Policies to Support the Development of Indonesia’s Manufacturing Sector during 2020–2024: A Joint ADB–BAPPENAS Report

PART 1

Structural Transformation and the Relevance of the Manufacturing Sector

1

Indonesia’s New Growth Normal: The Need to Transform the Economy during 2020–2024

1.1 Introduction

Indonesia is immersed in a challenging situation: after the Asian financial crisis (AFC) of 1997–1998, it has not been able to return to the high growth rates it had attained prior to it, about 17% per year during 1990–1997, against 5.3% during 2000–2017 (Figure 1.1). It seems that after recovering from the AFC, Indonesia entered a new normal with gross domestic product (GDP) growth at around 5%–5.5%. While this is high for world standards, the government of the world’s fourth most populous nation (over 260 million people) would like to eliminate poverty faster, create good employment, and attain upper-middle-income status as soon as possible. To achieve these goals, growth will need to increase. Can Indonesia achieve an average GDP growth rate of 7%–8% during 2020–2024?

Figure 1.1 Indonesia’s Actual Growth Rate, 1960–2017 (%)

Source: World Bank. World Development Indicators. http://databank.worldbank.org/data/home.aspx (accessed August 2018).

This is the first chapter out of a total of 15 that make up this report. Together, the chapters try to provide a coherent answer to the question above, in the context of Indonesia’s options for 2020–2024.

The implicit working framework of this report is that development is based on three components. The first is accumulating productive capabilities. This component acknowledges that development is about more than simply increasing income, which could happen as a result of a resource bonanza. Capabilities encompass all inputs that go into the production process; more specifically, they refer to the ability to produce by using and developing new technologies and organizations. However, since some of these inputs are tradable (e.g., machinery) everyone has access to them. What truly differentiates countries is their ability to design and use nontradable capabilities (e.g., a law).

Second, accumulating capabilities leads to structural transformation, that is, the rise of new industries to replace traditional ones, and to diversification and upgrading (concepts defined precisely in the next section) of the productive structure. The idea of structural transformation encompasses the concepts of diversification and upgrading an economy’s productive structure, and acknowledges that not all activities have the same consequences for development. High-technology manufacturing is clearly better than traditional farming in enabling countries to upgrade their productive capabilities.

Despite progress in the 1980s and early 1990s, Indonesia’s economy remains less diversified and sophisticated than those of other East Asian economies, and still depends significantly on natural resources. Why does this matter? In today’s global economy, differences in living standards among nations remain large. One important reason why such differences continue to exist is the fact that production capabilities are unequally distributed across countries. Indicators of production capabilities can be found in the data on international trade, as the basket of product classes in which developed countries excel in exporting is very different from that found in developing economies, in terms of both diversification and sophistication. The combination of these two notions results in measures (and rankings) of the complexity of economies and of the products they export. The report will discuss these three fundamental concepts, and refer to them in several chapters, especially Chapters 9 and 10. These concepts are essential to understand why Indonesia has not progressed faster, and, consequently, what Indonesia must do to move forward.

Third, in market economies, private firms are the agents of economic transformation, but their actions need to be considered in a framework of public action. In today’s world, economic development requires a mix of market forces and public sector support. High-technology manufacturing, for example, does not develop naturally in backward economies. Unless governments promote such activities and help the private sector, the market will pull a backward economy toward the same type of activities that it was doing previously (e.g., agricultural products or simple textiles), activities often based on its comparative advantage of natural resources or cheap labor.

The next two sections introduce in some more detail the concepts of diversification, sophistication, and complexity used in this report to analyze the Indonesian economy. The analysis emphasizes the view that development entails the accumulation of productive capabilities and structural transformation (in the direction of industrialization). The basic argument is that, in recent decades, Indonesia has been slowly transforming its economy and developing more complex sectors. Faster growth during 2020–2024 will be very difficult unless it speeds up this process.

1.2 The Need to Understand the Roles of Diversification, Sophistication, Complexity, and Structural Transformation

This section defines and explains the notions of diversification, sophistication, and complexity used in this report.

Diversification in the modern literature on structural transformation refers to the variety of products that an economy produces. It is measured by the number of products a country exports with revealed comparative advantage (RCA) (Box 1.1). Diversification is documented in Figure 1.2. The People’s Republic of China (PRC) and India stand out with very high values (especially the PRC, which exports with comparative advantage almost half of the product classes), reflecting in part their large size. Indeed, with their large population bases, these countries have many producers, and are therefore able to export in more product classes than smaller countries that are at a comparable level of development. Japan, Thailand, Indonesia, and Hong Kong, China have intermediate diversification, while Cambodia and Bangladesh rank low. In the case of Indonesia, the report also highlights the lack of improvement after 2007.

Box 1.1 Revealed Comparative Advantage

Revealed comparative advantage (RCA) is calculated as the ratio of the share of product X in the country’s export basket to the same ratio at the world level. Algebraically:

where E refers to exports, c and p denote economies, p and p' denote products, and P and P are the sets of economies and products, respectively. This equation defines RCA (for an economy and a product) as the proportion of an economy’s exports of a certain product divided by the proportion of world exports of that product. A country exports with revealed comparative advantage in product X if the product’s RCA>1. In the analysis, the higher the number of products exported with RCA>1, the more diversified an economy. This indicator, shown in Figure 1.2, is based on a database with export data on 5,111 product classes and 149 countries.

Source: Authors.

Figure 1.2 Economic Diversification of a Group of Selected Asian Economies, 2000, 2007, and 2014

Note: The database contains a total of 5,111 products.

Source: Authors’ calculations based on CEPII’s BACI Database. http://www.cepii.fr/CEPII/en/bdd_modele/presentation.asp?id=1 (accessed August 2018).

Economic diversification is of paramount importance for a developing economy such as Indonesia. Generally, a key difference between today’s economies and ancient ones is that the former are made of a significantly larger number of different things, many of which were not available in earlier times. This increase in diversification is probably the most conspicuous aspect of economic development, and a chief difference between the complex process of economic development and the aggregate process of economic growth.

During the Industrial Revolution, England’s economy did not grow by simply multiplying its ability to produce the shields and armor of medieval times. It expanded as a result of the introduction of new products and technologies. The steam engine powered locomotives, looms, pumps, and even the world’s first computer, known as Babbage’s calculating machine. This increase in diversification is also true of more recent growth miracles, such as those of Japan and the Republic of Korea (ROK). Both these countries have come to dominate markets in which they had little or no participation a few decades before entering them, such as markets for automobiles, ships, medical equipment, industrial machinery, and electronics.

The relevance of economic diversification has increased in recent decades. Prosperous economies differ from those that are not, both in the diversity of the inputs they have available and in the diversity of the outputs they produce. These differences imply that developed countries participate in more industries and in more markets than developing countries do, since the former can perform activities that few other countries can and which are widely demanded. In a world where new activities tend to emerge as a combination of old activities, wealth is not a consequence of having more but of having the right combinations of capabilities and inputs.

Evidence illustrating the importance of diversification has been highlighted in recent work on international and regional development. The evidence shows that the economies and employment levels of countries and regions that export a diverse set of products grow faster, in part because they have a varied set of industries and, through them, a larger number of productive capabilities. A diverse set of industries and capabilities, in turn, creates inter- and intra-industry spillovers that give rise to clusters of productive activities in which a firm’s competitiveness is strongly dependent on the existence of other firms in the same or similar sectors.

Understanding the role of diversification in economies has been historically difficult. Why, for example, are natural resources—as in the case of Indonesia—so good at generating income and foreign exchange, but so bad at kick-starting development? The lack of answers to this question can be partly traced to a historical disregard for the diverse and disaggregated nature of the world economy. Aggregate macroeconomic descriptions make little or no difference between capital goods, such as tractors, pumps, and refrigerators, beyond what can be captured through the cost of their parts or through the wages and years of schooling of the workers involved in their production. Moreover, when traditional theories have attempted to incorporate the diversity of the world into their models, they have done so through extremely symmetric assumptions in which goods are represented through a continuum that has no parallel in the real world. The failure to incorporate diversification into theories of economic growth and development is a widely recognized limitation.¹ In recent years, however, new streams of literature are helping to improve the understanding of the role of diversity by highlighting its role at the level of countries and cities.²

There are other reasons why economic diversity is important, which go beyond the path dependence intrinsic to development. For example, export diversification matters because it can lower volatility and instability in export earnings. Such portfolio effects can help hedge against the risk inherent in markets with uncertain returns. In fact, economic downturns turn out to be shorter-lived in countries that are more diversified.³ Another channel is the negative and nonlinear impact of natural resources on growth through their effect on institutional quality.⁴ Countries that are rich in natural resources are less likely to implement growth-enhancing reforms or to improve their investment climates.⁵ Although resource revenues make a handsome contribution to fiscal coffers, they also pose several challenges: what to do with the revenues earned (spend now or invest—the time profile of consumption); where to invest (foreign assets or domestic assets); and how to balance public and private sector actions (that is, government consumption and investment in relation to private sector consumption and investment). It is therefore important for resource-rich countries like Indonesia to find the right balance between these opposing forces. On the one hand, capital is scarce and therefore returns from investment at home are likely to be higher. On the other hand, the investment might be riskier and run into supply-side constraints causing the economy to overheat.

Probably the strongest argument in favor of diversification is obtained by putting aside any theoretical discussions on its potential merits, and by observing the reality of the world. Despite any theoretical construct, the reality is that developed countries display relatively low levels of export concentration, while countries with low per capita income export a very limited range of goods. In fact, except for commodity booms and other bonanzas, economic growth tends to occur with increased diversification. Hence, arguing whether diversification or specialization makes sense for countries might be a distraction in a world where diversification appears to work strongly.

Finally, some authors have studied empirically the determinants of export diversification using a world dataset spanning 1962–2000.⁶ They use several measures of diversification, including the Gini, Herfindahl, and Theil indices. They find that (i) trade openness induces concentration, not export diversification; (ii) financial development helps countries diversify their exports; (iii) real exchange rate overvaluation is negatively related with export diversification; (iv) exchange rate volatility is uncorrelated with diversification; (v) capital accumulation contributes positively to export diversification; (vi) remoteness reduces export diversification; and (vii) improvements in terms of trade tend to concentrate exports, but this effect is lower for countries with higher levels of human capital.

Sophistication refers to how standard (or the opposite, ubiquitous) a country’s export basket is. It is proxied by an index of the number of countries that export a product with comparative advantage. The standardness indicator is the average ubiquity of commodities exported with comparative advantage by a country. Ubiquity of the product class is the number of countries exporting the product with comparative advantage. Therefore, the indicator of standardness (S ) can be interpreted as follows: on average, the products exported by country c are exported by S countries.⁷ In the analysis, the lower this number the better. The idea behind this indicator is that some countries specialize in product classes that are rather unique (i.e., few countries specialize in them), while other countries specialize in common product classes (i.e., many countries specialize in them). Figure 1.3 shows this indicator, along with diversification, for 2014. It is clear that standardness is less sensitive than diversification to country size, as the PRC and India no longer stand out. The economy with the least standardized export basket is Japan, closely followed by Taipei,China; the ROK; and the PRC. The countries with most standardized export baskets are Cambodia and Bangladesh. Indonesia’s export basket is of average standardness compared with those of other Asian countries.

Figure 1.3 Standardness and Diversification, Selected Asian Economies, 2014

Notes: Standardness is the number of countries that on average export country c export basket. Diversification is the number of products country c export with RCA>1.

Source: Authors’ calculations based on CEPII’s BACI Database. http://www.cepii.fr/CEPII/en/bdd_modele/presentation.asp?id=1 (accessed August 2018).

Complexity encapsulates the idea that some products can be produced and successfully exported without much (advanced) knowledge, while other products (or services) can be produced only by those who possess advanced capabilities based on state-of-the-art knowledge. The notion of product complexity reflects the impact of capabilities and knowledge: the higher the complexity of a product, the more capabilities and knowledge are needed to successfully produce and export it. Thus, advanced countries (more complex economies) may produce and export a wide range of products, including complex and not-so-complex products, while countries with a less advanced production system produce and export only products with low complexity. Box 1.2 explains how country and product complexity indices are