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We should gain more from FDI
Amid the uncertainty in the global economy, good news seems to come from our Investment Coordinating Board (BKPM)
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mid the uncertainty in the global economy, good news seems to come from our Investment Coordinating Board (BKPM). Indonesia will remain a major foreign direct investment (FDI) destination (The Jakarta Post, Jan. 2).
In fact, inward FDI realization jumped to a new record high of US$587.41 million in the third quarter of 2012, or 22 percent higher than the previous year. However, is that the only news we can expect to hear regarding the presence of foreign investment in our economy? What about the impact of the inward FDI, especially in the manufacturing industry, where about a quarter of our national output lies?
Alongside its determinant factors, the impact of inward FDI on the performance of the host developing economies has been intensively studied over the past two decades. This is based on the fact that developing economies have increasingly relied on inward FDI as a source of assistance for economic development, but on the other hand the effectiveness of this policy has been questioned.
A slew of recent studies on FDI impacts have signaled mixed results. Likewise, as FDI policy in East Asian developing economies is distorted, so has the impact in each of the host economies varied. Throughout the last three decades most of the host economies in East Asia have benefited substantially from FDI inflows mainly in terms of employment and export expansion, but the evidence on output and productivity enhancement is mixed (Urata, 2006; Sussangkarn, et al., 2011).
Therefore, there is contradictory evidence to the orthodoxy of the undoubted positive impact of inward FDI. The orthodoxy is based on the view that FDI can directly convey output, capital and employment augmentation to the host economy. In addition, FDI is also expected to have an indirect impact in terms of productivity and technology spillovers. FDI is also recognized as bringing long-term investment. However, this orthodoxy ignores the other face of FDI. FDI may also have a negative impact.
First, foreign plants can reduce the productivity of domestic plants through competition or crowding-out effects. Second, foreign plants may exploit the host market and its resources without bringing any productivity spillovers, when they are able to prevent their firm-specific advantages from leaking to domestic plants. Thus, what is good for foreign investment does not always correlate with the host economy.
Furthermore, recent FDI impact studies confirm that the benefits of FDI might only appear under some conditions relevant to the host economy. Host economy characteristics, which include human development and technological levels, quality of institutions and trade policy regimes, are influential since they relate to the degree and speed of the host economy in channeling the benefit of foreign investment.
So, the new wisdom in this field is that the benefits of inward FDI are not unalloyed. Rather, it depends on the capacity of the host economy to utilize and channel the effects positively.
Indonesia as a developing economy has gone through the dynamic phases of industrial development, where foreign investment has shown a long period of extensive involvement.
Indonesian policymakers have long been in favor of the FDI-assisted development agenda. With regard to FDI policy, since the 1970s there have been various financial incentives and other special facilities offered to attract more inward FDI to the economy.
As a result, the economy as a whole — and particularly its manufacturing sector in the period of the 1980s-1990s, also later in the mid 2000s after the economy’s recovery from the Asian financial crisis — has been perceived as an attractive destination for foreign investment. This preference is notably affected by the economy’s inclination to greater openness toward both foreign investment and trade.
However, several empirical studies of FDI impacts on the Indonesian manufacturing sector, including our own for the period of 1990-2010, uncover two interesting findings.
First, in general the beneficial impacts of inward FDI on the performance of the Indonesian manufacturing sector, either directly or indirectly, are not strong.
Productivity spillovers from FDI to domestic plants are at a low level, due to the lack of linkages between foreign and domestic plants. Supply-chain linkages between foreign and domestic plants are well-known as an important conduit for productivity and technology spillovers.
This is caused by several factors. Our industrial structure is still underdeveloped, that is to allow for the existence of an adequate number of qualified domestic suppliers and supporting industries.
Furthermore, the open-trade policy regime that was first introduced in the mid-1980s has given an incentive for the preponderance of foreign manufacturers to fulfill their needs by intermediate inputs from external markets.
Foreign plants have benefited more from the policy, whereas domestic plants have failed to take advantage. This is, in part, due to the excess of trade liberalization in the economy.
Progressive trade liberalizations of our economy have allowed for multinational firms to exercise efficient direct production, particularly due to low labor costs but at the expense of domestic suppliers. Moreover, this also reflects the low technological capacities of the domestic plants.
Indonesia’s high economic growth plus FDI incentives have succeeded in attracting large amounts of FDI, which to some extent creates positive impacts. But, the sudden shift from the import-substitution policy toward the export-promoting policy in the mid-1980s which then introduced progressive trade liberalizations into the economy have merely increased our dependency on intermediate input imports, rather than enlarging the opportunity and capacity of the domestic plants. It means our industrial policy has been outperformed by trade policy.
Looked at from this point of view, the policymakers apparently have been unsuccessful in channeling more advantages from FDI. Therefore, their aim to attract more FDI needs to be questioned. Instead, in order to gain more from FDI, it is important and timely for policy makers to shift their focus from attracting more FDI to building more channels of FDI impacts.
The next item on the agenda of the policymakers includes synergizing the trade policy with industrial policy. Particularly, some initiatives should be taken in order to build stronger linkages between foreign and domestic plants, as well as to reduce the economy’s high dependency on imports of intermediate inputs. This is imperative since in the near future we are going to encounter a more liberalized trade regime.
In this respect, the development strategies and experiences of Japan and East Asian newly industrialized economies (Hong Kong, Taiwan, South Korea and Singapore) provide good lessons. During their earlier stage of development, these economies applied distinctive trade policies which were characterized as a coordinated pursuit of infant-industry protection and export promotion.
Thus, their development strategies involved interrelated trade and industrial policies. That is to allow for a constant upgrading of their industrial structures based on the development of technological capabilities, sometimes with the help of appropriate import protections, government subsidies and institutional building.
Another important item on the agenda is to create some incentives and healthy environments to improve the level of technological capabilities of domestic manufactures. This is crucial in order to increase the productivity and technology spillovers from FDI, through higher supply-chain linkages between foreign and domestic plants, and greater learning capacities of domestic plants.
For that reason, more incentives that facilitate the upgrading of technological capabilities of domestic manufacturers, such as in the use of new technologies or machinery, are needed. Likewise, it is also important to leverage the quality of educational institutions in the economy, both in the higher education and
vocational institutions.
The author, a lecturer at UPH Surabaya business school, is pursuing a PhD at the international trade and commerce department of Kyungsung University, Republic of Korea.
