Small and medium-sized manufacturers, though still a vital contributor to the economy, now serve largely as satellite vendors in the domestic supply chain. 

BY PETER TZENG

Taiwan’s small and medium enterprises (SMEs) have been credited with playing a crucial part in the island’s economic development over the past half century, and despite the emergence in recent years of large private corporations such as Taiwan Semiconductor (TSMC) and Acer, they continue to perform a highly important role. In 2008, Taiwan’s SMEs comprised 97.7% of all businesses and employed 76.58% of the island’s workforce. Unlike the situation in such neighboring countries as Korea and Japan, Taiwan’s SME sector to a large extent has been the engine that drives the economy.

The precise definition of an SME varies from country to country, depending on domestic economic conditions, and may even change within a given country over time. Taiwan has revised its definition nine times over the past 42 years. Currently, for a manufacturing or construction company, it entails having fewer than 200 regular employees and less than NT$80 million (about US$2.5 million) in paid-in capital. Other criteria are used for service businesses.

Over the years, the success of Taiwan’s SMEs has caused many policymakers around the world to regard the Taiwan experience as a valuable example. In 2004, for example, the United Nations Conference on Trade and Development (UNCTAD) published a report commending Taiwan for its exemplary SME policies, particularly regarding their early development. For decades, government officials from developing and developed countries alike have paid visits to Taiwan to seek the secret ingredient behind the fruitful SME environment.

But although Taiwan has long served as a paradigm of SME development, in recent years the government has revised some of the ways in which it approaches this sector. Robert Lai, Director-General of the Small and Medium Enterprise Administration (SMEA) under the Ministry of Economic Affairs (MOEA), explains that SME policies today differ greatly from what they were decades ago. “The international economic environment is changing all the time,” he says, so policies must adapt accordingly.

But do government SME policies today complement the international environment as well as they did in the past? In the 1960s and 1970s, Taiwanese SMEs achieved the kind of success that they did because of a perfect combination of domestic conditions and international market trends. The large enterprises that existed in Taiwan at that time were primarily companies – some state-owned and some private – that had been transferred from the China mainland when the Kuomintang (KMT) moved to Taiwan in 1949. They almost exclusively targeted the domestic market.

The KMT government developed policies that favored these businesses’ domestic operations, notes economist Chao Wen-heng of the Taiwan Institute of Economic Research (TIER), but at the same time constrained them from expanding internationally in an effort to avoid reemergence of the kind of public-private collusion that had existed during its rule on the mainland. As export opportunities arose with the flourishing of world trade in the age of containerized shipping and telecommunications breakthroughs, the emerging SMEs filled the vacuum, targeting the international market without having to compete directly against domestic industrial giants.

That era was also characterized by strong foreign demand for labor-intensive manufactured products. As labor costs in Taiwan were quite low at the time, Taiwanese SMEs were avidly sought out by foreign importers, often as subcontractors producing according to the customers’ designs. The Taiwanese companies’ limited size and flat management also gave them remarkable flexibility, enabling them to respond rapidly to changes in market conditions or the specific needs of the foreign buyers. As a result of that flexibility and the opportunity to cooperate with foreign firms, the UNCTAD report says, Taiwanese SMEs were able to “leverage new levels of technological capability,” above and beyond those of the larger domestic firms.

This unique “dichotomous structure” – in which the SMEs focused on the international market while the large companies concentrated on the domestic market – worked well for both types of enterprises and lasted for many years. But in the late 1980s, this system was challenged by changes in both domestic policy and the international environment. As the Taiwanese government liberalized its regulations and became less restrictive, it stopped inhibiting large companies from looking outwards. At the same time, international demand for Taiwanese goods shifted to IT products, many of which were suitable for mass production. Large IT companies gradually came into being, capturing more and more export business with the benefit of economies of scale.

Outcompeted overseas, the Taiwanese SMEs found they had little choice but to revert to the domestic market. But utilizing their experience as manufacturing subcontractors, they began working together with the larger domestic enterprises that were now controlling the export sector. Essentially, a critical supply chain was forged. The SMEs supplied parts, components, and materials to the bigger Taiwanese enterprises, which in turn made finished products on an OEM basis for foreign customers.

A “dichotomous structure” thus remained, but the roles were now effectively reversed. In the mid-1980s, SMEs accounted for more than 70% of all of Taiwan’s direct export sales. By the late 1990s – in the course of little more than a single decade – that figure had dropped to nearly 20%.

This shift created two major disadvantages for Taiwan’s SME sector. First, it meant they had to retreat from any product lines that required mass production, and therefore economies of scale, as they could not compete against the newly arisen large domestic enterprises. Second, given their place in the above-mentioned supply chain, the SMEs are now at the mercy of the large enterprises that call the shots by providing them with production contracts.

Other trends have also added to the rather pessimistic picture for Taiwan’s SMEs, including the “major challenges” posed by globalization, notes Robert Lai. Large-scale, multinational operations naturally require a greater division of labor and stronger economies of scale to minimize production costs. Before the role reversal in the late 1980s, SMEs could have faced this challenge by expanding the size of their operations in a natural process of survival of the fittest. But now that the large enterprises have a substantial hold on the export trade, that option is not so easily available.

Migration into services

Second, Taiwan business is in the midst of a transition away from manufacturing and into the service sector. SMEs are participating actively in this migration, and in fact the number of manufacturing SMEs in Taiwan has been decreasing steadily ever since 1992. Is this a problem? TIER’s Chao Wen-heng says the answer is yes. Citing the economic theory called the “Cost Disease,” he notes how a greater emphasis on services, though perhaps natural as any economy develops, can have the effect of holding down productivity gains, with a negative impact on GDP growth.

A third factor is the growing attention in China to worker rights, as seen in last year’s enactment of a more comprehensive labor law. That may be laudable as a matter of public policy, but it has presented problems for Taiwanese SMEs that set up operations on the mainland because it represented a source of cheap labor. Vice Director Cliff Y.P. Hsu of the National Association of Small and Medium Enterprises (NASME) estimates that four out of ten Taiwanese SMEs with factories in China are now attempting to relocate because of financial pressures deriving from the new labor law. Many are returning to Taiwan, but others are moving to such Southeast Asian countries as Indonesia and the Philippines.

Fourth, it has been Taiwanese government policy, particularly during the previous Democratic Progressive Party (DPP) administration, to push for banking-sector consolidation by encouraging smaller banks to merge or be acquired. The growing size of the banks makes it more difficult for SMEs to obtain financing, however, as larger financial institutions are more interested in larger projects with greater potential return. The financing has been further exacerbated by the impact of the global financial crisis, since lenders may regard SMEs as especially vulnerable in this economic climate.

But the financial crisis has revealed an even greater weakness among the SMEs. As satellite suppliers to the large domestic firms, Taiwan’s SMEs risk being squeezed out of the supply chain. Chao notes that many large enterprises responded to the recent financial hardships by “passing their risk onto SMEs” – eliminating certain supplementary SME-provided services rather than laying off their own personnel. Even after the economy recovers, this vulnerability will remain, says Chao. Whenever a large enterprise feels that its bottom line is being threatened, it may look to its subcontractors to bear the sacrifice.

Even before the recent financial crisis struck, the total number of SMEs in Taiwan had been on the decline. According to the SMEA’s annual White Paper, that figure has been decreasing since 2006, and the number of new SMEs started each year has been falling since 2005. While he considers that decline to be a significant worry, especially in terms of its impact on unemployment, Chao describes the reason for the trend as “a mystery.”

In this difficult environment, it is SMEA’s duty to use its NT$8 billion (US$245 million) annual budget to best advantage in helping the SMEs to survive and prosper. In fact, Taiwan still boasts one of the strongest SME support systems in the world. The cornerstone of SMEA’s efforts is the SME Credit Guarantee Fund (SMEG), a non-profit organization established in 1974. Considering that lack of financing is one of the biggest obstacles for small and medium enterprises, more than 80% of the annual SMEA budget is earmarked for this Fund. SMEG allots credit guarantees to SMEs whose business plans are deemed to have high prospects of success.

Although this type of financing is common in developed and developing countries throughout the world, in some other respects Taiwan’s SME infrastructure appears to be unique. SMEA, for example, makes a great effort to nurture its SMEs from inception to maturity, advising them at every step of the development process. As an example of the kind of service offered by SMEA, Lai points out that his staff keeps an eye out for products that should have good market opportunities in other countries and then encourages Taiwan SMEs to develop products to meet that demand. SMEA also prides itself on its localization efforts. It has set up small SMEG offices in all corners of Taiwan so as to spread awareness of the fund to all those aspiring to be an entrepreneur.

In addition, MOEA seeks to foster “industry clusters,” encouraging SMEs engaged in the same or similar industries to locate their operations near one another – often in the same industrial park – so that they can exchange information and learn from each other. Clustering may also help them overcome their weak economies of scale by developing economies of scope – for example, cooperating to engage marketing and distribution on a larger scale than would be possible individually. And through incubation programs, MOEA has arranged for over 100 colleges and universities in Taiwan to allow SMEs to use capital-intensive equipment on campus to conduct research, minimizing the entry barrier of sunk capital for new start-ups.

Furthermore, MOEA collaborates with research institutes on the island, such as the Industrial Technology Research Institute, to help provide SMEs with state-of-the-art technology. The UNCTAD report cited this form of public-private cooperation as vital to the success of Taiwan’s SMEs, contrasting it to the situation in peer countries like Japan and South Korea, where much of the technology is in the hands of large companies that lack the flexibility to innovate and to quickly turn technological advancements into commercial opportunities.

But the fact remains that Taiwan’s SMEs are in a decline, with global trends instilling a Darwinian atmosphere in which small enterprises are gradually being weeded out in favor of larger ones. Is the continued erosion of SMEs inevitable?

According to several experts interviewed for this article, there is more that the SMEA can do to help these companies, but it needs to be more selective. NT$8 billion may seem like a lot of money, but it does not go far if the effort is aimed at invigorating 97.7% of the businesses in Taiwan. A more practical approach would be to devote the resources only to the areas likely to yield the most impressive results.

Wu Hui-lin, an economist and research fellow at the Chung-Hua Institution for Economic Research (CIER), adopts a different perspective – focusing not on policy, but rather on culture and the entrepreneurial spirit. Taiwanese businesspeople are often successful because they are diligent and ambitious. They want to be “the head of the chicken, not the tail of the ox.” While the macroeconomic environment strongly affects the chance of success for SMEs, it is also relevant to look at how the cultural mindset of Taiwanese people may be changing. Whether due to globalization, the greater affluence of the society, or other factors, the new generation of Taiwanese seems to have less appetite to strike out on their own and start a new business.