This chapter presents a conceptual framework to assess the enabling conditions and diffusion channels through which FDI affects SME productivity and innovation. It also provides a set of diagnostic tools to benchmark countries and regions according to their potential to benefit from FDI and SME linkages, taking into consideration the type of investment that they attract, the performance of SMEs, as well as economic, structural and geographical factors. Selected indicators are drawn from a range of OECD and non-OECD databases.
Policy Toolkit for Strengthening FDI and SME Linkages
1. Conceptual framework and diagnostic tools
Abstract
Context and motivation
A complex nexus of short-term and structural changes is transforming international production systems and global value chains (GVCs). COVID-19 and Russia’s war against Ukraine hit GVCs very hard, with uneven impact across countries and places in the OECD and partner countries. Asymmetries in the impact of the pandemic reflected differences in the local endowment of health and economic resources, policy reactions, and the strength of disruptions across business activities and value chains. The effects of the war also differ depending on places’ exposure to Russia and Ukraine and are diffusing through a variety of channels, including energy and commodities trade; the supply chains of transport equipment, basic metals and non-metallic products; and financial and business linkages. These recent and ongoing transformations add to the challenges and structural changes already at play before the crisis, arising from technological development, regionalisation of trade, increasing international economic and political tensions and growing need to build more sustainable production systems (OECD, forthcoming[1]).
In light of these challenges, innovation and productivity will play an increasingly critical role in helping firms, regions and countries seek greater competitiveness, sustainability and resilience. Besides the contribution of innovation and productivity to economic growth, new rationales have emerged to support and enhance their diffusion – including limiting dependencies in materials and energy sources.
The academic and policy literature has identified small and medium-sized enterprises (SMEs) and foreign direct investment (FDI) as two important contributors to productivity and innovation. On the one hand, SMEs make up the industrial fabric of many places, accounting for about two-thirds of total employment and 50-60% of business sector value added in the OECD area. They are also key actors for social cohesion, the training and integration of young people into the working environment, and the delivery of services in remote areas or niche markets that are not profitable enough for larger-scale firms (OECD, 2019[2]). On the other hand, FDI contributes to the knowledge base and capital stock of host countries and regions. Beyond its direct contribution to capital investment and employment generation, FDI can benefit host economies through knowledge and technology spillovers, which can help drive productivity growth in local firms, especially SMEs.
Changes in the global trading and investment environment provide opportunities for the upgrading of SMEs. Participation in GVCs can enable SMEs to enhance productivity by capturing technology and knowledge spillovers, upgrading workforce and managerial skills and raising innovation capacity. Recent analysis showed that firms engaged in GVCs recovered faster from the COVID-19 crisis, suggesting that GVCs have contributed to their economic resilience (Giglioli et al., 2021[3]; Constantinescu et al., 2022[4]; OECD, forthcoming[1]). SME internationalisation and integration in GVCs can be achieved directly through trade (i.e. by supplying or sourcing companies located abroad) or indirectly by establishing linkages with foreign affiliates of multinational enterprises (MNEs).
While SME performance is influenced by a variety of market, policy and other factors, this Policy Toolkit focuses on the specific role of FDI-SME linkages and spillovers as drivers of productivity and innovation. It aims to provide policymakers with a set of principles and tools to maximise the benefits of FDI to the host economies through knowledge and technology spillovers, ultimately strengthening innovation and productivity growth in local SMEs. Based on existing literature and empirical evidence, Chapter 1 presents a conceptual framework to better understand the nature of FDI-SME relationships. It identifies the core enabling conditions under which FDI can positively affect SME productivity and innovation and the main channels enabling knowledge and technology diffusion from FDI to domestic SMEs. It also provides a set of diagnostic tools to benchmark FDI-SME spillovers’ enabling conditions and the performance of diffusion channels across OECD countries and regions. Building on this framework, Chapter 2 then discusses how institutional settings, regulatory conditions, policies and programmes can enable or deter these FDI-SME linkages. It does so by going beyond the evaluation of single policy measures, and rather looking at the policy mix consisting of various policy measures that are developed and implemented with different objectives, target different actors, and involve multiple levels of government.
This Policy Toolkit does not investigate the entire spectrum of GVC relationships but focuses only on knowledge spillovers that arise from foreign MNE affiliates in host-economy markets. The scope of the project covers strategic partnerships between SMEs and MNE affiliates based in the same country (excluding overseas/cross-border partnerships) and value chain linkages through buy and supply relationships between SMEs and MNE affiliates based in the same country (excluding cross-border trade).
Spillovers from FDI to domestic SMEs depend on a set of enabling conditions. These include the volume and local embeddedness of foreign-owned affiliates in the host country or region, as well as the existence of a productivity gap between investing foreign MNEs and domestic SMEs, the former having access to a broader range of innovation assets and resources and performing better on average. The potential of spillovers resulting from FDI is also related to the existence of absorptive capacities of local SMEs and the capacity to adapt when they get exposed to activities of foreign firms. Attractiveness, embeddedness, performance and spillovers are affected by a range of enabling conditions related to the economic, geographical and structural characteristics of the host country or region, which hold the potential to enhance (or hamper) knowledge and technology diffusion from FDI.
While adequate enabling conditions are necessary, they are not sufficient. To maximize the potential for FDI spillovers, domestic SMEs need to have linkages (direct or indirect) with foreign MNEs. This may occur through different types of connections and interactions providing opportunities for knowledge and technology transfers. These include buyer-supplier linkages along value chains or formal strategic partnerships (e.g. joint ventures) between foreign MNEs and domestic SMEs. They also include the mobility of workers from affiliates of foreign MNEs towards local SMEs; and the competition or imitation effects that may occur following the market entry of foreign MNEs, e.g. as a response to the introduction of new quality standards or better managerial practices by the foreign entrant.
The scope for productivity and innovation spillovers on domestic SMEs is ultimately determined by the interaction of enabling factors (FDI spillover potential, SME absorptive capacity; economic, geographical and structural characteristics of host countries and regions) and diffusion channels (value chain linkages; strategic partnerships; labour mobility; competition and imitation effects) (Figure 1.1). Besides economic and market conditions, policy, regulatory and institutional settings play an important role in fostering FDI and SME linkages. Public policies aiming to enhance spillovers cut across a range of policy domains, including investment promotion, SME development, innovation and regional development.
Figure 1.1. Understanding FDI spillovers to domestic SMEs: conceptual framework
Source: OECD elaboration.
Box 1.1. Key terms and definitions
What are foreign firms/MNEs?
Although foreign firms generally refer to firms owned or controlled by investors that reside in an economy other than that of the firm, researchers and policymakers alike use different criteria to define foreign firms. It is therefore useful to distinguish between the definition of foreign firms used in the context of analyses of foreign direct investments versus foreign firms defined in the context of activity of multinational enterprises (AMNE).
In the context of FDI, foreign ownership considers cross-border investments made with the objective of establishing a “lasting interest” in an affiliate that is resident in an economy other than that of the direct investor. The lasting interest is evidenced when the direct investor owns at least 10% of the voting power of the direct investment enterprise (OECD, 2009[5]) (OECD, 2023[6]). Therefore, firms are defined as foreign when foreign investors own at least 10% of their equity stocks, in line with the OECD Benchmark Definition of Foreign Direct Investment (OECD, 2009[5]).
In the context of OECD’s Activity of Multinational Enterprises database (AMNE Database), foreign ownership is generally determined using the principle of controlling interest. While in most countries the controlling interest is based on majority ownership (owning more than 50% of equity stake), other countries also consider minority control (between 10% and 50%) (Cadestin et al., 2018[7]). The AMNE database identifies three categories of firms: foreign-owned firms (foreign affiliates), domestic multinational enterprises (MNEs), and other domestic firms (Cadestin et al., 2018[7]). Foreign affiliates are firms where more than 50% of the controlling interest is owned by investors outside of the country. MNEs consist of domestically-owned firms with affiliates abroad. Other domestic firms include domestically-owned firms without affiliates abroad.
In this OECD report, the terms “foreign firms”, “foreign MNEs”, “foreign investors” and “foreign affiliates” are used interchangeably.
What is FDI?
In this OECD report, the term “FDI” is used interchangeably to refer to investment flows and stocks, according to the benchmark definition of FDI (above), and to refer to the activities of foreign affiliates of MNEs.
What are SMEs?
Small and medium-sized enterprises (SMEs) are firms which employ up to 249 employees. It is worth noting that while this size-class breakdown reflects the most common statistical definition across OECD countries and is also used by the European Commission (EC), there are cross-country differences in the definition. For example, the United States considers SMEs to include firms with fewer than 500 employees. In addition to the number of employees, the EC also includes annual turnover and balance sheet total as additional criteria.
The potential for FDI spillovers
The technological advantage of FDI can generate knowledge and productivity spillovers to domestic SMEs
Foreign firms can be an important source of knowledge diffusion for domestic firms. The OECD FDI Qualities Indicators suggest that sectors receiving more FDI tend to experience higher growth in labour productivity and in the intensity of research and development (R&D) than other sectors (OECD, 2019[8]; OECD, 2022[12]). One potential explanation for this correlation is that foreign firms are on average more productive than domestic firms (Figure 1.2), which is linked to their greater access to technology, better managerial skills and more adequate resources for capital investment than domestic firms. Recent work at the Bank of England shows that foreign-owned firms in the United Kingdom are around twice as productive as domestically‑owned firms (Batten and Jacobs, 2017[13]). Some of this reflects the fact that foreign firms tend to be larger and more export-intensive, both features associated with higher productivity levels. Larger firms can indeed harness economies of scale – including through their relationship with the parent company – which are not available to smaller firms, especially local SMEs (OECD, 2019[2]). Exporters are connected though GVCs to international networks where they can source knowledge. Nonetheless, even after controlling for size, export status, age, and sector, the UK study finds foreign‑owned firms to be around 50% more productive than domestically-owned ones (Batten and Jacobs, 2017[13]).
The performance premia of foreign firms, after adjusting for size, sector and other demographic characteristics, suggest that knowledge and technology spillovers of FDI could be leveraged on to close productivity gaps. However, the ability to do so also depends on the capacities of SMEs to absorb knowledge spillovers, which are assessed in the next section. The OECD FDI Qualities Indicators (OECD, 2019[8]) show considerable variation across countries in the productivity gap between foreign-owned and domestic firms, with substantial gaps in some countries and negligible gaps in others (Figure 1.2). The capacity gap between foreign firms and domestic SMEs is often measured in terms of performance gaps (e.g. productivity/technology gaps) (OECD-UNIDO, 2019[14]) (Gal and Witheridge, 2019[15]) (Farole and Winkler, 2014[16]).
When MNEs enter a new market or country, they organise and coordinate their activities in different ways following optimisation strategies. As firms’ production processes become more disaggregated, they progressively place functions in the most suitable locations, considering region- rather than just country‑specific factors. This includes not just factor endowments, such as capital and labour, but also geographic location and enabling factors including access to skills, accessibility, infrastructure, investment in R&D, quality of institutions and policy framework on tariffs, taxes, product and labour market regulation (Johansson and Olaberría, 2014[17])
The nature of the linkages with local enterprises is typically related to the mode of governance of the GVC, dictated by the MNE leading the chain (Gereffi, Humphrey and Sturgeon, 2005[18]). MNEs can establish a subsidiary (hierarchy mode/FDI), entrust their supply chain activities to independent suppliers through arm’s length trade (market-based mode), or enter into contractual arrangements with partner firms such as contract manufacturing, joint ventures and licensing agreements (contractual partnerships). Evidence suggests that MNE activities are often orchestrated through a combination of different governance modes, reflecting the diversity of relationships with suppliers and partners who operate in the same value chain (Andrenelli et al., 2019[19]).
Figure 1.2. There are large cross-country differences in productivity gaps between foreign and domestic firms
Note: The figure compares labour productivity levels between foreign and domestic firms. If the score is >0, foreign firms outperform domestic firms and vice versa if it is less than 0. Foreign firms are firms with at least 10% foreign ownership. For more details, please see methodology (Annex B) in (OECD, 2019[8]).
Source: OECD FDI Qualities Indicators, based on World Bank Enterprise Surveys (2019[8]).
The magnitude of spillovers often depends on the type and characteristics of FDI
The potential for spillovers is determined by the volume of FDI inflows received and several MNE characteristics that illustrate to what extent FDI is effectively embedded in the local economy. FDI local embeddedness refers to the depth and extent of a foreign venture’s ties to the local environment. Such characteristics include:
The type of FDI: A greenfield investment is more likely to involve the implementation of a leading technology in the host country and to be accompanied by a direct transfer of knowledge and technology from the parent firm to the new affiliate (Farole and Winkler, 2014[16]). On the other hand, the merger or acquisition (M&A) of a domestic firm allows foreign investors to access the host country’s technology as well as already established business and knowledge networks. In this case, the deployment of the foreign investor’s technology would be implemented more gradually, making additional knowledge spillovers to domestic firms less likely in the short-term (Crespo and Fontoura, 2007[20]) (Braconier, Ekholm and Midelfart Knarvik, 2001[21]). In a study on the effects of Japanese FDI in the US market, Branstetter (2006[22]) confirms that higher spillover effects took place from Japanese affiliates and finds no spillovers from acquisitions. The setting of branch plants of MNEs, which have headquarters located far away, could, however, have negative consequences on local growth (e.g. lack of stable jobs, lack of R&D activities, limited backward linkages, appropriation of government support and lack of spillover effects) in lagging regions of developed countries (Sonn and Lee, 2012[23]).
FDI motives: Foreign investors may enter a country to expand sales in a new, often large, market (i.e. market-seeking); to tap into natural resources (resource-seeking), which is often the case in commodity sectors and agribusiness; or to achieve efficiency (efficiency-seeking) either by reducing costs (e.g. labour costs) or by acquiring new local assets (asset-seeking) in the form of technology, innovation and related skills. In this regard, a distinction is made between technology-exploiting and technology‑seeking FDI (Smeets, 2008[24]; Driffield and Love, 2007[25]). Technology-exploiting FDI is motivated by the desire to exploit a technological advantage abroad, while technology-seeking FDI tries to capture knowledge spillovers from domestic firms in host countries. Perhaps not surprisingly, empirical evidence from the UK shows that technology-seeking FDI does not generate knowledge spillovers, whereas technology‑exploiting FDI does (Driffield and Love, 2007[25]). Similarly, market-seeking FDI tends to use more local suppliers than efficiency-seeking FDI, thereby increasing the likelihood of knowledge spillovers taking place on the domestic economy (Jordaan, Douw and Qiang, 2020[26]). It is easier for local SMEs to integrate with an MNE supplying the domestic market as the latter may be more inclined to source inputs locally, as opposed to exporting MNEs that operate within established global supplier networks and have higher product and service quality demands. The motive also influences the location of the investment. Crescenzi, Dyevre and Neffke (2018[27]) note that technological giants are more effective at minimising knowledge leakage by locating their investments in more remote areas or in areas where the cognitive gap between these highly innovative firms and local firms may be too large for any knowledge transfer. In general, FDI motives are often interlinked, so that they cannot be fully separated but rather emerge in combination.
The country of origin of FDI: Recent OECD empirical work finds that FDI from higher-productivity countries generates stronger spillovers in the host economy than FDI from lower-productivity countries (Gal and Witheridge, 2019[15]). Along the same lines, Gorodnichenko, Svejnar and Terrell (2014[28]) find that FDI coming from OECD countries (vis-à-vis FDI from non-OECD countries) brings about stronger productivity benefits for SMEs in the host economy, mostly through backward linkages. Other scholars have looked at the heterogeneity in the origins of FDI, finding that the more diverse the FDI in terms of country of origin, the higher the positive effect on domestic firm productivity. However, in the case of China, FDI from culturally similar places such as Hong Kong and Chinese Taipei has a stronger impact on local SME productivity than FDI from Western countries (OECD, 2017[29]).
The sector in which the investment is made: MNE strategies vary across industries, according to their knowledge, technology or capital intensity (and that of potential partners), with different implications for knowledge transfer (Figure 1.3).
In resource-based industries, such as mining, spillovers tend to be limited reflecting their high capital intensity and the high degree of specialisation that is required to extract and process raw materials. If governments are to build a stronger base of suppliers, they often need to look beyond the mining industry and strengthen skills in related services (Farole and Winkler, 2013[30]).
In industries of standardised and simple products for which little formal cooperation between GVC participants is required (e.g. agricultural commodities), arm’s-length market transactions are the most preferred MNE strategy (UNCTAD, 2013[31]) (Gereffi and Fernandez-Stark, 2016[32]). In this case, MNEs influence the supply chain through their role as clients (especially if they are large clients in markets with a narrow client base), and suppliers, many of them SMEs, learn from the demands placed upon them and from market feedback.
In sectors where quality (e.g. pharmaceuticals) and a commercial presence (e.g. marketing/advertising, financial services) are important, the establishment of a subsidiary allows MNEs to secure high levels of quality in production and a direct access to clients in the domestic market. Knowledge and technology transfers are more likely to take place from the parent firm to the local subsidiaries, with potential benefits arising from the diffusion of innovation in the host country.
In knowledge-intensive sectors such as the IT hardware and automotive industries, contractual partnerships (e.g. contract manufacturing, licensing agreements) seem to matter the most (Andrenelli et al., 2019[19]). MNEs exert some influence over their partners, through contract agreements, or more implicitly via their bargaining power (UNCTAD, 2011[33]). In the car industry, on average, around three quarters of all first-tier suppliers in a manufacturer’s global production chain operate through contractual partnerships, of which over three quarters are with foreign‑owned enterprises (Lejarraga et al., 2016[34]).
In high-tech sectors, FDI can generate productivity spillovers, if R&D labs are not self-contained and have developed knowledge-intensive partnerships with the rest of the economy (OECD, 2016[35]). At the country level (Bulgaria, Poland and Romania), Nicolini and Resmini (2010[36]) find that horizontal FDI spillovers occur only in labour-intensive sectors, while vertical FDI spillovers are mostly observed in high-tech sectors. In the more advanced context of the United States, Keller and Yeaple (2009[37]) find that FDI spillovers are particularly strong in high-tech sectors, while they are largely absent in low-tech sectors. The size of FDI spillovers is economically important, accounting for about 14% of productivity growth in U.S. firms between 1987 and 1996.
The size of the MNE: Smaller MNEs may be more likely to buy from, or subcontract to, domestic SMEs, increasing the scope for knowledge spillovers, whereas larger MNEs are able to draw on internal resources. An increasing number of small high-growth multinational companies drive job creation and innovation in knowledge-intensive sectors (OECD, 2010[38]).
The degree and structure of foreign ownership is also an important factor affecting the strength of linkages between domestic and foreign firms. Empirical evidence shows that MNEs with fully-owned foreign affiliates exert greater control upon the technologies they transfer to their foreign locations, leading to more consistent efforts to avoid knowledge and technology leakages (Konwar et al., 2015[39]). In contrast, multinationals with more domestic participation may have greater potential for linkages with the local economy due to better knowledge of and well-established relations with domestic supplier networks (Farole and Winkler, 2014[16]). This is particularly the case for joint venture agreements, which have been found to have positive horizontal spillovers as opposed to the presence of fully owned foreign affiliates that have a negative impact on local firms (Abraham, Konings and Slootmaekers, 2010[40]). Joint ventures can also further contribute to spillovers through labour mobility given the increased participation of locals at the owner or top management level and the considerable skill development opportunities that this involves. However, as highlighted in Chapter 2, restrictions on foreign ownership as a means to achieve knowledge spillovers should be generally avoided as they have been found to deter FDI, especially when intellectual property rights are not protected (OECD, 2021[41]).
Figure 1.3. GVC governance of selected industries and knowledge diffusion implications
Source: OECD elaboration based on UNCTAD (2013[31]) and Gereffi, Humphrey and Sturgeon (2005[18]).
Diagnostic tool
Box 1.2 includes a checklist of questions allowing policymakers to assess the potential for FDI spillovers on domestic SMEs, focusing on the type of FDI that the country attracts and the characteristics of foreign MNEs.
Box 1.2. Checklist of questions to assess the potential for FDI spillovers
What is the volume of FDI that the country attracts and how does it compare with FDI trends in peer economies?
What type of FDI is more prevalent (e.g. greenfield investment, M&A) and what are the key investment motives of foreign MNEs (e.g. technology-exploiting, market-seeking, efficiency-seeking FDI)?
What are the main countries of origin of FDI (e.g. higher or lower-productivity economies)?
What is the sectoral composition of FDI? Is FDI concentrated in sectors with higher average productivity level or technological and R&D intensity?
What are the characteristics of foreign MNEs operating in the country in terms of size, degree of foreign ownership, productivity and technological intensity?
How large is the productivity gap between foreign MNEs and domestic SMEs?
How do foreign MNEs perform in terms of export capacity and contribution to international trade? To what extent does FDI drive the country’s integration into GVCs?
The potential for FDI-SME spillovers across countries can be measured and monitored through a range of internationally comparable indicators, as described in Table 1.1. These indicators aim to reflect how a country/region benchmarks along the dimensions described in this section. The relative position of a country compared to the OECD (or EU) median, and possibly a sample of benchmarking countries, offer insights on the potential for FDI spillovers in the host country.
Table 1.1. Benchmarking the potential for FDI spillovers across countries and regions
Source: Authors’ elaboration.
The absorptive capacity of local SMEs
SMEs with higher productive and innovative capacities are better positioned to absorb knowledge and technology spillovers from FDI
The term “absorptive capacity” refers to the ability of a firm to recognise valuable new knowledge and integrate it productively in its processes, i.e. to innovate. The stronger its absorptive and innovative capacity, the higher its chances to benefit from FDI (Abraham, Konings and Slootmaekers, 2010[40]; Girma, Görg and Pisu, 2008[42]).
The absorptive capacities of SMEs depend on their prior capital endowment and level of productivity, i.e. their endowment of financial, human and knowledge-based capital and efficiency in creating value from it. To innovate, a firm creates, acquires and recombines innovation assets (such as technology, data and brands, organisational settings and processes, business models and networks), using firm-specific skills and know-how as well as transversal and technical skills1. The firm also bears a range of costs associated with the innovation process, from investment in innovation assets and the purchase of knowledge services, to hiring and (re)training, to the transaction costs related to the transformation. These costs could become obstacles to the innovation process (e.g. in the digital transition), especially when the firm has limited room (and size) to increase economies of scale (OECD, 2019[2]) (OECD, 2021[43]) (OECD, 2021[41]).
The absorptive capacities also depend on the firm’s ability to access the strategic resources needed to adapt to market conditions and innovate. The extent to which SMEs can access and make use of these strategic resources will determine their ability to benefit from knowledge and technology spillovers (OECD, 2019[2]):
Access to finance: Accessing appropriate sources of finance across all stages of their life cycle is critical for SMEs to start their business operations, innovate and grow (OECD, 2019[2]) (OECD, 2020[44]) (OECD, 2022[45]). Conversely, financing constraints can weigh on their investment and innovation capacity, and negatively impact their productivity. SMEs combine different forms of funding, both internal (profits and revenues) and external (bank credit, equity funding, etc.) to support their activities and growth. Internal profits and revenues remain their primary source of funding. Bank credit is their primary source of external funding, but funding options also differ across firms, e.g. alternative debt for SMEs with lower risk of default but limited return on investment, or equity instruments for innovative ventures with high growth potential and higher return on investment, but at higher risk (OECD, 2020[44]) (OECD, 2015[46]; OECD, 2018[47]).
Typically, SMEs face internal and external barriers in accessing finance, due to a lack of collateral to be provided as guarantees, or insufficient financial skills of owners and managers. External market barriers arise from information asymmetries between financial institutions and SMEs, and the relatively higher costs for funding institutions to serve SMEs. For some segments of the business population, especially new firms, start-ups, and innovative ventures with high growth potential, these challenges are more pronounced (higher uncertainty, more intangible and difficult to collateralise assets). The same is true for groups under-represented in entrepreneurship, such as women, youth, seniors and migrants (OECD/EU, 2017[48]).
Access to skills: Skilled workers are a key asset for competition in a knowledge-based economy (Autor, 2013[49]; Grundke, R, et. al., 2017[50]). Highly skilled employees, in particular, are more likely to be involved in performing complex tasks that drive firm competitiveness and productivity growth (Acemoglu, 2002[51]) (OECD, 2018[52]). Skilled employees are also vital for enhancing technology and innovation absorption as well as breaking into new markets. Improving the skills of workers can, for instance, strengthen the position of SMEs in GVCs by helping them specialise in higher value-added activities (e.g. technologically‑advanced industries, complex business services) (OECD, 2017[53]). Skilled employees are also valuable for SMEs to manage organisational change encountered during company transitions due to fast growth or when exporting for the first time (OECD, 2015[54]).
SMEs have typically greater difficulty in attracting and retaining skilled employees. They tend to lack the capacity and networks needed to identify talent. They tend to offer less attractive remuneration and working conditions (Eurofound, 2016[55]), paying salaries 20% lower on average than large firms (OECD, 2019[2]). Smaller firms have fewer possibilities and resources to engage in the skills development of their employees; lack dedicated internal training capacity; have a smaller revenue base on which to distribute the fixed costs of training; and have fewer employees to organise replacement once one is on training (OECD, 2021[56]; OECD, 2021[57]). Furthermore, SMEs tend to experience higher job turnover, which limits their capacity and willingness to invest in human capital.
Access to innovation assets: Innovation –from the creation of new ideas in R&D laboratories to the commercial diffusion of technologies – involves the interaction and use of different assets.
Digital technologies open opportunities for SMEs to reduce costs and achieve economies of scale without mass and enable differentiation and specialisation that are major levers on their competitiveness (OECD, 2021[43]). Digitalisation can trigger a virtuous circle of transformations, as technology adoption reinforces further technology adoption, and supports SME scaling up (OECD, 2022[45]).
Data have emerged as a strategic asset, enabling efficiency gains (e.g. supply chain dynamic optimisation) and enhancing innovation capacity (e.g. improved products or services with artificial intelligence, or new business models based on the selling or licensing of data) (OECD, 2022[45]).
Cloud computing (CC) is a pivotal asset for the digital transition of SMEs as it allows them to upgrade without incurring the upfront investments associated with hardware and recurrent expenses on maintenance, IT team and certification. CC services are flexible and scalable, meaning that SMEs can access extra processing power or storage capacity, databases or software, in quantities that suit their needs (OECD, 2019[2]).
Intellectual Property Rights (IPRs), i.e. patents, trademarks, copyrights or industrial designs, are instrumental for firms to ensure they can appropriate the benefits of their innovations by giving them a temporal monopoly. They also enable the valorisation of intangible assets, for instance through licensing or as collateral for financing growth (OECD, 2022[45]). Recent evidence shows that SMEs with prior IPR activities are more likely to grow than other SMEs, even more if they bundle different types of IPRs (EUIPO, 2020[58]).
Networks constitute another form of capital as they contribute in different ways to SME performance: knowledge networks for innovation creation and technology transfer, production and supply-chain networks for cost reduction that increasingly support knowledge flows, or strategic and commercial networks for accessing strategic resources and increasing market outreach (Nilsson, Magnusson and Enquist, 2003[59]) (OECD, forthcoming[1]).
While the barriers to the effective use of these technologies have decreased, accessing innovation assets is particularly challenging for smaller firms that struggle to find and use the technology, data, information and networks that would enable them to participate in and benefit from innovation activities. Smaller firms are less likely to engage in R&D, reflecting both lack of capacity as well as incentives. Acquiring frontier technology and related skills remains out of reach for smaller players or requires them to have a high specialisation that limits the scope of R&D spillovers and reduces the financial incentive of taking risks (OECD, 2016[60]). SMEs lag in the digital transition and the more sophisticated the technology, the larger the gap (OECD, 2021[43]). SMEs for instance are 2.4 times less likely to perform big data analysis than larger firms (OECD, forthcoming[1]). SMEs tend to privilege trade secrecy as their default mode of protection and struggle to deal with the large and complex range of IPR mechanisms (OECD, 2019[2]) (OECD, 2022[45]). Although they are more dependent on external sources of knowledge, SMEs are also less well integrated into knowledge networks (OECD, 2013[61]) (OECD, forthcoming[1]). Consequently, their contribution to innovation -and their opportunities to benefit from innovation- remains subdued compared to larger firms.
The absorptive capacities of SMEs also depend on the quality of the business environment and external factors, which vary substantially across countries. A conducive business environment creates the right conditions to do business but also provides incentives to bear the costs and risks of innovating. SME and entrepreneurship performance in relation to innovation is defined by a complex set of business conditions (OECD, 2019[2]), as well as the quality of local entrepreneurship ecosystems (OECD, 2021[62]) (OECD, 2019[63]). These factors include the institutional and regulatory framework (e.g. IP laws and enforcement, taxation, regulation), market conditions (e.g. competition intensity and neutrality, trade openness, business dynamics), and infrastructure (e.g. connectivity and access to affordable and quality broadband, availability of knowledge platforms and networking interfaces) (Figure 1.4). The role of infrastructure in strengthening SME absorptive capacities is examined in the Section below, while the institutional and regulatory framework and market conditions in Chapter 2.
Figure 1.4. Drivers of SME and entrepreneurship performance
Source: OECD SME and Entrepreneurship Outlook (2019[2]).
The heterogeneity of the SME population explains differences in their capacity to benefit from FDI spillovers
SMEs vary in terms of age, size, business model, market orientation, sector and geographical area of operation. This means that different types of SMEs have different growth trajectories and therefore different chances to enter into knowledge-sharing relationships with foreign MNEs and benefit from FDI spillovers (OECD, 2019[2]). Not all SMEs are able or willing to scale up and participate in global markets and value chains. The following SME characteristics therefore matter to appreciate their absorptive capacity.
Age: The existing evidence on the implications of a firm’s age for its absorptive capacity is not conclusive. According to some studies, the experience accumulated by mature firms would be an asset in identifying and exploiting valuable external knowledge (Cohen, 1990[64]); (Zahra, 2002[65]). Additionally, higher reputation and status would make older firms more likely to access diverse knowledge sources and thus become early movers in exploiting useful knowledge (Nooteboom, 2000[66]). Better human capital and HR management practices are also found to be enhancing factors of older firms’ absorptive capacity by some scholars (Lund Vinding, 2006[67]); (Minbaeva, 2014[68]); (Hayton, 2005[69]). Recent empirical work based on firm microdata show that most high-growth firms are in fact mature firms of six-years and more (OECD, 2021[70]). Other studies suggest that younger firms, although often smaller and thus equipped with less financial resources, would be more flexible to innovate and less affected by organisational inertia (e.g. rigid and formalised routines, roles and behaviours) than their older counterparts, making them more likely to benefit from knowledge spillovers (Huergo, 2004[71]); (Hannan, 1984[72]); (Hansen, 1992[73]). Tengjian Zou (2018[74]) found an average negative effect of age on firms’ absorptive capacities. This, however, appears to be more relevant for mature firms. The relationship between age and absorptive capacity seems to be less significant for young firms.
There are a few “born global” SMEs that aim for international markets from the start (Lamotte and Colovic, 2015[75]; OECD, 2019[2])). They usually operate in knowledge-intensive niche markets and can serve as key partners of foreign multinationals in developing new products and providing knowledge-based services. In France, for example, the presence of “born global” SMEs is significant, particularly in services where around 65% of firms fall under this category (Lejarraga et al., 2016[34]). These highly innovative young SMEs invest in R&D, technology upgrading, training and organisational innovation.
Size: Larger SMEs are often found to benefit more than smaller ones from the presence of FDI (Crespo and Fontoura, 2007[20]). Recent OECD empirical work shows that small firms experience very few or no positive spillovers from FDI, as they are less likely to invest in innovation or have access to knowledge networks. There is, however, a small positive impact on the productivity of medium-sized companies, if these are located geographically close to the foreign investor (Lembcke and Wildnerova, 2020[76]). Empirical work based on US data shows, however, opposite results, with low-productivity small firms benefitting more from FDI spillovers than high-productivity larger firms (Keller and Yeaple, 2009[37]).
Sector and position in value chain: SMEs that operate in tradable sectors, sectors with stronger linkages to more productive foreign buyers/suppliers or sectors that have become more central to global production, display faster productivity growth (Criscuolo and Timmis, 2018[77]) (OECD, 2019[2]). Firms and industries operating at the core of complex production networks have access to a greater variety of foreign inputs, and potentially a broader range of technologies, as compared to those at the periphery.
Being part of a large corporate group and/or foreign ownership: Finally, the ownership structure of the firm is likely to have an impact on its absorptive capacity. Being part of an international business group, either domestically- or foreign-owned, can be a factor of SME performance (Dachs and Ebersberger, 2009[78]). On the one hand, foreign subsidiary SMEs can overcome some obstacles to the innovation process such as the lack of funding or market information as they can rely on the financial resources, technology and managerial expertise of their parent multinational group, and therefore become themselves a source of knowledge spillovers for domestically-owned firms. Comparative advantages of group membership may also stem from the possibility of learning from the previous experience of the parent MNE in other countries and markets.
Foreign ownership can also help overcome the constraints that usually affect the performance of smaller businesses, by facilitating access to knowledge, global marketing linkages, and better managerial and financial resources. Corsi and Prencipe (2018[79]) found that foreign venture capital and private equity have a higher potential to spur the innovation performance of independent SMEs as compared to other forms of foreign investment. The integration of an SME into the global network of a foreign company via a “brownfield” investment can also spur productivity growth. Benefits may extend to other companies in the same region via the local supply and demand linkages of the acquired company (Lembcke and Wildnerova, 2020[76]). Guadalupe, Kuzmina and Thomas (2010[80]) found that acquisitions via brownfield investments lead to improvements in firm performance, with acquired firms being more likely to engage in innovation and assimilate new foreign technology – although it cannot be excluded that this is partly due to foreign firms selecting the best performers within local industries in view of the acquisition.
On the other hand, non-subsidiary SMEs may have greater flexibility and less restrictions than subsidiary SMEs, and therefore may have greater capacity to customise and differentiate products and services.
Diagnostic tool
Box 1.3 includes a checklist of questions allowing policymakers to assess the absorptive capacities of domestic SMEs, focusing on firm performance and capacity to access strategic resources.
Box 1.3. Checklist of questions to assess the absorptive capacities of SMEs
What are the characteristics of the SME population in terms size, average age, location, sector and position in GVCs (upstream or downstream position in GVCs)?
What is the share of SMEs belonging to an enterprise group relative to independent SMEs?
What is the contribution of SMEs to value added, employment and exports?
What are the main internal and external barriers that SMEs face in accessing finance?
How do SMEs perform in terms of access to skills, including with regard to entrepreneurial skills, workforce skills, and on-the-job training opportunities?
How do SMEs perform in terms of access to innovation assets, including technology, innovation networks, R&D investment, data, IPRs and information?
What is the degree of digitalisation of SMEs?
The SME absorptive capacities can be measured and monitored through a range of internationally comparable indicators, as described in Table 1.2. These indicators aim to reflect how a country benchmarks along the dimensions described in this section. The relative position of a country as compared to the OECD (or EU) median, and possibly a sample of benchmarking countries, provide some insights on the absorptive capacities of SMEs in the country. The following table focuses on metrics aiming to assess internal SME capacities, with the exception of indicators monitoring the business environment that are discussed in the section below.
It is worth noting that while these indicators provide an international comparable measure of SME capacities, some limitations have to be considered. First, although these indicators are generally available at the national level, the data availability at the sub-national level is scanter and/or less timely. Second, while the proposed indicators capture a wide range of SME absorptive capacities, some areas are still under development. These include indicators related to environmental, social, and governance criteria that could potentially increase SME absorptive capacities and GVC integration. Ongoing OECD work is examining how different ESG indicators – such as emissions by SMEs and information on decent work – and other indicators that could be relevant to benchmark SME performance along the framework presented above (OECD, 2019[2]) could be compiled into the OECD Data Lake on SMEs and Entrepreneurship, which serves as a one-stop-shop platform for SME&E policy analysis and mainstreaming (Box 1.4).
Table 1.2. Benchmarking SME absorptive capacities at country or regional level
Source: Authors’ elaboration based on the OECD Data Lake on SMEs and Entrepreneurship.
Box 1.4. The OECD Data Lake on SME and Entrepreneurship
Infrastructure in support of SME&E policy analysis and mainstreaming
Benchmarking SME&E performance and policies requires mobilising a wealth of indicators and policy information across a broad range of domains of expertise (OECD, 2019[2]). Data drawn from both OECD and non-OECD sources are available in a variety of formats and can be organised in different ways according to their primary source. Accessing SME&E policy data could be made more cost‑efficient by enabling data concentration in a single platform and automating updates. Risks related to data treatment could also be reduced.
Such a data management system that covers the full spectrum, from data collection, to storage, to treatment, to analysis, to dissemination, could enhance analytical capacity and broaden the knowledge base on SME&E business conditions, performance and policy. It could enable more in-depth data exploration, e.g. relationships between business conditions and SME&E sector features, or country patterns in business conditions and similarities in national SME&E system, etc.
A “data lake” is aimed to break the silos of data organisation that often reflect silos of expertise. It also aims to enable the use of big data (e.g. by making possible to store large volumes of unstructured data and apply new data analytics methods). Unlike relational databases and traditional data warehouses, data lakes are also less dependent on original data architecture and more flexible to adjustments in time. Along those lines, the OECD is developing a new “data lake” (platform) of relevant indicators and policy information in order to expand the SME&E policy knowledge base and develop cross-cutting evidence that could contribute to the mainstreaming of SME&E policy considerations in other policy domains (OECD, 2023[81]).
Economic, structural, and geographical characteristics of countries and regions
The magnitude of FDI-SME spillovers depends on several economic, geographical and structural characteristics of the host country and its subnational regions. Factors relating to the national endowment, the macroeconomic context, structure of the national/regional economy, sectoral drivers of growth, productivity and innovation as well as to the level of integration in the global economy are expected to affect the potential for FDI-SME spillovers.
The industrial structure, specialisation and technological sophistication of the domestic economy influences SME capacities and the type of FDI attracted
Structural factors such as a country’s specialisation, industrial structure, positioning in GVCs and the sophistication of its infrastructure and technology are crucial determinants of a dynamic FDI-SME ecosystem. These factors are overall difficult to reverse or alter in the short term, being the outcome of natural configurations, market dynamics and past economic and policy choices (OECD, 2021[82]). Also, not all countries have the same technological assets and capacities. There is a high degree of heterogeneity in endowment and industrial patterns, leading to differentiated impacts on FDI and SME performance.
Differences in the comparative advantage of economies result in differing FDI profiles, with some countries attracting more knowledge-intensive investment than others. These differences are not static, however, and may evolve over time. Countries with more advanced industrial structures tend to attract FDI in higher value added value chains, involving more productive and technology-intensive activities, that allow them to further advance the industrialisation process (Benfratello and Sembenelli, 2006[83]; Criscuolo and Martin, 2003[84]). Economies characterised by a high degree of technological sophistication may also appeal more to investors seeking to gain from domestic technology and acquire knowledge and technical capabilities. On the other hand, economies at early stages of the industrialisation process may benefit more from investments in lower value added sectors where local producers, often SMEs, have a comparative advantage, allowing them to move up the value chain within those sectors into more complex activities and increase their chances to engage with internationally‑oriented firms (OECD, 2019[8]).
Being driven by natural endowments and regional assets such as geographic location, natural resources, urban or rural settings and demographics, these specialisation patterns may differ even within countries (OECD, 2007[85]) (OECD, 2022[86]). Urban centres tend to have greater endowment of human and physical capital than rural areas, including more favourable demographic trends, high skills intensity and quality infrastructure, leading to higher concentration of knowledge-intensive FDI and SMEs with strong absorptive capacities. In many OECD economies, rural regions have found ways to exploit their resource endowment in an efficient manner and achieve growth levels similar to those seen in metropolitan areas by specialising in activities that take into account location-specific comparative advantages (OECD, 2009[87]).
The size and exposure of the economy to international markets also matters for the development of FDI-SME linkages. The OECD FDI Qualities Indicators suggest that smaller OECD economies like Luxembourg, Ireland, Belgium and Hungary have lower shares of domestic sourcing by foreign MNEs due to their smaller domestic market for inputs while larger economies (e.g. France, Italy, United States) have significantly higher shares (OECD, 2019[8]). When considering the potential for FDI-SME spillovers in small versus large economies, these findings should be interpreted with caution. GVC integration typically reduces the share of domestic linkages while disproportionately increasing the pace of domestically produced value added growth due to efficiency gains. SMEs operating in small economies can therefore still benefit from knowledge spillovers arising from the internationalisation of the economy. In fact, integration into GVCs is an important driver of productivity growth and can have important consequences on the ability (and incentives) of local SMEs to exploit the knowledge transmitted through international production networks (Gal and Witheridge, 2019[15]). For this reason, a potentially more important policy objective for small economies could be the growth in the absolute value of domestic linkages.
Economic geography factors matter for knowledge diffusion
Economic geography factors matter in MNEs’ optimisation strategies and for knowledge spillovers. When deciding where to invest, foreign firms are considering the specific factor endowment of a region - rather than just country - following market-seeking, resource-seeking, asset-seeking, or efficiency-seeking rationales (i.e. FDI motives) (OECD, 2019[8]). SMEs and their innovation capacities are also an important determinant of FDI location decisions. Foreign MNEs choose to invest in specific countries or regions based on the availability of local suppliers and partners and the capabilities of local entrepreneurial ecosystems. SMEs too remain predominantly local actors embedded in nearby markets and ecosystems. SME activity and performance are unevenly distributed within countries, with high concentration of R&D and innovation activities and investments in a few regions, and large cross-regional disparities in productive capacities (OECD, 2016[88]). Some regions have a disproportionate share of SMEs often attributed to differences in entry costs, input factors or talent across regions (Ponzetto, 2009[89]); (Guiso and Schivardi, 2011[90]); (Lucas, 1978[91]).
The attractiveness of regions to investors and entrepreneurs depends on a number of factors like the availability of land, the qualifications of the local workforce and/or cost of the available labour force, proximity to key international and domestic markets, and the presence of an ecosystem conducive to attracting researchers in the R&D field, which are all highly territorialised and vary geographically within a country (OECD, 2022[86]). Access to quality public services (including health and education) and attention to well-being, including social and environmental concerns, are important arguments for attracting talent and boosting the supply of more qualified local labour, capable of meeting the needs of companies and of innovating. To capture these dimensions, measurement initiatives to quantify the attractiveness and competitiveness of regions beyond economic performance are fundamental (OECD, 2022[86]). Under this lens, local conditions of quality of life are taking the front seat in regional policy and planning strategies, with the recognition that economic development and human and planetary well-being are inextricably linked.
The localised nature of FDI and SMEs means that geographical proximity between the two affects the likelihood of knowledge spillovers, especially as far as tacit knowledge is concerned (Jacobs, 1993[92]). Recent OECD work confirms that domestic firms which are located near foreign firms in the same region are more likely to benefit from knowledge spillovers than other firms (Lembcke and Wildnerova, 2020[76]). Knowledge spillovers from MNEs have been found to be the strongest up to 10 km from the lead firm and progressively decay between 10 and 50 km, partly reflecting production linkages but also through other channels such as the mobility of managers. Knowledge flows to geographically closely located domestic firms are also higher when regions host smaller and non-frontier innovator MNEs. This is explained by lower technology gaps between non-frontier MNEs and domestic firms and thus improved absorptive capacities of domestic firms, enabling them to benefit from the presence of FDI (Crescenzi, Dyevre and Neffke, 2018[27]).
These spatial and agglomeration effects point towards the important role that industrial clustering can play in supporting SME participation in GVCs (Kergroach, 2018[93]) and attracting FDI that creates linkages with the local economy. Positive agglomeration economies occur when the spatial proximity of firms, workers and customers reduces production costs through external economies of scale and network effects (OECD, 2019[2]). Clusters create an environment that is conducive to productivity growth through the presence of interconnected companies, specialised suppliers, specialised workers, service providers and firms in related industries (Porter, 1990[94]; OECD, 2009[95]). These effects can lower market entry costs for SMEs, promote risk sharing of sector-specific infrastructure, provide access to better intermediate inputs and enlarge the pool of workers with similar skills (Delgado, Porter and Stern, 2010[96]; Puga, 2010[97]), thus attracting further entrepreneurial activity and forming larger business networks.
Evidence from the United Kingdom shows that firms located in clusters benefit from FDI, both in the same sector of the foreign affiliate and in other sectors (De Propris, Driffield and Menghinello, 2005[98]). However, these benefits do not materialise for companies located outside the clusters. Clusters that are built bottom up from regional industrial specialisation are more likely to lead to long-term spillovers as they have a greater ability to evolve to fit into continually useful niches in GVCs. Menghinello et al. (2010), using evidence from Italy, found that the joint presence of inward FDI and industrial clusters generates a positive effect on local enterprise productivity (Menghinello, De Propris and Driffield, 2010[99]). In the context of Eastern Europe (Poland and Romania), Franco and Kozovska (2008[100]) found that FDI has a positive impact on the productivity of local clusters, but that there are also “reverse spillover effects” through which MNEs benefit from local clusters by sourcing local knowledge and technology (Franco and Kozovska, 2008[100]). Some other studies find that while the advantage of clustering exists, it tends to decline over time.
The quality of the network and knowledge infrastructure is key for building resilient FDI-SME ecosystems
Infrastructure is a key enabler of agglomeration and connectivity. Network infrastructure is critical for a dynamic business ecosystem and for firms’ entry into distant markets and engagement in GVCs (OECD, 2019[2]). A well-functioning infrastructure (including logistics, energy, Internet) ensures secure and cost-efficient access to strategic resources, including skills and business partners. A recent study of the World Trade Organisation shows that logistics and infrastructure costs remain among the major challenges SMEs face in joining GVCs, and lead firms within GVCs face in finding suppliers (World Trade Organisation, 2016[101]).
Transport infrastructure can influence the decision of where to locate new investment projects. Air connectivity, for instance, can help attract FDI and the most talented individuals who also tend to be the most internationally mobile (Oxford Economic Forecasting, 2006[102]) (OECD, 2018[103]). Transport infrastructure allows regions and cities to leverage benefits from concentration by expanding commuting opportunities for their workers and facilitating access to markets. This creates benefits for places and for workers who can access better-matching and better-paid jobs without bearing the burden of moving to a different place. Intra-urban and suburban transport infrastructure serves to integrate rural regions into the local labour market of the cities located in their proximity, thereby creating a greater variety of job opportunities and raising the living standards of their inhabitants.
Information and communication technologies (ICT) infrastructure sustains the digital transformation of SMEs and their participation in innovation activities. Accessing high speed networks allows SMEs to connect with suppliers and customers, obtain real-time information and provide real-time responses to fast‑evolving markets and supply chains (OECD, 2019[2]). Results of a sample survey of UK firms with low‑speed and high-speed internet connection show that greater ICT intensity is positively related to firm level productivity (OECD, 2015[104]). Other studies on German and Irish firms pointed out that the use of broadband connections has a positive and significant impact on their innovation activity (Bertschek, Cerquera and Klein, 2013[105]; Haller and Lyons, 2015[106]). A recent OECD report on the digital transformation of SMEs shows that access to high-speed broadband is a prerequisite for their transformation and, despite the diverse forms of digitalisation across industries, explains cross-industry differences in value creation (OECD, 2021[41]). The COVID-19 pandemic has accelerated the need for better digital infrastructure as more people than ever work from home, engage in distance learning and even access healthcare online.
Energy infrastructure also matters for SME operations. Affordable energy supply can influence the cost of doing business and bring multiple benefits to SMEs, including reducing intermediate consumption and costs, raising product quality and visibility, improving operations and workplace environment, gaining access to new markets, reducing vulnerability to energy price volatility or ensuring compliance with environmental standards (OECD, 2019[2]). The quality of the energy infrastructure also has implications for FDI location decisions. Foreign MNEs may be put off by the lack of sustainable and affordable green energy in a specific country or region.
Finally, R&D infrastructure is critical for developing vibrant entrepreneurial ecosystems, where foreign MNEs and local SMEs can engage in knowledge-intensive collaborations (OECD, 2019[2]). R&D and innovation facilities as well as e-infrastructure such as e-libraries, online platforms and databases give SMEs access to cutting-edge technologies and act as a catalyst for attracting technology-intensive FDI, innovative startups, and world-class researchers. In increasingly knowledge-based economies, the availability of this type of infrastructure allows SMEs to develop their digital capabilities and access innovation assets while it also serves as a platform of public-private collaboration bringing together actors across disciplines, sectors and borders.
Diagnostic tool
Box 1.5 includes a checklist of questions allowing policymakers to assess the enabling conditions for FDI-SME spillovers.
Box 1.5. Checklist of questions to assess the economic, structural and geographical characteristics of the host country and region
What is the industrial structure and specialisation of the economy?
What sectors and value chains drive economic growth, productivity and innovation? Is economic activity concentrated in high-technology and knowledge-intensive sectors?
What is the level of GVC integration (both through backward and forward linkages)? What sectors are better integrated into GVCs? Are there opportunities for increased integration in underperforming sectors?
Are there regional disparities in economic growth, productivity and innovation performance? What is the industrial structure and specialisation of regions?
What is the geographic distribution of FDI in the host economy?
To what extent does SME performance vary across regions (e.g. in terms of innovation, skill-intensity, internationalisation, access to finance, etc.)?
How do regions perform across key factors that shape their attractiveness to investors and entrepreneurs, including proximity to domestic and international markets, availability of skills, employment, well-being, environmental quality and social cohesion?
Is there any evidence of market-driven industrial clustering either at the sectoral or regional level?
Do foreign MNEs and local SMEs have access to well-functioning network and knowledge infrastructure (e.g. transport, energy, high-speed broadband, R&D and networking infrastructure)?
The enabling conditions for FDI-SME spillovers can be measured and monitored through a range of internationally comparable indicators, as described in Table 1.3.
Table 1.3. Benchmarking economic, structural and geographical conditions for FDI-SME spillovers
Source: Authors’ elaboration.
The diffusion of FDI-SME spillovers
For FDI-SME spillovers to occur, domestic SMEs should be exposed directly or indirectly to foreign MNE activities. SMEs are directly exposed to MNE activities when they are tied to them through business linkages. They are indirectly exposed to MNE activities through market mechanisms or the influence MNEs can exert on their ecosystems.
Prior research has identified a set of channels through which FDI can contribute to SME productivity and innovation (Görg and Strobl, 2005[107]; Crespo and Fontoura, 2007[20]; Smeets, 2008[24]):
Value chain linkages, involving knowledge spillovers from foreign MNEs to their suppliers (upstream) and customers (downstream).
Strategic partnerships, which involve knowledge and capacity transfer during formal collaborations, for example in the area of R&D or workforce/managerial skills upgrading.
Labour mobility, which induces spillovers when workers move from foreign MNEs to local companies or when they start their own company (corporate spin-outs).
Competition effects, when an above-average efficient MNE enters the market, particularly if domestic companies are operating in the same sector or value chain segment, and even when they are not located in the same region.
Imitation effects, which arise when domestic firms imitate the products and practices of the foreign MNE. These effects are more likely to occur at the local level.
Value chain linkages involve knowledge spillovers from foreign MNEs to their suppliers and customers
Value chain linkages refer to the relationships of foreign-owned companies with local buyers (downstream linkages) or suppliers (backward linkages). FDI spillovers are more commonly found in these vertical relationships than in the relationship between MNEs and potential local competitors (horizontal spillovers), as rivalry is more naturally embedded in the latter (Rojec and Knell, 2017[108]); (Javorcik, 2004[109]); (Blalock and Gertler, 2008[110]). Buyer-supplier networks play a key role in business innovation processes as firms, beyond their own group, turn more often towards clients and the market to source knowledge. A large empirical literature has investigated the influence of business linkages on the firm’s innovation performance (Faems, van Looy and Debackere, 2005[111]); (Miotti and Sachswald, 2003[112]); (Modi and Mabert, 2010[113]); (Nieto and Santamaría, 2007[114]), arguing that supplier involvement adds expertise and gives a different perspective on problem solving and product development by the firm. Collaborating with customers also helps identify market opportunities and trends earlier, and improve design at earlier stages of development. Collaboration for innovation is more frequent with suppliers and customers than competitors, especially with suppliers in the case of large firms whose value chains are more integrated (OECD, 2017[115]). In fact, collaboration is seen as a driving force in supply chain management and a key component of corporate strategies for mitigating risks and developing resilient supply chains (Horvath, 2001[116]).
Figure 1.5. Importance of buyer-supplier linkages for the innovative firm
Source: Kergroach (2020[117]) based on the EU community innovation survey 2016 (Eurostat, 2016).
Forward linkages between MNEs and local buyers have a positive impact on local enterprise productivity mostly through the acquisition of better quality inputs, which were not locally available before (Criscuolo and Timmis, 2017[118])). Many MNEs, especially in industrial sectors such as machinery, often offer training to their customers on the use of their products as well as information on international quality standards (Jindra, 2006[119]). Backward linkages with suppliers will generate knowledge spillovers when MNEs require better quality inputs from local suppliers and are willing to share knowledge and technology with them to encourage the adoption of good business practices. Doan, Maré and Iyer (2014[120]) find positive backward spillovers for small firms in New Zealand and give two main possible explanations: small domestic firms in upstream position benefit from economies of scale when they jointly supply MNEs and/or, given the technology gap between the local small firms and the MNE, they use the supply relationship to catch up technologically.
The training and on-the-job learning opportunities offered by MNEs may also be extended to the workforce of local companies with which they develop buyer-supplier linkages. For instance, foreign-owned firms provide staff training to domestic suppliers to ensure efficiency and product quality (OECD, 2019[8]) or to local customers as a service and a way to consolidate their client base. This is the case in the digital economy, where large platforms provide online and free training to their users, often SMEs, to help them adopt their technology and software package (OECD, 2021[41]).
Not all MNE suppliers can benefit to the same extent from knowledge transfers, tier 1 suppliers being more likely to get more. In many value chains, tier 1 suppliers are typically a small number of large enterprises that supply inputs or services directly to the lead MNE through contractual partnerships such as contract manufacturing and services outsourcing agreements (UNCTAD, 2013[31]; Abonyi, 2005[121]; ABDI, 2015[122]) (see also Figure 1.3). Depending on the industry, they can be highly specialised and usually capture the bulk of knowledge spillovers by working closely with the MNE to ensure that inputs adhere to global quality standards. These large enterprises are generally surrounded by a pool of smaller suppliers, often SMEs, who operate predominantly through arm’s length market transactions at the bottom of the supply chain. These are usually SMEs with low absorptive capacity and can be easily replaced by other suppliers that offer better comparative advantages, such as lower labour costs (Abonyi, 2005[121]) . In rigid GVC structures, there is little room for direct knowledge transfer from the lead MNE to lower-tier suppliers. Therefore, SMEs in the lower tiers can only benefit from spillovers from larger enterprises that are located on the second and third tiers. This may be particularly important in sectors that have a large productivity gap between SMEs and MNEs. Further examples are provided below.
In the car manufacturing industry, lead car manufacturers (often MNEs) are responsible for design, branding and final assembly, while first-tier suppliers (often successful domestic companies) support them by producing complete subsystems in cooperation with a large network of lower-tier suppliers and subcontractors. These first-tier suppliers have increasingly developed into global suppliers with highly specialised capabilities as they work with the lead firm to deliver customised car parts and components, and sometimes take a larger role in the production process, including design (Lejarraga et al., 2016[34]). They often have the intellectual property of the components' design and cannot be easily replaced by other lower-tier suppliers.
In the electronics industry, the GVC consists of lead firms and contract manufacturers, followed by a vast pool of other market players such as software vendors, distributors and producers of more generic components (Kawakami and Sturgeon, 2010[123]); (Nathan, 2020[124]); (de Backer and Miroudot, 2014[125])). The rise of supplier capabilities has allowed large firms (MNEs) to outsource their operations to contract (domestic) manufacturers who have become “turn-key suppliers” with a high degree of autonomy, offering a full package of services to lead firms, and often managing the entire manufacturing network with minimal support. Evidence shows that the expansion of these turn-key suppliers towards new functions in the value chain has occurred in conjunction with diversification into new industries such as the automotive, aerospace and defence sectors (Raj-Reichert, 2018[126]). The activities undertaken by contract manufacturers differ across companies, although they can range from providing only production services to undertaking production as well as design activities.
Strategic partnerships are increasingly common in knowledge-intensive and high-tech industries
The emergence of GVCs has brought new types of MNE-SME partnerships, especially in high‑tech and knowledge-intensive industries, where knowledge transfer and cross-border R&D projects are a common practice. These partnerships can take many forms, including joint ventures, licensing agreements, research collaborations and R&D and technology alliances (Andrenelli et al., 2019[19]). The form the co-operation will take will depend on each partner’s comparative advantage. For instance, in case of cultural or spatial barriers difficult to manage, the MNE can rely on small locally embedded distributors. If the market is hard to transact in, it could set up a joint venture, as opposed to a simpler license agreement. Overall, strategic partnerships are frequently deployed in knowledge-intensive and high-technology sectors, which rely heavily on R&D, while they seem to be less important for MNEs in medium- and low-technology industries. An explanation may be the fast-changing nature of these industries and their products, which may favour the flexibility of strategic partnerships over FDI (Andrenelli et al., 2019[19]).
Strategic partnerships are the result of a shift towards an open mode of innovation, which has made innovation more accessible to SMEs (OECD, 2019[2]). Open innovation has increasingly been seen as a way for accelerating internal innovation and expanding the markets for external use of innovation (Chesbrough, 2003[127]). Large firms have increasingly taken part in the open innovation transformation by developing strategic partnerships with smaller enterprises or by setting up innovation labs and accelerators where start-ups and other small firms can nurture new business ideas and business models. Recent OECD work on Southeast Asia finds that productivity spillovers from strategic partnerships, such as manufacturing/marketing agreements and joint ventures, depend on firm-level characteristics, such as firm size, (foreign) ownership, internationally-recognised certifications and staff training, i.e. absorptive capacities (OECD-UNIDO, 2019[14]).
The movement of highly skilled workers from foreign MNEs to domestic SMEs can bring new knowledge and skills to local markets
Labour mobility can be an important source of knowledge spillovers in the context of FDI, notably through the move of MNE workers to local SMEs – either through temporary arrangements such as detachments or long-term arrangements such as open-ended contracts – or through the creation by MNE workers of start-ups (i.e. corporate spin-offs).
Existing evidence suggests that firms established by MNE managers are more productive than other local firms (Görg and Strobl, 2005[107]). Similarly, evidence from manufacturing in Norway suggests that workers who moved from foreign-owned to domestic firms retain part of their knowledge and that they contribute 20% more to the productivity of their firm than workers without foreign firm experience (Balsvik, 2011[128]). Recent OECD research on Ireland shows that over the period 2009-15 more than one in four employees at foreign-owned companies either moved to a domestic firm or became self-employed. In addition, more than one in three start-up founders had previously worked at a foreign-owned company (OECD, 2020[129]). Labour mobility within Ireland is also very common among high-skilled researchers who have produced patents. One out of two patent inventors changed employer at least once during the period 2006-2016. As most inventors are based in foreign-owned companies, FDI spillovers related to inventor mobility play an important role in Ireland.
On the other hand, research on Portugal provides a more sceptical perspective on potential productivity spillovers on domestic firms resulting from the mobility of workers (Martins, 2011[130]). Domestic firms in Portugal tend to hire ‘below-average’ workers from foreign firms who take, on average, pay cuts (which is consistent with involuntary mobility). It suggests that worker mobility is unlikely to be a major source of productivity spillovers from foreign to domestic firms. However, movements from domestic to foreign firms translate into considerable pay increases in Portugal but also in other EU Member States (Becker et al., 2020[131]). This pay increase is consistent with generally higher remunerations paid by foreign firms vis-à-vis their domestic counterparts (OECD, 2022[132]). As foreign firms attract some of the best workers in domestic firms where they experience a wage increase and acquire new knowledge, productivity spillovers from worker mobility may also (or rather) occur from domestic to foreign firms.
Competition with foreign MNEs and imitation of their business practices provide significant learning and upgrading opportunities for domestic SMEs
The entry of foreign-owned firms will also heighten the level of competition on domestic companies, putting pressure on them to become more innovative and productive. The new standards set by foreign-owned firms – in terms of product design, quality control or speed of delivery – can stimulate technical change, the introduction of new products, and the adoption of new management practices in local companies, all of which are possible sources of productivity growth. Foreign-owned firms can also become a source of emulation for local companies, for example by showing better ways to run a business. Imitation and tacit learning can, therefore, become a channel to strengthen enterprise productivity at the local level. This is particularly relevant for activities that are deemed positive but risk bearing. Evidence from Scotland points to SMEs benefiting from MNE and other large firms’ experimentation on the implementation of new green technologies and techniques (Medhurst et al., 2014[133]).
However, if local companies are not quick to adapt, competition from foreign-owned companies may also result in the exit of some domestically-owned firms. Increased competition for talent may also make it more difficult for local companies to recruit skilled workers, particularly in more remote areas where this labour pool is smaller (Lembcke and Wildnerova, 2020[76]). These effects are more likely to happen to local companies which operate in the same sector or value chain function of the foreign-owned company, which is the main reason why horizontal spillovers from FDI are so rare and, when they happen, they mostly involve larger domestic companies (Gorodnichenko, Svejnar and Terrell, 2014[28]).
Diagnostic tool
Box 1.6 includes a checklist of questions allowing policymakers to assess the extent to which spillovers take place through the FDI-SME spillover channels.
Box 1.6. The diffusion channels of FDI-SME spillovers: Checklist of questions for policymakers
To what extent do foreign MNEs source intermediate goods and services from domestic SMEs (relative to sourcing from abroad or from other large domestic enterprises)?
To what extent do domestic SMEs purchase inputs from foreign MNEs (i.e. share of foreign MNEs’ total output that is purchased by local SMEs as an input to their production)?
What is the position of domestic SMEs in global value chains (GVCs)? To what extent are they engaged in GVCs?
How do the activities of foreign investors align with the activities of SMEs (e.g. in terms of sector and value chain segment in which they operate)?
How common are strategic partnerships between foreign affiliates and local SMEs (e.g. joint ventures, licensing agreements, research collaborations, business networks, etc.)?
How common and likely is the mobility of workers from foreign MNEs to domestic firms? What is the wage premium of foreign MNEs compared to domestic firms?
What extent are new standards set by foreign affiliates (e.g. product design, quality control, speed of delivery, etc.) adopted by domestic SMEs?
Is there any evidence of tacit learning/imitation by domestic SMEs of foreign MNEs operating in the same sector or value chain?
Is the high level of market competition a hampering factor for innovation in SMEs? How common is cooperation on R&D and other innovation activities between domestic SMEs and competitor enterprises in the same sector?
The depth and breadth of FDI-SME spillover channels can be measured and monitored through a range of internationally comparable indicators, as described in Table 1.4.
Table 1.4. Benchmarking FDI-SME spillover channels at country and region level
Source: Authors’ elaboration.
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Note
← 1. There is a wide range of innovation skills that are relevant to the innovation processes. Skilled workers typically have strong cognitive (e.g. literacy, numeracy and problem solving), management and communications skills, and a readiness to learn. ICT skills are of particular relevance for making use of emerging digital technologies, such as cloud computing, the Internet of things or big data (OECD, 2017[135]). However, firms also need workers with strong social and emotional skills (e.g. communication, self-organisational skills) that complement cognitive skills. Successful employers also need employees with entrepreneurial skills and mindsets to help firms identify, create and act upon opportunities, and adapt to change (OECD, 2019[136]) (OECD, 2019[2]).