TRADE AND INVESTMENT liberalization effects on sme development: a Literature review and a case study of INDONESIA

1. Effects of International Trade Reform on SMEs
It is generally believed that trade liberalization should beneficial for domestic economy as well
as the world as a whole. At an aggregate level, the channels through which trade reform could bring
benefits are broadly the followings: improved resource allocation; access to better technologies, inputs
and intermediate goods; economies of scale and scope; greater domestic competition; availability of
favorable growth externalities like transfer of know-how and many others.2
Until quite recently, more attention has been given to macroeconomic effects of international
trade reforms.3There is now a small but growing empirical literature on the effects of international
trade liberalization at a disaggregate level. Theoretically, reform towards international trade

2. Effects of Investment Liberalization on SMEs
As with trade liberalization, investment liberalization should also take into consideration what
impact (positive and negative) would have on the SMEs. Theoretically, investment liberalization affects
SMEs in a number of ways. On the positive side, a better investment environment generates many new
firms or/and encourage existing firms (including SMEs) to expand their production capacities. The
expansion of local SMEs can also take place with direct link to LEs, including MNCs/FDIs through
e.g. subcontracting production linkages (‘complementary effect’). In other words, MNC/FDIs act as a
growth source for local SMEs. Moreover, most often in the literature, MNCs/FDIs have been claimed
as positive factors for developing countries firms for breaking entry-barriers into export markets.
Several studies have appeared to examine the export-spillovers effect of FDI on domestic firms and
this often take place through subcontracting arrangements.13Although these studies do not categorize
domestic firms by size, it can be assumed that well developed SMEs (i.e. those with better
technologies, high skilled workers, and good management systems) can benefit from this spillovers
effect. On the negative side, however, reform towards FDI liberalization has the effect of increasing
new LEs at the cost of existing SMEs unable to compete (‘competition effect’). Thus, ‘complementary
effect’, rather than ‘competition effect’, can be considered to minimize the negative impact of
investment liberalization on SMEs.
Unfortunately, due to limited literature exclusively on the effect of investment policy reform
on SMEs in Indonesia, it is hard to say whether the long-term gradual process of investment
liberalization, started first by the introduction of Foreign Direct Investment Law in 1967 marking the
beginning of the openness to FDI, and followed by the ‘real’ liberalization with the introduction of
various incentives to attract FDI (including more sectors open for FDI) in the second half of the 1980s
and reached the climax after the crisis 1997/98 with the IMF Reform Agreement, has created
complementary net effects or competition net effects on local SMEs.14However, there are many case
studies on subcontracting in Indonesia which may give some insight, and the majority of these studies
conclude that such production linkages do not develop smoothly despite of investment liberalization
and this is attributed to many factors: local SMEs cannot meet the required standard of quality due to
their lack of technology and skills, market distortion, and the institutional coordination problem
indicated by, among others, the lack of consistency and coherence in policy, underdeveloped business
Effects of the Reforms on SMEs in Indonesia.1 Growth in Units and GDP Contributions
Clearly, the development of manufacturing industry and non-oil/gas exports in Indonesia has
been an important success of the era of deregulation of international trade and investment in the
country. However, there are always concerns regarding the survival of SMEs in the country. Questions
remain: (i) can local SMEs survive if imports are allowed to freely enter the domestic market; (ii) have
export opportunities been more open for local SMEs since the reforms; (iii) do local SME have
enough capacity to develop or increase their exports; and (iv) how best can SMEs enhance their ability
to supply foreign invested firms and thus participate more actively in regional or global production
networks as sub-contractors of MNEs?
With respect to the first question, the answer is positive. Figure 7 indicates that after a slightly
decline in 1998 as a consequence of the economic crisis, the number of SMEs kept growing since then.
As already discussed in the literature survey (see again Section II.1), van Dierman at al. (1998) tried to
assess the impact of more aggressive trade and investment policy reforms shortly after the economic
crisis in 1997/98 related to the IMF sponsored deregulations under the Letter of Intent (LOI) on SMEs
in the manufacturing industry in Indonesia. They conclude that the likely impact varies by subsector or
group of industry. SMEs in the pre-crisis most protected industries were expected to be adversely
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affected than those in the less protected ones. This figure may suggest, however, that although many
SMEs may have been damaged, in overall, the reforms have not affected SMEs negatively