As the largest economy in South-east Asia and the 10th-largest worldwide in terms of purchasing power parity, Indonesia’s vastly expanding middle-income base has enticed an influx of international manufacturers over the years. These factors have allowed the sector to perform sturdily over the last decade, despite the global economic slowdown in consumption. Industry has long served as a vital engine of growth for the Indonesian economy and it continues to play a pivotal role in the development of the nation’s business climate.

TRENDS: Nurturing investor confidence is a top priority of the current business-oriented government at a time when Indonesian industries are confronted with a number of obstacles hindering competitiveness. To date, investors that hesitate to enter the market have pointed to the nation’s bureaucratic landscape of corruption and legal uncertainty, in addition to limited infrastructure. However, major efforts undertaken by an eager government, with President Joko Widodo at the helm, have seen the nation improve its investment profile. On the back of robust domestic consumption, low wages and a dynamic shift towards loosening protective policies, investor appetite has been on the rise.

Confidence indicators were given a further boost in May 2017, when the ratings agency Standard & Poor’s (S&P) upgraded Indonesia’s sovereign ratings to investment grade, a move that boosted the Indonesia Stock Exchange; shares jumped 3%, which was the largest intraday percentage rise since October 2015, settling 2.6% higher than the previous day. S&P’s decision to upgrade Indonesia’s sovereign credit outlook to “BBB-”, up from the previous junk status of “BB+”, mirrors the decision that ratings agencies Fitch and Moody’s made years ago. However, it does open the country up to an even wider pool of investors. The subsequent intraday stock market movements mainly reflected the reactive attitude of speculative investors, though the new rating should have a positive impact on foreign investment, by sustainably bolstering manufacturing activity over the long term.

As has been the case in recent history, the manufacturing sector remains the largest driving force behind the nation’s economic evolution. Due to dependency on raw commodities, progress in the sector stagnated from 2003 until the commodity boom of 2011, a period which saw complacent investment and weak policy intervention. However, since then there have been significant advancements. According to data from Statistics Indonesia (BPS), manufacturing contributed 20.5% of national GDP in 2016. In terms of individual segment contribution to manufacturing’s total, the food and beverage industry had the greatest input with 32.8%. It was followed by metal, computer, electronics and electricity equipment, with 10.7%; transportation equipment, with 10.5%; and chemicals, pharmaceuticals products and herbs, with 9.9%. If all segments of the industrial sector are combined, the total domestic direct investment (DDI) for 2016 equates to Rp106.8trn ($8bn), or a 49.4% share for the year. Combined foreign direct investment (FDI) in industry, meanwhile, amounted to $16.7bn, which represented 57.6% of total FDI realisation in 2016.

KEY INDICATORS: In recent times manufacturing activity has benefitted from strong domestic consumption, as well as increasing efforts by the government to introduce pro-market reforms. Consequently, investor sentiment has improved and raised overall manufacturing output with it.

For instance, in April 2017 new export orders increased for the first time in seven months, and order books rose for the second successive month. Reflecting the end of a six-month contraction in export orders, the Nikkei Indonesia manufacturing purchasing managers’ index (PMI) reached a new 10-month high in April 2017, peaking at 51.2. Over the last five years the manufacturing PMI in Indonesia has averaged around the 50-point line, the point which differentiates expansion from contraction. After four months of uninterrupted growth Indonesia’s manufacturing sector fell into contraction in June 2017 when its PMI score fell to 49.5. While export orders grew at the fastest pace seen in nine months, output decreased for the first time in three months as new orders declined, albeit only marginally. Despite the contraction, the outlook for the period from June 2017 to June 2018 is positive, mainly based on the forecast that economic growth would hold steady at 5%, on top of the fact that the PMI average for the second quarter of 2017 was higher than that of the first quarter.

CURRENCY CONCERNS: Even with PMI gains and increased export orders, manufacturers have had to contend with a relatively weak rupiah against the dollar in recent times, and the depreciation of the currency has led to increased input costs. The food and beverage segment was arguably the hardest hit, as imported goods account for more than half of total inputs for the segment. With the rupiah depreciating, manufacturers have experienced exchange rate losses when importing necessary raw materials, such as sugar, wheat and milk; this in turn has translated into higher prices for dairy and other processed products.

Although the manufacturing segment is heavily affected by inflation and exchange rate pressures, Indonesian manufacturers of labour-intensive commodities – including toys, textiles and basic consumer electronics – retain a competitive advantage over Chinese producers of the same products. According to Jing Bing Zhang, research director of IDC Worldwide Robotics, rising wages in China have already led to low-cost manufacturing to move operations from there to other countries. Additionally, a 2017 report from JLL, a global real estate consultancy, forecasts Indonesia’s manufacturing sector will grow by 6.5% in 2021, with the report identifying Indonesia as its top pick for industrial property investment in the region.

In terms of employment, Indonesia’s manufacturing segment hit a record high in June 2016, according to the manufacturing PMI, but by July 2017 employment had contracted for the 10th consecutive month. Even so, Indonesia’s manufacturing sector was estimated to have 16.3m active workers in 2017. Considering these sizeable numbers, the development of the manufacturing industry has become a top priority for the government, as it could greatly reduce Indonesia’s unemployment rate.

METALS, MACHINERY & ELECTRONICS: The metals, machinery and electronics segment has seen investment grow impressively, which is indicative of the segment’s expansion: DDI in the fourth quarter of 2016 alone amounted to Rp5.7trn ($429.7m), and FDI over the same period totalled $1.1bn. While a mixture of factors can explain the sector’s FDI appeal, local consumption has arguably been the greatest driving force of this increased investment.

For slightly more than a decade Indonesia’s domestic market for electronics has experienced robust growth, spurred on by greater per capita purchasing power and improved consumer sophistication, as well as the desire to take advantage of the enhanced living standards that urbanisation allows. As a result of these dynamics, the average amount of personal income that Indonesian consumers spend on electronic devices continues to rise.

Indeed, in terms of market opportunities, Indonesia offers the largest and fastest-growing client base in South-east Asia, a market that remains largely untapped. The electronics segment is expected to grow by a yearly average of 10% up until 2020, according to the Ministry of Industry, with the home appliances segment leading the way.

In addition to the strong consumption figures, investors continue to enter the nation’s electronics manufacturing segment for a host of other reasons. By the end of 2015 Indonesia had successfully cemented itself as an electronics manufacturing centre, with more than 250 companies operating in the segment. Moreover, the country’s manufacturing capabilities only look set to improve. According to official statistics from the Indonesia Investment Coordinating Board (BKPM), the metals, machinery and electronics segment attracted $2.5bn for a total of 690 projects in 2014 alone, representing a 43% increase from 2010. The growing investment trend has remained robust in recent years, with the segment attracting $3.9bn in FDI throughout 2016, a 56% increase from 2014 inflows.

FOOD & BEVERAGE: Indonesia’s food and beverage industry has served as a major employer and a notable generator of foreign investment. According to BKPM, it was the third-largest investment channel for foreign investors in the manufacturing segment with some $1.5bn being invested in 2015, coming behind metal, machinery and electronics with investments of $3.1bn, and chemicals and pharmaceuticals with $1.96bn. In terms of domestic investment, the food and beverage segment occupied the top spot in 2016, with Rp32trn ($2.4bn) in DDI. Indonesia’s food and beverage segment is forecast to grow by 8.5% over the course of 2017, which indicates strong performance, but a number of major food producers expect even higher growth rates, at almost double the industry average. According to a report published by Indonesia Investments, Garuda Food, a subsidiary of the Tudung Group, anticipated 15% growth in 2017, up from 10% in 2016, while dairy products company Ultrajaya Milk Industry also expected a 15% increase in revenues in 2017.

MEDICATIONS: Indonesia’s pharmaceuticals industry has grown significantly in recent years and has managed to attract billions of dollars in investments. On the back of the government’s ambitious universal health care scheme – which is aimed at providing all citizens with access to a wide range of health services by 2019 – the country has managed to entice some of the world’s largest pharmaceuticals companies, including Novartis, Merck, Bayer, Boehringer Ingelheim and Pfizer. As a result, FDI for the segment amounted to $2.9bn in 2016, while DDI added up to Rp30.1trn ($2.3bn). In early 2016 the increase in FDI was supported by the government’s decision to raise the allowed foreign ownership percentage from 85% to 100% for pharmaceuticals factories that produce raw materials.

The Widodo administration is eager to ease the nation’s dependency on the import of raw materials, particularly in the production of medicine. According to market reports, the industry imported roughly 90% of all raw materials for medicine at an estimated cost of $526m in 2016. Industry players have cited the government’s decision to allow full foreign ownership of pharmaceuticals factories that produce raw materials as a critical measure that needed to be taken to ensure the longevity and success of the nation’s 2019 universal health care initiatives. According to statistics from Bisnis Indonesia, domestic pharmaceutical sales increased by 13% in 2016, reaching Rp71.1trn ($535.2m).

STEEL: In terms of the country’s heavy industries, steel fabrication is expected to grow on the back of new infrastructure projects, according to Hidayat Triseputro, executive director of the Indonesian Iron and Steel Industry Association. “Market prospects are very good,” Triseputro told OBG. “The government wants local products used in the construction of major infrastructure projects.”

As a result of increased infrastructure spending, steel sales in Indonesia grew by 9% to 12.7m tonnes in 2016, up from 11.5m tonnes in 2015. Although the government’s endeavours to alleviate infrastructure bottlenecks have bolstered the local steel industry, steel manufacturers are still feeling the brunt of the oversupply of steel, resulting from China exporting its steel at low prices as its major domestic infrastructure works slow. This has meant that Indonesian consumption of local steel has suffered to varying degree, as low-cost imports are being dumped into the market. At the end of 2016 the per capita steel consumption was relatively low, at 49 kg per year. In order to ease the impact of Chinese imports, local manufacturers have urged the government to better monitor steel trade, as this would lessen the negative impact on local producers.

Local production does not meet the existing domestic demand for steel, and industry insiders have pointed to trade deals with China as a hindrance to the development of the domestic steel industry. Currently, Indonesian steel importers can enjoy exemptions from import duties on alloy steel, a policy which is not being effectively managed. According to market reports, many imports of carbon steel have very low alloy content, thereby reducing the need to develop steel production.

Triseputro told OBG, “Developing the local production base is a priority. We are optimistic as an industry that policymakers will take the necessary steps to protect our products.” While some industries have benefitted from free trade arrangements, the steel industry still requires closer mitigation. The challenge now is to remove market distortions, like tariffs, while also adhering to ASEAN commitments.

In an effort to advance the domestic steel industry and improve its contribution towards overall GDP growth, the government has set a 2020 target of 70 kg per capita steel consumption, with domestic product accounting for around 60% of total consumption. “Importation of steel from China is an unfair trade due to their huge capacity and access supply,” Triseputro told OBG.

Driven by major infrastructure projects, Indonesia’s domestic steel industry is now primed for growth. According to statistics from BPS, Indonesia imported $450.4m worth of steel in June 2017, a decrease of 25% on the year before, although this number is slightly skewed by the religious festival of Ramadan starting at an earlier point in 2017.

CARS: The automotive sector is also poised for greater expansion, with a growing number of international carmakers closing in on the market. In addition to increased FDI interest, vehicle sales are trending upwards, and with the vast majority of Indonesians yet to own a car, the growth potential of this industry is considered highly valuable. “Due to changing market demands, the automotive sector now has the opportunity to shift its focus from commercial vehicles to passenger vehicles,” Hafid Hadeli, president director of Adira Finance, told OBG. Infrastructure investments are also expected to be a boon for car sales (see Transport chapter). “The development of new roads and highways will assist in opening the path for the domestic automotive market’s strong growth potential, especially in the next five years,” Mukiat Sutikno, president director of Hyundai Mobil Indonesia, told OBG.

One of the key drivers of the segment is the rising popularity of low-cost green cars – an affordable and fuel-efficient vehicle category that was introduced to the Indonesian market in late 2013 – as well as multipurpose vehicles, which have long been popular with Indonesian drivers.

In spite of growing demand, the production capability of the domestic automobile industry is currently underutilised. At the start of 2017 the total installed capacity was measured at 2.2m units, though output for the year was anticipated at 1.2m units, some 55% below capacity.

Even though car purchases are set to rise in coming years, the long-term growth rate will inevitably slow at some point, as penetration increases and the market matures. In the medium term, improved regulation and increased vehicle finance options are expected to bolster the market, with sales growth over the next five years expected to average at around 11.5% per year (see analysis).

TEXTILES: Indonesia is ranked among the top-10 largest textiles producing countries in the world. This industry has long played a vital role in GDP contribution and job creation. Imported products occupy the dominant share of the $10bn market, while domestic textile products accounted for 30% of total textile earnings over the 2012-17 period.

With ample room for growth, the government has set a bold export revenues target of $75bn from textiles and garments by 2030. Even though the segment has been faced with increasing international competition in recent years, the textiles industry expanded by 45% between 2010 and 2015, with GDP contribution rising from $7bn to $10.2bn. According to statistics from the Ministry of Industry, investment in the textiles and textile products industry was valued at Rp7.5trn ($565.3m) in 2016, while export earnings increased to $11.9bn, and the segment accounted for 17% of all manufacturing jobs.

The domestic garment industry has strong potential, but it is also faced with structural obstacles that could restrict growth, including inadequate technology and limited private investment. As a result, the sector is heavily dependent on the import of raw materials, such as yarn, cotton and other fabrics. The nation produces a substantial amount of cotton, though the textiles industry tends to favour higher-quality imports from the US and Australia. Taking into consideration these import requirements and the added pressures of the weakening rupiah making imports more costly, the Indonesian textiles industry risks losing ground to its regional competitors Cambodia and Myanmar. Both of these nations have managed to persuade a number of Chinese manufacturers to set up operations in their respective countries in recent years.

According to the Indonesian Textile Association, 90% of the basic material needed for finished textile products is imported. Cloth, for example, often comes from South Korea, China or Japan. In spite of the high import dependency, data from BPS showed that the country’s exports of textiles rose 3.8% year-on-year in the first quarter of 2017. To narrow existing gaps and close in on market opportunities, policymakers are eager to develop Indonesia’s upstream textiles segment, which should help ease dependency on the import of raw materials. In order to achieve this, the textiles industry was identified as one of the 10 priority industry groups that are to receive dedicated financial and technical support under the Master Plan of National Industry Development (RIPIN) 2015-35.

In particular, the changing working conditions in China could present new opportunities for the textiles industry in Indonesia. Today China is by far the world’s dominant garment and textile force, although given the labour-intensive nature of garment manufacturing, many industry onlookers have cited the rise in minimum wages in China as an opportunity for Indonesia to persuade manufacturers to shift operations to its shores.

MASTER PLAN: In an effort to diversify production, encourage investment and enhance productivity, the government introduced the RIPIN 2015-35, an updated master plan for the nation’s industrial estates. The plan is targeted at increasing the economic contribution from non-oil and gas manufacturing sectors by assisting with the advancement of industrial estates, particularly those situated outside of Java. “The availability of industrial estates is essential for the development of Indonesia’s economy,” Yoshihiro Kobi, president director of Bekasi Fajar, told OBG. “With the government’s support of good infrastructure and recent years’ efforts to streamline the process of starting a business in Indonesia, the private sector is set to play a large role in effective development.”

Establishing more than 200 industrial zones across the country, especially in less-developed regions, should help distribute investment around Indonesia to promote growth in new areas. Alongside these new zones, supply chains will be implemented across industries and infrastructure will be developed. These elements will create a platform where investors, suppliers and consumers all benefit from improved economies of scale, leading to a more competitive manufacturing sector.

EPP: To achieve these targets, the government began employing a number of economic package policies (EPPs) in the second half of 2015, aimed at the priority areas identified under RIPIN targets, including food, textiles, footwear, automotive, basic metals and minerals, electronics and more. In order to develop these priority industries, EPP funds have been directed at developing tax incentives, creating a new minimum wage calculation and updating the negative investment list in line with the move towards allowing greater foreign ownership in the production of raw materials for pharmaceuticals.

Since their inception, EPPs have managed to bolster investor confidence by improving Indonesia’s overall industrial competitiveness through a variety of means, such as: the introduction of deregulation measures; the reduction of red tape to ease the investment process; and changes to fiscal policies, including import and export taxes, to lessen the restrictions they impose. These efforts are having a visible impact, but more work remains to be done.

“Although the government has increased its efforts to deregulate investment and improve the ease of doing business in Indonesia, a number of challenges remain. Conflicting regulations for different raw materials – including for sugar, water and plastic – pose a significant concern for industry players. Furthermore, permits continue to be a huge burden in Indonesia, as we need to have 198 permits for each factory that is opened,” Martin Gil, president director of Coca-Cola, told OBG.

Follow-up EPPs have further strengthened investor sentiment, by introducing measures to cut electricity tariffs for labour-intensive manufacturing and allowing tax incentives for asset revaluation, as well as enabling microloans for more than 30 export-oriented small and medium-sized enterprises.

Even though the economic stimulus packages have not addressed all the shortfalls of the manufacturing segment, they have been responsible for boosting Indonesia’s economic evolution in a number of ways. For example, in order to combat Indonesia’s high logistics costs, transportation ports now have integrated billing and payment services, which was a major step forward in technology adoption in state-run entities. The implementation of these types of policies – including the interest rate tax cuts for exporters and the creation of a one-stop shop for licences to invest in industrial estates, among others – continues to be met with approval from domestic and foreign investors. These measures, coupled with the easing of restrictive investment policies, demonstrate the government’s commitment to re-industrialisation.

That said, many industry leaders believe that these measures are only elementary steps. “There are many manufacturing companies that spend a large part of their budget on logistics. Efforts so far have not made a big impact on decreasing costs in Indonesia’s remote areas,” Iwan Irwanto, president director of American Standard Indonesia/Lixil, told OBG. “The current government initiatives to significantly improve conditions should reduce logistics costs in the future,” he added.

GLOBAL SUPPLY CHAIN: Indonesia and its trading partners are closing in on trade deals that are expected to widen access to regional and international markets, as well as accelerate integration with global supply chains. With negotiations ongoing, the successful completion of trade deals will help attract investors into priority industries.

The potential conclusion of five major trade deals in 2017 is perhaps Indonesia’s greatest opportunity to increase access to foreign markets and entice larger sums of FDI. Negotiations over the Regional Comprehensive Economic Partnership (RCEP) – a proposed free trade agreement (FTA) that will include the 10 member states of ASEAN, plus Australia, China, India, Japan, South Korea and New Zealand – are currently taking centre stage. Officially under way since the ASEAN Summit that was held in Cambodia in November 2012, it is expected that RCEP talks will be concluded by the end of 2017.

The RCEP is considered as the best alternative to the Trans-Pacific Partnership (TPP), as the combined economies of RCEP member states collectively account for some 3.4bn people and a combined total GDP of $49.5trn, which equates to more than one-third of the world’s total GDP.

While RCEP discussions have been fairly slow, the collapse of the TPP has sped up negotiations. There are still ongoing contentions surrounding the trade of goods and services, such as the free movement of workers and intellectual property rights, but ASEAN members seem eager to conclude the RCEP, in an attempt to mitigate rising concerns about global protectionist endeavours, which have been buoyed by Brexit and the US decision to exit the TPP.

WIDENING MARKETS: In addition to the RCEP, Indonesia has also accelerated talks over two other comprehensive economic partnership agreements, the largest being with the European Free Trade Association and the second with Australia; both are expected to be finalised before the end of 2017. Indonesia is also discussing two major FTAs, one with Peru and one with Chile, which were nearing conclusion in the second quarter of 2017. Looking ahead, Indonesia is approaching Sri Lanka, Bangladesh, Nigeria and Mozambique about the prospect of signing preferential trade agreements. On top of these negotiations, Indonesia is in the midst of a joint feasibility study with the Eurasian Economic Union, a bloc of 183m people that includes Russia, Armenia, Belarus, Kazakhstan and Kyrgyzstan.

For the most part, industry analysts believe that the combined deals will bolster trade growth through the aftermath of several years of global economic slowdown. While this opinion is primarily based on the advantages stemming from an integrated global supply chain, other market analysts believe that Indonesia should improve its overall competitiveness and enhance the ease of doing business before entering any trade deals, as they may hold Indonesian industries back from progress. For instance, Indonesia’s eco-friendly practices are still behind international norms in many regards, with limited green factory concepts, such as waste management and natural lighting.

Even so, the government is determined to close these trade agreements to diversify export destinations and achieve the export growth target of 5.6% for 2017, up from the $144.4bn export total of 2016.

OUTLOOK: Indonesia’s large population as well as its expanding middle-income bracket translates into a formidable consumer base. This factor alone will keep foreign investors intrigued, but the long-term success of the nation’s manufacturing base will depend on how well policymakers create a consistent and fair playing field, which will require addressing structural needs. Already, many of the existing gaps are gradually being narrowed, as RIPIN and EPPs gain greater traction.

According to Rahardjo Jamtomo, executive director of the Indonesian Chamber of Commerce and Industry, shifting away from the export of raw materials will be a key priority for the country moving forward. Jamtomo told OBG, “Value-added industries need to be a priority in order to promote industrial development, especially the processing of mining and agricultural goods. As has been done with the mining industry, we should promote our downstream segment, as this will improve export earnings.”

A number of the hurdles restricting Indonesia’s competitiveness in the manufacturing sector relate to financing technology and market penetration. Likewise, the long-term development of the industry requires improvements in infrastructure, particularly better access to power, water and deepwater ports; areas that the government and private sector can develop together. Given the measures taken by the Widodo administration to promote infrastructure and create a more enticing destination for foreign investment, the industrial base is set to expand.

Additionally, there will be more export opportunities for Indonesian producers, as manufacturers begin to realise the advantages of having a single market under the coming RPEC free trade arrangement, particularly for those within the fast-moving consumer goods segment. Ongoing efforts by policymakers to re-energise foreign investment and promote structural reform, such as measures to alleviate logistical constraints, will be vital in reining in operating costs. In spite of these measures, however, a weaker Indonesian rupiah is likely to continue to drive up input prices, in turn leading to