Service-sector reforms enhance manufacturing productivity: Evidence from Indonesia

Victor Duggan, Sjamsu Rahardja, Gonzalo Varela 22 May 2013

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Just as Cinderella was the forgotten sister with great potential, so service-sector foreign direct investment may be the neglected sibling of trade policy. As trade and foreign direct investment regimes have become more liberalised in recent decades, tariff reductions and foreign direct investment in manufacturing have hogged the limelight while foreign direct investment in services has often remained a wallflower. In fact, most restrictions on foreign direct investment flows today are in the service sector (UNCTAD 2004), reflecting the fact that governments – particularly in developing countries – are not willing to allow unrestricted foreign entry into sectors they consider sensitive or strategic.

The importance of service-sector reform

As Hoekman (2006) has noted, research on trade in services makes up only a small share of the total output in the international economics literature, reflecting, in part, the scarcity of data on policies and flows. Indeed, foreign direct investment in services has been as much the Cinderella of the trade literature as of trade policy.

The work that does exist linking service-sector reform and economic performance focuses on four different channels:

  • Services reform and economy-wide gains.
  • Services reform and service-sector performance.
  • Services reform and manufacturing export competitiveness, and the most closely related to our study.
  • Services reform and manufacturing productivity.

Empirical evidence

There is a growing strand of empirical research suggesting that the latter channel – linkages between service-sector reform and manufacturing firms’ productivity – may be more significant than previously credited. This phenomenon has been previously explored in the context of inter alia the Czech Republic (Arnold, Javorcik and Mattoo 2007), Chile (Fernandes and Paunov 2008) and India (Arnold, Javorcik, Lipscomb and Mattoo 2011), and for the sub-Saharan African region (Arnold, Mattoo and Narciso 2008). Broadly speaking, they find service-sector reform to be positively and significantly associated with productivity in manufacturing, with reforms in trade-related service sub-sectors – such as transport, communications and finance – having the greatest impact.

In a recent paper (Duggan, Rahardja and Varela 2013), we explore linkages between service-sector reform and productivity in downstream manufacturing in Indonesia since the east Asian crisis. We use firm-level data on manufacturers’ productivity from 1997-2009 and the OECD’s FDI Regulatory Restrictiveness Index, combined with data from Indonesia’s input-output tables regarding the intensity with which manufacturing sectors use services inputs. We also note that, even if the OECD restrictiveness indicator is designed for foreign direct investment barriers, it likely captures the overall policy-reform stance, which will have a stronger effect on service quality than policies targeting foreign direct investment exclusively.

Our results suggest that the relaxation of restrictions on service-sector foreign direct investment is associated with improvements in the perception of service-sector performance and, more importantly, in manufacturers’ productivity. We find that 8% of the observed increase in manufacturers’ total factor productivity during the period under study is accounted for by the relaxation of restrictions on service-sector foreign direct investment. We find further that if Indonesia were to match the foreign direct investment restrictiveness levels of reform champions South Korea or Brazil, the resulting total factor productivity gains would be in the order of 5% and 6% respectively. Productivity gains accrue to domestic and foreign manufacturers alike, with the most productive firms benefiting most.

Not all reforms are equal

Gains are related, in particular, to the relaxation of restrictions in both the transport, and in the electricity, gas & water sectors – among those most closely interlinked with manufacturing. These gains are associated, moreover, with the relaxation of foreign equity limits, screening and prior approval requirements, but less so with discriminatory regulations that prevent multinationals from hiring key personnel abroad.

Figure 1. Service usage intensities across manufacturing sectors

Source: Authors’ calculations based on input-output tables, BPS.

Indonesia: Reformed service sector driving post-crisis recovery

Since the east Asian crisis, Indonesia has undergone political and economic transformation, with stability becoming entrenched. It is one of the largest and fastest growing economies in Asia, in turn one of the world’s most dynamic growth poles. The business environment has also improved dramatically. Overall, the country has become more open to trade and foreign direct investment, liberalisation being particularly deep in the immediate aftermath of the crisis.

Figure 2. Change in restrictiveness over foreign direct investment in Indonesia’s services sector

Source: Authors’ calculations based on OECD.

Indonesia is relatively open in terms of trade in goods, but restrictions on foreign participation in the services sector remain pervasive, despite broad-based liberalisation efforts since 1997. According to the OECD’s 2012 Index, Indonesia’s service-sector foreign direct investment regime is the second most restrictive of 55 countries. Since a country’s foreign direct investment stocks are negatively associated with the restrictiveness of their foreign direct investment regime as measured by the OECD, and since its inward foreign direct investment stocks and flows lag regional peers, evidence would suggest that Indonesia has further scope to attract foreign investment.

While foreign direct investment flows now broadly reflect the size of Indonesia’s economy, the country accounting for both 1.2% of world foreign direct investment flows and 1.2% of world GDP, it still lags far behind regional peers and accounts for only 0.85% of global stocks of inward foreign direct investment. In 2011, the southeast Asia region accounted for 3.1% of global GDP, but 5.3% of global stocks of foreign direct investment and 7.6% of global foreign direct investment flows.

Nevertheless, the relaxation of regulatory restrictions in Indonesia, together with an increasingly attractive domestic market and relatively lower labour costs have contributed to a strong recovery in inward foreign direct investment flows across all sectors following their post-crisis reversal. Despite the relatively restrictive regime, foreign direct investment flows have been particularly strong in the services sector, accounting for 40.1% of all inward foreign direct investment in 2011, driven in turn by investments in the Trade and Transport & Communications sub-sectors.

Goods and services: Mutually reinforcing liberalisation

Openness in the services sector is part and parcel of a comprehensive liberal trade policy. The benefits of liberalising the services and goods markets can be mutually reinforcing, the full potential of each not being realised without adequate openness in the other.

As it is the case in most emerging economies, there is a strong case for further opening up services in Indonesia. Services is not only the largest and fastest growing sector in Indonesia, it is also strongly interlinked with all productive sectors, accounting for more than a third of all intermediate inputs, 21.7% of manufacturing inputs, and half of all inputs into the services sector itself. It can be expected, therefore, that improving productivity in services would create a positive feedback loop, generating a greater impact on overall economic performance. Access to more, better or cheaper services can be expected to improve productivity at all Indonesian firms, enabling them to better compete in the global marketplace.

Therefore, increased openness in the services sector not only implies increased foreign presence. It implies, more broadly, a relatively liberalised regime with lower barriers to entry, inducing increased competition between foreign and domestic providers alike. One would expect this competitive dynamic to deliver:

  • Better and more reliable provision of existing services.
  • The introduction of new services.
  • The reduction of prices in the services sector.

One would expect, furthermore, increased productivity, trade and output in the services sector, and improved economy-wide performance through interlinkages between the productive sectors.

Our research suggests that Indonesia’s current policy stance is not only holding back improvements in service-sector performance, but could be having a detrimental impact on the productivity of downstream manufacturers. Restrictive regimes for foreign direct investment in domestic freight, logistics, transport, and wired telecommunication, for example, are preventing competition and innovation, potentially imposing significant costs on manufacturers. Opening up those service sectors to foreign investment by increasing the cap on foreign equity ownership may reap significant economy-wide dividends, facilitating productivity gains needed to achieve the Indonesian government’s ambitious growth targets.

References

Arnold, J B Javorcik, M Lipscombe, and A Mattoo (2010), “Services Reform and Manufacturing Performance: Evidence from India”, CEPR Discussion Papers, 8011, Washington, DC.

Arnold, J, B Javorcik, and A Mattoo (2011), “Does Services Liberalization Benefit Manufacturing Firms? Evidence from the Czech Republic”, Journal of International Economics 85(1),136–46.

Arnold, J, A Mattoo, and G Narciso (2008), “Services Inputs and Firm Productivity in Sub-Saharan Africa: Evidence from Firm-Level Data”, Journal of African Economies 17(4), 578–99.

Duggan, V, S Rahardja, and G Varela (2013), “Service Sector Reform and Manufacturing Productivity: Evidence from Indonesia”, Policy Research Working Paper 6349, World Bank, Washington, DC.

Fernandes, A M, and C Paunov (2012), “Foreign Direct Investment in Services and Manufacturing Productivity: Evidence for Chile”, Journal of Development Economics 97(2), 305–21.

Hoekman, B (2006), “Trade in Services at 25: Theory, Policy, and Evidence”, Mimeo, World Bank, Washington, DC.

UNCTAD (2004), World Investment Report: The Shift Towards Services, New York and Geneva.

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Topics:  Development Industrial organisation

Tags:  FDI

Consultant with the PREM-Trade Division, East Asia & Pacific region, World Bank

Senior Economist, World Bank

Economist in the International Trade Department, World Bank

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