Are global value chains leaving Indonesian SMEs behind?

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Arip Tirta, President, Evermos, Prasanti W. Sarli, Head of Social Impact, Evermos

• In developing economies, such as Indonesia, a majority of the people (97.2%) are employed by small and medium enterprises (SMEs).
• To boost the economy, these SMEs must grow into larger businesses.
• By participating in the global value chain, SMEs can stand a better chance of economic development.

Indonesia is on the verge of hitting the middle-income trap. Despite the massive growth across the country over the past two decades, it can’t seem to reach its true potential. This might be due to the lack of large long-standing businesses in the country. Most businesses are small in scale and have difficulty scaling up. The lack of large established enterprises also affects the long-term income potential of ordinary citizens.

In most OECD countries, although only 1% of the enterprises can be considered large, they employ about 40% of the countries’ workforces. While in developing economies, such as Indonesia, a majority of the people (97.2%) are employed by small and medium enterprises (SMEs). This becomes a problem because SMEs are volatile in nature and cannot always provide long-term security for employees, health benefits or even the possibility of a rise in income in the long term. Hence, to boost the economy it is only natural that these SMEs need to grow into more established enterprises.

Indonesia, however, had been slow to grow local businesses, despite decades of campaigns to support local products. SMEs are still uncompetitive and account for only about a third of total value added or exports. This gap is due to SMEs’ relatively low productivity as a result of their small scale and limited experience, making them have less access to finance for investments, information skills and technology.

By participating in the global value chain, SMEs can stand a better chance of economic development. Sadly, most of the time these benefits are mainly enjoyed by larger firms and/or multinationals, leaving SMEs behind. This is the case, even when data suggests that SMEs with greater exposure to imported intermediate products and foreign technologies have higher labour productivity.

This is interesting given that most of the time when we think about benefiting from participation in the global value chain for SMEs, we think about how to increase the SMEs’ ability to export. But with the global value chain, participation can go both ways, it can be in receiving input from the global value chain in the form of intermediate products to produce finished products, or it can be by exporting outputs of finished products.

Figure 1 Image: Data Source: Javier López González (2017), “Mapping the participation of ASEAN small- and medium- sized enterprises in global value chains,” OECD Publishing

DISCOVER

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SMEs do not need to export to benefit from the global value chain, they can also make use of intermediate products from the global value chain to increase productivity and make them more competitive, even domestically. This path has been taken by other ASEAN countries ahead of Indonesia. Unlike Indonesia, whose participation in the global value chain is mainly in the form of sales of raw materials used by other countries to produce exports, Singapore, Malaysia, Thailand, the Philippines and Vietnam have had a stronger manufacturing element to their participation and have relied on foreign value-added links to develop their export competitiveness (see Figure 2). Singapore, a small open economy, has specialized in supplying services and is the country with the highest degree of participation in the region.

Figure 2 Image: Data source take from González, J. L. (2017). Mapping the participation of ASEAN small-and medium-sized enterprises in global value chains.

This reluctance to participate in the global value chain by obtaining input might be a contributing factor to Indonesian uncompetitiveness. Just by focusing on the global value chain in textile, clothing and footwear production, Indonesian textile imports are much less than Vietnam’s, with almost only a third of Vietnam’s export ability.

But, even if Indonesia is serious about increasing imports of intermediate products, with the current production efficiency Indonesia can still not reach Vietnam’s standard of value creation. The difference between Indonesian and Vietnamese per dollar value creation is about 24%, which is attributed mainly to losses in production, whether in inefficient cutting (10-15%) or in lower quality production, resulting in losses during the quality control step (5-10%).

Without addressing inefficiencies and maximizing opportunities within the global value chain, Indonesia faces significant income loss and risks falling into the middle-income trap, hindering its aspirations to enhance manufacturing capabilities and competitiveness. The ability to scale depends on access to the global value chain, whether through importing intermediate products or exporting final goods; Indonesian SMEs lack access to both. If Indonesia is serious about increasing its manufacturing ability and, hence, bringing its country on par with other countries, it must address these issues now before it really does fall into the middle-income trap – just like many others before.