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.

Vikram Nehru
Nehru was a nonresident senior fellow in the Carnegie Asia Program. An expert on development economics, growth, poverty reduction, debt sustainability, governance, and the performance and prospects of East Asia, his research focuses on the economic, political, and strategic issues confronting Asia, particularly Southeast Asia.
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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.

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.