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Series“Offshore Expansion by Small and Medium Enterprises” Part I Key Points in Offshore Expansion by Small and Medium Enterprises | Tatsuya Hoshino, Research Director Vietnam Economic Research Institute [Date of Issue: 28/April/2011 No.0194-0794]

Date of Issue:28/April/2011

Series“Offshore Expansion by Small and Medium Enterprises” Part I
Key Points in Offshore Expansion by Small and Medium Enterprises

Tatsuya Hoshino
Research Director
Vietnam Economic Research Institute

Economic globalization has led Japanese trade to soar, while the swift appreciation of the yen following the 1985 Plaza Accord has encouraged more Japanese firms to set up operations offshore, lifting foreign direct investment to US$74.6 billion in 2009. Small and medium enterprises too have been actively developing offshore operations as a way of maintaining and expanding their business, or to develop new clients. Most firms target China and ASEAN, but these horizons are expected to widen in the coming years.

1. Economic globalization
(a) Two key developments since the 1990s have been the globalization of the world economy and the economic advance of many East Asian countries. Within the Association of Southeast Asian Nations (ASEAN), formulation of the ASEAN Free Trade Agreement (AFTA) and the Common Effective Preferential Tariff (CEPT) scheme has stimulated intraregional trade. China’s accession to the World Trade Organization (WTO) in 2001 ushered China officially into the global economy, while countries and regions around the world have been concluding free trade agreements (FTAs) and economic partnership agreements (EPAs), accelerating the pace of economic globalization. Japan’s trade volume too subsequently soared.

The growth of large firms’ export-oriented production also expanded production for export markets amongst the small and medium enterprises (SMEs) subcontracted by these large firms. Japan’s trade scale then experienced anther surge, with both exports and imports increasing more than 60 percent in the five years from 2002 (FY2007 exports amounted to US$712.7 billion, imports US$621 billion). Moreover, close to half of this trade volume was with Asia, a trend which also impacted heavily on SMEs.

(b) The sharp yen appreciation following the Plaza Accord in 1985 pushed up Japanese companies’ offshore ambitions, with many heading overseas in search of competitive local resources and labor forces. Japanese firms’ foreign direct investment in offshore operations rose sharply from 2005, reaching around US$74.6 billion in 2009, of which US$20.6 billion was in Asia and US$3.5 billion in ASEAN.

Japanese direct investment has been declining overall since FY2008, but this trend has yet to be echoed in direct investment in Asia, which maintains a slight upward trend.

Looking more closely at direct investment in Asia, the figures for ASEAN and China are as below. Investment in China continues to grow, but investment to ASEAN with large firms having completed their initial round of large-scale investment, most investment is now simply additional to that, keeping the overall investment amount flat. Small-scale direct investment to ASEAN by SMEs is growing, with the trend toward more investments but with no increase in the overall value.

2. Status of offshore SME expansion
(a) As their customers have moved operations offshore, the associated SMES have accompanied them in order to continue to requests from customers that they continue to supply parts and materials. In other cases, even where customers have not required the shift, SMEs have developed offshore operations at their own risk and on the basis of their own judgement in order to maintain that supply of parts and materials to customers. The ratio of offshore production in the manufacturing industry has risen amidst an ongoing shift into Asia where high growth levels continue.

As at 2005, the Ministry of Economy, Trade and Industry’s Survey of Overseas Business Activities put the ratio of local SME affiliates by region at 25 percent in the West and 65 percent in Asia, with 10 percent elsewhere. Of the 65 percent located in Asia, 26 percent were in China, 25 percent in ASEAN, 14 percent in Korea, Taiwan or Hong Kong. Around 40 percent were consequently in ASEAN, Korea, Taiwan and Hong Kong excluding China.

(b) According to a Ministry of Internal Affairs and Communications survey, where in 1996 5,431 SMEs had offshore factories, subsidiaries or affiliates, by 2006 that figure had grown by around 40 percent to 7,551 firms. By industry, machinery-related manufacturing (machine and metal parts, electronic parts, etc.) accounted for 46 percent and non-manufacturing (wholesale and services, information communications, transportation, etc.) 54 percent, suggesting that more firms are engaged in non-manufacturing than manufacturing.

(c) According to the 2008 Survey of SME Business Conditions, which targets around 6,700 SMEs, some 24 percent (1,600 firms) of these have overseas operations, of which the bulk—1,122 firms or 70 percent—are involved in manufacturing (machinery, textiles and apparel, chemicals and plastics, metals, etc.). Of the 1,600 SMEs with offshore operations, around 45 percent are engaged in direct investment, while 35 percent have business or technical tie-ups and around 60 percent are importing or exporting (this figure includes some firms from the previous two categories). The number of SMEs engaged in foreign direct investment has been increasing since 2002.

3. Key points in SME offshore expansion
(a) Why do SMEs go offshore?
The main purposes of offshore expansion by SMEs are to cut production costs (particularly personnel costs) and to maintain or expand business, which is why most go to East Asia. SMEs give a number of different reasons for their decision to set up operations offshore—some say that because of the difficulty that SMEs have in growing their business within Japan alone, they opted to look offshore while they were still relatively robust; others made the decision because they had gone as far as they could at home and needed to break out of a management crisis. Some typical cases are as follows:
(i) SME went offshore to cut production process costs (personnel costs), with products exported to the parent company or customers back in Japan or to third countries, not sold locally.
(ii) SME went offshore in response to a request from a large client which had also moved offshore.
(iii) SME made its own decision to go offshore with the aim of expanding its business with major clients and other Japanese firms that have set up offshore operations as well as to develop a wide range of new clients.
(iv) SME made its own decision to go offshore to find new customers in local markets.

According to a Mitsubishi UFJ Research and Consulting survey, since 2001, 33 percent of manufacturing SMEs which have set up operations in East Asia have done so to cut costs and export their products to the parent firm, etc., while 20 percent have done so at the request of a major client and 37 percent on the basis of their own judgement. Note that the last category outweighs the others. It is extremely positive in terms of the future that more than one third of SMEs are setting up offshore on their own accord.

(b) Main conditions determining where SMEs will go offshore
Various conditions pertain in terms of SMEs selecting an offshore destination for manufacturing, but very few regions satisfy those conditions fully. SMEs therefore tend to consider whether the region in question will meet the minimum necessary conditions, which are as follows:
(i) Whether costs—and particularly personnel costs—can be cut;
(ii) Whether the minimum necessary infrastructure for manufacturing is in place (places to build plants, power, water supply and sewerage, access, transportation, etc.);
(iii) Whether the necessary number of staff/workers can be employed;
(iv) Whether raw materials and products can be taken in and out smoothly (local transportation, shipping to Japan and third countries, etc.); and
(v) Whether there are unreasonably strict regulations regarding local production, sales, raw material imports and product exports, or receipts and payments (government regulations on foreign capital).

Up until the 1990s, most Japanese SMEs set up in the developed ASEAN countries (Thailand, Malaysia, Singapore, Indonesia, the Philippines), but as of around 2000, China became extremely popular as a region that also satisfied the above conditions. Since around 2005, however, soaring personnel costs in China and the introduction of some regulations on foreign capital, as well as the desire to avoid the risk of focusing all resources in one country saw India and Vietnam begin to attract more Japanese SMEs. Direct investment (business operations) in Vietnam more than tripled over 2005 and 2006 as more firms opted for Vietnam as a production base to take advantage of the merits of its cheap labor force. Currently, around 1,000 Japanese affiliates are operating in Vietnam. Total investment by Japanese firms in Vietnam in FY2010 amounted to US$2.0 billion (license base) across 138 projects, while aggregate investment from 1988 through 2009 stood at US$17.1 billion. Most Japanese firms establishing plants in India are large automobile or information communications companies.

In terms of the future prospects for SME movement offshore, it seems likely that in addition to Vietnam, SMEs will also target Indonesia and Cambodia. Five years down the track, Myanmar could also attract growing attention due to its large population and land area, as well as its many resources.

(original article : Japanese)
(For the Japanese version of this article)

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