ECONOMIC RECOVERY IN INDONESIA:

THE CHALLENGE OF COMBINING FDI AND REGIONAL

DEVELOPMENT

by
Fredrik Sjöholm

Working Paper No. 84

November 1999

Postal address: P.O. Box 6501, S-113 83 Strockholm, Sweden. Office address: Sveavägen 65
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 Economic Recovery in Indonesia:

The Challenge of Combining FDI and Regional Development

Fredrik Sjöholm

The European Institute of Japanese Studies

Stockholm School of Economics

P.O. Box 6501

S-113 83 Stockholm

Sweden

Email: fredrik.sjoholm@hhs.se

JEL classifications: O18; R30; F23

Keywords: Indonesia; Economic Growth; Foreign Direct Investment; Regional Development

Abstract

Indonesia has been severely hurt by the recent economic crisis, which has been accompanied

by social tensions. Still, there are reasons to be optimistic about Indonesia's future. The

economic crisis may have bottomed out and the difficult transition to democracy has started.

For a sustainable long-term recovery, it is essential that Indonesia is able to attract FDI

inflows, and manages to achieve a reasonably equal spatial development of growth.

Unfortunately, there is a possible contradiction between FDI and even regional development

since FDI tends to locate in concentrated clusters. This paper discusses some requirements for

2
a long-term recovery of Indonesia, which special focus on FDI and an even spatial

development.

Introduction*

Indonesia has during the last two years witnessed an economic crisis that is without

comparison for over 30 years. Since the outbreak of the crisis in September, 1997, Indonesia's

GDP has fallen by about 15%; the share of population under the poverty line has increased

substantially; unemployment rates are high and large parts of the financial and business

sectors have been forced out of business.

Moreover, grave regional tensions have plagued various parts of Indonesia. Riots are

frequent and there are demands for independence in several provinces. Certainly, there are

several explanations to the regional tensions such as ethnic and religious factors. In addition,

the economic crisis is important for two reasons. Firstly, the ethnic and religious tensions are

probably connected to the economic recession and increased poverty. The recession has

increased unemployment and lowered incomes, which triggers, in Indonesia as in most other

countries, hostilities against people of different belief or ethnicity. Secondly, there has been

widespread accusations from the periphery - the outer islands - that they are not receiving a

fair share of the national income which, it is argued, is instead confiscated by the center - Java.

Fortunately, there are signs of a possible recovery; or at least, the crisis may have

bottomed out.1 Moreover, the transition to democracy has been smoother than many expected.

Hence, the foundation for an economic recovery seems to be in place, but it will by no means

come automatically. On the contrary, economic policies have to take in to account the totally

new economic and political conditions in comparison to the pre reformasi period. The purpose

of this paper is to discuss requirements for a sustainable economic recovery of Indonesia.

3
 The first question one has to ask is where a potential growth can be generated? It

seems likely that any economic recovery will depend on the manufacturing sector, since other

sectors are either too plagued by the crisis or too small to be engines of future growth. For

instance, large parts of the service industry such as banks and insurance companies are more

or less bankrupt. However, some parts of the service industry, mainly tourism, may be able to

play a more important role in the future. Moreover, volatile oil prices and difficulties in

expanding the already substantial oil production will be a drawback on Indonesia's most

important export good. The agriculture sector is of large importance in the short and medium

term since it employs a large part of the rural population, and increased harvests would have a

positive impact on large segments of the population. However, growing population and

increased pressure on arable land will most likely restrict the agriculture sector's possibility to

act as an engine of growth in the longer term. Clearly, raw materials are important for many of

the outer islands, but such production is hardly the foundation for long-term growth.

Concentration in natural resource production, including oil and agriculture, tend to generate a

relatively poor growth performance (Sachs and Warner 1995, 1999). Whereas rich resource

endowments was an advantage for industrialization and growth during the 19th century, falling

transport costs have later diminished this growth effect. On the contrary, there are several

reasons to an observed negative relation between natural resources and economic growth. For

instance, "Dutch disease" - appreciation of the currency due to increased export revenues from

resource export - may shift resources away from sectors with high growth potential to non-

tradable sectors with lower growth potential. Another explanation is that resource

endowments may increase rent seeking: firms and individuals are more focused on lobbying

for economic rents than to concentrate on efficient use of the resources (Lane and Tornell

1995). The negative effects from reliance on raw materials seem to be present in Indonesia

4
where both "Dutch disease" and rent seeking has increased during times of rising oil prices

(Rigg, 1991 ch. 8; Auty, 1995 ch. 10).

Hence, it seems reasonable to expect that any more substantial recovery will have to

rely on increased manufacturing production. We will therefore concentrate our discussion on

the prospects of the manufacturing industry but our arguments would be valid also for other

sectors of the Indonesian economy.2

The second question is what are the requirements for a development path through

increased manufacturing production. Arguably, any sustainable recovery will have to rely on

two crucial factors: an even spatial growth and an increased inflow of foreign direct

investment (FDI). An economic growth that benefit all provinces is required for political

reasons; it is likely that the tensions within and between different parts of the country will

increase if not all parts experience increased standards of living. Historically, Indonesia has

managed to achieve a reasonable even spatial development through large inter-regional

transfers of resources, which was possible by the high degree of centralization of Indonesia.

However, the system is presently changing with far-reaching decentralization being

implemented in an attempt to decrease some provinces' claims for total independence. As a

consequence, it will be difficult to pursue with extensive inter-regional transfers when the

central government's revenues will decrease.

FDI is important since the crisis in Indonesia has wiped out a large part of the domestic

financial capital. Moreover, it would be desirable if the FDI would be evenly geographically

distributed since that would facilitate an even spatial development of Indonesia.

Unfortunately, FDI tend to cluster together in clusters. Hence, there is a risk for growing

regional inequalities in Indonesia, which may lead to a continuation of social tensions.

This paper analyzes the issue described above; any sustainable recovery will require

special attention to FDI and spatial equality. We will put special emphasis on the contradiction

5
between FDI and spatial equality and we will also suggest some policy measures to overcome

this conflict.

The rest of the paper is organized as follows. Section two includes a brief description

of the Indonesian financial crisis with special emphasis on the consequence of low FDI

inflows. Section three discusses reasons to the relatively small FDI inflows and section four

gives a brief overview of the current state of the Indonesian manufacturing sector. Section five

discusses possible location patterns for new FDI and section six discusses policy measures for

decreased concentration. The paper ends with a concluding section.

The Indonesian crisis and the role of (lack of) FDI

The crisis that we have witnessed in East and Southeast Asia during the last two years

struck most people with surprise. Some observers were suspecting that an economic crisis was

approaching but very few would have expected the crisis to be so serious and to strike so

many countries in the region. Surely, there were signs that the rapid Korean development

would start to stumble because of, for instance, heavy debt ratios of the Chaebols. Similarly,

some observers were predicting a crisis in Thailand because of the huge current account

deficit. In comparison few, if any, observers were seeing the future crisis in Indonesia and

most were astonished by the extent of the economic recession. Highly respected economists

were arguing as late as after the crisis had started in Thailand, that the risk of a similar

development in Indonesia was low.3 Why did so many observers believe that Indonesia would

stay out of the turmoil that had started to strike other countries in the region? One reason was

that most of the economic fundamentals looked assuring in the beginning of 1997. The

economic growth was high, 8% in 1996. Accordingly, the investment figures amounted to

some impressing 36% of GDP, which were interpreted as a proof of continued expectation of

high growth of incomes and living standards. Furthermore, the inflation was around 8%,

6
somewhat higher then in the other South East Asian countries but not a very alarming figure in

light of the high growth of GDP and investments. Finally, the current account deficit was

increasing during the 1990s but it was still substantially lower than in Malaysia and Thailand.

So this was the picture in the summer of 1997; there seemed to be no sign of the

coming crisis. What was it then that the observers missed to notice? Obviously, the root of the

crisis is complex and includes a host of interacting factors.4 Some factors were endogenous

such as a weak financial sector and badly developed economic and political institutions. Other

factors are more unfortunate and exogenous to their character, such as the drought from El

Ninõ and the recession in Japan. In addition, the role of FDI is, arguably, one of the most

important issues to consider in explaining and understanding the recent development in

Indonesia. As previously said, it is this latter factor that we will concentrate our discussion on.

If there is any lesson to be learned from economic crises such as the one in Mexico in

1995, it is that large current account deficits are unsustainable in the long run. A deficit in the

current account means that imports are higher than exports. Such a condition is, per se,

nothing to be surprised about, since it is part of a country's initial stage of development;

machinery and intermediate goods have to be imported from abroad and the country's own

capacity to export is not fully developed. However, the larger the deficit the more likely is a

change in the exchange rate so that the balance between import and export is restored. Hence,

the size of the current account is important but perhaps equally important for the development

of a crisis is how the deficit is financed. The Indonesian deficit was substantially smaller than

the deficit in Thailand and also smaller than the one in Malaysia. However, whereas a country

like Malaysia to a relatively large extent financed its deficit through a capital inflow in terms

of FDI, Indonesia has financed its deficit through external borrowing. As an comparison, in

Malaysia FDI inflow in 1996 was around 8 per cent of GDP and 19 per cent of gross domestic

fixed capital formation. The corresponding figures for Indonesia were 2.8 per cent and 9 per

7
cent respectively (Hill and Athukorala, 1998 p. 25). When large capital outflows forced

through devaluations in the region, the different financing of the current account deficits led to

different outcomes. In for instance Malaysia, the foreign firms were still in the country; the

value of their assets had been devalued in home currency terms but there was in most cases no

economic reasons in closing down existing factories. In Indonesia the depreciation of the

Ruphia led to an increase in the foreign debt; the initial crisis changed to a debt crisis when a

US$ 80 billion debt tripled in local currency.

Why did not Indonesia attract enough FDI?

There are several reasons why Indonesia chose to finance capital inflows through

external borrowing rather than through FDI. One crucial factor is the widespread suspicion

against foreign involvement in general and FDI in particular, which goes back to

independence in 1949. President Sukarno was deliberately using an aggressive stand against

what he called the NEKOLIM - neo-colonialists, colonialists and imperialists (Cribb and

Brown, 1997, p.85). The focus on NEKOLIM was an attempt to unite the Indonesian

population against a possible foreign threat and thereby avoid internal tensions. The hostility

against foreign influences peaked with nationalization of foreign firms during the 1950s. This

nationalization program was only one part of a general mismanagement of the economy,

resulting in high inflation, large budget deficits, low growth, and increased poverty in the

beginning of the 1960s. The collapsing economy fueled social tensions and led to the turbulent

years in the mid 1960s with the rise of President Suharto. The economic problems forced the

new regime to launch the New Order with rather drastic economic reforms. One of the most

challenging tasks for the new regime was to secure capital for the economy. There were two

possible sources - the non-pribumi (ethnic Chinese) or foreign transnational companies

(Winters, 1996). The New Order chose to convince foreigners to invest in Indonesia since the

8
non-pribumis were severely discredited as being too sympathetic towards the dissolved

Indonesian Communist Party. The previous hostility made foreign investors skeptical against

Indonesia and they required substantial reforms of the whole economy. The reforms were

launched under the supervision of the technocrats - American trained economists - and

included a far-reaching liberalization of the foreign investment regime. However, the liberal

foreign investment regime was not to survive for long. As previously said, the independence

struggle against the Dutch together with Sukarno's outspoken hostility against the western

economies, made large segments of the Indonesian society suspicious against foreign

ownership. The suspicion did not disappear during the first years of the New Order. Instead,

riots broke out in 1974 at the time of a visit by the Japanese Prime Minister Tanaka. The

protests were directed towards foreign interests - especially Japanese but also including non-

pribumis. Fortunately for President Suharto, the first OPEC agreement increased oil revenues

sufficiently to allow him to neglect foreign investors and instead approach the protesters'

demands.5 The reaction was to take several steps back from the initiated liberalization;

licenses and permissions for FDI were again restricted, several sectors were closed off to

foreigners, and tax holidays and import allowances of foreign MNCs were reduced.

After decreasing oil prices in the beginning of the 1980s, the strategy was once again

forced to change with a new liberalization phase. The liberalization was accelerated in the

1990s, this time because of the emergence of China as a strong competitor for FDI. Despite

the last 15 years of liberalization, it seems that the suspicion against foreign firms is present

and widespread in the Indonesian society.

What does the present situation look like?

The economic recession in Indonesia has affected different parts of the economy with

various degrees of seriousness. From table 1 it is seen that the number of establishments in the

9
manufacturing sector has decreased with about 11 per cent between 1996 and 1998, and the

number of employees has decreased with about 16 per cent. All individual sectors have

decreased with two exceptions - the number of establishments in Basic Metals and the number

of employees in Other manufacturing. The largest decline has been in sectors such as Non-

metal Minerals and Paper products. These sectors are characterized by an orientation towards

the domestic market rather than being engaged in export. On the contrary, the most export

intensive sector, Wood products, has gone through the crisis with a relatively small decline.

Other sectors such as Other manufacturing and Basic Metals have also relatively large shares

of the establishments engaged in exports and have shown relatively small decreases.6 Hence,

not surprisingly, those sectors that are engaged in exports and which have been able to benefit

from the depreciated Ruphia have also been able to balance the negative effect of a collapsing

home market.

Table 1 about here.

As previously argued, Indonesia is likely to be more dependent on FDI in the future.

Unfortunately, foreign interest to invest in Indonesia has decreased despite the deregulation of

the economy. For instance, the amount of capital in approved FDI projects decreased with 64

per cent between 1997 and 1998 (BPS 1999, p. 459). Once again, the need for foreign capital

is urgent. The bad experience of foreign indebtedness together with small prospects of foreign

banks accepting further loans, does not give Indonesia any alternative to substantial inflows of

FDI. The decline in approved FDI is therefore alarming and has to be reversed. Political

stability is the most important factor for attracting foreign investors. Foreign investment in

Indonesia will be negligible with continued clashes between, for instance, students and

military, Christians and Muslims, Dayaks and Madurese, pribumis and ethnic Chinese.

10
Political stability will be determined by the political maturity among the Indonesian political

parties, the population, and the military forces, but it should be noted that stability is a

necessary but not sufficient requirement for increased FDI. What was enough for attracting

FDI before 1996 will not be enough when the turmoil has blown over and changed the

economic landscape of East and South East Asia. Most countries in the region have

implemented liberalization of FDI regimes and economies at large, during the last couple of

years. Hence, the competition for FDI has increased. The situation is aggravated by economic

recessions in some of the large home countries of FDI, most notably Japan, Korea and Hong-

Kong. The economic problems in these countries have decreased the supply of FDI in the

South East Asian region. It should be stressed, however, that it is still possible to attract large

amounts of FDI if the right policy measures are taken. For instance, Thailand's FDI inflow

during 1997-98 is as large as the substantial inflows between 1991-96 (Brimble et al., 1999).

A favorable investment climate includes a host of factors ranging from a well-trained

labor force to good legal institutions. It is important to concentrate on actions that can be

implemented with relatively short notice, and which are likely to have a relatively favorable

effect on inflows of FDI, since it is not possible to address many of these factors immediately.

The most important action to take is probably to create a level playing field between domestic

and foreign firms. Remaining regulations such as non-tariff barriers, cartels, local content

conditions, and ownership regulations, should be abolished. It is therefore worrying that some

liberalization that was initiated after the crisis seems to have come to a halt. For instance, it is

reported that monopolies and cartels that were supposed to be dismantled, still are present and

an obstacle to increased FDI.7

Regulations do not only discriminate against foreign firms, but also against many

domestic ones that lack the possibility to affect the regulatory framework and the potential to

benefit from it by receiving rents. Moreover, the regulatory framework is not only

11
discriminatory, it is also creating an economic environment were resources are used in an

inefficient way. Regulations foster inefficiency because it reduces competition, and it should

be stressed that even those foreign firms that do get around the restrictions and locate in

regulated sectors, tend to be relatively inefficient. For example, the automotive industry has

been heavily regulated in Indonesia since the beginning of the 1960s with governmental

interventions ranging from tariffs and non-tariff barriers to various local content programs.

The result has been an inflow of foreign assemblers. However, domestic as well as foreign car

assemblers have failed to achieve international competitiveness, and had negative total factor

productivity growth even after 30 years of protection and government support (Okamoto and

Sjöholm, 1999a). Foreign firms in other sub-sectors of the automotive industry have shown a

positive productivity growth but domestic firms have, again, a negative growth. Hence, there

does not seem to be any spillover of technology from foreign to domestic firms.8 One reason

could be that spillovers require a competitive environment to force foreign firms to import

sophisticated technologies from the parent firms, and to force domestic firms to try to get

access to this technology (Sjöholm, 1999c). Hence, regulations limit competition and do not

force domestic and foreign producers to increase their efficiency.

Moreover, one main obstacle for attracting foreign investment is the requirement for

ownership sharing: foreign firms have to join up with an Indonesian partner to be allowed to

operate in Indonesia. The economic argument is to increase the degree of technology

diffusion; the domestic partner will get access to foreign technology and can use it in other

projects. However, the multinational's choice of technology transferred to the affiliate is

dependent on the risk of loosing some of it, and the company is likely to transfer relatively

less sophisticated technology if it is forced to join up with a local partner. Indeed, ownership

sharing in Indonesia is not found to increase in the degree of technology diffusion (Blomström

and Sjöholm, 1999). The degree of ownership sharing has decreased in recent years. For

12
instance, in 1992 foreign investors were allowed to possess 100 per cent of the equity in

certain projects and in 1994 the number of such projects was enlarged together with an

abolishment of the mandatory reinvestment policy. There are signs of a positive effect on

technology transfer through FDI from this liberalisation; FDI entering after 1990 tend to have

relatively high productivity levels (Okamoto and Sjöholm, 1999b). Still, foreign investors are

reported to fear that the government will launch new regulations in an attempt to once again

gain support from nationalistic parts of the society.9

But where will the new FDI be located?

As previously said, the last couple of years have been characterized by social tensions

unseen in Indonesia since the crackdown on communists in 1965-66. The violence has come

in two different shapes. Firstly, there have been claims for independence in Aceh, East Timor,

and Irian Jaya. The result for the two former provinces has been widespread clashes between

Indonesian military or militias and independence movements. Whereas East Timor has

received independence, the situation in Aceh is still unstable and unclear. Irian Jaya has so far

been saved from more widespread violence. These three provinces are somewhat different

from the rest of Indonesia. Two of them were not part of the Indonesia that received

independence in 1949, Irian Jaya, which was incorporated in 1963, and East Timor, which was

occupied in 1975. Moreover, Aceh has a strong regional identity, fueled by the memory of the

firm resistance against the Dutch, and with strong cultural and historical ties with the

Malaysian peninsula. Presumably, these three provinces would claim independence

irrespective of the economic situation, but maybe not as strong without the crisis. It is likely

that the crisis for instance allowed East Timor to vote for independence since it weakened the

Indonesian government's bargain power in the international community. In other words, the

world would probably have been more reluctant to intervene for East Timor if the Indonesian

13
economy had continued to grow with eight per cent a year. The political and economic price

for such actions would then have been too heavy for countries with national interests in the

region.

The second type of social or regional tension that we have witnessed in Indonesia is

between different ethnic or religious groups. This type of conflict seems to be fueled by

increased poverty although other factors such as the transmigration program has aggravated it.

When poverty increases it is common to blame the hardship on groups of people that are

located in the vicinity but that can be separated from the own group by for instance religion or

ethnicity (Olzak, 1998). Moreover, heterogeneous states run the largest risk of poverty driven

ethnic conflicts (Gurr, 1994). In a country like Indonesia, with several hundred ethnic

communities and all the large religions present, it is not difficult to find scapegoats for

deteriorating living conditions. This is what has happened to the ethnic Chinese, the Madurese

on Kalimantan, and the Bughis in Ambon, just to name a few of the recent targets of ethnic

violence.

All Indonesian governments since independence have realized the need for an even

spatial development for avoiding social tensions. As a result, an ambitious program for inter-

regional transfer of resources exists and the regional policy framework in Indonesia is the

most developed in the region (Hill, 1997 p. 291). The foundation of the extensive

redistribution program is the central governments large control of tax collection and mining

revenues. The resources are distributed throughout the country via the Inpres program and

other direct grants to the provinces.10 Hence, a requirement for the program is a large degree

of centralization and Indonesia is one of the most centralized countries in the world. For

instance, the central government earns roughly 93 per cent of total fiscal revenues and

accounts for more than 90 per cent of public spending (Buentjen, 1998). The redistribution

program seems to have been successful in achieving an even spatial development. Regional

14
income inequality as measured by income or household expenditures has decreased in

Indonesia since the mid 1980s, which contrasts the development in for instance Thailand and

the Phillipines (Hill, 1997, pp. 282-86). Although there may be different factors behind this

development, it seems reasonable to expect that the government's redistribution program has

played an important role.

However, the present situation is one with a decentralization of the Indonesian political

structure. There is an almost complete political consensus in Indonesia that decentralization is

a requirement for a sustainable democratization of Indonesia. Two laws have been launched

during 1999 to increase the autonomy of provinces and districts.11 As a result, provinces and

districts will be receiving more independence from Jakarta and they will keep more of their

own tax incomes. As an example, districts will keep 90 per cent of building tax, 80 per cent of

land tax, 80 per cent of forest and fishery revenues, 15 per cent of oil and 20 per cent of gas

revenues (Antlöv, 1999). Districts and provinces are also given responsibilities over

infrastructure, natural resources, health care, education and natural resource management.

Clearly, there are reasonable political arguments behind decentralization. For instance,

a greater regional independence will presumably soften demands for total independence in for

instance Aceh and Irian Jaya. Moreover, it may be necessary for a deepening of the democracy

that more decisions are made closer to the people that are affected by them.

One drawback with decentralization may be the difficulties in continuing inter-regional

transfers of resources. If the center receives substantially fewer resources, there will be limits

on the amount of resources it can transfer to relatively poor regions. Again, it is important that

an economic recovery will be spread across Indonesia. If not, social tensions may continue. As

previously said, any sustainable recovery has to involve a large degree of manufacturing and

the increased production has to be generated by a large inflow of FDI. Hence, we would prefer

a localization of manufacturing and FDI in various parts of the country since the possibility for

15
the center to affect regional disparities is likely to decrease. If FDI and manufacturing locates

also in poor regions, this would balance any decrease in transfers from the center.

Table 2 shows the regional concentration of manufacturing production and FDI in

1996, the last year before the crisis.12 About 60 per cent of the Indonesian population live on

Java, and about 20 per cent on Sumatra. However, the manufacturing industry is more

geographically concentrated with about 80 per cent of employment and value added on Java. It

is especially Jakarta and West Java that have proportionately large shares of manufacturing.

Besides Jakarta, West Java and East Java it is only two provinces that have a larger share of

manufacturing than their share of population - Riau which is part of the Singapore-Johor

growth triangle and East Kalimantan with large production of timber related products. FDI in

Indonesia is even more concentrated than manufacturing in general. West Java hosts the bulk

of foreign activity with about half of the foreign firms' employment and half of their value

added. In addition to West Java, only Jakarta and Riau have proportionately large shares of

FDI.

Table 2 about here.

Hence, manufacturing is heavily concentrated and foreign owned firms are even more

concentrated.13 West Java and Jakarta host most manufacturing and FDI, whereas large parts

of Indonesia have basically no manufacturing in general and no FDI in particular. If the

situation in 1996 is an indicator of where a possible increase in FDI will be located, the

situation would be alarming from a regional development perspective. The figures in table 3

on FDI applications confirm the picture of a high concentration. The figures are on total FDI

applications since figures on the manufacturing sector were not available. Java is the

destination for almost 72 per cent of the approved FDI projects and 66 per cent of the capital.

16
The potential pattern of future FDI is, hence, highly concentrated although to a lesser extent

than what was shown for historical data. The less concentrated pattern is mainly caused by the

inclusion of FDI in for instance tourism and mining, which are proportionately important for

some of the provinces outside of Java. Still, large parts of Indonesia, including Sulawesi,

Eastern Indonesia and parts of Kalimantan and Sumatra, are receiving very small amounts of

FDI.

Table 3 about here.

There are economic reasons behind a concentrated localization pattern of FDI.14

Foreign firms establish themselves in Indonesia for two reasons: to get access to the domestic

market and/or to use a favorable production site. If the FDI is primarily driven by market

considerations, they are likely to localize as close to the center of the market as possible. In

other words, FDI focused on supplying the Indonesian market with goods or services will

minimize transport costs by being close to areas with large (and wealthy) population. In the

case of Indonesia this will be on West Java. The localization effect from the second reason to

FDI, production advantages, is less obvious. Since wages are higher in urban areas, such as

Jakarta, FDI should tend to locate in the periphery of Indonesia rather than in the center.

However, wages are only one part of production costs and other important factors such as

availability of adequate infrastructure - electricity, roads, and harbors - tend to favor West

Java including Jakarta. Furthermore, agglomeration effects are likely to favor the center at the

expense of the periphery; new FDI tend to locate where there is a pool of trained labor, and

labor tend to migrate to locations with large number of firms. In addition, some foreign firms

are part of larger industry groups that cooperate not only in their home markets but also among

their foreign affiliates. This type of network is particularly present among Japanese FDI, and

17
will for logistic reasons favor a clustering of foreign firms. Moreover, there is a tendency for

foreign firms to consider availability of international schools and other facilities for the

foreign staff and their families, which again favor the center. Finally, foreign firms will

minimize political risks and uncertainties by avoiding provinces with social tensions or with

strong demands for independence, which may favor Java at the expense of some of the outer

islands.

The agglomeration effects described above - a tendency for firms to cluster in the

center of a market - will of course be present for domestic as well as foreign firms. The

concentration effect is likely, however, to be less significant for domestic firms. When a

domestic entrepreneur starts a company he will probably do it in the region where he lives.15

Only when the activities are expanded is the entrepreneur considering alternative production

sites. Hence, an entrepreneur from for instance Ujung Pandang will start his first business in

Ujung Pandang. The reason is familiarity with home locations and the advantages that this

brings to the entrepreneur. For instance, the entrepreneur has relatively good knowledge about

consumer preferences in the home area. Moreover, it is easier to raise capital or to find

suitable labor in areas where you have a personal network to rely upon. There are for obvious

reasons no such determinants for where FDI will be localized. As a consequence, foreign

firms will show a more concentrated localization pattern than domestic firms.

What can be done to decrease the concentration of manufacturing and FDI?

As discussed above, manufacturing production and FDI are heavily concentrated to

West Java, leaving large parts of Indonesia without any presence of these, arguably, central

factors for economic recovery. Since political stability requires some degree of spatial

equality, the situation may seriously threaten any sustainable recovery. Although there are

18
economic explanations to concentration of FDI and manufacturing production, it is possible to

soften the concentration by various policy measures.

The first policy measure may be to invest in infrastructure in the periphery. After all, if

poor infrastructure increases the costs of production, we would expect a relocation of

production if infrastructure investments will be directed towards the periphery. This positive

effect on production costs would, accordingly, increase localization of FDI in the periphery.

However, there are two conflicting forces at work and the result on production in the

periphery from improved infrastructure is not clear. Whereas FDI that locates in Indonesia for

production concerns may be more diffused over the country from improved infrastructure, the

same improved infrastructure may lead to a more concentrated pattern among FDI that are in

Indonesia to supply the domestic market. The reason for the latter effect is that relatively poor

infrastructure may force some foreign firms to be present in many parts of the country. When

infrastructure is improved, the same foreign firms may be able to supply the whole market

from one location. Hence, improved infrastructure enables firms to consider the whole of

Indonesia as one market when they previously had to deal with, for instance, Sulawesi,

Sumatra, and Java, as separate markets. To sum up the effect on concentration from improved

infrastructure, it depends to a large extent on whether the FDI are conducted for market access

or to utilize cheap production possibilities. Foreign owned firms in Indonesia have a

significantly larger share of their production in export in comparison to domestically owned

firms (Ramstetter, 1999). Still, even among foreign owned firms is it only in a few

manufacturing sectors that the bulk of the production is exported, most notably in Tobacco,

Apparel, Leather, Footwear, Wood, and Professional goods. Hence, it seems reasonable to

expect that any effect from improved infrastructure will, at least, be ambiguous and not

necessarily reduce the concentration.

19
 Trade liberalization is one policy measure that is likely to reduce the industry

concentration. Import substitution has been argued to be a major force behind the

concentration of industries and population in to large cities in developing countries (Elizondo

and Krugman, 1996). The mechanism is, as described previously, forward and backward

linkage effects between consumers, employees, and industries.16 When most production is for

a relatively small domestic market, the market access effect will dominate the choice of

location and result in a concentrated industry. Firms locate were the consumers are, and

providers of inputs are attracted to areas were there is a large demand for their services and

goods. When foreign trade is liberalized, more domestic producers will have their main

markets abroad and more of the required inputs will be imported, which lessen the centrifugal

force. On the contrary, high wages and land costs in the industrialized center will be an

incentive for firms to localize in the periphery.

The Indonesian trade policy has been substantially liberalized since the mid 1980s,

which may be one reason for an observed decrease in manufacturing concentration (Sjöholm,

1999d). However, the liberalization notwithstanding, there is still large obstacles for

international trade. It should be emphasized that not only tariffs and quotas but also various

regulations and bureaucracy limits the amount of international trade. Anderson and

Marcouiller (1999) find corruption and imperfect contract enforcement to constrain trade far

more than tariffs do. Indonesia has still large problems with nepotism, corruption, complicated

regulations, and restrictions in trade licenses. Hence, a better institutional framework with

more transparency and less regulations may enhance trade and thereby a more regionally

diversified industry. The task is likely to be difficult, since for instance corruption has been an

important part of the Indonesian economy at least since the Japanese occupation (Cribb and

Brown, 1997). An independent and investigating media together with a clear and transparent

regulatory framework are crucial elements.

20
 Trade liberalization enhances spatial equality but is hardly a sufficient policy. Even if

trade liberalization will decrease concentration of FDI and manufacturing, it is unsure how

large the effect will be. As previously said, agglomeration effects tend to favor regions that get

a head start in industrialization or as a location for FDI. These effects will presumably

continue to favor Java in the future, and to some extent balance cost disadvantages. Another

problem is that any outlocalization of manufacturing and FDI is likely to be spread out over a

long time period. In other words, it may take years before for instance East Indonesia will

receive more substantial amount of manufacturing and FDI. The need to generate a more equal

spatial growth seems too urgent to allow Indonesia to rely on this slow process. While trade

liberalization may achieve a long-run sustainable situation, it is likely that additional measures

are required in the short and medium term.

Hence, it seems reasonable to expect manufacturing and FDI to be heavily

concentrated in the foreseeable future. It is therefore difficult to see how Indonesia will

manage to achieve equal spatial growth without inter-regional transfer of resources. If

manufacturing and FDI will be generating the future growth, it will be necessary to tax

provinces were they are present and to transfer resources to where they are missing.

Concluding remarks

There are reasons to be optimistic about Indonesia's future. The economic crisis may

have bottomed out and the difficult transition to democracy has started. However, there are

great challenges ahead on the road to a complete economic recovery. Two crucial factors in a

sustainable long-term recovery are the ability to attract FDI inflows, and to achieve an even

spatial development. FDI is required since other capital funds may not be available and

because of the bad historical experience of relying on foreign loans. Even spatial development

21
is required for political reasons: if a recovery is not felt throughout the country, it is likely to

result in social tensions.

Unfortunately, there is a contradiction between FDI and even regional development

since FDI tends to locate in concentrated clusters. The concentration of FDI can be balanced

by policy measures and most important is a continuation of the trade liberalization. However,

it seems unlikely that such policy measures will be enough for achieving growth in living

standards throughout the country. One possibility would be to continue with the redistribution

program but there is a risk that the present decentralization in Indonesia will prevent such a

program. There are valid arguments for a decentralization of the highly centralized Indonesian

economic and political system. Decentralization is likely to decrease the claims for regional

independence and may also deepen the democracy. However, whereas the claims for total

independence may decrease, there may be greater social tensions in other parts of Indonesia

when poverty remains or even increases following a decentralization policy. It will be more

difficult to pursue an active redistribution program if income sources for the central

government are handed over to the provinces. Hence, although some provinces are likely to

benefit from the decentralization, others may find themselves worse off. Again, remaining

poverty in some of the outer islands may lead to a situation where clashes between ethnic and

religious communities will continue. It therefore seems necessary to continue with some inter-

regional transfer of resources. To combine such transfers with the present decentralization will

be a major challenge for Indonesia.

22
 Endnotes
*
I am grateful for valuable suggestions and comments from Ari Kokko and Örjan Sjöberg.
1
For a discussion of positive signs in the Indonesian economy see Pardede (1999).
2
For instance, we will focus on regional pattern of manufacturing production which seems to

be highly correlated with other regional figures such as GDP, and social indicators (Hill,

1997).
3
See for instance quotes of IMF and the World Bank in Lindblad (1997).
4
For a discussion of several important factors behind the Indonesian crisis see Hill (1999).
5
It should be noted that although Suharto took impression of the demands, the military and

police forces arrested 770 people who participated in the demonstrations and riots (Ricklefs

1993, p. 300).
6
For a survey of export in the Indonesian manufacturing sector see e.g. Sjöholm (1999a,

1999b)
7
Far Eastern Economic Review (1999a).
8
Spillovers refer to technology transfer from foreign to domestic firms, which can be caused

by for instance support of linkage industries or by turnover of employees (Blomström and

Kokko, 1998).
9
Far Eastern Economic Review (1999b).
10
Inpres - Instruksi Presiden (Presidential Instruction).
11
Law no. 22/99 on local government, and law no. 25/99 on fiscal relations between the

center and regions.

12
Irian Jaya and the Moluccas are now divided in two provinces each and East Timor has

received independence.

23
13
Hill (1987) and Sjöholm (1999d) find a similar concentration of the Indonesian

manufacturing sector.
14
For a discussion of possible localization patterns of FDI see e.g. Sjöberg and Josefson

(1998).
15
See e.g. Mueller and Morgan (1962).
16
See Hirschman (1958).

24
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29
Table 1. Development of the Indonesian manufacturing sector 1996-98.

Sector Number of Number of

establishments employees (1000-

persons)

1996 1998 Change 1996 1998 Change

1996-98 1996-98

(%) (%)

Total 22,997 20,422 -11.2 4,215 3,536 -16.1

Food, Beverage, Tobacco 5,608 5,178 -7.7 810 673 -16.9

Textiles, Clothing 5,230 4,574 -12.5 1,355 1,116 -17.6

Wood Products 3,145 2,777 -11.7 562 523 -6.9

Paper Products 1,035 877 -15.3 165 128 -22.4

Chemicals 2,581 2,386 -7.6 486 431 -11.3

Non-metallic Minerals 2,158 1,715 -20.5 190 132 -30.5

Basic Metals 182 197 8.2 50 41 -18.0

Fabricated Metal Prod. 2,596 2,298 -11.5 523 419 -19.9

Other Manufacturing 462 420 -9.1 73 73 0.0

Source: BPS (1999).

Note: The figures refer to large and medium sized manufacturing establishments. The figures
for 1998 are estimates.

30
Table 2. The Geographic pattern of the Indonesian manufacturing sector 1996 (All figures in
per cent).
Province Share of Share of Share of Share of Share of
total labor force value added foreign labor foreign
population force value added
Sumatra 20.9 10.9 13.9 12.3 15.4
Aceh 2.0 0.4 0.7 0.4 1.0
North Sumatra 5.7 4.3 4.9 2.2 4.9
West Sumatra 2.2 0.4 0.5 0.4 0.3
Riau 2.0 2.9 4.8 8.2 8.9
Jambi 1.2 0.7 0.5 0.1 0.0
South Sumatra 3.7 1.2 1.6 0.6 0.1
Bengkulu 0.7 0.1 0.0 0.0 0.0
Lampung 3.4 0.9 0.9 0.4 0.2

Java-Bali 60.4 82.3 79.3 84.3 81.9

Jakarta 4.7 10.6 16.7 13.7 18.7
West Java 20.1 36.3 40.2 51.4 49.8
Central Java 15.2 12.9 7.1 4.3 2.3
Yogyakarta 1.5 0.9 0.6 0.3 0.8
East Java 17.4 20.9 14.5 14.4 10.2
Bali 1.5 0.7 0.2 0.2 0.1

Kalimantan 5.4 4.0 4.5 2.1 1.9

West Kalimantan 1.9 1.0 1.3 0.3 0.2
Central Kalimantan 0.8 0.4 0.4 0.5 0.7
South Kalimantan 1.5 1.2 1.2 0.8 0.8
East Kalimantan 1.2 1.4 1.6 0.5 0.2

Sulawesi 7.1 1.3 1.0 0.8 0.5

North Sulawesi 1.4 0.3 0.2 0.2 0.0
Central Sulawesi 1.0 0.1 0.0 0.0 0.0
South Sulawesi 3.9 0.8 0.8 0.6 0.5
Southeast Sulawesi 0.8 0.1 0.0 0.0 0.0

Eastern Indonesia 6.2 1.2 0.8 0.4 0.2

West Nusa tengara 1.9 0.2 0.1 0.0 0.0
East Nusa tengara 1.8 0.0 0.0 0.0 0.0
East Timor 0.4 0.0 0.0 0.0 0.0
Moluccas 1.1 0.6 0.4 0.0 0.0
Irian Jaya 1.0 0.4 0.3 0.4 0.2
Source: Own calculations on data supplied by Biro Pusat Statistik.

31
Table 3. The geographical pattern of approved foreign investment projects 1997-98 (All

figures in per cent of total).

Province Projects Capital

Sumatra 13.6 26.5
Aceh 0.6 1.6
North Sumatra 2.5 7.9
West Sumatra 0.6 0.4
Riau 7.8 15.4
Jambi 0.3 0.4
South Sumatra 0.8 0.4
Bengkulu 0.3 0.1
Lampung 0.7 0.3

Java-Bali 76.9 67.0

Jakarta 31.8 16.5
West Java 29.3 28.4
Central Java 3.1 11.1
Yogyakarta 0.8 0.0
East Java 6.8 10.1
Bali 5.1 0.9

Kalimantan 4.9 3.8

West Kalimantan 1.3 0.6
Central Kalimantan 1.8 2.1
South Kalimantan 1.0 0.0
East Kalimantan 0.8 1.1

Sulawesi 2.3 1.3

North Sulawesi 0.9 1.1
Central Sulawesi 0.3 0.0
South Sulawesi 0.2 0.0
Southeast Sulawesi 0.9 0.2

Eastern Indonesia 2.4 1.3

West Nusa Tengara 0.8 0.1
East Nusa Tengara 0.2 0.1
East Timor 0.1 0.0
Moluccas 0.5 0.0
Irian Jaya 0.8 1.1
Source: BPS (1999, p. 460).

32