Executive summary
This Policy Toolkit offers advice to national and subnational governments on how to increase productivity and innovation spillovers from foreign direct investment (FDI) to domestic small and medium-sized enterprises (SMEs) and the local economy. It provides a conceptual framework for understanding the main enabling conditions and channels of FDI and SME spillovers and a set of diagnostic tools to assess potential in countries and regions. It also provides an assessment tool for the effectiveness of policy and institutional frameworks enabling FDI-SME linkages, with a typology of policy initiatives that can increase the impact of FDI on local productivity and innovation. This typology is derived from a mapping of institutions and policies across the 27 EU Member States and an in-depth pilot assessment of FDI-SME ecosystems in Portugal and the Slovak Republic.
Building back better after the COVID-19 crisis, enhancing resilience to future shocks, achieving a net zero transition and reducing inequalities will require higher productivity and more innovation, requiring, in turn, policies and enabling environments that foster greater diffusion of knowledge, technology and skills across heterogeneous regions. As firms and places look for new drivers of competitiveness and resilience within shifting global value chains (GVCs), strengthening FDI-SME ecosystems is key. Beyond its direct contribution to capital and employment, quality FDI can benefit host economies through knowledge and technology spillovers that increase productivity of domestic SMEs. FDI can also transmit new and more sustainable and responsible standards in business practices to SMEs in their value chains. In turn, SMEs and their innovation capacities are an important determinant of FDI location decisions, since foreign investors often choose specific locations based on the quality of local suppliers and the performance of SMEs. Resilient, reliable and innovative SMEs have become a strategic asset in multinationals’ investment and due diligence strategies.
Even if countries or regions attract quality FDI and host highly performing SMEs, FDI-SME spillovers may not materialise automatically.
Besides economic and market conditions, public policies and institutional arrangements play an important role in fostering knowledge and technology diffusion from FDI to local economies. A broad mix of policies can increase the magnitude of spillovers, by targeting FDI flows and characteristics, the absorptive capacity of SMEs, or some structural, economic and geographical factors (e.g. regional inequalities, or the presence and size of industrial clusters). Other public policies can also reinforce more specifically the FDI-SME spillover channels by targeting value chain linkages, encouraging strategic partnerships, easing labour mobility, or promoting competition effects.
This broad range of policies is typically implemented by multiple institutions operating at different levels of government (national and/or subnational), and across different sub-national dimensions, as well as at the intersection of investment, SMEs and entrepreneurship, innovation and regional development policies.
This Toolkit identifies the following strategic objectives for policy intervention:
Improving the governance framework for FDI-SME policies. Efficient co-ordination and alignment among the multiple institutions involved in the design and implementation of FDI-SME policies is key to reducing information asymmetries and transaction costs. The design of coordination mechanisms (e.g. formal or informal, top-down or bottom-up) should be carefully tailored to national contexts and their overall governance systems (e.g. federal versus central). Because FDI-SME policies can be introduced by various levels of government, including at the regional and local levels and including between sub-national governments, robust multi-level governance arrangements are instrumental in effective implementation. National strategies or action plans on investment promotion, entrepreneurship and innovation can also help overcome policy silos and create an integrated vision across the government. Good governance practices also include systematically evaluating policy impact and consulting with foreign investors and local SMEs.
Attracting productivity-enhancing FDI. The magnitude of spillovers is influenced by the volume and the type of FDI received, and the degree of FDI local embeddedness – i.e. the depth and extent of the investment’s ties to the local environment. An open, transparent and non-discriminatory regulatory environment is fundamental to attract FDI that creates linkages with the host economy. Different types of investment incentives (e.g. direct financial support, tax relief, regulatory concessions) can also be used to promote productivity-enhancing FDI, but their provision should be transparent, subject to regular review, and geared towards economic activities with higher potential for knowledge diffusion. Investment promotion agencies (IPAs) are key actors in delivering targeted investment promotion and facilitation packages, combining intelligence gathering (e.g. market studies), sector-specific events (e.g. business fairs, country missions) and pro-active investor engagement initiatives (e.g. one-to-one meetings, enquiry handling).
Fostering SME absorptive capacity. SMEs with strong absorptive capacity – i.e. ability to identify valuable knowledge from FDI and use it productively to improve their performance – are better positioned to benefit from FDI spillovers. On average across the EU area, 63% of measures in the FDI-SME policy mix are aimed at improving SMEs’ performance. Enhancing the quality of the regulatory environment (e.g. in product and labour markets, taxation, competition, insolvency regimes, licensing systems) can help improve SMEs’ capacities and incentives to scale up, and engage in knowledge-intensive collaboration with FDI. Beyond conducive regulatory frameworks, strengthening SMEs’ absorptive capacity requires a comprehensive mix of business support services to help them access the strategic resources they need to improve productivity (i.e. skills, finance and innovation assets). Raising the quality of local network and knowledge infrastructure, including universities, research institutions, technology transfer offices, business incubators and accelerators and other facilities can also contribute to creating knowledge and synergies.
Enhancing economic, structural and geographical factors. FDI-SME spillovers also depend on the economic, structural and geographical characteristics of the host countries and regions, such as their industrial specialisation, resource endowment or the existence of agglomeration economies. New industrial policies as they increasingly aim to strengthen innovation investment and networks, including through stronger GVC integration, can reinforce specialisation patterns and promote innovation diffusion. Strengthening clusters is also increasingly part of the FDI-SME policy mix as agglomeration facilitate FDI attraction and spillovers.
Strengthening the diffusion channels of FDI-SME spillovers. One way to increase diffusion is by promoting value chain linkages and strategic partnerships between FDI and domestic SMEs, e.g. through supplier development programmes or incentive schemes targeting foreign investors. Other initiatives can support the mobility of highly skilled workers from FDI to the domestic entrepreneurial ecosystem. Beyond active labour market policies, leveraging spillovers from labour mobility may require addressing structural challenges related to the capacity and skills endowment of domestic SMEs. In this perspective, governments may seek to expand the local talent pool by providing regulatory or financial incentives to facilitate the immigration of business talent from abroad or implementing international work placement and employee exchange programmes. FDI-SME knowledge diffusion can also be incentivised by creating market conditions for fair competition and knowledge exchange between foreign and domestic firms, e.g. through favourable intellectual property rights (IPRs) protection frameworks. Indeed, for innovation to blossom, start-ups and SMEs need to be able to appropriate the benefits of their investments and compete on a level playing field with incumbents and larger actors. When it comes to developing spillovers channels, EU countries appear to put the accent on strengthening value chain linkages and developing strategic partnerships between FDI and domestic SMEs (objectives that are respectively supported by 19% and 13% of FDI-SME measures on average), while only a smaller share of measures (3-4%) address the issues of labour mobility and competition.