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08 Feb 2016

Foreign Direct Investment, Spillover Effects, and Productivity Growth

Suyanto, March 2010
Curtin University of Technology

This thesis examines the spillover effects of foreign  direct investment (FDI) on firm-level  productivity  with reference to the Indonesian manufacturing sector.  The key hypothesis is that FDI at the industrial level generates firm-level productivity gains. While FDI has played a vital role in the impressive expansion of the Indonesian manufacturing industry over the past three decades, its effects on firm-level productivity remains a controversial issue. This thesis contributes to  resolving  this  controversy by decomposing productivity growth into three principal sources (i.e. technological progress, technical efficiency change, and scale efficiency change), so that the productivity gains from FDI can be examined through technical and scale efficiencies as well  as technological change.

Two productivity methods are adopted to investigate the spillover effects of FDI on firm productivity, while taking into account the unique characteristics of each sector of the manufacturing industry. The stochastic production frontier method is applied to test the spillover effects on productivity levels. The  Malmquist  productivity index method is used as a decomposition procedure,  which enables spillover effects on productivity growth to be assessed.

Within the framework of these two productivity methods, this study presents three empirical analyses. The first analysis investigates the spillover effects of FDI on firm productivity levels in the aggregated manufacturing industry, using plant-level panel data from 1988 to 2000. The results show evidence of positive spillover effects, both for the full sample of all firms and for the sub-samples of domestic and foreign firms. Further, it shows those firms with research and development (R&D) activities gain more from FDI than those without R&D activities. Estimations of sub-samples for periods before and after the 1997 economic crisis show evidence of positive FDI spillover effects during both periods. When the productivity spillover models are estimated for 9 two-digit industries and 24 three-digit industries, separately, the results support the argument that a firm‟s absorptive capacity and industrial characteristics influence the ability to elicit economic benefits from FDI. These estimation results are robust when measured against an alternative stochastic production frontier model. The second analysis focuses on the spillover effects of FDI on firm productivity growth. The outcome of the decomposition method  is  that the nterplay between technical efficiency change, technological change, and scale efficiency change result in positive TFP growth for the manufacturing industry. Technological rogress  turns out  to be the major source of productivity growth, and technical efficiency and scale efficiency  also contribute  substantially  to the positive growth of TFP. In a test of the spillover hypothesis, this study finds a positive relationship between FDI and TFP growth. It also finds that FDI contributes positively and significantly to technical efficiency improvement, technological progress, and scale efficiency enhancement. In a search for the spillover effects in two-digit industries, the results suggest that positive spillovers are not an automatic consequence of FDI presence, but rather that they depend largely on the characteristics of firms in each industry. Endogeneity checks show that the estimation results are clear from a problem of simultaneous equation bias.

The  last analysis is performed on the  four-digit  disaggregated  industrial level of Garments and Electronics. The results complement the findings of the aggregated industrial analysis carried out in the first and the second analyses. The results indicate the uniqueness of each industry in gaining an economic benefit from FDI.

Several policy implications follow from the above findings. Firstly, the findings of positive productivity spillovers  at  the aggregated manufacturing level suggest that the government should continue to provide FDI-friendly environment and deregulation policies related to FDI. This could include the simplifying of administrative process for FDI, additional incentives for foreign firms that are willing to transfer their knowledge to domestic firms and further trade policy reforms in order to develop a more competitive environment in the manufacturing sector. Secondly, outcomes from the decomposition analysis suggest that incentives should be provided to FDI that generates advanced managerial  knowledge as well as those  that provide  up-to-date technology transfer. Thirdly, results from the case study suggest the importance of improving the capacity of domestic firms in order to actualize the spillover benefits from FDI.

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