About Nick: i am an economist based in malaysia. I write about development economics, while sneaking in a pop culture reference or two.

The (Unconventional) Role of SMEs and Micro-Enterprises for Economic Development

Published in The Edge, September 2019.

Research on firms is crucial for understanding economic development. While plenty of attention is, rightfully, directed towards households and governments – the other economic actors – we must not forget that firms are where economic activities are organised and carried out. As such, understanding the state of firms for a given country is critical in evaluating that country’s potential for future economic development. 

One of the most striking lessons from economic history around the world is that becoming an advanced, high-income economy requires the existence and participation of large home-grown firms. More specifically, with very few exceptions, these large home-grown firms that are so crucial to development of their respective nations are those that compete globally and are at the forefront of the technological frontier. 

There are several reasons for this. Being at the technological frontier tends to require heavy capital expenditure spending or heavy spending on research and development, which are typically only possible at large firms. Economies grow primarily from ‘learning by doing’ which requires large-scale on-the-job training, with employees teaching and learning from each other – an outcome far more likely in large firms. Then there are also issues of coordination across industries and value chains to achieve scale, which almost, by definition, can only be done at large firms.

A recent study by economists Marcela Eslava, John Haltiwanger and Alvaro Pinzon lends empirical evidence for this observation on the primacy of large firms. The study focuses on manufacturing plants in Colombia and the United States and asks the question, “Are there differences in the nature of the firm in Colombia and the United States that explains the large productivity differences between firms in those countries?” 

The authors find that, relative to United States firms, Colombia has an “overwhelming prevalence of micro-establishments, a deficit of superstar plants, and less strict market selection pressure for underperforming plants.” Micro-establishments, as defined in this study, are firms with fewer than ten employees. In the US, micro-establishments account for 50% of total firms, hiring 4% of total manufacturing employment, while in Colombia, micro-establishments account for a whopping 87% of total firms, hiring 32% of total manufacturing employment. 

The authors argue that the huge prevalence of these micro-establishments, many of whom are low productivity firms, point to a business environment in Colombia that allows poor performers to remain in the market. The interesting follow up question is therefore, why do such firms continue to survive and remain in the market? 

In Malaysia, according to the Department of Statistics, there are approximately 694,000 Micro-Enterprises in Malaysia, making up 75% of total firms in Malaysia. The definitions are slightly different – the study defines Micro-Enterprises as those with 10 or fewer employees whereas the definition of Micro-Enterprises in Malaysia are those with 5 or fewer employees. If we were to expand the thinking to also incorporate Small and Medium Enterprises (“SMEs”), there are approximately 907,000 Small and Medium Enterprises (“SMEs”), making up 98.5% of total firms in Malaysia. For context, there are 942 publicly listed companies, a mere 0.1% of the total number of SMEs. SMEs employ approximately 10 million workers, about two thirds of Malaysia’s total number of employed people. Of these 907,000 or so SMEs, nearly 90% of them are in the Services sector. 94% of micro-enterprises as in the Services sector. 

The fact that 90% of Malaysian SMEs or 94% of micro-enterprises are in the Services sector is not, by itself, indicative of a healthy or otherwise state of Malaysian firms. However, when combined with research done by Malaysian economist Allen Ng that traditional services comprises the bulk of Malaysia’s Services industry as opposed to modern services, it is therefore highly probable that the vast number of these firms are engaged in traditional services which are usually low value-added, low productivity services.  

If this is true, then the same question that was asked of the Colombian micro-establishments also applies to Malaysian SMEs and micro-enterprises. If, indeed, they are in low productivity services, why then are so many of them still in the market and allowed to survive? Is access to financing just too easy for these firms? Or is Malaysian bankruptcy law too lenient? Whatever the case, the fact that these firms are in low productivity services, without the benefit of scale, means that their returns are unlikely to be strong. Consequently, they are unable to re-invest to either train their employees or to acquire new technology to become more productive. 

In a healthy environment, we should see a continuous entry and exit of firms. Indeed, that some firms need to die off is part of the natural circle of life for any thriving economy. The economic history of the East Asian miracle nations – Japan, Taiwan, South Korea – point to a continuous process of weeding out unproductive firms either via natural deaths or via a series of industry consolidations that lead to larger, more productive firms thriving in their respective industries. This process of firm ‘turnover’ was a significant reason why these countries developed firms which became world-beaters such as Hyundai, Sumitomo Mitsui and Mitsubishi, among others.

The other issue with the prevalence of Malaysian SMEs and micro-enterprises in low productivity economic activities is also that both the business owners and employees of these firms may find it difficult to increase their earning power. This then leads to slower growth in domestic demand which has an impact not only on the short-term indicators of the Malaysian economy such as private consumption, but also on the structure of the Malaysian economy. Joe Studwell, founding editor of the China Economic Quarterly, argues in his book, “How Asia Works” that land reform for agriculture in Japan, Taiwan, South Korea and even China (albeit in a hugely circuitous way that included the disaster of the Great Leap Forward) unlocked surpluses and savings to build the manufacturing bases in those countries. 

Now, land reform may be extremely difficult to achieve in Malaysia today. But the logic of unlocking surplus and savings still holds. Thus, what if we could achieve that same outcome of surplus and savings by increasing large productivity gains in SMEs and micro-enterprises to the point that some of these business owners become more ambitious and try to build larger firms, or some of these employees transition towards more high value-added economic activities? Land reform in the East Asian miracles gave small farmers a sense of ownership of their land; SME and micro-enterprises owners already have that – the question is how do we raise productivity such that we generate surpluses and savings that can be relocated to more productive uses in the economy?

To be clear, this idea is one which is unproven and certainly worthy of serious skepticism. We don’t know if the type of gains from land reform can be achieved by unlocking productivity gains from SMEs and micro-enterprises. But, if there is a chance to get those types of gains, there is therefore a chance to write a new chapter in Malaysia’s economic development history and to therefore chart a new path towards a much stronger, much more resilient economy built on the shoulders of a healthy state of Malaysian firms. 

Gearing Up in the New Trade Ecosystem