With labor short and competition tough, Taiwan is urging its companies to improve quality if they are to maintain their export drive.

"If local industries fail to sharpen their competitive edge, Taiwan products will be gradually edged out of the international market" by goods produced in Taiwan-backed firms in China and Southeast Asia, the Ministry of Economic Affairs said.It urged domestic companies to upgrade product quality to meet the stiffer competition from those areas. Both are developing rapidly, fueled by heavy flows of foreign investment in technology and management.

Improving quality is also proving difficult, however.

A separate ministry survey shows just over 80 percent of Taiwan's small and medium-sized businesses struggle to hire research and development staff. About 75 percent termed the labor shortage their biggest woe.

The survey, conducted every three years by the ministry, polled 1,500 firms, concentrating on 1992-94 conditions.

In response to the labor shortage, 74 percent of respondents described themselves as in a "transitional" mode, trying to enhance products or move into new areas. Twenty percent said they had already done so and 4 percent said they'd tried but failed.

One indication of the change in emphasis from manufacturing is that employment in the island's service sector exceeded 50 percent of total employment this year for the first time.

Half of the companies with operations abroad said the main impetus was

finding cheap labor. Less than one-fifth gave market exploration as the primary reason.

China remains the most popular investment destination for all Taiwan businesses, with 75 percent of those quizzed in the small/medium category having operations there. Thailand and Malaysia came next as popular destinations.

Malaysia's international trade and industry minister, Rafidah Aziz, said during a recent visit to Taiwan that her government is "comprehensively improving" its investment climate to attract more foreign investors, particularly from Taiwan.

Taiwanese firms invested about $1.15 billion in Malaysia last year, vaulting it into first place. Japan ranked second at $706 million, followed by the United States ($501 million) and Singapore ($425 million).

Taiwan's investment in Malaysia in 1994 was three times the 1993 level, when it placed third after the United States and Japan.

Most Taiwan investments in Malaysia are technology- or capital-intensive,

because Malaysia is also chronically short of skilled labor.

China is the world's largest recipient of overseas investment, with a total of $68 billion pledged last year. Funds actually came to $27.7 billion, up 38 percent over a year earlier, government figures show.

Direct foreign investment in Taiwan last year was under $1.5 billion, according to the Council for Economic Planning and Development. Interest rebounded in the first eight months of this year, however, with $1.48 billion recorded by the commission, an increase of 60 percent from the 1994 period.

American companies set the pace, boosting investment more than 200 percent to $452 million in the eight months.