Foreign Direct Investment and Economic Growth:

Empirical Evidence from Indonesia

by

Abdul KHALIQ

A final Project submitted in partial fulfillment of

the requirements for degree of

Master of Arts in Economics

University of Hawai’i at Manoa

Masters Program in Economics

Fall 2006

Approved by _____________________________________________________
Ilan Noy (Professor in Department of Economics)

Date _____________________________________________________
 Department Economics
University of Hawai’i at Manoa

Foreign Direct Investment and Economic Growth:

Empirical Evidence from Indonesia

by Abdul KHALIQ

Academic Advisor: Ilan Noy

Professor in Department of Economics

Abstract

The paper investigates the impact of foreign direct investment (FDI) on economic growth

using sectoral data for FDI inflows to Indonesia over the period 1997-2006. The results

present that, on the aggregate level, FDI has a positive effect on economic growth.

However, on the differential sectors, the results show that the effects of composition of

FDI on economic growth vary across sectors by examining the twelve sectors of

economy; namely, farm food crops, livestock product, forestry, fishery, mining and

quarrying, non-oil and gas industry, electricity, gas and water, construction, retail and

wholesale trade, hotels and restaurant, transport and communications, and other private

and services sectors. Interestingly, the results seem to support the argument that

extractive FDI, e.g. forestry and mining, might not enhance economic growth.

Keywords: Foreign direct investment, economic growth, and Indonesia.

i
 CONTENTS

Page
Abstract i
Contents ii
List of Figures and Tables iii

1. Introduction 1

2. Theoretical framework 2
2.1 Theoretical developments on growth and foreign direct investment 3
2.1.1 Theories of growth 3
2.1.2 FDI-growth nexus 5
2.2 Empirical studies on FDI-growth nexus 7
2.2.1 Cross-country evidence 8
2.2.2 ASEAN-countries evidence 11
2.2.3 Other-countries evidence 13

3. Foreign direct investment and economic growth in Indonesia 15

3.1 An overview of Indonesian economy 15
3.2 Economic growth and structural change 15
3.3 Foreign direct investment in Indonesia 19
3.3.1 An overview 19
3.3.2 Investment policy 20
3.4 Trend and composition of FDI 22
3.4.1 Approved FDI 22
3.4.2 Realized FDI 24

4. Methodology and data 27

4.1 Methodology 27
4.2 Data 29

5. Empirical results and analysis 30

6. Conclusion 34

References 36
Appendix 40

ii
 LIST OF FIGURES AND TABLES

Page
Figure
1. Gross Domestic Product by Industrial at Constant 2000,
Structure, 1986-2005 (percent) 18

Tables
1. Gross Domestic Product by Industrial at Constant 2000 Prices,
Growth Rate, 1984-2005 (Y-o-Y Growth Rate, Percent) 16
2. Trend of Foreign Investment Planning Approvals
by Sector, 1997 - July 31, 2006 (Millions of US$) 23
3. Trend of Foreign Investment Realization (Permanent Licenses)
by Sector, 1997 - July 31, 2006 (In Millions of dollars) 25
4. Aggregate, Sectoral and Time Effects of FDI in Indonesia 31

iii
1. Introduction

Foreign direct investment (FDI) has been playing a key role in the changing

nature of economic development of developing countries. Currently, many countries

compete for foreign investment. Every country, including Indonesia, is aggressively

encouraging FDI inflows to accelerate economic growth. Due to the effects of FDI are

relatively various on economic growths of developing countries, this study examines the

roles of FDI inflows on economic growth in Indonesia.

Since the Government of Indonesia (GOI) liberalized its economy, started by

introducing the Foreign Investment Law No. 1/1967 in the year 1967, adopting a free

foreign exchange system in 1970 then followed by liberalization of the financial sector in

1980s, a number of foreign investors have invested in Indonesia. These investors have

contributed a lot in the development of Indonesian economy. As it happened, before the

economic crisis on July 1997, Indonesia has experienced rapid economic growth rate

with amounted to around 7% over the period 1970-1996 and has been reported as the

sixth destination to foreign direct investment inflows in 1995 1 .

Although Indonesian has been an attractive destination for foreign investment

and experienced remarkable economic growth, when compared with other regions, e.g.

China, Thailand, and Vietnam, not many studies have been conducted on the effects of

FDI on economic growth. Moreover, most existing studies have been concentrated on the

aggregate effects growth of FDI. No known study to the best of our knowledge has been

documented on the effects of the sectoral composition of FDI inflows on economic

growth in the case of Indonesia.

1
World Investment Report 1995

1
 Two important questions are posed: Does FDI lead to Indonesia’s economic

growth? What differences the impacts of sectoral composition of FDI on Indonesian

economy? To explore these issues, this study utilizes an empirical estimation

methodology to investigate and analyze the effects of FDI inflows on economic growth in

Indonesia as well as other related variables. A comprehensive review of FDI is beyond

the scope of this study, but it highlights the general trends and common features of

foreign direct investment in Indonesia over the period 1997-2006.

The remaining discussion is organized into five sections. The second section

provides a brief review of the theoretical and empirical studies on the relationship

between FDI inflows and economic growth. An overview of economic growth and FDI

inflows in Indonesia is presented in the third section. In the fourth section contains the

specification of the model and data. The fifth section provides the empirical results.

Concluding remarks is gathered in the last section.

2. Theoretical Framework

The objective of this section is to review the literature on the interaction between

foreign direct investment (FDI) inflows and growth. The discussions on the impact of

FDI on growth are not only heated, but also entail significant policy ramifications. On

theoretical grounds there is a significant basis for expecting FDI to have a positive

relationship on economic growth, while the empirical evidences are complex and often

contradictory. This section discusses together the theoretical framework and empirical

evidence on the links between FDI inflows and economic growth.

2
2.1. Theoretical Developments on Growth and Foreign Direct Investment

Growth theories provide the theoretical frameworks for analysis of foreign direct

investment and economic growth. In this section briefly surveys the main features of

growth theories that are commonly used to analyze the interaction between FDI and

economic growth.

2.1.1. Theories of Growth

For centuries, economists have paid much attention to economic growth of

nations. Since the days of Adam Smith (1776) this subject has been studied continually

such as Thomas Malthus (1798), and David Ricardo (1817), and, much later, Frank

Ramsey (1928), Allyn Young (1928), Frank Knight (1944), and Joseph Schumpeter

(1934). Those classical economists’ ideas provide basic ingredients of economic growth

studies. These ideas have included the basic approaches of competitive behavior such as

the importance of accumulating basic factors of production, i.e. capital, labor and land;

and encouraging efficiency and productivity by expanding markets (Bende-Nabende,

1999). These ideas also emphasized the function of diminishing returns and its relation to

the accumulation of physical and human capital, the interchange between per capita

income and the growth rate of population, the role of technological advance in increasing

labor specialization, and the discovery of new goods and methods of production (Barro

and Sala-i-Martin, 1995).

Solow (1957), who is recognized as the founder of neoclassical growth theory,

has developed an important contribution to growth theory, known as growth accounting.

The main idea behind growth accounting method is that the output growth can be

3
decomposed into the contribution of the growth rate of inputs such as technology, capital,

labor, inward FDI, or by incorporating a vector of additional variables in the estimating

equation, such as imports, exports, institutional dummies etc. The growth accounting

approach can be derived from the following equation:

Y = AΦ ( K , L, Ω), (1)

where Y, K, L, and A are output, capital, labor, and the efficiency of production,

respectively; Ω is a vector of ancillary variables.

Taking the logarithms and time derivatives of equation (1) yields:

g y = g A + ζg k + ψgl + γgω , (2)

where gi is the rate of growth of i = A, y, k , l , ω , (the subscripts are defined per capita

terms), and ζ ,ψ , and γ are, respectively, the elasticities of output with respect to physical

capital, labor and the ancillary variables.

In fact, in equation (2) the contribution of inputs to output growth does not

necessarily equal the rate of output growth. The gap between the rate of output growth

and the contribution of input growth defines the rate of total factor productivity (TFP)

growth, or the Solow residual. That is, it represents the conventional measure of the

various forms of technological change.

However, Solow’s model might be deficient because it does not really explain the

rate of exogenous technological progress, and consequently led to the birth of new or

endogenous-growth theory in the mid-1980s. Endogenous growth models introduce a

theory of technological change into a production process. In contrast to Solow’s model

based on diminishing returns to capital, endogenous-model growth rates can be

increasing over time (Romer, 1986). According to Helpman (2004) endogenous growth

4
theory emphasized two critical channels of investment which affect economic growth.

Firstly, through the impact on the range of available products, and secondly, through the

impact on the stock of knowledge accessible for research and development (R&D).

Mankiw, Romer, and Weil (1992) have analyzed another implication of Solow’s

model. According to them, omitting human capital accumulation in Solow’s model would

cause biased estimation of the coefficient on saving and population growth. Next, they

modified Solow’s model by adding human capital as well as physical capital. They

assumed that all countries have the same Cobb-Douglas production function applies to

human capital and physical capital. They also assumed the same rate of technological

change. In addition, they assumed the same rate of human and physical capital

depreciation. Based on these assumptions they presented that income per capita variation

of cross-country is a function of variation in the rate of saving, the rate of population

growth, and the level of labor productivity. Thus, they recommend that using an

augmented Solow growth model has the potential to clarify international differences in

income per capita.

2.1.2. FDI-Growth Nexus

Economic models of endogenous growth have been applied to examine the effect

of FDI on economic growth through the diffusion of technology (Barro, 1990; Barrel and

Pain, 1997). FDI can promote economic growth through creation of dynamic comparative

advantages that lead to technology progress. Hence, foreign direct investment is usually

viewed as an effective channel of technological transmission from developed country into

5
developing countries and foster economic growth in developing countries (Solow, 1956;

Balasubramanyam et al., 1996; Borensztein et al., 1998).

Romer (1990) and Grossman and Helpman (1991) have calibrated Romer’s

(1986) model and assume that endogenous technological progress is the main engine of

economic growth. They classify that knowledge is a factor of production, whereas Romer

(1986) reflected on knowledge as a parallel by product of investment. Romer (1990)

argues that FDI accelerates economic growth through strengthening human capital, the

most essential factor in R&D effort. He also emphasizes that an economy will experience

faster economic growth with large stock of human capital rather than a large population.

Moreover, Grossman and Helpman (1991) conclude that endogenous technological

change drives economic growth. An increasing in competitions and innovations as a

results of technological progress encourage increasing productivity and, thus, promoting

economic growth in long run.

Findlay (1978) has developed Solow’s model and assume that the growth rate of

technology diffusion as an increasing function of FDI. By distinguishing between inputs

into foreign capital (a developed country) and domestic capital (a developing country), he

verifies that an increase in foreign capital increases domestic capital. However, he

argues that the rate of technological transfer in a developing country is a decreasing

function rather than an increasing function of both the relative technology gap and the

share of FDI in the total capital stock.

Reis (2001) have formulated a model to draw the effects of FDI on economic

growth when investment returns may be repatriated. She states that after the opening of

the economy domestic firms will be replaced by foreign firm in the R&D sector. This

6
may decrease domestic welfare due to the transfer of capital returns to foreign firms. In

this model, the effects of FDI on economic growth depend on the relative strength of

interest rate effects. If the world interest rate is higher than domestic interest rate, FDI has

a negative effect on growth, while if the world interest rate is lower than domestic interest

rate, FDI has a positive effect on growth.

Furthermore, Firebaugh (1992) lists several points why FDI inflows may be less

profitable than domestic investment and why FDI may even be detrimental. The country

may gain less from FDI inflows than domestic investment, because of MNCs are less

likely to contribute to government revenue (due to tax incentives or transfer pricing); FDI

is less likely to encourage local entrepreneurship; MNCs are less likely to reinvest

profits; MNCs are less likely to develop linkages with domestic firms; MNCs are more

likely to use inappropriately capital-intensive techniques. However, FDI may be having

negative effect on economic growth, when it: “crowd out” domestic businesses; and

stimulates inappropriate consumption pattern thus reducing domestic savings.

2.2. Empirical Studies on FDI-Growth Nexus

Although, theoretically, much attention has devoted to the relationship between

FDI and growth, the empirical evidence on the issue remains controversial. The

controversy has arisen partially due to the lack of a conceptual design and a succinct

testable hypothesis (Balasubramanyam et al., 1996), partly because of data insufficiency,

either in cross-country or time series during investigations, and an endogeneity problem

(Li and Liu, 2005).

7
2.2.1. Cross-Country Evidence

Borensztein et al. (1998) examine the interaction of FDI on economic growth in

cross country regression framework, using data on FDI flows from OECD countries to

sixty-nine developing countries over the period 1970-1989. They propose that FDI is an

important vehicle for adoption of new technologies, contributing relatively more to

growth than domestic investment. In addition, they find, through the relationship between

FDI and the level of human capital, that FDI has a significant positive effect on economic

growth. However, they qualify their results in as much as the higher productivity of FDI

only holds if the host country has a minimum threshold stock of human capital.

Within a new growth theory Bulasubramanyam et al. (1996) have observed the

relationship between FDI and growth in the context of differing developing countries

trade policy regimes, i.e. export promoting and import substituting countries. Using cross

section data to analyze forty-six developing countries over the period 1970-1985, they

support the Bhagwati’s hypothesis that FDI increases growth in countries which adopt

outward oriented trade policy than in those following an inward oriented policy. They

also find positive interaction between FDI and human capital in the economic growth

process.

Liu and Liu (2005) apply both single equation and simultaneous equation system

techniques to investigate endogenous relationship between FDI and economic growth.

Based on a panel of data for 84 countries over the period 1970-1999, they find positive

effect of FDI on economic growth through its interaction with human capital in

developing countries, while that negative effect of FDI on economic growth via its

interaction with the technology gap.

8
 Bengoa at al. (2003) has illustrated the relationship between FDI and economic

growth using panel data for eighteen Latin American countries over the period 1970-1999.

They show that FDI has positive and significant impact on economic growth in the host

countries. However, to get positive effects of FDI on growth in the long term, the host

country requires adequate human capital, political and economic stability and liberalized

market environment.

Moreover, the volatility of FDI and financial adjustment has been observed by

several economists such as De Gregrio and Guidotti (1995), Alfaro et al. (2004), and

Durham (2004). De Gregrio and Guidotti (1995) highlight that financial liberalization and

stabilization must be applied to host country in attempt to attract FDI inflows. Alfaro et al.

(2004) argue that countries with well-developed financial markets not only magnetize

FDI inflows but also allow host countries to gain extensively from FDI.

Meanwhile Carkovic and Levine (2002) utilize General Method of Moment

(GMM) to observe the relationship between FDI and economic growth. They use World

Bank and IMF data for 1960-1995 for large cross-country data set, and find the FDI

inflows do not exert influence on economic growth. They also highlight that interaction

between FDI and growth does not rely on the stock of human capital. In addition, they

argue that there is no significant correlation when allowing for the FDI effects on growth

to rely on the income per capita level.

Choe (2003) adapts a panel VAR model to explore the interaction between FDI

and economic growth in eighty countries in the period 1971-1995. He finds Granger

causality relationship between FDI and economic growth in either direction. However,

the effects are rather more visible from economic growth to FDI than FDI to economic

9
growth. These results imply that significant relationship between FDI inflows and growth

does not indicate that high FDI inflows stimulate high economic growth.

In addition, Agosin and Mayer (2000) has examined a panel of data for 32

countries (12 in Africa, eight in Asia, and 12 in Latin America) over the period 1970–1996

and conclude that FDI is not always good for a host country’s development. In some

cases, FDI inflows can harm the host country by creating “crowding out” effect for

domestic investment and displace domestic enterprises that go bankrupt. However, they

are unable to examine what types of policies will maximize the FDI share to total investment

in attempt to have positive effects of FDI inflows on total investment. Meanwhile, Lumbila

(2005), who conducts a panel analysis of economic growth effects of FDI using data for 47

African countries, finds a positive impact of FDI on growth in Africa.

Based on Levine and Renelt’s model (1992), Stocker (2000) empirically tests

economic effects of FDI for a large cross-section and in each country individually. Using

data for seventy-two countries over the period 1980-1995 he finds that the role FDI on

overall growth, domestic capital formation or export performance has no significant

correlations. These results contrast to the empirical evidences of Borensztein et al. (1998)

and Bulasubramanyam et al. (1997) that argue that FDI inflows boost economic growth.

Alfaro (2003) investigates the direct interaction between FDI and economic

growth by dividing the types of FDI inflows in the major sectors of economy, namely,

primary, manufacturing, and services. Using cross section regressions with forty-seven

countries data for the time period 1980-1999, she finds different effects of FDI exert

different sectors of economy on economic growth. FDI inflows in primary sector have a

negative effect on growth, whereas FDI inflows in manufacturing tend to have positive

10
correlation on growth. Furthermore, FDI inflows in service sector have an ambiguous

effect.

2.2.2. ASEAN-Countries Evidence

Bende and Nabende at al. (2001) study the impact of FDI through spillover

effects on economic growth of the ASEAN-5 for the period 1970-1996. They find that

FDI accelerates economic growth either directly or through spillover effects. In detail,

they show that impact of FDI on economic growth is positively signed and significant for

Indonesia, Malaysia, and Philippines, while negative relationship for Singapore and

Thailand. Similarly, Marwah and Tavakoli (2004) test the effect of FDI on economic

growth of the ASEAN-4, namely, Indonesia, Malaysia, Philippines, and Thailand. Using

time series annual data over the period 1970-1998, they find that FDI has positive

correlation with economic growth for all four countries.

Moreover, Damooei and Tavakoli (2006) examine Thailand and Philippines. They

utilize the CES generalization of Cob-Douglas production function to test how robust is

the elasticity of FDI inflows on growth over the period 1970-1998. They show a positive

relation between FDI and economic growth for Thailand and Philippines when both

countries faced identical foreign capital intensities. In similar results, Vu (2006) presents

a positive effect of FDI on growth for Vietnam. On the other hand, Chowdhury and

Mavrotas (2003) find different result. Indeed, they point out that Malaysia and Thailand

have bidirectional causality between FDI and economic growth.

In similar vein, Choong et al. (2005) have explored the role of domestic financial

system in transmitting the technological diffusion embodied in FDI inflows on

11
Malaysia’s economic growth. They employ unrestricted error correction model (UECM)

in testing cointegration relationship between economic growth and FDI as well as some

ancillary variables over the period 1970-2001. They find that FDI stimulates a positive

technological diffusion in both short- and long-run when the evolution of domestic

financial institutions has reached a certain minimum level. It means that FDI would

promote economic growth if a host country has a well-developed and well-functioning

financial sector.

Kohpaiboon (2003) studies trade policy effect on FDI contribution to Thailand’s

economic growth. Using macroeconomic time series data over the period 1970-1999, he

also shows consistent results with Bulasubramanyam et al. (1996) who supports

Bhagwati’s hypothesis. The impact of FDI on growth tends to be higher under export

promotion trade policy in contrast to import substitution trade policy. These findings

propose liberalization of trade and investment to maximize the benefit of FDI on

economic growth.

Most recently, Vu et al. (2006) have enriched empirical study on the impact of

FDI on growth by studying sector-specific FDI inflows for both China over the period

1985-2002 and Vietnam over the period 1990-2002. Applying augmented production

function they conclude that FDI has positive and statistically significant impact on

economic growth. They also show positive effect of FDI through labor productivity on

economic growth. Furthermore, they show different effects cross economic sectors of

FDI on economic growth. They find that the manufacturing sector appears to gain more

than other sectors from sector-specific FDI.

12
 Regarding Indonesia in particular, few detailed studies on the impact of FDI on

economic growth have been conducted. Although Bende and Nabende at al. (2001) and

Marwah and Tavakoli (2004) have documented the effects of FDI on the economic

growth of ASEAN, there are no studies of which we are aware that focus on Indonesia.

Only Bachtiar (2003) has examined the impact of FDI on the growth rate of Indonesia.

Using time series data (1970-2000) and employing a single equation model, he finds an

important contribution of FDI to economic growth that indicated by a positive sign of

FDI’s coefficient in gross domestic product (GDP).

2.2.3. Other-Countries Evidence

With regard to one specific country, the role of FDI in promoting economic

growth has been widely conducted. Various studies provide some evidence of FDI effects

on economic growth of China. Using provincial data Chen et al. (1995), Berthelemy at al.

(2000) and Zhang (2001) find that, generally, FDI has a positive effect on economic

growth of China. This result supports the hypothesis that productive foreign capital

promotes economic growth. However, Wen (2003) only gets positive relationship

between FDI and growth for China’s coastal provinces.

Shan et al., (1997) investigate the causality linkage between inflow of FDI on real

output growth in China based on the Granger no-causality procedure, developed by Toda

and Yamamoto (1995), using quarterly and seasonally-adjusted data. The results show a

two-way causality running between industrial growth and inflow of FDI growth. It means

that the result does not support the FDI-led growth hypothesis because FDI and industrial

growth have reinforced each other. Furthermore, Charaborty and Basu (2002) apply the

13
technique of cointegration and error-correction modeling to test the effect of FDI on

growth in India using annual data over the period 1974-1996. They conclude that

economic growth is not Granger caused by FDI, but economic growth attracts FDI

inflows.

Balamurali and Bogahawatte (2004), with different perspectives, have studied the

interaction of FDI on economic growth in Sri Lanka using Johansen’s full information

maximum likelihood for the period 1977-2003. They find that foreign direct investments

have responded positively to economic growth and there is bidirectional Granger

causality between foreign direct investment and domestic investment. Similarly, Liu at al.

(2002) show bidirectional causality between economic growth, FDI inflows and exports

for China. In contrast, Athukorala (2003) notices no strong correlation between FDI and

economic growth of Sri Lanka.

Another empirical study by Bende-Nabende and Ford (1998) develop a simple

dynamic model to examine the effects of FDI on endogenous growth in Taiwan. Using

macroeconomic data for the period 1959-1995, they prove a positive correlation of FDI

on output. In addition, they state that human capital and technological change influence

economic growth indirectly. Using the Augmented Dickey-Fuller test (ADF), Akinlo

(2004) has investigated the relationship between FDI inflows and economic growth in

Nigeria over the period 1970-2001. He has concluded that FDI inflows have a small

positive effect, not a statistically significant effect, on economic growth. In contrast, he

presents that human capital has a positive and statistically significant effect on economic

growth.

14
3. Foreign Direct Investment and Economic Growth in Indonesia

3.1. An Overview of Indonesia Economy

The Government of Indonesia (GOI) progressively liberalized its economic

system. It was started by reforming foreign exchange system in 1970. Then it was

followed by liberalization of the financial sector in 1980s, particularly in banking sector.

In attempt to attract foreign capital, Indonesia enacted the investment law No. 1 in 1967.

As it happened, Indonesia has become preferred destination for foreign investment.

Indonesia has experienced rapid economic growth rate with amounted to around 7% over

the period 1970-1996 and has been identified as the sixth place for foreign direct

investment inflows in 1995 2 . Unfortunately, the economic crisis resulted in net private

capital outflows from Indonesia. Data from Bank Indonesia presents negative foreign

direct investment, on average about US$ 3 billion for each year over the period 1998-

2002.

3.2. Economic Growth and Structural Change

Indonesia, before the 1997 economic crisis, has experienced remarkable economic

development. Per capita real GDP has increased from US$ 70 in 1966, one of the world’s

poorest countries, to US$ 1,071 in 1997. The GDP growth rate has increased consistently

at annual rate of more than 7 per cent from 1990 up to the second half of 1997. At the

time, Indonesia came to be among the “Asian Tigers”. However, economic growth rate

fell suddenly in 1998 when East Asian Crisis hit Indonesia. GDP contracted by 13

percent in 1998. In general all sub-sectors of economy had decreased dramatically from

2
World Investment Report 1995

15
their high-growth trajectories except for farm food crops, non-food-crops, fishery, oil and

gas mining, electricity and water, and communications sectors (see Table 1).

The worst hit sectors were construction, services, and financial sectors. These

sectors have experienced high growth rate before mid 1997 due to financial liberalization.

Moreover, financial liberalization has attracted huge capital inflows to Indonesia,

including short term capital, such as portfolio investment. These massive capital inflows

were an important potential engine of economic growth and led to over investment

(Nasution, 1998). However, due to poor financial control and weak prudential regulations

has led to deterioration of bank and finance, transport, construction, and services sectors

when the Asian Crisis hit Indonesia.

Table 1 Gross Domestic Product by Industrial at Constant 2000 Prices, Growth Rate, 1984-2005 (Y-o-Y Growth Rate, Percent)

No. Sector 1986-1990 1991-1996 1997-1999 2000-2003 2004-2005

1 Agriculture, Livestock, Forestry and Fishery 2.80 2.87 0.70 3.07 2.87
a. Farm food crops 2.32 1.75 0.43 1.97 2.73
b. Non-food-crops 3.65 4.92 1.23 5.57 2.22
c. Livestock product 2.53 5.58 -0.91 5.43 3.11
d. Forestry 3.24 0.15 -0.07 0.34 -0.67
e. Fishery 5.22 5.26 4.64 4.13 5.58
2 Mining and Quarrying 2.39 4.71 -0.56 1.28 -1.44
a. Oil and natural gas 1.88 1.35 -2.69 -2.51 -3.26
b. Oth. mining and quarrying 9.10 19.42 3.08 8.70 1.46
3 Manufacturing 10.52 10.58 -0.72 5.03 3.38
a. Refinery oil 7.43 3.67 1.84 0.69 -2.69
b. LNG 6.91 3.86 4.44 -3.00 -4.32
c. Non-oil and gas mfg 11.77 11.88 -1.12 5.95 4.29
4 Electricity, gas and water 14.83 12.87 8.21 7.65 5.86
5 Construction 8.07 12.38 -10.31 5.44 7.41
6 Trade, hotel and Restaurant 8.22 7.44 -4.07 4.84 7.14
a. Retail and wholesale trade 7.99 7.28 -4.38 4.77 7.32
b. Hotels and Restaurant 9.42 8.12 -2.84 5.16 6.30
7 Transport and Communications 7.10 8.81 -2.93 9.54 13.18
a. Transport 6.62 7.67 -6.28 7.52 7.54
b. Communications 10.98 15.72 10.36 14.43 23.97
8 Banks and Finance 7.41 9.67 -3.38 6.16 7.41
9 Other services 5.59 4.17 -4.40 3.42 5.00
a. Public 6.17 1.92 -1.45 0.97 1.78
b. Other private and services 4.41 7.78 -7.39 6.17 8.02
Gross Domestic Products 6.26 7.27 -2.60 4.45 4.72

Source: Annual Report BPS, 2006

16
 The construction sector growth rate has decreased from 7.16 percent in 1997 to

negative 36.36 percent in 1998. Nevertheless, the construction sector increased slightly in

1999. An increasing in construction sector was actually due to rebuilding of building

destroyed in “May 1998” demonstrations, but its growth rate still reached negative 1.73

percent due to the capacity constraint. Prior to economic crisis, transport and services

sectors increased more than 8 percent and 4 percent per year over the period 1986-1996,

respectively, yet these sectors decreased to negative 6 percent and negative 4 percent in

the period 1997-1999, respectively.

Other badly hit sectors were trade, hotel and restaurant, and transport sectors.

Trade, hotel and restaurant sector experienced contraction by -4.07 percent per year in the

period 1997-1999. The transport sectors were contracted by -6.28 percent in the period

1997-1999. Furthermore, the recovery of these sectors depend on the recovery of

financial sector, while financial sector experienced a deep plunge in the period 1997-

1999, where its contraction was -3.38 percent per year. In addition, financial sector faced

largest contraction -26.54 percent in 1998 due to the increasing in losses in banking

sector because of negative spread, increasing in bad loans, and losses on foreign

exchange transactions.

After reaching its lowest growth in 1998, the Indonesian economic sectors started

to recover continually, some dramatically. The economic growth rate was slightly

positive, 0.8 percent in 1999. According to Feridhanusetyawan and Pangestu (2004) the

positive economic growth represents the natural rebound effects of the economy after

experiencing a massive contraction. This positive economic growth has continued in

2000. Although Indonesian political situation was unstable at the time, the economic

17
growth increased 4.9 percent. This performance was principally still a rebound effect, led

by exports and household consumption but restrained by investment. The growth rate

decreased to 3.83 percent in 2001 when the global economy was concurrently slowdown

and the September 11th attacks.

Figure 1 Gross Domestic Product by Industrial at Constant 2000, Structure, 1986-2005 (percent)

100%

80%

60%

40%

20%

0%
1986-1990 1991-1996 1997-1999 2000-2003 2000-2005
Agriculture, Livestock, Forestry and Fishery a. Farm food crops
b. Non-food-crops c. Livestock product
d. Forestry e. Fishery
Mining and Quarrying a. Oil and natural gas
b. Oth. mining and quarrying Manufacturing
a. Refinery oil b. LNG
c. Non-oil and gas mfg Electricity, gas and water
Construction Trade, hotel and Restaurant
a. Retail and wholesale trade b. Hotels and Restaurant
Transport and Communications a. Transport
b. Communications Banks and Finance
Other services a. Public
b. Other private and services

Source: Annual Report BPS, 1986-2005

Economic growth in Indonesia was accompanied by significant structural change

over the period 1986-2005 (see Figure 1). Since the beginning of the mid-1980s, the

importance of the agriculture sector and mining sector has declined. Over the period

18
1986-1990, the shares of agriculture and mining sector have averaged 20.03 percent per

year and 14.08 percent per year, respectively. Meanwhile, by the period 2000-2005, the

shares of these sectors averaged 14.85 percent per year and 9.83 percent per year,

respectively.

The share of manufacturing sector had improved from averaged 19.96 percent per

year over the period 1986-1990 to 27.82 percent per year in the period 2000-2005.

Moreover, transport and communication sectors, service sectors, and bank and finance

sectors had seen concurrent rapid growth and development. These achievements were as

a consequence of changing in economic development strategies – a move away from

inward-oriented strategy, public-sector-led growth towards outward oriented strategy,

private-sector-led growth (Bachtiar, 2003).

3.3. Foreign Direct Investment in Indonesia

3.3.1. An Overview

FDI in Indonesia has a long and unique history. It began with the Dutch Colonial

era from 1870s to 1941. It was followed by the Japanese Colonial era in the period 1942-

1945, the “Old Order” era (Indonesian: Orde Lama) over the period 1945-1965, the

“New Order” era (Indonesian: Orde Baru) in the period 1966-1999, and the

“Reformation” era starting in 1999, respectively.

In the Dutch Colonial era, although FDI has played an essential role in the

Indonesian economic development, FDI did not guarantee to make Indonesia prosperous.

FDI was treated as a medium to exploit Indonesian natural resources. This condition was

continued in the Japanese Colonial era. The Indonesian economy was devastated due to

19
prohibition many raw material imports, shipping equipment out, and labor supplies

disrupted. Thus, there was a vacuum of new foreign direct investment inflows.

Under the “Old Order” regime, the government paid little attention to economic

development. The government was grappling with the transition from colonialism to

independence. The government also faced many domestic political and military problems.

Most potential resources were not utilized wisely to accelerate economic development. In

the event, there was no new inward foreign direct investment.

Since the “New Order” regime, the government saw a sharp change in economic

policy, with introducing multi-year economic plan (Indonesian: Rencana Pembangunan

Lima Tahun, REPELITA) to maintain economic development. The economic policy

became much more market oriented. The government adopted a positive political attitude

toward the role of FDI in economic development. The government believed that FDI is

an essential medium to transform Indonesia’s abundant resources to boost the Indonesian

economic development. FDI was seen to bring capital, technological innovations, and

skills needed for Indonesian development. Now in the “Reformation” era, the

government has continued to attract foreign investment.

3.3.2. Investment Policy

In attempt to stimulate foreign confidence and investment, the government of

Indonesia has enacted the Foreign Investment Law No. 1 of 1967, the Law No. 11 of

1970, government regulation No. 20 of 1994, and government regulation No. 83 of 2001.

The laws and regulations contained a number of attractive provisions which apply to all

20
firms under the jurisdiction of the Indonesian Coordinating Board for Investment (Badan

Koordinasi Penanaman Modal, hereafter referred to as BKPM) 3 , such as:

1. a guarantee for foreign companies to freely transfer profits and repatriate their

capital after a certain period;

2. granting a basic tax holiday for foreign investors;

3. exemption from payment of import duties and sales taxes on machinery and

equipment; and

4. granting foreign company to operate for a period of 30 years after its legal

formation.

To provide legal protection for foreign investors, up to 2005, the GOI has

concluded Investment Guarantee Agreement (IGA) with 61 countries 4 . Indonesia has also

signed bilaterally the Investment Promotion and Protection Agreements with 55

countries 5 . Furthermore, to avoid incidental double taxation on certain income such as

profits, dividends, interests, fees, and royalties, Indonesia has signed agreements (tax

treaties) with the 50 countries 6 . In addition, the GOI has participated in and signed an

agreement on the Convention on the Settlement of Investment Disputes in 1970 7 and

joined in the Multilateral Investment Guarantee Agency (MIGA) in 1986 8 .

By 1998, the GOI has introduced new policies on private investment. For example,

the approval of foreign investment over US$ 100 millions is no longer authority of the

President of Indonesia, but could be issued by the Minister/Chairman of the BKPM. The

3
Established in 1973 (Presidential Decree No. 20/1973).
4
http://www.aseansec.org/IAP/Indonesia.pdf
5
http://www.bkpm.go.id/en/info.php?mode=baca&cat=7&t=Investment&info_id=16
6
http://www.bkpm.go.id/en/info.php?mode=baca&cat=7&t=Investment&info_id=16
7
http://www.worldbank.org/icsid/treaties/ii-country.pdf
8
http://www.miga.org/sitelevel2/level2.cfm?id=1152

21
government also introduces "one roof services" for the approval and evaluation of

projects. Under “one roof services” system, the investor need not go to various

Government institutions in order to get investment license/approval either at the

preparation or implementation stage. Moreover, the GOI has streamlined and simplified

investment license/approval services by reducing the time-frame to issue foreign

investment approvals from 42 days to only 10 working days.

However, some business fields are restricted to both domestic and foreign

investment. According to Presidential Decree (Keputusan Presiden, KP) No. 96 of 2000

jo.118 of 2000, published by Indonesia’s Investment Coordinating Board, there are some

“negative investment lists” to domestic and foreign investment. There are 11 sectors that

are absolutely closed to all domestic private investment and foreign investment, while

there are eight business fields that are closed only to foreign investment. Those closed

business fields are germ plasma cultivation, concession for natural resources, contractors

in the field of lumbering, taxi and/or bus transportation, small scale sailing, trading and

trading supporting services, radio and television broadcasting services providers, and

motion picture production industry (see detailed list in appendix I).

3.4. Trend and Composition of FDI

3.4.1. Approved FDI

Since the Foreign Investment Law was enacted in 1967 until July 2006, the

government of Indonesia has approved FDI inflows with total value of US$ 315.22

billion and the number of approvals has reached 15,395 projects. The trend of approved

FDI inflows increases during the last three decades from US$ 38.6 billion in 1967 to US$

22
119.3 trillion in 1997. This trend has decreased to 53.9 trillion in 1999, but gradually

increased to 318.3 trillion on July 2006. The tremendous increase in approved FDI

inflows can be attributed to the following factors: restoration of political and economic

stability, consistent macroeconomic policies, a relatively large domestic market,

availability of cheap labor, and abundant natural resources.

Table 2 Trend of Foreign Investment Planning Approvals by Sector, 1997 - July 31, 2006 (Millions of US$)

No Sector 1997-1999 2000-2003 2004-2006 1997-2006

Acc. Annual Acc. Annual Acc. Annual Acc. Annual
I Primary Sector 26,042.1 8,680.7 1,898.3 474.6 2,332.8 777.6 30,273.2 3,027.3
1 Food Crops & Plantation 19,865.9 6,622.0 1,263.2 315.8 917.0 305.7 22,046.1 2,204.6
2 Livestock 656.7 218.9 92.5 23.1 86.0 28.7 835.2 83.5
3 Forestry 1,317.2 439.1 211.1 52.8 129.3 43.1 1,657.6 165.8
4 Fishery 1,361.6 453.9 89.2 22.3 226.6 75.5 1,677.4 167.7
5 Mining 2,840.7 946.9 242.3 60.6 973.9 324.6 4,056.9 405.7

II Secondary Sector 166,660.6 55,553.5 25,985.8 6,496.5 15,889.2 5,296.4 208,535.6 20,853.6
6 Food Industry 29,791.3 9,930.4 1,853.9 463.5 2,030.6 676.9 33,675.8 3,367.6
7 Textile Industry 9,820.8 3,273.6 850.9 212.7 644.4 214.8 11,316.1 1,131.6
8 Leather Goods & Footwear Industry 278.7 92.9 289.8 72.5 132.3 44.1 700.8 70.1
9 Wood Industry 3,698.4 1,232.8 431.9 108.0 172.2 57.4 4,302.5 430.3
10 Paper and Printing Industry 44,748.9 14,916.3 2,146.6 536.7 586.8 195.6 47,482.3 4,748.2
11 Chemical and Pharmaceutical Industry 36,690.5 12,230.2 14,548.2 3,637.1 6,945.1 2,315.0 58,183.8 5,818.4
12 Rubber and Plastic Industry 3,651.4 1,217.1 761.9 190.5 409.5 136.5 4,822.8 482.3
13 Non Metallic Mineral Industry 12,787.4 4,262.5 876.0 219.0 1,171.8 390.6 14,835.2 1,483.5
14 Metal, Machinery & Electronic
Industry 18,790.7 6,263.6 2,869.6 717.4 2,239.5 746.5 23,899.8 2,390.0
15 Medical Preci. & Optical Instru,
Watches & Clock Industry 189.5 63.2 47.8 12.0 20.9 7.0 258.2 25.8
16 Motor Vehicles & Other Transport
Equip. Industry 4,317.9 1,439.3 1,048.5 262.1 1,388.6 462.9 6,755.0 675.5
17 Other Industry 1,895.1 631.7 260.7 65.2 147.5 49.2 2,303.3 230.3

III Tertiary Sector 38,547.8 2,849.3 27,666.4 6,916.6 13,271.5 4,423.8 79,485.7 7,948.6
18 Electricity, Gas & Water Supply 11,789.5 3,929.8 491.6 122.9 902.6 300.9 13,183.7 1,318.4
19 Construction 2,759.9 920.0 1,497.6 374.4 4,331.3 1,443.8 8,588.8 858.9
20 Trade & Repair 372.6 124.2 3,776.6 944.2 2,065.6 688.5 6,214.8 621.5
21 Hotel & Restaurant 5,160.7 1,720.2 7,977.2 1,994.3 976.9 325.6 14,114.8 1,411.5
22 Transport, Storage & Communication 7,735.8 2,578.6 9,856.3 2,464.1 3,869.1 1,289.7 21,461.2 2,146.1
23 Real Estate, Ind. Estate & Business
Activities 8,344.1 2,781.4 410.9 102.7 485.6 161.9 9,240.6 924.1
24 Other Services 2,385.2 795.1 3,656.2 914.1 640.4 213.5 6,681.8 668.2
Total 231,250.5 77,083.5 55,550.5 13,887.6 31,493.5 10,497.8 318,294.5 31,829.5

Note :
1 Excluding of Oil & Gas, Banking, Non Bank Financial Institution, Insurance, Leasing, Mining in Terms of Contracts of Work, Coal Mining in
Terms of Agreement of Work, Investment which licenses issued by technical/sectoral agency, Porto folio as well as Household Investment.
2 Value of Investment Planning in Million US$. = New Project + Expansion + Change of Status
3 Data of Investment Planning Approvals in 2002 until 2004 change from data published by BKPM in the period of June 2006 since in July 2006
BKPM received Investment Planning Approvals issued by regions.
4 Tentative data, including investment planning approvals issued by regions received by BKPM until July 31, 2006.
5 Acc. refers to accumulation.
Source: BKPM, 2006

Table 2 shows the trend of favorable sectors for foreign investments based on

approval up to 2006. During the period 1997-2006, the largest amount in terms of value

23
of approved investment was to the secondary sector reaching the value US$ 208.5 billion.

It has contributed 65.5 percent of total approval value of FDI. Moreover, approved

Investments in both tertiary and primary sectors was very small with total value US$ 7.95

billion and US$ 3.03 billion or 25 percent and 9.5 percent of total, respectively.

Of the approved FDI inflows in secondary/manufacturing sector, the chemical and

pharmaceutical, paper and printing, food, and metal, machinery & electronic industries

reached the largest approved FDI inflows. The total value was amounted US$ 163.2

billion or 51.29 percent of total approved FDI inflows. The other was less than 5 percent

of total approved FDI inflows.

Meanwhile, over the period 1997-2004, the largest amount of approved FDI

inflows was from Asia and Europe with total value US$ 58.2 billion and US$ 29.7 billion,

the share of 47.05 percent and 24.01 percent of total approved FDI inflows, respectively.

Moreover, a closer look at the countries, the largest amount of approved FDI inflows was

from United Kingdom amounting to 553 projects. It has reached the value of US$ 18.25

billion and contributed 14.76 percent of total approved FDI inflows. The other leading

investors were Japan, Singapore, and Malaysia with the share of 10.87 percent, 8.7

percent, and 5.55 percent, respectively.

3.4.2. Realized FDI

Compared with approved FDI, realization of FDI was relatively a small part or

only 17.5 percent of total approval value of FDI over the period 1997-2006. Of the

twenty-four sectors – leather goods & footwear industry, rubber and plastic industry,

motor vehicles & other transport equipment industry, transport, storage & communication,

24
and trade & repair – have received the largest investment with the share of 62.4 percent,

46.2 percent, 44.1 percent, 40.6 percent, and 35.8 percent of total value realized FDI

inflows, respectively. The remaining was less than 35 percent of total realized FDI

inflows.

Table 3 Trend of Foreign Investment Realization (Permanent Licenses) by Sector, 1997 - July 31, 2006 (In Millions of dollars)

No Sector 1997-1999 2000-2003 2003-2006 1997-2006

Acc. Annual Acc. Annual Acc. Annual Acc. Annual
I Primary Sector 219.9 73.3 616.0 154.0 1,012.1 337.4 1,848.0 184.8
1 Food Crops & Plantation 79.5 26.5 369.3 92.3 590.3 196.8 1,039.1 103.9
2 Livestock 60.0 20.0 28.3 7.1 84.3 28.1 172.6 17.3
3 Forestry 17.5 5.8 - - 118.8 39.6 136.3 13.6
4 Fishery 22.4 7.5 27.4 6.9 26.9 9.0 76.7 7.7
5 Mining 40.5 13.5 191.0 47.8 191.8 63.9 423.3 42.3

II Secondary Sector 12,295.3 4,098.4 10,391.0 2,597.8 8,982.1 2,994.0 31,668.4 3,166.8
6 Food Industry 899.3 299.8 1,074.8 268.7 1,361.6 453.9 3,335.7 333.6
7 Textile Industry 367.8 122.6 727.3 181.8 613.1 204.4 1,708.2 170.8
8 Leather Goods & Footwear Industry 203.7 67.9 120.5 30.1 112.8 37.6 437.0 43.7
9 Wood Industry 61.4 20.5 351.6 87.9 122.4 40.8 535.4 53.5
10 Paper and Printing Industry 316.7 105.6 874.6 218.7 863.5 287.8 2,054.8 205.5
11 Chemical and Pharmaceutical Industry 3,241.4 1,080.5 2,877.0 719.3 1,868.6 622.9 7,987.0 798.7
12 Rubber and Plastic Industry 982.8 327.6 670.5 167.6 572.5 190.8 2,225.8 222.6
13 Non Metallic Mineral Industry 330.4 110.1 220.4 55.1 264.6 88.2 815.4 81.5
14 Metal, Machinery & Electronic
Industry 4,836.4 1,612.1 2,289.3 572.3 1,652.1 550.7 8,777.8 877.8
15 Medical Preci. & Optical Instru,
Watches & Clock Industry 57.5 19.2 21.6 5.4 16.3 5.4 95.4 9.5
16 Motor Vehicles & Other Transport
Equip. Industry 881.9 294.0 961.1 240.3 1,137.6 379.2 2,980.6 298.1
17 Other Industry 116.0 38.7 202.3 50.6 397.0 132.3 715.3 71.5

III Tertiary Sector 4,053.8 1,351.3 10,920.3 2,730.1 7,234.9 2,411.6 22,209.0 2,220.9
18 Electricity, Gas & Water Supply 209.8 69.9 3,231.2 807.8 173.2 57.7 3,614.2 361.4
19 Construction 442.9 147.6 554.9 138.7 1,355.2 451.7 2,353.0 235.3
20 Trade & Repair 89.5 29.8 775.5 193.9 1,359.1 453.0 2,224.1 222.4
21 Hotel & Restaurant 895.5 298.5 584.5 146.1 346.5 115.5 1,826.5 182.7
22 Transport, Storage & Communication 1,142.0 380.7 4,503.5 1,125.9 3,073.3 1,024.4 8,718.8 871.9
23 Real Estate, Ind. Estate & Business
Activities 900.7 300.2 510.9 127.7 383.8 127.9 1,795.4 179.5
24 Other Services 373.4 124.5 759.8 190.0 543.8 181.3 1,677.0 167.7
Total 16,569.0 5,523.0 21,927.3 5,481.8 17,229.1 5,743.0 55,725.4 5,572.5

Note :
1. Excluding of Oil & Gas, Banking, Non Bank Financial Institution, Insurance, Leasing, Mining in Terms of Contracts of Work, Coal Mining
in Terms of Agreement of Work, Investment which licenses issued by technical/sectoral agency, Porto folio as well as Household Investment.
2. Tentative data, including permanent licenses issued by regions received by BKPM until July 31, 2006.
3. Acc. refers to accumulation.
Source: BKPM, 2006

Table 3 presents recent trends in favorable sectors of realization of FDI inflows.

Over the period 1997-2006, the realization of FDI has reached 5,367 projects with a total

investment value of US $ 55.7 billion, on average per year US$ 5.57 billion. A closer

look at theses sectors, secondary/manufacturing sector has the largest received foreign

25
investment with total value US$ 31.67 billion or 57.83 percent of total realized FDI

inflows. The heavy concentration of realized FDI inflows in manufacturing sectors is due

to pursuing the policy industrializations since 1960s.

Of the twelve major industry groups of manufacturing sector, four sectors – metal,

machinery and electronic industry, chemical and pharmaceutical industry, food industry,

and motor vehicles and other transport equipment industry – have received the largest

foreign investment. For the period 1997-2006, they accounted for about 67 percent of

realized FDI inflows in manufacturing or 41.42 percent of total realized FDI inflows.

They have also been quite large FDI inflows into the paper and printing, textile, and

rubber and plastic industries. The remaining five industries – leather goods & footwear,

wood, non metallic mineral, medical prescription and optical instrument, watches and

clock, and other – have received less than 5 percent of realized FDI inflows in

manufacturing.

Furthermore, there have been structural changes in the realization of FDI inflows

over the period 1997-2006. During the period 1997-1999, manufacturing sector alone

received for almost two-third of the total of realized FDI inflows, but its share declined

markedly thereafter. In contrast, the share of tertiary/service sectors has increased from

24.5 percent of total realized FDI inflows over the period 1997-1999 to 39.9 percent of

total realized FDI inflows over the period 2004-2006. In fact, the share of transport,

storage & communication services has increased significantly from 6.89 percent of total

realized FDI in the period 1997-1999 to 15.65 percent of total realized FDI in the period

2004-2006.

26
4. Methodology and Data

4.1. Methodology

In order to investigate the impact of sectoral FDI inflows on the economic growth

rate of Indonesia, we follow the model used in Tam et al. (2006). The starting point of the

augmented Cobb-Douglas production function framework in which FDI is incorporated

as one of factor inputs is derived from the following equation:

Y = ALα F β D γ (3)

where A captures the exogenous state of ‘environment’, Y is the real gross domestic

product (GDP), L represents the level of labor, F denotes foreign direct investment (FDI),

and D stands for domestic investment (DOM).

Assuming equation (3) to be linear in logs and taking the natural logarithms and

time derivatives equation (3) yields:

g y = g A + αgl + β g f + γg d (4)

where g n is the growth rate of n = A, y, l , f , d , (the subscripts are defined sectoral

terms), and α , β , and γ are, respectively, the elasticities of output with respect to labor,

FDI and DOM.

Next, letting sector i and time t operate within the theoretical framework, the

following equation is used for empirical study:

g y it = g A + αglit + β g f it + γg d it + ai + uit (5)

i = 1,..., N ; t = 1,..., T

where i subscripts refer to different sectors and t refers to different time within sectors –

i.e. different sectoral outputs measured at different time. The ai term is treated as a set of

27
an unobserved sectoral effect or a sectoral fixed effect and uit is time varying error or

idiosyncratic, representing unobserved factors that change over time and affect g y it

(Wooldridge, 2003).

Applying the fixed effect estimator in the panel data for each i, average the

equation over time, we obtain:

g y it = g A + α glit + β g f it + γ g d it + ai + uit (6)
1
where g y it =
T
∑ g yit , with t = 1, … T and so forth. Due to ai fixed overtime appears
in equation (5) and (6), respectively, we factor equation (4) out from equation (3) for

each t and end up with:

(g y it ) ( ) ( ) ( ) ( ) (
− g yit = g A − g A + α g lit − g lit + β g f it − g f it + γ g d it − g d it + uit − uit ) (5)

which can be rewritten as

g *yit = g *A + αg *lit + βg *fit + γg *dit + u *it (7)

where g *yit = g y it − g yit , and so on.

Adapting equation (7) into an empirical one presents, as a benchmark, the

following equation:

GDPit = β1 + β 2 FDI it + β 3 DOM it + β 4 LABit + uit (8)

where GDP is the economic growth rate and LAB, FDI, DOM are level of foreign direct

investment, domestic investment, and labor, respectively. The i term corresponds to the

twelve sectors; namely, farm food crops, livestock product, forestry, fishery, mining and

quarrying, non-oil and gas industry, electricity, gas and water, construction, retail and

wholesale trade, hotels and restaurant, transport and communications, and other private

and services sectors, respectively. The expected signs for all variables are positive.

28
4.2. Data

This study uses the yearly cross section time series data (panel data) for 12 sectors

from 1998 to 2006. Some advantages using panel data are: (1) dealing with heterogeneity

(Kennedy, 1998); (2) more informative data (Baltagi, 1995); and (3) alleviating

measurement error and endogeneity (Temple, 1999). All data are compiled from Central

Bureau Statistics (Biro Pusat Statistik, BPS) and Investment Coordinating Board (Badan

Koordinasi Penanaman Modal, BKPM). The data on gross domestic product are

compiled from Central Bureau Statistics. The GDP growth rate is calculated based on

GDP in 2000 constant price. While the data on foreign direct investment (FDI), domestic

investment (DOM), and labor (LAB) are obtained from Indonesian Coordinating Board

for Investment.

Basically, there are 3 indicators generally used to seek Indonesian investment

trend. Firstly, gross fixed capital formation which is taken from the national account

published by the BPS. However, gross fixed capital formation excludes all kinds of

financial assets. Thus, gross fixed capital formation can not simply stand for actual

investment. Secondly, from balance of payments (BOP) data issued by Bank Indonesia

that includes foreign direct investment. Nevertheless, FDI data in the BOP also contain

non-FDI objects such as financial transactions with commercial banks. But it does not

include FDI in oil and gas sectors. Hence, we can not decide whether the BOP tends to

overestimate or underestimate the FDI figures. Thirdly, approved FDI and realized FDI

data issued by the BKPM. These data are widely used to evaluate investment trends.

However, data from BKPM does not include the oil and gas, and financial sector. Also,

29
the approval data sometimes include unrealistic projects with huge amounts, which

distort figures. Therefore, we utilize realized FDI data.

5. Empirical Results and Analysis

The purpose of this empirical analysis is to examine the differential effects of FDI

on economic growth in Indonesia. The twelve main sectors of investment has been

investigated; namely, farm food crops, livestock product, forestry, fishery, mining and

quarrying, non-oil and gas industry, electricity, gas and water, construction, retail and

wholesale trade, hotels and restaurant, transport and communications, and other private

and services sectors. In other words, this study is observing the effects of not only the

level of FDI inflows but also the possible effects of the sectoral composition of FDI

inflows on the economic growth.

Following Alfaro (2003) and Tam et al. (2006), this study looks at the direct

effects of the different sectors of FDI inflows on economic growth utilizing a fixed effect

estimation method. This method allows us to control unobserved sector heterogeneity and

the associated omitted variable bias. We have 108 observations in the model from 12

sectors for the time period 1998-2006.

Empirical estimations have been conducted on the basis of the theoretical model

discussed in section 2 and section 4. The ordinary least square (OLS) regressions

involved several steps of estimation which started by testing a benchmark model and

followed by adding time-fixed effect, sectoral-fixed effect, and interaction FDI and

dummies variable, respectively. The estimation results have been documented in Table 4,

for every step specification respectively.

30
Table 4 Aggregate, Sectoral and Time Effects of FDI in Indonesia

(1) (2) (3) (4) (5)

FDI 0.0058177*** 0.0019138* 0.0066765*** 0.0009805
(1.32) (2.13) (1.23) (0.98)
DOM 0.001658 0.0000771 0.0019036 -8.31e-06 -0.0000706
(0.81) (0.18) (0.84) (-0.02) (-0.16)
LAB -0.0002284*** -0.0000412*** -0.0002358 3.50e-06 0.0000526
(-1.32) (-1.16) (-0.67) (0.05) (0.60)
DFFC 6.567644 -2.24934 -1.65005
(0.42) (-0.79) (-0.44)
DLP 3.660765 -2.304383 -0.6640917
(0.27) (-0.96) (-0.20)
DFtry -0.550428 -6.499638* -4.782858*
(-0.04) (-2.69) (-1.74)
DFish 5.125106 -0.8169081 -0.436855
(0.38) (-0.34) (-0.11)
DMQ 1.026033 -4.827188* 0.4938888
0.08) (-2.00) (0.15)
DNOG -2.458393 -5.55117 -4.865807
(-0.06) (-0.75) (-0.61)
DEGW 3.888237 0.9861025 2.709898
(0.30) (0.43) (0.97)
DConst -1.027617 -4.985861* -6.246788*
(-0.08) (-2.13) (-2.04)
DRW 3.472162 -3.276088*** -4.156869***
(0.25) (-1.32) (-1.22)
DHR 2.262471 -2.690811 -1.567009
(0.17) (-1.13) (-0.50)
DOPS 4.688946 0.1426545 0.8262029
(0.36) (0.06) (0.20)
FDIxDFFC -0.0009353
(-0.05)
FDIxDLP -0.0107348
(-0.10)
FDIxDFtry -0.0202444
(-0.45)
FDIxDFish 0.126183
(0.38)
FDIxDMQ -0.0891473*
(-2.07)
FDIxDNOG -0.0008724
(-0.44)
FDIxDEGW 0.0003341
(0.18)
FDIxDConst 0.0115287*
(1.82)
FDIxDRW 0.0085277
(0.92)
FDIxDHR 0.0018495
(0.22)
FDIxDTC 0.0023655***
(1.51)
FDIxDOPS 0.0022188
(0.26)
Obs 108 108 108 108 108
Prob > F 0.4418 0.000 0.9980 0.000 0.000
2
R 0.0254 0.9645 0.0341 0.9716 0.9754
Adj R2 -0.0027 0.9604 -0.1113 0.9643 0.9644
Root MSE 25.238 5.015 26.569 4.7617 4.7528
Notes: t-ratios in parentheses. *significant at 5%; **significant at 10%;***significant at 25%.
Farm food crops (FFC); livestock product (LP); forestry (Ftry); fishery (Fish); mining and quarrying (MQ); non-
oil and gas industry (NOG); electricity, gas and water (EGW); construction (Const); retail and wholesale trade
(RW); hotels and restaurant (HR); transport and communications (TC); and other private and services sectors
(OPS).
Column (2), (4), and (5) have time fixed effects.

31
 Table 4 presents the main results which are the effects of FDI inflows, domestic

investment, and labor on economic growth. The regressions show FDI inflows, domestic

investment, and labor to have positive and insignificant correlation on economic growth.

Column (1) shows FDI to have a positive moderate correlation on growth, but is not

statistically significant. It seems that FDI inflows do not have an impact on economic

growth when correlations are not controlled. Domestic investment and labor have

positive effects; however, the effects are not significant.

Column (2) is the regression result using time-fixed effects. The effect of FDI

remains positive and becomes statistically significant at the 5% level of confidence. It

means that FDI inflows affect the economic growth of Indonesia in positive way.

Moreover, D98 turn out with a negative effect and statistically significant at 5% level of

confidence (see also column 4 and 5). It means that some factors in the year 1998 have

negative effects on Indonesian economic growth. As it happened in 1998, financial crisis

hit ASEAN countries; its effects have been so much more devastating in Indonesia than

in the other ASEAN countries. FDI inflows in Indonesia have decreased in value from

US$ 119.3 billion in 1997 to US$ 58 billion in 1998.

Column (3) is tested with the sectoral-fixed effects. The effect of FDI itself does

have a moderate positive effect on growth; however the sectoral compositions of these

FDI are found to be insignificant. We find a positive effect of farm food crops, livestock

product, fishery, mining and quarrying, electricity, gas and water, retail and wholesale

trade, hotels and restaurant, transport and communications, and other private and services

sectors, respectively. Although not significant, forestry, non-oil and gas industry, and

construction sectors have a negative effect on economic growth. Moreover, the

32
manufacturing (non-oil and gas industry) sector investments are expected to have a

positive effect on economic growth through backward and forward linkages in

Indonesian economy does not arise (see also column 4 and 5). It seems that different sub

sectors within the non oil and gas industry play different roles in influencing local

economy. It may be also caused by the institutional and regulatory environment in

Indonesian economy after financial crisis generate a dominating negative effect of non-

oil and gas industry of FDI inflows on economic growth. This result is contradictory with

previous study that have been conducted by Alfaro (2003) and Tam et al. (2006)

Furthermore, column (4) presents the regression result including both time- and

sectoral-fixed effects. FDI level itself does not have a positive significant effect on

economic growth, while the compositions of these FDI are found to be a negative effect

and statistically significant. We find negative effects of forestry, mining and quarrying,

and construction sectors on economic growth and become statistically significant at 5%

level of confidence. The significant negative effect of these sectoral FDI on growth varies

from -6.499638 to -4.827188. It means that these sectors have limited linkages to local

development economy as they usually utilize few domestic intermediate goods in their

activities. It may also be caused by a negative effect of extractive industries, e.g. forestry

and mining, on domestic economy. According to Sachs and Warner (2001), the possible

factor that extractive industries have a negative effect on economy is FDI inflows could

create a crowding out effect on domestic firms. This crowding out changes the local

market structures of industries and increase inefficiencies due to high concentration rates

of ownership. The changing in local market structures could raise rent-seeking activity

and deteriorate the institutions of local economy. Furthermore, the significant FDI

33
inflows in such natural resources related industries may change the real exchange rate

and create negative incentives for production in the tradable good sectors (Sala-i-Martin

and Subramian, 2003).

Finally, column (5) presents the results of estimation that include all of the

variables – excluding FDI aggregate – time fixed effect, sectoral fixed effect, and FDI-

sectoral dummies interaction terms. We find that forestry, mining and quarrying, and

construction sectors are no longer significant at the 5% level of confidence. Furthermore,

we find a negative correlation between FDI-dummies mining and quarrying and

economic growth and statistically significant at 5% level of confidence. In contrast, an

interaction of FDI with retail and wholesale sector and transportation and communication

yield a positive effect on economic growth and significant result at 10% and 25% level of

confidence but economically small.

6. Conclusion

This study has investigated the impact of FDI on economic growth in Indonesia in

different economic sectors employing FDI inflows data for the period 1997-2006. Based

on the literature review, in general inward FDI has positive effects on economic growth.

In this study, we found that, at aggregate level, FDI has a positive effect on economic

growth. However, at sectoral level, the effects of FDI on economic growth vary across

sectors by testing the twelve sectors of economy; namely, farm food crops, livestock

product, forestry, fishery, mining and quarrying, non-oil and gas industry, electricity, gas

and water, construction, retail and wholesale trade, hotels and restaurant, transport and

communications, and other private and services sectors.

34
 Interestingly, FDI in the electric, gas, and water and private services have a

positive correlation with economic growth. However, FDI in forestry and mining sectors

has a negative effect on economic growth. The results seem to support the argument that

extractive FDI might not enhance economic growth. Furthermore, the expectation that

manufacturing sector has a positive effect on economic growth does not arise. Therefore,

these empirical evidences suggest that Indonesia should not only focus on attracting on

more foreign direct investment inflows but also investigate the policies that will

maximize the benefits from FDI inflows through appropriate composition of FDI inflows.

35
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Appendix I
Negative Investment List

NEGATIVE LIST BASED ON PRESIDENTIAL DECREE 96/2000

jo.118/2000

ATTACHMENT I :

LIST OF BUSINESS FIELDS ABSOLUTELY CLOSED FOR INVESTMENT

AGRICULTURAL SECTOR

1. Cultivation and processing of marijuana and the like

MARINE AND FISHERY SECTOR

2. Collection/utilization of sponge

INDUSTRIAL AND TRADING SECTOR

3. Industries producing chemicals harmful to the environment, such as penta

chlorophenol, Dichloro Trichloro Ethane (DDT), dieldrin, chlordane, carbon
tetra chloride, Chloro Flouro Carbon (CFC), methyl bromide, methyl
chloroform, halon etc.
4. Industries producing chemicals stipulated in Schedule - 1 of the Chemical
Weapon Convention (sarin, soman, tabun, mustard, levisite, ricine and
saxitoxin)
5. Industries producing weapons and related components
6. Industries producing cyclamate and saccharine
7. Industries producing alcoholic drinks (liquor, wine and drinks containing
malt)
8. Casino and gambling facilities

COMMUNICATIONS SECTOR

9. Air traffic system providers (ATS providers), ship certification and

classification inspections
10. Management and operation of Radio Frequency Spectrum and Satellite Orbit

40
 Monitoring Stations

MINING AND ENERGY SECTOR

11. Mining of radioactive minerals

ATTACHMENT II :

LIST OF BUSINESS FIELDS CLOSED TO INVESTMENT IN WHICH A

PART OF THE SHARE ARE OWNED BY FOREIGN CITIZENS AND / OR
FOREIGN BUSINESS ENTITIES

FORESTRY AND PLANTATION SECTOR

1. Germ plasma cultivation

2. Concession for natural forests
3. Contractors in the field of lumbering

COMMUNICATION SECTOR

4. Taxi/bus transportation services

5. Small-scale sailing

TRADING SECTOR

6. Trading and trading supporting services, except: Large-scale retailers (malls,

supermarkets, department stores, shopping centers), wholesale trading
(distributors/wholesalers, exporters and importers), exhibition/convention
service providers, quality certification service providers, market research
service providers, warehousing services outside seaports, and after-sale
services.

INFORMATION SECTOR

7. Radio and television broadcasting services providers, radio and closed circuit
television broadcasting services, and multimedia and printed media.
8. Motion picture production industry (film production, film technical services,
export and import film business, film distributors and motion picture theatre
operation).

ATTACHMENT III:

LIST OF BUSINESS FIELDS OPEN TO INVESTMENT UNDER

CONDITION OF A JOINT VENTURE BETWEEN FOREIGN AND

41
DOMESTIC CAPITAL

1. Building and operation of seaports

2. Electricity production, transmission and distribution
3. Shipping
4. Processing and provision of potable water for public use
5. Atomic power plants
6. Medical services, including the building and operation of hospitals, medical
checkups, clinical laboratories, mental rehabilitation service, public health
maintenance security, rent of medical equipment, assistance services for
health aid and evacuation of patients under emergency conditions, hospital
management services and services for testing, maintenance and repair of
medical equipment
7. Telecommunications
8. Regular/non-regular commercial airliners.

ATTACHMENT IV

LIST OF BUSINESS FIELDS OPEN TO INVESTMENT UNDER CERTAIN

CONDITIONS

MARINE AND FISHERY SECTORS

a. Cultivation of fish in fresh waters

a. Open to foreign investments for freshwater turtles, nila gift, sidat, kodok
lembu, fresh water giant shrimps and thillapya sp;
b. In cooperation with small-scale fishery business
b. Fishing of demersal fish (big fish, grouper and other sea fish)
- except ZEEI areas of the Malacca Strait and Arafura sea

INDUSTRIAL SECTOR

3. Industries producing wood pulp

a. raw material obtained from imported chips or guarantee of raw material
supplied from industrial timber estates (HTI)
b. other than sulfonating and/or chlorination (C 12)
4. Industries producing pulp made of other cellulose fibres or other materials
- other that sulfonating and chlorination (C 12)
5. Industries producing chloro alkali
- other that those using mercury
6. Processing of finished/semi-finished goods made from mangrove wood
- raw material coming from mangrove cultivation
7. Money printing industry

42
 - Operational licenses from BOTASUPAL -BAKIN and approval from Bank
Indonesia required
8. Special printing industries (postal stamps, duty stamps, Bank Indonesia
negotiable papers, passports and stamped postal matter)
- Operational licenses from BOTASUPAL - BAKIN required
9. Milk processing industry (powder and sweetened condensed milk)
- processing (not only repackaging)
10. Plywood and rotary veneer industries
- only for The Irian Jaya Province (Papua)
11. Sawn timber industries
a. only for the Irian Jaya province (Papua)
b. outside the Irian Jaya province (Papua), only using logs from non natural
forests
12. Ethyl alcohol industries
- Technical grade, being only used as raw materials and auxiliary materials of
other industries.
13. Industries producing raw materials for explosives (ammonium nitrate)
- Only in cooperation with business entities which have secured a
recommendation from the Ministry of Defense
14. Industries producing explosives and components for industrial (commercial)
use
a. Only in cooperation with business entities which have secured a
recommendation from the Ministry of Defense.
b. Only manufacturing activities, while storage and distribution are executed
by companies appointed by the government.
15. Electricity planning and supervision consulting services
Open to foreign investments with the provision that:
a. PLTA (Hydro power plant) with a capacity above 50 MW,
b. PLTU (steam power plat) with a capacity above 55 MW,
c. PLTP (geothermal power plant) with a capacity above 55 MW,
d. Main electrical relay station with a voltage above 500 KV,
e. Transmission networks with a voltage above 500 KV
16. Electricity equipment construction, maintenance, installation services,
development of technology supporting the supply of electricity and testing of
electricity installations.
Open to foreign investments with the provision that:
a. Main electrical relay stations with a voltage above 500 KV,
b. Transmissions networks with a voltage above 500 KV
17. Petroleum and natural gas drilling services
Open to foreign investments with the provisions that:
a. only for offshore drilling,
b. especially for locations outside the Eastern Indonesia Region, must
cooperate with national partners operating in a similar business field.
18. Power plant businesses

43
 - Open to locations outside Java, Bali and Madura

TRADING SECTOR

19. Restaurants
- Open to foreign investments with the special provision that they must be
located in tourism areas/zones and/or integrated with hotels
20. Game services
- Open to foreign investments with the special provision that they must be
located in tourism areas/zones and/or integrated with hotels.

Source: http://www.bkpm.go.id/

44