indirectly invests in both


domestic and foreign companies through its investment holding
company, Temasek, and the Government of Singapore Investment
Corporation, which manages government funds. These investments
can support Singapore’s economic strategies by targeting key
sectors and business activities. As in the case of Malaysia, the
resulting government linked corporations (GLCs) are managed
independently.



General SME financing



Singapore has initiated a number of financial assistance


programmes targeting SME start-ups, as well as SME growth and
internationalization. Most of these financing programmes are led by
government agencies, such as SPRING Singapore, IE Singapore and
the EDB, but administered through a network of participating
financial institutions. Financial support includes loans for specific
investments as well as for working capital.



Since the early 2000s, there have been several new


government initiatives aimed at financing local entrepreneurs and
SME in the early start-up phase. To assist promising entrepreneurs




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interested in starting a business, Singapore launched the
Entrepreneurial Talent Development Fund. The Fund works with
higher education institutes to co-invest with students in their
business ideas. Other programmes provide equity financing for
newly established SMEs with strong growth potential, such as the
SPRING Start-up Enterprise Development Scheme (SEEDS). To
date, the initiative has invested in various growth sectors, such as
science and technology, ICT, and business services. To help micro-
enterprises access working capital, the Micro Loan programme is
available to companies with less than 10 employees.



Financial programmes to support the growth and


internationalization of established SMEs have a long history in
Singapore. The Small Industry Finance Scheme, launched in 1976,
has been a major source of working capital and financing to upgrade
or expand operations. Within a decade, the programme had been
extended to the service sector as well. It has since been renamed the
Local Enterprise Financing Scheme (LEFS), and recently ceased its
working capital services, focusing instead on loans to purchase or
upgrade equipment and other assets. The Loan Insurance Scheme
(LIS) has helped fill the gap by insuring working capital loans to
eligible SMEs.



Upgrading SME capabilities


Singapore's objective to strengthen the capabilities of
domestic SMEs has been pursued through a number of general and
specific initiatives. At the industry-level, SPRING and IE Singapore
mange the Local Enterprise Association Development (LEAD)
programme, which partners with industry associations to fund broad
initiatives to improve the capabilities of their SME members. Over a
dozen industry associations have participated so far. LEAD is
complemented by the Capability Development Programme (CDP),
which directly assists SMEs to improve capabilities at the enterprise
or strategic grouping level.




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To enhance human capital in SMEs, a number of enterprise-
level programmes have been made available. For example, the
Management Development Programme (MDP), administered by
SPRING, trains SME CEOs and senior managers through courses
customized to the company's needs. Although not specific to SMEs,
they are also encouraged to use the general Skills Development
Fund (SDF), where employers may be eligible to have the majority
of course fees covered at designated training centres.


Box III.1. Enhancing SME innovation capabilities


The TIP seeks to develop the capabilities of SMEs to innovate and
move up the technology ladder. TIP assistance is available to SMEs
struggling to innovate due to lack of funding, scientific resources or
technological know-how. Eligible SME projects are those that involve the
application of science and engineering to develop new products, processes
or business models. Using TIP funding, SPRING Singapore has established
COIs with the assistance of local universities and polytechnics to help
small firms take innovation to the next level. Such COI have been set up in
key industry sectors, such as environmental and water technology, food
manufacturing, marine, precision engineering and electronics.


Two local SMEs provide examples of how TIP assistance with
product development can enhance enterprise competiveness. TIP funding
covered 50-70 percent of the R&D costs for Nutri-water, a beverage with
nutraceutical ingredients developed by Field Catering Supplies with expert
assistance from one of SPRING's COIs. In another example, a
manufacturer of garment production systems, AMS system, used TIP
funding and staff at COIs to improve the technological skills of its staff.
This helped the firm develop AMS E3000, a cutting-edge production
system using radio-frequency identification technology to increase
efficiency by 200 percent.


Source: The Straits Times, August 26, 2009.




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Other capability enhancing programmes focus on building
innovative, technology-intensive SMEs. An early programme in this
area was the Small Industry Technical Assistance Scheme.
Introduced in 1982 to accompany early SME financing efforts, it has
since been renamed Local Enterprise Technical Assistance Scheme.
The programme partially subsidizes the cost of engaging consultants
to upgrade and modernize business operations. Another notable
initiative is the Technology Innovation Programme (TIP).
Administered by SPRING, it aims to enhance technology
infrastructure to support product and process innovations in SMEs.
The programme co-funds technology-oriented innovation projects
by SMEs and supports a network of Centres of Innovation (COIs)
(box III.1).

Promoting SME market expansion


Due to the relatively small domestic market, overseas
expansion is very important to the success of Singapore SMEs.
According to a Government survey of SMEs in 2009, 69 per cent
had established overseas ventures. In line with Singapore’s
development strategy of broad global engagement, the Government
has made strong efforts to facilitate the expansion of domestic SMEs
into international markets, including through overseas investment.
These efforts include, among others, financing, tax incentives and
grants.



Special financing for international expansion has been made


available to SMEs. Key examples include the Growth Financing
Programme, where the EDB makes long-term equity investments in
promising SMEs, and the Internationalization Finance Scheme,
which facilitates loans for SMEs to acquire foreign assets or pay
foreign expenses.



In addition to finance, the Government provides broad-


based tax incentives to encourage Singaporean companies to enter




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foreign markets. For example, companies can deduct double the
eligible expenses for approved overseas market development
projects. Moreover, they can use current year losses from approved
overseas investments to defer taxes from profitable domestic
operations for up to two years.



To help SMEs build the necessary capabilities to venture


abroad, a special programme focused on internationalization has
been created under the CDP (see above). This programme facilitates
the development of a broad range of firm-level capabilities (e.g.
branding, design, manpower, franchising and licensing, e-
commerce) for the purpose of overseas expansion. A recent related
initiative is the SME Market Access Programme, which is designed
to encourage SMEs to enter new markets. It helps cover third party
costs of entering new markets, which often pose entry barriers for
smaller companies. Examples of these costs include those related to
submission of legal documents, product listing fees, and identifying
distributors and partners.



Other government initiatives take a more selective and


targeted approach to SME assistance, evaluating the international
growth potential of particular firms, as well as their relationship to
key sectors targeted in FDI policy goals. This approach focuses
attention on SMEs that, with some special assistance, can be
successful in their own outreach to international markets. For
example, SMEs selected by the EDB as a Promising Local
Enterprise (PLE) are evaluated on whether they have the potential to
achieve local TNC status, that is, to develop into a regional and
global company (box III.2). Initiated in 1995, the programme met its
goal of producing 100 PLEs with S$100 million in sales by 2005.




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Box III.2. Local SME expansion into the global electronics
market


Today, AEM Holdings Inc. is a publicly-listed company with a
global workforce of 1,100 and operations in Malaysia, Philippines and
China. It designs and manufactures equipment, precision engineering
products, chemicals and organic substrates, as well as engineering
materials and services for the microelectronics industry.


AEM was originally established as Ever Technologies (Singapore)
in 1992. The company was selected by EDB as a PLE for local TNC status
in 1996. It was also awarded Pioneer Status. These designations qualified
the firm for special assistance programmes to support further growth and
aid its entry into global markets. Currently, AEM is a leading local
enterprise which helps support the microelectronics industry in Singapore
and the neighbouring region. Its subsidiary, Microcircuit Technology (S)
Pte Ltd, is the first and only advanced organic substrates plant in
Singapore.


Source: Singapore Investment News, November 2007.



D. FDI-SME linkages: policies and programmes



The early presence of significant foreign investment in


Singapore generated strong demand for local partners. At the same
time, an early focus on developing a healthy SME sector through
financial assistance and capability development programmes
allowed for TNC-SME linkages to take place more naturally. Of
additional importance were government skill programmes to
increase the local pool of human capital in engineering, business
management and information technology. These efforts ensured that
local SMEs had the necessary absorptive capacity to create and
benefit from supplier linkages with TNCs. Nonetheless, the
Singapore Government has implemented policies that actively target
FDI-SME linkages. Many existing linkages can be traced to the
Local Industry Upgrading Programme (LIUP), initiated in 1986 by
the EDB.




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The Local Industry Upgrading Programme

Since its inception, the LIUP has helped support the transfer


of technology, marketing, and business process knowledge from
TNCs to domestic SMEs. Under the programme, TNCs are
encouraged to “adopt” SMEs in their value-chain, and government
support is provided to both parties through three progressive stages
of SME development (table III.2). An initial stage seeks to improve
efficiency in general SME functions. During a second stage, new
products and processes are transferred to the SME. The third stage
envisions joint research and product development with TNC
partners. Essentially, the LIUP offers various forms of
organizational and financial assistance to upgrade vendor
relationships. This flexibility ensures that the programme meets the
specific needs of the TNC and their suppliers.



By the mid-1990s, the LIUP had already recorded many


successes. For example, studies by the LIUP found that suppliers in
the early years of partnerships with large firms improved
productivity by 17 per cent on average, while value added per
worker rose by 14 per cent. By 1994, 180 SMEs and 32 buyer firms,
including 28 foreign TNCs, had formed partnerships under the
Programme (Battat et al, 1996: 29). Around 70 per cent of these
partnerships were concentrated in the electronics industry, which
had been prioritized by the EDB (box III.3). The LIUP continued to
expand over the decade, and by 1999, there were 670 local vendors,
30 TNC affiliates, and 11 large local organizations participating
(UNCTAD 2001: 177).




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Table III.2. The Local Industry Upgrading Programme


Objective  To upgrade, strengthen and expand the pool of local
suppliers to foreign affiliates, by enhancing their
“efficiency, reliability and international competitiveness”


 The programme provides support for local suppliers to
upgrade through collaborations with TNCs


 Local suppliers are also encouraged to expand
internationally


How it
works


 The LIUP is implemented in 3 phases:
- Phase 1: improvement of overall operational


efficiency, such as production planning and
inventory control, plant lay out, financial and
management control techniques


- Phase 2: introduction and transfer of new
products or processes to local enterprises


- Phase 3: joint product, process research and
development with foreign affiliates’ partners


Incentives


 The LIUP’s activities include a variety of organizational
and financial support measures for upgrading vendor
relationships (e.g. contributions to salary of foreign
affiliate representatives seconded to local suppliers)


Source: EnterpriseOne, Singapore.




Box III.3: Early LIUP participants in the electronics industry


In the late 1980s, Hewlett Packard's Singapore affiliate assisted its LIUP
partner, FJ Industrial, to set up production facilities with the process
control equipment and sanitized rooms needed to manufacture
technologically advanced membrane switches and circuits. The SME’s
manager and engineer received training at a factory in Los Angeles and
Hewlett Packard placed a large initial order with FJ Industrial to supply
switches and circuits for its calculators and computers.


/…




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Box III.3 (concluded)


Another early TNC participant was STMicroelectronics, which
first established in Singapore in 1969. In the late 1980s, it joined the LIUP
in an effort to further improve the skills of its suppliers. This was seen as
an important complement to their transition from assembly and testing
activities to investments in R&D and wafer fabrication. Through the LIUP,
the EDB subsidized over 50 per cent of the costs for supplier staff to be
trained in STMicroelectronics' European plants. Initiatives such as these
helped nine indigenous companies evolve into significant local and
international players.


Source: UNCTAD (2001: 177); Lim and Fong (1991: 130-31); Interviews with
STMicroelectronics.



Under the LIUP, local suppliers have been encouraged to


follow their TNC customers to other affiliate locations, particularly
in the South-East Asian region. For instance, AT&T’s local partner,
San Teh, expanded enough to claim 14 per cent of the global market
for rubber conductive key pads. In another example, Close
cooperation with its LIUP partner helped Next Technology meet the
US Food and Drug Administration’s good manufacturing criteria
(Brown, 1998). Other SMEs, such as Advanced Systems
Automation, and Manufacturing Integrated Technology, have also
evolved into first-tier internationalized suppliers (Matthews, 1999).



Although initially based primarily in the electronics


industry, the LIUP programme has since expanded to include other
areas. For instance, the LIUP became active in the aerospace
industry in the early 2000s, with initiatives led by Rockwell Collins
and Honeywell (Box III.4). Specific attention has also been paid to
the information technology industry, leading to the creation of the
Infocomm Local Industry Upgrading Programme, which is based on
the LIUP model. Major TNCs participating in this programme have
included Cisco System, Apple, Hewlett Packard, Microsoft and
Oracle (Coe and Perry, 2004).




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Box III.4. Honeywell Aerospace joins LIUP


In 2003, Honeywell, the global technology and manufacturing
company, announced that its Aerospace Electronics Systems (AES)
business unit would be joining the LIUP. AES, with its role in sourcing
materials form the local and regional market for operations in the United
States, had a clear interest in supporting the development of a pool of
competitive and reliable Singaporean suppliers. Beginning with a set of 15
supplier firms, the LIUP would support AES suppliers in meeting the
TNC's specifications, quality requirements, and help instill best practices in
production.


Source: www.asian-aerocad.com.


E. Conclusion

Singapore has developed an extensive network of SMEs


providing parts, components and other services to TNCs in key
industries. These linkages have led to significant technology transfer
and productivity improvements for local companies. Although many
linkages have arisen spontaneously due to private interaction
between TNCs and SMEs, government policy has also played an
important role. Since as early as the late 1970s, government
financial and technical assistance has been made available to local
SMEs, helping them improve their capabilities, which has in turn
allowed them to establish supplier relationships with major TNCs.
To maximize the benefits arising from these linkages, the
Government targets and continues to target these supplier
relationships through programmes such as the LIUP.













IV. “BEST PRACTICES” LESSONS FOR
CREATING BENEFICIAL FDI-SME LINKAGES



The SME sector constitutes a large and socially crucial


segment in most economies. SMEs contribute substantially to GDP
and are important sources of job creation and entrepreneurial
potential. However, these firms typically confront obstacles that
block their growth and development. Small size hinders access to
resources needed for expansion, principally adequate financing but
also human capital and technology. Most SMEs lack the internal
R&D capacity and funding necessary to translate innovative ideas
into concrete business projects. Many governments create SME
promotion programmes that seek to overcome these obstacles, but
they also often lack sufficient funding, technology and market
outreach to meet their goals.


One way to supplement available resources and spur SME
development is to create linkages between the foreign affiliates of
invested TNCs and domestic SMEs. Expanding SMEs as suppliers
of a foreign affiliate’s export-oriented production is a typical
representation of this relationship. Benefits arising from these
relationships may include, among others, exposure to new market
opportunities, upgraded management skills, new technology, greater
access to capital, and increased internationalization. Countries
considering the promotion of linkages to foster SME development
should conduct an assessment of the prevailing conditions and focus
on three interrelated elements that are essential for beneficial
linkages:


 TNC willingness to participate and increase local
sourcing of supplies and/or services;


 SME capability to work with TNCs and meet their
required standard of quality and reliability;


 A mutual interest/gain in establishing a lasting business
relationship.




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Governments have the ability to influence all three elements
through policies and programmes. The case studies of Malaysia and
Singapore presented in this report, in addition to previous UNCTAD
experience, point to a number of best practices, as well as mistakes
to avoid.

A. Ensure a favourable business climate for SMEs and TNCs


The potential for building linkages should be considered in
the context of a host country's investment climate. Ensuring a
favourable business climate is critical to attracting foreign investors
in the first place, but also for assisting local SMEs to overcome
some of the constraints they face.



1. Attracting FDI is a precondition for creating linkages


Foreign investors need to see a relatively open stance towards
FDI. The openness, integration and clarity of national laws and
policies frame a country’s investment climate and influence FDI
decisions. Efficient, effective and transparent business facilitation
also helps attract FDI.


Both Malaysia and Singapore have always put a relatively
strong emphasis on FDI attraction. In Malaysia, policy reforms,
including the introduction of the Investment Incentives Act in 1968,
the establishment of free trade zones in the early 1970s, and the
provision of export incentives alongside the acceleration of open
policy in the 1980s, laid the foundations for a surge of foreign
investment. FDI in sectors targeted for growth by domestic
industrial policies also received favourable treatment, including
significant financial support and other incentives. Apart from these
factors, sound macroeconomic management, sustained economic
growth and the presence of a well functioning financial system have
made the country an attractive destination in which to do business.




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The country was ranked by UNCTAD’s World Investment
Prospects Survey 2007-2009 among the top 20 most attractive
countries for FDI. The recent financial crisis and subsequent
recession has led to additional measures to improve the investment
climate.



Singapore’s small internal market and lack of physical


resources underpinned an early commitment to open trade and
investment policies. Attracting FDI was treated as an essential
element of the industrial policy designed around an export-oriented
growth strategy. Complementary national policies promoted
improvements in human capital and business infrastructure,
financial incentives encouraged FDI in competitive sectors, few
strategic sectors restricted FDI, and regulations were applied equally
to foreign and national firms. Clear national laws have been
reinforced by proactive bilateral, regional and international efforts to
sign agreements ensuring a stable legal framework for international
business. Singapore has also ranked extremely high in terms of ease
of doing business and low corruption.

2. Cater to the specific needs and concerns of SMEs


SMEs are fragile with respect to some key regulatory
constraints because they do not have the same ability as large
corporations to confront administrative burden.



Complicated and inefficient tax codes, high start-up costs,


bureaucratic complications and distortions, inflexible labour codes
and other indirect labour costs bear most heavily on SMEs, raising
their cost of doing business and depriving them of the flexibility to
adapt. Improvements in the business climate make it easier for
informal businesses to enter the formal sectors, for new companies
to be established and for micro-enterprises to develop into SMEs.




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In Malaysia, problems related to doing business are
especially burdensome for local SMEs. Foreign investors may have
the ability to overcome bureaucratic constraints through high-level
project facilitation. Some facilitative measures, such as SME
advisory services, may help in the short run, but broader reforms are
necessary. Singapore, on other hand, has made considerable
progress to simplify administrative burden on companies. To
encourage private sector initiatives, administrative burdens have
been reduced to a minimum, thereby providing significant benefits
to local SMEs and their development.

B. Strengthen the SME sector


A strong and well-developed SME sector is essential for
linkages to occur. SMEs need to be at a level of development where
it is realistic for them to engage in business relationships with larger
TNCs. The latter will not willingly participate in linkages
programmes if that means working with SMEs that do not operate
under modern standards of operations, management and quality
control that are essential to them. Yet, domestic SMEs in developing
countries face important constraints. It is therefore essential that
comprehensive support be provided through SME promotion and
development programmes to strengthen the absorptive capacity of
local firms and ensure that they are "partnership-ready" to capture
linkage opportunities.



Required support to bring domestic enterprises up to TNC


and international standards usually includes technology upgrading to
improve product quality and production processes, development of
human capital and managerial skills to compete in international
markets, and access to financing to enable SMEs to invest in capital
equipment and human resources. Appropriate design and
development of these supportive mechanisms should be based on a
comprehensive business diagnosis and auditing of domestic firms to




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understand precisely their deficiencies and needs, so that critical
areas for improvement can be identified and addressed.



1. Give sufficient policy priority to general SME goals

SMEs are a major part of the economy and need to receive early
and adequate attention in economic development strategies.


In most countries, SMEs constitute over 90 per cent of
domestic business establishments and represent substantial shares of
employment and GDP. Nevertheless, most industrial policies focus
on larger enterprises that can reach the economies of scale and scope
needed to compete with foreign firms in open domestic and
international markets.



With the exception of some basic credit facilitation,


Malaysia provided very limited services to SMEs in its early stages
of development. When support for the sector was forthcoming, it
was often selective, leaving local Chinese-owned SMEs to grow
largely outside of these programmes. The relative lack of broad-
based SME programmes limited the development of the sector.
Since the mid-1990s, however, there has been a proliferation of
programmes addressing multiple constraints across the SME sector.
In Singapore, SME-focused programmes came about earlier and
encompassed both financing and capability enhancements.
Moreover, Singapore’s early promotion of human capital and
business infrastructure was a benefit to both domestic and foreign
firms.



Successful SME promotion programmes require an accompanying
policy priority that can gain the attention and resources needed to
attain this goal.



Initially, Malaysia treated SME development as a desirable,


but low priority, goal. It was not until the late 1990s and early




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2000s, with the creation of SMIDEC in 1996 and the NSDC in
2004, that efforts were made to prioritize the sector at high levels of
government. Consequently, in the 2006 Third Industrial Master
Plan, the SME sector was labelled as a key growth priority.



Early policy direction in Singapore also overlooked the


potential of the sector, yet not to the same extent as Malaysia. In
1987, the SME sector gained explicit recognition as a policy priority
in the SME Master Plan, which envisioned developing indigenous
SMEs into global enterprises. The 1998 Competitiveness Report laid
out a clearer policy goal, describing three types of SMEs with
growth potential. These policy goals were refined and reinforced by
the SME 21 Report in 2000.



Build local SME capabilities to enhance the potential for linkages.


While SMEs can benefit from linkages with TNCs, this
requires a certain set of pre-existing capabilities in order to attract
TNC partners and to absorb knowledge and technology spillovers
through this relationship. Malaysia’s experience highlights this
point. Under the Vendor Development Programme, Malaysian
SMEs were set up as suppliers to TNCs with little attempt to ensure
their preparedness. Moreover, restrictions related to ethnicity limited
the entry of many qualified firms. Partly as a result, the
programme’s automotive project in particular has been relatively
unsuccessful, with limited local enterprise development. The more
successful linkage initiatives in Malaysia were those involving joint-
capacity building (e.g., the Industrial Linkage Programme and the
Global Supplier Programme), where TNCs were assured of adequate
suppliers and given the chance to pool resources with the
government to improve SME capabilities. Thus, to create and
benefit from linkages, general SME capabilities must meet a certain
threshold.





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Both countries currently employ programmes that seek to
build SME capabilities by encouraging entrepreneurship, human
capital development and the upgrading of technology and innovation
capabilities. Malaysia's efforts in this area were quite limited until
the late 1990s and early 2000s. For example, the Vendor
Development Programme was created in the late 1980s, but relied
almost exclusively on TNCs to build SME capabilities. More
recently, a clear policy shift towards the objective of building
internationally competitive SMEs has driven a proliferation of SME-
related initiatives on multiple fronts. Most ministries and relevant
agencies have developed or enhanced programmes to build SME
capabilities and support SME growth. In Singapore, policies
regarding SME capabilities have been more consistent and were
included as early as 1982, with the introduction of the Small
Industry Technical Assistance Scheme to provide consulting
services for SME upgrading.



Both countries have also invested heavily in R&D-related


infrastructure projects that have helped increase the capacity of local
enterprises. For instance, Malaysia created Cyberjaya as a “hub”
location for computer technology firms, linking it with the
Multimedia Superhighway Corridor (MSC) project. The project
offered exceptional financial incentives to develop the ICT sector.
Nearly three-fourths of SMEs in the sector have qualified for MSC
status, although some limits are imposed on benefits. In Singapore,
the Government commissioned three science parks along with the
large infrastructure projects at Fusionopolis and Biopolis.



2. Policy and programme structure for SME promotion

Policies and programmes can be both horizontal and targeted.


Proactive government interventions to favour specific
SMEs, industries, or sectors need to be carefully designed. This type




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of targeting will result in disproportionate amounts of funding and
assistance provided to a limited number of firms. While the
grooming of a few SMEs deemed to have the potential to become
home-grown TNCs might be a fine option, there are examples of
such efforts essentially precluding the growth of other viable local
firms. In general, a strategy of selecting winners requires flexibility
and should be coupled with elements of a more horizontal approach.



Both Malaysia and Singapore mixed horizontal and targeted


SME promotion. Currently in Malaysia, general SME efforts across
all sectors are complemented by sector or industry-specific services.
For example, standard financing support is made available to a wide
range of SMEs. At the same time, specialized government-linked
corporations (GLCs) offer skill and technology upgrading
programmes to SMEs in the ICT, halal and biotechnology
industries, which have been identified as priority areas. Similarly, in
Singapore, SME 21 has been following a three-tiered approach,
including broad-based support to promote Singapore as an SME
hub, as well as targeted sector- and enterprise-level SME goals.



Targeting requires transparent, merit-based SME selection.



Beginning with Malaysia’s New Economic Policy (NEP) in


the 1970s, SME sector initiatives have often given preference to
Bumiputera SMEs. These preferences resulted in two negative
effects: inhibiting the growth of some local Chinese SMEs, while
discouraging certain FDI that might have provided significant
linkage opportunities. For example, in the case of the Vendor
Development Programme, quality and cost difficulties of new
Bumiputera SMEs undermined the programme's objectives. The
selection of SMEs based on non-economic criteria failed in many
cases to bring along associated economic benefits and limited the
growth of the SME sector.




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Although some preferential programmes persist, recent
initiatives in Malaysia have employed more merit-based SME
selection. For example, the SME Corp, when administering
programmes such as the Global Supplier Programme (GSP), picks
successful SMEs for promotion based on the criteria of TNCs, with
only the most suitable being selected for assistance with specialized
training programmes. To help with assessment, a comprehensive
rating system called SCORE was recently created, assigning SMEs
anywhere from one to five "stars". The foreign-owned retailer
Tesco, for instance, agreed with SME Corp to set a minimum rating
of three stars for food processing SMEs to be eligible in its GSP-
sponsored supplier development programme.



Similarly in Singapore, the Promising Local Enterprise


(PLE) programme reflects a targeted approach with merit-based
selection. The EDB selects specific SMEs assessed capable, with
special assistance, of developing into regional or global companies.
SMEs are selected based on assessment criteria that evaluate the
strength of core competencies, growth-oriented management and the
capacity and critical mass to grow. The EDB works with SMEs that
achieve "local TNC status" to develop new capabilities, identify and
facilitate strategic alliances, and provide growth capital in addition
to other capability-related benefits.

Option: focus on larger SMEs that are usually smaller in number
but have more significant economic impacts.


One way to balance between horizontal and targeted
approaches might be to prioritize programmes for medium-sized
enterprises. These firms have larger economic impacts and their
collective numbers are smaller than the universe of micro-
enterprises that comprise almost 80 per cent of Malaysia’s SMEs.
This option leaves out most broad-based programmes and misses
entrepreneurial start-ups that may provide new competitive
advantages. However, the subset of SME promotion programmes




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designed primarily to create FDI-SME linkages is generally focused
on medium-sized SMEs. These SMEs are more likely than their
smaller counterparts to possess capabilities needed for linkages that
result in “win-win” scenarios.

Consider decentralization, but ensure that programmes are
effectively coordinated and prioritized.


Both targeting and implementation of SME-related
programmes may be easier to manage in sub-national units that are
closer to both local SMEs and foreign affiliates. Decentralization of
SME programmes at the local level can be linked to more results
within the sector and may produce more direct SME development
impacts. However, coordination of these policies and programmes is
important.



The successful experience of the Penang Development


Corporation (PDC) demonstrates the advantages of having local
economic development institutions focused on the provision of
research infrastructure, skill development centres and specialized
incentives for both TNCs and SMEs. The recent creation of five
economic growth corridors has adopted a similar approach, seeking
to develop regional strengths without being confined by sub-national
political boundaries. The country’s privately managed sector-
specific GLCs were also able to manage programmes for SMEs and
adjust them to specific market environments.



In addition to providing more flexibility, decentralization


offers a laboratory to develop best practice policies and programmes
that can later be expanded at the federal level. For example, the
Global Supplier Programme, administered country-wide by SME
Corp, is based on the success of a programme originating at the
Penang Skill Development Centre.





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Large-scale decentralization, however, has led to problems
of coordination in Malaysia. After the country placed a higher
priority on SME promotion in 2003, SME programmes spread
across 14 ministries and 60 agencies, diffusing both resources and
priority targets. Since 1996, the role of SME Corp and its
predecessor, SMIDEC, has been to address this problem by
providing programme coordination across the complex web of
horizontal and targeted SME initiatives. The organization, for
instance, incorporated regional training centres into its broad-based
skill development programmes for SMEs. Another notable move
towards more effective programme governance was the creation of
the National SME Development Council (NSDC) in 2004, tasked
with providing high-level leadership and coordination with other
aspects of the country's strategic development plans.



Simplify procedures for SMEs and/or help them navigate
administrative hurdles.


In Malaysia, SMEs have expressed concern regarding what
they see as overlapping programmes, often with separate
administrative procedures. The proliferation of regional, federal and
sector-based institutions and agencies has expanded the bureaucratic
complexity facing SMEs, many of which have limited capacity to
navigate the system. Malaysia has tried to address these concerns by
ensuring efficient administration (e.g. many GLCs have explicit
guarantees regarding the processing of applications) and by creating
SMEinfo, a "one stop" information portal with details on
programmes and associated administrative requirements. However,
SMEs would still benefit from more consolidated services in this
area.




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3. Formulate an appropriate definition of SMEs


Be cautious with SME definitions, as these determine programme
eligibility.


Countries require a definition of SMEs to analyze and
understand their own SME sector, and to determine which firms are
eligible for government programmes. There are a number of
variables that can be used to define and classify SMEs, and these
may need to be adjusted depending on sector or type of business
establishment. The level of foreign ownership is another important
consideration.



Malaysia adopted a standard SME definition using number


of full-time employees and annual sales with differentiated levels
for micro, small and medium-sized enterprises. The definition also
adjusted the numeric criteria between two categories of business
activity, recognizing that manufacturing, agribusiness and related
services are typically larger in scale than primary agriculture, ICT
and other services. The 30 per cent Bumiputera equity criteria for
SME programme eligibility under Malaysia’s New Economic Policy
requirements applied to both domestic and foreign enterprises.



Singapore has employed several SME definitions under


different government plans, but generally focused on number of
employees and fixed assets, increasing the quantitative limits for
both measures in later programmes. A qualifying standard of at least
30 per cent local equity was added to Singapore’s SME definition.



Avoid static criteria that can miss entrepreneurship and risk ending
successful ventures prematurely.



One challenge in promoting SMEs arises in defining and


designing programmes that can encourage the creation of SMEs as




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well as their growth. The SME sector is populated by innovative
entrepreneurs with creative talents, many ready with new business
proposals but blocked from their execution by financial or other
operational constraints. SME programmes with a minimum size
threshold based on employees, sales, or assets, are often
inaccessible. To avoid this problem, both Malaysia and Singapore
have focused certain programmes on entrepreneurship and start-up
SMEs. For instance, the Entrepreneurial Talent Development Fund
in Singapore has helped finance start-up costs for new business
ideas developed by students at institutes of higher education.



Another definitional challenge for SME creation arises in


determining when to terminate programme support for successful
SMEs, especially for enterprises venturing into international
markets. Assistance programmes with strict eligibility based on
specified employee numbers, fixed assets, or sales risk "graduating"
successful SMEs, resulting in a withdrawal of support. This could
happen despite a need for continued support to establish a market
presence in foreign competition or as the SME is preparing to add a
higher value-added component to its business. Some provision for
flexibility in case evaluation and/or follow-up programme
availability may be desirable to recognize the diversity of SME
operations and the challenges they face at particular stages of
growth.



4. Measure programme outcomes

Seek standards to evaluate SME programme outcomes.


Clear, quantifiable, and comparable measures of success
would permit transparent evaluations of relative returns produced
from resources spent across various SME promotion programmes.
Unfortunately, few such measures are systemically available in
Malaysia and Singapore, due to differences in programme
objectives, the timing of outcomes and other intervening variables.




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Some outcomes can be measured from a zero base for new SMEs,
but assessing the contribution of promotion programmes to
incremental increases in existing operations is more difficult,
presenting a counterfactual situation that assumes what would have
happened without the programme’s assistance. The intervening role
of TNC’s operating through FDI-SME linkages further complicated
an evaluation of government efforts. Although one set of common
criteria would not apply uniformly across programmes focused on
different sectors and stages of SME development, particular benefit
measures can be selected that best match each programme’s
objectives, providing at least programme-specific outcome
measures.


Rather than looking at the relative performance of different
programmes, another option is to set goals regarding aggregate SME
performance and to monitor progress. For instance, Singapore’s
SME21 Report established baseline measures of success for the
principal goals of its 10-year strategic plan. The Report called for
tripling the number of SMEs with over S$10 million in sales,
doubling annual labour productivity in the retail sector, and
quadrupling the number of SMEs with e-commerce transactions; all
by 2010. Again, however, the relative impact of policy factors on
SME outcomes is very difficult to determine.



Anecdotes convey real but partial results.


The most common success measure offered by government
programmes in both Malaysia and Singapore consists of anecdotal
stories about SMEs that received promotional assistance and
expanded their operations, often reaching into export or even
overseas markets. Cause-and-effect impacts remain suggestive in
cases of broad-based programmes, but can be more persuasive for
narrowly targeted assistance. Although counterfactual limitations




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still exist, success stories are most convincing where they involve
direct FDI-SME linkages.



Anecdotal stories do not provide a broad or cumulative


evaluation, but summaries with specific details that link assistance
given to outcomes produced can at least reflect a concrete
application of programme goals. If agencies are required to reveal
unsuccessful as well as successful cases, comparative analyses could
provide useful insights regarding conditions and characteristics
associated with beneficial programme performance.

C. Attract linkage-prone foreign investors


Government policies can target the attraction of FDI in areas
with growth potential that match well with local endowments and
development strategies. It can thus provide more potential for
sustainable linkages to take place. At the same time, certain types of
foreign investments are more prone to use local suppliers in a given
economy. Such type of investors should be subject to specific
attention by the investment promotion authorities.



1. Attract FDI to strategic sectors



Target FDI in sectors and industries with significant growth
potential.



In Malaysia, the Government played a direct role in


selecting sectors for FDI attraction in accordance with its national
industrial strategy. In each of its phases of industrialization,
Malaysia defined high-priority industrial sectors and set long-term
strategies for their development in their respective Industrial Master
Plans. In the 1970s, for example, the Government targeted export-
oriented FDI in the electronics and electrical industry. The Penang
Development Corporation was very effective at creating




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infrastructure and incentives tailored to particular TNCs. Within a
decade, Malaysia became the world’s largest exporter of electronic
semi-conductors. The competitiveness of this sector in Malaysia
helped ensure significant linkage opportunities for local firms.



After years of prioritizing industrialization in more heavy


and technology-intensive industries, the Government has sought to
promote value-added activities in agriculture and agro-business.
Accordingly, FDI policy has, for instance, targeted retail TNCs such
as Tesco to provide a market for local food processing companies.



Singapore has also relied on FDI targeting to move from


attracting FDI in labour-intensive manufacturing to FDI in capital-
intensive manufacturing, and, more recently, FDI in knowledge-
intensive activities. The fiscal regime provided incentives for
investors that would bring new industries to Singapore and create
strong links with the local economy. For example, Honeywell's
Singaporean aerospace subsidiary was granted support from the
EDB, which envisaged its potential to help upgrade local suppliers.



Excessive sectoral focus is risky as it is difficult for governments to
identify winners and there is a danger of bypassing new
opportunities.


Although attracting FDI in key economic sectors may be
effective, there are also risks associated with excessive sectoral
focus. Significant resources may be invested in sectors where
comparative advantages are absent and fail to develop. At the same
time, there is a risk of not supporting nascent opportunities that may
have significant development potential. While Malaysia successfully
attracted FDI in the electronics and electrical sector, its experience
targeting FDI in the automotive sector shows the risks of focusing
on industries that may not be appropriate due to factor endowments,
the quality of the supplier base, or other aspects of the local context.




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2. Assess FDI characteristics to determine SME linkage
potential

Different types of FDI have different propensities to form linkages.


Various characteristics of FDI may determine the potential
for foreign affiliates to develop beneficial linkages with domestic
SMEs. Key factors include sector or industry, the local affiliate’s
years of experience in the host country, the affiliate’s role in the
TNC’s global network, and the home country of the TNC.



Sector characteristics


A sector’s relative competitiveness, technological change
and structure of business activities will shape the length and depth
of its engagement with the host country and, therefore, the nature of
potential SME linkages. For example, buyer-driven sectors of the
garment industry suffer price competition pressures and periodic
location shifts that generally restrain the creation of deep or long-
term linkages between a foreign affiliate and specific local SMEs.
Malaysia’s experience with the electronics sector, in contrast,
showed that a higher level of technical quality requirements created
a more substantial TNC interest in establishing and maintaining
supplier linkages over time. Sectors marked by changing technology
also offer the potential for outsourcing and product spin-offs, as
TNCs concentrate resources on higher value-added elements. In
general, linkage opportunities appear greater where business
activities can be separated into discrete segments, such as in food
processing, IT services or retail supply.



FDI longevity and role of foreign affiliate in TNC network




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Research on the ASEAN region suggests that a foreign
affiliate gains greater autonomy over time, relying less on the
parent’s supply-chain network. This autonomy can lead to
identifying and creating beneficial relationships with local suppliers
in the host country. One indicator of how FDI longevity may impact
such linkages is that a foreign affiliate’s age is negatively associated
with its import propensity (Giroud and Mirza, 2006). Intel’s long
experience in Malaysia traced a record of progressive outsourcing to
local SMEs, often assisted by Intel to establish their supply capacity.
Similarly, the long-term presence of Honeywell's aerospace
activities in Singapore helps explain its willingness to join the Local
Industry Upgrading Programme (LIUP) in order to help develop
local suppliers.



A foreign affiliate’s potential for high value-added linkages


with local SMEs also depends on the affiliate’s role in its TNC’s
global network. Both Malaysia and Singapore have traditionally
placed high priority on efforts to establish themselves as a “hub” for
regional TNC networks, particularly in high technology sectors and
knowledge-based industries. Whereas Malaysia originally used
foreign trade zones and more flexible licensed manufacturing
warehouses to encourage FDI in manufacturing clusters, the
country’s new emphasis is reflected in its development of
technology-heavy Cyberjaya and the promotion of the Multimedia
Super Corridor. By attracting FDI involved in a TNC’s R&D
operations, the host country gained higher value-added business
with a longer time-horizon.



TNC home country


Some experiences point to general differences in how
foreign affiliates from various home countries handle issues relating
to local management and technology transfer. Whereas Malaysians
often hold senior managerial positions in affiliates of TNCs from




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North America and Europe, senior managers in Japanese affiliates
typically come from Japan. This difference affects the extent to
which TNC knowledge regarding business strategy and operations
are diffused locally. For instance, many former employees of
American-owned Intel have used their acquired skills and expertise
to found new SMEs, often with Intel as their first customer.



Similar differences are apparent in terms of technology


transfer, with East Asian TNCs being slower and more reluctant to
share technological know-how with their suppliers. Of course, some
differences are interrelated with the longevity of an investment and
the nature and level of technology involved in particular projects.
However, the priority placed by many host countries on attracting
and benefiting from higher technology FDI underlines the potential
significance of these characteristics.

D. Foster and develop linkages


With the necessary conditions in place, namely the presence
of significant FDI and a supportive framework for local SMEs,
supplier linkages are likely to emerge. TNCs have an incentive to
use and develop local suppliers to lower costs. SMEs will seek
partnerships with TNCs to increase their customer base and acquire
new knowledge and technology. Yet, despite these tendencies, a
purely market-based approach may fail to result in an optimal level
of linkages. Reasons for this may include, among others, poor
information on linkage opportunities, limited TNC confidence in
local suppliers, or a lack of compensation for TNC knowledge or
technology transfers. Government policies and programmes can help
overcome these constraints, ultimately facilitating the creation and
deepening of linkages between foreign affiliates and local SMEs.

However, government efforts must ensure that participation
in supplier linkage relationships remains voluntary on both sides.




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Coercive measures are likely to fail. Allowing TNCs to retain
control over the selection of their domestic partners is a better
approach, and usually results in strengthened confidence in the
partnerships. In short, linkages must be "win-win" to take place.

1. Use facilitative programmes to match TNCs with local
SMEs

Provide information and incentives to encourage TNCs to use local
suppliers.


By providing information and contacts on local SMEs, or
offering assistance to test local supplier capabilities, government
programmes can encourage supplier linkages with TNCs, even
during the pre-investment phase. Regional and country-level
investment promotion authorities in both Malaysia and Singapore
often provide matching services as they facilitate foreign
investments. Often, these organizations rely on extensive databases
and directories that include detailed information on SMEs. These
can be made publicly available as well to assist the private research
efforts of TNCs looking for local suppliers. Moreover, programmes
such as SCORE in Malaysia, and the PLE programme in Singapore,
can provide rigorous and credible assessment of SME capabilities,
helping to earn the confidence of potential TNC customers.



Building local linkages often involves a “cost” to foreign


affiliates in terms of time and resources, especially if local SMEs
have weak capabilities. In these cases, some level of government
support during the developmental process may be justified to
overcome information or capability “gaps”, and to reduce costs and
risks for TNCs to pursue local linkage strategies. Although
restrictions may be used, such as performance requirements linked
to local content, international agreements increasingly constrain
such restrictions as their imposition can discourage FDI. Facilitation




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measures and/or financial incentives provide alternative
inducements. However, there are limits to what can be
accomplished. The provision of incentives to foreign affiliates may
be of little use if local procurement markets are seriously
underdeveloped (Rodríguez-Clare, 1996; Belderbos et al., 2001).
This underscores the need for governments to focus on building
SME capabilities as a pre-requisite to successful linkage
programmes.



Accommodate open access or inside “seeding”.


Alternatively, the TNC may follow a process sometimes
known as “seeding” by assisting local managers interested in
developing a new SME. Choosing to work with “known” partners
who are familiar with the TNC’s products and standards provides
reassurance regarding the reliability and quality of a new supplier.
This approach can stimulate more substantial, direct assistance from
the TNC than would otherwise occur. As illustrated in Intel’s
multiple spin-offs in Malaysia, the TNC may even second technical
personnel to the new firm and provide training for new employees.
Government programmes can work in cooperation with TNCs to
facilitate and support this phenomenon.

2. Seek FDI-SME linkages that move beyond "dependent"
to "developmental"

Linkages can be characterized as “dependent” or
“developmental”.1


Dependent linkage relationships between SMEs and foreign
affiliates are characterized by short-term supplier contracts and
limited, if any, involvement of the TNC in upgrading SME
capabilities. Developmental linkages, on the other hand, enable and
assist local SMEs to grow and prosper through long-term supplier
relationships. These provide more stability for SMEs, and by




74 How to Create and Benefit from FDI-SME Linkages






UNCTAD Investment Advisory Series B


strengthening internal capabilities, allow them to respond better to
changes in demand and new product specifications or inputs.



Foreign investors are also better off encouraging


developmental linkages, which ensure a reliable local sourcing
capacity over the longer term. In addition, developmental linkages
that assist local SMEs and communities to grow within the
framework of the host country’s development policy represent good
corporate social responsibility.



Ensure that linkage programmes address SME capabilities


Linkages that teach SMEs about supplier operations and
processes constitute a useful, but limited, first step toward
increasing local SME capacities. To push these linkages in a more
developmental direction, TNCs need to make sustained efforts to
assist SMEs to become reliable and high-quality suppliers. While
some TNCs may have an interest in doing so, this can not always be
expected. Government support may be necessary.



In Malaysia, the ILP and the GSP not only match TNCs


with local enterprises, but also provide support to upgrade supplier
capabilities for their engagement in advanced production processes
and global supply chains. Singapore's LIUP is similar in this regard.
These programmes offer a variety of support measures, including
tax incentives for TNCs and SMEs, special financing, and subsidies
for training and product development, among others. The TNC
usually works with the SME to formulate the specific details of this
assistance in order to ensure that it caters to their specific needs.



Value the many forms of knowledge transfer from foreign affiliates
to SMEs




Chapter IV 75







UNCTAD Investment Advisory Series B


Technological upgrading of local supplier firms is a priority
for host countries and several governments have adopted measures
to encourage technology transfer from TNCs to SMEs and to
strengthen technological cooperation between the two. Technology
transfer can occur through many types of FDI-SME linkages,
depending both on the TNC’s willingness to share knowledge and
techniques and the SME’s capacity to absorb and utilize it. High-
value technology is unlikely to be transferred outside the TNC’s
control, but linkages can facilitate other beneficial knowledge
transfers such as assistance with inventory management, marketing
techniques and new practices in finance or purchasing. Process
technology transfer can take place through the provision of
machinery and equipment as well as technical support for
production planning, quality management, and inspection and
testing procedures. Transfers also often occur through sharing
product design and specifications, technical consultations, and
feedback on SME performance.



In Singapore, SMEs have benefited mainly from indirect


technology transfer such as learning through quality testing and
diagnostic feedback, know-how disclosure in product design, and
exposure to good manufacturing practices (Wong, 1992). However,
government programmes such as the LIUP have helped SMEs move
up the value chain from original equipment manufacturers to
original design manufacturers. This, in turn, has encouraged linked
TNCs to consider further nurturing their technological capabilities
(Chew and Yeung, 2001).



Expand markets through TNC networks


TNC networks accessible through FDI-SME linkages can
also open new markets for domestic firms. For instance, Tesco
stocked its local and overseas shelves with products from
Malaysia’s SME suppliers and introduced some firms to direct
customer connections overseas. Government initiatives, such as the




76 How to Create and Benefit from FDI-SME Linkages






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Global Supplier Programme provide training and mentoring services
that help SMEs build the capabilities to seize opportunities within a
TNC’s global supply network.


Certification by TNCs can be particularly advantageous for
SMEs that require endorsement of their product to facilitate
expansion in domestic as well as international markets. Beyond cost
competitiveness, foreign customers must be convinced of a new
supplier’s product quality. FDI-SME linkages can reassure potential
foreign customers, as reflected in the accreditation effect of
Globetronics’ strong supplier links with Intel.



Note



1 Driffield and Mohd Noor (1999).







V. CONCLUSION

Promoting beneficial linkages between foreign affiliates and
domestic SMEs represents a politically attractive goal for both host
governments and invested TNCs. However, the measureable
economic return from such programmes is often uncertain, at least
when compared to the clear challenge of assisting so many firms of
diverse quality and commitment. Studying the experiences of
countries with positive FDI and SME outcomes, such as Malaysia
and Singapore, can help identify key factors affecting programme
success.


The two countries examined in this case study both
followed proactive encouragement policies to promote SMEs and to
create beneficial TNC-SME linkages. Malaysia pursued several
development strategies that attracted different types of FDI. Early
SME programmes primarily served socio-economic goals which
sometimes restricted FDI operations as well as SME sector growth.
Malaysia’s recent policy shift to prioritize SME development has
sparked a proliferation of government programmes, including some
successful programmes specifically designed to support FDI-SME
linkages. In Singapore, early reliance on FDI was accompanied by
programmes to assist certain SMEs that could develop competitive
international capabilities. The large FDI presence in Singapore
provided opportunities to forge beneficial linkages with SMEs,
initially through supplier relationships that later expanded SME
capacity and sometimes provided international outreach.

The case experiences of these two countries can provide
insights, but not a recipe for other countries that seek to promote
SME development. A realistic self-assessment of each country’s
economic conditions and FDI climate should inform the chosen
goals and approach to SME promotion. The potential for beneficial
FDI-SME linkages will depend on many factors, including the
foreign affiliate’s sector, operational activities, and role in the
TNC’s global network. For their part, host countries can invest in




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basic infrastructure and human capital to improve conditions for
both local entrepreneurs and foreign investors. More targeted
assistance can help at several stages to overcome start-up obstacles
for SMEs, spur increased technical capacity, and support
international market outreach. FDI-SME linkages, facilitated by
government programmes, can contribute to each of these stages by
offering initial training and mentoring, expanding and upgrading
SME supplier capabilities, and providing foreign market
endorsements and channels for overseas sales.

The capacity of host governments to provide effectively
designed and efficiently executed SME promotion programmes will
largely determine their success. Financial and other support for
SMEs, along with targeted incentives for FDI, are sometimes
needed to overcome initial barriers to creating FDI-SME linkages.
However, cost-saving coordination of government programmes and
low-cost business facilitation measures can be equally important
factors in supporting SME growth. By establishing an environment
conducive to creating beneficial FDI-SME linkages, a host
government can encourage entrepreneurial innovation, provide
opportunities for commercial realization and exploit untapped
reserves in its SME sector for growth and development.







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Yasuda Nobuyuki (1991). Malaysia's New Economic Policy and the
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SELECTED UNCTAD PUBLICATIONS ON
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DIRECT INVESTMENT


(For more information, please visit www.unctad.org/en/pub)


World Investment Reports
(For more information visit www.unctad.org/wir)



World Investment Report 2010. Investing in a Low-Carbon Economy.
Sales No. E.10.II.D.1. $80.
http://www.unctad.org/en/docs//wir2010_en.pdf.

World Investment Report 2009. Transnational Corporations,
Agricultural Production and Development. Sales No. E.09.II.D.15. $80.
http://www.unctad.org/en/docs/wir2009_en.pdf.

World Investment Report 2008. Transnational Corporations and the
Infrastructure Challenge. Sales No. E.08.II.D.23. $80.
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World Investment Report 2007. Transnational Corporations, Extractive
Industries and Development. Sales No. E.07.II.D.9. $75. http://www.unctad.org/
en/docs//wir2007_en.pdf.

World Investment Report 2006. FDI from Developing and Transition
Economies: Implications for Development. Sales No. E.06.II.D.11. $75.
http://www.unctad.org/ en/docs//wir2006_en.pdf.

World Investment Report 2005. Transnational Corporations and the
Internationalization of R&D. Sales No. E.05.II.D.10. $75.
http://www.unctad.org/ en/docs//wir2005_en.pdf.

World Investment Report 2004. The Shift Towards Services. Sales No.
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World Investment Report 2003. FDI Policies for Development: National and
International Perspectives. Sales No. E.03.II.D.8. $49. http://www.unctad.org/
en/docs//wir2003_en.pdf.

World Investment Report 2002: Transnational Corporations and Export
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en/docs//wir2002_en.pdf.

World Investment Report 2001: Promoting Linkages. 356 p. Sales No.
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World Investment Report 2000: Cross-border Mergers and Acquisitions and
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Ten Years of World Investment Reports: The Challenges Ahead. Proceedings
of an UNCTAD special event on future challenges in the area of FDI.
UNCTAD/ITE/Misc.45. http://www.unctad.org/wir.



Best Practices in Investment for Development
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How Post-Conflict Countries can Attract and Benefit from FDI: Lessons
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Bilateral Investment Treaties 1995—2006: Trends in Investment Rulemaking.
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Preserving Flexibility in IIAs: The Use of Reservations. 104 p. Sales No.
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International Investment Agreements in Services. 119 p. Sales No.
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The REIO Exception in MFN Treatment Clauses. 92 p. Sales No. E.05.II.D.1.
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Investment Policy Monitors


Investment Policy Monitor. A Periodic Report by the UNCTAD
Secretariat. No. 3, 7 October 2010.
http://www.unctad.org/en/docs/webdiaeia20105_en.pdf

Investment Policy Monitor. A Periodic Report by the UNCTAD
Secretariat. No. 2, 20 April 2010.
http://www.unctad.org/en/docs/webdiaeia20102_en.pdf

Investment Policy Monitor. A Periodic Report by the UNCTAD
Secretariat. No. 1, 4 December 2009.
http://www.unctad.org/en/docs/webdiaeia200911_en.pdf



IIA Monitors and Issues Notes

IIA Issues Note No. 1 (2010): Latest Developments in Investor–State
Dispute Settlement.
http://www.unctad.org/en/docs/webdiaeia20103_en.pdf

IIA Monitor No. 3 (2009): Recent developments in international
investment agreements (2008–June 2009).
http://www.unctad.org/en/docs/webdiaeia20098_en.pdf

IIA Monitor No. 2 (2009): Selected Recent Developments in IIA
Arbitration and Human Rights.
http://www.unctad.org/en/docs/webdiaeia20097_en.pdf




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IIA Monitor No. 1 (2009): Latest Developments in Investor-State Dispute
Settlement.
http://www.unctad.org/en/docs/webdiaeia20096_en.pdf

IIA Monitor No. 2 (2008): Recent developments in international
investment agreements (2007–June 2008).
http://www.unctad.org/en/docs/webdiaeia20081_en.pdf

IIA Monitor No. 1 (2008): Latest Developments in Investor– State
Dispute Settlement.
UUhttp://www.unctad.org/en/docs/iteiia20083_en.pdf

IIA Monitor No. 3 (2007): Recent developments in international
investment agreements (2006 – June 2007).
http://www.unctad.org/en/docs/webiteiia20076_en.pdf

IIA Monitor No. 2 (2007): Development implications of international
investment agreements.
http://www.unctad.org/en/docs/webiteiia20072_en.pdf

IIA Monitor No. 1 (2007): Intellectual Property Provisions in
International Investment Arrangements.
http://www.unctad.org/en/docs/webiteiia20071_en.pdf

IIA Monitor No. 4 (2006): Latest Developments in Investor-State Dispute
Settlement.
http://www.unctad.org/sections/dite_pcbb/docs/webiteiia200611_en.pdf

IIA Monitor No. 3 (2006): The Entry into Force of Bilateral Investment
Treaties (BITs).
http://www.unctad.org/en/docs/webiteiia20069_en.pdf

IIA Monitor No. 2 (2006): Developments in international investment
agreements in 2005.
http://www.unctad.org/en/docs/webiteiia20067_en.pdf




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IIA Monitor No. 1 (2006): Systemic Issues in International Investment
Agreements (IIAs).
http://www.unctad.org/en/docs/webiteiia20062_en.pdf

IIA Monitor No. 4 (2005): Latest Developments in Investor-State Dispute
Settlement.
http://www.unctad.org/en/docs/webiteiit20052_en.pdf


IIA Monitor No. 2 (2005): Recent Developments in International
Investment Agreements.
http://www.unctad.org/en/docs/webiteiit20051_en.pdf

IIA Monitor No. 1 (2005): South-South Investment Agreements
Proliferating.
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QUESTIONNAIRE
Best Practices in Investment for Development


Case Studies in FDI: How to Create and Benefit from FDI-SME
Linkages


Lessons from Malaysia and Singapore
Sales No. E.10.II.D.12



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