Promoting the growth of domestic small and medium-sized enterprises (SMEs) represents an important development objective in most countries for both economic and socio-political reasons. Domestic SME development can:

  • Increase employment
  • Create local value-added
  • Improve domestic innovation and entrepreneurial capabilities
  • Generate economic growth

Although there are obvious benefits from SME growth, many developing countries lack the resource base or a sufficient market size to foster further internal expansion. Some specific obstacles to SME growth in these situations may also include the following:

  • Limited access to fund and credit. SME funding is essential not only to cover the start-up, expansion and working capital requirements, but also for research and development purposes, as SMEs too often lack assistance for developing new ideas and turning them into marketable products. Yet, the cost of capital is often high-priced for SMEs, particularly in times of economic uncertainty, when lenders tend to be more risk averse.
  • Deficiencies in human capital and difficulties in establishing the required programmes, both in terms of the overall education system and on-the-job training. For instance, universities and vocational institutions may face challenges to supplying the managerial and technical training programmes needed to support local business operations.
  • Weak infrastructure with respect to information and communication technologies, transportation and energy, can limit access to markets and erode business revenues. Evidence shows that such constraints, including the digital divide, present particular challenges for SMEs across many business sectors.
  • Limited access to information on prospective markets and clients. Many SMEs have little experience, particularly in becoming suppliers to foreign affiliates or exporting to foreign markets.
  • Extent of government regulation and compliance costs. These cover many issues like taxation and reporting requirements. The cost of complying with national and international standards can be very expensive for SMEs.


Foreign direct investment (FDI) can enhance local SME development through linkages between foreign affiliates and domestic SMEs. These linkages can take several forms, including backward, forward or horizontal. Backward linkages exist when foreign affiliates acquire goods or services from domestic firms, and forward linkages when foreign affiliates sell goods or services to domestic firms. Horizontal linkages involve interactions between foreign affiliates and domestic firms engaged in competing or complementary activities. Linkages offer benefits to foreign affiliates and domestic SMEs as well as to the economy in which they are occurring (Blomström et al., 2000).

For affiliates of transnational corporations (TNCs), such benefits may include:

  • Lowering transaction costs
  • Providing greater flexibility
  • Spurring local adaptations and
  • Fostering corporate social responsibility.

For local SMEs, potential gains relate to:

  • Increased local market opportunities
  • Upgraded management skills
  • Benefiting from new technology
  • Facilitating their access to capital and increased possibility of internationalizing their business.

For the host economy as a whole, linkages can stimulate economic activity through substituting local inputs for imported ones. The strengthening of domestic firms can in turn lead to spill overs to the rest of the host economy. Linkage-related benefits to domestic firms and the local economy are not automatic. The ability of a host country to fully Chapter I 3 UNCTAD Investment Advisory Series B benefit from linkage-related spill overs (i.e. the economy’s “absorptive capacity”) is determined to a great extent by the technological and managerial capabilities of existing domestic firms. Few spill over benefits will be captured if large “capability gaps” exist. When domestic firms are characterized by weaker capabilities, foreign affiliates often decide to use preferred foreign suppliers within or outside the host country.

By analyzing the interactive effects of both government and private sector factors in countries like Malaysia and Singapore, useful insights can be derived regarding the circumstances under which different policy and programmatic options can yield the best results.

Reference: UNCTAD’s investment advisory series