Indonesia: Manufacturing was a key driver of the Indonesian economy from the 1980s up

Manufacturing was a key driver of the Indonesian economy from the 1980s up until the end of the 1990s. The sector continues to be a major source of employment for the country by employing 14.4 million people as per the end of 2010. From presently on productivity and increase levels have not matched that of regional competitors in core industries such as textiles. Indonesia presently faces a transformed world trading environment from its heyday; faced with fierce competition from free trade agreements across the ASEAN and China.

Such competition has served to highlight the inadequacies in areas such as technology, infrastructure inclunding the slow pace of reform in industry regulations to attract foreign investment . However a stable political and economic environment, the latter having been largely fuelled by domestic consumption, is raising confidence in the manufacturing sector for both local and international investors. Moving up the price added chain in order to fully take chance of the country’s wealth of natural resources will be the next step to raise Indonesia’s manufacturing competitiveness on the world stage.

Indonesia Manufacturing Real Annual Increase by Sector

Source: Ministry of Trade

Indonesia’s manufacturing sector is highly diverse and a reflection of the vast array of natural resources at the country’s disposal. This ready availability of precious commodities has been to the detriment of the development of price added manufacturing processes and products. Rampant natural resource extraction of products such as bauxite and Crude Palm Oil (CPO) are largely destined for export to be used in price added processes in markets such as China for aluminium in automotive production and in cosmetics for both products respectively.

Indonesia has been losing out by being at the bottom of the price chain only. The % of price added for key manufacturing industries such as food, beverage and tobacco has hovered at around 30% for the completed decade. The government is actively trying to address this issue through both carrot and stick measures. Export taxes are being levied on raw materials such as CPO by up to 25% while the Law on Mining and Minerals of 2009 determines that by 2014, all extracted materials must undergo price added processes before they can be exported. The government is promoting the numerous opportunities in the downstream sector to foreign investors. Proposals from the Ministry of Trade regarding revisions to the Negative Investment Inventory that would increase foreign ownership in industries with large capital requirements are being discussed as per mid 2011. The construction of downstream facilities close to the sources of the raw materials will as well serve to develop the regions outside of Java such as for cocoa processing in Sulawesi.

In terms of foreign direct investment , manufacturing does continue to be the majority popular sector in the economy. Investment in the sector rose over the course of 2010 by 12% from 2009 and the initial half of 2011 has seen a increase of 5-6%. Government incentives are currently being prepared (as of April 2011) for foreign investors to establish manufacturing bases in Indonesia to boost exports, under the Coordinating Ministry for Economic Affairs.

Such incentives will include tax holidays for investors in key sectors such as textiles and garments inclunding raw material producers in areas where the country is lacking. Indeed, high production costs due to the myriad of import taxes that are imposed on the vast majority of raw materials needed for production is a major disadvantage for the manufacturing industry. Additional domestic production facilities of raw materials such as chemicals for the textile and pharmaceutical industry are a vital component for Indonesia to reach the Ministry of Industry target of 8% increase in manufacturing by 2014. Incentives will certainly generate interest from investors seeking to find a production base in Asia and HEDGE their risk against rising wages in China, but it will take large steps in infrastructure development and bureaucratic reform to really revitalise the sector’s ailing industries.

Manufacturing continues to attract the major share of FDI inflows into Indonesia

Sources: Bank Indonesia & the World Bank

The introduction of the ASEAN - China Free Trade Agreement (CAFTA) in January 2010 has had an in general negative impact on the country’s manufacturing sector. The agreements presented a double edged sword in terms of providing tariff free access to China’s raw materials, while allowing the market to be flooded with Chinese made goods.

The rapid inflow of Chinese textiles, electronics, footwear, cosmetics, food and beverages has seen the trade deficit with China in non oil and gas trading widen by 44% to $2.27 billion at the end of April 2011. In labour intensive industries, the CAFTA has highlighted the challenges Indonesia faces in trying to take on China by price alone considering the latter’s larger capacity and superior infrastructure that makes transportation an average of 5% of total production costs as opposed to 15% in Indonesia. However, while en masse production is where China and others hold a competitive chance; Indonesia has the opportunity to position itself in terms of quality. In textiles for example, Indonesia’s fabric and yarn producers saw an initial drop in sales to domestic garment producers in the aftermath of the CAFTA; from presently on this reversed with domestic sales up by 33% in Q1 2011 compared to Q1 2010.

Other products such as footwear have seen a similar trend as the request from local manufacturers for quality and reliability has trumped that of price in the wake of increased consumer spending and confidence. That is not to say that the challenge has been met, indeed imports of Chinese goods are still rising and Indonesia’s labour intensive industries will have to play to their strengths to remain competitive.

Better investment in research and development to generate innovation and move to additional high technology industries is a necessity for the manufacturing industry. Compared with other major emerging markets such as Brazil, China and India which have seen increase in their exports of medium and high technology industries at an average of 25% over the completed decade, Indonesia’s have grown at only 15% (OECD). The Long Term Development Plan of the country to 2025 specifically addresses this issue and includes research, for which spending only accounts for 0.1% of GDP, as one of seven core pillars (see Cooperating with Industry on Education & Research). A National Innovation Committee under Professor Zuhal of Al Azhar University who was formally the Minister of Research and Technology, was set up in 2010 to formulate policies to promote innovation in strategic industries for economic development.

While such efforts are a step in the right direction for attitudes towards the next of manufacturing; to be effective they must be accompanied by financing. Banks have been reluctant to lend towards the manufacturing sector due to its low competitiveness and sluggish increase in labour intensive sectors. From 2009 to 2010, loans to the manufacturing sector decreased by 13.1% compared to an increase in over 40% for the mining sector according to Bank Indonesia. The lending rate to the sector has remained high at 12-15% compared to 5-6% for other nations (see Making the Banks Work for the Real Economy). For 2011, Bank Indonesia has placed manufacturing as one of the priority sectors for lending by the country’s banks, although this does exclude timber and textile producers. Loan figures for Q1 2011 show that so far disbursement is 10% under target for the sector, while manufacturing loan requests accounted for only 2.7% of the total. The requests for loans is likely to pick up as the year progresses to above the 14% for 2010 as investment plans are consolidated in line with the announcement of expected government incentives and tax breaks.

Non Oil & Gas Manufacturing Contribution to GDP by Subsector 2010

World Business Guide Indonesia - 2012