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Study: Liberalizing Foreign Investment in Services Boosts Manufacturing in Indonesia

Gonzalo Varela's picture

Rice sacks on a truck in Indonesia. Source: http://www.flickr.com/photos/ricephotos/6025129068/Sometimes trade policy works through unexpected channels. In the case of Indonesia, opening the services sector to foreign investment appears to be a way to significantly boost the productivity of domestic manufacturing firms, according to recent joint research from the World Bank’s Office in Indonesia and the International Trade Department. This finding has implications for governments around the world that have restricted foreign investment in services – such as transport, electricity and communications – that are vital to other productive sectors in the economy.

Foreign direct investment, or FDI, is investment in the local economy by foreign-based companies. In recent years, there has been growing recognition that the benefits of FDI – increased competition and resource availability, as well as the transfer of knowledge and technology – outweigh the risks, but the services sector has been slow to liberalize. Globally, services sectors are the target of the most restrictions on the flows of foreign direct investment (FDI). Historically, governments have restricted this type of investment because of concerns around national sovereignty. Put bluntly, governments worry that they will have little control over large, multinational corporations that own majority stakes in firms operating in sectors considered to be strategic within their borders, such as ports, telecommunication companies, etc.

The services sectors are vital to Indonesia’s economic health. They account for half of the country’s employment and more than half of its gross domestic product (GDP). More importantly, services are well-linked to all other sectors of the economy. In fact, services make up 35 percent of inputs into all of the countries productive sectors, including a range of manufacturing industries.

Indonesia executed a wave of liberalization after the Asian financial crisis. While services lagged behind other sectors, reforms did open up some competition in services. The government set up bodies to regulate services and abolished monopolies held by state-owned enterprises, allowing space for more private operators, including those with foreign investment. These reforms had a tremendous impact on the country’s growth, and helped cement its position as one of the largest and fastest-growing economies in Asia.

Despite these efforts, however, the services regime in Indonesia is the second-most restrictive (after China) of 55 countries surveyed by the Organization for Economic Co-operation and Development (OECD). Our research used several sources of data to examine the impact of services-liberalizing reforms between 1997 and 2009 on the productivity of Indonesian manufacturing firms. The logic was this: if services related to logistics and freight transportation are sheltered from foreign investment and competition, for example, a domestic chemical manufacturer in Indonesia will have fewer options to choose when contracting trucking or freight forwarding services, which will likely affect the quality of service provided. Allowing a foreign-owned company (a firm with more than 50 percent of equity owned by foreign investor) to provide trucking or freight forwarding services would increase competitive pressures on the sector and increase the quality of the service obtained by that chemical plant.

We found that post-Asian-crisis reforms in Indonesia added roughly 0.4 percentage points annually to the productivity of manufacturing firms between 1997 and 2009. The relaxation of policies restricting FDI in the service sectors accounts for 8 percent of the total productivity growth that manufacturers achieved during the study period.

We found that both domestic-owned and foreign-owned manufacturing firms benefited from reforms to the services sectors. Better-performing firms benefited most from the liberalization. Importantly, we found that not all reforms were equal. Liberalization of the transport, electricity, gas and water sectors were most important to manufacturers. Additionally, lifting certain restrictions mattered more than lifting others. In particular, relaxing equity restrictions so that foreign firms could eventually hold a majority on a domestic firm’s board of directors is important. Anecdotally, this type of concession allows foreign owners to better influence operations and makes them more apt to deploy their best systems and technology.

Indonesia has a long way to go in lifting services restrictions. But the evidence shows that allowing more flexibility in foreign investment in services could have a tremendous impact on the economy overall. It would benefit domestic producers as well as foreign companies and is key to sustainable, long-term development.

Comments

Submitted by Gerginto on

Dear Mr. Varela,

This paper has been an extraordinary insight for me, since recently i have been involved in studying and examining the financial liberalization effect in Indonesia due to ASEAN Economic Community (AEC).

From what i have learned from your paper, it was stated that liberalization in services could boost the manufacturing, and recalling at Notes section number 5 "transportation, communications and finance are top three priority sector according to Arnold", and it is very clear that we have the same idea on this.

Yet there is an interesting fact "China is the most restrictive country, however currently China is one of the largest economies in the world".

Question is, how China can become one of the largest economies and the most restrictive countries at the same time and how China can increase its competitiveness with lower transfer knowledge since there is fewer FDI as a result of restriction.

Thanks.

Gerginto - Fiscal Policy Agency - Ministry of Finance of Indonesia

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