The effect of liberalization in trade and finance to wage skill premium in Indonesia

The wage inequality remains one of the most discussed subjects when we look on the effect of liberalization, either in developed or developing countries. However, growing literature on this issue tends to give more focus on the effect of trade liberalization to the wage inequality rather than other form of liberalization, like financial liberalization that normally occurs in the same period. This paper contributes to literature by measuring the effect of both liberalization in trade and finance to the skill premium, the wage difference earned by skilled and unskilled labor, in Indonesia.

Recent studies have shown that trade liberalization gives mixed effects to the wage skill premium in the developing countries. In one side, most studies found that trade liberalization increases the wage skill premium in countries like Argentina (Galiani & Sanguinetti, 2003), Chile (Harrigan & Reshef, 2015), and other developing countries in more general term (Godlberg, Khandelwal, Pavcnick, & Topalova, 2010). Meanwhile, the opposite effect of trade liberalization that shows reduction in the skill premium is true in Brazil (Gonzaga, Filho, & Terra, 2006), and Indonesia through reduction in input tariffs (Amiti & Cameron, 2012).

Nonetheless, there is also no consensus in the literature on the effect of the financial liberalization to wage inequality. The financial liberalization does reduce the income inequality in the cross country analysis (Delis, Hasan, & Kazakis, 2014), although other research shows that this is true for some conditional term, like financial development (Baumann & Lensink, 2016) and human capital (Li & Yu, 2014). In the other hand, recent literature has shown that the financial liberalization through lower control on credit, interest rate, and barriers to entry are more likely to aggravate the income inequality (Naceur & Zhang, 2016). Moreover, study by de Haan & Sturm (2016) also show that the financial liberalization does widening the income inequality despite the quality of financial development.

Indonesia, in the early 1990s, has experienced these two major types of liberalization. The first is the liberalization in trade market by reduction in tariffs, both for input and output tariffs. The second liberalization is in financial sector through relaxation in financial regulation. These include lower credit and interest controls, ease the barriers to entry of financial institutions, and relax the restriction on international capital flows. Taking the two types of liberalization into account, we argue that liberalization in trade and finance has intertwined effects to the wage skill premium paid by firms in Indonesia.

To measure the extent of liberalization in tariff reductions and financial openness to wage in manufacturing sectors, we use the period for the years 1990 to 2000, which considered as the main liberalization period in Indonesia. The main data source for this research is the Industrial Survey (Survey Industri). This is a census of firm-level manufacturing establishments in the country with at least 20 employees. The source of tariff information is the UNCTAD-TRAINS database, retrieved through the World Integrated Trade Solutions (WITS) system of the World Bank. Following (Amiti & Cameron, 2012) and (Amiti & Konings, 2007), we distinguish between the reduction in tariffs on output and intermediate input by generating a proxy based on the Indonesian input output table of 1990 which consists of 161 sectors. Lastly, we use the indices from financial reform database by Abiad, Detragiache, & Tressel (2008) to measure financial liberalization in Indonesia. The database measured qualitative indicators of restrictions in seven different dimensions in financial sector policy and later on translated into sub index. Each sub index is coded from zero (fully repressed) to three (fully liberalized).

Our preliminary result shows three interesting findings. First, we found significant result that the liberalization in finance is actually increase the wage skill premium in Indonesia. The result therefore are rejecting our initial hypothesis that both liberalization will reduce wage inequality, although we support previous study that trade liberalization does decreases the skill premium for firms that import their intermediate inputs. Second, the effect of financial liberalization which aggravates the inequality is more profound to firms that export their products. Meanwhile, for firms which import their inputs, we found significant but weak impact of financial liberalization that reduces the wage skill inequality. Lastly, we can't find significant effect on the joint interaction between liberalization in trade and finance to wage skill premium.

Most probably, both liberalization gets through different transmission mechanism to affect the wage skill premium. As lower input tariffs increase the incentives of the firms to import high skilled intermediate goods for production, the firms will reduce their demand for skilled labor and will increase their demand for low skilled labor, resulting lower inequality for both types of labor. So there will be a substituting effect between intermediate imported inputs for skilled labor as a result of cuts in tariffs. Meanwhile the financial liberalization tends to be benefit export oriented firms as the ease of accessing source of finance will help them to buy new machines and build new factories to meet global demand. The expansion will also force the firms that export their products to meet higher standards and requirement in the global market so they demand more skilled labor to work with, resulting wider skill premium.

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