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Should Indonesia Worry About Imported Intermediates?

Gonzalo Varela's picture

City and traffic lights at sunset in Jakarta. Source - Jerry Kurniawan, World BankIndonesia finds itself at a crossroads on the trade policy map. A turn in one direction may mean more openness and greater regional integration. A turn the other way—more protectionism and economic nationalism. Those advocating for the proper course share common concerns: the country’s increasing current account imbalance, deindustrialization in sectors built on booming commodity prices, and rising imports of intermediate inputs.

This last factor is perhaps most contentious. There are concerns that an increased reliance on imported inputs will slash domestic jobs and the local value added to exports. But are concerns about increased reliance on imported intermediates justified?
 

The global industrialization model has changed dramatically over the last few decades. Production is now fragmented, broken up into individual stages and spread across several locations and several firms—wherever the necessary skills and materials are available at competitive costs. This fragmentation of production processes creates international networks of supply chains all contributing to a single final good. The trading of inputs (intermediates) in this process has grown substantially, as the growth of imports of intermediates mirrors the growth of manufacturing exports along the chain.

And this has been the case in Indonesia. Recent World Bank research shows the availability and use of imported intermediates in the country has been associated with greater output growth, greater value added, and higher productivity. This has led to more jobs and higher wages. Furthermore, imported intermediates have been associated with improving product quality and expanding the number of products produced. In this way, they can be seen as contributing to the diversification of the Indonesian economy.

Contrary to concerns, the use of imported intermediates has not been associated with a decline in local manufacturing of inputs, less value added domestically, or job destruction. In fact the opposite is true. A rise in imported intermediates should be viewed as a positive sign. Indonesian firms are shifting away from resource-based and low value-added production toward more sophisticated production processes, and a careful examination of sector- and firm-level data show this to be true in a number of ways.

First, Indonesian firms that actually do use imported inputs are exceptional performers. They grow faster. They produce more. They add more value to products. And as a consequence, they demand more domestic intermediates. They’re more productive, hire more people, and pay better wages. Wages offered by a firm that sources 10 percent of its inputs from abroad are roughly 3.7 percent higher than one which does not.

Second, Indonesian firms have improved product quality through the use and availability of imported inputs in the market. Often times, these imported versions have helped firms that use them to relax technical constraints that were preventing them from improving their production processes or from climbing up the value ladder into a more sophisticated product. In addition, even if firms do not actually use the imported intermediates, the availability of these foreign inputs in the market adds competitive pressures to producers of domestic intermediates, which likely helps domestic firms further.  

To hammer that point home, our research shows that low import restrictions on imported intermediates actually has a substantially greater impact on the likelihood of producing higher quality products than the usage of imported inputs. We find a one percentage point reduction in input tariffs—from say 3.5 percent to 2.5 percent—would increase the probability of producing high quality products by more than 1 percent.

Third, the use and availability of imported intermediates facilitated by lowering tariffs has also boosted firms’ product diversification processes. Increases in firms’ use of imported intermediates by 10 percentage points, for example, are associated with an increase in a firm’s product scope by 1.22 percent. A similar effect results from a reduction in input tariffs by 1 percentage point. Interestingly, results suggest that increases in the varieties of imported intermediates have no bearing on firms’ diversification performance.

By adding to the pool of available resources, firms gain access to a more varied, cheaper, or higher quality inputs. These imported intermediates, therefore, can potentially be used to improve a firm’s production processes. It may also be true that better-performing firms are better positioned to access and afford these inputs, and, at the same time, are in a better position to innovate and improve. More importantly, what our analysis reveals is that the country’s best-performing firms are most adversely affected by restrictions on access to imported intermediates.
 
In our research, we focused on tariff restrictions, since these are more easily measurable. However, restrictions to access intermediates from the rest of the world also include complex non-tariff barriers or inefficient trade logistics systems that increase the costs of importing. These restrictions may have negative sector- and economy-wide knock-on effects in terms of productivity and, ultimately, job creation and wages. The evidence unveiled in our research should be kept in mind by policymakers envisioning a faster growing and more inclusive Indonesia.
 
Global production networks continue to expand, deepen ties, and cut costs. For emerging economies like Indonesia, access to and use of foreign intermediates will need to keep pace. The challenge is to make the most of this opportunity.

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