Diversity, Internationalization and Innovation: The new perspective of small and medium enterprise policy

YASHIRO Naomitsu
Consulting Fellow, RIETI

A virtuous cycle between internationalization and innovation

From 2002 through the end of 2007, the Japanese economy experienced the longest expansion in its post-war history. However, the economic growth during this period was driven primarily by robust export demand, whereby significant performance gaps emerged between export industries which took advantage of strong world economic growth and domestic industries which faced sluggish household consumption. Such disparity in performance was also observed between large enterprises (LEs) with significant operations overseas and small and medium enterprises (SMEs) with limited presence outside Japan. The uneven recovery, which caused significant strain in the Japanese economy, served as a sobering reminder of the need to transform the nation's economic structure into one that allows a broader range of entities including SMEs to benefit from globalization.(note 1) It is believed that the internationalization of business activities - for instance, in the form of exporting and/or launching operations overseas - is not just about capturing demand overseas but has greater significance to the growth of Japanese companies. Specifically, participation in overseas markets would bring opportunities for broad types of innovation, including the absorption of advanced technologies, the development of new products and services, and the formulation of a brand strategy tailored to the needs and tastes of local consumers. Success in such innovation would enable companies to further capture markets overseas. The existence of this interaction between internationalization and innovation has been confirmed by recent studies(note 2) and some specific cases and it is likely that such a virtuous cycle will be established more particularly for SMEs that have greater room for internationalization than LEs. It is an extremely important challenge for SMEs to realize such synergy between internationalization and innovation so that they can see globalization as source of growth instead of a threat.

Motivated by these policy perspectives, the Research Institute of Economy, Trade and Industry and the Institute of Economic Research of Kyoto University jointly held a symposium entitled "Diversity, Internationalization and Innovation: The new perspective of small and medium enterprise policy" on February 15. In what follows, I will report, from an organizer's viewpoint, on the key issues raised in the discussions at the symposium and draw some policy implications.(note 3)

"Crouching dragons" and the initial costs for internationalization

Supporting internationalization efforts of domestic firms has become one of the key SME policies in recent years. Due to the substantial costs involved in advancing into overseas markets, only those companies that are highly productive and capable of earning profits after covering all such costs would internationalize their operations.(note 4) Therefore, from the viewpoint of realizing the aforementioned virtuous cycle for a broader spectrum of companies, it is justifiable for the government to mitigate initial costs for internationalization. Initial costs for internationalization typically include the cost of collecting information about overseas markets and the cost of securing local marketing channels. The Japan External Trade Organization (JETRO) and other like organizations provide relevant overseas information and offer various support programs including overseas marketing assistance. Meanwhile, Yasuyuki Todo, associate professor at the University of Tokyo, points out the existence of a large mass of "crouching dragons", companies that are just as productive as exporting companies but have yet to internationalize their operations.(note 5) The presence of those crouching dragons suggests that existing government policies are not capturing some of the essential entry costs related to internationalization. For instance, companies cannot simply bring in their domestic products into overseas markets with different income levels and cultural backgrounds. Instead, they need to develop and/or modify products in accordance with the tastes and needs of local consumers so that they can appeal and sell in specific overseas markets. At the same time, companies must have a robust financial standing that can withstand the volatile sales in global markets.(note 6) While such prerequisites to internationalization, would require SMEs considerable labor and costs of SMEs, conventional government policy supporting internationalization does not include any scheme that assists such efforts.

Requirements for successful innovation

In order to achieve successful innovation after advancing into overseas markets, companies have to be investing zealously on innovative activities to begin with. Keiko Ito, an associate professor at Senshu University, has shown that companies with prior research and development (R&D) activities tend to achieve a greater productivity gain after entering export markets than those without. Also, successful companies need to have an effective mechanism for collecting and absorbing innovation seeds from local markets. Engaging in business-to-consumer (B2C) transactions in which they would be in direct contact with the local market can be important from this perspective. When conducting business-to-business (B2B) operations, companies should seek to build relationships with local companies rather than dealing only with local affiliates of Japanese companies. It is particularly important to have a valuable local partner that provides helpful information. Developing new products through interactions and collaborations with local and foreign companies seems like a promising new form of innovation through internationalization. For example, we can assume a case in which a Japanese manufacturer possessing technology partners with a foreign trading company with marketing and designing capabilities to develop new products for Asian markets. Government support in post-internationalization, promoting penetration into the local market and new business development including exports to wider destinations will play an important role in linking SMEs' internationalization with successful innovation and growth. At present, however, government support measures of this kind are not as extensively available as those designed to assist internationalization itself.

In the face of spreading globalization and the shrinking domestic market resulting from an aging population, Japanese companies are now being forced to focus once again on the global market. Against this backdrop, SMEs with high potential are expected to develop into global companies and act as driver of innovation thereby bringing diversity and dynamism to the Japanese economy. Meanwhile, the internationalization of SMEs may be inhibited by factors attributable to being small in size, for instance, due to financial constraints or because their financial standing is too weak for risk-taking associated with going global. If this is indeed the case, an effective policy supporting internationalization should include measures to help SMEs build-up the capability to be viable as an exporting company. Such measures may even include a financial support scheme that goes beyond the existing framework. Such a support package could be a meaningful opportunity for policy coordination between JETRO and SME support organizations. The program, however, should not be universally applied to all SMEs but should be targeted at selected companies, i.e. those that have been found - based on evaluation against objective criteria - to have high potential to achieve innovation once their operations are internationalized. The intensity of R&D activities is one example of such criteria. It is known that R&D activities shape a company's ability to absorb knowledge and technology.(note 7) Thus, it is assumed that the greater the intensity of a company's R&D activities, the greater the likelihood that the internationalization of its operations will lead to innovation. Until now, promoting entry into overseas markets seemed to be the primary goal of internationalization support measures. However, a greater policy focus should be placed on "what should be achieved through internationalization." It would be fortunate if the discussion at the recent symposium on a virtuous cycle between internationalization and innovation contributes to the development of relevant policies.

April 6, 2010
  1. A robust domestic demand growth supported by improved labor income is the essential factor for realizing sustainable economic growth in Japan. This would require significant improvement in labor productivity in the service sector, which accounts for 80% of Japan's employment. This in turn, cannot be achieved without structural adjustment in inefficient industries.. For a more detailed argument of this point, which is not the subject of this article, see Yashiro (2008).
  2. Regarding the effect of exporting as a driver of innovation activity, see Salomon and Shaver (2005), Yashiro and Hirano (2009), and the 2009 White Paper on Small and Medium Enterprises in Japan. For examples of a virtuous cycle between exporting and innovation, see Aw, Robert and Winston (2007).
  3. What is discussed in this article is my personal view and does not necessarily reflect the views of other lecturers and panelists at the symposium. For specific presentations made at the symposium, see the symposium summary published on the RIETII website.
  4. According to Wakasugi et al. (2008), the average labor productivity of exporting companies is 50% higher than that of non-exporting companies.
  5. See Todo (2009).
  6. I am grateful to Masanori Matsuura, Chairman of Matsuura Machinery Corporation, and JETRO Executive Vice President Toyojiro Maruya for providing many valuable insights regarding actual obstacles for SMEs aspiring to advance into overseas markets.
  7. See Cohen and Levinthal (1989).
  • Todo, Yasuyuki. "Strengthening the Fundamentals of the Japanese Economy: Expanding exports rather than creating domestic demand generates stability and growth," Nihon Keizai Shimbun, July 29, 2009, Keizai kyoshitsu column (English translation by RIETI)
  • Matsuura, Masanori. Ichigo Ichie: Watashi ga deatta subarashiki hitobito [Once-in-a-lifetime Encounters: Wonderful people I met]. Matsuura Machinery Corporation, 2009.
  • Wakasugi, Ryuhei, Yasuyuki Todo, Hitoshi Sato, Shuichiro Nishioka, Toshiyuki Matsuura, Banri Ito, and Ayumu Tanaka. 2008. "The Internationalization of Japanese Firms: New findings based on firm-level data." RIETI Discussion Paper Series 08-J-046 (Full text in Japanese; abstract available in English).
  • Yashiro, Naomitsu. "Japan's Economy on Thin Ice: Why did domestic demand-led growth fail to happen?" RIETI Column 0177, February 26, 2008.
  • Aw, Bee Yan, Mark J. Roberts and Tor Winston. 2007. "Export Market Participation, Investments in R&D and Worker Training, and the Evolution of Firm Productivity," The World Economy Vol. 30 (1): 83-104.
  • Cohen, Wesley M. and Daniel A. Levinthal. 1989. "Innovation and Learning: The two faces of R&D," The Economic Journal Vol. 99: 569-596
  • Salomon, Robert M. and Myles J. Shaver. 2005. "Learning by Exporting: New Insights from Examining Firm Innovation," Journal of Economics and Management Strategy Vol. 14 (2): 431-460
  • Yashiro, Naomitsu and Hirano Daisuke. 2009. "Do All Exporters Benefit from Export Boom?-Evidence from Japan." Kyoto University Institute of Economic Research Discussion Paper 689

April 6, 2010