Five industrial policy principles for small open economies

How are small open economies doing at industrial policy? Better than one might expect. OECD analysis shows that they tend to pursue less distortionary industrial policies than larger economies, avoiding the trap of propping up weak sectors.  But the room for error is narrow. In a world where production no longer respects sectoral or national borders, getting industrial policy wrong is a luxury that small open economies cannot afford. This blog post provides five principles for using industrial policy to build resilience and competitiveness without giving up the openness these economies depend on. 

A common criticism of industrial policy is that it can prop up inefficiencies by channelling support to ailing sectors that can’t compete. Small open economies seem to have largely avoided that trap. OECD Quantifying Industrial Strategies data show that in large economies sectoral support tends to flow toward industries with weak export performance: the first graph below shows the negative relationship between sectoral support as a share of sectoral value added and relative comparative advantage. In other words, larger economies seem not to back winners, but to support struggling sectors instead. This is in clear contrast to small open economies in the second graph. Facing intense international competition, continuing to avoid such distortions is key for them. 

The risk of distortions doesn’t stop at the border. For economies that depend on open markets for demand, inputs and access to knowledge, triggering subsidy races or fragmenting trade would be especially self-defeating. Openness, in this context, is not merely an attribute but a strategic asset to be protected. 

Targeting is unavoidable. No small open economy can support every sector: fiscal space is tighter, innovation ecosystems less diversified, and financing capacity more constrained. OECD data illustrate this: small open economies spend around 1.48% of GDP on grants and tax expenditures, compared to 1.68% in larger economies, some 12% less. 

No small economy can be at the global frontier in every field, so choices have to be made. Industrial strategy must determine where to push for frontier innovation and where, instead, to focus on absorbing and diffusing technologies developed elsewhere, a judgement that rests on a clear-eyed diagnosis of the economy's strengths, weaknesses and emerging opportunities. The record of small open economies is mixed, dotted with failures but also success stories. Korea, at the time a small open economy, pushed successfully into heavy and chemical industries in the 1970s and, from the 2000s, pivoted to biopharma, diagnostics, medical technology and advanced manufacturing. 

The design challenge is one of calibration. Too narrow a focus risks over-specialisation and vulnerability to sector-specific shocks; too broad a focus dilutes scarce resources to the point of irrelevance. The right approach pairs targeted support with investment in coordination, information-sharing and facilitation, not subsidies alone, alongside sustained monitoring and evaluation so that funds can be redirected when they underperform. For small open economies, with their comparatively limited means, this targeting window is especially narrow and hard to hit.

Most industrial policy still targets sectors in isolation, and OECD data show this is especially true of small open economies. They devote a third of their industrial policy spending to sector-targeted measures (0.47% of GDP out of 1.48%), against less than a quarter in larger economies (0.41% of GDP out of 1.68%). Yet this approach is increasingly at odds with how production actually works. 

Modern production is fragmented across countries and stitched together through complex input-output linkages, and small open economies are woven in more tightly than most. Their integration into global value chains runs deeper, and their dependence on cross-border production networks is greater than in large economies. Recent OECD Trade in Value Added (TiVA) estimates (2024) show how wide the gap can be: foreign value-added accounts for as much as 65% of exports in Luxembourg and 42% in Ireland, against 22% in Germany and 8% in the United States. On average, small economies rely on foreign inputs two to five times more heavily than large ones. 

The implication is that targeting a single sector, without regard for where it sits in the wider production network, risks missing the very channels through which policy effects travel. A disruption in one small but critical upstream input can cascade far beyond the sector first affected, as the global semiconductor shortage of the early 2020s demonstrated vividly. 

Effective industrial policy in small open economies must therefore shift from a sectoral to a value chain logic. This does not mean abandoning sector-based instruments, but embedding them in a broader framework that accounts for network position, cross-sector linkages and cross-border dependencies, one that reveals where intervention yields the greatest economy-wide return, in both growth and resilience.

For small open economies, no industrial strategy is purely a domestic affair. The costs of industrial policy, in subsidies and tax expenditures, are borne at home, yet its benefits often spill abroad through knowledge spillovers or increased demand for foreign goods. Resilience, in this context, means strengthening the international linkages on which these economies depend, not retreating from them.

The danger lies in unilateral competition. When countries vie for the same industries through ever-larger subsidies, the result is a race to the bottom in which public resources are transferred to firms with little lasting economic gain. Co-ordination offers the alternative. Through bilateral partnerships or multilateral frameworks such as the Important Projects of Common European Interest, countries can pool resources, reach the scale needed to compete globally, and align incentives rather than duplicate efforts. For small open economies in particular, co-ordination is not an optional add-on but a structural feature of any effective industrial strategy. 

In small open economies as in large ones, industrial policy cannot do its job alone. Competition policy keeps markets contestable and prevents protected industries from hardening into rent-seeking monopolies, a particular risk in small economies where each sector holds few players and concentration is naturally higher. Trade policy preserves access to inputs and export markets, a necessity for economies of this kind. Innovation policy aids the absorption of foreign technology and supports the diversification that reduces long-run vulnerability. Without coherence across these domains, even well-designed industrial policy can be undermined by the very environment in which it operates. 

Each of these five principles points back to the same balance, between the openness that drives prosperity and the resilience that guards against its risks. Getting this balance right is not easy. But it is precisely where the OECD’s work on industrial policy can make a concrete difference, offering a coherent framework, robust evidence, proven data methodologies and a basis for international collaboration, helping governments diagnose needs more precisely, monitor results and adjust course when policies fall short.  

Industrial policy has returned to a world more fragmented, more uncertain and more strategic than it was a generation ago. For small open economies, success is genuinely difficult: it requires being targeted but open, strategic but not distortive, national in design yet international in co-ordination. The goal is not to choose between openness and resilience, but to make the openness these economies depend on more resilient, while avoiding the familiar traps of poorly targeted support, weakened competition and measures that outlive their purpose.