85983 MARCH 2014 • Number 138 Nothing to Fear but Fear Itself: Evidence on Imported Intermediates in Indonesia Sjamsu Rahardja and Gonzalo Varela The combination of an increasing trade imbalance, concerns about deindustrialization after several years of booming commodity prices, and rising imports of intermediate inputs and capital goods over the last decade has triggered new restrictive trade measures that have been gaining ground in Indonesia. The Indonesian government is concerned about the impacts that an increased reliance on imported inputs may have on domestic jobs and value added. In addition to use of imported intermediates by firms involved in global production networks, firms use these intermediates for various reasons, including value, variety, and quality. Drawing on the findings of recent research, this note examines the charac- teristics of firms that rely on imported intermediates, and the role of these foreign intermediates on product quality upgrading and product diversification in Indonesia during 1998–2009. After a careful examination of sector- and firm-level data from Indonesian manufacturing, analysis uncovered three important findings: first, that users of import- ed inputs in Indonesia are exceptional performers. These firms grow faster in terms of output, value added and employ- ment; they are more productive; and they pay higher wages. Second, both the use and the availability of imported inputs have contributed to improved product quality in Indonesian manufacturing. Third, firms’ product diversification processes have been boosted by lower tariffs on inputs and by increased usage of imported versions. In light of these results, this note argues that facilitating imports of intermediate inputs is crucial to the performance of the most dynamic firms and that these intermediate imports diversify the Indonesian manufacturing sector while helping firms climb up the value chain. Trends in Usage of Imported Intermediate production stages into different locations (Baldwin 2011). Inputs This production fragmentation implies establishing interna- tional networks in which firms located in different countries Over the last two decades, the industrialization model has produce and trade different components of a single final shifted toward the separation of production stages across sev- good. Thus, intermediate goods travel to their final destina- eral locations, accompanied by increased trade in intermedi- tion by indirect routes (figures 1 and 2). ates. Processes of production, from inputs to final goods, have Increases in imports of intermediates necessary for par- increasingly been fragmented, with each process now carried ticipation in these international production networks, then, out wherever the necessary skills and materials are available at should not pose a threat to the sustainability of the current competitive costs. Production fragmentation has been facili- account, since they are followed by increases in exports. In tated by lower transport costs and technological advances that Indonesia, the importance of international production net- enable manufacturers to improve productivity by “slicing” works in the increases in imports of intermediates is con- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 1. Increase in Share of Imported Inputs in Production Figure 2. Increasing Imported Components in Countries’ Exports (ratio of imported inputs to total inputs) (imports content of exports) Russian Federation China India Brazil South Africa South Africa Indonesia United Kingdom United Kingdom 2005 China Germany 2005 2000 Poland 1995 2000 Germany Korea, Dem. Rep. of 1995 Israel Romania Vietnam Romania Taipei, Taiwan (China) Mexico Korea, Dem. Rep. of Singapore Taipei, Taiwan (China) Singapore 0 0.2 0.4 0.6 0.8 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 Source: OECD, Input-Output Tables. Source: OECD, Input-Output Tables. firmed by the close relationship between the growth of im- thus widening their availability, is vital for both Indonesian ports of intermediates and the growth of manufacturing and foreign firms serving the domestic market. For domes- exports, as shown in figure 3.1 When exporters anticipate in- tic firms, access to high-quality and a variety of intermedi- creases in demand for their output, the demand for interme- ates can help firms create products that will enable them to diates increases—domestic and imported versions. And the seize growth opportunities in an economy where consump- reverse is also true, of course. Figure 3 focuses on 2008–10, a tion by the middle class is rising quickly. For foreign firms, period of turbulent trade flows, and shows this close link. The access to imported intermediates helps them maintain the sharp deceleration of manufacturing exports in the last quar- quality and specifications of their products, thereby ter of 2008 came with a sharp deceleration of imports of in- strengthening Indonesia’s ability to attract more foreign di- termediates. In fact, from March 2009 to September 2009, rect investment. when manufacturing exports actually fell, imports of inter- Amiti and Konings (2007), for example, looked at Indo- mediates also fell dramatically.2 nesian manufacturing census data from 1990–2001, and found that a 10 percentage point fall in input tariffs led to a Imported Intermediates and Performance productivity gain of 12 percent through learning, quality, and Manufacturers benefit from having access to varied, inex- variety effects. This gain was found to be at least twice as high pensive, and good quality intermediates. Indonesia is no as the gains from reducing output tariffs, which may arise via exception. The flexibility to import intermediate inputs, tougher competition effects. Goldberg et al. (2010) show that expansion in the num- Figure 3. Strong Relationship between Export Growth and Growth ber of products produced by Indian manufacturing firms of Intermediate Imports during Trade Collapse in 2009 during the 1990s was in part a direct consequence of cheaper, 0.4 more varied, and better quality imported inputs. Tariff reduc- Mar-2010 tions lowered prices and increased volumes of existing im- 0.3 Dec-2010 ports, but they also meant access to new types of intermediate growth of manufacturing exports 0.2 inputs from the rest of the world. These new inputs, in turn, Jun-2010 resulted in an increase in the number of products manufac- 0.1 Mar-2008 tured by firms, or “firms’ product scope,” which explained Dec 2009 - nearly a quarter of manufacturing output growth. The lower 0 Dec-2008 price of intermediates due to trade liberalization represented -0.6 -0.1 0.4 -0.1 a boon for domestic firms, as their costs fell. Firms could then Jun-2009 growth of imports of intermediates use their cost savings to cover the fixed costs of entering new -0.2 product lines. In addition, having access to higher quality in- Mar-2009 Sep-2009 termediate inputs and capital goods helped ease technological -0.3 constraints. Source: Authors’ calculations, based on the Indonesian Statistical Office (BPS). 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise New Evidence from Indonesia a contraction in domestic input-producing sectors. However, firms that can access imported inputs have faster rates of Rahardja and Varela (2013) explore the links between the use growth for output, value added, and employment. Compar- and availability of imported intermediates and different as- ing firms that use imported inputs with those that do not, pects of the industrialization process in Indonesia during the within narrowly defined sectors, those in the former group last decade. Three datasets combined helped shed light on tend to display a better growth performance than those in the their investigation. First, Indonesian manufacturing census latter group in terms of output, value added, and employ- data traces all registered manufacturing firms in Indonesia ment creation (figures 4 and 5). Thus, the use of imported with 20 or more employees, on average, containing informa- inputs is not associated with job destruction, but rather with tion for about 20,000 firms per year for 1998–2009. The job creation. census data contain information on usage of imported inter- Jobs created by firms importing intermediate inputs pay mediates, on the main products produced by each firm at the higher wages. The rapid employment growth exhibited by 9-digit ISIC (International Standard Industry Classification) level, and on the prices firms obtain in the market for these firms that use imported inputs is very good news for Indone- products. The second valuable source of data are the input- sians searching for quality jobs. The real wage premium ob- output tables constructed by the Indonesian statistical office tained by a worker in a firm that sources 10 percent of its in- (BPS). Finally, Indonesian tariff data are obtained from the puts from abroad is about 3.7 percent. Why can firms that TRAINS dataset of the World Bank. use foreign intermediates afford to pay, on average, higher Tariffs on intermediates faced by each manufacturing sec- wages? tor were calculated as a weighted average of each product-level Fact 2: Acess to Imported Intermediates tariff, where the weights are given by the share of that product Helped Indonesian Manufacturers Move Up (input) in the total input bill of the manufacturing sector. the Quality Ladder Three specific questions were asked by Rahardja and Varela (2013): To examine the role of increased access to imported inter- i. What are the characteristics of users of imported inputs? mediates on product quality, this analysis assumes that a ii. What role has the availability and use of imported inputs firm produces a high-quality product when the weighted played in quality upgrading at the firm level? average of the unit values corresponding to a firm’s three ii. What role has the availability and use of imported inputs main products (defined at the 9-digit ISIC level of disaggre- played in product diversification at the firm level? gation) is above the median of the weighted average of the There are three important facts to consider when investi- unit values of the same narrowly defined sector (defined at gating these questions. the 5-digit ISIC level of disaggregation). Such a disaggrega- tion means that the within-group variation in unit values is Fact 1: Users of Imported Intermediates in more likely to be related to the degree of differentiation of Indonesia Are Exceptional Performers the product or its quality content than to substantial differ- One concern is whether the increased use of imported inter- mediates will result in less value added domestically, or cause Figure 5. Sectors That Import More Inputs Generate More Employment Figure 4. Sectors That Import More Inputs Expand More 1 proportional growth in employment, 2005–9 proportional growth in value added, 2005–9 3.5 0.8 3.0 y = 1.3947x + 0.2293 0.6 2.5 R² = 0.1234 0.4 y = 0.8525x - 0.0486 2.0 R² = 0.2414 1.5 0.2 1.0 0 0 20 40 60 80 100 0.5 -0.2 0 imported inputs/total inputs share (%) -0.4 0 20 40 60 80 100 - 0.5 imported inputs/total inputs share (%) -0.6 Source: World Bank staff, based on BPS data. Source: World Bank staff based, on BPS data. 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise Figure 6. Effects of Selected Variables on the Probability of less likely to be subject to endogeneity than the actual usage Producing High-Quality Products of foreign inputs, for example, if there is a third factor, un- controlled for, that affects both the quality of the product 1 percentage point reduction in tariffs on inputs and the decision to import inputs, such as time-varying en- trepreneurial characteristics of the firm. In addition, as al- 10 percentage point increase in share of imported inputs on ready mentioned, they also capture the disciplining effect total inputs that they may have on quality and price of domestic inputs via pro-competition effects. At the same time, it should be 10% increase in TFP noted that this approach underplays the role of cumbersome nontariff measures, such as nonautomatic import permits and preshipment inspections, on which no systematic data exporters/nonexporters were found. Maintaining low import restrictions on imported inter- 10% increase in firm size mediates has a substantially greater impact on the likelihood of producing better quality products than the actual usage of -3 -2 -1 0 1 imported inputs. Input tariff reductions not only make more percent varied, cheaper, and better quality inputs available from for- Source: World Bank staff, based on Industrial Census data, BPS. eign markets, but they also incentivize quality improvements Note: Estimated effects from a probability model of imported inputs’ use and and price reductions in domestic versions by adding competi- availability (and controls) on relative product quality. tive pressures. In fact, evidence suggests that a reduction in input tariffs by 1 percentage point, from, say, the median level ences in specification, cost structures, and so forth. The of 3.5, to 2.5 percent, would increase the probability of pro- 5-digit level includes specific activities such as “manufac- ducing high-quality products by almost 1 percent. This rela- ture of batteries” (code 31400) or “manufacturing of bis- tively larger effect hints at some pro-competition effects that cuits” (code 15413).3 lower input tariffs may have on the price and quality levels of Two channels may link imported intermediates with domestically produced inputs, which, in turn, affect the qual- product quality upgrading. The first is the actual use of an im- ity of the final goods produced by Indonesian firms. ported input that may embody higher technology content These results suggest that the availability and use of im- than a domestic version, or that may enable the relaxing of a ported intermediates do contribute to firms’ improved per- technological constraint that was preventing a firm from im- formance and quality upgrading, even if, generally, it is better proving its production process. The second channel is the in- performing firms that are best able to access and afford such creased availability of inputs in the market that arise from intermediates. While firm productivity and growth may im- lower trading costs (lower tariffs or lower transport costs), pact on the intensity with which firms use imported inputs, which may in turn induce manufacturers of domestic ver- it is unlikely that the productivity or growth of firms affects sions of inputs to improve their quality or reduce their prices. changes in tariffs. Moreover, many of the changes in the tariff Effect of increased use of imported inputs regime in Indonesia were part of the structural reforms un- Careful data analysis reveals that, in Indonesia, increasing the dertaken after the East Asian crisis, as part of the negotia- usage of such inputs by 20 percentage points makes it about 1 tions with multilateral financial institutions, adding to the percent more likely that better quality goods will be pro- validity of a causal relationship between imported interme- duced.4 Although the effect is statistically significant, its size diates and product quality. is modest from an economic point of view. In addition, a 20 percentage point increase in the usage of imported intermedi- Fact 3: Use of Imported Intermediates Has ates is a very extreme change, given that about 70 percent of Helped Indonesian Manufacturers Diversify firms do not use foreign inputs, and for only 15 percent of Their Production Bundle firms, foreign inputs account for more than one fifth of total Recent research shows that economic development is associ- inputs (figure 5). ated with production diversification, at least during initial Effect of increased availability of imported inputs stages.5 Through diversification, countries can reduce vulner- To capture the effect of availability of imported inputs, the abilities to price or demand shocks, and build a wider set of variable that captures the use of imported inputs is substi- capabilities. The acquisition of production capabilities for an tuted for the weighted average of input tariffs that manufac- increasing range of goods is an important source of knowledge turing sectors face, disaggregated at the 2-digit ISIC level. spillovers and can be key to growth and development (Haus- Methodologically, using tariffs is attractive because they are mann, Hwang, and Rodrik 2005). 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise In Indonesia, increased availability of imported interme- percent increase in a firm’s product scope, above and beyond diates has played an important role in facilitating product di- any effect induced by the actual usage of foreign inputs. versification.6 Three channels are explored by Rahardja and Increased variety of imported intermediates has no Varela (2013): clear effect on firms’ product diversification. Once input tar- i. Increased use of imported intermediates could facilitate iffs and usage levels of imported inputs are included in the product diversification, since imported inputs may relax regression analysis, the effect of imported intermediates’ va- technological constraints to diversify, or make it profit- riety is insignificant. One explanation for this may be that, able to do so. over the period considered, firms had already determined ii. Increased availability of imported intermediates may their set of input requirements, rather than accommodating trigger pro-competition effects, inducing cost reductions new varieties. and quality improvements among domestic versions of Interestingly, results also suggest that greater effective intermediates, given a certain usage of imported inter- protection facilitated product diversification. If developing mediates. new products is costly, tariff protection at the output level in- iii. Increased varieties of imported intermediates could facil- creases the effective protection rate of that particular output. itate product diversification. This may act as an incentive, enabling existing firms to appro- Increases in firms’ use of imported intermediates have priate extra profits and finance the costs of discovering and been systematically associated with increases in product vari- developing new products. Given the known distortions asso- ety. Results from the econometric analysis suggest that a 10 ciated with tariffs, and the fact that what is an “output” for percentage point increase in the share of imported intermedi- some firms is an “input” for others, this result suggests that ates on total inputs is associated with an increase in varieties policy makers should consider alternative ways of tackling the produced by 1.22 percent (figure 7). market failures associated with product diversification rather Given firms’ use of imported intermediates, reduced in- than employing tariff protection.7 put tariffs help to further increase the number of varieties Conclusion produced. This provides some evidence that the channels out- lined in (i) or (ii) that operate through lower prices of import- The availability and use of imported intermediates among ed intermediates or pro-competitive effects that lower input manufacturers in Indonesia has resulted in greater output tariffs may have on the costs and quality of domestic versions growth, greater growth in value added, higher productivity, of intermediates are active and play a role linking the avail- and, consequently, more and better paid jobs. Imported inter- ability of imported inputs and product diversification. In fact, mediates have also been linked to quality improvements in a 1 percentage point reduction in input tariffs induces a 1.22 domestic inputs and with the widening of firms’ product scope, thus contributing to the diversification of the Indone- Figure 7. Effects of Selected Variables on the Firms’ Product sian economy. Scope Imported intermediates can improve production pro- cesses if they add to the pool of available inputs from which domestic firms can choose. Firms then have access to a better exporter premium variety of intermediates with better value for the money. It may be the case that, in certain instances, better-performing firms are those that are able to access and afford imported in- termediate inputs, rather than those imported intermediates themselves being drivers of superior performance. Neverthe- 10 percentage point increase less, what is clear from this analysis is that imposing restric- in shared imported inputs tions on the use of imported intermediates will hurt the best- performing firms most. This may have negative sector- and economywide knock-on effects in terms of productivity, and ultimately job creation and wages. 1 percentage point reduction The use of imported intermediates has not been associ- in input tariffs ated with a decline in manufacturing in Indonesia. On the contrary, it may be a sign that manufacturing is shifting away 0 .02 .04 .06 .08 .1 .12 from resource-based and low value-added production and into more sophisticated production processes in which man- Source: World Bank staff, based on Industrial Census data, BPS. Note: Estimated effects from fixed effects model of imported inputs use, ufacturers tend to specialize in certain parts of the overall pro- availability, and variety (and controls) on product diversification. duction stages. , 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise The increasing importance of global production net- tus, the ownership structure (foreign/domestic), and the works and reductions in trade costs suggest that reliance on share of imported inputs on total inputs. The model includes foreign intermediates will increase in emerging economies sector-fixed effects (at the 5-digit ISIC level) to absorb any such as Indonesia. The challenge is to make the most of this time-invariant sector determinant of unit values, and year opportunity and to ensure that firms do not end up locked dummies to control for macroshocks that affect unit values into the lower end of processing and assembling activities that across the board. require limited knowledge content, but instead climb up the 4. Other factors, such as the size of the firm and its productiv- quality ladder into design and branding. ity levels, positively affect the probability of producing high- To reap the maximum economic benefits, policy makers quality products. Results suggest that exporters seem to pro- can help ensure that imported intermediates and capital duce, on average, products with unit values about 2.24 goods continue to be accessible to firms. Changes in the inter- percent below those produced by nonexporting firms with national structure of production have increased the costs of similar characteristics. protectionism. Trade barriers are likely to negatively affect the 5. See, for example, Imbs and Wacziarg (2003) or Hesse competitiveness of domestic producers rather than protect (2009). them. Measures that restrict firms’ access to imported inter- 6. The analysis follows Goldberg et al. (2010) quite closely. mediates, in fact, act as a tax on domestic value added. In ad- The authors analyzed the role that imported intermediate in- dition, nontariff measures such as delays in customs’ pre- puts had on domestic product growth in India over 1987–97, clearance stages for imported intermediates can add inventory and found that lower input tariffs accounted for, on average, costs and cause severe disruptions in the functioning of the 31 percent of the new products introduced by Indian firms. production network, with potential consequences on firms’ 7. Data also reveal that larger firms and exporters tend to pro- location decisions, and therefore on value added, job creation, duce more varieties than smaller and nonexporting firms, as and poverty reduction. expected. Exporters, for example, produce 10 percent more varieties than nonexporters, on average, while a firm that is About the Authors 10 percent larger than average tends to produce 1.7 percent more varieties than average. Sjamsu Rahardja is a Senior Economist with the World Bank, in the Poverty Reduction and Economic Management (PREM) Net- References work, East Asia and Pacific Region. Gonzalo Varela is a Trade Amiti, M., and J. Konings. 2007. “Trade Liberalization, Intermedi- Economist with the World Bank’s PREM Trade Unit (gvarela@ ate Inputs, and Productivity: Evidence from Indonesia.” Ameri- worldbank.org). can Economic Review 97(5): 1611–38. Baldwin, R. 2011. “Trade and Industrialization after Globaliza- Notes tion’s 2nd Unbundling: How Building and Joining a Supply Chain Are Different and Why It Matters.” NBER Working 1. In fact, the correlation between the growth of manufactur- Paper No. 17716. ing exports and the growth of imports of intermediates over Goldberg, P., A. Khandelwal, N. Pavcnik, and P. Topalova. 2010. this period is 91 percent. “Imported Intermediate Inputs and Domestic Product Growth: 2. Similarly, an analysis of 2010–12 shows that the decelera- Evidence from India.” Quarterly Journal of Economics 125 (4): tion in exports happens at the same time as a deceleration of 1727–67. Hausmann, R., J. Hwang, and D. Rodrik. 2005. “What You Export imports of intermediates. If one focuses on the relationship Matters.” Journal of Economic Growth 12 (1): 1–25. between intermediate imports and manufacturing value add- Hesse, H. 2008. “Export Diversification and Economic Growth.” ed, instead of exports, the links are also strong, but operate Commission on Growth and Development, Working Paper 21, with substantial lags. IBRD/World Bank, Washington, DC. 3. The probability of a firm, I, at time t, producing goods with Imbs, J., and R. Wacziarg. 2003. “Stages of Diversification.” Ameri- can Economic Review 93 (1): 63–86. quality above the median of a sector, s, is explained by the size Rahardja, S., and G. Varela. 2013. “The Role of Imported Interme- of the firm, proxied by the log of the number of employees, diate Inputs in the Indonesian Economy.” World Bank mimeo, the log of the firm’s total factor productivity, its exporting sta- Washington, DC. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK    www.worldbank.org/economicpremise