TKDN | Krisna 'imed' Gupta

A Simple Model of Local Content Requirements

Tue, 29 Mar 2022 14:09:58 +0700

Discussions about increasing the use of domestic products and anti-import sentiments have long echoed among public officials. Lately, these conversations seem to be growing ever more frequent. Of course, using domestically produced goods is not inherently a bad thing. The problem arises when it is forced. Like any other kind of love, love for domestic products is no fun when it is coerced. One of the instruments Indonesia is currently pushing hard is TKDN.

What is TKDN?

, or Tingkat Kandungan Dalam Negeri (Local Content Requirement), has become increasingly popular in Indonesia¹. When mandated for a given industry, TKDN requires that a minimum share of a final product contains domestic content. This content can include labour, machinery, and raw materials. For example, , as of April 2022, must meet a 35% TKDN threshold, meaning all 5G devices on the market must have at least 35% local content (or, equivalently, at most 65% imported components).

TKDN effectively prevents firms from simply selling imported goods. Products must be manufactured domestically. Imported components are allowed but capped. The idea is that TKDN will encourage producers to set up factories in Indonesia. I wrote a bit about this effect in . The resulting investment would create jobs. In a country with high informality like Indonesia, formal employment can be a good avenue for improving welfare². TKDN is also expected to build production capacity and technological capability among domestic suppliers of intermediate goods.

TKDN is popular with governments partly because it is “free” (unlike subsidies, it does not require budget outlays). Moreover, anti-import policies tend to be popular with the public, potentially boosting politicians’ approval.

At first glance, raising TKDN does seem beneficial. If investment flows in, there should be additional value added. However, it is important to understand that the concept of value is neither static nor exogenous. The value of a product can rise or fall depending on its inputs. For instance, does a 5G device with high domestic content perform as well as a fully imported one? Can a high-TKDN product compete in global markets? Does building a smelter really capture more value ?

The answer is not necessarily yes. Several theoretical papers dissect how value and productivity shift between intermediate-input producers and final-good producers³ ⁴ ⁵. There is indeed a trade-off, and TKDN does not automatically produce outcomes as optimal as they may appear, especially if TKDN fails to raise productivity in the sector it aims to protect.

In this post, I try to illustrate this trade-off using a very simple model.

The Model

Suppose there is a final-good producer that often needs imported inputs. These inputs could in principle be substituted domestically, but for the firm, imports are cheaper and offer higher value added. Real-world examples might include or .

If we focus solely on the input-sourcing decision, the firm has the production function:

$$F(M,N) = \alpha M + N$$

where $M$ is the quantity of imported inputs and $N$ is the quantity of domestically sourced inputs. Meanwhile, $\alpha$ represents the quality of imported raw materials relative to domestic ones. If $\alpha > 1$, then imported goods are of higher quality. We also assume imported inputs are cheaper ($P_M

The firm is required to purchase a minimum share $k$ of domestic raw materials:

$$ P_NN \geq kP(\alpha M + N) $$

$$ \text{where } k \in (0,1) $$

The firm wants to meet demand $F(M,N)=Q$ at the lowest possible cost. That is, the firm solves:

$$ \min P_MM+P_NN $$

$$ s.t. \ \alpha M+ N \geq Q $$

$$ P_NN \geq kP(\alpha M + N) $$

$$ k \in (0,1) $$

Since the problem is linear, we can use linprog. I will use the following parameters:

$$ P_M=1 $$

$$ P_N=3 $$

$$ α=1.5 $$

$$ k=0 $$

$$ P=9 $$

$$ Q=30 $$

First, let us define the function:

from scipy.optimize import linprog
def TKDN(Pm=1,Pn=3,α=1.5,δ=1,k=0,P=9,Q=30):
 c_ex1 = np.array([Pm, Pn])
 A_ex1 = np.array([[-α,-1],[k*P*α, k*P-Pn]])
 b_ex1 = np.array([-δ*Q,0])
 res_ex1 = linprog(c_ex1, A_ub=A_ex1, b_ub=b_ex1, method='revised simplex')
 names=[f'imported inputs = {res_ex1["x"][0]}',
 f'domestic inputs = {res_ex1["x"][1]}',
 f'production cost = {Pm*res_ex1["x"][0]+Pn*res_ex1["x"][1]}',
 f'firm profit = {Q*P-Pm*res_ex1["x"][0]-Pn*res_ex1["x"][1]}']
 for i in names:
 print(i)

The default numbers above should not be taken literally – $P_M=1$ is simply a numeraire, or base price. Because the problem is linear (and therefore invariant to affine transformations), $P_N=3$ can be interpreted as meaning domestic raw materials are three times more expensive than imported ones.

Winners and Losers

Now let us use the function we just defined. Remember the linprog dependency from scipy. For the no-TKDN case, we set $k=0$:

TKDN()

imported inputs = 20.0
domestic inputs = 0.0
production cost = 20.0
firm profit = 250.0

What about a TKDN where domestic content must be at least 20% of total final-product value?

TKDN(k=0.2)

imported inputs = 8.0
domestic inputs = 18.0
production cost = 62.0
firm profit = 208.0

As we can see, TKDN causes the final-good producer’s profit to fall and total cost to rise. However, the domestic input supplier gains additional revenue of $18 \times P_N$. In other words, TKDN tends to benefit domestic raw material sellers but hurts final-good producers.

When TKDN is set to 40%, the model crashes – the final-good producer is better off not producing at all.

If we tabulate TKDN from 0 to 30% (in 10% increments):

k	M	N	C	$\pi$
0	20	0	20	250
10%	14	9	41	229
20%	8	18	62	208
30%	2	27	83	187

What about total domestic value added? Although TKDN raises value added for the input producer, it reduces value added for the final-good producer. With TKDN=0, the input producer’s value added is 0, while the final-good producer’s profit is 250. At TKDN=10%, the input supplier gains 9 but the final-good producer loses $250-229=21$. So total value added actually declines.

What about the government? Assuming duty-free imports, government revenue comes from corporate income tax. With TKDN=0, the input supplier pays no tax. The final-good producer pays corporate income tax of $t \pi$ where $t$ is the tax rate. If we assume the domestic input supplier’s cost is 0, then the supplier’s income is $P_N \times N$. Total government revenue becomes:

$$GR=t(P_N-c)N+t \pi$$

where c is the marginal cost, linear in output. I use c=2 so the domestic firm needs to charge $P_N=3$ to earn a margin of 1, the same as the importer. If domestic costs were low, they could sell at a lower price and win orders from the final-good producer.

Let us calculate government revenue at a 20% tax rate:

t=0.2 # corporate income tax
Pn=3 # domestic input price
c=2 # so firms can't sell below 3
brp=('0%','10%','20%','30%')
taxs=((Pn-c)*0*t+250*t,
(Pn-c)*9*t+229*t,
(Pn-c)*18*t+208*t,
(Pn-c)*27*t+187*t)
for x,y in zip(brp,taxs):
 print(f'At TKDN={x}, total GR = {y}')

At TKDN=0%, total GR = 50.0
At TKDN=10%, total GR = 47.6
At TKDN=20%, total GR = 45.2
At TKDN=30%, total GR = 42.8

The higher the TKDN, the lower the total income tax from the two firms. Although tax from the domestic firm rises, tax paid by the final-good producer falls because profits shrink. So even though TKDN appears not to require fiscal expenditure like subsidies, the inefficiency it generates carries a hidden cost to the state budget as well.

This is on top of the budget spent on enforcing TKDN rules. For instance, to verify that a firm complies with TKDN, it must be surveyed for a TKDN certificate. The first two product certificates are paid for by the government, funded from the state budget. This does not include the systems and human resources the government must allocate for TKDN enforcement. Moreover, for the third product onward, the firm must bear the certification cost itself, further reducing profits and consequently the corporate income tax paid.

So Is TKDN Good or Bad?

The issues above illustrate potential problems created by TKDN. This linear model, while somewhat arbitrary, does a reasonable job of explaining TKDN’s short-run effects. More representative (but more complex) models can be found in the footnotes.

One important caveat is that we cannot simply assume $Q$ and $P, P_M, P_N$ remain constant under TKDN. It is possible that instead of becoming more efficient, domestic input producers become complacent under protection and show no improvement at all. Rather than improving, they may even raise prices because the final-good producer has no alternative as long as TKDN binds.

Furthermore, TKDN makes domestic final-good producers less competitive against foreign ones. Why? Because foreign producers can access cheap, high-quality inputs without TKDN constraints. As a result, domestic final-good producers cannot compete in global markets and are forced to rely on the domestic market. Unable to compete with imported finished goods either, they will demand protection too.

This is why IMEI blocking exists. Domestic phone manufacturers do not want to compete with imported phones that are not subject to TKDN. Has the public ever been told how much of the state budget is spent on implementing IMEI blocking?

Finally, once TKDN is in place, it is very hard to roll back. Firms that have already made large investments to comply with TKDN would suffer significant losses if the policy were suddenly removed and firms that did not invest could enter the previously protected market. Therefore, firms that have already invested to meet TKDN have a strong incentive to lobby the government to maintain and enforce TKDN rules.

TKDN can be considered successful if domestic input producers actually learn and improve. For example, if their industry grows and becomes efficient enough to match import prices ($P_N \leq P_M$), or improves quality to surpass imports ($\alpha \in (0,1)$). If this happens, $k$ is no longer binding and TKDN can be declared a success, depending on how large and how fast the domestic industry’s improvement is.

Therefore, policymakers who have already adopted TKDN should continuously monitor $\alpha$ and $P_N$ (or more precisely $\frac{P_N}{P_M}$). If there is no progress, it is hard to expect domestic industry to become efficient and competitive, and the desired advantages will not materialise. Coercion alone is unlikely to succeed. The government may need to complement TKDN with other policies that promote efficiency. So yes, the regulatory burden just keeps growing.

Alternatives to TKDN

There are several alternatives to TKDN⁶:

Improve the business climate. This one seems obvious. But nothing beats this approach. It is hard for industry to advance when upstream sectors are protected, and both importing and exporting carry high administrative costs. Customs officials still engage in .
Leverage CSR. Ask multinational companies whether they can help develop local firms as suppliers.
Provide training for workers and component suppliers. Training is essential for improving the quality of local businesses and workers. A government that understands industry should be able to identify what training is needed and deliver it. This also costs money, but it is far better spent than on enforcing TKDN.
Improve logistics processes and physical infrastructure. This too seems obvious.
If all else fails, using tariffs and subsidies, though not ideal, is still better than TKDN. Of course, the main problem with tariffs is trade agreements and retaliation. Tariffs are easier to quantify than TKDN, making them more likely to face challenges at the WTO. Subsidies burden the budget directly, unlike TKDN which burdens the budget and the economy indirectly. Such is life when your policymakers and politicians cannot calculate hidden costs.

Update

A new book on TKDN has just been released for those who want to learn more. It is an edited volume by Lili Yan Ing and Grossman⁷. One particularly interesting chapter is by Yessi Vadila⁸.

I will discuss it further some other time. Mention me on if you have comments, criticisms, or suggestions. Thanks.

Fernando, O., & Ing, L. Y. (2022). Indonesia’s Local Content Requirements: An Assessment on Consistency with Free Trade Agreement Commitments. ERIA Discussion Paper Series, 420. ↩︎
Gupta, K., & Mardjono, E. (2021). Indonesia Emas Berkelanjutan 2045: Kumpulan Pemikiran Pelajar Indonesia Sedunia Seri 01 Ekonomi. LIPI Press. ↩︎
Grossman, G. M. (1981). The Theory of Domestic Content Protection and Content Preference. The Quarterly Journal of Economics, 96(4), 583-603. ↩︎
Veloso, F. M. (2006). Understanding Local Content Decisions: Economic Analysis and an Application to the Automotive Industry. Journal of Regional Science, 46(4), 747-772. ↩︎
Lin, S.-H., & Weng, Y. (2020). Can strengthening the local content requirements meet a government’s need to raise industrial productivity and production? Journal of Applied Economics, 23(1), 316-328. ↩︎
Hufbauer, G., Schott, J. J., Wada, E., Cimino, C., & Vieiroand, M. (2013). Local Content Requirements : A Global Problem. Peterson Institute for International Economics. ↩︎
Ing, L. Y., & Grossman, G. M. (2023). Local content requirements: promises and pitfalls. Routledge. ↩︎
Vadila, Y., & Christian, D. (2023). Effects of Local Content Requirements on Trade. In B. Hoekman & K. Saggi (Eds.), The Political Economy of Trade Policy: Theory, Evidence and Applications. Routledge. ↩︎

Notes from watching "Ngobrol Tempo" on "Import Substitution of Electronics Products"

Fri, 04 Mar 2022 07:17:38 +0700

This morning I watched “Ngobrol Tempo” on YouTube. The show featured officials from the Ministry of Industry, the Ministry of Trade, and Gabel, the electronics manufacturers’ association. The topic was how to pursue import substitution for electronics products, amid the Ministry of Industry’s policy to cut imports by 35%. I found the program quite interesting and was very pleased with how Bu Ratna from Tempo moderated the discussion. Several points struck me as particularly noteworthy.

The Government’s Typical Mercantilist View

The first, naturally, is the government’s characteristically mercantilist outlook. By mercantilist I mean the state sees itself as an individual firm: a competitive nation is one whose exports exceed imports. Imports mean losing, exports mean winning. Exports mean profit, imports mean loss. This mercantilist view is quite popular not just in the Indonesian government but also among the general public, and even in other countries’ governments.

In this show, the mercantilist view was quite segmented, focusing on electronics products. They even brought up sectoral trade deficits, noting that in certain HS codes, Indonesia is a net importer. Interesting, because I usually hear the government talking about bilateral trade deficits. Here they went as far as sectoral trade deficits. Very specific. I wonder, if there were a show about CPO, would we discuss the CPO surplus? Probably not.

It is indeed difficult to use exports and imports as indicators of industrial competitiveness. It is hard to pin micro-level conclusions on trade deficits, which are fundamentally a macro phenomenon. In today’s world of rapid financial transactions, you cannot discuss trade deficits without discussing financial flows. As a country that targets capital inflow, it is natural for the current account to be negative. Moreover, Indonesia imports a lot of capital goods and components, which arguably represents good use of FDI.

Trade deficits must also be viewed alongside overall trade. Indonesia’s exports in other products are enormous. You cannot expect surpluses in everything. Do not forget dutch disease, where exports in one sector reduce competitiveness in another. So trying to discuss a deficit in a single sector seems problematic. Besides examining how to curb imports, the government should also scrutinize the financial management of companies in high-export sectors. Are they saving a lot? Holding cash? Paying dividends? Reinvesting? Are their savings overseas or domestic? How much does the state earn from export industries?

Comparing with Vietnam

The second hallmark is comparing with Vietnam. This has been trendy not just in government but also among consultants and academics. Comparing with Vietnam has intensified because of Global Value Chains (GVC). They say that in the early 2000s, Indonesia’s share of world trade was 0.9% while Vietnam’s was 0.25%, but by 2019, Indonesia’s share was 1% while Vietnam’s was 2%.

Some problems with comparing Indonesia to Vietnam:

Vietnam is a small country. Its GDP and $\frac{\text{GDP}}{\text{capita}}$ are still below Indonesia’s. They don’t have a large market, so they are compelled to exploit the global market. Indonesia? Its domestic market alone is enormous. That is why it is “easy” to pursue protectionist policies.
Vietnam’s exports are large but so are its imports. That is, the value added is small. What is called “Vietnam’s huge electronics exports” is actually the work of many countries. Vietnam just happens to be the final assembly location. If you look only at trade statistics, you overestimate Vietnam’s electronics manufacturing.
Vietnam is called a GVC success story not because it is protectionist, but precisely because it embraced globalization. That is why its imports are so large. Because it embraced globalization, it also managed to sign trade agreements with other countries faster than Indonesia. The fact that Indonesia’s textiles face 15% tariffs to the EU while Vietnam pays 0% is partly due to this.
As shown below, while Vietnam’s $\frac{\text{trade}}{\text{GDP}}$ ratio is enormous, its trade balance is not that different from Indonesia’s. Don’t forget that Vietnam ran trade deficits continuously from 1986 to 2011. If I recall correctly, the late 90s was when they started attracting FDI.

So given the differences in size and approach (import substitution vs. export expansion), there is little point in overly comparing ourselves with Vietnam. Vietnam also lacks natural resources to export and its domestic market is too small. It is natural for them to depend on the global market. That said, comparing institutions (ease of doing business, logistics management, trade agreements) remains perfectly reasonable.

Oh, and this should also be linked to the mercantilist school. Just because a country exports a lot does not mean it is doing well. Vietnam’s per capita income is still below Indonesia’s. They make fancy phones, but how many Vietnamese can buy them? This is because the value added that actually stays in Vietnam is tiny (labor-intensive). Indonesia wants to go 4.0, right?

Furthermore, we are in the same boat, aren’t we? Indonesia exports massive amounts of coal and CPO, yet many regions still struggle with electricity and cooking oil is now expensive. Is that good? What is the point of exports if ordinary people’s income and consumption barely change?

Public Policy

The show also touched on several interesting policy points. The panelists were asked what policies are being or will be implemented to boost the competitiveness of electronics products and curb imports. The speakers explicitly mentioned WTO constraints on their policymaking. In other words, their policies must be in line with international rules such as trade agreements and the WTO.

Trade Barriers

Several trade-related policies were mentioned:

Non-tariff barriers (NTBs) such as SNI and TKDN (local content requirements).
Trade remedy and anti-dumping measures.
Reviewing trade agreements, including the Information Technology Agreement.
Technical considerations for import approval (effectively another NTB).
Use of the Commodity Balance Sheet (Neraca Komoditas – also effectively an NTB).

These NTBs will be focused on 25 electronics products, mostly consumer electronics. They claimed that the AC import approval regulation (Permendag 64/2020) successfully attracted foreign investment. According to Gabel, thanks to this new NTB, domestic AC supply rose from 20% of total AC sales in Indonesia (i.e., 80% imported) to 30% (imports down to 70%). As usual, the ones complaining are AC retailers whose stock comes from imports.

I have heard the first two points many times. But the last two are fairly new. Apparently, the Ministry of Industry wants to introduce import quota licensing for downstream electronics products through technical considerations. If implemented, products like TVs, refrigerators, and ACs would need to apply for an import permit from the Ministry of Industry, specifying the quantity they wish to import. The Ministry would then issue a technical approval specifying the allowed import quota.

The problem is that this kind of technical-approval-based import licensing is precisely what the Commodity Balance Sheet is meant to eliminate. Eventually, products covered by the Commodity Balance Sheet should be importable according to the balance sheet without technical approval, just through the Ministry of Trade. The Commodity Balance Sheet is supposed to be fully implemented by 2023, so why push for technical approvals?

One more thing: using technical approvals or Commodity Balance Sheets will also face WTO problems because they are basically quota restrictions. This is what happened with Brazilian chicken. The question now is whether major exporting countries to Indonesia – such as China, Japan, and South Korea – will file a dispute like Brazil did.

Investment Policy: Expertise or Financing?

On investment, it seems new investments will receive tax holidays or corporate income tax reductions. This incentive is premised on the logic that foreign investment will help increase domestic production capacity. Once again, Vietnam is frequently cited as a model for attracting foreign investment and boosting exports. Why? Because foreign investment brings not just physical capital but also know-how (both managerial and technical) and international production networks (foreign suppliers and buyers). Foreign investment also absorbs a lot of labor and outsources various things from domestic producers (spillover). All these advantages make the potential tax revenue loss from tax holidays worthwhile.

Gabel raised an interesting point about Indonesia’s electronics industry. They said Indonesia is already quite competitive in ASEAN. However, Indonesian consumers are still low-end. Household electricity is still dominated by 900 watts. The best-selling AC in Indonesia is the 1/2 HP model, to avoid circuit breakers tripping. Refrigerators are also small because many Indonesian workers are paid daily, so they shop daily – no need for a large fridge. As a result, the electronics market in Indonesia can be considered a commodity: easy to copy with no differentiation advantages.

If that is the case, the role of foreign investment in terms of technical know-how is almost nil. Since the products are still low-end, complex high-end features and large-capacity manufacturing are not really needed. If know-how is not really needed, shouldn’t domestic investment suffice?

But investing in Indonesia is difficult. Interest rates are high, banks do not accept production equipment as collateral, and the government keeps issuing bonds with attractive yields (crowding out). Domestic investors lack liquidity, while foreign investors are happy to enter Indonesia because interest rates abroad are low and Bank Indonesia zealously maintains a stable exchange rate (by raising interest rates, LOL). Crowding out intensifies when the export sector fails to boost domestic liquidity.

Fragmented Policy

Back to the first discussion: trade is a macro issue. There is so much to consider. Competition, domino effects, etc. Expensive electricity, extortion, and protection of upstream industries (like steel) all play crucial roles. Exports from other sectors (CPO and coal, for instance), the money supply, exchange rates, and interest rates all have massive effects. It is certainly difficult to use a macro lens (total imports) to make policy for micro phenomena (the competitiveness of the electronics industry using trade barriers).

On upstream protection, it was also amusing to hear India mentioned as having cheaper automotive products than Indonesia, even though Indonesia has been pampering its automotive sector since the 80s (lots of incentives and protection). Don’t forget that steel in India is cheaper and more competitive than in Indonesia. If steel is cheap, literally almost every other industry will also be cheaper (including construction and capital goods).

From this show, I still feel that the policies being adopted are somewhat fragmented and poorly coordinated. Both ministries need to talk with other institutions handling capital flows, interest rates, energy, export commodities like mining, CPO and coal, and so much more. Fair enough – the speakers were from the Ministry of Industry and the Ministry of Trade, so the policies discussed naturally focused on trade barriers.

But Gabel’s secretary general made an interesting point: if import substitution is to be taken seriously, it must be discussed nationally. Too many factors are at play. I have heard the 35% import substitution program trumpeted by the Ministry of Industry too many times while others (Ministry of Finance, Ministry of Agriculture, Ministry of Energy, Bank Indonesia, etc.) seem to never mention it.

One more thing. No country can export everything. Not every sector needs to be a champion with a trade surplus. Not every country that exports a lot in one area (Vietnam in electronics) also exports a lot in another (Vietnam does not export coal or CPO). Inefficient policies will only reduce people’s purchasing power, and we will be back to selling low-end products.

BTW, the show I watched is below. Let me know what you think! Mention me at @imedkrisna