How Investment and Trade Shape the Economic Transformation of Indonesia


Economic transformation into more manufacturing-based growth is still in the appetite of Indonesian policy makers. According to its latest development plans, Indonesia plans to utilise foreign investment and international trade to reduce the saving-investment gap, source important know-how, and exploit the Global Value Chain (GVC). However, Indonesia is growing more protectionist in its approach to international trade, while its openness to international capital is not progressing. The contrast between the plan and the policies could be traced to concern about current account deficit. Having a deficit on the current account is the consequence of importing capital, and this thesis tries to provide a framework to think about why short-term deficit on the current account is necessary for Indonesia’s economic transformation. Three papers organized in three chapters are used to argue the importance of openness in trade and investment for Indonesia’s economic transformation toward manufacturing. The first paper utilises the GTAP model, a multi-sector, multi-region static, structured economic model to show the impact of higher investment on Indonesia’s economy. The result suggests that opening the economy without any additional government intervention to capital distribution will lead to a higher growth of manufacturing sectors in a long-run scenario. Movement of factors would favour manufacturing sectors as growth is higher in these sectors, which will increase overall economic growth and welfare. Additionally, this paper provides the dynamics of Indonesia’s investment policy since the new order, and how Indonesia can improve its openness to the global capital market. The long-run result shown in the first paper is not a linear one, however. There will be a transition from the investment phase, where deficit in the current account must be tolerated, to the production phase where investment is diminishing and the interest rate is converging with the global economy. The second paper aims to show the dynamics of Indonesia’s economic transition, due to the openness, using a dynamic version of GTAP model called GDyn-FS. Indeed, the simulation shows that Indonesia will have a larger current account deficit during the investment phase, which last for 10 years since the implementation of more open policies. However, in 2050, Indonesia will see a higher current account thanks to improvement in the productivity of manufacturing sectors. The second paper also discusses Indonesia’s latest attempt for reform, the Omnibus Law, also called the Job Creation Law, which sees measures to improve Indonesia’s business climate significantly. Interestingly, along with the reform initiated by this Law, Indonesia’s appetite for economic protectionism does not seem to fade. The government keeps discouraging imports through both Tariff and Non-Tariff measures such as quota restriction and local content requirement. These measures, however, could potentially reduce competitiveness of manufacturing sectors since they restrict access to the international intermediate inputs market and prevent integration with the GVC. The third paper uses data from Indonesian customs matched with manufacturing survey to find relationship between import-reducing policies and firms' productivity. To reduce bias from potentially endogenous investment and intermediate input decisions by the firms, the Levinsohn-Petrin algorithm is added to the standard panel data fixed-effect regression. The result shows that import-reducing policies would reduce firms' total factor productivity as well as employment. More importantly, these policies hurt smaller firms more, which may put pressure on them to exit the market and affect competition negatively. While import-reducing policies are used with the intention of protecting local manufacturers, they are in fact hurting manufacturers in the higher chain of value and will be detrimental to Indonesia’s goal toward economic transformation.

PhD Thesis
Krisna Gupta
Krisna Gupta

Research mainly on international trade and investment policy and its impact on firms. Indonesia in particular is my main geographical focus.

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