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«adb economics no. 411 working paper series october 2014 ASIAN DEVELOPMENT BANK   ADB Economics Working Paper Series Industrial Policy in Indonesia: ...»

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The first phase of Indonesia’s modern industrialization effort started with the “New Order” in 1966 up to the AFC that culminated with the end of Soeharto’s 32-year regime. From the second half of the 1960s to the early 1970s, Indonesia focused on stabilizing its macroeconomic environment and setting the foundation for future growth. In the late 1970s to the early 1980s, windfall from the oil price boom provided the GOI with the resources to proactively pursue economic development policies. The end of the boom led to a series of structural adjustment packages through the 1980s, putting the economy back on track until the AFC hit Indonesia harder than other Asian economies in 1997.

1966 to 1973: Stabilization and Adjustment

When the New Order came into power in 1966, the economy was in a less than ideal state. Between 1960 and 1965, real GDP per capita had been falling, inflation was running high and accelerating, and fiscal deficit was burgeoning from monetary expansion (Lewis 1994, Rock 2003). Indonesia was also facing capital flight as well as shortages in food, spare parts, and raw materials (Rock 2003). Among the government’s first tasks was to address these problems. Balanced budget requirements were quickly put in place to prevent the deficit from worsening, and the country’s debts were later rescheduled in 1976. The GOI also adopted an open capital account with full convertibility of the rupiah, which appealed to foreign investors.

                                                            

The New Order refers to Soeharto’s regime (1966–1998), while the Old Order refers to Soekarno’s regime (1945–1965).

Indonesia held its legislative election in April, and its presidential election in July 2014.

Industrial Policy in Indonesia: A Global Value Chain Perspective | 7

1970s to early 1980s: Assertive Intervention and Protectionism

Macroeconomic condition was stabilized by the time of the oil boom in 1973, allowing the economy to benefit from an inflow of resources. Further, in a rare case of preemptive adjustment, Indonesia prepared for the impact of the Dutch disease by undertaking devaluation in 1978 when its balance of payments was not under severe pressure (Lewis 1994). This preemptive exchange rate adjustment helped offset the impact of the real appreciation from the oil windfall. This technical control over macro policy was in contrast to Indonesia’s micro policies, including sector policies, which often were heavily influenced by various considerations and interests (Rock 1999).

From the 1970s to the early 1980s, Indonesia’s trade and industrial policy was largely set by the then Ministry of Trade and Industry, which was often seen as interventionist. Trade taxes were not an important contributor to the budget, overcast by significant contributions from the oil sector. The resources provided by the latter allowed the GOI to flexibly respond to whatever industrial policy that was being pursued, using trade taxes and non-tariff measures as policy tools. The choice of sectors or industries was rarely based on economic feasibility, but rather on those deemed to be of strategic importance, such as base metals, petrochemicals, and auto parts. This inevitably led to high business costs, exacerbated by complex and opaque administrative procedures, including customs clearance processes (Lewis 1994).

Industrial policies were also pursued through restrictive and discretionary investment procedures. Complex investment approval and licensing processes were in place, along with the proliferation of regulations and restrictions. Sectors were either open or close for investment, differentiated by the status of the firms, whether they are foreign, domestic or small-scale enterprises.

Investment was open and import facilities were made available only for sectors on the investment priority list. Aspiring investors often had to devote substantial resources to have their sector of interest added to the list, after which the sector might be closed to others. This practice gave enormous discretionary power to the Investment Coordinating Body (Badan Koordinasi Penanaman Modal or BKPM). Investment decisions were often made based on what were considered as the ’right’ sectors or industries rather than on the economic feasibility of the project. Protection was also provided to the domestic upstream industries through stringent local content requirements also known as “the deletion programme.”4 Extensive regulations on foreign and domestic investments continued well into the 1990s (Rock 1999).

The GOI’s pursuit of industrial development objectives was also done through its state-owned enterprises (SOEs). SOEs have played an important role in industrial deepening and high technology investment since Soekarno’s era, partly because of Indonesia’s weak domestic private sector, apart from few large family-run conglomerates. SOEs contributed a quarter of non-oil manufacturing value added during 1974–1975; the share would be even greater if the oil sector was taken into account (Lewis 1994). The GOI used the revenue from oil windfall to channel massive amounts of investments through existing or newly created SOEs, including those in oil refinery, petrochemicals, fertilizers, and steel. The primary goal was not always to foster competitiveness, but to meet production targets and create backward linkages. SOEs also often had to be concerned with non-economic objectives, such as regional development and price stabilization. Such strategy for industrialization had been inefficient and costly, not just to consumers but also to other downstream users.





                                                            

This involved deleting the product from the list of components that can be imported once domestic suppliers were identified.

8 | ADB Economics Working Paper Series No. 411 Another hallmark of the New Order was favoritism in preferential allocation of lucrative import and distribution licenses, and the rise of patrimonial network between the state (or high-ranking government officials) and the Indo-Chinese business community known as cukongism (Rock 1999).

The relationship between stable macroeconomic situation and interventionist micro policies, however, was not as distant as some scholars claimed. The former facilitated the growth of the few conglomerates that in turn provided resources to the political elites. The business elites’ dependence on the political elites helped guarantee their acceptance of the GOI’s localization and rationalization policies. This interventionist and arguably inward-looking period nevertheless highlighted the general consensus that Indonesia should not limit the development of its industries to its short-term static comparative advantage (Rock 1999).

Mid-1980s to 1996: Rationalization and Export Orientation

At the height of the boom, the oil sector contributed up to 70.0% of total revenue, but the boom did not last forever. Oil price began falling in the early 1980s and accelerated in 1986 during which the price dropped by two-thirds in just 6 months. Indonesia was able to escape the worst by half, anticipating this in recognition of its excessive dependence on oil and implementing preemptive structural adjustments.

A series of structural adjustments was undertaken during 1983 and 1984, including the rationalization of a public investment program and the cancellation or rescheduling of projects. A comprehensive tax reform was also introduced, although it did not initially include tariff reform (Lewis 1994). The most fundamental change was the realization that industrial development cannot be achieved by leaving protection from import competition to work its magic, and there is a need to ensure the emergence of competitive firms.

The mid-1980s saw a period of reforms. Among the key reforms was the customs reform in 1985, which significantly reduced clearing time and import costs. This was soon followed by the adoption of the first deregulation package in May 1986, which included the Agency for Import Duty Exemption and Restitution (Pusat Pengelolaan Pembebasan dan Pengembalian Bea Masuk or P4BM).

The P4BM put in place duty drawback facilities and tariff exemption to replace the export subsidy scheme which was General Agreement on Tariffs and Trade (GATT) incompliant. The scheme allowed firms to gain access to internationally competitive inputs. Unconditional ex-ante tax exemption or ex-post rebate, which replaced complex licensing, also significantly reduced business costs and uncertainties. Management of the scheme was placed under the Ministry of Finance, instead of the Ministry of Trade and Industry. The former was deemed more insulated from vested interests than the latter. Strict processing time reduced the room for rent-seeking behavior. These reforms contributed to boosting export competitiveness (Lewis 1994). The rupiah was further devalued by 45.0% in August 1986, after which the GOI pursued the policy of pegging the rupiah to the dollar with frequent nominal adjustment.

The May 1986 reform package was followed by more packages, each targeting a different sector or policy. These reform efforts substantially reduced non-tariff restrictions both in terms of coverage and degree. Between 1985 and 1992, the percentage of imports covered by quantitative restrictions dropped from 43.0% to 3.0%, as the average nominal tariff declined from 22.0% to 9.0%.

The fact that the GOI chose to undertake reform in stages, without setting an initial target at the outset, reflected the only possible way to navigate through domestic politics. This strategy was successful in creating an expectation of continued reform.

Industrial Policy in Indonesia: A Global Value Chain Perspective | 9 The GOI also reformed its investment regime by replacing the investment priority list with the investment negative list (Daftar Negatif Investasi or DNI), and undertaking further deregulation. The reform efforts led to a prolonged investment boom, with the value of investment projects approved by The Indonesia Investment Coordination Board (Badan Koordinasi Penanaman Modal or BKPM) rising from $1.7 billion in 1986 and peaking at $12.5 billion in 1991 (Lewis 1994). This success could not be credited to a single factor, but rather an interplay of various reform packages with varying impacts across sectors and industries.

By mid-1980s, labor intensive exports had replaced inefficient SOE-led industries as the country’s engine of economic growth. Indonesia also underwent a period of rapid structural change, as exports diversified from simple consumer goods and basic resource processing to a wider range of manufactures with increasing technological sophistication (Aswicahyono et al. 2010). The country soon emerged as a significant industrial exporter.

In 1996, Indonesia joined the middle-income group. This achievement, however, was shortlived as the country almost immediately fell back following the AFC during 1997 and 1998. It took another 6 years before Indonesia regained its middle-income status.

B. Economic Crisis (1997–1998) In 1997, Asia faced a deep economic crisis, which started with the collapse of the Thai baht. Indonesia was among the worst hit in the region. It experienced a large scale capital flight in the second half of 1997, rapid depreciation and financial distress (Aswicahyono et al. 2010). There was a loss of macroeconomic control, as the rupiah depreciated from Rp2,500 per US dollar to Rp17,500 at its worst point, and inflation was running at over 100.0% on an annualized basis. By 1998, the economy had contracted by almost 14.0%. The economic crisis culminated with the end of Soeharto’s 32 years of authoritarian regime in May 1998. The collapse of domestic and foreign investment continued for years after the crisis. Because the global economy remained buoyant despite the AFC, firms were impacted differently by the crisis depending on, among others, their market orientation.

C. Post-crisis (1999–2007) 2000 to 2004: The Recovery Period Indonesia has struggled to regain its growth momentum in the period following the AFC. From 2000 to 2005, average growth was just at 4.5%, considerably lower than the pre-crisis average of 7.3% from 1990 to 1996. Performance varied across sectors, but the slowdown was even more pronounced in manufacturing, where output since 2000 had been growing at little more than half the pre-crisis rate (Aswicahyono et al. 2010). Indonesia was hit relatively harder that other Asian economies for a number of reasons. Some assumed that with sound macroeconomic management and relatively wellperforming international economy, exporting firms in Indonesia would have enjoyed a boost of competitiveness from depreciation. However, many businesses also held foreign-denominated debts, which rendered them in trouble.

The first priority of the GOI post-AFC was to regain control over macroeconomic stability. The GOI sought assistance from multilateral institutions, including the International Monetary Fund (IMF).

While Indonesia had kept a broadly open economy at the time of the AFC (after the 1980s reform), there was further liberalization during 1997–1998 as part of the conditions imposed by the IMF in 10 | ADB Economics Working Paper Series No. 411 exchange for loans. The country exited the programme in 2003, and until very recently had continued with its policy. Both political and macroeconomic stability was restored by 2004.

Indonesia was unable to recoup the outflow of investment following the crisis. It was the only economy that registered net FDI outflow for several years. Indonesia enjoyed annual FDI inflows averaging $2.7 billion before the crisis, but was experiencing average net annual outflows of $1.4 billion for 5 years after the crisis (Aswicahyono et al. 2010).

Recovery performance varied across sectors. In general, sectors in which demand was less elastic and are more export oriented were able to recover faster, while sectors with elastic demand or protected sectors feeding into the domestic market took the worst hit. The food processing sector, for example, did not record negative growth, and growth declined less sharply during the crisis. The resource-based sector recovered slowly post-crisis despite the boost in competitiveness from real effective exchange rate depreciation, partly because of the difficulty in securing input supply.



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