Back on track: Leveraging strengths to resume upwards trends

Indonesia has all the makings of an industrial powerhouse: a young and talented population, relatively cheap labour and a large domestic market. The country has the capacity and the conditions to develop industry, specifically export-oriented industries. Manufacturing is also vitally important to Indonesia. Without it and without its growth, the country will have a difficult time addressing its current account deficit, escaping the middle-income trap and taking the edge off the commodity cycle. Building up industrial capacity is the answer to many of the country’s problems: it will provide both growth and a cushion from external shocks, but this will not be easy to achieve. While the country is attracting considerable foreign direct investment (FDI) and is regarded generally as a good place to do business, various challenges and long-term issues work against this transition. Like many countries, Indonesia is dealing with wage pressures and a flood of imports that are making it difficult to hold on to and build a manufacturing base. It also faces infrastructural challenges that will slow industrial development.

Before & After

Before the Asian financial crisis of 1997-98, Indonesia was well on its way to becoming much like its neighbours: a low-cost, export machine. According to a 2012 World Bank study entitled “Picking Up the Pace”, non-oil and gas manufacturing comprised between 10% and 14% of GDP in the six years prior to 1997. However, between 2001 and 2010 this rate plummeted into the 2-8% range. The country went from one building up capacity fast to one struggling to maintain it. According to the study, export growth of non-oil and gas products rose annually at a rate of 21% between 1990 and 1995; that fell to 5.1% in the 2000-05 period.

Much explains this relatively poor performance of industry and the failure to increase manufacturing export production. The particularly devastating crash the country experienced after the run on its currency destroyed confidence in the economy and that, along with political instability and some violence, served to scare off investors and depress local confidence. However, this only partially explains the country’s experience, for neighbours like Thailand were similarly affected and have managed to rebuild and, in fact, outperform expectations.

Missed Steps

During its recovery, Indonesia failed to make several key investments, such as in transportation and power infrastructure, two segments that remain weak. The lag in these areas has had a material impact on the growth of industry.

Indonesia ranked 120th in the World Bank's “Doing Business Survey 2014”, and 175th in the Starting a Business category out of 189 nations. Investors were wary of a market where electricity supply was unstable and where it may be difficult to both ship in components and ship out finished products.

Home to abundant natural resources, Indonesia encouraged and courted investment in mining, minerals and oil and gas, to the possible detriment of investment in and development of other productive sectors. World Bank statistics, for example, show a long-term and persistent decline in manufactured exports as a percentage of total exports, from a high of 53% in 1993 to a low of 34% in 2011. (For comparison, Thailand has remained above 70% since 1994.) As the global price of commodities rose, the ratio of these goods compared to the total amount of goods traded increased. Still, resources did seem to impact manufacturing in Indonesia more than in regional competitors.

Too Many Imports

As Indonesia started to stabilise its politics and was in a good position to turn attention to manufacturing, another threat emerged: imports. The country found that as the economies of the West remained weak, Chinese-manufactured goods flooded in and made it difficult for the local factories to stay in business. In 2012 Indonesia recorded a $22bn trade surplus, but a $5.6bn trade deficit with China (its largest trade deficit with any country) amid a flurry of dumping complaints. “Often, the companies cannot compete in terms of price,” Baari la Inggi, executive secretary at the Indonesian Textile Association of Greater Jakarta, told OBG.

Tricky Ties

Some blame trade agreements for the imbalance. The ASEAN-China Free Trade Agreement (ACFTA), signed in 2002 and made effective in 2010, was seen as creating the world's largest free trade area, but Indonesia has found that the initiative seems to provide China with much more access to Indonesia’s markets than the other way around. Cheap manufactured goods have poured in while resources have flowed out of Indonesia to China, putting the country in the unenviable position of being the provider of low-value added materials and the consumer of finished goods. However, Ministry of Trade numbers suggest that the benefits of the pact have been on the whole balanced. Between 2009 and 2012, Indonesian exports to China grew 37% while China’s exports to Indonesia were up 31%. But the country’s trade associations argue that these figures obscure reality and that certain industries have been especially hard hit, such as garment and footwear. Revisiting the agreement, however, is difficult, as it was negotiated between six ASEAN member states and China and would require all parties to be involved in the talks. As for future agreements with ASEAN, industry players warn that Indonesia must be able to secure its own advantages. “With increased ASEAN integration in 2015, Indonesia will see an increase in products entering the market from our South-east Asian neighbours. Conversely, it is important for Indonesian companies to establish themselves in these markets as well to remain competitive,” Edwin Sutiono, director of Indonesian peanut manufacturer Dua Kelinci, told OBG.

Wages

What is putting the most stress on Indonesian industry, however, is the rise of wages. While the country was for many years one of the cheaper places in the region, recent labour demands have closed the gap and have led some to reconsider Indonesia as a manufacturing hub. In 2012 the minimum wage in the Jakarta area rose 44%, and unions demanded a 50% increase for 2013. Though they did not achieve their demands – they were instead awarded 11% – the pressure is still on. It was likely not one jump in wages in 2012 that is the main problem – as a one-time adjustment to move people to a living wage, it may have made sense – but the persistent demands for higher wages year after year threaten to eat away at the country’s cost advantage. “Wage increase is a challenging issue faced by all developing countries, and Indonesia’s attitude needs to change whereby they must accept that the majority of the workforce is unskilled and therefore disproportionate increases cannot be tolerated,” Tedja Sukmana Hudianto, president director of Steel Pipe Industry of Indonesia, told OBG.

Competitive Edge

According to the Centre for Strategic International Studies, wages in Indonesia have risen 30% since 2010. That compares with 14.2% in Thailand, 8.4% in China, 6.7% in Vietnam, 5.2% in Cambodia and 3.3% in Malaysia. Jakarta’s minimum wage is now about the same as that of Indonesia’s main competitor, China. At current exchange rates, the minimum wage in Indonesia is about $200 per month, roughly the same as that of a worker in Beijing or Bangkok, but substantially higher than what a typical worker in rural China receives, which can be as low as $140 per month. If wages continue to rise at the pace of previous years, Indonesia will soon lose any competitive advantage it has price-wise over countries in a better position in terms of logistics, utilities and regulations. “Increases every year make a problem,” Endang Susilowati, deputy chairperson of the legal and advocacy division of the Employers Association of Indonesia, told OBG.

What is most worrying for the manufacturing sector, however, is what does not show up in the official numbers. According to some industry advocates, certain more extreme elements within the trade unions are making unreasonable demands and many of the demands go far beyond the law. Endang explained that the headline number is bad enough, but unions are looking for as much as Rp3.7m ($370) in 2014. She goes on to explain that much more goes on behind the scenes. For example, a strict severance pay schedule is set by law: someone who has worked for a firm less than one year gets one month pay if fired; over one year and less than two, they get two months, as so on. But when layoffs occur, the reality is quite different. Endang says that in the event, unions will use somewhat aggressive tactics to extract higher benefits. They will camp out in front of factories and threaten managers. She adds that foreign firms are particularly good targets as they are more likely to pay, which in turn ruins the market for everyone. “If you are a foreign company, you pay what they ask to solve the problem,” Endang said. “If they get big money from a foreign company, it becomes a benchmark.” IT'S THE ECONOMY: The gutting of the low-wage manufacturing sector has profound implications for the overall economy. According to the US Department of Agriculture, textiles and textile-related manufacturing employ some 10% of the population and generate 1.56% of Indonesia’s GDP. About 6.5% of the country’s exports are textiles and related products. The loss or even the stagnation of sales in the low value-added sectors has the potential to weaken the economy where it hurts most – employment and exports. Loss of these jobs threatens instability among the poorest in society, as well as a weakening in the country’s current account position when it can least afford it. With a growing and young population and precarious balance of payments situation, the manufacturing sector has an importance beyond its contribution to the GDP.

Highs & Lows

The outlook is decidedly mixed. According to Statistics Indonesia, the manufacturing sector has been volatile in recent quarters. In the first quarter of 2013, manufacturing production fell some 2.2% from the fourth quarter of 2012 and rose only 1.12% in the second quarter of the year over the first, and 0.15% in the third quarter over the second. Some sectors appeared to face considerable headwinds. In the second quarter of 2013, textile manufacturing was down approximately 6.99% on the year, while food product manufacturing was up only 0.22% in the second quarter of 2013 over the first quarter. For full-year 2013, manufacturing growth slowed but nevertheless held up well overall. According to Statistics Indonesia, non-oil and gas manufacturing was up some 10% in 2013, in current local currency terms. That is down from 11% growth in 2012 and 12% growth in 2011. The textile, leather products and footwear industries grew 10%, up from 9% a year earlier, while the food, beverages and tobacco industries grew 8%, down from 14% in 2012. Statistics Indonesia’s full-year survey of large and medium manufacturing showed good growth, albeit slightly slower. For all companies in this category, growth was 5.64% for 2013. The worst showing was for textiles, which dropped 8.65% during the year.

Challenges

Concern is now growing in Indonesia that the industrial sector is too small and that it is slowing just as commodity prices are falling, meaning that the natural hedge of industrial production is not doing what it should. It is feared that two key components of the economy are sputtering together and that an opportunity may have been lost. When commodity prices were high, the country should have poured the resulting cash flow into infrastructure and a manufacturing base. That would have left it in good stead as the inevitable pullback in resource prices occurred. While all nations have trouble managing this transition, some have been somewhat successful. Thailand and Malaysia are good examples of South-east Asian economies that have extended beyond resource dependency in order to build a manufacturing and services future. Indonesia did not so effectively recycle its commodity surpluses and has a half-finished manufacturing sector and an incomplete infrastructure one.

At the same time, while industry has been greatly challenged by higher wages, a lack of investment and intense global competition, it has also in some ways been doing well. Indonesia, while neither the least expensive nor the most competitive of regional economies, occupies a safe and comfortable middle ground that is proving to be a good place to be over time. Its factories have been working with customers for decades in some cases, and their quality and productivity has been assured and maintained. While some of the frontier markets may be able to beat Indonesia in terms of price, they are still very much untested. The relationships with customers are not as strong and they have not been as thoroughly vetted as those in Indonesia.

Child Protection

Additionally, Indonesia has made good progress in child labour protection. While it is still regarded as a country of “extreme risk” in the Maplecroft Child Labour survey, it has ranked higher than Myanmar and Bangladesh, two countries that are serious competitors to Indonesia in terms of low-cost manufacturing. While issues persist in this regard, many of the most egregious examples of child labour are in the informal sector among small, local factories, not at larger ones typically used by international brands which tend to operate at higher standards. This assurance of quality and adherence to the law has tended to encourage investors to choose Indonesia. “Buyers always meet with our factories,” Endang said. “They don't want to gamble with other countries.”

Endang added that Indonesia has another advantage over some other developing countries. It has been through its political turmoil, in the late 1990s, and while that was a difficult time for the country, it is ahead of many competitors in terms of reform. Egypt remains unsettled, China has yet to experience major liberalisations, Myanmar is just getting started, but Indonesia is relatively settled. While the country still sees some protests, they tend to be more protests of participation, attempting to influence the system, rather than protests that threaten what the country has put into place.

Industry participants also note that the country has additional strengths. It may be low-cost relatively speaking, but Indonesia has a deep base of experience and talent and substantial installed capacity. So while China is capturing quite a sizable portion of business and might be more advanced in certain regards, Indonesia still maintains resilience at some levels. It can hold its own in some higher-end products categories. “Regarding products from China, they are only competing at the low end. At the high end, they are not competing with us,” Binsar Marpaung, secretary general at the Indonesian Footwear Association (Aprisindo), told OBG.

Falling Currency

But perhaps the greatest advantage of Indonesian industry is the decline in the rupiah. The country’s currency fell more than 20% in a year, and this has helped make manufacturing products cheaper against those from other regional manufacturers, especially China. The rupiah fell almost 24% against China’s renminbi. In December 2014 Indonesian exports hit their highest point in almost two years. Between January and November 2013, non-oil and gas exports to China were up slightly on the same period the previous year, and may have hit a record high for the full year.

While it is still too early to declare a trend, it appears that the country’s weak currency is beginning to make Indonesian goods more attractive in foreign markets and to foreign investors. While a falling rupiah has the potential to lead to a paper loss for non-Indonesian corporations, it also makes labour and assets cheaper. Observers say that when multinationals should jump in is a delicate calculation to make, but many foreign corporations seem to be finding this a good time to enter the market. Prices are low and the domestic market is attractive.

Foreign Investment

Realised FDI hit a record in 2013, up 22% to Rp270.4trn ($27.04bn). The fourth quarter of 2013 was especially strong in terms of capital inflow, with FDI up some 25.4% on the previous year. As is the case with exports, at time of print it was still too early to tell whether this is a sustainable trend going into 2014, but all indications are that foreign investors are looking favourably on the country. Manufacturing appears to be an especially popular target for foreign capital. In 2010 the country received $2.3bn of FDI in manufacturing, or 26% of the total. In 2011 that number was $6.8bn, or 34.9% of the total, and the following year $11.8bn (47.9%). In 2013 total FDI in manufacturing hit $15.8bn, or 55.4% of the total.

Indeed, Indonesia has been experiencing something of a rush. Car makers have been especially enthusiastic. In 2013 Toyota said it would build a $9.2m car engine factory in the country as Japanese manufacturers continue to move capacity to South-east Asia and away from China. That same year, General Motors reopened a mothballed assembly factory in Bekasi with a $150m investment. Honda opened its second factory in the country in early 2014, making a Rp3.1trn ($310m) investment.

The Ministry of Trade said that the activity in the sector would result in major investments by parts and components suppliers. Indeed, in 2013 Hankook, the Korean tyre manufacturer, opened a $353m facility in Indonesia and in early 2014 it said it would be expending capacity there. Other sectors were also quite active. In late 2013 Philip Morris Indonesia said it would be investing $174m in kretek cigarette production. It will be expanding production at two facilities and building a new factory in Karawang.

Outlook

Given the recent history of the sector, the outlook for Indonesian industry is decidedly mixed. Manufacturing is under stress given the intensity of global competition, the lack of domestic infrastructure and rising wages. That said, Indonesia also has several advantages that should help it surpass these challenges: an abundance of raw materials, domestic stability, a well-educated workforce and continuing appeal as a destination for foreign direct investment. Though national and presidential elections in April and July 2014, respectively, may bring some uncertainty for investors, on the whole most indicators point to a year of expansion for the economy. The challenge for the industry sector at this point is to make sure that demands for increased wages and a lack of infrastructure do not derail the return and rise of Indonesian manufacturing.

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The Report: Indonesia 2014

Industry Retail chapter from The Report: Indonesia 2014

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