Foreign Direct Investment and Firms' Productivity Level: Lesson Learned from Indonesia

This paper analyses the effects of foreign direct investment (FDI) on local firms' productivity in Indonesia. We found evidence of increased local firms' productivity associated with the presence of FDI. Our estimate shows that intra-industry and forward linkage mechanisms have a positive effect on local firms' productivity. This suggests that FDI may have stimulated emulation in the domestic firms through demonstration effect and inter-firm worker mobility within the same type of industry, which will in turn result in an improvement of the productivity of the domestic firms. However, despite those positive effects, we argue that Indonesia has not been successful in maximizing the benefits from the presence of FDI. In particular, FDI does not contribute to the development of local supporting industries as it failed to promote backward linkage spillover. For this reason, Indonesia needs to provide the right incentives to encourage FDI for the development of domestic supporting industries.