The economy is surging ahead, and as it expands authorities are seeking to make the transition from low-cost production and supplying raw materials to more advanced nations to a high-value-added manufacturing industry. It will not be easy, for as wages rise and investments are made, some companies, or entire industries, will be left behind. National champions and possibly international players will emerge, but along the way much will be lost. The temptation will be to resist change and support sectors that would be better left to wither. It is also tempting to force the process and engage in industrial policy and protectionism.

Indonesia has not historically been an industrial country. In 1961 valued-added industry was only about 16% of GDP; agriculture was about 50% in the 1960s. Over time, the ratios have nearly reversed, with industry really taking off in the 1970s and again in the 1990s. It now represents almost half of GDP, while agriculture is down to about 15%. Over the past 50 years, the country’s industrial sector has gone through a few stages of development, and in the past few years Indonesia has started working its way up the value chain, albeit like most nations in its position, reluctantly.

LIBERALISATION: Following the extreme economic nationalism of the Sukarno administration, the Suharto government worked to normalise economic polices and reintegrate with the world economy. Still for much of the time, tariffs were high and import substitution was practised. But in the 1980s the country began to aggressively reform. Tariffs came down and markets were opened. While the Asian financial crisis brought some of these policies into question, the general trend has been one of reform, so much so that Indonesia for a time was one of the more open economies in the region. “It is an open market,” Mohammad Mansur, the chairman of the Indonesian Pulp & Paper Association, said of the pulp and paper industry. “In the 1970s import duties were 60%. Now, they are 0-5% to make the industry competitive, as it was not protected by the government. We have to be able to compete.”

MIXED RESULTS: The results have been mixed. While the economy has grown, industry has not developed extensively. Because of the open markets, imports have flooded in and consumer spending has remained high. Major sectors, such as automobiles, food and beverage, are controlled by foreign interests and as of yet few international Indonesian brands exist.

The lack of any major progress in terms of industrialisation has people now calling for some form of protectionism to be reinstated. It is not so much a matter of rejecting liberal economics, but of realising that much of the rest of the world is not following the tenets of free market theory. A number of sectors are now dealing with the challenges that come with this change. Hadi Sutiono, the president director of snack producing firm Dua Kelinci, told OBG, “Indonesia is one of the world’s largest sellers of in-shell peanuts. The industry is first trying to cope with the vast domestic market, but at the same time measuring potential expansion opportunities outside the national boundaries.”

BARRIERS: The result is the growth of a wide range of non-tariff trade barriers designed to protect local industry from foreign competition, especially from China. The country is also encouraging more domestic manufacturing. Early in 2012 it imposed export taxes of up to 20% on 34 types of ores, including gold, copper and nickel, to increase processing within the country, and said it plans to ban exports of unprocessed minerals by 2014. The government also said it would prevent anyone from exporting without a plan in place to build a smelter. Indonesia also has export taxes on other raw materials, including palm oil and cocoa beans. “It will be good for the economy,” said Bambang Sujagad, the deputy chairman of the industry, research and technology sector at the Indonesian Chamber of Commerce and Industry (KADIN), of the smelter rules. “For nickel, the value added is 20 times compared if you send ore.”

In many ways what Indonesia is doing is not unlike what is happening in many countries around the world. Resource nationalism is on the rise and many governments simply want to get more out of their commodities. Indonesia may not be going back to the days of import substitution, but it sees itself missing out on much of the value chain and letting others take most of the profits. The country wants to stop resources being taken out, processed and returning as finished goods. The strategy is slowly evolving, but it appears that this now low-key industrial policy involves both sides of the equation, keeping resources in and manufactured goods out. It also seems to involve trying to get Indonesians to buy Indonesian. “It is not easy to be part of the world,” said Bambang. “The only thing we can do is educate the people to buy wholly Indonesian products or more Indonesian products, at least 5%.”

INDUSTRY ADVANCING: But as nationalism slowly advances, a more productive and long-term trend is gaining momentum in the background, a trend that could be endangered by major negative moves on the policy front (rating agencies have already noted “policy” slippage and say they are watching). As the government is engaging in dubious industrial policy, industry is getting on with business. The country is in a particularly good position these days, with an economy that is strong, large and increasingly integrated with the rest of the ASEAN region. For investors, this is very attractive and as a result investments are pouring into industry. International companies see Indonesia as a good market in and of itself and a good platform from which access the wider regional market. In the case of these industries, liberalisation has been a great success.

Auto is perhaps the best example. Japanese manufacturers dominate the market and have done so for years. Toyota has a 37.6% market share, Daihatsu (a Toyota group company) 16.4%, Mitsubishi Motors 12.9%, Suzuki 9.9%, Honda 7.3%, Nissan 4.6% and Isuzu 3.5%, according to figures from consultancy firm Frost & Sullivan. They have established a strong presence, and it can be argued that because of the level playing field and lack of a national champion, Indonesia is one of the largest auto markets in ASEAN.

More importantly, the process is continuing. Japanese manufacturers are building off their base and expanding their presence in the country. Honda is building a second auto plant in Indonesia, in addition to another motorcycle plant, with the total investment expected to be around $321m. Toyota is investing $534m in a second auto factory, and is building an engine factory, and late in 2012 said its investment will be Rp26trn ($2.6bn) for the next seven years. Other Japanese manufacturers are making investments to add capacity or to set up new factories in the country: Suzuki Motors will invest close to $800m; Nissan Motors around $400m; Astra-Daihatsu around $233.3m; and Isuzu Astra Motor Indonesia $111.1m.

BREAK WITH THE PAST: The nature of the investments suggest a break of sorts with the trends of the past. The Japanese manufacturers are not just bolting on more capacity to their worldwide operations; they are upgrading the role of Indonesia in their global supply chains. After the events in Fukushima and the floods in Thailand, Japanese automakers have given Indonesia a more central role in their South-east Asia operations. They now see an advantage to having more capacity on the ground in Indonesia, both because it would balance exposure elsewhere and because the country has a sizable domestic market in its own right. A good example of the shift is a move to transfer the manufacturing of the Toyota Fortuner from Thailand to Indonesia. “The Fortuner was previously produced in Thailand,” said Tira Ardianti, the head of investor relations at Astra Motors. “But because of some issues there, they moved production. They started to think about finding another production base.”

Ardianti goes on to explain that the car market in the country is far better than a casual visitor to the capital might at first think. While Jakarta certainly has too many cars, the rest of the country is lacking in vehicles. The latest World Bank figures for 2008 suggest that 60 people per 1000 have an automobile, compared with over 150 in Thailand and over 350 in Malaysia. As Indonesia prospers, cars per 1000 will begin to close in on ASEAN means. According to the financial security firm Bahana Securities, overall wages have been steadily rising on a real basis over the past few years: it was up 5% in 2011, 9% in 2012 and an estimated 20% in 2013. Meanwhile, unemployment is dropping: it was down from 10.3% in 2006, to 6.1% in 2012, to an estimated 5.7% in 2014. Bahana is forecasting 15% growth in auto sales over the next five years and 18% in 2013. “With only 5% penetration, only one in 20, there is a lot of room to grow,” said Astra’s Ardianti. “That is why we are attracting a lot of interest. Indonesia is a good market, and a potential product base.” Indeed, Adrian Joezer, an analyst at Mandiri Sekuritas, told OBG: “They will buy more cars. The outlook is really good.”

There are also plans to expand in new directions. Sudirman M R, the president director of Astra Daihatsu, said: “One positive government initiative is to develop and promote low-cost green cars. Indonesian car companies will be interested in investing in this, although now they are in a stand-by position, waiting for an invitation from the government to join the initiative.”

VALUE ADDED: More value added is being generated locally, and more of the production process is moving to Indonesia. Subcontractors, for example, are setting up in the country. Denso, Hankook, Bridgestone and Takata are all making or planning to make major investments in Indonesia. The Japanese supplier network is being replicated. More interestingly perhaps are the efforts under way to bring some of the highest value-added and most complex processes onshore.

Design, for example, is one subject that has received quite a bit of attention. While Indonesia has never had its own Proton-like national car, it has a long history of attempts at creating an indigenous vehicle.

IPTN, the state aircraft maker, teamed up with Rover to try and manufacture an automobile in the 1990s. The Timor national car project, as it was known, was halted in 1998 when KIA motors, the partner, went bankrupt, as was the case for the Bimantara project, whose partner was Hyundai. The Bakrie Group tried to build a car, but the project was cancelled due to the 1997 crisis.

Then there was the Macan, Tawan, Gea and Kancil, which all failed due to lack of funds or a poor concept. But the idea is gaining more interest now as Indonesia is becoming wealthier and already has a strong base of foreign manufactures. In October 2012 local press even reported that Joko Widodo, the governor of Jakarta, had declined to use the Toyota Land Cruiser he had been provided and opted instead for a vehicle made by a local vocational school.

It is also possible that the country will get more involved in making some of the more critical structural components of automobiles. At present, steel used in the making of cars is imported from Japan and Korea, but that could soon change. In late December 2012 Krakatau Steel signed a joint venture agreement with Nippon Steel and Sumitomo Metal Corporation to manufacture steel. The new company, Krakatau Nippon Steel Sumikin, is 49% owned by the Indonesian company and 51% owned by the Japanese partners. The plant will produce flat steel products for carmakers.

EXPORTS: The auto industry as a whole is growing fast. Domestic sales were up 26.7% in the first 10 months of 2012 over the same period in 2011. Total production was up 28.1% in the 10-month period. In early December 2012 the Association of Indonesian Automotive Industries estimated that car sales had crossed the 1m threshold, putting Indonesia in close competition with regional leader Thailand, at 1.1m in 2012.

In previous years, domestic sales have shown strong growth:16.9% in 2011 and 57.3% in 2010. But what has been most remarkable is the growth of exports. The country went from a net importer to a net exporter of vehicles in 2007 and sold more than 100,000 units overseas in 2011, three times the number in 2006; 2012 was a particularly strong year, with 146,495 units exported in the first 10 months.

The auto industry is a good example of how an industry should be managed. The market has been kept open, with the exception of distribution. And while import duties are high, they have been coming down (reduced from 50% to 40% in 2011 for sedans). The result is a competitive group of firms that are benefitting the local economy and becoming international players.

INDUSTRIAL GROWTH: Industry as a whole is doing quite well. In the second quarter of 2012 output by medium and large manufacturers was up 2.55% year-on-year; for small and very small manufacturers it was up 2.11%. Industrial production picked up nicely toward the end of 2012, hitting 8.88% in November 2012. In August 2012 the Purchasing Managers’ Index hit a nine-month high of 51.6, up from 51.4 in July and the third month above 50, a number that indicates an improvement in business conditions. While exports are lagging, consumer spending is carrying the economy.

For some, this is not ideal. Indonesia has historically been one of the more consumer-driven economies in East Asia. While many economies in the region have been investment- and savings-focused, the balance in Indonesia has been tilted toward spending. This has made it resilient, but at the same time has left it without the industrial base found elsewhere in the region. “About 60% of GDP is from consumption,” said KADIN’s Bambang. “But 60% should be from value added.”

Nevertheless, a good deal of investment has been going on in addition to the frenetic activity in autos, and some of it is quite cutting edge and advanced, suggesting that the country is pivoting from low to higher value added. For instance, Pertamina, the state oil and gas company, signed a memorandum of understanding in July with Len Industri, a state-owned enterprise that grew out of the National Electronics Institute, to manufacture photovoltaic cells.

The country is also interested in getting into the military and defence equipment manufacturing segment. Its defence contractors are working with South Korea to make fighters and submarines, and with China to build anti-ship missiles. The idea is not only to replace expensive defence-related imports but also to gain an entrance into the arms business. The country has already exported four patrol aircraft to South Korea.

JAPANESE MODEL: Most industrial investment is based on following the Japanese model. International firms are looking to Indonesia as a good manufacturing base and are setting up there. L’Oréal is establishing its largest manufacturing operation in the world at Cikarang, while Procter & Gamble will be opening its first factory in the country in 2012. General Motors and Volkswagen are also making investments. Other areas attracting international funds are food, recycling, steel and cement. In 2012 the country reached a record level of foreign direct investment (FDI), and towards the end of the year Indonesia’s Investment Coordinating Board said there was $75bn of FDI in the works.

The local industrial sector is fraught with problems though, and the next few years will be challenging for Indonesia. There are the perennial issues: infrastructure is poor and foreign investors are wary of getting involved in the country if it is not able to solve serious logistics and transportation problems. Bureaucracy, corruption and simply the complexity of making large investments are also holding back investments. While Japanese firms have proven to be patient, flexible and have a long history in the country, newcomers may not be so prepared. At the end of 2012 Foxconn, the Apple subcontractor, said it was delaying its investment, which was to eventually be as large as $10bn, by three to six months due to problems in getting the right agreements from the government and issues in finding the right local partner.

The biggest challenge for industry in the country is how to manage the transition from low to high value-added. It is not an easy task, and it is already proving to be a problem for Indonesia. On the one hand, low-value-added industries such as textiles are desperately fighting the rise in wages and seeking protection from international competition. They recognise that the country is changing and that higher wages will mean a better economy and more consumer demand, but they also know that it could result in the gutting of their industry and are not sitting back idly. On the other hand, resource nationalism and more generally nationalistic industrial policies are getting more attention as individuals and politicians see other countries benefitting greatly from Indonesia’s resources.

SUNSET FOR SOME: Both these forces are potentially dangerous for the country’s development. Supporting sunset industries can be expensive and leave the economy with inefficient and excess capacity. Social disorder and strikes will slow growth and scare away investors. Excessive restrictions on resource companies, especially if the restrictions are seen as arbitrary and lacking in transparency, could result in less foreign investment in general.

So far, the smelter requirement is getting a good response. The government said at the end of 2012 that it had received 185 proposals for $555bn of investment in smelter capacity, and it is expected that 30 of the proposals will be accepted. Indeed, four majors – Freeport Indonesia, Vale Indonesia, Eramet and Aneka Tambang – are said to have signed on already and agreed to abide by the smelter policy. In addition, at least two Chinese groups have said they will invest a total of $8.6bn in smelters in Indonesia. Oriental Mining and Minerals Resources and Rui Tong Investment said it will commit $1.5bn; Beijing Shuang Zhong Li Investment Management said it will invest $7.1bn.

The concern now is that regulations will become more complex and onerous ahead of the 2014 election. Already, the smelter rule has been inconsistently applied, first requiring the facilities by 2014 and now allowing some leeway. Foreign companies are reporting other issues related to law and government: legal challenges, demands for political contributions and the possibility that the new mining law will be declared unconstitutional.

OUTLOOK: Strong growth is almost guaranteed in the short to medium term for industry in Indonesia. Most if not all the proposed manufacturing investments will happen, and the simple math of an expanding economy will lead to an expanding industrial base. Imports will have an impact, and no doubt goods coming from places like China will crowd out some capacity locally. Those flows will not go away right away. But over time, even that threat will be tempered as foreign manufacturers find it makes more sense to put their own factories on the ground rather than ship to Indonesia.

What Indonesia needs to do now is carefully manage the changes that it is experiencing at the moment and for the next few years. While it must take action – raising the minimum wage, enforcing labelling, encouraging more processing domestically – it must be careful not to go overboard. A rise in wages will feed through to the domestic economy and create its own compensating growth, but years of double-digit rises and repeated industrial action risk choking off growth and shutting down the economy. Lightly protecting industry and passing laws that make local processing more attractive will be welcomed, while unpredictable and unreasonable demands will scare away investors. Domestic investors may also get worried and money could flow overseas. A measured approach will be appreciated, even if it does lead to higher wages and more restrictions, and industry will continue to develop if balance is maintained.