Abstract

This paper investigates the determinants of firm innovation in Indonesia. We focus on the impact of institutions and access to finance on innovative activities of Indonesian firms. We employ the quality of local regulations index constructed by the Indonesia’s Regional Autonomy Watch (KPPOD) as an exogenous measure of institutions. For firm level variables, we use the World Bank Enterprise Surveys (WBES) for Indonesia. We analyse (i) the determinants of product innovation, and (ii) the determinants of innovative activities by constructing a composite index comprising two dimensions of innovation: product innovation (registered patents) and process innovation (quality certification and use of foreign-licensed technology). We contend that our flexible approach is more appropriate to analyse firm innovation determinants in developing countries such as Indonesia.

We merge KPPOD and WBES data for the econometric analyses, and conduct binary logit, ordered logit, and poisson regressions. Controlling for firm characteristics and industry fixed-effects, we find that better institutional quality at the local level is associated with more innovation. We also find evidence that firms experiencing major obstacle in access to finance are less likely to innovate. We demonstrate that access to finance is more critical for small and medium enterprises (SMEs) whereas institutional quality is more important for large firms. We unveil further finding that the positive impact of better institutions on innovation is asymmetrically distributed. Better local institutional quality disproportionately benefits non-constrained firms. The policy implication of our findings is that improving institutional quality alone is not sufficient. Without significant progress in reducing frictions in the credit market by lowering asymmetric information in the credit market, better institutional quality will lead to greater innovation gap. We argue that a well-balanced ‘policy mix’ aiming for stronger local institutional quality and better access to finance is necessary both to promote innovation and to lower innovation gap.