Indonesian Manufacturing Needs a Shot in the Arm

Source: Getty
Article
Summary
Services and commodities have fueled Indonesia's recent growth, but only manufacturing can create high quality jobs and help the country escape the middle-income trap.
Related Media and Tools
 

Indonesia’s economic performance is deservedly receiving plaudits these days. Its economic growth has been the highest in Southeast Asia, its inflation has been low, its fiscal policy has been prudently managed, the sovereign debt burden has declined, and the balance of payments has been broadly, well, in balance. The economy emerged largely unscathed from the global financial crisis in 2009–10, further proof of its resilience. And in recognition of the country’s solid financial situation, two credit-rating agencies upgraded Indonesia’s sovereign credit rating to investment-grade level. Indeed, Indonesia’s economic performance has been considered so good that leaders of the struggling advanced economies listened attentively at the recent G20 meeting in Los Cabos, Mexico, as President Yudhoyono recounted Indonesia’s experience during the Asian financial crisis and how the country has emerged better and stronger.

But while Indonesia may have learned the lessons of the Asian financial crisis well, its story of growth with stability is diminished in one crucial respect. Indonesia’s excellent performance has been driven by services and commodities, not manufacturing. In fact, the role of manufacturing has significantly declined in all dimensions of the economy—its value added,1 its share of exports, and its share of employment (see figures 1–3). Indonesia’s export growth was driven by robust global commodity prices, thanks in part to China’s seemingly insatiable appetite for raw materials. And GDP growth has been fueled largely by services, thanks in part to strong consumer demand and an appreciating exchange rate.

Services and commodities have fueled Indonesia's recent growth, but only manufacturing can create high quality jobs and help the country escape the middle-income trap. Services and commodities have fueled Indonesia's recent growth, but only manufacturing can create high quality jobs and help the country escape the middle-income trap. Services and commodities have fueled Indonesia's recent growth, but only manufacturing can create high quality jobs and help the country escape the middle-income trap.

Should Indonesia be concerned that manufacturing is declining in importance? Absolutely. Manufacturing is an important driver of growth. It tends to generate large economies of scale within firms, industries, and urban areas—much more so than agriculture, mining, or services—creating a virtuous circle between competitiveness and scale. It creates high-quality jobs, significantly boosting productivity and wages. And manufacturing firms become part of regional and international production networks and benefit from specialization, international know-how, the transfer of technology, and access to markets. 

For the most part, neither services nor commodities tend to deliver the same economy-wide benefits as manufacturing, and their ability to create significant numbers of high-quality jobs is considerably more limited. Still, some observers have pointed to increased services employment in Indonesia as a “bright spot” in the economy. True, services employment has increased, but the bulk has been in low-productivity informal activities—street hawking, domestic help, microenterprises, and so on. There just aren’t enough high-productivity employment opportunities available yet in the services sector. 

If there were, one would expect to see real wages rising. In fact, the real wage of Indonesia’s unskilled labor—which still constitutes the bulk of the labor force—has declined steadily over the last five years (see figure 4). With wages stagnant or shrinking at the lower end of the income distribution and incomes rising at the upper end, it should come as no surprise that between 2006 and 2011, Indonesia (along with Russia) saw the largest increases in income inequality worldwide.

Services and commodities have fueled Indonesia's recent growth, but only manufacturing can create high quality jobs and help the country escape the middle-income trap.

Indonesia needs to address three priorities to bolster manufacturing and reverse this trend. First, it must build more infrastructure—and fast. Manufacturing growth is sensitive to the availability of infrastructure—especially energy, roads, ports, and telecommunications (broadband in particular). It is no accident that Indonesia’s pattern of growth is beginning to resemble India’s, where infrastructure is in a deplorable state. In 2011, the World Economic Forum ranked Indonesia 82 out of 139 economies in infrastructure availability and quality—just ahead of Vietnam (83) and India (86). 

The government is already taking steps in the right direction. The Indonesian parliament just passed the long-awaited Land Acquisition Law and the government allocated $150 billion to finance infrastructure projects over the next five years. The government also announced a new head of the National Land Agency and the impending issuance of regulations for implementing the Land Acquisition Law. While this energetic push for infrastructure is very encouraging, the challenge should not be underestimated. 

For some time now, the government has consistently underspent the capital budget, and the bulk of capital expenditures (43 percent) tends to be spent in the last month of the fiscal year—a practice that erodes the quality and efficiency of spending. Avoiding this will require considerably better and more realistic upstream expenditure planning so that downstream implementation encounters fewer bottlenecks. 

Second, Indonesia must cut through some of its notorious red tape. Companies consistently identify corruption and the bureaucracy as the biggest impediments to doing business in Indonesia. According to the 2012 Doing Business indicators prepared by International Finance Corporation, a part of the World Bank Group, Indonesia ranks 129 out of 183 countries, a shockingly low position that has deteriorated by three notches from last year. Indonesia gets particularly bad marks when it comes to starting a business, enforcing contracts, and resolving insolvency, in part because the authority in these areas has been decentralized to local governments. In addition, labor market restrictions inhibit firms from hiring. 

Even so, much progress has been made in improving the investment environment. Several city governments have established one-stop shops for business licenses, and the national government set up a computerized system for business registration. Moreover, Indonesia’s Investment Coordinating Board announced near-record levels of foreign direct investment for the first quarter of this year, although the bulk of it is destined for commodities production, not manufacturing. Building on this success, the president just appointed a highly respected economist to be the board’s new chairman, whose key task will be to tap fresh sources of foreign direct investment, particularly from China, where labor-intensive exporters are facing rising wage costs and a steady real appreciation of the renminbi.

Finally, Indonesia must adopt an exchange rate policy that is supportive of manufacturing. The country’s real effective exchange rate has climbed steadily since the Asian financial crisis.2 Indeed, it has appreciated nearly 24 percent since early 2000, driven by rapid growth in commodity export earnings on the back of high global commodity prices. Arguably, Indonesia is suffering from a case of Dutch disease, where high commodity earnings drive the exchange rate to the point that manufacturing becomes internationally uncompetitive. The wrong response would be to protect Indonesian manufacturing against international competition—and there are some indications that policies may be going down this slippery slope. 

The country should take a different tack. It should, in fact, do what other responsible commodity exporters are doing—create a commodity fund that collects the royalties and other tax earnings denominated in foreign exchange, invest these conservatively in financial assets, and use the long-term real earnings to finance development projects on a sustainable basis. Not only will this reveal a more realistic picture of Indonesia’s long-term public finance situation, it will also help the exchange rate reach a level that is market-driven and yet supportive of manufacturing in the long run.

The praise that Indonesia is receiving these days for its macroeconomic management should not lead to complacency. The Indonesian economy’s dependence on the production of commodities is risky given rising volatility in global commodity markets. And commodities cannot be relied on to drive long-term growth at a rate that would increase wages and lead to a more equal distribution of income. Indonesia should instead look to manufacturing, which can capture economies of scale, technology transfer, and the potential for innovation to drive rapid long-term growth. Only by developing its manufacturing prowess can Indonesia avoid the middle-income trap that has ensnared so many other middle-income countries. And for that it needs continued and steady reforms of its policies and its bureaucracy.

1  Value added is the net output of a sector after adding the value of all outputs and subtracting the value of all inputs and factors of production, such as land, labor, and capital.

2  The real effective exchange rate is an index that combines the exchange rate of the Indonesian rupiah and those of Indonesia’s main trading partners using trade shares as weights and after taking into count relative rates of inflation.  

 

The author is grateful to Navtej Dhaliwal for research assistance.

End of document

Comments (1)

 
 
  • gzanini
    No argument with the need for boosting the manufacturing sector and your recommendations, but I disagree with your dismissal of the importance of services and services trade. In nominal terms, Indonesia has experienced the lowest growth rate (6.7%) in services exports among ASEAN countries in the period 2006-10.   Its economy is also one of the closest to foreign services providers, depriving its own manufacturers from efficient and low cost private services.   As a share of GDP, Indonesia's services exports fell from 8% in 2004-05 to 4% in 2009-10 (only above the abysmally low level of Myanmar at 2%).   This while Malaysia and Thailand have kept their import openness ratios is in the 13-15% range and Singapore, where wages are highest, in the 43-44%. Indonesia cannot afford to neglect the needs and opportunities for services exports, nor it can continue to maintain a highly restrivtive policy and regulatory regime vis-a-vis foreign services providers, for the good of its own final consumers and also of its own manufacturers.
     
     
    Reply to this post

     
    Close Panel
  • Report Abuse
Source http://carnegieendowment.org/2012/06/26/indonesian-manufacturing-needs-shot-in-arm/cbbg

More from The Global Think Tank

In Fact

 

45%

of the Chinese general public

believe their country should share a global leadership role.

30%

of Indian parliamentarians

have criminal cases pending against them.

140

charter schools in the United States

are linked to Turkey’s Gülen movement.

2.5–5

thousand tons of chemical weapons

are in North Korea’s possession.

92%

of import tariffs

among Chile, Colombia, Mexico, and Peru have been eliminated.

$2.34

trillion a year

is unaccounted for in official Chinese income statistics.

37%

of GDP in oil-exporting Arab countries

comes from the mining sector.

72%

of Europeans and Turks

are opposed to intervention in Syria.

90%

of Russian exports to China

are hydrocarbons; machinery accounts for less than 1%.

13%

of undiscovered oil

is in the Arctic.

17

U.S. government shutdowns

occurred between 1976 and 1996.

40%

of Ukrainians

want an “international economic union” with the EU.

120

million electric bicycles

are used in Chinese cities.

60–70%

of the world’s energy supply

is consumed by cities.

58%

of today’s oils

require unconventional extraction techniques.

67%

of the world's population

will reside in cities by 2050.

50%

of Syria’s population

is expected to be displaced by the end of 2013.

18%

of the U.S. economy

is consumed by healthcare.

81%

of Brazilian protesters

learned about a massive rally via Facebook or Twitter.

32

million cases pending

in India’s judicial system.

1 in 3

Syrians

now needs urgent assistance.

370

political parties

contested India’s last national elections.

70%

of Egypt's labor force

works in the private sector.

70%

of oil consumed in the United States

is for the transportation sector.

20%

of Chechnya’s pre-1994 population

has fled to different parts of the world.

58%

of oil consumed in China

was from foreign sources in 2012.

$536

billion in goods and services

traded between the United States and China in 2012.

$100

billion in foreign investment and oil revenue

have been lost by Iran because of its nuclear program.

4700%

increase in China’s GDP per capita

between 1972 and today.

$11

billion have been spent

to complete the Bushehr nuclear reactor in Iran.

2%

of Iran’s electricity needs

is all the Bushehr nuclear reactor provides.

78

journalists

were imprisoned in Turkey as of August 2012 according to the OSCE.

Stay in the Know

Enter your email address in the field below to receive the latest Carnegie analysis in your inbox!

Personal Information
 
 
Carnegie-Tsinghua Center for Global Policy
 
No. 1 East Zhongguancun Street, Building 1 Tsinghua University Science Park Innovation Tower, Room B1202C Haidian District, Beijing 100084 China
Phone: + 86 10 8215 0178 Fax: + 86 10 6270 3536