Indonesian manufacturing and the middle-income trap

Indonesia’s economic performance is deservedly attracting a lot of praise 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 its external payments have been broadly in balance. The Indonesian economy emerged relatively unscathed from the global financial crisis, which is further proof of its resilience. And in recognition of the country’s solid financial situation, two credit rating agencies have upgraded Indonesia’s sovereign credit rating to investment-grade level.

Yet this story of growth with stability is diminished in one crucial respect: Indonesia’s excellent performance has been driven by services and commodities, not by manufacturing. In fact, the role of manufacturing has significantly declined in all dimensions of the economy: its value added, its share of exports and its share of employment. So far Indonesia’s export growth has been driven by robust global commodity prices, thanks in part to China’s seemingly insatiable appetite for raw materials.

Indonesia should be concerned that manufacturing is declining in importance. Manufacturing is an important driver of growth because it tends to generate large economies of scale within firms, industries and urban areas, which in turn creates a virtuous circle between competitiveness and scale. By creating high-quality jobs, manufacturing significantly boosts productivity and wages. And as manufacturing firms become part of regional and international production networks, they benefit from specialisation, international know-how, transfer of technology and access to markets.

Neither services nor commodities deliver the same economy-wide benefits as manufacturing, and their ability to create significant numbers of high-quality jobs is considerably more limited. Though some observers have welcomed increased services employment in Indonesia, the bulk of this growth has been in low-productivity informal activities. This is because there just aren’t enough high-productivity employment opportunities available in the services sector yet. If there were, one would expect to see real wages rising. But the real wage of Indonesia’s unskilled labour — the bulk of the labour force — has declined steadily over the last five years. As a result, between 2006 and 2011 Indonesia saw the second largest increase in income inequality worldwide.

To boost manufacturing and reverse this trend, Indonesia needs to address three priorities.
First, it must quickly build more infrastructure because manufacturing growth is sensitive to the availability of infrastructure — especially energy, roads, ports and telecommunications. 

Indonesia’s pattern of growth is beginning to resemble India’s, where infrastructure is in a deplorable state. The government is already taking steps to reverse this trend such as passing the long-awaited Land Acquisition Law in May 2012, and allocating US$150 billion to finance infrastructure projects over the next five years.

Second, Indonesia must cut through some of its notorious red tape. Companies consistently identify corruption and the bureaucracy as the biggest obstacles to doing business in Indonesia. The World Bank’s 2012 Doing Business indicators revealed that Indonesia has dropped three places from last year, to 129 out of 183 countries. 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 decentralised to local governments.

But it’s not all bad news. Much progress has been made in improving the investment environment, with several city governments establishing one-stop shops for business licenses, and the national government setting up a computerised system for business registration.

Finally, Indonesia must adopt an exchange rate policy that is supportive of manufacturing. The country’s real effective exchange rate has appreciated nearly 24 per cent since early 2000, driven by rapid growth in commodity export earnings on the back of high global commodity prices. Indonesia is arguably 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.

Instead, Indonesia should 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. This would reveal a more realistic picture of Indonesia’s long-term public finance situation while helping the exchange rate reach a level that is both market-driven and supportive of manufacturing.

The praise that Indonesia is receiving for its macroeconomic management should not lead to complacency. Rising volatility in global commodity markets turn the Indonesian economy’s dependence on the production of commodities into a risky business. And commodities cannot be relied on to drive long-term growth, increase wages and lead to a more equal distribution of income. Only by developing its manufacturing sector 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.

Vikram Nehru is a senior associate in the Asia Program and Bakrie Chair in Southeast Asian Studies at the Carnegie Endowment for International Peace.
An earlier version of this article was first published by the Carnegie Endowment for International Peace. East Asia Forum