This article first appeared in Forum, The Edge Malaysia Weekly on September 2, 2019 - September 8, 2019

Research on firms is crucial to understand economic development. While a lot of attention is, rightfully, directed to households and governments, we must not forget that firms are where economic activities are organised and carried out. Thus, understanding the state of the companies in a given country is critical to evaluate its potential for future economic development.

One of the most striking lessons from global economic history is that becoming an advanced, high-income economy requires the existence and participation of large, homegrown firms. More specifically, and with very few exceptions, these large, homegrown firms that are so crucial to the development of their respective nations are those that compete globally and are at the forefront of technological frontiers.

There are several reasons for this. Being at the forefront of technology tends to require heavy capital expenditure or heavy spending on research and development, which are typically only possible at large firms. Economies grow primarily from learning by doing, which requires large-scale on-the-job training, with employees teaching and learning from each other — an outcome far more likely in large firms. There are also issues of coordination across industries and value chains to achieve scale, which, almost by definition, can only be done at large companies.

A recent study by economists Marcela Eslava, John Haltiwanger and Alvaro Pinzon provides empirical evidence for this observation on the primacy of large firms. The study focuses on manufacturing plants in Colombia and the US and asks the question, “Are there differences in the nature of the firm in Colombia and the US that explain the large productivity differences between firms in those countries?”

The authors found that, relative to US firms, Colombia had an “overwhelming prevalence of micro-establishments, a deficit of superstar plants and less strict market selection pressure for underperforming plants”. Micro-establishments, as defined in this study, are firms with fewer than 10 employees. In the US, micro-establishments account for 50% of total firms, providing 4% of total manufacturing employment, while in Colombia, micro-establishments account for a whopping 87% of total firms, providing 32% of total manufacturing employment.

The authors argue that the huge prevalence of micro-establishments, many of which are low-productivity firms, points to a business environment in Colombia that allows poor performers to remain in the market. The interesting follow-up question is, therefore, why do such firms continue to survive and remain in the market?

In Malaysia, according to the Department of Statistics, there are 694,000 micro-enterprises, making up 75% of total firms. The definitions are slightly different — the study defines micro-enterprises as those with 10 or fewer employees whereas the definition of micro-enterprises in Malaysia is those with five or fewer employees.

If we were to expand the thinking to also incorporate small and medium enterprises, there are about 907,000 SMEs, making up 98.5% of total firms in Malaysia. For context, there are 942 public-listed companies, a mere 0.1% of the total number of SMEs. SMEs employ about 10 million workers, about two-thirds of the country’s total number of employed people. Of these 907,000 or so SMEs, nearly 90% are in the services sector and 94% of micro-enterprises are in the services sector too.

The fact that 90% of Malaysian SMEs or 94% of micro-enterprises are in the services sector is not, by itself, indicative of a healthy or otherwise state of Malaysian firms. However, when combined with research done by Malaysian economist Allen Ng that traditional services comprise the bulk of the nation’s services industry, as opposed to modern services, it is therefore highly probable that the vast number of these firms are engaged in traditional services that are usually low value-added, low-productivity services.

If this is true, then the same question that was asked of the Colombian micro-establishments also applies to Malaysian SMEs and micro-enterprises. If indeed they are in low-productivity services, why then are so many of them still in the market and allowed to survive? Is access to financing just too easy for these firms? Or is Malaysian bankruptcy law too lenient? Whatever the case, the fact that these firms are in low-productivity services and without the benefit of scale means that their returns are unlikely to be strong. Consequently, they are unable to reinvest to either train their employees or to acquire new technology to become more productive.

In a healthy environment, we should see a continuous entry and exit of firms, indeed,  that some need to die off is part of the natural circle of life for any thriving economy. The economic history of the East Asian miracle nations — Japan, Taiwan and South Korea — point to a continuous process of weeding out unproductive firms, either via natural death or a series of industry consolidations that led to larger, more productive firms thriving in their respective industries. This process of firm turnover was a significant reason why these countries developed companies that became world-beaters such as Hyundai, Samsung, Honda, Sony, Sumitomo and Mitsubishi, among others.

The other issue with the prevalence of Malaysian SMEs and micro-enterprises in low-productivity economic activities is that both the business owners and employees of these firms may find it difficult to increase their earning power. This then leads to slower growth in domestic demand, which has an impact not only on the short-term indicators of the Malaysian economy, such as private consumption but also on the structure of the economy.

Joe Studwell, founding editor of the China Economic Quarterly, argues in his book, How Asia Works that land reform for agriculture in Japan, Taiwan, South Korea and even China (albeit in a hugely circuitous way that included the disaster of the Great Leap Forward) unlocked surpluses and savings to build the manufacturing bases in those countries.

Now, land reform may be extremely difficult to achieve in Malaysia today. But the logic of unlocking surpluses and savings still holds. So, what if we could achieve that same outcome of surpluses and savings by increasing large productivity gains in SMEs and micro-enterprises to the point that some business owners become more ambitious and try to build larger firms, or some employees transition towards more high value-added economic activities? Land reform in the East Asian miracles gave small farmers a sense of ownership of their land; SME and micro-enterprise owners already have that — the question is, how do we raise productivity such that we generate surpluses and savings that can be reallocated to more productive uses in the economy?

To be clear, this idea is one that is unproven and certainly worthy of serious scepticism. We do not know if the type of gains from land reform can be achieved by unlocking productivity gains from SMEs and micro-enterprises. But if there is a chance to get those types of gains, there is a chance to write a new chapter in Malaysia’s economic development history and to chart a new path towards a stronger, much more resilient economy built on the shoulders of a healthy state of Malaysian firms.

Nicholas Khaw is an economist with the Khazanah Research and Investment Strategy Division

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