Driving sustainable performance through green innovation and circular practices: the role of capabilities, finance, and institutions in SMEs sector

Circular economy practices (CEP) are vital for enhancing the sustainability and competitiveness of the SMEs in the manufacturing industry. Drawing on the Resource-Based View, Dynamic Capabilities Theory, and Institutional Theory, this study explores how internal capabilities and external enablers drive sustainable performance (SP) in China. Specifically, it examines the influences of knowledge management capability (KMC), environmental strategic orientation (ESO), and green finance accessibility (GFAC) on green innovation capability (GIC) and CEP, alongside the moderating role of institutional quality for sustainability (IQS). Survey data from 234 SMEs in the electronics, machinery, and auto parts industries were analyzed using Partial Least Squares Structural Equation Modeling (PLS-SEM). The results demonstrate that GIC is a critical mediating mechanism, transforming strategic, knowledge-based, and financial resources into operational CEP. A sequential mediation pathway (GIC to CEP) effectively links these enablers to SP. Additionally, IQS significantly strengthens the relationship between CEP and SP, confirming that regulatory clarity and enforcement are essential for realizing the performance benefits of circularity. These findings provide actionable insights for SMEs seeking to finance and innovate their circular transition, and for policymakers aiming to design supportive institutional frameworks.