INDONESIAS STRATEGY

FOR INDUSTRIAL UPGRADING

Haryo Aswicahyono

Centre for Strategic and International Studies (CSIS)

June 2004

UNSFIR working papers are intended to generate transparent public discussions on

alternative development policy choices for Indonesia. As a result, it is a standard
operating procedure at UNSFIR to actively encourage comments, suggestions and
criticisms. Please direct your comments, suggestions and criticisms to the authors.
The views expressed in this paper are strictly personal and must not be attributed to the
United Nations Support Facility for Indonesian Recovery (UNSFIR) or any UN agency.

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Indonesias Strategy for Industrial Upgrading

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Contents

ABSTRACT..................................................................................................................................................V
PREFACE.....................................................................................................................................................V
ABOUT UNSFIR........................................................................................................................................ VI
INTRODUCTION ......................................................................................................................................... 1
THE INDONESIAN ECONOMIC GROWTH EXPERIENCE................................................................. 2
THE STRUCTURAL CHANGES IN THE ECONOMY .......................................................................................... 3
During the crisis .................................................................................................................................. 7
THE ROLE OF ECONOMIC POLICY .............................................................................................................. 11
Stabilization period: 1966 to 1970..................................................................................................... 12
Petroleum boom years: 1971 to 1981 ................................................................................................ 12
The adjustment to lower oil prices: 1982 to 1985.............................................................................. 12
Swift and effective liberalization: 1986 to 1991 ................................................................................ 13
Deregulation fatigue: 1992-1997....................................................................................................... 13
INDUSTRIAL UPGRADING: POLICY DEFICITS AND CHALLENGES.......................................... 14
GREATER IMPORT DEPENDENCE ............................................................................................................... 14
SPECIAL TREATMENT FOR SPECIFIC SECTORS ........................................................................................... 15
THE INFANT INDUSTRIES THAT NEVER GROW UP ...................................................................................... 16
INDUSTRIAL UPGRADING: AUTOMATIC ADJUSTMENT PROCESS OR EXPLOITATION OF INCREASING RETURNS
TO SCALE?................................................................................................................................................ 17
THE WAY FORWARD ............................................................................................................................. 18
SHORT TERM ............................................................................................................................................ 18
MEDIUM TERM ......................................................................................................................................... 19
LONG TERM ............................................................................................................................................. 22
TOWARDS A COMPETITION-DRIVEN POLICY ................................................................................ 22
REFERENCES .......................................................................................................................................... 25

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List of Tables
Table 1 - Composition of manufactured exports, 1975 to 1997..........................................5
Table 2 - Composition of manufactured exports, 1975 to 1997..........................................8
List of Figures
Figure 1 - Indonesias structural change, 1960 to 2001.....................................................3
Figure 2 - Indonesias composition of exports, 1963 to 2001.............................................4
Figure 3 - Indonesias technological intensity for manufactured exports, 1980 to 2002 ...5
Figure 4 - Total factor productivity in the manufacturing sector, 1961 to 2000 ................6
Figure 5 - Quarterly manufacturing growth, 2000 to 2003 ................................................8
Figure 6 - Indonesias export competitiveness, 1995 to 2001 ............................................9

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Abstract
In the period of rapid growth prior to the crisis, Indonesia underwent massive economic
transformation, characterized by drastic changes in economic structure, trade patterns and
industrial formations. This transformation has been associated with Indonesias trade and
industry policies over the last three decades. While there have been significant changes in
both policies and performance over this period, important strategic questions remain.
What is the link between polices and performance? What does this link mean for shaping
a future comprehensive trade and industry policy for Indonesia? This paper provides an
overview of Indonesias past rapid economic development, past policy deficits and
discusses strategies for further industrial upgrading in the future. The papers suggest
moving to a more competition driven policy and identifies policy deficits that need to be
addressed by policy over different timeframes short term, medium term and long term.

Preface
This paper was originally presented at a workshop on Why Trade and Industry Policy
Matters? held at the Hotel Millennium in Jakarta on 14 and 15 January 2004. The
workshop was jointly sponsored by BAPPENAS, the Ministry of Industry and Trade and
UNDP with the support of UNSFIR. UNSFIR would especially like to thank the Brighten
Institute for providing valuable support for this workshop. In consultation with the
author, this paper has been revised since the workshop.
UNSFIR is extremely grateful to the author for contributing this paper in an area of
policy that needs to be addressed for the revitalization of the manufacturing sector and
the Indonesian economy. It is well recognized that the author is an expert in this area and
the dissemination of his knowledge is much appreciated. UNSFIR would also like to
extend its gratitude to the Centre for Strategic and International Studies for supporting
this workshop.
This paper and the public discussion it has stimulated will be used primarily in preparing
a consultative White Paper on industry policy. The final White Paper will strategically
set out Indonesias future approach to industry policy. The Jaringan Kebijakan Publik
Indonesia (or JAJAKI) will be the centrepiece for active discussion in shaping this White
Paper for Indonesia. Indonesians with an interest or affected by industry policy will have
an opportunity to contribute to the preparation of this White Paper.

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About UNSFIR
The United Nations Support Facility for Indonesian Recovery (UNSFIR) is a project
established by the Government of Indonesia and the UNDP to stimulate examination of
policy options for the country at an important point in the countrys development. The
work aims to engender wide public discussion of the issues involved in order to build a
new social and political consensus for effective and sustainable policy implementation.

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Introduction
During the period of rapid growth prior to the economic crisis, Indonesia underwent
massive economic transformation, characterized by drastic changes in economic
structure, trade patterns and industrial formation. This process has been associated with
the changing patterns of Indonesias trade and industrial policies for the last three
decades, from an import substitution strategy in the 1970s, agricultural protection in the
late 1970s and early 1980s, and then trade and financial liberalization since the late
1980s. Since the period of rapid trade liberalization in the late 1980s, international trade
activities have become important components in Indonesias economy. Both values of
exports and imports have increased substantially, while the structure of exports has also
changed dramatically. The process of industrialization has also been rapid, and various
indicators show that the process of industrial upgrading, from low to higher value added
manufacturing and from the dominance of natural resource based to labor intensive
industries and then to capital intensive industries, has been taking place.
While there have been significant changes in both policies and performances, there is still
a question whether there is an explicit linkage between the two. Some questions remain.
Is there any special policy that led to the special performance of Indonesian exports? Or
is there any policy deficit that led to disappointing performance of a certain sector? Is
there any failure of coordination between trade and industrial policies, and between those
two policies and others? Why are there persistent structural weaknesses in Indonesias
manufacturing industries? The analysis of those issues are crucial in preparing a
comprehensive trade and industrial policy for Indonesia in the coming years. The
challenges ahead are clear. Indonesia has to recover from the crisis and to sustain
economic growth by developing comprehensive trade, industrial and investment policies.
Furthermore, Indonesia has to develop trade and industrial policy that enhances economic
competitiveness in the global market, while at the same time preparing for the new
millennium round of the WTO.
The objective of this paper is to present an overview of Indonesias rapid economic
development, by focusing on the changing patterns of trade and industrial structure, the
changing trade and industrial policies, and the process of industrial upgrading. The paper
analyzes the process of industrialization, including policy deficits and challenges, and
discuses the strategy to facilitate further industrial upgrading in the future.
This paper is organized as follows. The first section of the paper presents the stylized
facts of Indonesias rapid economic development during the last three decades, by
focusing on the changes in economic structure, trade patterns, and policy directions. The
second section provides the discussion on industrial upgrading, including the challenges
that Indonesia is currently facing. Finally, the third section discusses the strategy to
facilitate rapid industrial upgrading in the future.

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The Indonesian economic growth experience

Before the period of rapid economic growth from 1970 to 1997, the performance of the
Indonesian economy under Soekarno administration from 1945 to1966 had been very
poor. Apart from low economic growth, there were food shortages, spiralling inflation
and a general breakdown in communications and infrastructure. In terms of social
indicators, such as illiteracy rate, infant mortality, and others, the quality of life was
lower compared with that in neighbouring countries. Higgins as quoted in Hill (1994),
among others, referred to Indonesia as a basket case, because production and investment
had been stagnant, or even fallen, and real per capita income in 1966 was probably below
that of 1938 (Booth and McCawley 1981).
The situation changed under Soehartos administration. Despite its authoritarian regime,
Soehartos administration from 1967-1998 had in fact produced much superior economic
outcomes. Under the New Order regime, Soeharto and his cabinet in its first five years
produced dramatic results beyond the most optimistic expectations. Hyperinflation, at a
rate of 1 136 per cent in 1966 was restrained to 17 per cent by the 1970s and further
reduced to around 8 per cent by the 1990s. Since then, and until the current economic
crisis, the government has zealously kept inflation at single digit levels. Macroeconomic
stabilization and liberalization of the capital account, including a more favourable
investment law and oil windfall clearly enhanced Indonesias capacity to finance
economic development. The bold reforms resulted in rapid economic growth and an
extremely rapid transformation from the 1960s to 1997. Since the 1960s, Indonesia has
made consistently impressive economic progress particularly from the late 1980s until
1996, during which period GDP increased at between 7 and 9 per cent annually.
The transformation of the Indonesian economy since 1966 has been remarkable. High
economic growth, together with low inflation, raised per capita income more than tenfold from $70 in 1969 to $1100 in 1997 (current prices). The growth success was
matched by similar successes on the distribution side. The number of people living below
the poverty line was reduced from 70 million in 1970 to 26 million in 1993. This meant a
five-fold reduction in the percentage of people living below the poverty line from 60
per cent to 14 per cent during the same period.
Even though foreign aid continued to be a significant source of economic development,
the experience prior to the crisis showed that the capacity to service debt was sustainable
and was gradually being complemented by tax revenue. Government investment, once
occupying the commanding heights of the economy, had been gradually replaced by
private and foreign investment. At the same time, non-oil export earnings which
amounted to around 70 per cent of total exports in the 1990s had gradually replaced oil
revenue, which was the main source of foreign exchange earnings in the 1970s. As a
result, the economy had been more resilient to external shocks for much of this period.

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The structural changes in the economy

Rapid structural change has also been the landmark of Indonesias New Order economic
development. The agricultural sector, which once dominated the economy, declined from
56 per cent in 1965 to 16 per cent in 1997 or a third of its 1965 share (refer to Figure 1).
Meanwhile, the manufacturing sector had grown tremendously at around 13 per cent per
year over the 1975 to 1997 period. As a result, the manufacturing share, which was a
mere 8 per cent in 1965, surpassed the agricultural sector in 1991, and in 1995
manufacturing value-added contributed 24 per cent of GDP, three times its 1965 level.
Figure 1 - Indonesias structural change, 1960 to 2001
per cent
45

40

35

Agriculture
Industry - non-manufacturing
Industry - manufacturing

30
percentage of GDP

Services
25

20

15

10

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

1965

1964

1963

1962

1961

1960

Source: World Bank (2004).

Bold economic reforms, especially export promotion, and sound macroeconomic

management since the beginning of the New Order produced the export boom from the
early 1980s. Figure 2 depicts the pattern of Indonesias exports since 1965. Until the late
1970s, manufacturing exports constituted no more than 4 per cent of total exports. By
1987, the share of manufacturing exports had surpassed the share of agricultural exports,
and in 1992, overtook the share of oil, mineral, and basic metal exports. As the share of
agricultural and primary product exports declined and the share of manufacturing exports
increased, Indonesia became less prone to external terms of trade shocks. Figure 2 shows
a large swing in the share of agricultural and other primary commodities. This is a
common feature in primary product exporting countries that face large fluctuations in
commodity prices.

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Figure 2 - Indonesias composition of exports, 1963 to 2001

per cent
90
Agriculture

Fuel, Ores and Metals

80

Manufacturing

percentage of total exports

70

60

50

40

30

20

10

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

1984

1983

1982

1981

1980

1979

1978

1977

1976

1975

1974

1973

1972

1971

1970

1969

1968

1967

1966

1965

1964

1963

1962

1961

1960

Source: World Bank (2004).

When one looks into a more detailed picture on the technology intensity of
manufacturing exports, it would be obvious that there have been massive changes in the
patterns of export. The data in Figure 3 and Table 1 show that during the early 1980s
Indonesias manufacturing export structure was dominated by resource based
manufacturing products of 91 per cent. The importance of resource based manufacturing
exports has been diminishing steadily and by the early 1990s has been replaced by low
and medium technology manufacturing exports. Since mid-1990s the share of low
technology products has been declining steadily from 50 per cent in 1993 to 32 per cent
in 2002, while the share of medium technology products remain more or less constant,
hovering around 18 to 20 per cent. In contrast, high technology products have been
growing tremendously at a rate of around 20 per cent during the whole period.

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Figure 3 - Indonesias technological intensity for manufactured exports, 1980 to

2002
per cent
100

Resource Based

90

Medium Tech
High Tech

80
percentage of manufacturing exports

Low Tech
70

60

50

40

30

20

10

2000

1995

1990

1985

1980

Source: UNCTAD (2004).

Table 1 - Composition of manufactured exports, 1975 to 1997a

US millions and per cent
Sector
Value of exports
Resource based
Low technology
Medium technology
High technology
Manufacturing
Share of exports
Resource based
Low technology
Medium technology
High technology
Manufacturing

1980

1993

3 819
161
95
110
4 185

US millions
4 453
8 959
3 288
1 093
17 794

91
4
2
3
100

25
50
18
6
100

2002

1980-93

1993-2002

10 381
11 601
7 661
5 782
35 875

1.2
36.2
31.4
19.3
11.8

per cent
10.4
2.9
9.9
20.3
8.1

30
32
21
16
100

-9.5
21.9
17.5
6.7

2.1
-4.8
1.6
11.3

a The sum of the parts may not add to totals due to rounding.
Source: UNCTAD (2004).

This remarkable achievement was clearly a result of a successful export promotion

program. Hill (1996) listed several factors that contributed to the effectiveness of export
promotion policies. First, there was credible macroeconomic management and a political
predisposition toward moderately low inflation, thus facilitating the large effective
devaluation of the 1980s. Second, saving and investment rates were high, with oil and
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gas revenues of the 1970s being recycled into physical infrastructure, education, and food
crops. Third, liberal trade reforms were introduced from the mid-1980s. Finally, a range
of other micro-economic, efficiency-promoting reforms began to have an important
effect.
The deregulation era of the 1986 to 1996 era was perhaps the best period in Indonesias
economic history in terms of structural change and productivity growth in the economy.
The opening-up of the economy, the reduction of government involvement, the switch
from capital-intensive/import-substitution industry toward labour-intensive/export
oriented industry seems to boost economic efficiency. Capital growth was lower in this
period compare to the earlier period, yet the economy still grew at more than 7 per cent
(refer to Figure 4). It is clear from the figure that the economic growth during this period
was more akin to productivity driven growth, compare to input driven growth of the
1970s. Total factor productivity (TFP) growth during this period was higher and
contributed more to economic growth compare to that of 1972 to 1981 period. None of
the deregulation years shows negative TFP growth, compare to four years of negative
TFP growths during 1971 to 1985 periods. Moreover, TFP growth was less erratic during
the deregulation periods compared to that of the pre-deregulation era. Moreover,
Indonesias experience shows that the impact of major deregulation policies in 1986 were
long lasting, spanning almost a decade. During 1986 to 1996, TFP contributed to more
than 30 per cent of economic growth.
Figure 4 - Total factor productivity in the manufacturing sector, 1961 to 2000
per cent
15

10

1996

1991

1986

1981

1976

1971

1966

1961

-5

-10
GDP growth

TFP growth

-15

-20

Source: Authors calculations.

It should be admitted that other performance indicators do not show up as rosy as that of
the TFP. For instance, export growth did slow down prior to the crisis. During 1993 to
1996, Indonesias exports grew at 10 per cent, well below the 1990 to 1992 average of 15
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per cent. However, a closer look at the causes of the slowdown reveal that the slowdown
was cyclical in nature rather than structural factors or reduced competitiveness
(Aswicahyono and Pangestu 2001). This is evident from the observation that declines in
export prices were an important factor in the decline in the growth of the value of exports.
The detailed analysis of trade mapping indicates that the slowdown of exports were also
related to exports being destined to markets facing declining demand, rather than due to
declining competitiveness (Aswicahyono and Pangestu 2001). The constant market export
analysis indicated that while Indonesia did specialize in products whose world demand
was declining, the aggregate country effect was still positive indicating that the mix of
export destinations still led to markets where import demand was growing, although the
importance of exports going to growing markets declined from explaining the 54 per cent
of the export differential in 1985 to 1989 to only 20 per cent of the export differential in
1989 to 1996. More importantly, the competitive effect, which is the ability to improve
market share in destination markets, was positive and contributed more to the explanation
of export growth above the standard growth.

During the crisis

Only recently has the Indonesian economy shown signs of recovery, but the delayed
recovery and continuing problems reflects those that surfaced during the crisis. Over the
last nine months, inflation and interest rates have continued to fall. Fiscal consolidation,
bank and corporate sector restructuring is continuing, while capital outflow has turned into
an inflow. Favourable macroeconomic conditions have been translated into positive
consumer confidence and business sentiment.
However, there is little evidence that increasing macroeconomic stability and reduced
vulnerability is translating into higher growth. Growth has been mainly driven by
consumption and investment, while exports weakened and the slow down in
manufacturing growth continues to drag down overall growth. It is likely that Indonesia
may be settling into a medium-low growth equilibrium unless measures are taken to
invigorate exports and the manufacturing sector.
One of the important factors behind the modest growth performance is the weakening of
the manufacturing sector. Figure 5 and Table 2 clearly indicates the decelerating trend of
year-on-year manufacturing growth since the first quarter of 2000.

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Figure 5 - Quarterly manufacturing growth, 2000 to 2003

per cent
7%

per cent

5%

3%

1%
1

2000

2001

2002

2003

Source: Authors calculation.

Table 2 - Composition of manufactured exports, 1975 to 1997

per cent
Sector
Petroleum and gas
Petroleum refinery
Natural gas
Manufacturing excluding petroleum and gas
Food, beverages and tobacco
Textile, leather and footwear
Wood and wood products
Paper products
Chemicals and rubber
Cement and non-metals
Iron and basic steel
Transport equipment, machinery and appliances
Miscellaneous manufacturing products
Total manufacturing
Gross domestic product

1993-97

2000-03

2.1
1.7
2.7
11.1
16.2
5.4
2.2
10.6
8.8
13.4
7.9
5.2
9.5
10.0
7.1

-3.8
-5.1
-1.9
4.7
2.4
5.1
1.0
2.6
11.7
9.6
-0.6
9.8
18.6
3.8
3.8

Prior to the crisis, manufacturing industries were growing at a rate of 10 per cent per
year, much higher than the overall rate of GDP growth. The growth rate declined
considerably to a meager 3.8 per cent during 2000 to 2003. The weakening of the
manufacturing sector took place across the board, notably in the large resource intensive
sector such as petroleum and gas; food, beverages and tobacco; wood and wood
products; and paper and printing. However, amidst the gloomy picture, we witnessed an
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outstanding performance by chemical industries, transport equipment and other

manufacturing products.
One factor that distinguishes Indonesia's growth performance from the rest of the crisisaffected countries is Indonesia's poor export performance (Aswicahyono and Maidir
2003). Figure 6 confirms the previous discussion on economic growth.
Figure 6 - Indonesias export competitiveness, 1995 to 2001
per cent
4.0
loosing competitiveness in fast growing market

gaining competitiveness in fast growing market

Change in commodities' share in world market

3.0

2.0

1.0

-0.10

-0.08

-0.06

-0.04

-0.02

0.0
0.00

0.02

0.04

0.06

0.08

-1.0

0.10

Minerals
Wood Products
Electronics
Clothing
Chemicals
Fresh Food
Processed food
Textiles
Leather products
Basic manuf.
Misc. manuf.
Electronic comp.
Non-elec. mach.
Transport eq.

-2.0

loosing competitiveness in slow growing market

gaining competitiveness in slow growing market

-3.0
Change in country's share due to competitiveness

Source: Author calculations based on UNCTAD (2004).

The vertical axis in the figure indicates the dynamics of the sector in the world market,
the horizontal axis measures change in Indonesia's shares of the world trade due to the
competitiveness factor, while the size of the bubbles reflects the importance of the sector
to Indonesia. Figure 6 reveals an interesting story behind the lag of dynamism in
Indonesian exports. First, due to increases in the oil price on the world market, the share
of mineral exports in the world market has increased considerably during the period 1995
to 2001. Unfortunately, Indonesia missed the opportunity to ride the wave of growing
demand. Second, even though Indonesia is still competitive in many products, notably
wood products, these products have been lagging behind and their share in the world
market has been shrinking. Third, Indonesia has been losing competitiveness in two
labour intensive industries, miscellaneous manufacturing and leather products. Fourth,
Indonesia has gained competitiveness in fast growing sectors such as electronics,
electronic components and transport equipment.
A more detailed analysis which is not shown here reveals that the poor performance of
Indonesia's exports has been caused by Indonesia's inability to adjust export structure to
bring it into line with the dynamics of world demand. It is therefore imperative for
economic recovery that Indonesia reinvigorate exports through increased competitiveness
and the creation of a more flexible economy in which firms can relocate their resources
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in line with world market dynamics. The question now arises, what factors hinder such
dynamism?
While the value of Indonesias exports declined rapidly during the crisis, the slow down
has actually started far before the crisis. According to Magiera (2000) the single most
important factor causing Indonesias weak performance has been the decline in its
international export prices. Declining prices for international primary commodities
preceded the crisis and deepened during the slowdown in demand due to the crisis in East
Asia. There are several underlying reasons for the decline in manufactured goods prices
in dollar terms. First, the collapse of domestic demand at the onset of the crisis led
exporters to shift sales from domestic to export markets, and in order to do so they had to
offer lower prices. Second, given the reliance on buyers for markets, exporters were
pressured by buyers to provide large price discounts given the large depreciation of the
Rupiah. The price discounts were also deemed necessary to offset the increased risk of
doing business in Indonesia after the disruption of supplies in the April to June 1998
period at the depth of the political turmoil.
Another factor contributing to the decline of exports was the problem with trade
financing (Magiera 2000 and Feridhanusetyawan, Pangestu and Habir 1999). The
problems with the banking sector and eventual collapse meant that exporters faced
constraints in obtaining trade financing. The bigger exporters or those who are
subsidiaries of multinational companies or have an established network with buyers and
suppliers were able to overcome the problem by obtaining trade financing through their
parent company or arranging financing through suppliers and buyers. Some also relied on
their own internal capital. Nevertheless, overcoming the issue of trade financing will still
be important to facilitate export growth. The crux of the problem is of course the
breakdown of the banking sector and the various schemes that have been introduced
during the crisis have not worked since they depend on the restoration of the banking
system to issue letters of credit, and restoration of confidence with regard to the
government and government guarantees.
The real effective exchange rate also affected export growth during the crisis. Prior to the
crisis Indonesia adopted a policy of continuous depreciation of around 5 per cent per year
since 1988 to compensate for the inflation and other currency changes. Just prior to the
crisis, in 1995 and 1996, the weakening of the yen, and a shift in policy to allow the
exchange rate to appreciate as part of the response to the influx of capital inflows led to a
decline in price competitiveness of Indonesias exports. During the crisis, despite the
large nominal depreciation of the Rupiah, the real effective depreciation was much less.
The dramatic nominal depreciation up to the last quarter of 1998 has been offset by
inflation close to 100 per cent in 1998, and since the last quarter of 1998 the
strengthening of the Rupiah (although still subject to wide fluctuations). Thus, it is
estimated that the real effective depreciation now amounts to around 50 per cent
compared to the pre crisis period.

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The role of economic policy

The tremendous growth and remarkable structural change in Indonesias economy since
the mid-1960s invited the obvious question: Why? Was this extraordinary growth and
structural change simply a historical accident, or were there systematic factors behind the
success story.
Economic transformation is the result of the interplay of many factors. However, at the
risk of doing some violence to the actual diversity, it is useful to divide the factors into
three groups universal, country-specific and policy. The first group, universal or
general factors, has been the focus of economic development theory. Included in these
general factors are Engels law and Lewis two-sector model that predict the familiar
structural change in an economy. The declining share of the agricultural sector and the
increasing share of the manufacturing sector as income rises. Despite the universality of
economic transformation, it is by no means uniform across countries. This suggests there
are other factors affecting the course of transformation.
The second group of factors, which are the country-specific factors unique to individual
countries, such as factor endowments, initial conditions, and historical accident also play
an important role. The Hecksher-Ohlin neo-classical theory suggests that differences in
factor endowments determine comparative advantage, which in turn influences trade
patterns.
Factor endowment approaches to comparative advantage may very well explain
Indonesias export pattern. A large proportion of Indonesias exports consist of products
derived from natural resources. However, the negative impact of resources booms, which
is known as Dutch disease, may retard industrialization, even de-industrialize a nation,
and create a bias in the economy against the non-oil traded sector. Indonesia did suffer
from Dutch disease (Pangestu 1986 and Warr 1992), but performed relatively well in the
management of the windfall of oil revenue compared with other oil rich countries
(Cassing 1987, Pinto 1987 and Gelb and Associates 1988). The Indonesian case
illustrates the point that variations in performance across countries cannot be attributed
solely to differences in endowments.
The third group of factors, policies and institutional factors explains the variations in
performance across countries with similar endowments. Through institutions and
economic policies, governments can change an economys incentive structure and hence,
determine resource allocation and efficiency. For the market mechanism to work
efficiently, an economy needs institutions that enforce contracts impartially and make
property rights secure over the long term. These are examples of some of the institutions
and economic policies required in order for a nation to realize its productive potential
through the market mechanism.
A body of evidence has centered around the analysis of the development experience of
highly successful East Asian countries has led to general agreement that a market friendly
approach to development is the best broad economic development strategy. Specifically,
the approach stresses the importance of investment in people; improving the climate for
enterprise; opening economies to international trade and investment; and getting
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macroeconomic policy right (World Bank 1991). More recently, attention has been
diverted to related issues linking trade and productivity growth (Havrylyshyn 1990 and
Tybout 1992), and in particular, the argument that productivity grew faster in outwardoriented countries than in inward-oriented countries (World Bank 1991 and 1993). All in
all, the Indonesian economic achievement since the Soeharto took the presidential chair
had been very good indeed. As it will be argued in the following discussion, this is partly
due to economic policy direction.
Economic policies had undoubtedly contributed to the rapid economic growth between
1967 and 1997. To understand the critical role of the economic policy to the Indonesian
economy, it seems important to provide a brief description on the evolution of
Indonesias economic policies since the mid-1960s. The evolution of the economic
policies can be grouped into five episodes as follows.

Stabilization period: 1966 to 1970

During the period from 1966 to 1970, the Governments focus was on economic
stabilization, that is, controlling inflation. The return to economic orthodoxy in the form
of a fiscal disciplined and tight monetary policy brought inflation down quickly. Ties
with the international donor community were re-established. Physical infrastructure that
had been neglected for years was rehabilitated. All of these factors resulted in a strong
investment response.

Petroleum boom years: 1971 to 1981

In the early period of the oil boom, the government adhered to reasonably open trade and
investment policies. However, by the late 1970s, the government had embarked on a
more interventionist path, especially in the area of industrial policy. There were at least
four major channels through which government intervened during this period. First,
through domination of state owned banks, which provided subsidized credit to favoured
clients. Second, the direct involvement in production was through state own enterprises,
mainly in heavy industry. Third, through rising barriers to imports. Finally, through a
complex set of regulation aimed at promoting various industrial policy objectives, such
as spatial dispersion, small industry development and indigenous business development.

The adjustment to lower oil prices: 1982 to 1985

Oil prices began to soften in 1982, and then decline sharply in 1985 to 1986. The policy
response was initially ambivalent. Macroeconomic policy followed promptly, through
tight fiscal and monetary policy and two large devaluations in 1983 and 1986, while
microeconomic reform was undertaken at a slower pace. Only by the mid-1980s did
microeconomic reform become effective and wide-ranging. The major microeconomic
reforms included the removal of entry barriers to the banking sector and credit subsidies;
the replacement of the corrupt custom service in 1985 by a Swiss Company, SGS; the
introduction of an efficient and clean duty drawback system in 1986; the liberalization of
foreign investment; and the reduction of trade barriers.
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Swift and effective liberalization: 1986 to 1991

This period has been one of further liberalization and recovery, which witnessed a larger
role for the private sector and an emphasis on exports. The Rupiah was again devalued in
September 1986, followed by a series of substantive trade reforms in October 1986,
January 1987, November 1988 and May 1990. The devaluation, combined with tight
macroeconomic management, maintained the competitiveness of the real effective
exchange rates, while the substantive deregulations tackled the high cost economy. In
contrast, the effectiveness of the 1978 devaluation in promoting exports was eroded by
the appreciation of the Rupiah, due to the oil boom, and the high cost economy.
In May 1986, the old export certificate scheme that was subject to abuse was replaced
with the duty drawback system that was more precise and less prone to corruption. The
approved importers system, which became a non-tariff instrument was abolished and
converted into tariff equivalents in the October 1986 package and subsequent
deregulation packages.
The long awaited financial reform was announced in October 1988. The reform increased
competition among banks resulting in increased mobilization of public monetary assets
and reduced interest rates. Foreign and domestic investment was gradually deregulated
during 1986 to 1994, especially for export oriented foreign direct investment.

Deregulation fatigue: 1992-1997

The first major trade and investment reforms during this period were included in June
1991 deregulation package. These reforms further reduced non-tariff barriers and
replaced them with tariff and export taxes; reduced general tariff levels; and reopened
several business areas, which are previously included in the negative lists (lists of
industries closed to foreign investments) to new domestic and foreign investment. The
removal of non-tariff barriers included the abolition of import bans on cold-rolled steel,
sheets and tin plates. The reforms also abolished export bans on copra and palm oil as
well as the exclusive rights of several companies to export palm oil based products.
The above reforms were followed by a series of trade and investment reforms in July
1992, June and October 1993, June 1994, May 1995 and June 1996. The main elements
of these reforms were a range of tariff reductions; changes in trading arrangements for
certain commodities in the form of the removal of non-tariff barriers; improvement in
trade facilitation measures such as duty draw back scheme and procedures on bonded
zones; and shortening the lists of activities closed to domestic and/or foreign investment.
However, many economists expressed their concern that the country was experiencing
deregulation fatigue during this period. They argued that the reforms were to slow, much
less comprehensive than they had hoped, and did not include various sensitive
agricultural commodities, and several important manufacturing commodities. Moreover,
several policy aberrations emerged during this period. Among the controversial cases
were the clove monopoly; restrictions on inter-island trade of oranges from West
Kalimantan in 1991; the increase of the tariff surcharge on propylene and ethylene
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imports in 1993; and exemptions from 35 per cent luxury taxes for national car, the
Timor. All of these cases were related to the Presidents family and/or cronies.

Industrial upgrading: policy deficits and challenges

By looking at the changing structure of the economy, the changing patterns of export,
and the direction of trade and investment policies, one could easily conclude that the
economic opening in general, trade and financial liberalization in particular has
contributed to impressive macroeconomic performance and rapid growth of
manufacturing and trade activities in the late 1980s and early 1990s. The stylized fact has
also shown that the process of industrial upgrading, from lower value added to higher
value added manufacturing, from traditional primary sector to modern secondary and
tertiary sector, took place from 1986 to 1997 prior to the crisis. The collapse of export
and import during the crisis created some interruption in the process, but various cases
show that the process of industrial upgrading has continued during the crisis. The fact
that electronic and machinery industries has emerged and became the leading
manufacturing sectors at the expense of the declining role of textile, garment and shoes,
show that the process of industrial upgrading seems to continue.
But a closer look at the linkage between trade and industrial policy and performance, one
could also find some policy deficit or even policy failures that have led to sub-optimal
economic outcomes. Even one could also argue that Indonesias failure in surviving the
recent economic crisis has been partly due to some failures and shortfalls in those
policies. Massive currency depreciation in 1998 should have been able to boost exports,
but in fact, exports declined very significantly during the crisis. It might be the case that
some deficits in trade policies could not be blamed as the only source of weakening
exports, but at least, export performance would have been better if trade policies were
optimal.
The following three examples show some shortfalls in trade and industrial policies by
looking at the linkage between policies and performance in the last three decades.

Greater import dependence

Economic and trade liberalization has clearly led to impressive performance of both nonoil exports and imports since the mid-1980s. The majority of import consists of capital
and intermediate goods, which are mostly the inputs for the production of exports. In
other words, Indonesias export sector relies heavily on imported inputs. The question is
whether this phenomenon is a natural consequence of the endowment effects or is a result
of some policy failures. The fact shows that both factors matter.
Given the scarcity of capital and the abundance of labour, the pure endowment effects of
trade liberalization would naturally lead to increasing import of capital goods and exports
of labour-intensive products. But there are also some policy effects that led to greater
dependence on imported inputs. First, the upstream industries, such as steel,
petrochemicals, heavy machineries, ships and others have been heavily protected. This
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non-competitive nature of upstream industries led to expensive inputs. Second, there

have been special export promotion policies that have encouraged the purchase of inputs
from overseas. These include, for example, zero import tariffs when the imported goods
are used to produce export commodities. Combined with the application of domestic
value added tax for all domestically purchased input, exporters would prefer to import
their production inputs. Third, strong exchange rates during the export boom period has
also contributed to greater dependence on imported inputs. Massive capital inflows in
early 1990s clearly led to a strong Rupiah, which certainly made imported inputs
cheaper. Another factor is the impact of international networks of production. Many
multinational companies in the automotive, machinery and electronic sectors, have
relocated their production plants to Indonesia because of its cheap labour. Because the
domestic component of the production process is mostly labour and land, this growing
trend of international networking clearly led to increasing imports of capital and
intermediate goods.
The dependence on imports was not seen as a problem during the economic boom in
early 1990s. But with drastic exchange rate depreciation during the recent crisis,
imported inputs became very expensive and the collapse of imports partially led to a
sharp decline in exports in 1998. Combined with the failure in trade finance due to the
collapse of the domestic banking sector, the transaction cost of imports became very
expensive. In other words, the benefit from the weak Rupiah has been offset by the
increasing cost of imports.

Special treatment for specific sectors

While trade liberalization in manufacturing sectors has been very progressive since the
mid-1980s, some non-competitive behaviour and policies remain. In other words, trade
liberalization was basically conducted with some exception. Some sensitive
manufacturing sectors such as automotive, petrochemicals, heavy machinery and ships
are still protected. This is not a specific Indonesian case because trade liberalization is
basically a political process with political-economic consequences.
The ambivalence in liberalizing trade in the mid 1980s was partly a reflection of the
conflict within the cabinet, between the technocrats who were in favor or deregulation
and liberalization and other ministers who were inclined towards import substitution and
protectionism. Towards the end of the 1980s, the second group began to move closer to
the first group, and therefore the drive towards economic deregulation and liberalization
was stronger. But apart from these two groups, there was also the Minister of Research
and Technology, Habibie, who embarked on several high-tech projects to develop aircraft
and shipping industries, which of course required heavy protection. Minister Habibie
received the needed support from the President and as a result the protection to these so
called strategic industries like aircraft and shipbuilding industries were heavily protected.
In addition to the massive resource waste, other consequences of this policy failure
include non-competitive shipping industry, high inter-island transport cost and the
collapse of fishing industries.

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In the mid-1980s, in the early period of trade liberalization, the existence of the exclusion
list was perhaps more acceptable because liberalization itself should be seen as a gradual
process. But the items on the exclusion list remained, and in fact there have been some
new items on the list in the later period of liberalization in the mid-1990s. Part of the
reason is strong lobby of the vested interest groups and excessive practices of Cronyism,
Collusion and Nepotism (KKN) during the last ten years of Soehartos administration. It
is ironic that general economic liberalization that has been pursued since the mid-1980s
was followed with increasing incidence of KKN practices since the early 1990s. The role
of the private sector clearly increased due to liberalization, but it is also clear that not
everyone has the same chance to enter the market. Some sectors are reserved for some
privileged individuals, and therefore privatization programs were sometimes seen as
shifting the monopoly right from the state to some selected individuals.

The infant industries that never grow up

A case in point is Indonesian automotive and automotive component industries. It can be
argued that no Indonesian manufacturing industry has received more policy and
analytical attention than automobiles. It is one of the largest manufacturing sectors, and it
has recorded rapid growth for most of the 30 years since 1967. But in 1998 to 1999 it felt
the effect of the economic crisis perhaps more than any other major sub-sector. It has also
been the subject of intense policy intervention, and variously regarded as a spearhead of
technological modernization and a vehicle for the diffusion of imported, principally
Japanese, know how. However, one consequence of this intervention is that it has
probably attracted more rent seeking activity than any other major manufacturing activity
in the country. It has consistently received very high levels of import protection. By the
mid 1990s, the Soeharto family and their immediate associates had begun to enter the
industry, most conspicuously in the case of the ill-fated national car, the Mobnas
initiative.
Despite the rapid growth of output from 1967 to 1997, and much improved production
capabilities, the industrys development record has been very disappointing. This is a
classic case of an infant industry, which has failed to grow up. High protection and
intense regulation have resulted in a fragmented industrial structure in which few, if any
firms have production runs that approach minimum efficient scale and an environment
where political/bureaucratic connections are the most important arbiter of commercial
success. Like the nations aircraft industry, this has been another case of back-to-front
industrialization, in which assembly activities have been promoted prior to the
establishment of a well-developed supplier base. In the process, Indonesia has missed out
on the opportunity to become Southeast Asias leading automotive nation. That position
is now clearly occupied by Thailand, which in the early 1990s was able to switch more
quickly from import substitution to export orientation, and to attract large foreign
investment in anticipation of a more open ASEAN market for the industry.

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Industrial upgrading: automatic adjustment process or exploitation of

increasing returns to scale?
While in general the process of industrial upgrading has been taking place in Indonesia,
the problems above show that there are some imperfections. The question, therefore, is
whether the industrial upgrading is really an automatic adjustment process? The general
answer to the question would be yes, but as will be discussed later, we should inject some
qualification to the general principle.
Industrial upgrading should be seen as an automatic adjustment process through the
process of moving-up the ladder in terms of comparative advantage. By looking at a
static process, the comparative advantage, and thus trade pattern of a country is
determined by its factor endowments. And therefore, as discussed earlier, Indonesia
should specialize in unskilled labour intensive and natural resource sectors in the early
stage of industrialization. However, comparative advantage is a dynamic phenomenon.
As a country accumulates capital, during the course of industrialization, and all the
characteristics of a labour surplus economy are diminished, the country will loose its
comparative advantage in its traditional sector and should move up the ladder of
comparative advantage and the lower rung of the ladder will be occupied by countries in
the earlier stages of development (Balassa 1977).
At the micro level, this adjustment processes occurs mainly through the firms response
to changing relative factor prices. As a country accumulates capital, marginal product of
labour increases and pushes the wage rate upward another way of saying that labour is
becoming relatively scarce factor and capital is becoming relatively abundant factors.
And because labour is freely moved across sectors in the long run, wages will be
equalized across sectors. Thus, the changing in relative prices will affect not only the
sector that accumulates capital, but also the whole economy. As the wage rate increases,
unskilled labour intensive industries become uncompetitive and the firm should invest in
a more advance production process and use more skilled labour to survive in the new
environment.
However, the automatic adjustment argument is questioned by the publication of a
theoretical growth model with increasing-returns-to-scale of production technology by
Romer (1986). Increasing returns is shorthand for a wide range of technological
possibilities learning by doing, spillovers in knowledge accumulation, agglomeration
economies among suppliers of specialized inputs to production and so on. Numerous
models have been developed that take into account one or the other aspects of increasing
returns and their influence to economic development in general and to industrialization
process in particular. Economic theory has settled on three broad categories concerning
determinants of economic growth, namely, productive knowledge (technology), skills
and incentives (Jovanovic 2000).
A key element in many of these models is the possibility of multiple equilibria in the
presence of economies of scale. That is, when there are external economies, it will often
happen that the return to committing resources is higher the more the resources
committed. A growth model developed by Sachs and Yang (2001) is particularly relevant
to the discussion at hand. The model is a modification of a model developed by Murphy,
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Shleifer and Vishny (1989). The Murphy-Sleifer-Vishny (hereafter MSV) model shows
how market-size effects can create external economies among firms investing in
industrialization. The main thrust of the MSV model is the argument put forwarded by
Rosenstein-Rodan in 1943 that if various sectors of the economy adopted increasing
returns technologies simultaneously they could enlarge their markets and make
industrialization profitable. A key ingredient that makes this approach works is the
feedback loop between the extent of the market and economies of scale.
The MSV model argues that a large population size has a positive effect on
industrialization. However, as the East Asian experience suggests, this may not always be
the case. The so-called four tigers Korea, Taiwan, Hong Kong and Singapore had
been industrialized ahead of their bigger neighbours such as China and Indonesia.
Moreover, empirical evidence provided by Dasgupta (1995) rejects the aforementioned
scale effect. As pointed out by Sachs and Yang, a large country can be locked into
development trap if its transaction efficiency is low. In other words, there may be a tradeoff between economies of scale and transaction costs. Indeed, Murphy, Shleifer and
Vishny recognize this problem. Hence, Sachs and Yang modify the MSV model by
taking this trade-off into account. In essence, the Sachs-Yang model argues that an
industrialization process may proceed only if transaction costs are low enough to allow
the economy to exploit the interaction between the extent of the market and economies of
scale. According Sachs and Yang transaction conditions are affected by geography,
institutions, transportation and communication technology. As will be discussed further
later, the idea of improving transaction conditions is particularly relevant to the current
Indonesian situation.
The thrust of our argument is then to return to orthodoxy, in which the upgrading process
is achieved through an automatic process of climbing the ladder of comparative
advantage. Any interventionist policy intended to exploit economies of scale should take
into account the trade-off between transaction costs and economies of scale. Considering
the low quality of Indonesias institutions, the general strategy should be removing all
the distortions in the market that makes firms failed to respond to the changing
environment. At the same time, government should focus on its proper role of providing
high quality public goods and institutions at low costs.

The way forward

Short term
In the very short term, what needs to be done is to ensure that the existing sources of
competitiveness can be maintained until the more pressing medium term issues can be
dealt with. This includes maintaining macro economic stability; keeping a check on wage
increases so that they do not surpass labour productivity; exploring any potential for
breakthroughs in ensuring trade financing can function in the short term without having
to wait for the banking sector to recover; utilizing foreign direct investment and networks
for market access; obtain the lowest cost inputs; and overcome financing constraints.
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One factor that would play a crucial role in sustaining Indonesias recovery and industrial
transformation in the near future is the return of foreign direct investment. The economic
growth during the crisis has been fuelled mostly by private consumption, and there is a
question whether strong consumption can be sustained in the long run without the
accumulation of saving. With massive public debt, the government will be no longer the
engine of growth. With global recession, exports are expected to remain weak and the
remaining source of growth would be investment. Unfortunately, the performance of
investment, especially foreign direct investment, has been disappointing.

Medium term
However, structural factors such as increased competition, issues of increasing
productivity and increasing value added which were already being flagged prior to the
crisis will be important if export growth is to be sustained in the medium term. There is a
whole range of issues that needs to be addressed. First, one should not forget the lessons
already learned such as maintaining competition in the domestic market, which was
already experienced by Indonesia. Furthermore, a recent study on Korea and Japan found
that imports have a stronger effect on productivity than do exports. Imports provide
competitive pressure on local products and can influence productivity by embodying
technological gains of the country of origin and contributing to the product, and can be
effective to assimilate new technologies (Yusuf 2000). The importance of other factors
conducive to exports such as foreign direct investment and international networks,
appropriate macroeconomic policy and building up competitive supporting industries so
that the reliance on imported inputs are reduced, are all also important.
The familiar problem of reliance on imported inputs has to do with the early phase of
manufactured export development that Indonesia is in, and also with the fact that there
are policy flaws and mistakes. The policy of domestic-content, besides being no longer
allowed under the Trade Related Investment Measures (TRIMS) agreement at the World
Trade Organisation, has also not worked effectively and is not a viable option for
Indonesia. The facility to allow duty free imported inputs for export production was
important in the early phase of trade deregulation when one could not immediately
reduce tariff levels. However, the fact that domestic components, which are indirect
exports, do not receive this facility implies that there is a preference to use imported
inputs. The facility of duty free inputs should be extended to domestic components and
inputs that are used in export production as well. An even more ideal strategy would be
to reduce tariff levels affecting core inputs and components, and provide the right
incentive environment for the development of an efficient and viable domestic support
industry. The natural protection provided by the net effective 50 per cent depreciation of
the Rupiah should provide the perfect opportunity to do so.
The most crucial medium term issue and the key to increasing competitiveness in the
medium term will obviously be to enhance its technological capability. Lall et al (1999)
ranks Indonesias technological capability as the lowest compared with the other East
Asian economies given that the late starter status in export orientation industrialization
meant that its development of a technological base is much more recent and had not
taken root yet.
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Lall et al (1999) usefully summarizes the main strategic issues with regard to retaining
and sustaining export competitiveness as follows. The key is how to better realize
existing comparative advantage such as natural resources and the low cost of labour, and
at the same time beginning to build up new advantages skills, technological
capabilities, clusters and so on. The first phase of an export oriented strategy is the
easiest one where general reforms restores comparative advantage, and the realization of
existing advantages involves less risk, effort and externalities. However, to sustain rapid
growth of manufactured exports, economies must evolve to the next and more complex
stages as has been experienced by other East Asian economies. Inevitably this will
involve investment and development of various capabilities procurement, production,
engineering, design, marketing and so on. In order to develop these capabilities,
economies need to have a strategy of utilizing foreign investment combined with the way
governments and institutions help enterprises to develop necessary capabilities and
utilize externalities. The role of investment in human capital through education, training
and the incentive system, are also crucial.
The advantages of multinational companies in contributing to the competitiveness of the
export of manufactures are well known and has been demonstrated in the case of
Indonesia prior to the crisis, by developing the electronics sub sector, and during the
crisis, by providing access to markets and financing. Domestic firms also enjoy the
benefit of the link to multinationals through a partnership or buyer-supplier relationship,
exports facilitation, especially during the weakening of international demand, and trade
financing during the collapse of the domestic financial sector.
In terms of building up local capabilities, there are several areas trade policies, financial
sector policies, infrastructure development, industrials structure, skills formation,
technology promotion and role of foreign direct investment (Lall et al 1999). The first
three areas have already been mentioned and under the IMF program of reforms,
Indonesia has already embarked on steps to respond to the issues in each area. As for the
latter two areas, these are crucial in ensuring competitiveness and have only to date
received lip service in Indonesia. The experience of the crisis should also remind us of
the lesson of how paying attention to these two areas facilitated an export led recovery in
Korea and to a lesser but still important extent in Taiwan.
What needs to be done by Indonesia is to seriously address skills formation and
technology promotion and to maximize the role of foreign direct investment. Skill
formation and export competitiveness are generally an accepted need, but the need has
become even more urgent given the rapid pace of technological change, information
technologies and the so called knowledge-based economy, which will determine the
competitive edge based on knowledge and information, and ability to adapt and to be
flexible. On a scale of 1 to 10, Indonesia scores the lowest out of the East Asian
economies in terms of the percentage of the population enrolled in secondary and tertiary
education (World Bank 2004). More importantly, as Lall et al (1999) points out, the
pattern of skills needed for competing in modern manufacturing have changed. There has
to be a shift from focusing on quality and quantity of education (that is, general
enrolment levels) and training by firms, to more high level and specialized training with
close collaboration and links between educational institutions and industry needs.
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Indonesia compares very poorly with other East Asian economies for tertiary level
enrolments in technical subjects (Lall et al 1999). It also has one of the lowest levels of
technology imports and scientists and engineers per million people out of the East Asian
economies (World Bank 2004).
Technological activity or promotion is often measured by research and development
expenditures as a rough indicator of technological effort. As expected, data on research
and development expenditures in productive enterprises as a percentage of GNP in
developing countries do roughly correspond to the technological level of their exports.
Based on this indicator, the percentage productive enterprises spend on research and
development in the more developed newly industrialise economies is about 10 times
higher than the new newly industrialise economies and Latin America. Asia as a whole
accounts for 86 per cent of research and development scientists and engineers in the
developing world. Out of the East Asian developing economies, Korea and Taiwan are
leaders, whilst the other Southeast Asian economies including Indonesia are somewhat
lower.
Multinationals and foreign direct investment also plays an important role in technological
capability of a country. If Indonesia is to participate in the producing and selling the most
dynamic products in the global market and products which require more complex
technology and levels of product differentiation, there is no way to do so without
participation of multi-national corporations.
Regression analysis shows that the significant determinants of revealed comparative
advantage in high technology exports are foreign direct investment and research and
development expenditures, for medium technology exports skills (technical enrolment),
research and development and risk (measured by index of economic stability), low tech
exports are wages, skills and risk, and resources based exports research and development
(Lall et al 1999).
The implications of sustaining competitiveness in the medium term are clear. Indonesia
will sooner or later have to make the move into activities that lead to greater
technological learning, rapid technical progress and greater spillover effects. Structural
change can be a catalysed by effective industrial policy and foreign direct investment.
Different Asian exporters based their competitiveness on very different agents and
factors. Korea and Taiwan have a strong domestic base of enterprises, skills, innovation
and institutions. Others like Indonesia have weak domestic enterprises, a shallow
technology base, an export sector isolated from local industry and an inadequate skill
creation system. Therefore, Indonesia faces challenges in skill and technology capability
development (Lall et al 1999).
Indonesia will need to build a broad and deep base of human capital like the more mature
newly industrialise economies in East Asia. Other than continuing to develop the
quantity and more importantly quality of secondary and tertiary education, emphasis on
special skills especially in the technical area also needs to be accelerated. To develop
technological capability an incentive environment that promotes competition and
innovation, and is supported by the appropriate institutions will be needed.
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Long term
Is industrial targeting the answer for long-term industrial development? Empirical
evidence in the past shows, that industrial targeting is not the elixir. Pack (2000) shows
that using a variety of assumptions, perhaps as much as 1 percentage point of growth in
the manufacturing sector might have been attributable to industrial targeting, implying
one-third of 1 per cent of GDP growth. Allowing other secondary effects, the increase in
aggregate growth rates induced by industrial targeting may have been perhaps 0.5 per
cent a year, hardly trivial, but not the secret of success.
It should be admitted, that the experience of Japan and Korea that pursues industrial
targeting via import substitution was rather exceptional. The explanation is that industrial
targeting in both countries was accompanied by either effective competition policy, or
clear performance criteria, whether by holding contests as in Japan (Stiglitz 1996), or by
linking preferential interest rates and tariffs on imported goods to success in export
markets. In any case, industrial policy requires clean, effective, and insulated
bureaucracy and policy maker which is a scarce factor in Indonesia.
As shown earlier, Indonesia has gone through several episodes of economic policy from
the first generation of industrial policy, that is, from import substitution to export
orientation, and is now entering into third generation policies in a difficult situation.
Mody (1999) proposed the third generation of industrial policy called Internal Capability
Building. He argues that in the past industrial policy gives too much attention on a single
objective, namely growth, and neglects two other equally important objectives
efficiency and reducing vulnerability. In addition to the traditional policy instruments,
trade policy, investment policy, competition policy, and policies relating to factor inputs
are needed. He also emphasized, the neglected important supporting instrument such as
educational and technology policy, social capital and environmental standard.
It is immediately recognizable that with multiple objectives, there will be conflicts and/or
synergy among objectives, this should be taken into account in the decision making
process. Secondly, with multiple instruments, comprehensiveness, to a certain degree, is
important. It is also important to design an interface among instruments because the
instruments are bound to overlap each other. It is a complex and daunting task, but worth
pursuing given the importance of institutional building as shown by Hahn and Kim
(2000).

Towards a competition-driven policy

It is clear that Indonesia needs an institutional support for trade and industrial policy in
an open and competitive economy that produces optimal and efficient economic
outcomes. A solid institutional framework is required to reduce risk, transaction costs,
and to ensure a well functioning market mechanism. Without a comprehensive
institutional framework, economic policy tends to be ad-hoc, reactive, partial, and may
lead to rent seeking activities. In addition, any trade and industrial policies should be
developed based on the framework of competition principles and should be formulated in
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the form of competition-based policies. The basic principle of competition-based policy

is centered in the process on competition itself, which includes four important
components.
First, trade and industrial policy has to be comprehensive. The policy should be
formulated in coordination with other policies, such as labour, investment, governance
and finance. They should be comprehensive and consistent, and not partial, approach to
those policies, and the government needs to make sure that the objectives of various
policies do not contradict each other. The policy may consist of both domestic and border
policies, and there should be good coordination between the two to ensure
comprehensiveness. With regard to decentralization, the government has to ensure that
any trade and industrial policies are in harmony, between central and local policies, and
between one sector and another. Second, the policy has to be transparent. There should
be clear rules of the game, with an effective mechanism of public disclosure, to make
sure that every economic agent has perfect information about the rules. Transparency is
important to reduce uncertainty, which in turn could reduce transaction costs. Third, the
policy has to be non-discriminatory because equal treatment for every economic agent is
important to create a level playing field. Non-discriminatory treatment would also ensure
that there would be no rent seeking activities and special treatment for special sectors and
vested interest groups. Finally, there should also be an effective system of accountability
and checks and balances on the policies. But an effective system of checks and balances
requires a solid legal system, especially legal enforcement, which unfortunately, cannot
be developed overnight.

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Balassa, B. 1977, A Stages Approach to Comparative Advantage, World Bank Staff
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Booth, A. and McCawley, P. 1981, The Indonesian Economy Since the Mid Sixties, in
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