Indonesia: An economy that lacks of dynamism

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.