Adopting an export promotion (EP) strategy can bring rapid industrialization and fasten economic growth. Relocating plants from developed countries to developing countries can stimulate the developing country’s exports increasing revenues. Lower-production costs resulting from lower wages have led Indonesian firms to speed up non oil-gas exports. This strategy faces new challenges as other countries can rapidly erode this comparative advantage. Technology innovation using more efficient labor resources may also reduce the competitiveness of domestic producers.

The current political instability in Indonesia has ruined this major advantage and other developing countries aggressively promoted special incentives packages in attracting FDI. Neighboring countries have also developed modernized infrastructures and facilities to support foreign activities. Dunning (1995) explained that a firm’s choice of location for exploiting its advantages would be influenced by the distribution of immobile resources such as infrastructure and by non-market forces such as political instability.

Dealing With Multinational Enterprise

The essential determinants of the location of direct investment are the policy framework, facilities, and economic performance of the host country (World Investment Report, 1998). To explain the differences in FDI inflows among countries and to ascertain why firms choose a specific country, it is necessary to understand the character of multinational enterprises. In general, FDI takes place when firms combine their specific advantages with the location-specific advantages of host countries by internalization of their operations. The choice of a specific-location for FDI depends on the motive, the type of investment, the industry, the size and the strategy of investors. The framework for FDI should consist of rules and regulations concerning foreign subsidiary operations, treatment for investors, and functions of the market.

In the era of globalization, the concern is that the policy should move to adopt more open and market friendly regimes. Many of the governments that are most successful in attracting FDI are also among those that best meet the requirements for good governance (Oman, 2000). The requirements include sound public finances and legitimacy, promoting credibility and confidence. Continuous improvement in regulatory policy is necessary and it is important to make sure that the regulations will be implemented at all levels of the bureaucracy with the same understanding. A comprehensive investment policy needs to be coherent and credible. This policy should use FDI as an element for integrating the economy into the global environment.

Negative FDI values in 1998, 1999, 2000, and 2001 mean that the investment atmosphere is not yet offering a conducive environment. The most important factors to attract foreign investors are safety, security, and political stability. Foreign firms view that the government did not make a serious step to improve legal certainty and government bureaucracy. A comprehensive investment policy must conduct transparency and non-discrimination, which are the principles of good governance (Soesastro et al, 2002). The policy should be based on a government that has clear and unambiguous principles.

Matching the Development Strategy and Foreign Direct Investment 

An increase in income generally brings a corresponding expansion of trade, in which product demands increase. The products become more diversified in terms of variety within a group of industries. In order to compete in the global market, each country continued to specialize in production of similar goods with differentiated characteristics (Romer, 1987). The increase in intra-industry specialization rather than inter-industry specialization promotes liberalization and facilitates the process of tariff reduction (Bhagwati, 1986).

The trend showed a significant increase in the contribution of trade to the increase in national income. Since the liberalization era is not avoidable, manufacturing specialization through improvements in quality and efficiency is a requirement. The growth of industries that manufacture export products should compensate for the increase in import products. If tariff cuts lead to more trade, the export promotion strategy is able to generate more income.

In the IS era, the government may unconsciously provide domestic industries with incentives to add capacity that may cause over supply in the domestic market. An EP strategy removes these unintended consequences such as excess capacity, excess inventories, and bottlenecks (Bhagwati, 1990). An uncompetitive environment preserves less efficient firms generating lower quality products with higher prices. Industries under a protectionist regime tend to incur high economic costs because of inefficiency in allocating resources. Favoritism in subsidies and incentives for producers of IS products often leads to unfair or unequal treatment ignoring efficiency. By opening the market, domestic and foreign firms are exposed to the international market to increase their competitiveness. They were encouraged by the prospect of higher exports, which can cover their investment.

The empirical results indicate that Indonesia has to favor an export promotion strategy to deal with foreign firms. During the export promotion era, Indonesia attracted more FDI. This strategy increased the contribution of foreign affiliates to support economic growth. The export promotion strategy also improved domestic firm competitiveness and thus increased trade.

Evaluation

There are several determinants affecting and directing capital flows. FDI is not solely the outcome of pull (the host country) factors, but push factors have also been at work in the potential home countries. Japan is the biggest foreign investor in Indonesia. The Asian financial crisis and the Japanese economic slowdown over the last ten years impacted their investment flows to ASEAN countries, including Indonesia. Japanese products in electronics, computers, motorcycles, and automobiles, which are Japanese a strength, face tough competition from new industrialized country’s products and other developing country’s products. Some of Japanese firms, including Sony, have closed their foreign subsidiaries to improve efficiency by streamlining their organization structures. The rise of China’s market has also altered potential investors from developed countries and new industrialized countries who may invest in Indonesia.  

Pursuing an EP strategy means Indonesia opens its market to foreign capital and continues to conduct trade reform. This strategy stresses the importance of competition policies to increase competitiveness. Investment policies must be developed in conjunction with competition policies (Soesastro et.al., 2002). Adopting this strategy by lowering the barriers and providing incentives for manufacturing of export products does not guarantee foreign investors. But it may offer fewer opportunities for exploitation or unfair treatment.

In a less protectionist environment, market forces and comparative advantage in reducing production costs are the targets of foreign investors. Economic performance and the standard of living become essential factors for the domestic market to attract foreign investors. A better standard of living has been associated with more variety in terms of product demands. Developed countries, with their high income per capita provide potential markets for investors. This describes why developed countries are the major destination of FDI.  The sharp reversal in economic fortunes has made Indonesian people more focused on consumable expenditures for their physical necessities. They are generally not in a position to buy high quality products offered by branded foreign manufacturing from developed countries. The decrease in Indonesian incomes has made some potential market segments disappear. New industrialized countries, other developing countries, and domestic manufacturing could provide the same products (electronics, motorcycles, computers etc.) at lower prices. This makes established-foreign manufacturers need to reconsider their production in Indonesia. 

In a more open environment, most investment will rely on comparative advantage strategies to lower production costs. The Japan External Trade Organization (JETRO) indicated high facilitation and infrastructure cost as being incurred when Japanese companies implemented their FDI projects. Complex bureaucracy and problems with local government regarding taxes have deterred potential investors. Labor strikes and demonstrations have characterized Indonesian manufacturing since the crisis. Although the government has required mandatory minimum payments based on minimum physical needs, workers felt that their salaries were not enough to cover daily expenditures. Most of them ask for additional payment, which confused not only foreign manufacturing but also domestic manufacturing as well. Since the crisis, foreign firms and domestic firms faced difficulties dealing with labor unions. The policy should cover all elements in creating an attractive environment, including the labor element. The government must integrate all sources to reduce production costs by offering lower facilitation costs and an improved labor environment.

Although the extent and quality of technology transfer from foreign firms to domestic firms is difficult to assess, most foreign firms had a limited impact in the upgrading of technology for local firms. In the case of Indonesia, the contribution of higher technology industries to value-added manufacturing between 1985 and 1997 did not increase, while the production of low technology industries extended (Figure 1). The Central Bureau of Statistics (2000) reported that most investments were in labor-intensive manufacturing to employ lower wages workers. Foreign manufacturing behaved similarly to agricultural export commodities since many of them exported products with minimal processing and limited value added. Many investments in the automobile industry and the electronic sector were intended to benefit from cheap labor. The companies were relying heavily on imported components and machinery.

6.            SUMMARY AND CONCLUSION

Summary

                Foreign Direct Investment has played an essential role in sustaining Indonesian economic activities. In 1967, UU (Law) No.1, the first act concerning foreign investment policy was established to facilitate foreign capital entry. This law offered several incentives for investors such as tax exemption for a period of 2 to 5 years since a firm started its operation and released taxes for reinvested earnings. Repatriated companies were returned to their previous owner to restore investor confidence. The government opened most of sectors for foreign investors to increase their contribution in fastening economic growth.

                Supported by the raise of oil prices, the government gradually tightened foreign investment policy. During 1970s, exploitation of natural resources in forestry, mining and the petroleum industry characterized foreign activities. Substantial revenues from oil explorations enable government to invest and subsidize in domestic industries by pursuing an import substitution policy. Recognizing the importance of the manufacturing sector and anticipating the oil price decline, several export orientation policies were introduced since 1982. The government tried to reduce its dependence on oil incomes by supporting export-oriented manufacturing industries. Motivated by comparative advantage strategies, foreign manufacturing relocated their factories to Indonesia to employ lower wage labors.  

                This study explores the effectiveness of foreign activities in supporting the GDP growth of Indonesia in two different development strategies. Empirical results indicated that a more open environment improved contribution of FDI to economic growth. The outward looking policy increased the efficiency of domestic investment and Indonesian human resource capabilities as well. Indonesians were motivated to learn new technology and management expertise brought by foreign establishments.

                Domestic firms may receive externalities from FDI through subcontract activities. They learned how important is to maintain the quality of product and material. It enables Indonesian entrepreneurs to achieve continual gains in productivity while satisfying customers’ expectation for quality and prompt delivery. FDI has extended some of ideas about efficiency and fuller utilization of resources including human resources.

                An export promotion strategy was proved to be effective to attract more foreign investors until the financial crisis hit Indonesia in 1997. There are several determinants must be considered in investing across border such as policy framework, facilities, and economic performance of the host country. Although during the EP era Indonesian opened most of sectors to foreign capital and offered lower facility costs, the entry of capital inflows was far from realized. Foreign firms are aware about political instability and legal certainty in Indonesia’s environment. Labor unrest and demonstrations confused the manufacturing sector, which is the key sector of an export-oriented strategy. The financial crisis started in the mid 1997 hardly damaged the economy of Indonesia. Most of economic activities were plummeted indicating a low level of economic performance. Foreign firms need to reconsider their subsidiary operations since several domestic market segments disappeared.

Since the crisis, a more liberal policy was unsuccessful to attract direct investment. An unfavorable political condition and frequent labor strikes in Indonesia ruined comparative advantages of lower facility and labor costs. The most effective strategy to deal with foreign investors is to provide a conducive environment by improving political stability and government bureaucracy.

The capability of domestic industries is important to support foreign activities in increasing their local contents and reducing the dependency on imported components. The government needs to encourage reinvested earnings to deepen their subsidiary operations. Labor-intensive industries to employ lower wages dominated manufacturing activities in Indonesia. The Ministry of Trade and Industry report indicated the decline of investment in medium and higher technology industry. That means transfer of technology from foreign firms to domestic entrepreneurs is limited. Improvement in domestic capabilities is required since Indonesia will more rely on incomes through exporting domestic products.

This study mostly focuses on benefits and spillover of FDI while limit the explanation about domestic investment. The prior result appeared that the effect of the export promotion strategy is less effective for domestic entrepreneurs. Indonesian economy was dominated by a few largest companies working on the basis of establishing multi-sector and diversified business interests. They only put little concerns on advanced manufacturing industries. The advantage of this strategy was the rapid accumulation of capital and consequent growth through a broad front of corporate activity and a diversification of business risk. The disadvantage was the lack of concentration on building core competencies in manufacturing by most companies.

Some researchers have mentioned a positive correlation between the level of human resources and the rate of GDP growth per capita. Human resources have to be considered the major source of development through invention and innovation in manufacturing technology. It would be useful to test the link between FDI and the level of human capital. Training conducted by foreign firms to prepare the labor force to cope with new technology suggests an increase in human capital knowledge and capabilities.

Conclusion

Although Indonesia has opened more sectors for foreign investors, there remains a discrepancy between the degree of openness stipulated in the law and the actual scope for investment implementations. The complexity of the administrative procedures also acts as a barrier to foreign firms. Both domestic and foreign firms complain about cumbersome and time-consuming investment approvals. Efforts to provide a favorable political and legal investment environment play an important role in foreign capital inflows. The most important strategy is to frame the environment within which foreign firms operate by introducing various performance requirements for their activities.

The overall policy of foreign investment is to encourage investments in the non oil-gas sector and value-added products. The government tried to reduce dependence on the oil-gas sector by increasing exports in manufacturing products and opening the economy to foreign capital. Exposing the local environment to international opportunity costs brings incentives for the domestic and foreign resource allocation to produce more efficient outcomes. A more open environment attracted more FDI and its benefits flare around affiliated industries and accrue competitiveness in the global market.