Introduction

The purpose of this chapter is to examine the likely implications of the formation of AFTA on the volume and pattern of foreign direct investment (FDI) in the ASEAN region. There is avast and growing body of literature on ASEAN and AFTA. An important aspect that has not received adequate attention relates to the implications of AFTA for FDI in the region. This is a serious omission because FDI has acted as one of the most important sources of economic growth for all countries in the region, and therefore issues relating to the impact of AFTA on the relocation of industries in the region are likely to be important points of contention in the implementation of the proposed regional tariff preference scheme.

To assess the possible implications of AFTA for FDI in the region, we adopt the following two-step approach. In the first step, potential channels through which the formation of a free trade area (FTA) could affect FDI flows are identified by reviewing the relevant theoretical literature. This is done in order to provide an objective framework for evaluating such arrangements. In the second step, quantitative evidence relating to economic and political performance of AFTA is analysed in light of the criteria established in step one to make inferences about the subject at hand. Given the ex ante nature of the analysis, we are compelled to invoke the assumption that the proposal will be fully implemented (an assumption which does not seem unrealistic, for reasons discussed later in the chapter). The formation of a FTA has implications for both the members of the arrangement (insiders) and the countries excluded from the arrangement (outsiders). We focus on the former aspect only. Furthermore, we consider only the implications for the volume and composition of FDI; welfare implications of such changes are beyond the scope of the analysis.

Introduction

In the 1990s the creation of preferential trading groups (PTGs) in the global economy has become highly controversial, both among scholars and in the body politic of affected countries. Regarding the former, because global free trade maximizes international efficiency by providing a global division of labour, economists argue that a world without barriers to trade — that is no preferential treatment favouring domestic producers over foreign producers — would be one in which world economic welfare would be greatest. Hence, PTGs are inferior to multilateral agreements under the General Agreement for Tariffs and Trade (GATT), for non-discriminatory free trade dominates free trade areas that do discriminate (between member and non-member countries). However, an increasing number of economists maintain that PTGs can be used as an effective complement to trade liberalization under GATT. Also, they note that advocacy of free trade in the 1990s goes well beyond mere liberalization of tariffs, as has been done traditionally under GATT, to include a host of other issues such as non-tariff barriers, subsidies, trade in services, etc., which are far more difficult to change, especially in the light of the tremendous diversity of GATT's 117 member states. PTGs are easier to negotiate because they involve fewer countries which usually have relatively similar interests. In short, the advocates of PTGs tend to agree that free trade is best, but recognize that the proper comparison is not between PTGs and multilateral free trade, but rather between free trade and the (highly imperfect) status quo. This division in the discipline of international trade is one of the most dramatic in recent memory.

Moreover, in the United States and elsewhere in the developed world outside of the European Union (ELI) — formerly the European Community, or EG — the PTG option is relatively new, at least with respect to domestic politics.

Southeast Asian security is intertwined with the overall East Asian/ I Western Pacific situation. The East Asian picture today is a mixed one. The optimism about the future of the region based on a number of positive factors is now tempered with some political and security uncertainties. Tensions have built up in the Taiwan Strait which carry risks of military conflict and serious implications for U.S.-China relations. The situation on the Korean peninsula also looks more dangerous than it did a year ago. But first, the positive factors.

Positive Factors

These are well known. Most of the East Asian economies continue to roar ahead and economic interdependence continues to grow. The relationship between economics and interstate security is a complex one. It depends upon what forces impinge upon decision-making at any particular juncture. However, the relationship has been a positive one in much of East Asia in recent years. High growth rates also help to keep domestic social and political problems manageable. For instance, sharp declines in economic growth in countries such as Indonesia and China, which have serious underlying social problems, could produce social and political instability.

In the political-security field, relations between the major powers — the United States, China, Japan, and Russia — if not always amicable, have not been characterized by enmity, as was the case during the Cold War. The U.S. military presence and the U.S.-Japan defence alliance, widely regarded as the linchpin of East Asian security, continue and their importance was reaffirmed in the February 1995 U.S. Department of Defence document entitled United States Security Strategy for the East Asian Region.

ASEAN has been enormously successful as a confidence-building mechanism among its members and will continue to discourage interstate conflict within the Southeast Asian subregion. And in the Asia-Pacific region as a whole there is unprecedented dialogue on political, security, and economic issues at both the bilateral and multilateral levels. Two important region-wide multilateral institutions, the ASEAN Regional Forum (ARF) and the Asia-Pacific Economic Co-operation (APEC) forum, have been established in recent years for dialogue and co-operation on security and economics, respectively.

Conclusions

This study investigates the effects of the 1983 financial reform on the financing and investment behaviour of manufacturing establishments in Indonesia during the period 1981–88. The 1983 financial reform was part of an overall structural adjustment programme such as tax reform and trade reform; hence changes in the behaviour of manufacturing establishments may be attributed to other reforms as well as those in the financial sector. However, the study has tried to approach and identify the effects of the financial reform in many different ways.

The full sample of 2,970 manufacturing establishments has at least three years of positive output. Consequently, by the nature of the data, new entrants to the market after 1985 have been excluded. Clearly, as suggested by the literature, these young establishments are likely to face financial difficulties that have not been captured.

Secondly, the study has calculated descriptive statistics of profitability and financial structure for different categories of firms, both before and after liberalization. Those data suggest that smaller firms benefit disproportionately from enhanced access to external fundings after the reform, despite the increase in interest rates. There is a process of convergence of productivity levels among various categories of establishments, a feature that may suggest increasing economy-wide efficiency.

Thirdly, in order to explore analytically the way in which the financial reform may have affected these changes, an appropriate econometric method — the Generalized Method of Moments — is used to capture the dynamic structure of the model and compensate for the presence of general heteroskedasticity across firms over time. Observations with zero-investment level then had to be eliminated, reducing the sample size to 523 establishments. A full explanation of the econometric restrictions is provided in Chapter 3, section 3. However, the analysis of the differences between including and excluding zero-level investment suggests that the findings will be reinforced if an appropriate method is found to employ the full sample.

Introduction

The discussion in the previous chapter shows that Indonesian manufacturing establishments seem to have different access to credit according to their characteristics. Evidence also exists that the elimination of administered interest rates and credit ceilings has changed previously negative real interest rates to relatively high positive rates. Relying on recent theoretical and empirical studies on the link between financial market imperfections and real activity, this chapter will examine whether the deregulation of the banking system has resulted in any relaxation of financial constraints that firms face in their investment behaviour. In particular, this chapter will analyse whether different types of firms have different financing behaviour before and after the financial reform.

In order to analyse cross-sectional variations in financing and investment behaviour before and after the financial reform, establishment data for the manufacturing sector that are currently available in suitable form for the period 1981–88 only will be used. The 1981–84 period will be referred to as the “prederegulation” period on the assumption that changes instituted late in 1983 had insufficient time to affect real investment decisions until well into 1984, while 1985–88 will be referred to as the “post-deregulation” period. This dichotomization suggests a once-for-all regime shift that considerably exaggerates the reality. Rather, there was a fairly continuous process of deregulation of various aspects of the economy after mid-1983. Furthermore, the response of economic agents to these reforms took place fairly gradually. Nevertheless, for our purposes, the 1983 reforms were extremely significant for increasing levels of real interest rates, and reducing credit controls on individual banks. Dominant state banks were forced to act more autonomously and to base their lending decisions more on commercial criteria than had been the case before the reform.

Review of the Literature on Investment and Financial Constraints

Over the last decade, studies that link financial structure and investment behaviour have been put on firmer theoretical ground, borrowing heavily from the economics of information and incentives.

Introduction

During the 1980s, Indonesia undertook a series of structural reforms in response to its deteriorating economic situation especially in the market for Indonesia's primary export, petroleum products. It was recognized that high economic growth could not be sustained by export earnings alone, and that diversification from oil-related export was needed. The deregulation of the banking system removed control on interest rates and administratively determined credit ceilings were abolished. The devaluation of the rupiah and trade deregulation were part of the programme to stimulate economic growth and improve resource mobilization.

This chapter gives an overview of the Indonesian economy and discusses the process and effects of the financial liberalization. The reform in the financial sector should be examined in the context of the whole economic reform. Macro-economic and financial-sector indicators of 1981–88, which reflect the economic growth, capital accumulation, and financial deepening will be presented, as well as the behaviour of interest rates, and a brief review of the financial system in relation to the industrial policy. There is also an assessment on whether the dramatic switch in the regulatory regime generated any efficiency and growth benefits as predicted by financial repression literature (McKinnon 1973; Shaw 1973).

Macro-Economic Review and Economic Background to Deregulation

Since 1968 Indonesia has been having a high rate of growth, facilitated considerably by high oil prices in the 1970s and early 1980s. As an oil exporter, Indonesia experienced two major booms, in 1974–77 and 1979–82. The period of oil boom, which began with a quadrupling of oil prices in 1973 and continued with high prices until 1982, had profound effects on the Indonesian economy. Table 1.1 shows the growth of its gross domestic product (GDP) since the beginning of 1970. During the first period of the oil boom (1972–81), the average annual change was 8.1 per cent, a very high figure compared with other developing countries.

APPENDIX I: DATA CONSTRUCTION

This appendix describes the procedure used to construct my data set, including the method used to construct annual capital stocks and stocks of debt that are not available in the original survey data.

Data Construction

The data has been taken from the annual surveys on manufacturing establishments conducted by the Central Bureau of Statistics since 1975. An additional data set, which proves to be very useful because it contains data on capital stocks and exports, is the 1986 Census of Manufacturing Establishments. The number of establishments in the annual survey varies from 8,300 establishments in 1975 to around 14,000 in 1988, and the 1986 census has 5,830 establishments with complete capital stock data.

I select a sample of firms from those two sources as follows. As there is no data available on financial sources prior to 1981, a sample period which runs from 1981 to 1988 is used. The 1981–88 survey data include 4,400 firms with complete data for at least three sequential years of output. The census data include 5,430 firms. Merging the 1981–88 survey with the 1986 census set brings the total number of firms to 3,192. I then construct a capital stock estimate by back-casting and forecasting the capital stocks, using the capital stock from the 1986 census data as a benchmark (see below for details). Leaving out establishments that have negative and zero capital stock and outliers, and keeping firms that have at least one year of positive investments, leaves us with 2,970 establishments (data set I). The frequency of each category of firms is given in Table 1 of this appendix. This data set is used to calculate the tables in Chapter 2 and the summary statistics in Chapter 4, section 4.

A very large number of firms report zero investment for many years. I am unable at this time to determine whether reporting of zero investment is in fact a non-response or represents a real observation of very low investment. I run a logit estimation of investment where it takes a value of 1 if investment is positive, and zero otherwise, the results of which are given in Table 2 of this appendix.