Research & Policy Briefs From the World Bank Malaysia Hub No. 65 November 18, 2024 Leveraging Foreign Direct Investment in Indonesia: Assessing Foreign Investor’s Use of Domestic Suppliers Tristan Reed, Mochamad Pasha, Alvaro Gonzalez After Indonesia liberalized investment rules, foreign direct investment (FDI) increased. The government promoted linkages between foreign investors and local firms, but the impact on employment and productivity remains to be determined. Manufacturing survey data indicate a modest role for local suppliers, with three-fourths of jobs from FDI created directly within foreign firms, and only one-fourth upstream. Evidence suggests success in policies encouraging the local transformation of imported inputs: foreign firms source 83 percent of inputs locally, compared to 71 percent for domestic firms. Job creation, labor productivity, and wages at foreign firms declined, likely due to the increased use of unskilled labor, while in upstream local firms, productivity and profitability grew, but wages remained stagnant. Overall, FDI is mainly "domestic market-seeking" rather than “export-oriented” or "efficiency-seeking," intended mainly to serve a large and competitive local market. Investment in research and development (R&D) is low. Indonesia may be missing key opportunities for more profound economic transformation and poverty alleviation by not engaging more with international markets and innovation. There are emerging opportunities to attract "efficiency-seeking" FDI to boost exports and enhance upstream linkages. Introduction What is FDI used for at foreign firms? Foreign direct investment (FDI) has expanded rapidly in Many of the jobs created through FDI by foreign-owned firms in Indonesia, but it still needs to catch up to other large emerging Indonesia do not raise wages; thus they do not raise living markets as a share of GDP. Indonesia has inward FDI worth 22 standards.. The impact of FDI on an industry takes time to percent of GDP, while the Arab Republic of Egypt has 34 emerge. Five years after a 1 percent increase in FDI in percent, and Vietnam has 55 percent, the most recent data Indonesia, production employment, which refers to jobs (UNCTADstat, WDI) show. In 2017, the Philippines, an island directly involved in manufacturing of goods or services in an state with a lower GDP per capita than Indonesia, overtook industry increases by 0.15 percent (figure 1, panel a). This Indonesia by this measure to have inward FDI worth 29 percent suggests that FDI is associated with job creation. Troublingly, of GDP (UNCTADstat, WDI). however, this increase in employment coincides with a decline in the real wage rate of about 0.1 percent over five years The Indonesian government has implemented significant (relative to other industries not receiving FDI) (figure 1, panel reforms to attract FDI, most notably by passing Law No. b). An explanation for the wage decline is falling labor 25/2007, which unified the framework for all investment productivity. Over this five-year period, labor productivity also activities and replaced outdated regulations. Initially met with fell by 0.1 percent (figure 1, panel c). The wage decrease cannot mixed reactions, the law has been revised multiple times, with be explained by labor market power because profit margins recent updates in 2021. Subsequent liberalization increases FDI dropped by 1 percentage point (although not statistically flows to liberalized sectors, Montfaucon, Senelwa, and Doarest significant) (figure 1, panel d). If employers had strong labor (2023) show. Attracting foreign investment depends on a market power, they could suppress wages to boost profit robust policy framework and efficient business practices. While margin, but in this case, profit margins also decline. While FDI Indonesia has made progress, legal and regulatory reforms are appears to create employment in foreign firms, it does not ongoing to fully leverage FDI’s potential for job creation, drive productivity and wage growth that could raise living innovation, and economic growth. standards. At the same time, it generates less significant profit The government has also focused on enhancing FDI's margins; lower margins, in turn, make additional foreign impact on development by promoting upstream linkages investment less attractive. between foreign-owned and domestically owned firms. Such One explanation for declining wages after FDI is that foreign linkages are crucial for knowledge diffusion and economic direct investment projects are more intensive in unskilled labor. growth. This Policy Brief quantifies the magnitude and effects The Indonesia Labor Force Survey classifies workers as unskilled of FDI and business linkages in Indonesia, analyzing how if they have not yet completed secondary school. Though the changes in FDI affect outcomes within and for downstream share of skilled workers has increased over time in most industries. The analysis uses data from the Indonesia industries, consistent with investment in human capital across Investment Coordinating Board and the annual Manufacturing the country, the share of skilled workers has grown more slowly Industry Statistics, categorized by foreign and domestic in sectors where FDI has grown faster. In some industries with ownership at the 2-digit ISIC Rev 4 level. Further details on the significant FDI growth (namely, Machinery, ISIC 28 and approach are provided in the Technical Appendix. Machinery repair, ISIC 33), the share of skilled workers has fallen. Affiliations: Tristan Reed is an economist with the Development Research Group (DECMG), World Bank. Mochamad Pasha is an economist in the World Bank East Asia and Pacific. Alvaro Gonzalez is lead economist in the World Bank East Asia and Pacific. Acknowledgements: The authors would like to thank Alexandre Hugo Laure, Aufa Doarest, Agnesia Adhissa Hasmand, Gonzalo J. Varela, Ivan Anton Nimac, Priyanka Kher, and Habib Rab, as well as the participants of the Prosperity Practice Group Knowledge Exchange Indonesia, for their valuable comments and suggestions. Nancy Morrison provided editorial assistance. Objective and disclaimer: Research & Policy Briefs synthetize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Leveraging Foreign Direct Investment in Indonesia: Assessing Foreign Investor’s Use of Domestic Suppliers Figure 1. Foreign direct investment in Indonesia from foreign-owned firms creates jobs but does not increase wages, productivity, or profit margins Direct effects of FDI on foreign owned firms a. Production employment b. Wage rate .25 .05 .2 Percent change 0 Percent change .15 −.05 .1 −.1 .05 −.15 0 −.2 0 1 2 3 4 5 0 1 2 3 4 5 Years after 1 percent increase in FDI Years after 1 percent increase in FDI c. Labor productivity d. Gross profit margin .1 2 Percentage point change 0 Percent change 0 −.1 −2 −.2 −.3 −4 0 1 2 3 4 5 0 1 2 3 4 5 Years after 1 percent increase in FDI Years after 1 percent increase in FDI Source: Statistik Industri; Indonesia Investment Coordinating Board. Note: The analysis covers 2008-2018. The line shows the cumulative impact over five years following a 1 percent increase in FDI compared to industries that did not receive FDI. The dotted line indicates a 90 percent confidence interval. FDI = foreign direct investment. Production employment refers to jobs directly involved in manufacturing of goods or services. Most FDI can be classified as “domestic market–seeking” or FDI in Indonesia appears to be primarily domestic “efficiency-seeking,” with efficiency-seeking investments market–seeking rather than efficiency seeking. Declining labor having more significant potential for scale and development productivity in foreign firms after FDI (figure 1, panel c) impact. FDI is “efficiency-seeking” when multinational firms suggests that foreign direct investment does not seek to choose to locate in a country because it is highly productive, increase productive efficiency. Consistently, exports do not allowing them to export at internationally competitive grow significantly after foreign direct investment. Indonesia’s prices and potentially undertake research and development. participation in global value chains is low and, in some cases, In contrast, in “domestic market–seeking” investment, declining, as documented by the International Finance foreign-owned firms invest in meeting domestic demand they Corporation (IFC) Country Private Sector Diagnostic (IFC 2019). cannot meet by importing into that country: for instance, At the same time, given that foreign firms’ profit margins do because of tariff or nontariff measures or simply because of low not rise after FDI, foreign investment does not appear to be value per weight of their goods, as in the case of beverages and “rent-seeking.” It is primarily invested to capture excess profits certain food products. Because domestic market–seeking in the local market. Together, these results suggest that FDI investments target only the domestic market, their potential projects in Indonesia are intended mainly to serve a large and employment growth is limited by the size of the domestic competitive local market. Though FDI may not achieve economy.1 In contrast, the potential employment growth from productivity gains, one benefit of FDI in Indonesia appears to efficiency-seeking investments is more significant and is limited be increased demand for domestically produced inputs. Five only by the size of the global export market. Efficiency-seeking years after a 1 percent increase in FDI, domestic input investments also have greater potential to raise wages because purchases rose by 0.18 percent, and imported input purchases of their emphasis on productivity and innovation, which can changed little. The productivity benefits of FDI may potentially translate into higher wages for skilled workers. lie upstream. 2 Research & Policy Brief No.65 Only in two industries is FDI significantly associated with these industries and that further “efficiency-seeking” investment wage growth and employment growth, a pattern called the could be attracted. creation of “good jobs.” These industries are Textiles (ISIC 13) and Electrical Equipment (ISIC 27). Though these industries How prevalent are business linkages between foreign may serve only the domestic market, wage growth suggests and domestic firms, and what are their effects? productivity growth that could be used to gain a competitive advantage in international markets. Only in two sectors is FDI The Indonesian automotive industry offers compelling evidence significantly associated with increases in exports. These for learning spillovers triggered by foreign investment. For industries are Other Manufacturing (ISIC 32) and Metal Goods, instance, Japanese automakers appear to generate vertical and Not Machinery and Equipment (ISIC 25). This pattern suggests backward spillovers (Takii and Narjoko, 2012). Vertical spillovers that Indonesia may have a strong comparative advantage in directly benefit local metal component producers supplying Table 1. Most inputs purchased by foreign-owned firms in Indonesia are produced domestically Percent of input value produced domestically RIPIN Foreign firms Domestic firms Priority ISIC Sector Code Industry 1999 2009 2019 1999 2009 2019 All Industries 75 78 83 47 51 71 YES 16 Wood 97 95 96 95 87 95 YES 31 Furniture 94 84 93 84 61 84 YES 10 Food 90 86 93 81 79 89 YES 23 Nonmetal Minerals 62 82 90 41 26 82 YES 17 Paper 62 75 87 48 82 96 YES 28 Machinery 81 64 86 45 34 85 YES 29 Vehicles 32 62 81 9 62 63 YES 22 Rubber/Plastic 84 92 80 66 77 81 YES 20 Chemicals 58 82 80 48 61 70 YES 13 Textile 72 62 78 48 53 74 YES 33 Machinery Repair 100 100 77 23 12 89 YES 24 Base Metal 37 62 71 35 31 66 YES 15 Leather/Footwear 36 53 61 46 44 54 YES 14 Apparel 52 54 58 45 41 55 YES 21 Pharma 59 31 55 25 5 48 YES 27 Electrical Equipment 58 54 52 28 68 65 YES 30 Other Transport 62 37 36 13 71 43 YES 26 Computers 12 84 27 31 57 35 NO 11 Beverage 94 84 94 87 66 96 NO 18 Printing/Media 93 95 92 97 100 86 NO 12 Tobacco 94 87 80 72 68 67 NO 19 Coal/Petroleum 75 78 78 21 76 78 NO 25 Metal Goods 59 57 64 33 51 61 NO 32 Other Processing 59 63 58 36 36 43 Source: Statistik Industri Note: Sectors with over 70 percent domestic input usage are shaded blue, with darker shades indicating higher usage. Red shading denotes sectors using less than 55 percent domestic inputs, with darker shades indicating even lower usage.. . ISIC = International Standard Industrial Classification; RIPIN = Rencana Induk Pembangunan Industri Nasional (National Industrial Development Master Plan) 2015–2035. 3 Leveraging Foreign Direct Investment in Indonesia: Assessing Foreign Investor’s Use of Domestic Suppliers to these companies. Through collaboration and technical input from a firm in the supply chain, jobs are created upstream. from the Japanese firms, these suppliers experience product Recall that a 1 percent increase in FDI in Indonesia raised design and quality enhancements. This improvement then employment by only 0.15 percent after 5 years among foreign ripples outward through backward spillovers, benefiting other firms in the same industry (figure 1, panel a). After a 1 percent clients (local and foreign) of the now-improved local suppliers, increase in FDI in downstream industries, employment in the which consequently gain the capacity to produce better-quality upstream sector increases by only 0.05 percent after 5 years products. (figure 2, panel a). Combining these estimates, about three-fourths of jobs created by FDI are in foreign firms, and Overall, linkages between FDI projects and domestic firms one-fourth of jobs created by FDI are through upstream are widespread. Foreign firms purchased about 83 percent of linkages.2 In contrast to the direct effects of FDI on foreign the value of inputs from domestic producers in 2019, more firms, upstream effects of FDI increase labor productivity, than in the past and typically more than domestic firms in the which grows by about 0.15 percent 5 years after a 1 percent same industry (table 1). In most sectors prioritized by the increase in FDI downstream (figure 2, panel c). They also National Industrial Development Master Plan 2015–2035 increase the profit margin, which increases by 1.75 percentage (RIPIN), more than 75 percent of inputs purchased by foreign points (figure 2, panel d). Increases in the profit margin firms were domestically produced. In only two industries did upstream may account for the fact that the wage rate upstream foreign firms purchase less than 50 percent of inputs from does not rise after FDI despite increases in employment (figure domestic producers—Other Transport Equipment Industries 2, panel b). (ISIC 30) and Manufacture Computers, Electronics, and Optical Goods (ISIC 26). Overall, local businesses appear tightly One explanation for the association of linkages to FDI integrated with foreign-owned firms through input supply projects and productivity is that domestically owned firms relationships. primarily transform imported inputs before supplying them to foreign-owned firms. A 1 percent increase in FDI upstream is FDI increases upstream employment, productivity, and associated with an immediate 0.1 percent increase in imported profits through business linkages. When FDI occurs downstream input purchases by domestic firms; this percentage grows Figure 2. After FDI downstream, domestic firms create jobs and increase labor productivity, though wages are stagnant as profit margins rise Upstream effects of FDI on domestically owned firms a. Production employment b. Wage rate .1 .02 Percent change Percent change 0 .05 −.02 0 −.04 −.06 −.05 0 1 2 3 4 5 0 1 2 3 4 5 Years after 1 percent increase in FDI downstream Years after 1 percent increase in FDI downstream c. Labor productivity d. Gross profit margin Percentage point change .2 3 Percent change .15 2 .1 1 .05 0 0 −1 0 1 2 3 4 5 0 1 2 3 4 5 Years after 1 percent increase in FDI downstream Years after 1 percent increase in FDI downstream Source: Statistik Industri; Indonesia Investment Coordinating Board. Note: The analysis covers 2008-2018. The line shows the cumulative impact over five years following a 1 percent increase in FDI compared to industries that did not receive FDI.. The dotted line indicates a 90 percent confidence interval. FDI = foreign direct investment. Production employment refers to jobs directly involved in manufacturing of goods or services. 4 Research & Policy Brief No.65 slightly over time. Previous research has found that users of However, the imposition of tariffs and nontariff measures poses imported inputs in Indonesia grow faster in terms of value a potential threat to the efficacy of local content regulations. added and employment and have improved and diversified These trade barriers could complicate the importation of product quality in the market (Rahardija and Varela 2014). necessary inputs, thereby limiting the overall productivity and competitive advantage of domestic suppliers. Similarly to the direct effects of FDI on foreign firms, upstream FDI does not increase the export or intangible asset Indonesia needs to shift its investment promotion strategy investment of domestic firms, suggesting limited development to capitalize on the growing export opportunities to the United impact from business linkages to FDI projects. While upstream States and Europe. It should target investment promotion FDI leads to some increases in labor productivity, it does not toward efficiency-seeking and domestic market–seeking raise productivity to the point where domestic firms become projects. Indonesia has a significant opportunity to grow competitive enough to export and does not increase their exports to the United States and Europe as they seek to investment in innovative activities, including research and diversify its supply chains away from Chinese exports (World development (R&D). In Indonesia's economy, large firms hold Bank 2018, 2020). Yet, capturing this export opportunity will significant economic power and market influence, which may require foreign investment to contribute technology, limit competition and innovation in the manufacturing sector know-how, and trading relationships. Despite significant (World Bank, 2024). Despite regulatory reforms, persistent liberalization, export-oriented firms have yet to be attracted. issues such as regulatory overlap, low-quality regulations, and Efforts to attract them include the following. poor coordination create uncertainty (World Bank, 2022). This Identify the most productive local suppliers for FDI projects ambiguity not only hampers firms' investment and innovation and assess whether they have the capacity or willingness to but also deters new FDI, reducing competitive pressure expand exports. This evaluation can involve conducting supplier and further weakening incentives for innovation surveys and visiting the facilities of shortlisted candidates. (Hallward-Diemeier and Pritchett, 2015). Following the initial identification, these suppliers' willingness and capacity to expand their production capabilities to meet Policy implications export demands can be assessed. FDI in Indonesia has been a significant factor in job creation, Ensure tariffs and nontariff measures do not bind domestic particularly for the lower-skilled workforce. However, the firms supplying foreign investment projects. Business linkages impact of FDI on productivity could be greater and more with foreign firms rely on domestic firms' ability to transform precise. While it does provide jobs, there is little evidence to imported inputs. Trade barriers affecting these firms could hinder suggest that it substantially boosts productivity levels within their ability to supply domestic firms. In addition, policymakers the local economy. Moreover, these investments are could consider implementing measures to enhance market predominantly oriented toward serving the domestic market. competition and ensuring a more balanced regulatory This inward focus means that the projects are less concerned environment that encourages innovation across firms. with exports or driving innovation. This raises questions about the alignment of Indonesia's FDI with the broader evidence Notes that suggests exports are a crucial pathway to achieving 1 Intel’s decision in 1996 to invest in a semiconductor assembly and test (A&T) plant in Costa Rica is a leading example of long-term poverty reduction (Goldberg and Reed 2023). “efficiency-seeking” investment that exploited local human capital Indonesia may miss key opportunities for more profound and a duty-free investment zone to drive significant exports, economic transformation and poverty alleviation by not additional FDI into the technology sector, and GDP growth (see engaging more with international markets and innovation. World Bank Group/MIGA 2006). FDI in Viet Nam was a significant driver of export success and employment growth, even up to 16 Foreign firms in Indonesia predominantly source their years after the firms entered (McCaig, Pavcnik, and Wong 2023). inputs from domestic companies. This dependence on local 2 In domestically owned firms in the same industry as the industry inputs could indicate Indonesia's distinctive natural resources receiving foreign investment, jobs creation is negligible, or the impact of its local content regulations. These domestic suggesting minimal “horizontal spillovers” from FDI, as also firms typically transform imported inputs into finished goods, documented by Blalock and Gertler (2008). Upstream, the percentage increase in employment is similar for domestic and which adds value and enhances the domestic supply chain. foreign firms. References Blalock, Garrick, and Paul J. Gertler. 2008. “Welfare Gains from Foreign Direct Investment through Rahardja, Sjamsu, and Gonzalo Varela. 2014. “Nothing to Fear but Fear Itself: Evidence on Import Technology Transfer to Local Suppliers.” Journal of International Economics 74 (2): 402–21. Intermediates in Indonesia.” Economic Premise Number 138, World Bank. 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