Indonesia: An economy that lacks of dynamism

Haryo Aswicahyono

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. Favorable 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. The following figures and tables clearly indicate the decelerating trend in manufacturing growth (year-on-year) since the first quarter of 2000.

Prior to the crisis, manufacturing industries were growing at a rate of 10% per annum, much higher than the overall rate of GDP growth. The growth rate declined considerably to a meager 3.8% during 2000-2003. 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 outstanding performance by chemical industries, transport equipment and other manufacturing products.

Missed opportunity

Elsewhere in this edition, economist M. Chatib Basri shows that one factor that distinguishes Indonesia's growth performance from the rest of the crisis-affected countries is Indonesia's poor export performance. The following figures confirm Chatib Basri's observation and the previous discussion on economic growth.

The vertical axis in the figure indicate 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 important of the sector to Indonesia. The figure 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 (1995-2001).

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 labor intensive industries, miscellaneous manufacturing and leather products. Fourth, Indonesia have gained competitiveness in fast-growing sectors such as electronics, electronic components and transport equipment.

A more detailed analysis not shown here reveals that the poor performance of Indonesia's exports has been caused by Indonesia's inability to adjust her 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 in line with world market dynamics. The question now arises, what factors hinder such dynamism?

Unnecessary costs

Even though an Indonesian firm is very efficient and exchange rate, labor and capital costs are competitive in the world market, if it faces considerable transaction costs, such as transport costs and bureaucratic costs, the costs faced by domestic consumers will be high and our exports will become uncompetitive. There are numerous study showing that transaction costs in Indonesia are high. Two examples illustrate the point: port costs and bureaucratic costs.

It goes without saying that efficient ports are of critical importance factor to the national economy. The following figure shows that Tanjung Priok port is one of the least efficient ports in the region. Moreover, unit costs are the highest in the region.

The second factor that determines transaction costs is the quality of governance. The following figure shows disappointingly poor governance quality in Indonesia. The percentage rank of Indonesia is the lowest in all governance aspects: government effectiveness, regulatory quality, rule of law and control of corruption. The quality of government in Indonesia is even lower than that in Vietnam

Status quo

As far back as the 1940s, Schumpeter warned that adjustment in response to economic shock requires a painful creative destruction process, during which resources must be reallocated away from the "sick" parts of the economy to the "healthy" ones. Such creative destruction requires sophisticated institutions that can handle innumerable transactions to create and destroy production units efficiently.

The prolonged restructuring process in Indonesia and the previous table clearly show that Indonesia does not have such institutions. Moreover, the restructuring process is much more difficult during a recession because of the financial constraints faced by the "healthy" part of the economy. The labor that is released from the "sick" economy will feed into unemployment and the informal sector rather than into the "healthy" sector. Will shall now identify a number of factors that may hamper the process.

Growing protectionism

One of the most damaging effects of protection is that it prevents the growth of dynamic sectors and promotes the status quo. Unfortunately, we have recently witnessed a trend toward a more protectionist trade regime. These include such things as the reimposition of a number of non-tariff barriers, new valuation procedures as goods pass through customs, import licensing and antidumping measures (BIES Vol. 39, No. 3, 2003)

Financial intermediary

As mentioned earlier, another factor that is essential to the adjustment process is the resumption of lending, which in turn depends on lending rates. Lending rates have been stubbornly high despite the decline in SBI rates noted above. This could be the result of a number of factor: (i) due to past trauma, banks prefer to increase their interest spread in order to strengthen their balance sheets, (ii) banks may now insert higher risk premiums in their loan pricing, (iii) banks may also be cautious of sudden reversals in sentiment with concomitant large capital outflows, and (iv) lack of confidence in the legal system in protecting property rights (BIES Vol. 39, No. 3, 2003)

Labor

Finally, creative destruction also requires a flexible labor market, whereby the growing sectors may absorb labor released by the shrinking sectors. These include a rational minimum wage which reflects labor productivity, reasonable severance pay, and a fair dismissal process not only for labor but also for firms. In this regard, Indonesia's draconian labor law is inimical to the recovery process.

Conclusion

The resumption to high economic growth path seems to hinge not on new initiatives in industrial policy in which the government picks the winners and caters to specialized interest group. Given the poor quality of our institutions, it is quite likely that the government will only pick losers and encourage corruption. What Indonesia needs is a return to orthodox competition based upon rational economic policies, guarded by efficient, accountable and transparent institutions.