TRADE AND INVESTMENT LIBERALIZATION EFFECTS ON SME DEVELOPMENT: A LITERATURE REVIEW AND A CASE STUDY OF INDONESIA

International trade and investment policy have undergone fundamental change in Indonesia over the past two decades. Significant trade liberalization began in 1986 and since 1994 Indonesia has significantly reduced its applied MNF tariffs from an unweighted average of about 20% in 1994 to 9.5% in 1998. In 1998, tariffs on food items were reduced to a maximum of 5%. Besides tariffs, Indonesia has undertaken to remove all non-tariff barriers and export restrictions. Since the beginning of the 1997/98 Asian financial crisis, Indonesia has also deregulated its trade regime in the main agricultural commodities (except rice, for social reasons), terminated production and trade monopolies in certain intermediate industries (cement, plywood, rattan) and reduced export taxes on wood.

The impact of international trade and investment policy reforms on the Indonesian economy, focusing on economic growth and development of domestic manufacturing industry has been studied extensively enough. However, the implication of these trade and investment policy reforms on the growth of small and medium enterprises (SMEs) in Indonesia remains an under-researched area of both the literature on SMEs in Indonesia and in general.

Following a comprehensive review of the available literature on the effects of international trade and investment policy reforms in section II, overviews of International trade and investment reforms in Indonesia and of the development of Indonesian SMEs are given in, respectively, sections III and IV. Effects of the reforms on Indonesian SMEs are examined in section V, complemented by findings from a cased study of a cluster of Indonesian manufacturing SMEs in section VI. Conclusions and policy recommendations are in section VII.

No doubt that the surge in exports of manufactured goods from Indonesia that occurred in the late1980s until the mid-1990s coincided with a sharp increase in FDI in the country. Several previous studies have indicated that multinational enterprises (MNEs) were the source of a large portion of the surge of manufactured exports and also made important contributions to changes in export composition of Indonesia.
Trade policies in Indonesia also played an important role in the growth of the country’s manufactured exports and the change in composition of manufactured exports. James and Ramstetter (2005) emphasized how low protection which adopted by the Indonesian government in the 1980s with respect to certain industries was a key facilitator of rapid export growth of those industries. Despite a slowdown in export growth that began in 1996 and continued into 1998 with the Asian financial crisis, Indonesia did not reverse its export-oriented trade liberalizing reforms. After the crisis, many MNEs expanded their operations in Indonesia (Takii and Ramstetter 2004).

1. Effects of International Trade Reform on SMEs

It is generally believed that trade liberalization should beneficial for domestic economy as well as the world as a whole. At an aggregate level, the channels through which trade reform could bring benefits are broadly the followings: improved resource allocation; access to better technologies, inputs and intermediate goods; economies of scale and scope; greater domestic competition; availability of favorable growth externalities like transfer of know-how and many others.

Theoretically, reform towards international trade liberalization could affect (positively or negatively) individual local firms in four major ways:

• by increasing competition: lower import tariffs, quotas and other non-tariff barriers have the effect of increasing foreign competition in the domestic market, and this is expected to push inefficient/unproductive local firms to try to improve their productivity by eliminating waste, exploiting external economies of scale and scope, and adopting more innovative technologies, or to shut down. Openness of an economy to international trade is also seen as increasing plant size (i.e. scale efficiency), as local firms adopt efficient technologies, management, organization, and methods of production

• by lowering production costs due to cheaper imported inputs: local firms benefit from lower input costs, thereby allowing them to compete more effectively in both domestic markets against imports and in export markets;

• By increasing export opportunities: opening up to international competition will not only induce increased efficiency in domestic firms but it will also stimulate their exports;

• By reducing availability of local inputs: eliminating export restrictions on unprocessed raw materials will increase export of the items at the cost of local industries.

In Indonesia, within many existing studies on SMEs in the country, perhaps the only evidence on the effects of trade reforms before the 1997/98 economic crisis on SMEs’ exports is from a field study conducted by Berry and Levy (1994). They surveyed 91 SME exporters in three sub-sectors of manufacturing, and conducted intensive interviews with 30-40 public and non-profit agencies active in SMEs issues between January and June 1992. The three sub-sectors were garment in Jakarta and Bandung (both are in West Java), rattan furniture in Jakarta and Surabaya (East Java), and carved wooden furniture in Jepara (Central Java). From a total of 33 interviewed rattan product exporters, they found that all but one of the firms sampled exported 90% or more of their output, and 26 of 33 firms began exporting the same year they entered into production. Most of them started to export or increased their export share in their total production since the Indonesian government imposed bans on the export of unprocessed and semi-processed rattan in 1986 and 1988-89 respectively. So, it seems that the ban has been a key factor leading to a major expansion in rattan furniture exports of Indonesia’s SMEs.7Indeed, there are many cases, though unfortunately no official data are available, showing that free exports of raw materials have created difficulties for SMEs.

2. Effects of Investment Liberalization on SMEs

As with trade liberalization, investment liberalization should also take into consideration what impact (positive and negative) would have on the SMEs. Theoretically, investment liberalization affects SMEs in a number of ways.
On the positive side, a better investment environment generates many new firms or/and encourage existing firms (including SMEs) to expand their production capacities. The expansion of local SMEs can also take place with direct link to LEs, including MNCs/FDIs through e.g. subcontracting production linkages (‘complementary effect’).

On the negative side, however, reform towards FDI liberalization has the effect of increasing new LEs at the cost of existing SMEs unable to compete (‘competition effect’). Thus, ‘complementary effect’, rather than ‘competition effect’, can be considered to minimize the negative impact of investment liberalization on SMEs. SMEs in Indonesia, it is hard to say whether the long-term gradual process of investment liberalization, started first by the introduction of Foreign Direct Investment Law in 1967 marking the beginning of the openness to FDI, and followed by the ‘real’ liberalization with the introduction of various incentives to attract FDI (including more sectors open for FDI) in the second half of the 1980s and reached the climax after the crisis 1997/98 with the IMF Reform Agreement, has created complementary net effects or competition net effects on local SMEs.

FDI is an important source of technology transfer to local firms in developing countries,16suggesting that investment liberalization will also act as a stimulus for local SMEs from this perspective. Based on his study on the role of FDI in the so-called Newly Industrializing Countries (NICs) such as South Korea, Taiwan, Hong Kong, and Singapore, Soesastro (1998) states the following: there is no doubt that FDI plays an important role in cross-border flows, transfers and the diffusion of technology.