Globalization and the Automotive Industry ADEW 2011

7/27/2019 Globalization and the Automotive Industry ADEW 2011

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Globalization and the Automotive Industry:

Is Indonesia missing out?

Abstract

International trade in automotive and auto parts has grown rapidly during the last two decades but

Southeast Asia largest economy, Indonesia, is lagging behind in its export performance. This paper uses

comparative perspective in examining Indonesia's role in automotive production networks in the context of

the contemporary debate on opportunities for reaping gains from economic globalization through

engagement in global production sharing. Panel data regression on all countries for period 1988-2007 isapplied to analyse factors affecting a country’s participation in global production networks. The regression

result suggests that a country's ability to gain from global production sharing depends more on the service

link factors than production cost factors. Indonesia is indeed left behind in export side but not on the

import side of the global production network. The major factors which affect Indonesian condition are the

costly business practice and low quality of institutions and legal certainty which discourage foreign

investor

Keywords: automotive, auto parts, globalization, product fragmentation, global production networks,

Indonesia, Thailand.



I. Introduction

International trade in automotive and auto parts is growing rapidly in the last two decades where

the growth of automotive production reached the highest annual growth during the period 1989-

2000 with almost 5% growth per annum. There is a shift in a global production pattern from the

North America and European countries dominance in 1960 to Japanese dominance in 1970s and

1980s. And for the last twenty years some developing countries increased their production shares in

global market.

The participation of developing countries in automotive industry was made possible by the

technology development and innovations in telecommunication and transportation, which enable

automotive industry to fragment the production process into smaller segments in which

components of productions or assemblies can be relocated to different places based on cost

advantages. The relocation of segmented production process creates global production networks.

However Indonesia as the largest economy in Southeast Asian seems to miss out the opportunity to

reap gains from the globalization in the automotive industry.

This paper examines from a comparative perspective Indonesia's role in automotive production

networks in the context of the contemporary debate on opportunities for reaping gains from

economic globalization through engagement in global production network. Automotive industry is

considered as vital ingredients in national economic development strategies therefore government

involvement in automotive industry is quite intense. Therefore it is necessary to evaluate the role of

government policies in Indonesia on the development of the industry. Analysis on the dynamics of

Indonesian automotive industry is important to ascertain the impacts of government regulation on

the industry and determine Indonesian position in the global automotive industry.

A pooled panel data regression is undertaken to determine the factor affecting countries'

participation in production network in the automotive industry which has become increasingly

globalized over the past two decades. The regression result suggests that a country's ability to gain

from global production sharing depends crucially on labour cost as well as the quality of institutions



explaining the global production networks. Section 4 describes Indonesian automotive industry and

its position on global automotive production and trade. Section 5 presents the analytical framework

which includes model specification, variable constructions and data, and estimation method. Section

6 reports the result and discussion. Section 7 concludes.

II. Globalization in Automotive Industry

The automotive industry is one of the biggest in the world and employs more than eight million

people making the vehicles directly, and more than forty million people indirectly through related

manufacture and services sectors (OICA, 2007). In principle, the automotive industry is an assembly

industry, where more than a thousand parts and components are produced by independent

industries. Dicken (2003) categorized the major processes in the automotive industry prior to the

final assembly process into the manufacture of bodies, of components and of engines (as shown in

Figure 1).

Figure 1:

MAJOR

SUPPLYING

INDUSTRIES

Bodies

Components

1. Manufacture of mechanical and electrical

components (e.g. Instruments, carburettors,

braking systems, steering components, etc)

2. Manufacture of wheels, tyres, seats,

windscreens, exhaust systems, etc.

Engines and transmissions

Consumer

Market

Final

Assembly

Manufacture

and stamping of

body panels

Body

assembly

and painting

Steel and other

metals

Rubber

Electronics

Plastic

Glass



assembly line developed by Henry Ford in 1913. During the 1920s the US car production contributed

84% of world car production and in 1929 it started to export 10% of its production, which

accounted for 35% of the world market. The expansion of the US production urged the European

governments to protect their domestic car producers and promote their national automotive

industries.

The second transformation occurred at the end of 1950s with the implementation of the General

Agreement of Tariff and Trade (GATT). The significant reduction in tariffs integrated the markets

and enabled the European automotive producers to expand their markets with their specialization

on small cars which were energy-efficient. At the beginning of the 1980s the US’s domination of the

world’s automotive producers started to decline, while European production increased.

The third transformation occurred in the 1970s when Japan started to penetrate the world market

with their new lean production system. This new system enabled Japan to produce automotive more

efficiently compared to the US and Europe, with far fewer employees and a “just-in-time” system

compared to the “just-in-case” system operating in the US. The expansion of the Japanese automotive

industry threatened domestic production in the US and Europe and urged the US and European

governments to apply interventionist policies such as import quotas, tariffs and Voluntary Export

Restriction (VER). The differences between craft production, Fordist mass production and Japanese

lean production is summarized in Table 1.

Since 2000 China became one of the major car producers in the world and since 2008 it replaced

Japan’s position as the second largest car producer. India also shown significant growth in their car

production and its share in the global car production increased significantly from 1.5% in early 2000

to almost 5% in 2010.

Along with the continuous transformation, global automotive production experienced a change of

pattern as shown in Table 2. Global production of automobiles was dominated by North America and

European countries in 1960. North America contributed more than 50% of automotive production

while European countries shared almost 40% of global production or around 13 thousand units. The

US d G h i d f bil d i h i d D i h 1970



5

Table 1: Comparison among Craft Production, Fordist Mass Production and Japanese Lean Production

Characteristics Craft Production Fordist Mass Production Japanese Lean ProductionTechnology Simple, but flexible tools and

equipment using un-standardized

components

Complex, but rigid single-purpose

machinery using standardized component.

Heavy time and cost penalties involved in

switching to new products

Highly flexible methods of production

using modular component systems.

Relatively easy to switch to new

products

Labour Force Highly skilled workers in most

aspects of professional production

Very narrowly skilled workers design

products but production itself performed by

unskilled/ semi skilled “interchangeable”

workers. Each performs a very simple task

repetitively and in a predefined time and

sequence

Multi-skilled, polyvalent workers

operate in teams. Responsibilities

include several manufacturing

operations plus responsibility for

simple maintenance and repair

Supplier relationships Very close contract between

customer and supplier. Most

suppliers located within a single city.

Distant relationship with suppliers, both

functionally and geographically. Large

inventories held at assembly plant ‘just in

case’ of disruption of supply

Very close relationship with a

functionally tiered system of

suppliers. Use a ‘just in time’ delivery

systems encourages geographical

proximity between customers and

suppliers

Production volume Relatively slow Extremely high Extremely high

Product variety Extremely wide – each product

customized to specific requirements

A narrow range of standardized designs

with only minor product modifications

Increasingly wide range of

differentiated products

Source: Dicken (2003), table 4.2





An important characteristic of the auto parts is that there are few fully generic parts and

components which can be used in a wide variety of final products without extensive customization

such as in the electronics industry. This characteristic limits auto parts firms in reaching economies

of scale in production and economies of scope in design. The relationship between auto parts

suppliers and car assemblers are typically captive and relational. Many components are relatively

heavy compares to electronics industry therefore relocation to close proximity is preferable to a

more distant location. This condition leads to agglomeration in the automotive industry.

Sturgeon et al (2008) argue that the dispersion of the automotive industry has a nested geographical

and organizational structure. Global integration occurred through buyer-supplier relationships,

especially between car makers and their largest suppliers. Production tends to organize regionally

or nationally, where parts and components which are bulky and heavy tend to locate in close

proximity with the assembler to ensure on-time delivery and to save transportation costs.

Meanwhile smaller, lighter and standardized parts and components can be located at a distance totake advantage of lower labour cost and economies of scale. Vehicle development is concentrated in

a few design centres. As a result, local, national and regional production networks in automotive

industry are nested within the global organization and structures of the largest car maker firms.

There are three large regional clusters in the automotive industry: Europe, North America and Asia.

Within a region there is a tendency to shift investment locations to lower operating cost countries,

such as Mexico in North America, Spain and Eastern Europe in the European region and to Thailand

and China is Asia. Auto parts are more heavily traded within a region compared to the finished

goods. Within a country, production and employment are concentrated in a location which provides

better infrastructure and which in turn lowers the service link costs.

World’s auto parts trade increased significantly from $170 billion in 1990 to almost $700 billion in

2007, with an annual growth of 8.7% which reflects the higher intensity of global production

networks in the automotive industry (see Table 3). The world auto parts trade is dominated by the

EU(15) and North American countries. There is no significant change in the trend of auto parts trade

in the world during 1990-2007.



share are South Korea, Thailand and Indonesia. South Korea’s share increased from 1.5% in 1990-

1994 to more than 2.3% in 2007, while the increase on Thailand and Indonesia’s export shares are

relatively modest.

On the import side, the East Asian countries’ contribution is much lower than on export side. It only

contributes around 11% of world import, while the share of North American countries’ import is

around 32% which is higher than their export’s share. Most of ASEAN countries experienced a

decline in import value in 2000 due to the depreciation of their local currency caused by the Asian

financial crisis in 1997-1998, as this resulted in more expensive imported goods. In 2007, some

ASEAN countries such as Thailand and Indonesia recovered from the Asian financial crisis and their

imports of auto parts were even higher than the 1995 level. Although in 2007 the import value

increased more than double from the 1995 level, East Asian countries’ import share is relatively

constant at 11% of world auto parts imports.

Table 4 depicts the mapping of the East Asian auto parts trade. Most East Asian auto parts are

exported intra-regionally (36% of total East Asian exports), while exports to North American and EU

(15) countries are relatively lower (26% and 14% respectively). This pattern is consistent with the

characteristics of auto parts which are relatively heavier and larger than the electronics parts and

components. The larger the intra-regional export in East Asia over time reflects the stronger regional

production network in East Asia, as explained by Sturgeon (2008). Prior to 1995 Thailand was a

major export destination for East Asia with a share of 6%, but now, China is the top export

destination for the auto parts export (20% in 2007), followed by Japan (7%) and Thailand (4%). East

Asian exports to China are larger than exports to NIEs (8%) and slightly lower than exports to

ASEAN countries (11%).

Intra-region trade is more apparent on the import side, where 63% of East Asian imports of auto

parts come from East Asian countries. An increase in intra-regional imports in East Asia together

with an increase in East Asian imports from the EU (15) resulted in a sharp decline in imports from

North American countries. This pattern reflects an upgrade of the East Asian auto parts industry,

where some parts which originally came from North America can now be produced in East Asia.





Table 4: East Asian auto parts trade: geographic composition, 1990 - 2007

Percentage 1990 1995 2000 2007Export to

World 100.00 100.00 100.00 100.00

East Asia 20.97 32.20 28.36 35.59

Japan 0.94 2.15 4.32 6.58

China 0.96 6.12 5.97 9.88

NIEs3 7.35 9.19 7.83 7.84

Hong Kong 1.83 3.63 2.98 3.18 South Korea 3.03 2.59 2.83 3.23

Singapore 2.48 2.97 2.01 1.42

ASEAN5 11.73 14.74 10.24 11.29

Indonesia 3.49 3.94 2.79 2.89

Malaysia 2.06 3.20 2.51 2.55

Philippines 0.98 1.57 1.44 1.12

Thailand 5.16 5.81 3.01 3.79 Viet Nam 0.04 0.22 0.48 0.95

North America 43.37 35.00 35.88 25.88

EU (15) 16.92 15.69 16.95 14.41

Others 18.73 17.11 18.81 24.12

Import from

World 100.00 100.00 100.00 100.00 East Asia 56.03 59.36 59.29 62.82

Japan 48.29 43.89 32.18 23.24

China 0.72 5.08 10.95 18.88

NIEs3 3.96 5.50 6.38 7.93

Hong Kong 0.38 1.08 1.09 0.38

South Korea 2.23 2.23 3.09 6.39

Singapore 1.35 2.19 2.20 1.16 ASEAN5 3.07 4.89 9.78 12.77

Indonesia 0.21 0.51 1.66 2.83

Malaysia 1.30 1.99 2.53 1.64

Philippines 0.64 1.26 2.07 1.86

Th il d 0 92 1 10 3 12 5 37



III. Product Fragme

In the initial formulation, all pro

place as a single integrated

development together with in

development of a fragmented p

as shown in Figure 2(B). These

service links such as transporta

others services. Several patter

can be envisaged. Figure 2(C) s

another production block, whi

blocks exists where there is a si

these is assembled in the last p

the number of stages or produ

importance of service links.

Figure 2: Production Network

tation Theory

duction processes in the automotive industry w

roduction block as shown in Figure 2(A).

ovations in telecommunication and transport

oduction process which consists of more than

production blocks are not independent, but ar

ion, design, quality control, insurance, R&D, tel

s of interdependence between production blo

ows that an output of one production block can

e in Figure 2(D) a more complex relationshi

ultaneous operation of production blocks and

roduction block. The degree of fragmentation

ction blocks. As the degree of fragmentation in

re conducted in one

owever technology

ation promoted the

ne production block

connected through

communication and

ks and service links

become an input for

among production

the output of each of

can be measured by

creases, so does the



Production network started in t

other industries such as spor

machines, office equipments,

publishing. One example of th

example, has an assembly cen

several countries in East Asia, a

other East Asian markets. To

follows the same pattern whe

countries and then assemblies t

other East Asian markets.

Fragmentation theory was dev

th b ki d f th i t

e electronics and clothing industries and then

t footwear, automobiles, televisions and radi

ower and machine tools, camera and watch

global production network is Japanese car pr

re for cars in Thailand. This assembly centre

sembles those parts and then exports the finis

ota also has another assembly centre for SU

re Toyota Indonesia imports parts and comp

hese parts and components before exporting t

loped by Jones and Kierzkowski (1990). Prod

t d i t t t f d ti

radually spread into

o receivers, sewing

s and printing and

oducers. Toyota, for

imports parts from

ed cars to Japan and

s in Indonesia that

nents from several

e SUVs to Japan and

ct fragmentation is

( d ti bl k )



When a firm’s output increases

integrated production process

Cost (MC), or it can switch to a

flatter than TC1 because of tra

from an increased specializatio

caused by setting up new pro

emerge to connect the produc

process increases to TC2’. Notecost is independent of output le

is steeper than TC2.

Figure 3: Total Cost and Output

The process described in Figure

blocks and connecting service

combination of fixed cost and

above Y1 as shown in Figure 3, a firm can choos

otal Cost (TC1) which consists of some Fixed Co

fragmented production process with Total Cos

e-off between a lower MC and a higher FC. A l

of productive tasks and division of labour, whil

uction blocks. With a fragmented production

ion blocks, therefore the total cost of the fra

that TC2 and TC2’ are parallel because we assuvel. If service links cost is driven up by the leve

3 can be repeated to higher orders, creating a n

links as shown in Figure 4. For any degree

arginal cost within the production blocks ensu

e either to stay at an

st (0A) and Marginal

t of TC2. Here, TC2 is

wer MC is obtained

e an increase in FC is

block, service links

gmented production

e that service linksof output, then TC2’

mber of production

f fragmentation the

es that average cost



Figure 4: Cost and Output unde

Following the significant reduct

barriers, fragmentation is likel

international market. Firms ar

prices among countries in de

comparison between local prod

total cost (fixed and variable co

line H’ represents additional co

locate a production block in an

technologies available in that

Fragmentation

ion to international coordination costs such as

to occur first on a local or national basis an

able to take advantage of differences in tec

signing a more global production network.

uction networks and global production networ

t) when all production blocks are located in one

st associated with local service links. Suppose

ther country in order to take advantage of fac

ountry The home country has a lower marg

rade and regulatory

then spread to the

nologies and factor

igure 5 shows the

s. Line H represents

country (Home) and

now that a firm can

or endowments and

nal cost in the first



Figure 5: Total Cost and Output

The traditional theories of trad

of specialization according to c

production blocks. Both the

Heckscher-Ohlin model on fact

production blocks. The results

and fragmentation as level of

complicates the analysis since i

in the traditional theory into si

and components. The answer athe standard considerations of

relative cost and efficiency of s

2003).

: Effect of Foreign Service Links

are still relevant in the product fragmentation

mparative advantage is still a basis for a decisi

icardian model on the variety of factor pr

r prices and factor intensities provide explanat

rom comparative advantages add the gains fro

utput increases. The introduction of cross-b

increases the number of products being trade

tradable items if each of the final products ha

to which country will specialize on which itemcomparative advantage in the production blo

ervice links between any pair of countries (Kie

heory. The principle

n on the location of

ductivities and the

ons for trade within

increasing returns

order fragmentation

from two products

s two tradable parts

depends not only oncks, but also on the

rzkowski and Arndt,



rise whenever firms in one country supply not only their own industry, but foreign one as well. It is

no longer necessary for producers to master the entire production chains, therefore large and small

firms can save the learning cost and focus on component production

Based on production technology, the intensity of fragmentation depends on four factors (Lall, et.al,

2004): fist is the technical “divisibility” of the production process: not all production processes can be

divided into separate stages. Some industries have discrete stages of production and components

with different scale, skill and technology requirements which enable the stages then to be separated

and located at different locations and different ownership. Electronics and automotive

manufacturing are examples of these industries. On the other hand, the chemical industry, for

example, has continuous production process is not economically separable. Second, the factor

intensity of the process: the relocation of a production process to a low-wage site is economical only

if it is labour intensive and the reduced cost from labour is greater than the transportation and

coordination costs. Third, the technological complexity of each process: it is not always economical to

relocate a labour intensive process to a low-wage site unless the technology accompanying this

process is simple and stable enough to be conducted by low-wage countries. Finally, the value-to-

weight ratio of the product: the distance of relocation depends on the value-to-weight ratio of the

product. If the parts and components are light and of high value then the relocation of the process to

a further location in order to exploit cost differences is still economical. If the parts and components

are heavy and have low value then it is economic to relocate to proximate areas and encourage

agglomeration.

Service links are essential for production networks in order to connect production blocks into one

integrated production process. Following Kimura and Takahashi (2004) elements of service link

costs can be categorized into four groups: trade costs, investment costs, communication costs and

coordination costs.

Trade costs are those costs related to the trade of parts and components among production blocks

whether it happened in the same firm or with other firms (arm’s length firm), both domestic and

international. Most of production blocks located in foreign countries conducted through Foreign



Table 5: Elements of Service Link Costs

IV. Indonesian Automotive Industry

Automotive industry in Indonesia has been established since 1927, but it was mainly for trading

activities since the assembly activities was still very limited and the import of cars was not regulated.

After 1940s the assembly activities in Indonesia increased with the importation of completely

knocked-down (CKD) packs to increase labour utilization and technical skills as well as a saving of

foreign exchange. However with further declining of foreign exchange, even the importation of CKD

was ceased except for assembly for government’s need which was financed by government-to-

government grants from other countries (Witoelar 1983). The New Order government under

Soeharto in 1966 realized the need to increase the supply of all goods and commodities including

automobiles. The government allowed any kind of automobiles importation, from completely build

up (CBU), CKD, semi-knocked down (SKD) and even used cars. This surge of imported goods

hampered the development of assembly auto parts industry in Indonesia. The open door policy to

Category Subcategory Details

Trade Costs

transportation costs shipment charge, freight chargepolicy barriers tariff barriers: ad valorem tariff, specific tariff, non-tariff barriers

(quotas, others)

information costs search cost for sellers or buyers, research costs for preference of

foreign people

costs associated with the use of

different currencies

cost of exchange rate volatility, risk edge and uncertainty

legal and regulatory costs direct and indirect costs to deal with legal regulatory issues and

procedures

local distribution costs cost to utilize local infrastructure, and to efficiently deliver goods to

local consumers

Investment Costs

policy barriers indirect cost due to prohibition to entry, absence of national

treatment, and other fdi discriminated measures

information costs search cost for suppliers

contract enforcement costs direct and indirect costs to make sure

legal and regulatory cost direct and indirect costs to deal with legal regulatory issues and

procedures

Communication

Costs

telecommunication costs, internet fee

Coordination

Costs

timeliness indirect costs due to inadequateness of time delivery

uncertainty indirect cost due to uncertainty regarding coordination of a series of

activities from production to shipment of end productsSource: Kimura and Takahashi (2004)



extended; tax incentives were reduced; and the number of foreign personnel was restricted

(Pangestu 1996).

The major government policy that supports the development of auto parts industry was Deletion

Program in 1976. By Minister of Industry Decree no 307/1976, government schedules the gradual

deletion of specific components from the imported CKD packs used in the assembly of commercial

vehicles but not in passenger cars. One objective of deletion program is to stimulate technology

transfer from Japanese auto parts industry to local manufacturer through stable, durable and intense

subcontracting relationship between large car assembling firms and the local auto parts supplier

firms. However, in reality many of components intended to be made locally was actually assembled

from imported parts and components (Aswicahyono, Basri et al. 2000). Therefore government

intention to develop local auto parts manufacturer was not achieved.

The rapid development of assembly activities started in the early 1970s because of the oil boom.

Indonesian automotive market expanded strongly at the early 1970s because of oil boom with the

increase of makes and models. The large number of varieties create very segmented and small

market for auto parts industry and unable them to reach economies of scale. In 1983, government

attempted to rationalize the automotive industry by requiring car assembler to reduce the number

of car brands and models they assembled to achieve economies of scale. The objective was to have

larger market share for each brand and to increase efficiency and lower production cost. However

this regulation was not implemented effectively because of strong rejection from vested interests in

the industry. Another decree was stipulated in 1983 on compulsory use of locally made

components. However this decree was not successful due to the lack of technology, capital and skills

in technical areas of the small and medium scale manufacturers. It resulted on reluctance of foreign

car makers to invest heavily in locally small and medium manufacturer and created shallow, short

term and non-exclusive relationship between assemblers and auto parts manufacturers.

Since there was a little success of deletion program in fostering the development of auto parts

industry in Indonesia, in 1993 government terminated the deletion program and replaced it with the

Incentive program. In this program, assembler are not forced to use locally made auto parts, instead



In 1996, Soeharto signed a shocking decree appointing the Timor Putra Nasional (TPN) company

(owned by his son) as the sole manufacturer of the national car, Timor. TPN did not have one single

auto plant, with a joint venture with KIA Motor from Korea, they started to build factory in

Indonesian and meanwhile the cars were produced wholly in Korea and exported to Indonesia in

CBUs. As a national car, it received pioneer status with exempting it from import duties and luxury

sales tax. This national car program was heavily criticized by Japan, the US and the EU and they filed

complaint to WTO which then ruled that the program was a violation to WTO rules. Although the

national car program only last for a while it has big impact on automotive industry in Indonesia.

After the financial crises in 1998, Indonesia has to sign Letter of Intent under the IMF which requires

Indonesia to rapidly liberalize the market. Indonesian government introduced harmonized system

under WTO system in 1999. In this harmonized system, the local content programs were removed

and Indonesia signed the “trade-related investment measures” (TRIMS). The protectionist policy

toward automotive industry was replaced by market liberalization program. The June 1999 tariff

reform has significantly reduced the import tariff for CBU and CKD imports, but it remains relatively

high.

A frequent change in policies toward automotive industry in Indonesia creates uncertainty for both

domestic and foreign investments which in turn hampered the development of automotive industry

especially auto parts manufacturer. Transfer of technology from Japanese car makers to domestic

small and medium enterprises did not occur as expected since Japanese car makers are reluctant to

transfer the technology because they are unable to secure majority of ownership.

Automotive production network in Indonesia has developed rapidly for the last twenty years with

the increase number of car and motorcycle parts producers by three fold and four fold respectively.

The stronger local production networks are due to policies set up by Japanese car makers to

optimize local procurement for cost efficiency and minimizing exchange rate risk. However high

dependency on Japanese car makers hamper the development of domestic auto parts makers since

they are bind to a cooperation agreement which sometimes prohibit them to have cooperation with

other companies.



and Indonesia are relatively caught at assembling the same products such as radio-broadcast

receivers and resource based products, i.e. tyres. This condition reflects that Indonesia has been

relatively left behind in the automotive global production network compared to other ASEAN

countries, although it has potentials such as abundant labour and a relatively large market size.

V. Analytical Framework

The empirical model employed in this paper is based on Jones and Kierzkowski (1990)fragmentation theory which states that fragmentation will occur when production cost per se

drastically falls and the cost of the service links connecting the production blocks become low

enough. The aim is to answer two research questions; the first is on the determinants of a country’s

participation in the global production network, and the second question is whether Indonesia is left

behind in the global production networks compared to other countries.

This research provides new contribution to the empirical studies on the global production network.

While the existing studies focused on selected countries and group of countries, this research covers

all countries in the world and cover long period from 1988 to 2007. One reason to include all

countries in this research is to enable comparison between developed and developing countries as

well as between regions. It also avoids selection bias problem which would occur if countries are

selected based on the trade value or regions.

The existing empirical studies has separately analysed the determinants of the global production

networks. Jones et al (2005) and Golub (2007) focused on the role of service link in the global

production network. Lowering of service link costs promotes fragmentation and outsourcing of

output. The first study uses the business telephone charges as a proxy of service link cost. They

compare three regions: East Asia, EU 15 and NAFTA for period 1990-2000. The result supports the

theory that lowering of business telephone charges increases the trade of parts and components.

The second study uses the index of service link quality and costs as a proxy of service links. They

construct the index consisting of consisting of transport, communications, and electric power



Athukorala and Yamashita (2006) use the gravity model to examine the extent, trends and patterns

of the global production networks. They found that relative wage differentials are a significant

determinant of cross border trade in components (as well as the related final products).

In summary, the existing empirical studies find that global production network is explained by cost

differences among countries which consist of production cost and service links costs. The decision

on which country will specialize on which item depends not only on the comparative advantage bust

also on the relative cost and efficiency of service links.

V.1 Model Specification

The empirical model employed in this research is based on Jones and Kierzkowski (1990)

fragmentation theory which states that fragmentation will occur when production cost per se

drastically falls and the cost of the service links connecting the production blocks become low

enough. The decision on which country will specialize on which item depends not only on the

comparative advantage bust also on the relative cost and efficiency of service links. Therefore the

explanatory variables in the model can be grouped into production cost and service link costs. The

dependent variable is fragmentation index which is represented by the trade of parts and

components.

Production Costs

Production cost in this model consists of three variables: labour cost, quality of labour and

competitiveness. In the ideal model, the production cost should include capital cost as well.

However, capital cost is not included in the model because it is difficult to find comparable variable

for capital cost for all countries in the world.

Labour cost

As suggested by the standard international trade theory, comparative advantage is still relevant in

the fragmentation trade. Labour cost (RWages) is crucial in determining the location of production

bl k i d f i A i h l l b ill d i



countries with similar aggregate factor endowments can explain the trade across industry

(Grossman and Maggi, 2000; Ohnsorge and Trefler, 2004). A country with higher technology

intensity is expected to attract more production blocks and will increase the fragmentation index.

Competitiveness

Traditionally, the appreciation of domestic currency raises import and lowers exports. However in

the production networks the relationship can reverse. The response of a country’s exports to the

exchange rate should decline as the share of imported components for use in the manufacture of itsexport rises. Therefore the impact of relationship between changes in exchange rate (RER) and

trade will be negative in the presence of production networks. Moreover, as suggested by Arndt and

Hummer (2004), the sensitivity of trade to exchange rate will decline with the more intensive

fragmentation trade among countries. Then the exchange rate would not be significant in

determining the global production networks.

Service links costs

Besides the production costs listed above, the fragmentation index depends highly on service links

which connect the production blocks and ensure that the production blocks interact in the proper

manner. Basically, goods and services are traded among the production blocks both domestically

and across the border. Therefore it is possible to categorize service link cost into two types of trade

barriers, one is at-the-border trade barriers and another is behind-the-border trade barriers.

At-the-border trade barriers

Across-the-border trade barriers are barriers that affect the flow of goods and services across

countries (borders) which include freight cost and tariff and non tariff barriers.

Freight costs

One explanation of the rise in the international trade is a decline in the international transportation

costs (Hummels, 2007). The decline in the cost is associated with the innovations in transportation



Transportation costs co-vary with distance and it well explains the reason of countries trade with

their neighbours first. However distance is not a perfect measurement for the transportation cost

since it does not reflect the change in the quality of transportation. With the declining of air

transport cost and the technology development which enables parts and components to be relocated

in the smaller structure, long distance trade is relatively more attractive.

Therefore the expected sign of freight cost and value of trade can be either positive or negative

depends on the type of traded commodities.

Tariff

Vertical trade is more sensitive to tariff changes compares to final trade (Yi, 2003). Parts and

components are subject to a tariff every time they cross the border. Therefore any reduction in the

parts and components tariff will reduce the production cost, and the level of this reduction will

depend on how many times the fragmented product crosses the border. However, most of

production blocks are located in Special Economic Zone which might include Free Trade Zones

(FTZ), Export Processing Zones (EPZ), Free Zones (FZ), Industrial Estates (IE), Free Ports, Urban

Enterprise Zones and others. Therefore it is expected that the sign of Tariff is negative although it

might not be significant. Another type of trade barrier is Non-Tariff Barriers which are commonly

used by a country as a substitute of the abolishment of tariff barriers and are sometimes more

protective than the tariff barriers. Unfortunately the data on NTB is not widely available for allcountries; therefore it is not included in the model.

Behind-the-border trade barriers

Behind-the-border trade barriers refer to a variety of barriers that operate inside countries rather

than at the border, but that nonetheless can restrict trade. They include trade facilitation and

business and regulatory environment.

Trade Cost

Trade facilitation is generally defined as an improvement of efficiency in logistics and related trade-



Business and regulatory environment

Most of the production blocks located in foreign countries conducted through Foreign Direct Investment (FDI), therefore business and regulatory environment related to the FDI is important

factor determining participation in global production networks (Jongwanich,2009). FDI openness is

crucial in the automotive industry because with the possibility of having full foreign ownership in a

country, foreign car maker is willing to bring the latest technology and improve managerial practices

and close supervision of assembly/production by bringing in foreign technicians and managers. It is

expected that the more open the FDI policies in a country the higher the participation in a global

production network, then the expected sign of FDI_Openness is positive.

Institutional quality is relevant in the process of production fragmentation which involves

establishing a complex relationship between two parties engaging in specific investment

relationship. Expansion of production fragmentation will be limited if the quality of institutional is

low. Two indicators are used in the model to represent quality of institutions in a country; fist is the

cost of starting a new business (Buss_Cost) and second is the cost of enforcing a contract

(Contract_Cost). Long and expensive process in attaining a license for new business will discourage

not only foreign investors but also domestic investors in establishing production blocks in a country.

Meanwhile the efficiency of the judicial system in resolving a commercial dispute also affects

investment decision in a country, especially in the automotive industry where most investment is

capital intensive. The expected signs of these variables are negative.

Other variables

Market size

Trade of parts and components depends on market size of export destination and import source

countries. With a larger market size, it is expected that the trade flow of parts and components

increased. Therefore the expected sign for market size (Market) is positive.

Dummy variables



t it i

iit i

it it i

t it it it i

C T Market

Cost Contract Cost BussOpen FDI

Cost TradeTariff

Tech RER RWages FragIndx

,,10

98,7

6,5,4

,3,2,1,

_ _ _

_ Distanceln

lnlnln

ε ϕ β

β β β

β β β

β β β α

++∂++

+++

+++

+++=

where subscript i represents the i-th country, i = 1,2, .., 200, and t represent the year, t = 1988,

1989,… , 2007. The variables are listed and defined below with the expected sign of the coefficient

for independent variables in parentheses:

Frag_Indx Fragmentation Index – dependent variable

RWages Labour cost (-)

Tech Quality of labour (+)

RER Real exchange rate (-)

Distance Freight cost (+/-)

Tariff MFN tariff (-)

Trade_Cost Trade cost (-)

FDI_Open FDI openness (-)

Buss_Cost Cost for starting new business (-)

Contract_Cost Cost of enforcing the contract (-)

Market Market size (+)

T A set of time dummy variables

C A set of country dummy variablesα A constant term

V.2 Variable construction and Data



The end point is 2007, since this was the latest year for which data for most of variables are available

and data for 2008 – 2009 are susceptible from global financial crisis.

Fragmentation Index (dependent variable)

Dependent variable is the real value of export and import of parts and components. The trade data

are sourced from the UN Comtrade database1 and the data is originally expressed in the nominal

US$. The real value is derived using the US import price index collected from the US Department of

Labor2. The automotive industry uses one import price index for the three groups, i.e. the import

price index for automotive Parts & Accessories.

The Athukorala 2009 list is with some modification by including other parts and components which

are considered as auto parts by the Japan Auto Parts Industries Association (JAPIA) and the

Indonesian Automotive Parts and Components Industries Association (GIAMM). Additional parts and

components include tyres, safety glass, electronics parts for automotive, brakes, and safety airbags.

Production Cost

Labour cost

Labour cost is represented by real wage which is calculated from the nominal wages of each country

in US$ deflated by the US Wholesale Price Index (WPI). Nominal wage from the ILO-Laborsta3

database is expressed in the country’s currency therefore it should be converted into US$ using

nominal exchange rate for each country sourced from the WDI website4. However, only 113 of 200

countries have wages data.

US P e

wage RWages

*=

Wherewage denotes nominal wage in domestic currency for each country, e denotes the nominal

exchange rate in the US$ and US P denotes the US Wholesale Price Index as a deflator.

Q lit f L b



pharmaceuticals, scientific instruments, and electrical machinery. This ratio is available from the

WDI for 173 countries.

Real Exchange Rate

The real exchange rate (RER) is calculated by the following conventional formula:

e

w

eP

eP RER =

Where e denotes the nominal exchange rate measured in terms of foreign currency, w P is an index

of foreign price and d P is an index of domestic price. The producer (wholesale) price index is used

as proxy of w P and, the GDP Deflator is a proxy for d P .

RER based on the price index is not appealing in a pure cross-sectional context because the data only

reflect changes relative to the base year of the index used, with no indication of overvaluation or

undervaluation of a given currency. The alternative measurement is to use the deviation between

RER and the mean of RER over the period with the assumption that the mean of RER is the long-term

equilibrium of the RER (Soloaga and Winters, 2001).

Service links costs

Freight Cost

Some empirical models use distance (Distance) as a proxy of freight cost. Since this model use

unilateral trade instead of bilateral trade, the determination of distance (Distance) is not as

straightforward as in the gravity model. Therefore the distance is calculated between a country and

its major exporter and importer countries. First the major partner is determined for each region and

then each country in the region is assumed to have the same major partner. If a county is also a

major partner for the particular region then the distance is measured by the distance between that

country with its major partner.



FOB

Freight

FOB

CIF +=1

CIF value is the import value of each country, while FOB value is the world export to each country.

Although the calculation of Freight value using matched partner method is frequently used in the

literature (Baier and Bergstrand, 2001; Limao and Venable, 2001) there is a well-known

measurement error associated with this approach (Anderson and van Wincoop, 2004; Hummels and

Lugovsky, 2006; Hummels, 2007). It has been found that the calculated freight cost do not

necessarily reflect the real shipping cost variation. In fact, the freight cost calculated during the data

construction stage turned out strange and only two percent of the data satisfy the above condition.

Therefore this variable is dropped from the model.

Tariff

The tariff variable is sourced from the average applied MFN import tariff for manufactured goods

from the UNCTAD database5.

Trade cost

Cost for export and import are collected from the World Bank’s Doing Business Survey which

conducted on 183 economies from 2004 – 2010. Cost for export and import is sourced from the

Trading Across Borders indicators which compile procedural requirements for exporting and

importing a standardized cargo of goods by ocean transport. The cargo is a dry-cargo, 20-foot, full

container load of the domestic private, limited liability company that has at least 60 employees. The

company is located in the economy’s largest business city but not operate in an export processing

zone or an industrial estate with special export or import privileges and exports more than 10% if its

sales. For exporting goods, procedures range from packing the goods at the warehouse to theirdeparture from the port of exit. For importing goods, procedures range from the vessel’s arrival at

the port of entry to the cargo’s delivery at the warehouse.

Trade cost ( XCost and MCost ) measures the fees levied on a 20- foot container in U.S. dollars. These



The variable used to represent FDI openness is the Inward FDI Potential Index from World

Investment Report - UNCTAD which captures several factors (apart from market size) expected to

affect an economy’s attractiveness to foreign investors. The Inward FDI Potential Index is an average

of the values (normalized to yield a score between zero, for the lowest scoring country, to one, for

the highest) of 12 variables (see Appendix for detail). The expected sign for FDI openness is

negative since the higher the index means the lower the potential inward FDI.

Cost of Starting a New Business

The variable for measuring the cost of starting a new business is sourced from the from the World

Bank’s Doing Business Survey which conducted on 183 economies from 2004 – 2010. The cost

includes cost for all procedures that are officially required for an entrepreneur to start up and

formally operate an industrial or commercial business. These procedures include obtaining all

necessary licenses and permits and completing any required notifications, verifications or

inscriptions for the company and employees with relevant authorities. This definition only includes

procedures required of all businesses are covered. Industry-specific procedures are excluded.

Cost of Enforcing the Contract

This variable is also sourced from the World Bank’s Doing Business Survey. It measures the efficiency

of the judicial system in resolving a commercial dispute. The data are built by following the step-by-

step evolution of a commercial sale dispute before local courts and collected through study of the

codes of civil procedure and other court regulations as well as surveys completed by local litigation

lawyers and by judges.

Other variables

Market Size

Market size variable is different for export and import model. For export, market size is measured by

the real world import of auto parts which is sourced from the UN Comtrade database and the data is

originally expressed in the nominal US$. The real value is derived using the US import price index for



There is a possible two-way causation between behind-the-border trade barriers and trade flows. It

is possible that higher trade flows will stimulate lower behind-the-border trade barriers since

exporter and importer have more power to lobby the government to improve the trade facilities as

well as better institutions. The Hausman-Wu specification test is conducted to judge whether this

causation is a problem in the data compiled in this study. The result reject null hypothesis that there

is causality from trade flows to trade facilitation. Therefore there is no evidence that trade flow will

improve the trade facilitation and better institutions. However, this test requires the instrument

variables for trade facilitation variable. Following Djankov et al. (2006), the instrument used here is

the number of signature required from custom officials for processing trade transactions, number of

procedures to be completed to get a new business license and number of procedures to trace the

chronology of a commercial dispute before the relevant court. In addition, quality of democracy and

political institution from Polity IV database6 is used as an instrument. The democracy variable is the

difference between the democracy and the autocracy scores in this database, averaged over the

period 9−t . It implies measures the competitiveness and regulation of political participation, the

openness and competitiveness of executive recruitment, and the constraints on the executive. These

instrument variables are directly correlated to the behind-the-border trade barriers variables but

not directly related to the trade flows.

There are two estimation techniques available for panel data regression, fixed and random effect.

Since the difference among countries is important, the fixed effect estimation is used for this model.The fixed effect estimator can be implemented in three ways; time demeaning (or within

transformation), the first-difference or least square dummy variable (LSDV). The first two cannot be

implemented in this model since they will eliminate the time-invariant variables such as trade cost,

cost of starting a new business and cost of enforcing contract which are important in the model. On

the other hand, the LSDV technique with country and time dummies can handle the time-invariant

variables. Finally to guard against heteroscedasticity problem, the heteroscedasticity-consistent

standard errors (i.e. the White correction) are used.

VI Results and Discussion



parts as well as to determine whether Indonesia is left behind in the global production networks

compares to other countries.

From the diagnostic tests, the export model suffers from the endogeneity problems therefore LSDV

with two-stage least square is applied to correct for the endogeneity problems. Meanwhile the

import model does not have endogeneity problem hence the LSDV without two-stage least square is

applied.

Table 8 and 10 present the estimation results for export and import models respectively to answer

the first question which is the determinants of the global production networks. Table 9 and 11

present the estimation results to determine whether Indonesia is left behind in the global

production networks.

Table 6: Summary Statistics

Variable Variable Description Obs Mean Std. Dev. Min Max

FragIndx1 Real Trade Value (log) 2445 12.38 4.16 (0.66) 20.73

RWages Real Wages (log) 1245 7.91 2.31 (1.23) 13.99

Tech Quality of Labor (log) 2060 1.34 1.93 (10.87) 4.32

RER Rearl Exchange Rate (log) 529 0.07 3.10 (8.52) 8.61

Distance Distance to Major Partner (log) 2445 8.40 0.74 7.40 9.37 YWorld Real Value of World Import of Auto parts (log) 2445 22.44 0.37 21.33 23.11

GDPcap GDP per capita (log) 2249 8.13 1.58 4.45 11.55

Pop Population (log) 2012 15.82 1.98 10.91 21.00

FDI_Potential FDI Potential Index (log) 1734 3.81 1.00 - 4.95

Tariff MFN Tariff (log) 1795 1.83 0.97 (2.81) 4.72

Xcost Cost for export (log) 2093 6.89 0.46 5.97 8.43

Mcost Cost for import (log) 2093 7.04 0.51 5.91 8.42

Contract_Cost Cost for starting a new business (log) 2093 3.24 0.63 (2.30) 5.09

Buss_Cost Cost for enforcing contract (log) 2073 2.80 1.67 (1.61) 8.76

Notes: Appendix 3 summarizes the data sources



32

Table 7: Correlation Matrix

RWages Tech RER Distance YWorld GDPcap Pop

FDI_

Potential Tariff Xcost Mcost

Contract

_ Cost

Buss_

Cost

RWages 1

Tech 0.1003 1

RER 0.5828 -0.1429 1

Distance 0.3563 -0.1216 0.3386 1

YWorld 0.2132 -0.1726 0.3435 0.158 1

GDPcap -0.0354 0.509 -0.5438 -0.4699 -0.1955 1

Pop 0.1415 0.0754 0.1291 0.4249 0.0163 -0.1853 1

FDI_Potential 0.1577 -0.5038 0.551 0.3893 0.3495 -0.7502 -0.0709 1

Tariff -0.081 -0.3848 0.261 0.4755 -0.1095 -0.6443 0.2728 0.4353 1

Xcost -0.133 0.0887 0.1393 -0.0982 0.0751 -0.1123 0.0501 0.0599 0.027 1

Mcost -0.1433 0.0193 0.1147 0.0354 0.0604 -0.1841 0.172 0.0749 0.1823 0.9348 1

Contract_Cost 0.2892 -0.1827 0.4574 0.383 0.1646 -0.4895 0.2536 0.3984 0.4372 0.0221 0.1288 1

Buss_Cost 0.1854 -0.3895 0.4672 0.3484 0.3156 -0.6308 0.2998 0.6775 0.3838 0.0929 0.1191 0.3298 1

Variable desription:

RWages

Tech

RER

Distance

YWorld

GDPcap

PopFDI_Potential

Tariff

Xcost

Mcost

Contract_Cost

Buss_Cost

Cost for export (log)

Cost for import (log)

Cost for starting a new business (log)

Cost for enforcing contract (log)

Real Wages (log)

Quality of Labor (log)

Rearl Exchange Rate (log)

Distance to Major Partner (log)

Real Value of World Import of Auto parts (log)

GDP per capita (log)

Population (log)FDI Potential Index (log)

MFN Tariff (log)



VI.1. Export Side

Since export models suffer from the endogeneity problem for the behind-the-border trade barriers

then two-stage least square method is applied with quality of democracy and political institution and

the number of documents in export processing and the number of documents in the contract as the

instrumental variables. The analysis is separated into all countries, developed and developing

countries and three regions that have intensive production networks in the automotive industry as

presented in Table 8.

For first model where determinants are examined for all countries, the model resulted quite well

with 98% of the variation in the model can be explained by the explanatory variables. Most of the

coefficients have expected sign except for the FDI openness, Export Cost and Business Cost. From the

estimation result, labour cost, distance and market size determine country participation in the global

production networks as expected by the traditional trade theory. However business and regulatory

environment especially the certainty of business conduct in a country plays more important factor in

the global production networks than in the traditional trade patterns. This condition is well

explained by the characteristics of export in the global production networks where most of the

export is related to the intra-firm trade. Parent company sets up production blocks in a country to

produce parts and components which will be exported to other countries to be assembled. Although

a country has comparative advantage in the lower labour cost, but if business and regulatory

environment is not good, parent company will be reluctant to set up the production blocks because

of the high risk.

This condition is more apparent in the developing countries than developed countries. Coefficient of

labour cost in developing countries is negative as expected where lower labour cost will increase the

value of auto parts export while the coefficient for developed countries is positive. First this result

seems contradict with the theory however it actually explains the impact of heterogeneity of labour

in trade patterns. Developed countries are specialising in the high technology intensive product

which requires more skilled and higher paid labour therefore the labour cost in the developed

countries is positively correlated with the export value Business and regulatory environment is is



34

Table 8: Determinants of global production network, 1988 – 2007 – Export Model

All Countries Developing Developed Asia Europe America

Real Wages -0.695*** -0.438*** 0.462*** -0.201 1.721*** -0.747***

(0.136) (0.134) (0.111) (0.181) (0.230) (0.057)

Quality of Labour 0.073 -0.029 -0.015 0.141 0.582*** -0.722***

(0.076) (0.090) (0.101) (0.148) (0.119) (0.214)

RER 0.017 -0.013 -0.028* -0.012 0.010 -0.191**

(0.023) (0.029) (0.015) (0.056) (0.029) (0.097)

Distance -6.766*** -2.366** -3.179*** -3.926*** 0.028 -0.342

(1.056) (1.093) (0.122) (0.564) (0.604) (0.787)

Tariff -0.027 -0.067 0.004 -0.266** 0.604*** 0.085

(0.072) (0.077) (0.148) (0.119) (0.151) (0.124)

Export Cost 8.455*** 2.854*** -3.175*** 4.672*** 4.828*** 1.521***

(2.030) (0.435) (1.000) (1.719) (1.665) (0.550)

FDI Openness 0.203* -2.540*** -1.344*** -1.456*** 0.134 13.195***

(0.113) (0.904) (0.147) (0.309) (0.375) (0.799)

Business Cost 4.489*** -18.858*** 0.794 4.309*** 21.104*** -24.664***

(1.612) (2.959) (0.774) (0.365) (5.581) (0.852)

Contract Cost -18.333*** -5.083*** -6.002*** -4.505*** 40.899*** -59.066***

(2.289) (1.197) (0.341) (0.599) (12.414) (3.553)

Market 1.289*** 2.136*** 0.439*** 0.824*** 0.114 0.998

(0.166) (0.769) (0.142) (0.137) (0.218) (1.220)

Number of observations 355 184 174 65 157 82

Adjusted R2 0.983 0.985 0.993 0.992 0.971 0.990note: *** p<0.01, ** p<0.05, * p<0.1

Dependent variable: Real Value of Auto Parts Export

Export



Another comparison is among region which has intense automotive production networks namely

Asia, Europe and America. Asian region covers all countries in Asia plus Australia and New Zealand

because of their proximity to Asia. The estimation results are as expected.

In Asia, service link costs are more important than production cost in determining participation in

the global production networks. Labour cost is not significant while FDI openness and Contract Cost

are negative and significant. Tariff which is not significant in other model turns out to be significant

and negatively affects the export value in Asia. This unexpected result means that with the declining

in the tariff import, the export of auto parts from Asia is increasing. It is possible because most of the

exported auto parts use imported input in their production process therefore the declining in the

tariff import will increase imported input and in turn will increase the export. As expected the

coefficient for Contract Cost is significant and negative which means that participation in the global

production networks in Asia depends on the certainty of business activity in the country.

Meanwhile, automotive production networks in Europe depend on skilled and high paid workerswhich are consistent with the characteristics of developed countries explained above. Both real

wages and quality of labour have positive and significant coefficients. Tariffs, business cost and

contract cost are significant but with reverse signs. One explanation of these unexpected signs is

that parent companies in Europe locate their production blocks in their surrounding countries to

take advantage of the availability of skilled workers regardless of the service links costs related to

the production blocks.

On the other hand, America region which include the US, Canada and South Americans countries has

similar characteristics to developing countries than developed countries where service link costs are

more important than production costs in determining country’s participation in the global

production networks. The unexpected result is the positive and significant coefficient for FDI

openness which implies that country with less potential FDI condition will participate more in the

production networks.

The next research question is to determine whether Indonesia is indeed left behind in the

i d i k F hi d i bl f I d i i dd d i h



Table 9: Determinants of global production network, 1988- 2007 - Export Model by Group

All Auto PartsHuman Capital

Intensive

Unskilled Labour

Intensive

Technological

Intensive

Real Wages 0.659*** 0.663*** 0.926*** -0.216

(0.083) (0.092) (0.137) (0.376)

Quality of Labour 1.206*** 1.250*** 1.201*** 1.168**

(0.105) (0.115) (0.138) (0.460)

RER 0.194 0.202 0.201 -0.393

(0.236) (0.229) (0.305) (0.273)

Distance 0.991 1.117 2.155 -7.246***

(1.185) (1.150) (1.769) (2.454)

Tariff 1.188*** 1.191*** 1.872*** -0.006

(0.196) (0.214) (0.347) (0.690)

Export Cost 1.314 0.919 1.185 8.336**

(0.846) (0.834) (1.326) (3.281)

FDI Openness -1.710*** -1.529*** -2.658*** -0.615

(0.381) (0.377) (0.552) (0.662)

Business Cost -0.615 -0.816 -1.710 7.687***(0.973) (0.958) (1.498) (2.565)

Contract Cost 2.117*** 2.328*** 2.694*** -4.084***

(0.411) (0.418) (0.574) (1.464)

Market 0.786*** 0.769*** 1.144*** -0.096

(0.282) (0.253) (0.432) (0.717)

d_Ind -5.692*** -6.259*** -6.903*** 13.354**

(1.784) (1.780) (2.510) (5.430)

Number of observations 65 65 65 64

Adjusted R2 0 915 0 912 0 839 0 840

Export

Dependent variable: Real Value of Auto Parts Export



Automotive industry in Indonesia is a very protective sector as explained in the previous section and

a frequent change in policies towards the automotive industry creates uncertainty for both domestic

and foreign investments. With no majority of ownership before 1994, Japanese car makers were

reluctant to transfer the related technology to their partners in Indonesia which resulted in less

participation in production network compares to Thailand.

When comparing fragmentation determinants for different auto parts groups based on their factor

intensity, Human Capital Intensive (HCI) and Unskilled Labour Intensive (ULI) auto parts have

similar determinants with the overall auto parts and Indonesia is relatively left behind in these

groups. Meanwhile, Technology Intensive (TI) auto parts group has different determinants. The

coefficient for d_Ind is positive and significant which means that Indonesia is actually export more of

TI auto parts compare to the average of other Asian countries . Since most of the auto parts in this

category are relatively small therefore the distance is still significant.

In summary, country’s participation the global production network through the export of auto partsdepends more on the service link factors than production cost factors. Sound business and

regulatory environment is important since parent companies will be more willing to relocate their

production blocks to a country which can provide certainty for their business. This is more apparent

in the developing countries and Asian and America regions. Indonesia is indeed left behind because

of FDI policies in Indonesia are less open compares to neighbouring countries.

VI.2 Import Side

In addition to the export of auto parts, a country’s participation in the global production networks

can be analysed through the import of auto parts. Import of auto parts can be viewed as passive

participation in the global production networks. Car makers that relocate their production blocks in

a country usually require the inputs for the production blocks are sourced from their own country to

guarantee the consistency and quality of the products which will be sold domestically and for export

purpose. If most of the products are exported than the determinant of import part of the production

networks will be the same with the determinants of the export side of the production network. In the



38

Table 10: Determinants of global production network, 1988 - 2007 - Import Model

All Countries Developing Developed Asia Europe America

Real Wages -0.002 -0.051 0.266** 0.023 0.300*** -0.085***

(0.058) (0.042) (0.110) (0.287) (0.097) (0.027)

Quality of Labor 0.027 -0.004 0.061 -0.024 0.135* -0.078

(0.047) (0.053) (0.098) (0.128) (0.078) (0.062)

RER 0.014 0.037 -0.008 -0.131 0.021 0.043

(0.011) (0.025) (0.014) (0.085) (0.013) (0.039)

Distance 2.419*** 2.842*** -0.898*** 0.504 0.777***

(0.114) (0.089) (0.105) (0.389) (0.298)

Tariff 0.013 0.021 0.026 -0.129 0.078 0.063

(0.042) (0.052) (0.079) (0.142) (0.097) (0.065)

Import Cost -3.727*** 0.130 1.042*** 0.635 2.889*** 1.700***

(0.236) (0.151) (0.185) (1.085) (0.189) (0.203)

FDI Openness -1.189*** 0.338 -0.576*** -0.820* -0.638*** -0.548***

(0.064) (0.330) (0.132) (0.421) (0.053) (0.091)

Busines Cost 1.907*** 4.774*** -1.262*** 0.271 -0.748*** -0.275

(0.195) (0.770) (0.219) (0.853) (0.119) (0.196)

Contract Cost 0.663*** 0.622*** -3.738*** 1.398 0.560***

(0.163) (0.158) (0.693) (1.040) (0.147)

Market 1.048*** 1.295*** 0.383** -0.224 0.239* 1.155***

(0.124) (0.156) (0.187) (0.578) (0.144) (0.239)

Number of observations 372 188 184 65 165 82

Adjusted R2 0.989 0.986 0.989 0.962 0.992 0.995

note: *** p<0.01, ** p<0.05, * p<0.1

Import

Dependent variable: Real Value of Auto Parts Import



Labour condition, RER and import tariff do not significantly affect the import of auto parts in the

global production networks arrangement. It is because most of the trade under global production

networks is inter-firm trade where firms in host country are required to import the parts and

components from the parent country regardless of the labour condition, competitiveness and import

tariff. However, import of auto parts is determined by the import cost, FDI openness and the market

size of the country. Import cost and market size are the common determinants in the import model,

but FDI openness is specific determinants in import side of the participation in the global production

networks. FDI openness is important because the imported auto parts are used as the input for

production blocks established by the car makers and the decision of car makers to relocate the

production blocks in a country depends crucially on the investment climate. Business cost and

contract cost have positive and significant coefficients which imply that when it is more difficult for

foreign car makers to establish their own firms in a host country because of costly business practices

then local firms will establish their own firms and join the car maker as one of the production blocks.

One requirement imposed by foreign car makers to local firm to join their production network is toimport the auto parts from car maker’s production networks to guarantee the quality of the

products.

Comparing developing and developed countries on the import side, the estimation result for

developing countries reconfirms that when the business practices are relatively costly then the

import of auto parts will increase because local firms which join production network are required to

source their input from foreign car makers. Meanwhile, the estimation result for developed

countries is consistent with the theory except for the import cost. It is expected the import cost will

be negatively related to the import value but the estimation result is positive. Coefficient for labour

cost is positive since most of developed countries are endowed with the skilled labours therefore

imported input into the developed countries requires higher wages. Business cost and contract cost

are negatively related to import auto parts in developed countries which imply that better business

and regulatory environment in developed countries resulted in the higher import of auto parts.

Meanwhile, estimation results for three regions which have intensive production networks show

diff t d t i t f i F A i t i th ti ti lt l h



Table 11: Determinants of global production network, 1988 - 2007 - Import Model by Group

All Auto PartsHuman Capital

Intensive

Unskilled

Labour

Intensive

Technological

Intensive

Real Wages 0.010 0.056 -0.021 -0.052

(0.067) (0.069) (0.068) (0.070)

Quality of Labor 0.125 0.122 0.128 0.201

(0.134) (0.135) (0.134) (0.132)

RER -0.047 -0.101* 0.003 -0.000

(0.059) (0.060) (0.060) (0.062)

Distance 0.626* 0.525 0.764** -0.191

(0.336) (0.343) (0.332) (0.357)

Tariff 0.177 0.324 0.042 0.274

(0.266) (0.278) (0.259) (0.303)

Import Cost 0.768*** 0.738*** 0.799*** 0.668***

(0.206) (0.219) (0.195) (0.244)

FDI Openness -1.872*** -1.775*** -1.983*** -0.873*

(0.510) (0.531) (0.497) (0.514)

Busines Cost -0.388 -0.269 -0.489 -1.275**

(0.550) (0.571) (0.538) (0.641)

Contract Cost -0.500* -0.465* -0.556** -0.636**

(0.267) (0.281) (0.262) (0.285)

Market 1.081*** 1.122*** 1.027*** 1.588***(0.227) (0.234) (0.225) (0.249)

d_Ind 3.687*** 3.858*** 3.566*** 3.592***

(0.615) (0.645) (0.604) (0.664)

Import

Dependent variable: Real Value of Auto Parts Import



the production networks except for the Technological Intensive auto parts. In fact, the coefficients

are positive which mean that Indonesian imports are higher than the average of developing

countries. This condition is caused by the low quality of Indonesian auto parts production which do

not meet car makers’ standards and requirements therefore automotive firms in Indonesia have to

import most of their auto parts.

VII. Conclusion

Automotive industry experienced continuing transformation from European dominance in the

beginning of 20th century to the US dominance by the introduction of Fordism mass production in

early 20th century and to Japanese dominance in 1970s with the introduction of lean production

system. Saturated market in developed countries drives many carmakers to spread the market to

developing countries by setting up assembly and production base in individual country to serve the

domestic market. With the technology development and innovations in telecommunication andtransportation, automotive industry is able to fragment the production process into smaller

segments in which components of productions or assemblies can be relocated to different places

based on cost advantages. The relocation of segmented production process creates global production

networks. Product fragmentation enables developing countries to participate in the globalization of

automotive industry by focusing on their competitive advantage.

Indonesia as the largest economy in Southeast Asian also participates in the global automotive

industry. Automotive industry which was started in Indonesia in 1928 has shown slow development.

In comparative perspective, Indonesian position in the global automotive industry is quite weak. On

the production side, Indonesian position is below Thailand and Malaysia. While other ASEAN

countries have upgraded their auto parts industry from unskilled labour intensive to technological

intensive products, Malaysia and Indonesia are relatively caught at assembling the same products

such as radio-broadcast receivers and resource based products, i.e. tyres.

This study uses richer dataset than the existing studies since it includes all countries in the world for



country regardless of the labour condition, competitiveness and import tariff. FDI openness is

important because the imported auto parts are used as the input for production blocks established

by the car makers and the decision of car makers to relocate the production blocks in a country

depends crucially on the investment climate. If a country has costly business practice then local

firms will establish their own firms and join the car maker as one of the production blocks and they

are required to import auto parts from car makers’ production networks .

Indonesia is indeed left behind in export side of the global production network because of FDI

policies in Indonesia are less open compares to neighbouring countries. The major factors whichaffect Indonesian condition are the low quality of institutions and legal certainty which discourage

foreign investor to invest significant capital in Indonesia which is required for the technological

intensive auto parts. Automotive industry in Indonesia is a very protective sector and a frequent

change in policies towards the automotive industry creates uncertainty for both domestic and

foreign investments. With no majority of ownership before 1994, Japanese car makers were

reluctant to transfer the related technology to their partners in Indonesia which resulted in less

participation in production network compares to Thailand.

However, Indonesia is not left behind on the import side of production networks except for the

Technological Intensive auto parts. High intensity of Indonesian participation on the import side is

caused by the requirements of car makers to still import the auto parts because of the low quality of

auto parts production which does not meet car maker’s standards.

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Appendix

Appendix 1: List of country

1 Albania

2 Algeria

3 Andorra

4 Anguilla

5 Antigua and Barbuda

6 Argentina7 Armenia

8 Aruba

9 Australia

10 Austria

11 Azerbaijan

12 Bahamas

13 Bahrain

14 Bangladesh

15 Barbados

16 Belarus

17 Belgium

18 Belgium-Luxembourg

19 Belize

20 Benin

21 Bermuda

22 Bhutan

23 Bolivia (Plurinational State of)

24 Bosnia Herzegovina

25 Botswana

26 Brazil27 Brunei Darussalam

28 Bulgaria

29 Burkina Faso

30 Burundi

41 China, Macao SAR

42 Colombia

43 Comoros

44 Congo

45 Cook Isds

46 Costa Rica47 Croatia

48 Cuba

49 Cyprus

50 Czech Rep.

51 Czechoslovakia

52 Denmark

53 Dominica

54 Dominican Rep.

55 Ecuador

56 Egypt

57 El Salvador

58 Eritrea

59 Estonia

60 Ethiopia

61 Faeroe Islands

62 Fiji

63 Finland

64 Former Fed. Rep. of Germany

65 Former Yugoslavia

66 France67 French Guiana

68 French Polynesia

69 Gabon

70 Gambia



81 Guyana

82 Haiti

83 Honduras84 Hungary

85 Iceland

86 India

87 Indonesia

88 Iran

89 Iraq

90 Ireland91 Israel

92 Italy

93 Jamaica

94 Japan

95 Jordan

96 Kazakhstan

97 Kenya

98 Kiribati

99 Kuwait

100 Kyrgyzstan

101 Latvia

102 Lebanon

103 Lesotho

104 Libya

105 Lithuania

106 Luxembourg

107 Madagascar

108 Malawi

109 Malaysia

110 Maldives111 Mali

112 Malta

113 Martinique

114 Mauritania

125 Neth. Antilles

126 Netherlands

127 New Caledonia128 New Zealand

129 Nicaragua

130 Niger

131 Nigeria

132 Norway

133 Occ. Palestinian Terr.

134 Oman135 Pakistan

136 Panama

137 Papua New Guinea

138 Paraguay

139 Peru

140 Philippines

141 Poland

142 Portugal

143 Qatar

144 Reunion

145 Rep. of Korea

146 Rep. of Moldova

147 Romania

148 Russian Federation

149 Rwanda

150 Saint Kitts and Nevis

151 Saint Lucia

152 Saint Vincent and the

Grenadines

153 Samoa

154 Sao Tome and Principe

155 Saudi Arabia

156 Senegal

157 Serbia



169 Sudan

170 Suriname

171 Swaziland172 Sweden

173 Switzerland

174 Syria

175 Tajikistan

176 TFYR of Macedonia

177 Thailand

178 Timor-Leste179 Togo

180 Tonga

181 Trinidad and Tobago

182 Tunisia

183 Turkey

184 Turkmenistan

185 Turks and Caicos Islands

186 Tuvalu

187 Uganda

188 Ukraine

189 United Arab Emirates

190 United Kingdom

191 United Rep. of Tanzania

192 Uruguay

193 USA

194 Vanuatu

195 Venezuela

196 Viet Nam

197 Wallis and Futuna Islands

198 Yemen199 Zambia

200 Zimbabwe



50

Appendix 2: List of auto parts

No SITC FactorIntensity

Description

1 S3-6251 HCI Tyres, pneumatic, new, of a kind used on motor cars (including station wagons and racing cars)

2 S3-6252 HCI Tyres, pneumatic, new, of a kind used on buses or lorries

3 S3-62541 HCI Tyres, pneumatic, new, of a kind used on motorcycles and bicycles of a kind used on motorcycles

4 S3-62591 HCI Inner tubes

5 S3-62593 HCI Used pneumatic tyre

6 S3-69915 HCI Other mountings, fittings and similar articles suitable for motor vehicles

7 S3-69941 HCI Springs and leaves for springs, of iron or steel

8 S3-76211 HCI Radio-broadcast receivers not capable of operating without an external source of power, of a kind used in motor vehicles

(including apparatus capable of receiving radio-telephony or radio-telegraphy) incorporating sound-recording or reproducing

apparatus

9 S3-76212 HCI Radio-broadcast receivers not capable of operating without an external source of power, of a kind used in motor vehicles

(including apparatus capable of receiving radio-telephony or radio-telegraphy) not incorporating sound-recording or

reproducing apparatus

10 S3-76422 HCI Loudspeakers, mounted in their enclosures

11 S3-76423 HCI Loudspeakers, not mounted in their enclosures

12 S3-76425 HCI Audio-frequency electric amplifiers

13 S3-7841 HCI Chassis fitted with engines, for the motor vehicles of groups 722, 781, 782 and 783

14 S3-78421 HCI Bodies (including cabs), for the motor vehicles of groups 781,

15 S3-78425 HCI Bodies (including cabs), for the motor vehicles of groups 722, 782 and 783

16 S3-78431 HCI Bumpers, and parts thereof

17 S3-78432 HCI Other parts and accessories of bodies (including cabs)

18 S3-78433 HCI Brakes and servo-brakes and parts thereof

19 S3-78434 HCI Gearboxes

20 S3-78435 HCI Drive-axles with differential, whether or not provided with other transmission components



51

21 S3-78436 HCI Non-driving axles, and parts thereof

22 S3-78439 HCI Other parts and accessories

23 S3-78531 HCI Invalid carriages, whether or not motorized or otherwise mechanically propelled

24 S3-78535 HCI Parts and accessories of motorcycles (including mopeds)

25 S3-78536 HCI Parts and accessories of invalid carriages

26 S3-78537 HCI Parts and accessories of other vehicles of group 785

27 S3-88571 HCI Instrument panel clocks and clocks of a similar type, for vehicles, aircraft, spacecraft or vessels

28 S3-71321 TI Reciprocating piston engines of a cylinder capacity not exceeding 1,000 cc

29 S3-71322 TI Reciprocating piston engines of a cylinder capacity exceeding 1,000 cc30 S3-71323 TI Compression-ignition engines (diesel or semi-diesel engines)

31 S3-71391 TI Parts, n.e.s, for the internal combustion piston engines of subgroups 713.2, 713.3 and 713.8, suitable for use solely or

principally with spark-ignition internal combustion piston engines

32 S3-71392 TI Parts, n.e.s, for the internal combustion piston engines of subgroups 713.2, 713.3 and 713.8, suitable for use solely or

principally with compression-ignition internal combustion piston engines

33 S3-71651 TI Electric generating sets with compression-ignition internal combustion piston engines (diesel or semi-diesel engines)

34 S3-7169 TI Parts, n.e.s., suitable for use solely or principally with the machines falling within group 71635 S3-74315 TI Compressors of a kind used in refrigerating equipment

36 S3-74363 TI Oil or petrol filters for internal combustion engines

37 S3-74364 TI Intake air filters for internal combustion engines

38 S3-7438 TI Parts for the pumps, compressors, fans and hoods of subgroups 743.1 and 743.4

39 S3-74443 TI Other jacks and hoists, hydraulic

40 S3-7481 TI Transmission shafts (including camshafts and crankshafts) and cranks

41 S3-74821 TI Bearing housings, incorporating ball- or roller bearings

42 S3-74822 TI Bearing housings, not incorporating ball- or roller bearings; plain shaft bearings

43 S3-7484 TI Gears and gearing (excluding toothed wheels, chain sprockets and other transmission elements presented separately); ball

screws; gearboxes and other speed changers (including torque converters)

44 S3-7485 TI Flywheels and pulleys (including pulley blocks)

45 S3-7486 TI Clutches and shaft couplings (including universal joints)

f h l f



52

46 S3-7489 TI Parts, n.e.s., for the articles of group 748

47 S3-7492 TI Gaskets and similar joints of metal sheeting combined with other material or of two or more layers of metal; sets or

assortments of gaskets and similar joints, dissimilar in composition, put up in pouches, envelopes or similar packings

48 S3-74999 TI Other machinery parts, not containing electrical connectors, insulators, coils, contacts or other electrical features

49 S3-77812 TI Electric accumulators (storage batteries)

50 S3-77821 TI Filament lamps (other than flash bulbs, infrared and ultraviolet lamps and sealed-beam lamp units)

51 S3-77823 TI Sealed-beam lamp units

52 S3-77831 TI Electrical ignition or starting equipment of a kind used for spark- ignition or compression-ignition internal combustion

engines (e.g., ignition magnetos, magnetodynamos, ignition coils, sparking-plugs and glow plugs, starter motors); generators

(e.g., dy dynamos and alternators) and cut-outs of a kind used in conjunction with such engines

53 S3-77833 TI Parts of the equipment of heading 778.31

54 S3-77834 TI Electrical lighting or signalling equipment (excluding articles of subgroup 778.2), windscreen wipers, defrosters and

demisters, of a kind used for cycles or motor vehicles

55 S3-77835 TI Parts of the equipment of heading 778.34

56 S3-66471 ULI Safety glass, consisting of toughened (tempered) or laminated glass of toughened (tempered) glass

57 S3-66472 ULI Safety glass, consisting of toughened (tempered) or laminated glass of laminated glass58 S3-66481 ULI Rear-view mirrors for vehicles

59 S3-77313 ULI Ignition wiring sets and other wiring sets of a kind used in vehicles, aircraft or ships

60 S3-82112 ULI Seats of a kind used for motor vehicles

Appendix 3: Summary of data



53

Appendix 3: Summary of data

Variables Data Data Source Period Expected Sign

Labour cost Real wage LABORSTA Varies among countries (-)

Technology level Share of High Tech Export WDI All period (+)

Competitiveness RER WDI All period (+) for export model

(-) for import model

Trade Cost Export cost Doing Business 2004-2005 (-)

Import Cost Doing Business 2004-2005 (-)

Freight Cost Distance to Major Partner Haveman’s Data All period (+) / (-) depends on type

of commodities

Tariff Manufactured Goods MFN

tariff

TRAINS All period (-)

FDI Openness Inward FDI Potential Index World Investment Report All period (-)

Administration Cost Cost of Starting a new

Business

WB Doing Business 2004-2007 (-)

Cost of Enforcing the

Contract

WB Doing Business 2004-2007 (-)

Country size GDP per capita WDI All period (+)

Market size Export equation: World

Import for Final Assembly

COMTRADE All period (+)

Import equation: GDP per

capita

WDI All period (+)

PRODUCTION COST

SERVICE LINKS COST – Border Trade Barriers

SERVICE LINKS COST – Behind-the-Border Trade Barriers

OTHER VARIABLES

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