Indonesia needs structural reform to support trade liberalisation

Complaints about cheap Chinese goods flooding the Indonesian market as a result of the ASEAN–China Free Trade Area (ACFTA) frequently appear in the Indonesian media.

Given that Indonesia’s manufacturing products are often more expensive than their Chinese counterparts, these criticisms are perhaps justified.

But a closer look reveals that such complaints are not entirely rational, as Indonesia has many comparative advantages over China. In particular, Indonesia has significant natural resource endowments and a substantial supply of low-cost labour. Indonesia has a much younger population than China: the percentage of Indonesia’s population aged 0–14 is almost 10 per cent higher than that in the former, while the median age of the Indonesian population is nine years younger than in China. Indonesia’s unemployment rate is also 3.6 per cent higher than China’s, and average labour costs in the Indonesian manufacturing industry are less than half of China’s.

These comparative advantages will not disappear after policy intervention and will lead to serious trade gains if they are fully realised. Indonesia thus has the potential to develop a strong manufacturing industry and gain from trade liberalisation, particularly vis-à-vis China. But Indonesia’s competitive advantages have not been well developed in the past, meaning that many industries are not confident about facing competition from China.

Indonesia’s steel industry is a case in point. It is well placed to compete considering the abovementioned comparative advantages and Indonesia’s proximity to Australia, which is the major source of coal and iron ore for China’s steel products. Thus Indonesia has the potential to produce cheap steel products. But the steel industry too has joined the chorus, complaining about cheaper Chinese products.

These kinds of complaints mask the true potential of Indonesia’s international competitiveness, and if followed blindly will hurt the country’s industrial sector and its national economy in the long run. Developing the manufacturing industry would be a comprehensive way for Indonesia to exert its comparative advantages. A competitive manufacturing industry would help create enough jobs for its growing labour force and will help Indonesia gain from trade liberalisation.

The success of such an approach was demonstrated by China’s experience acceding to the WTO in 2001. Before then, and for a couple of years after, the WTO was viewed as a ‘wolf at the door’ because the reforms needed to bring in foreign investment and promote a market economy created huge pressure for domestic industries. Similar to the current situation in Indonesia, many Chinese industries also complained that China’s less competitive industries would suffer if tariffs were reduced and restrictions on foreign rivals lifted.

Ten years later, many Western brands have indeed entered the Chinese market, but Chinese products have also flooded the world market. China’s GDP quadrupled and exports almost quintupled in the 10 years following its accession to the WTO. Even industries that were not considered competitive, such as the automotive sector, have finally gained from trade liberalisation.

But so far Indonesia’s manufacturing industry has not been robust enough to meet the challenges created by the ACFTA. This is a direct result of insufficient investment in the manufacturing and related sectors, rather than an effect of trade liberalisation. For example, the high cost of steel products is a result of high transportation costs, long delivery times, high container rents and high electricity tariffs.

So, investment in the manufacturing sector and the establishment of a competitive manufacturing industry would be a key indicator of successful structural reform in Indonesia. There are many hurdles for such investment, including poor infrastructure, high electricity tariffs, restrictive labour regulation and onerous licensing controls. According to the World Bank’s Doing Business Index, Indonesia is ranked 129 among 183 countries,making its manufacturing sector a risky destination for investors. This also means the banking sector is less inclined to provide loans to the manufacturing sector.

But these hurdles are surmountable through well-executed policy intervention. One necessary policy intervention, as evidenced from China’s experience in entry to the WTO, is structural reform. Structural reform must aim to improve institutional frameworks, regulations and policies to minimise behind-the-border barriers and thus improve economic performance and regional economic integration. The opportunities to be had from openness to trade and FDI may not be realised if behind-the-border policies do not support competition and efficiency.

Structural reform in Indonesia would help support trade liberalisation by increasing the level and competitiveness of the country’s manufacturing industry. Structural reform in Indonesia must focus on improving regulations, governance, and legal and economic infrastructure. Promoting competition is not an immediate priority, as the country liberalised significantly following the Asian financial crisis of 1997–98.

But Indonesia must be prepared for the hard work required to implement structural reform. China’s experience shows the process is arduous and painful: in the past 10 years it has abolished, revised and adopted more than 3000 laws and regulations and lifted close to 7000 tariffs, quotas and other trade barriers in order to meet WTO criteria.

In the seven-year transitional period leading up to the formal implementation of the ACFTA in January 2010 Indonesia should have focused on structural reform. Now it seems that Indonesia was insufficiently prepared for the ACFTA, and so the agreement has become a scapegoat for this lack of reform. The Indonesian government now needs the political will to proceed with painful structural reforms in order to achieve open trade and a better future for the Indonesian people and their industries.

Xunpeng Shi is an Energy Economist at the Economic Research Institute for ASEAN and East Asia.