Document of A% X Oft The World Bank FOR OFFICIAL USE ONLY Report No. 3182-IND INDONES IA SELECTED ISSUES OF INDUSTRIAL DEVELOPMENT AN'D TRADE STRATEGY THE MAIN REPORT July 15, 1981 East Asia and Pacific Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency: Rupiah (Rp) US$1 = Rp 625 (November 1978) Rp 1 = US cents 1.6 Rp 1,000,000 = US$1,600 PRINCIPAL ABBREVIATIONS AND ACRONYMS USED BAPPENAS Government Planning Agency BAPINDO State-Owned Development Bank BKPM Badan Koordinasi Penanaman Model (Investment Coordinating Board), also ICB BPS Biro Pusat Statistek (Central Bureau of Statistics), also CBS CBS Central Bureau of Statistics GOI Government of Indonesia IDFC Indonesian Development Finance Corporation KIK Kredit Investasi Kecil (Small-Scale Investment Credit Program) KMKP Kredit Model Kerja Penanaman (Working Capital Credit Program) NAFED National Agency for Export Development PDFCI Private Development Finance Corporation of Indonesia PLN State Electricity Corporation PMA Penanaman Modal Asing (Foreign Investment Projects) PMDN Penanaman Modal Dalam Negeri (Domestic Investment Projects) FOR OFFICIAL USE ONLY INDONESIA SELECTED ISSUES OF INDUSTRIAL DEVELOPMENT AND TRADE STRATEGY Table of Contents Page No. SUMMARY AND CONCLUSIONS . .................. . i-xii 1. INTRODUCTION .... . . . . . . . . . . . . . . . . . . . . . 1 2. THE PATTERN OF INDUSTRIAL DEVELOPMENT . . . . . . . . . . . . . 4 Introduction .... . : . . . . . . . . . . . . . . . . . . . 4 An Overview .... . . . . . ................... 4 Recent Growth in the Industrial Sector. . . . 9 The Structural Characteristics ... . . . . . . . . . . . . . 12 Government Objectives and Policies for Industrial Development . 17 3. THE INCENTIVE STRUCTURE AND THE TRADE REGIME . . . . . . . . . 23 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 23 The Trade Policy Bias .... . . . . . . ....... . . . . 23 Implications for Labor-Intensive Industries . . . . . . . . . . 30 Current Obstacles to Exports ... . . . . . ...... . . . 33 The Devaluation of November 1978 . . . . . . . . . . . . . . . 34 Changes in Effective Exchange Rates . . . . . . . . . . . . . . 37 The Real Price Effects of the Devaluation . . . . . . . . . . . 42 4. THE'REGULATORY ENVIRONMENT . . . . . . . . . . . . . . . . . . 46 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . 46 The Types of Regulation .. . . . . . . . . . . . . . . . . . . 46 The Objectives of Industrial Controls . . . . . . . . . . . . . 50 The Procedures to Obtain Licenses . . . . . . . . . . . . . . . 52 The Criteria for Allocating Licenses . . . . . . . . . . . . . 53 The Regulatory System in Operation . . . . . . . . . . . . . . 55 The Economic Implications .... . . . . . . . . . . . . . . 58 Government Policies to Remedy the Situation . . . . . . . . . . 61 This report is based on the findings of a mission comprising Trent Bertrand (Consultant, State University of New York), Peter McCawley (Consultant, Australian National University), Demetrious Papageorgiou (Development Economics Department), Mark Pitt (Consultant, University of Minnesota), Sarath Rajapatirana (East Asia and Pacific Country Programs), Stewart Wallis (East Asia and Pacific Projects Department), and Armeane M. Choksi (Mission Leader, East Asia and Pacific Country Programs). This mission visited Indonesia in February/March 1980. A draft of the report was discussed with the Government from January to June 1981. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. -2- Page No. 5. THE EFFECTS OF FINANCIAL POLICIES ON INDUSTRIAL DEVELOPMENT 64 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 64 The Structure of the Financial Market . . . . . . . . . . . . 64 The Characteristics and Objectives of Financial Policy Formulation ... . . . . . ..... . . . . . . . 67 The Instruments of Policy ... . . . . ..... . . . . . . 69 Implications for the Industrial Sector . . . . . . . . . . . 71 6. POLICIES TOWARDS PRIVATE FOREIGN INVESTMENT . . . . . . . . 80 Introduction .... . . . . . . ..... . . . . . . . . . 80 Recent Trends and Developments . . . . . . . . . . . . . . . 80 The Impact of Recent Policy Initiatives . . . . . . . . . . . 84 7. A FRAMIEWORK FOR LONG-TERM INDUSTRIAL DEVELOPMENT . . . . . . 90 Introduction .... . . . . . . ..... . . . . . . . . . 90 Improving the Economic Climate . . . . . . . . . . . . . . . 91 Reshaping the Regulatory Environment . . . . . . . . . . . . 92 Restructuring Trade Policy ... . . . ..... . . . . . . 94 Financial Policy Reforms . . . . . . . . . . . . . . . . . . 99 Policies Toward Private Foreign Investment . . . . . . . . . 100 The Role of the Government ... . . . ..... . . . . . . 102 8. AN AGENDA FOR POLICY ADJUSTMENTS . . . . . . . . . . . . . . 105 Introduction ...................... . . . . . . . . . . . 105 Simplifying Administrative Controls . . . . . . . . . . . . . 106 Reforming Tax Laws and the Legal Infrastructure . . . . . . . 110 Reducing the Import-Substitution Bias . . . . . . . . . . . . 111 Sequencing Adjustments in Financial Policy . . . . . . . . . 117 Stimulating Private Foreign Invesment . . . . . . . . . . . . 123 INDONESIA SELECTED ISSUES OF INDUSTRIAL DEVELOPMENT AND TRADE STRATEGY Text Tables and Figures Table No. Page No. Chapter 2 2.1 The Structure and Growth of Production, 1960-78 . . . . . . 5 2.2 The Ownership Structure, 1974-75 . . . . . . . . . . . . . 14 2.3 The Geographical Distribution of Industry, 1974-75 . . . . 16 Chapter 3 3.1 Distribution of Effective Protection in Indonesian Manufacturing, 1975 . . . . . . . . . . . . . . . . . . . 26 3.2 Escalating Effective Protection, 1975 . . . . . . . . . . . 27 3.3 Labor and Capital Requirements in Indonesian Manufacturing by Trade Category, 1975 . . . . . . . . . . . . . . . . . 31 3.4 Effective Exchange Rates for Exports of Selected Items . . . 41 3.5 The Growth of Selected Indonesian Manufactured Exports, 1975-79 . . . , . . . . . . . . . . . . . . . . 43 3.6 Real Price Changes of Domestic Manufacturing, Imports and Exports .44 Chapter 4 4.1 Main Licensing Controls and their Objectives . . . . . . . . 51 4.2 Licenses and Permits Issued by the BKPM . . . . . . . . . . 54 Chapter 5 5.1 State Bank Lending to the Manufacturing Sector (April 1980) ..72 5.2 The Structure of Interest Rates, 1975-79 . . . . . . . . . . 73 Chapter 6 6.1 Foreign Investment Implementation and Approvals by Sector, 1967-79, excluding Investment in Petroleum and Banking .......... ....... ..... . 82 6.2 Foreign Investment Implementations and Approvals . . . . . . 85 - ii - Figure No. Page No. Chapter 2 2.1 Share of Manufacturing in GDP: An International Comparison; 1978 ...... . . . . . . . . ... .. 6 2.2 Per Capita Value-Added in Manufacturing: An International Comparison; 1978 . . . . . . . . . . . . . . 6 2.3 Actual and "Average" Structure of the Industrial Sector . 8 Chapter 3 3.1 A Comparison of Effective Protection Rates for Selected Sectors, 1971-1978 . . . . . . . . . . . . . . . 28 3.2 Import Duty and Sales Tax Collection Rates for Important Manufacturing Sectors, 1971-1978 . . . . . . . 29 3.3 Index of Nominal and Real Exchange Rates: Rupiah per Basket of Trading Partner Currencies . . . . . 36 3.4 Effective Exchange Rates for Textiles . . . . . . . . . . . 39 3.5 Effective Exchange Rates for Selected Items . . . . . . . . 40 Chapter 6 6.1 Nominal and Constant Price (1970) Series for Foreign Investment Implementation (1976-1979) . . . . . . . . . . 83 t1) SU1'MARY AND CONCLUSIONS Introduction At the time of independence, Indonesia inherited a small and very underdeveloped industrial sector. After the economic disruption of the middle 1960s, the Government set out to develop the sector so as to provide increasing incomes and employment to the rapidly growing population, and to exploit and process the country's natulral resources. Other elements which were included ia the country's industrial development objectives were, inter alia, regional dispersion, the prevention of the creation of excess capacity, the utilization of domestic raw materials, "orderly" industriali- zation, and the stimulation of indigenous entrepreneurship. Apart from involving itself directly in a number of large projects, the Government attempted to realize its varigus objectives through the creation of incentives to the private sector, and through direct regulation of private industrial activity. As a guiding principle for its development strategy, the Government's Third Five-Year Plan adopted the Development Trilogy of equity, growth and stability. As in many other developing countries, it lhas proven to be diffi- cult to realize a complex set of social and economic objectives without thle introduction of an equally complex set of public measures and regulations. Also, specific short-term policy problems have a tendency to be addressed in an ad hoc fashion and, as has happened in other developing countries, this tends, over time, to make the whole system unwieldy. Eventually, a situation may result in which the whole complex of Government interventions, through all kinds of unintended or side effects, obstructs rather than facilitates the attainment of the stated objectives. Evidence has been mounting that this has been happening in Indonesia. This report attempts to assist the Government in addressing these issues. It analyses the policy environment within which investment decisions are made by firms in the private sector and suggests short- and long-run policies that will stimulate industrial growth. It does not deal with public sector investment decisions and planning. The specific areas covered include the incentive structure and the trade regime, the impact of the 1978 devaluation on the manufacturing sector, the regulatory climate and the system of administrative controls, the financial policy environment and policies towards private foreign investment. In all these areas, policy reforms are required to enhance the international competitiveness of the Indonesian industrial sector because the industrial incentives conflict with many of the Government's priorities and stated objectives. The policy recommendations made in this report are not commodity-specific; they are, instead, specific recommendations designed to improve the general investment climate for firms in the industrial sector. These recommendations are supported, in most cases, by empirical evidence and reflect our currenrt knowledge and understanding of economic processes. In this summary, we review the main characteristics of the industrial sector, discuss our findings and present our main policy recommendations. The main report covers these topics more extensively and the five Annexes provide supporting detail. (ii') The Structure of the Manufacturing Sector The manufacturing sector in Indonesia has, over the period 1970-78, experienced a high average annual growth rate of value-added of 12.4%. But the base is very small; the share of manufacturing in GDP at 9% is below that of the mean value of all low-income countries (13%) and considerably less than that of middle-income countries (25%). A comparison between Indonesia and other Asian nations such as Malaysia (17%), Thailand (18%), Pakistan (16%) and Sri Lanka (23%) provides further evidence of the small size of the industrial sector. Within the industrial sector, the small and cottage firms are dominant in terms of numbers and employment; there are over one million such firms compared to 7,000 medium- and large-scale firms, and over 85% of manufacturing employment originates in these small firms. It is, however, the large and medium firms that contribute the most to manufacturing value- added - 80% of the total - and their productivity, defined as value-added per employee, is over twenty-five times that of the small and cottage firms. Employment in the large- and medium-scale firms has grown at a high average annual rate of 11.8% over the period 1970-73 and 8.6% from 1974-77, but the employment base is low; 916,000 workers were employed by these firms in 1977. Most of the observed growth in the manufacturing sector, over the 1970-78 period, can be attributed to the Government's investments in the large-scale, capital-intensive sectors such as cement, fertilizers, steel and pulp and paper. However, the observed decline in the overall growth rate in the manufacturing sector since 1975 may indicate that the stage of early import-substitution industrialization may be over in Indonesia; this is evidenced by a decline in the growth of "early" industries such as textiles and food processing. Preliminary estimates indicate a further decline in the growth rate of real value-added in 1979 to about 9% p.a., as compared to 11.6% p.a. over the period 1976 to 1978. Recent policy pronouncements and the stated objectives of the Third Five-Year Plan, Repelita III, are, in part, designed to reverse this trend. In particular, considerable emphasis is now being placed on the promotion of labor-intensive industries, on the expansion of manufactured exports and employment growth and on the stimulation of the private sector. However, at the same time, Repelita III also lays the basis of an ambitious program to develop a heavy industry base which will lay a large claim on public resources; one estimate indicates the total cost to be around $20 billion over the next five years. A large allocation to capital-intensive, public sector projects, as in the past, may restrict the availability of investment funds to and thus the development of the private sector which is already constrained by the policy environment. To exploit Indonesia's comparative advantage, and especially its large supplies of cheap labor, specific policies need to be designed to develop an efficient industrial base which would include an appropriate mix of labor-intensive and capital-intensive (natural resorce-based) sectors. (iii? The Incentive Structure and the Trade Regime For historical reasons discussed in more detail in the main report, the incentive structure governing the behavior of private entre- preneurs in Indonesia is now very complex and uneven. The system consists of numerous price and non-price interventions that greatly influence the incentives for production and exports. While the average level of protection for all tradeable goods is relatively moderate (about 30% in 1975), there is considerable variation of protection between various industries, ranging (in 1975) from +4315% for the tire and tube industry to -35% for the batic industry. There is, however, some evidence that this large variation in protection was reduced in (pre-devaluation) 1978. The adoption of policy instruments that have resulted in these substantial differentials appears to be largely in response to ad hoc requests from private firms and manufacturers' associations. The resulting biases in the incentive structure have encouraged the development of several industries that do not have a comparative advantage. As in many other developing countries, the instruments have also resulted in an overall trade policy which is biased towards production for the domestic market and against exports; the weighted average effective protection for the import-competing sectors was 61% in 1975, while that for the exportable sectors was -6.4%. The types of policies that have been instituted have also resulted in resources being allocated to the capital-intensive sectors and not, as intended by the Government, to.the labor-intensive sectors. Thus, the highly protected, import-competing sectors such as motor vehicles use significantly more capital and skills than the least protected ones such as kretek cigarettes and sawmilling; the latter group, which are the exportable sectors, use more than double the amount of labor per unit of value-added than the former group. This bias against exports, therefore, slows their growth and that of productive employment. The misallocation of resources resulting from the uneven nature of the incentive structure is also indicated by the dispersion across sectors of the domestic resource costs required to earn or save Ea unit of foreign exchange. The most highly protected sectors, as one might expect, have higher domestic resource costs and are relatively more inefficient than those with lower protection. The latter, which are essentially labor-intensive, include sectors such as wood products, sawmilling, tanneries and leather finishing, and certain classes of textiles. Because of her natural resource endownments, Indonesia also appears to have a comparative! advantage in certain capital-intensive sectors such as fertilizers, petroleum products and the LPG industries. Therefore, appropriate policies for resource allocation and reduction in the import-substitution bias will channel investment resources into those sectors that will most contribute to direct and indirect employment creation and export expansion. Apart from the incentive structure, there are many other obstacles to expanding exports. Some are related to the loading procedures at ports, and others are associated with the Government's transporation policies kiv) that are designed to protect the ailing domestic shipping industry. These factors increase the cost of Indonesian exports and contribute further to making them internationally noncompetitive. The newly instituted export certificate scheme is one of the most innovative programs introduced by the Government to expand exports, but further improvements in its administration are possible and needed to facilitate the exports of manufactured goods. In November 1978, the Government undertook a major policy step designed to boost exports and the production of labor-intensive industries. This was the devaluation of the rupiah by 33-1/3% and a simultaneous intro- duction of an export rebate schlemne combined with reductions in imnport tariffs and sales taxes for intermediate goods. Consequently, the import-substitution bias appears to have been partially mitigated; but this may only be a short- run phenomenon as, in the post-devaluation period, effective protection appears to be increasing on an ad hoc basis for individuals firms requesting and obtaining "temporary relief-from import competition. Nevertheless, as a result of this change in policy, exports in 1979 increased significantly over the 1978 level for several industries such as woven cotton fabrics (684%); clothing (341%); furniture (104%) and wood products (82%). The increase in incentives to export is indicated by the substantial increases in the actual exchange rates for individual export commodities; they range from a low of Rp 633 per dollar for monosodium glutamate to a high of Rp 900 per dollar for men's jeans. However, due to continued differences between Indonesian and foreign rates of inflation and the appreciation of the dollar since November 1978, the real exchange rate and, thus, the incentives to export have not been maintained. Most of the export growth, in the short period from 1978-79, has taken place in the labor-intensive industries; it has grown from a small base in 1978 and has been brought about, in many cases, by the presence of excess capacity and earlier decisions made to build capacity ahead of demand. Furthermore, the Government's incentive program, biased in favor of domestic sales rather than exports, is not conducive to long-run export growth. Therefore, despite the large magnitude of the devaluation, the emergence of the desired structural transformation awaits confirmation. The Regulatory Environment and Administrative Controls In addition to the system of incentives discussed above, the private sector is controlled through an extensive system of regulations which, as a whole, has a substantial disincentive effect and which restricts the expansion of industrial output. The main objectives of the regulatory system appear to include: employment creation and income distribution; the development of the indigenous entrepreneurs and the control of the non-indigenous business class; "orderly" industrialization; development of a strong industrial base; and regional dispersion. vv To achieve these objectives, a wide range of licenses and permits of various kinds is used. In principle, almost all forms of manufacturing economic activity require several licenses to operate; in addition to invest- ment licenses, firms usually also require other licenses such as trading licenses, and labor safety licenses. If firms engage in more substantial activities, then the number of additional licenses required increases significantly. Thus, the number of approvals required is substantial, and at times, difficult to arrange. Despite attempts at simplification in certain areas, the system remains unwieldy. Moreover, compliance with all requirements is generally difficult for industrial enterprises, and many firms appear to operate -n breach of many requirements for mlch of the time. In addition, enforcement of all of the requirements, for a range of reasons, appears to be difficult. The Investment Coordinating Board (BKPM) issues some of these licenses to certain investors and is assigned the dual responsibility of both controlling and promoting investment. Its procedures involve a detailed eva- luation of investment proposals. With the exception of very large projects (natural resource-based activities) undertaken by foreign investors, the costs of such a role played by the BKPM appear to exceed the benefits. The Industrial Priority List (DSP) system of controlling capacity, and the asso- ciated complex master list system on which import tariff rebates for capital equipment and raw materials are based, are the major instruments used by the BKPM to control investments. The Priority List for 1980 has been published with proposed changes which are intended to be less restrictive. Neverthe- less, this list specifies a large number of subsectors wlhich are subject to numerous licenses and differentiated tax and investment allowances and which, in turn, are dependent on several conditions specified for each subsector. Because of the procedures and time delays involved, the need to provide detailed reports and to obtain re-approval for project modifications from the BKPM after initial licenses have been issued, many domestic investors prefer to forego the tax incentives offered by the BKPM and to establish their firms under the Company Regulations Ordinance of 1934, the BRO regulations./l Consequently, the proposed plans of the Government to include the BRO sector under the DSP system would, therefore, not only increase the administrative burden of the Government, but would also impede the growth of the industrial sector, and result in the closing of a useful safety valve. In general, the large number of licenses and controls required and regulations promulgated every year by various Government bodies appear to have led to confusion on part of domestic and foreign firms and to their evasion, often because of the ignorance of their existence. Part of the confusion arises from the fact that many laws and rules date from the Dutch period and /1 Firms in the BRO sector are registered under the BRO regulations (Dutch Company Regulations Ordinance of 1934); these regulations are simpler than those which are applied to firms registered with the BKPM. (vi) have only been partially amended and are unsuited for the present industrial structure. Furthermore, the precise legal basis of many regulations affecting industrial development is not very clear. Laws and regulations are often couched in broad terms and, frequently, in ways that are ambiguous. Consequently, the system generates considerable uncertainty and adds to the scope for personnel discretion available to officials. In such situations, illegal payments become features of the regulatory system and such payments are often made either for the proper execution or for the adjustment of the rules. This situation is exaccerbated by the relatively weak administrative infrastructure. Areas most suscepti- ble to this form of payment are the taxation processes, when negotiations with tax assessors take place, and the customs clearance necessary for the imports of various goods; despite attempts at reform, import procedures at ports still cause considerable difficulties. Thus, the system tends to reward those who are capable of making such payments by erecting barriers for potential entrants who are not familiar with the various detailed procedures that must be followed to conduct business in Indonesia. Consequently, skills, such as dealing efficiently with the bureaucracy carry a premium, and the relatively smaller, inexperienced economically weak firms with fewer resources are, in practice, discriminated against. This clouded legal situation combined with the existence of irregu- lar payments seems to contribute, in great measure, to a general atmosphere of uncertainty within both the foreign and the domestic business community. This, in turn, shortens the time horizons of investors, discourages risk-taking and long-term investments and encourages the search for quick-yielding high profit activities. Additional costs which are imposed on the Indonesian economy through these regulations, include biases in favor of capital-intensive technologies, the large size of the bureaucracy required to administer the system, the resulting diversion of skilled manpower into nonproductive activities and foregone employment and output. None of these are conducive to the long-term growth of the industrial sector. In the final analysis, the regulatory environment imposes a high social cost that Indonesia can ill-afford to carry. The difficulties associated with the regulatory system have been recognized by the Government and attempts have been made to improve the situation. In March 1979, a series of reforms were introduced to improve the administration of tax laws, and in August 1979, a special team was appointed by the Minister of Industry to investigate the problems of the licensing system. The BKPM has been turned into a "one-stop" agency and foreign advisors have been hired to improve its operations. The Government has also made several attempts to improve the customs procedures, but with limited success as this is dependent upon numerous factors. These are all steps in the right direction, but clearly much remains to be done. Financial Policies Affecting the Industrial Sector The Indonesian financial sector is still in the early stages of development. It consists of a commercial banking system dominated by five state-owned banks, which are regulated by the central bank, Bank Indonesia, several private domestic and foreign banks and three development finance companies. However, the state banks account for almost 80% of the assets of all deposit money banks. They are also the major suppliers of credit to the industrial sector; their share in total outstanding credit is about 85%. Current-v the asset structure is characterized by a dearth of long- term credits; short-term credits, of maturity less than one year, account for approximately 77% of all credits to the manufacturing sector. This lack of long-term instruments has led to the roll-over of short-term credits; between 70% and 90% of all short-term credits are rolled over. Furthermore, almost 60% of all long-term manufacturing credit is allocated to large government-sponsored projects. Consequently, short-term credits have become an important source of financing investments in the private sector. Financial policies in Indonesia have attempted to play a strong promotional role in the development of the industrial sector. The four major objectives of these policies are the use of increased resources for overall development while maintaining price stability; the allocation of credit to priority sectors including industry; the promotion of economically weak entrepreneurs; and the creation of an institutional environment to increase the range of financial services. The major instruments used by the Government to achieve these objectives have been the budget, overall credit ceilings, a mandated interest rate structure, the rediscount rate and the proportion of loans rediscounted and various regulations. The differential nature of the rediscount rate and loan proportions rediscounted demarcate special credit schemes such as the KIB, and the KIK/KMKP programs, export credits and credit Kelayakan. The instruments used indicate that current monetary policies are characterized by a more administratively determined system than were the policies which were in effect before 1974. The post-1974 recourse to more direct controls was motivated, in part, by the price stabilization objective and partly by social and equity considerations. However, the pursuit of price stability has prompted the Government to emphasize the use of administrative policies that have ultimately resulted in a larger allocation of credit to large, state-owned, capital- and energy-intensive projects implies the neglect of the more labor-intensive, energy-conserving industries in the private sector. The current interest rate structure also hampers efforts at resource mobilization. Over the period 1975 to 1979, the regulation of interest rates led to negative or low positive real deposit rates which has (viii) diverted investment funds away from the formal banking sector. Furthermore, since on-lending rates for financial institutions are fixed, this mandated interest rate structure also precludes the issuance of bonds by institutions, such as BAPINDO, unless substantial subsidies are involved. This, in turn, further interferes with efforts to mobilize resources for industry and with the development of efficient financial intermediation. The subsidization of lending rates and the selective access to funds has also led to credit arbitrage and to the distortion of choices of technology against labor- intensive ones; this has a detrimental effect on employment creation and income distribution. The use of the interest rate as a viable policy instrument for resource allocation and economic efficiency has effectively been abandoned. As a result, the financial system is heavily dependent on overall credit ceilings to control the total money supply. Although the dependence on overall credit ceilings to contain liquidity can be justified as a short-term instrument, it has deleterious effects in the long run. The combination of ceilings and mandated interest rates leads to an allocation of credit based on the preferences of the banks for primary customers; this is, in all likelihood, a suboptimal allocation of capital. Furthermore, the preferences of the Government authorities for financing state enterprises and for ear-making lines of credit to "prime" customers further distorts the credit market and prevents credit allocation according to the opportunity cost of capital. The credit mechanism is also used as an instrument of social policy. While the support of the weaker economic group is an important objective, the choice of instruments results in high economic costs and to conflicts between economic and social policy. There is evidence indicating that credit rationing policies designed to enhance entrepreneurship among the weaker economic groups may not be completely successful in achieving their goals; the availability of cheap credit may not necessarily be the primary solution. Nevertheless, the political benefits to the Government from adopting these policies may exceed the economic costs; this is a determination that only the Government can make. Credit policies instituted in Indonesia have, directly or indirectly, also had a detrimental effect on financial intermediation for industry and on the banking sector. The ceilings on credit and the various regulations determining the allocation of this credit have led to the current excess liquidity position of the state banks. The same regulations prevent these banks from allocating credit based on the economic viability of the project if it does not meet particular sector or economic group requirements; at the same time, financially viable projects from the economically disadvantaged entrepreneurs are scarce. As a result, the state banks often deposit their excess funds in off-shore markets such as Singapore, and some of these funds are subsequently recycled into the country through these off-shore capital markets with a higher cost and a (ix) foreign exchange risk by non-indigenous Indonesians and joint venture firms. Consequently, the process of domestic financial intermediation is restricted and the development of the banking sector is hindered. Effective financial intermediation for industry is further inhi- bited by the dominance of the state banks in the financial system and by the absence of competition faced by these banks for deposit mobilization and loans. The state banks are heavily protected through subsidies from Bank Indonesia's rediscount facilities available to them for certain types of loans, additional subsidies on their deposit rates, regulations mandating insurance companies to invest part of their funds in time-deposits with state banks, tax incentives of various sorts, and the restrictions on entry of new foreign and domestic private banks into Indonesia. As a result, these state banks tend to be relatively inefficient in their lending and resource mobilization operations. This manifests itself in poor appraisals, lengthy loan processing time caused by extensive cross-checking, and high arrears. This is compounded by the multiple objectives imposed on state banks by the Government. Since these banks are, in effect, the largest source of long-term funds in the country, their protection from competition and the resulting inefficiencies continue to retard the development of an efficient financial system in which, at the early stages, banks have a rather important role to play. Furthermore, such policies not only retard the growth of the industrial sector, but also have a detrimental effect on the development of the economically disadvantaged entrepreneurs that particularly need financial and technical support. Foreign Investment in the Manufacturing Sector Foreign investment in the manufacturing sector accounts for almost 65% of total foreign investment in Indonesia excluding investments in the petroleum, banking and insurance sectors. Japan is by far the most important source country, accounting for 35% of all approvals (1967-78), followed by the US (11%) and Hong Kong (10%). Within the manufacturing sector, textiles account for the largest share (36%), followed by metal products (18%) and chemical and rubber products (15%). But, over the period 1967-79, actual investments amounted to only 44% of approved investments. This low rate reflects, in part, the delays associated with the implementation of projects and the difficulties associated with monitoring investment flows. Prior to 1974, the Government had adopted essentially "open-door" policies, but in the post-1974 period, these policies became increasingly restrictionist. The most important changes included increased control on foreign investment by sector and location, increased local ownership of foreign firms, requirements regarding more rapid promotion of Indonesians to managerial positions, restrictions on foreign firms engaging in distribution and marketing activities, and restrictions on the operations of foreign firms and joint ventures in the domestic market for investment credit. As a result, realized foreign investment peaked in 1974 at a level of $1.4 billion, and, compared to the 1970-74 period, it declined by 26% in real terms in the period 1975-79. Moreover, the size of one single project, the Asahan hydroelectric aluminum smelter, distorts the investment data significantly. The exclusion of this project shows that total approved investments dropped from about $4 billion in the five years, 1970-74, to less than $0.9 billion in the subsequlent five years, 1975-79. Furthermore, many Government policies that are not designed with private foreign investment and joint ventures in mind, nevertheless, have an impact on such investments. Foreign exchange policies (especially the 1978 devaluation), subsidy policies for wage goods and oil products, trade policies, and the regulatory system are examples of this. ks mentioned earlier, extensive controls have tied up considerable quantities of Indonesia's most scarce resources. In fact, although it is clear that the system contains many informal safety valves whereby control and interferences can be evaded, the costs of having such a system are high in the area of foreign investment. Established foreign and joint venture firms have learned to operate very profitably within the system. Nevertheless, the disincentives associated with such a system have acted as a very serious impediment to the inflow of new private foreign invesment. Many potential new entrants, encouraged by the Government s public relations abroad, are taken aback and disillusioned by the amorphous barriers erected in their paths by these regulations. It is not surprising, therefore, that most of the recorded private foreign investment since 1974 has been due to the expansion of existing firms rather than to the entry of new enterprises. Government policies specifically designed to encourage foreign investment and joint ventures into Indonesia also appear to cause some confusion in the foreign business community. Several managers have not succeeded in their attempt to understand the Government's objectives and intentions with respect to foreign investment. Furthermore, the disincentives, in terms of the legal framework, vague tax laws, the financial and physical infrastructure, and the regulatory environment, outweigh the tax incentives afforded to these investors by the BKPM. The Government has made significant efforts to alleviate many of the problems faced by these investors. But it appears that greater emphasis on the removal of disincentives, such as those mentioned above, and less on tax incentives, combined with a clear and unambiguous articulation of Government policies would go a long way to attract foreign investment into Indonesia. Policy and Recommendations and Conclusions Clearly, the Government sees the industrial sector as an important element in the overall socio-economic development of the country; it is, therefore, attempting to encourage industrialization while at the same time influencing its pattern so as to further a complex set of development objec- tives. The instruments used to attain these objectives have, in general, (xi) emphasized state intervention in the production process and have often been ad hoc and occasionally uncoordinated. This had led to a highly biased structure of industrial incentives which, however unintentional, has become inimical to the realization of some of the very objectives that the Government is attempting to realize. The same elements are also present in the regulatory environment and in the financial policy framework. What is now required is a careful review of the objectives of industrial policy and the extent to which they can be realized in practice through a policy framework that does not become so complex as to be counterproductive. This review can then lead to an articulation and implementation of a coherent policy program that safeguards the Government's main objectives of growth and equity while at the same time creating an investment climate in which Indonesian entrepreneurs are able to exploit the economic opportunities that arise. Consequently, the Government needs to consider reshaping the regu- latory environment to one that permeates certainty and inspires confidence in foreign and domestic investors. This involves a major simplification, rather than only a streamlining, of the complex licensing system and of the customs procedures at ports; this implies that "fewer" controls rather than "better" controls should be the long-run goal. Given the magnitude and the complexity of the task at hand, it is suggested that a Deregulation Commis- sion be established to disentangle the existing procedures for issuing licenses and to undertake a long-range reform of the Investment Priority List system for allocating licenses. Other major long-run tasks that need to be addressed by the Government relate to the tax regulations and the legal infrastructure. The positive impact of these changes is not likely to be great without simultaneous policy changes in the foreign trade sector. A major focus of the Government should, therefore, be on the long-run goal of creating a more open international trading environment. This implies a transition from the current import-substitution strategy towards eventually a neutral trade policy that gives approximately equal incentives to Indonesian manufacturers to produce for the domestic and foreign markets, and one that is based on the principle of comparative advantage as a criterion of efficient industrialization. This involves setting clearly specified time targets for replacing the existing import quotas by tariffs, reducing the variance in effective protection rates and eventually reducing the home market bias by lowering and equalizing tariffs on import substitutes with export incentives. Optimal export taxes, however, will be necessary for products, such as timber, in which Indonesia has a monopoly or quasi-monopoly power. As in many developing countries, the provision of credit in Indonesia constrains industrial development. The financial policy framework, therefore, also needs to evolve, in a phased manner, to ensure a smooth transition from an allocation system which is administratively determined to a price determined one. This implies that inflation control should not be undertaken through exclusive reliance on credit ceilings, but rather through the budget, the reserve ratio requirement, and rediscount (xii) rates. This will permit a more effective use of interest rates in allocating financial resources. Institutional reforms are also essential to expedite the process of financial intermediation; but administrative reforms alone, without a change in the financial policy environment will have only limited, short-run benefits. The above reforms should aid in eliminating many of the distortions in the manufacturing sector and, thus, stimulate domestic as well as foreign investment. But specific actions regarding foreign investment also need to be considered. They include, over the long run, obtaining an agreement within the ASEAN region to moderate and create more uniformity in incentives for foreign investment, relaxation on the restrictions on new investments and on the use of foreign workers, and a reconsideration, by the Government, of current ownership regulations that appear to be ineffective in permitting Indonesians to exercise control or in developing local entrepreneurship, but, instead, deter new foreign investments away from Indonesia. The Government can also undertake joint efforts with foreign firms to develop educational and training programs to enhance the quality of labor and to facilitate the transfer of technology. To support the weaker economic groups, the Government can provide cheap credit financed through direct subsidies to all banks rather than through the rediscount mechanism. This will require an annual allocation of a fixed quantum amount in the budget for the weaker economic group. Moreover, the KIK/KMKP credits targetted to the small entrepreneurs should also be continued. But all banks, state and private, should be encouraged to provide these credits by assuring them adequate margins through the budget subsidy. More effective support for economically disadvantaged firms may be provided by coordinating credit schemes with other programs such as the development of mini-industrial estates and industrial extension services that provide technical nonfinancial support. The Government may also consider a tax incentive scheme designed to encourage private firms to employ and provide training to the weaker economic group. A graduated tax incentive system could also be devised to eincourage private firms to increase their share of indigenous management and ownership. In addition, the state banks, in concert with Regional Development Banks, should be strengthened and encouraged to provide institutional equity funds to be treated as surrogate indigenous capital with the intention that these shares could be later sold to individual indigenous Indonesian investors. Additional policies that the Government may also undertake to promote economically weak firms include the establishment of special training facilities and business schools throughout Indonesia. All these reforms are discussed in much greater detail in Chapters 7 and 8 of the main report; Chapter 7 discusses the general framework and directions for a long-term industrial strategy in Indonesia, while Chapter 8 presents an agenda for specific and detailed policy adjustments and sequencing covering a ten-year period. These proposal for reform are made in the spirit that they present an alternative approach to attain the objectives of the Government of increasing growth and improving equity at a lower social cost than those incurred by current policies. 1. INTRODUCTION 1.01 Indonesia has recently entered the period of its Third Five-Year Plan, Repelita III (1979/80-1983/84). A key question currently facing Indonesian policy makers relates to the type of industrialization strategy that should be formulated in the medium and the long term./l This is an important issue since industrialization has barely begun in-Indonesia, parti- cularly when compared to the other countries in the region and in South Asia. 1.02 Since 1970, Indonesia has experienced a relatively high growth of the manufacturing sector of 12.4% p.a. (1970-78); this is higher than that of the rest of the economy which grew at 7.8% p.a. over the same period./2 Nevertheless, the underlying base of the manufacturing sector is still very small. Currently, this sector is characterized by a trade policy biased towards the domestic market, a substantial involvement of the Government in large capital-intensive projects, relatively low efficiency and productivity of state enterprises, a private sector that is regulated and controlled and, thus, constrained from rapid expansion, excess production capacity in many sectors, and a geographical concentration of firms (and manufacturing employment) in Java, particularly in Jakarta. Furthermore, since 1974, there has been increasing concern on part of the Government to involve the weaker economic group in the development of this sector. Consequently, state intervention in the production process, in the credit market and in the direction of private domestic and foreign capital have been the major instruments used to foster both the growth of the industrial sector and of the indigenous Indonesian enterpreneurial class. These issues, therefore, suggest the need to search for an industrialization strategy designed to enlarge the existing manufacturing base by laying the foundation for efficient industrial growth and to further the objectives of the Government to promote growth with improved equity (para. 2.26)./3 1.03 The importance of developing an industrial base in Indonesia cannot be based on arguments of static efficiency; the oil sector, which is clearly dominant is, in the short-run, the most profitable. However, Indonesia cannot depend on oil forever, and the expansion of an efficient industrial sector, based on the principle of comparative advantage, can lead to /1 In this report, unless where explicitly noted, "industry" will refer to the manufacturing sector and will exclude oil and other extractive sectors /2 See The World Development Report, 1980, the World Bank, August 1980. /3 These issues were identified in Indonesia: Growth Patterns, Social Progress and Development Prospects. The World Bank, Report No. 2083-IND, February 20, 1978. long-run benefits, and provide productive employment and increased income- earning opportunities. This structural transformation of the economy needs to be achieved as it is essential to the process of industrialization. The central feature of industrialization in most economies, is a decline in the share of value-added in primary production (agriculture and mining) and an increase in the share of industry (defined as manufacturing and construction); research in this field has shown that, in most countries, as incomes rise, the industry share tapers off at about 35% of GDP and then declines; subsequently services become more important. This process is simultaneously accompanied by a shift of labor out of primary production into industry and services./l The beginnings of such a structural transformation are already evident in Indonesia. 1.04 Indonesia is also one of the few countries that is relatively well-endowed with both natural resources and cheap labor. This implies that Indonesia should not focus exclusively on a labor-intensive industrialization strategy. Efficient industrialization requires a judicious mix of both capital- and labor-intensive industries. The need for accelerated indus- trialization, therefore, suggests a careful selection, on the part of the Government, of the instruments of economic policy to formulate an appropriate trade stragegy and to encourage industrial development. 1.05 In this report, it has not been possible to cover every issue because the problems of industrial development are far too complex to permit a careful analysis and treatment in one single attempt. However, those problems not discussed here will be addressed and analyzed in forthcoming special studies and reports. The focus of this report will be specifically on policies designed to foster industrial growth in the private sector; the issue dealing with public sector investment planning and decision-making is not addressed. Where appropriate, however, the report will discuss issues relating to the Government's investments in the large-scale, capital- intensive sectors. Issues specific to the small-scale industries have already been dealt with in a previous report;/2 this sector will only be discussed insofar as it is affected by the general industrial policy climate. Environmental issues are addressed only in the context of the regulatory and control system. Clearly, such issues are important, but their in-depth treatment has not been possible partly due to the mission's lack of expertise in this area. 1.06 While this report briefly reviews the performance of the industrial sector over the last 15 years and notes that impressive progress has been made, its basic focus remains on developing a forward-looking strategy for long-term industrial growth. Such an approach necessarily centers on a discussion of policy problems and constraints facing the sector today. /1 See H.B. Chenery and M. Syrquin (1975). Patterns of Development, 1950- 1970, Oxford University Press, New York. /2 Indonesia: Cottage and Small Industry in the National Economy, Report No. 2490-IND, The World Bank, November 9, 1979. Inevitably, this type of a discussion will be viewed by some readers as focusing too muclh on the difficulties facing the sector and not being fully appreciative of the complex choices confronting the policy-makers involved. Recognizing this, it is necessary to re-emphasize that major strides have indeed been made in the industrial sector. However, at the same time, it is important to note that the critical challenge now facing policy-makers is to develop an appropriate policy environment to deal with existing constraints and thereby provide the basis for a dramatic expansion in the role and size of the industrial sector. The analysis presented in this report is based on specific empirical findings; its focus is on the medium- and long-runl policy goals. Concern with immediate problems and short-run solutions is necessary, but it is not sufficient. The policy prescriptions, however, will provide, where possible, the specific short-run steps that will facilitate the transition process to achieve the medium- and long-run objectives. The specific recommendations made are designed to improve the overall investment climate; they are, therefore, not commodity-specific. The analysis and the resulting recommendations reflect our current knowledge and understanding of economic processes. Consequently, the recommendations made include numerous practical suggestions for improvements within the existing policy framework. 1.07 This report is divided into eight c'hapters. Chapter 2 summarizes the pattern of recent industrial development. It provides basic information on the structure of the manufacturing sector, including employment, value added, geographical distribution and exports, and reviews the Government's plans and recent policies. This is followed, in Chapter 3, by an analysis of the existing incentive system and its implications for labor-intensive industries and manufactured exports. This chapter also discusses the impact on the manufacturing sector of the recent devaluation (November 15, 1978) and of the economic policies that were either instituted simultaneously or shortly thereafter. A discussion of the regulatory environment as it affects the investment decisions of the private sector is presented in Chapter 4. Chapter 5 analyses the Government's financial policies and their implication for industrial growtlh, while Chapter 6 highlights the role of foreign investment in the manufacturing sector. Chapters 3 to 6, therefore, provide an analysis of recent important Government actions that have influenced industrial growth in Indonesia. The relevant policy implications are dis- cussed in the final two chapters. Chapter 7 presents a framework which forms the basis of and provides a general direction for a long-term industrial strategy in Indonesia, while Chapter 8 discusses an agenda for specific policy reforms, covering a ten-year period, designed to achieve the long-range goals. Moreover, most of the specific recommendations made in Chapter 8 can be accepted or rejected without requiring fundamental decisions on policy direction. The detailed, technical analyses are excluded from the main body of this report, but are presented in self-contained annexes for those wishing to delve deeper into the issues discussed in the main report. - 4 - 2. THE PATTERN OF INDUSTRIAL. DEVELOPMENT Introduction 2.01 The focus of this report is on economic policies designed to foster industrial growth and to transform the current structure of employ- ment and production in the industrial sector. To place this analysis into proper perspective, this chapter provides an overview of the structural transformation, the current status and the characteristics of the Indonesian industrial sector. It also briefly reviews the evolution of industrial policy objectives and the plans of the Government. An Overview 2.02 Indonesia is currently in the early stages of a structural transformation as shown by the share of industrial production in the economy; this is an imnportant indicator of the tranformation process (Table 2.1). Despite the high growth rate of manufacturing of 12.4% p.a., over the period 1970-78, the share of manufacturing in GDP (in 1978) at 9%, in nominal terms, is below that of the mean value of all low-income countries (13%), and considerably less than that of the middle-income (25%) and industrialized countries (27%)./1 This is indicative of the small base of the manufacturing sector in Indonesia. 2.03 Furthermore, compared to most other Asian nations, industry is considerably less important in Indonesia. For example, in 1978, the share of manufacturing in GDP in Malaysia was 17%; in Philippines 25%; in Thailand 18%; in India 17%; in Pakistan 16%; and in Sri Lanka it was 23%. An indicator of the absolute size of this sector is given by value-added in manufacturing. In Indonesia, this amounted to $1.67 billion in 1978 compared to $8.97 billion in India, $3.93 billion in the Republic of Korea and $2.33 billion in the Philippines. The population of a country such as India, however, may distort these figures. But adjustments for population show that in per capita terms, value-added in manufacturing in Indonesia is one of the lowest in Asia at $12.4. Figures 2.1 and 2.2 present a graphical comparison of selected countries./2 /1 In the World Development Report, 1980, Indonesia, with a per capital GNOMINAL PRICES DEFLATED BY THE UNIT VALUE INDEX OF MACHINERY EXPORTS FROM DEVELOPED TO DEVELOPING COUNTRIES SOURCE:ANNEX 5, TABLE S - 84 - Excluding the Asahan hydroelectric aluminum smelter project which accounted for $1 billion of approvals in 1975 - increasing to $1.7 billion in 1977 - firms that obtained approval in the 1975-79 period accounted for only about 16% of the total investment approved ($5.6 billion) in the entire post-1967 period. Thus, almost 84% of all investments approved from 1967 to 1979, were approved in the pre-1974 period. 6.08 It is also important to note that the size of one single project, the Asahan smelter, distorts the investment data significantly. This project alone accounts for 23% of total approvals (1967-79); the exclusion of this project shows that total approved investments dropped from about $4 billion in 1970-74 to less than $0.9 billion in 1975-79. Furthermore, this decline in approvals is evident for new projects of all sizes (Table 6.2). The large (78%) decline in approvals in the post-1974 period provides some evidence of the closing of the Government's" open door" policies. 6.09 Another manifestation of these more restrictive policies is that in the post-1974 period, existing firms rather than new firms have been undertaking new investments. In the 1975-79 period, approvals for expansions of existing projects, excluding Asahan, exceeded those for new projects by 47% in real terms. On the other hand, in the 1970-74 period, investment approvals for new projects were almost five times greater than those for the expansion of existing ones. These figures are not surprising since it is the existing firms rather than the new ones that are best able to operate under the increasingly restrictive environment because they have already undertaken the fixed costs associated with the initial establishment of the firms. Moreover, taking the inflation of the 1970s into account, total investment approvals declined by 26% in the 1975-79 period compared to the 1970-74 period if Asahan is included, and by 61% if it is excluded (Table 6.2). Thus, there is strong evidence indicating that the policies initiated in the mid-1970s have had a significant negative impact on new private foreign investment in Indonesia./l The Impact of Recent Policy Initiatives 6.10 The mid-1970s divides the policy framework under the Soeharto Government into two distinct periods. As mentioned earlier, from 1967 to about 1974, "open door" policies were adopted towards foreign investment; these involved the provision of liberal regulations, favorable incentives and various guarantees. These policies were significantly qualified in the latter half of the 1970s which increasingly constrained the operations of foreign entrepreneurs. The most important of these included increased controls on investments by sector and location, the exclusion of foreign investments in certain sectors, required rapid increases in local participation in ownership, /1 There is some cursory evidence of recent increases in private investment. But while that in the late 1960s and early 1970s was primarily due to private foreign capital, the current increase appears to be due to domestic capital. - 85 - Table 6.2: FOREIGN INVESTMENT IMPLEMENTATIONS AND APPROVALS 1967-69 1970-74 1975-79 Foreign Investment Implementation ($ million) Market Price - 1,655 1,707 Constant price (Series A) /a - 1,332 978 Constant price (Series B) lb - 1,194 753 Foreign Investment Approvals ($ million) Total investment /c 752 (100%) 3,924 (100%) 875 (100%)/d Foreign equity 280 (37%) 949 (23%) 200 (23%)/d Indonesian equity 31 (11%) 505 (13%) 121 (14%)7d Foreign loans 278 (37%) 2,193 (56%) 551 (63%)/d Debt/equity ratio 0.77 1.51 1.71 Approvals by Size of Firm ($ million) Less than $10 million Number 97 410 124 Value 234 1,233 407 $10-$40 million Number 17 62 17 Value 311 919 304 More than $40 million Number 4 18 4 (3) /d Value 205 1,772 1,881 (164)/d All investments Number 118 379 145 (144)/d Value 752 3,924 2,592 (875)1d Approvals for Projects (constant 1970 $ million) Total approvals 396 2,177 1,605 (856)/d New projects 393 1,822 863 (345)/d Approvals for expansions of existing projects 3 449 738 (504)/d /a Deflated by the Price Index of Machinery and Equipment. /b Deflated by the Unit Value Index for Machinery Exports from Developed to Developing Countries. /d Figures in brackets exclude the Asahan hydroelectric aluminum complex. /c Total investment does not equal to Foreign and Indonesian Equity plus Foreign loans as some investments are financed from retained earnings and because of data omissions in some applications. Source: Annex 5, Tables 5, 7, 8, and 9. - 86 - more rapid promotion of Indonesians into managerial positions, prohibitions on foreign firms in engaging in distribution activities, and various credit restrictions placed on foreign firms./l 6.11 Since 1974, investment applications from foreign firms to the BKPM have been subject to the requirement that the initial Indonesian share be at least 20% to be increased to 51% within 10 years from the start of operations. It appears that this time period will not be applied to firms that obtained their investment licenses before February 1974. There is, however, some ambiguity about this policy. At present, the policy consists of statements made by political leaders, guidelines issued by the BKPM and Presidential Decrees which may be interpreted as statements of policy rather than binding legislation. Moreover, there is also some uncertainty about the coverage, timing and penalties for the violation of these guidelines. 6.12 In practice, foreign firms have interpreted this ruling to mean that the initial share of Indonesian equity needs to be from 10-20% at the start of the project and increasing to 30-60% at the end of ten years; but the "start" of a project has varied from one project to another. In some cases, the BKPM had stipulated that the ten-year period should start from the moment it has approved the investment application, while in other cases, from the moment the capital goods have cleared customs, and still in others, from the moment commercial production has started. Furthermore, foreign firms remain unclear as to whether this regulation applies to the total amount of foreign equity or only to the expansion of an existing project. This policy has also added to the risks associated with plantation investments in agro-industrial projects where the first year of positive cash flow takes place usually between six and ten years from the start of the project. This policy has, therefore, deterred new investments in these areas. 6.13 Presumably, these ambiguities will be clarified in the future through actual practice or new legislation. For the moment, the Government has approached its objective in a flexible manner through negotiation or encouragement rather than forced compliance. One approach used by the Government to increase Indonesian equity in foreign firms is to provide extremely attractive incentives in terms of reduced taxation through lower rates, and special tax credits in the form of special depreciation allowances on revalued assets to foreign firms going public on the recently revitalized Jakarta stock exchange. In some cases, these incentives are so attractive /1 See Annex 5 for a detailed discussion of the specifics associated with these policies. This annex also discusses the Government's policies towards the natural resource-based industries; these industries are not the focus of this report. Annex 3 discusses foreign investment controls through the DSP list in detail, and Annex 4 discusses the credit restrictions placed on foreign entrepreneurs. - 87 - that the present value of the tax savings can exceed the value of the equity transferred to the public./l 6.14 Another major area of restrictions results from increased control on new investment. Certain fields have been closed to foreign investment from the start of the "open door" policies; these fields include munitions manufactures, harbors, telecommunications and electric power. Subsequent decrees prohibited new investment or continued operations in specific activities such as the cessation of forestry concessions to foreign firms in 1974. In December 1977, restrictions were placed on foreign firms in the area of marketing and distribution; no new foreign investments were permited and existing foreign firms had to sell out their interests in these activities. Restrictions were also placed on various aspects of about 40 light industries such as paint, cigarettes, and tire manufacture. Eventually, these restrictions became sufficiently numerous to warrant a systematic procedure which was introduced in February 1978 with the publication of the first DSP List. As mentioned in Chapter 4, the recent 1980 DSP List demonstrates an increased desire to restrict foreign investment so as to favor domestic, and in particular, the economically weak firms. This trend towards increased controls on foreign investment also manifests itself in regulations on the use of foreign skilled labor and management. Schedules for phasing out the use of foreigners in particular categories of jobs have been introduced for the forestry sector and for the oil and gas sectors. It is widely believed by foreign investors that such restrictions will soon apply to other sectors of the economy. 6.15 These restrictions, however, are not costless to the Indonesian economy. For example, the restrictions on distribution and marketing have led to the creation of relatively high cost Indonesian distribution firms resulting in higher retail prices. Moreover, the absence of foreign distribution firms has prevented Indonesians from developing the required marketing skills which can best be obtained by on-the-job training under experienced management. Apart from the inflow of capital, equipment and engineering designs, foreign investment provides essential knowledge in the areas of logistics, financial control, specific designs tailored to customers' requirements, and before- and after-sales services; it is in these areas that domestic firms and entrepreneurs have difficulties and which result in low efficiency and productivity. 6.16 Ownership restrictions have also, on many occasions, been counter- productive. These restrictions can be, and have been, avoided by using local firms or individuals as fronts. Equity sharing restrictions have been satisfied by allowing local partners to purchase shares on the basis of a loan from the foreign partners; all shareholders' rights are held by the /1 See Annex 5, Chapter 5 for details. These incentives are also provided to domestic firms. - 88 - foreign partner until the indefinite term loan is repaid. Another mechanism is for the foreign partner to surrender equity, but to maintain full control via long-term management contracts. These policies frequently end up as a way of generating rents for local partners in return for their ability to satisfy ownership regulations; any impact on developing enterpreneurial abilities is, therefore, likely to be minimal. Consequently, enterprising Indonesians concentrate on developing their connections and maximizing their returns as front men rather than on investing and acquiring the business expertise required for efficient production and distribution of products. This tends to prolong the control of established foreign firms that are not faced with effective competition from new foreign investment. 6.17 Furthermore, foreign firms that are concerned about protecting production or management secrets are reluctant to invest in areas where their control of this knowledge is threatened by regulations which force loss of ownership with controlling shares to be transferred to local firms or individuals. Such restrictions have limited foreign investment in the very competitive export-oriented fields that are important for the Indonesian economy. This recognition has led to some discussion in the Government on the need to relax these restrictions for export-oriented firms. This may facilitate the establishment of such firms, but they are likely to face difficulties in exporting their products. As noted (Chapters 3 and 4) administrative problems are pervasive in the customs department. Conse- quently, heavy costs are imposed on foreign (and domestic) firms because raw materials, spare parts and exports can be tied up for weeks until complex clearance procedures requiring several signatures are worked out. Because of the associated invisible costs, many foreign firms have expressed a strong preference for using neighboring countries as their base for regional exports. 6.18 The restrictions placed on the operations of foreign firms and joint ventures in the domestic market for investment credit (para. 5.29) partly reflect a belief that the net returns to Indonesia increase significantly with the transfer of investment resources from abroad or are significantly reduced if such projects compete for domestic credit. An inflow of debt or equity capital to Indonesia, however, generally involves a commitment on part of foreign firms for a future transfer in the opposite direction. Moreover, there is little reason to believe that Indonesia would incur exceptional losses through transactions undertaken by foreign enterprises in the domestic financial markets. In countries with severe constraints on potential domestic savings, both financial and technological transfers may be required and, in many cases, can be expected to occur simultaneously. However, in a country such as Indonesia where the central problem is not the availability of resources, but its efficient use, there is little justification for imposing credit restrictions that inhibit the flow of foreign investment. Removal of these restrictions would also work to eliminate the transfer of investment resources abroad which are then, in effect, brought back through off-shore borrowing with increased costs of financial intermediation; as discussed in Chapter 5, this cyclical transfer of resources has restricted the development of domestic financial institutions. - 89 - 6.19 The perception of many foreign firms is that arbitrary decision-making and uncertainty with respect to taxation is also a serious obstacle to good business practices and has a significant detrimental effect on foreign investment. It is claimed by these firms that currently, there is a large backlog in tax collection; for instance tax liabilities settled in early 1980 by foreign firms were predominantly for the 1974-75 period. Tax assessments are reported to be frequently adjusted upwards, a problem felt to be especially common for joint ventures. These problems have, however, abated after the introduction of the March 1979 reforms and the situation appears to be improving significantly. There is, however, no effective way of having tax disputes settled through the court system - all appeals must be made through the tax collecting agencies. Rebates on prepayments for corporate income tax, collected through the MPO tax on various transactions, frequently exceed corporate tax obligations; these are often refunded with a four- or five-year delay. 6.20 The costs associated with the BKPM investment procedures have already been discussed in Chapter 5. Many new foreign investors, not familiar with the process, find the difficulties insurmountable and watch the development of more elaborate regulations with concern. Many foreign managers claimed that the BKPM does not function effectively as a promotion agency; they claim that, in fact, it has managed to stifle new investments. Thus, despite the very generous tax incentives offered to foreign firms to invest in Indonesia, it appears that the benefits of these incentives do not exceed the costs associated with the restrictions. Furthermore, there is little evidence that tax incentives have had a significant impact on the level of foreign investment. In many countries, investors have often chosen to bypass applying for these incentives where they have that option. For example, in Thailand, it is estimated that over two thirds of foreign investment is carried out without going through the Board of Investment which offers special incentives similar to the BKPM. This small impact of these incentives is due to the limited value of various tax breaks or holidays in the early years of operation, or because firms can take tax credits in source countries for tax payments in Indonesia, or because the various costs of obtaining incentives are high relative to the benefits provided. On the basis of extensive discussion with foreign investors in Indonesia, it appears that special incentive systems remain a relatively minor factor in their investment decisions. On the other hand, it is the numerous controls and restrictions placed on foreign investment, combined with the weakness in the tax system and in the legal and commercial infrastructure that have led to the observed decline in foreign investment since the mid-1970s (para. 6.07), and to the expansion of existing firms rather than of new foreign firms in Indonesia (para. 6.09). Measures for stimulating new foreign investment in the man- ufacturing sector are discussed in Chapters 7 and 8. - 90 - 7. A FRAMEWORK FOR LONG-TERM INDUSTRIAL DEVELOPMENT Introduction 7.01 The previous chapters provided an analysis of various policy measures that the Government has adopted to encourage industrialization and influence the pattern of industrial investment. These measures, although often uncoordinated, have, in the recent past, focused around a philosophy of state intervention and around a trade strategy that has emphasized import- substitution over export promotion. As noted in Chapter 3, any benefits that were to be achieved in the early phase of such a trade strategy appear to have peaked and, given the increasing economic costs of such a strategy, its continuation is only likely to slow down industrial expansion and employment creation. 7.02 To ensure rapid, efficient industrial growth and increased employment and income earning opportunities which will contribute to the Government's objective of achieving equity, the Government may wish to consider the adoption of a strategy that would create an economic climate in which Indonesian entrepreneurs are able to exploit the investment opportunities that arise. Clearly, the Government has limited administrative resources. To the extent that it undertakes natural-resource based capital-intensive projects, it is important that they be selected and implemented carefully. But Indonesia also has comparative advantage in labor-intensive industries that can best be undertaken by the private sector. The expansion of such industries will enhance employment, output, exports and contribute to equity. The appropriate long-term industrial strategy for Indonesia is, therefore, one based on capital-intensive (or "basic industry") projects as well as labor-intensive ones. This necessitates an appropriate policy environment which facilitates the expansion of the industrial sector. This, in turn, involves the establishment of a regulatory environment that permeates certainty and inspires confidence in foreign and domestic investors; the institution of financial reforms that lay the basis for a faster development of the financial intermediation process; and the formulation of a trade strategy that facilitates the transition from an import-substitution biased economy towards a more outward-looking one until, eventually, a neutral trade regime is established. Since these policies affect all investment decisions, they are interlinked. Thus, changes in one direction alone (i.e. licenses) without simultaneous movement along other fronts (e.g. protection) could set up unanticipated and even undesirable distortions. Political reality may, however, mandate sequential changes. An overall policy restructuring would not only ensure that the inefficient use of resources is minimized, but would also contribute to creating a dynamic and internationally competitive economy. The purpose of this chapter, therefore, is to provide the broad framework which forms the basis of, and provides the general - 91 - directions for long-term industrial development in Indonesia./I The specifics of the policy adjustments associated with such a strategy are discussed in the next chapter. These proposals for reform are made in the spirit that they present an alternative approach which would accomplish the Government's objectives of growth and equity at a lower economic and social cost to Indonesia. Improving the Investment Climate 7.03 A major long-run objective of the Government should be to provide an economic environment that permits a rapid industrial expansion in line with Indonesia's actual and medium-term comparative advantage. Using comparative advantage as a criterion of efficiency will not only ensure that costly industrial efforts will be minimized, but that efficient resource allocation will also take place. Since Indonesia is relatively well-endowed with natural resources and with unskilled and low-skilled labor, it is important to change the focus of trade and industrial policies from the present directly inter- ventionist and protectionist policies to ones that are more promotional. This implies that although there would still be assistance to industry, industrial growth would be encouraged through indirect intervention which deflects the pull of market forces in the interest of public policy. The resulting structure of the industrial sector that will emerge will involve a mix of capital-intensive sectors based on Indonesia's natural resource endowments and in which the Government, at least in the short- and medium-term, will be involved (such as petrochemical, fertilizer and LNG projects) and labor-intensive sectors based on Indonesia's cheap labor (such as wood-processing, sawmilling, and certain classes of textile products) in which the private sector would be the primary moving force. 7.04 The Government, therefore, needs to emphasize the creation of an overall economic climate that is relatively stable and free from uncertainty and from the numerous existing impediments to industrial development and employment creation. Indonesia's remarkably free exchange regime is an excellent example of the general direction in which the Government could move in order to create a stable economic climate. This regime, on the one hand, and the restrictive regulatory environment for other economic trans- actions on the other, stand in sharp contrast to one another. An open econo- mic climate is probably more important in encouraging healthy industrializa- tion than any single policy tool on its own; minor policy adjustments will have only limited value if the overall climate is restrictive. But it must also be recognized that the process of achieving such an environment will be a slow one; it may take many years to accomplish the desired change. This implies that the transition process in the areas of regulatory, trade, finance and foreign investment policies must take place gradually. Such an /1 For the purposes of this report, the medium-term will be defined to mean five to ten years and the long-term as any time period exceeding ten years. - 92 - approach will preclude undesirable shocks to the existing industrial structure which, in the short-run, must be taken as given. But over time, under the influence of appropriate policies, the structure will slowly evolve towards one that will contribute to the development of industrial growth of both capital- and labor-intensive industries and to increased income earning opportunities, employment and thus to the Government's objectives of growth and equity. Reshaping the Regulatory Environment 7.05 Clearly, the most important change that would contribute to an improvement in the economic environment would be a sweeping overhaul and simplification of the complex licensing and regulatory system and of the customs procedures at the ports. This is not to imply that "better" controls need to be devised, but that "fewer" controls should be the long-run goal. As shown in Chapter 4, direct controls are not a deus ex machina which eliminate the allocative consequences of market failure and attain the objectives of the Government. The importance of deregulation, therefore, cannot be over- estimated since the economic costs of the present system far exceed the benefits. As a general rule, Indonesia would be best served by using broad tools that achieve limited goals, rather than detailed tools which are essentially ineffective in achieving ambitious objectives. This emphasizes the need for clearly enunciated and effectively enforced regulations that will lower uncertainty and inspire investor confidence. Similarly, the use of licenses to achieve noneconomic objectives requires a careful consideration of their economic costs and anticipated benefits. 7.06 This suggests an eventual three-way classification of the industrial sector for investment licenses: (a) a group considered to be of "high prior- ity" by the Government; (b) a "main" group; and (c) a cottage and small-scale industry group. The first group would consist of domestic firms involved in specified large-scale, capital-intensive industries such as cement, steel, petrochemicals and fertilizers which are subject to large economies of scale and long gestation lags and which, for economic reasons or otherwise, the Government would wish to supervise closely. This group could be subject to investment licenses, but the criteria for allocating these licenses should be clearly specified and be based on a careful cost-benefit analysis which determines the project's optimal scale, location, timing and choice of technology. Moreover, there appear to be no economic reasons for the BKPM to provide special tax or investment incentives to this group over and above those received by manufacturers in other subsectors. 7.07 The second group would consist of all firms currently classified under the BRO legislation as well as domestic firms currently registered with the BKPM. These firms would no longer be subject to investment licenses. Furthermore, the fiscal incentives provided by the BKPM to this group should not vary between industries, but should be uniform depending on the degree of - 93 - assistance that is to be judged appropriate for the entire manufacturing sector in the medium-run. Thus, the sector and firm-specific tax and invest- ment incentives currently offered by the BKPM should be replaced by general concessions available to all investors. In the long-run, these fiscal incentives should also be eliminated. These firms would then be subject only to annual registration with the local Department of Industry and be required to provide the information that is in the public interest. The cottage and small-scale industries, in the third group, currently face only registration requirements which are largely voluntary and widely ignored. No special changes, in the medium- or the long-run, are recommended for this group. They would, however, be affected by the general recommendations made below. 7.08 In the long-run, unless there are very strong economic justifica- tions for not doing so, the above distinction between these groups for investment licensing purposes should be eliminated. Investors would then be subject to annual registration licenses only; these would be issued automatically and would obligate the investor to provide information that would be useful to the public such as location, production, employment and planned expansion. 7.09 To facilitate officials seeking industry information and investors planning new investments and seeking market information, the basic information to be provided by all firms should be kept in an open public register. This should be maintained at the national, provincial and regency levels throughout Indonesia. 7.10 The general principle underlying the other licenses in Indonesia should, over the long-run, be changed to rely on the enforcement of current or new legislation with strong punitive measures, rather than the existing detailed licensing procedures which are extremely costly and largely ineffective. This involves a major policy change and an acceptance of a new approach to the problems of licenses such as the Domestic Purchasing License and the Labor Safety License. It is, however, important to note that, in general, the passage of new legislation or regulations is not a costless act. Consequently, the expected benefits and costs of such legislation must be carefully evaluated. For some other licenses, such as those required for transport, communication, internal and external trade, no legal mechanisms are necessary; these licenses only raise the social costs of production and should be eliminated. 7.11 Two major long-range tasks that also need to be given high priority by the Government are the reform of the tax regulations and the legal infrastructure. The Corporate Law system based on an Act introduced in 1847 requires considerable revision on several issues such as the limited liability of owners, issuance of shares and voting rights. The legal system which supports industrial policy also needs improving; some laws and regulations overlap, whereas there are inconsistencies between others. The ambiguities associated with the entire taxation process also needs substantial clarification. - 94 - Restructuring Trade Policy 7.12 The positive impact of changes in the regulatory environment is likely to be diminished without simultaneous policy changes in the foreign trade sector. A major focus of the Government should, therefore, be on the long-term goal of creating a more open international economic environment and on a more decentralized approach to industrial development. To this end, the current trade policy which focuses on high protection rates and import- substitution should give way to one that emphasizes lower protection and exports. As mentioned in Chapter 3, the exportable manufacturing sectors in Indonesia are much more labor-intensive and substantially less capital- and skill-intensive than the import-competing sectors. Thus, the employment costs to Indonesia of following an import-substituting, capital-intensive strategy are severe, and it is unlikely that the present strategy will attain the objectives of Repelita III and create many new jobs. The recent review of the Government to reduce nominal protection on final and intermediate goods and raw materials are steps in the correct direction. However, depending upon the proportions by which nominal tariffs are lowered on the various stages of production, an improper adjustment of the tariffs on intermediate goods and raw materials may have the unintentional effect of increasing effective protection on the final stages of production for some goods. 7.13 A related consideration is that the present domestic market in Indonesia is small in terms of purchasing power and is further restricted by the current high costs of manufacturing. The domestic market alone is unlikely in the near future to be able to support a high growth rate in the manufacturing sector. Indonesia must, therefore, become more outward-looking than it is at present. This, however, does not imply that the domestic market is not a source for industrial growth; it is, but it will require time to develop. Moreover, in addition to the need for policies of rural industrialization, policies in other sectors, such as agriculture, transport and related infrastructure, are essential to increase the agricultural surplus and the purchasing power of the domestic market and to facilitate the domestic and international distribution of goods. 7.14 The suggested change in the orientation of trade policy, however, does not imply an export-biased policy. The ideal, long-run policy would be one that is neutral to the domestic and foreign markets and one that is based on the principle of comparative advantage as a criterion of efficient industrialization. But given the existing bias towards the domestic market, a more outward-looking trade policy is now required. In addition, the benefits accruing to developing countries from exports are also significant - 95 - and have been well-documented./l The introduction of the export certificate scheme in 1978 has gone a long-way towards contributing to a more outward-looking economy. The desire of the Government to increase the coverage of goods eligible for export rebates will contribute even further to reducing the current trade policy bias. Moreover, such changes in policy will result in the establishment of efficient import-substituting industries that will also be able to compete with imports in the domestic market as the domestic demand increases over time. But it is important to emphasize that efficient import-substitution does not necessitate an import-substitution biased trade policy. In fact, the long-term neutral trade policy suggested above will not only exploit Indonesia's comparative advantage and boost exports, but will also establish efficient import- substituting industries. 7.15 Economies that have successfully transformed their import- substitution biased policies towards more neutral policy regimes include Korea, Singapore and Taiwan. The resulting change in export performance has been quite significant. In Korea, the share of exports in manufacturing output rose from 14% in 1966 to 41% in 1973. Over the same period, in Singapore, where the level of protection was lower, the share rose from 20% to 43% and, in Taiwan, from 19% to 50%. Because of their policies, these economies have also been able to withstand the shocks generated by the international trading environment of the 1970s (para. 7.20). On the other hand, India, Chile, Turkey and the Philippines are examples of countries that have pursued import-substitution biased policies for very long periods. All have used import restrictions at various times and all have had poor export growth. For example, India's share of exports in manufactured output fell from 9.4% in 1966 to 8.6% in 1973, many of India's import-substituting industries are economically inefficient, and the continued discrimination against primary exports by Chile and India also resulted in their relatively slow expansion./2 7.16 As shown in Chapter 3, Indonesia has potential comparative advantage in many labor-intensive sectors such as textiles and wood products. The country currently appears to be in a position to progress along the "scale" of comparative advantage to replace the exports of other countries, such as Korea and Taiwan as they move to "higher level" (more capital- and skill-intensive) /1 Increased export incentives will ease excess capacity currently preva- lent in many industries and partly generated by the import-substitution strategy; they will also reduce the need to hold excess inventories, eliminate critical bottlenecks, provide learning opportunities and aid in attaining high quality standards. See, for example, A.O. Krueger (1978) Liberalization Attempts and Consequences. National Bureau of Economic Research, New York; and B. Balassa (1978) "Exports and Economic Growth: Further Evidence." Journal of Development Economics, 5:181-189. /2 For details, see B. Balassa et al (forthcoming). Development Strategies in Semi-industrial Countries. The World Bank, Washington, D.C. - 96 - exports./1 But a caveat is necessary here. In many industries, labor productivity and capacity utilization still appear to be low. In addition, there is a shortage of skilled managers, engineers and technicians. These factors, therefore, may negate Indonesia's presumptive comparative advantage in some of these industries. 7.17 Nevertheless, the promotion of labor-intensive, manufactured export is explicitly endorsed in Repelita III. To that end, the Government should capitalize on the recent devaluation; such a devaluation, in many countries, has usually been the first step in the transition to a more outward-looking trade orientation and also in letting the official price of foreign exchange take an increasing role in the domestic allocation of resources. This devaluation can, therefore, be used to start the reform process in the foreign trade sector. The general principles involved would include setting clearly specified time targets for replacing the existing import quotas by tariffs, reducing the variance in effective protection rates, and eventually reducing the home market bias by lowering and thus equalizing tariffs on import- substitutes with any export incentives./2 In Indonesia's case, optimal export taxes will also be necessary for products, such as timber, in which Indonesia has quasi-monopoly power. Experience has, however, shown that there is no single "correct" sequencing of these steps./3 Some of these steps are currently being contemplated or have been undertaken by the Government. For example, some import quotas have been replaced by tariffs, while other quotas are under review, and, as mentioned before, the current plans to lower nominal tariffs may also have the effect of lowering the average rate of effective protection for the manufacturing sector. Moreover, the export certificate scheme has also contributed to reducing the import-substitution bias. 7.18 There will, of course, be some adjustment costs associated with this transition process, but these costs should not be used as a justification to postpone the transition; it would merely become more difficult and the adjustment costs would be even greater, the more prolonged and entrenched are the protectionist policies. Thus, the transition towards a more open trading environment must begin as soon as possible in Indonesia; once exporting firms face price and quality competition in the world markets, it is less likely that inefficiency will persist in the long-run. But, to minimize the adjustment costs, a gradualist approach to policy restructuring should be undertaken. The presence of various vested interests may also mandate initial changes only at the margin. It may, therefore be prudent to first increase /1 See B. Balassa (1979). A "Stages" Approach to Comparative Advantage" in Economic Growth and Resources, Proceedings of the 5th World Congress of the International Economic Association, September 1977, London, Macmillan. /2 The specifics associated with these principles are discussed in detail in Chapter 8. /3 The experience of many failed and successful attempts at transition towards a neutral trade strategy has been documented in Krueger (1978), op. cit. - 97 - exports, a policy that the Government has already undertaken, and then to liberalize imports. This implies not only providing the appropriate price incentives to exporters, but also eliminating other impediments to exports such as the administrative bottlenecks created by the various export documents required, the check-price system and quantitative export restrictions, and those created by internal and external transportation, interisland shipping and the loading procedures at ports. 7.19 Policies to expand exports are also strongly related to domestic and world inflation rates. Export incentives can evaporate if the domestic rate significantly exceeds the international rate. As shown in Chapter 3, there are some indications that domestic inflation has partially eroded the recent devaluation. Given that the objective of the 1978 devaluation was to provide increased incentives to exporters, to maintain the real value of these incen- tives and to prevent their deterioration due to inflation, the Government may wish to consider two alternative approaches. The first approach to compensate for changes in the relative inflation rates would be to consider a crawling or trotting peg exchange rate system. Under such a system there would be small but frequent changes in the exchange rate during inflationary periods. This would ensure the stability of the real exchange rate which has been shown to be more important than the level of this rate for expanding exports. Thus, the real incentives to exporters afforded by the exchange rate would not change due to domestic inflation. Delayed and sporadic devaluations under inflationary conditions would hamper the expansion of manufactured exports as they have in some other countries such as Argentina, Colombia and Pakistan. This appears to be a major lesson that emerges from both successful and unsuccessful attempts at liberalization. For example, the crawling peg system instituted in Brazil and Colombia led to much higher and stable exports and thus GNP growth. This system is, therefore, by far preferable to the large and infrequent parity changes that have so far characterized exchange rate policy in Indonesia. The second approach to maintain real incentives to exporters would be to index the export rebates provided to exporters. This may be a preferred, short-run solution and is discussed in para. 8.20 within the context of sequencing changes in overall trade policy. 7.20 Furthermore, despite recent actions by the Common Market,/1 the fears that a successful transition to a neutral trade regime will not generate the expected benefits because of a deteriorating external environment should not deter a move towards such a trade regime. Clearly, increased international protection is undesirable from Indonesia's point of view and retaliation in the form of cancelling or not awarding major contracts to firms from quota-imposing countries is a very real possibility. But apart from such actions, the relevant question for Indonesia is: what is the /1 The EEC recently imposed quotas on textile exports from Indonesia to the UK market for 1980: trousers and slacks (315,000 pieces); blouses (225,000 pieces); and shirts (171,000 pieces). However, on the day these quotas were imposed, the British Government, in a parliamentary report, reaffirmed its belief in an open international trading environment; hope- fully, the quotas, therefore, may be only temporary. - 98 - appropriate trade strategy from Indonesia's own self interest and point of view? The answer still remains that, in the long-run, a neutral trade strategy would best serve Indonesia's interests. Reverting to a more inward-looking import-substitution biased policy will not solve the problem of international protectionism nor will it serve the Indonesian industrial sector. On the other hand, a neutral policy will lead to increased production and exports of capital- and labor-intensive goods. Developed country protectionist policies may reduce that country's demand for some Indonesian labor-intensive products, but this may be compensated for by aggressive marketing policies in nonquota imposing developed countries and other developing countries. Therefore, as undesirable as international protectionism may be, there is little that Indonesia can do to affect the policies of developed countries and, thus, the search for solutions must remain in Indonesia developing a trade strategy such as the one suggested above in order to minimize the costs imposed by developed country trade policies. 7.21 Furthermore, despite the recent world recession and international protectionist sentiments, total world trade in labor-intensive manufactures has continued to expand. During the 1980s, manufactured exports from developing countries are expected to grow at 9% to 10% a year compared to a 3% to 4% annual growth rate for fuels and other primary products./l Admittedly, this growth in manufactured exports is less than that experienced by developing countries in 1979; it is, nevertheless, much larger than that anticipated for fuels and other primary products in the 1980s. Consequently, Indonesia should attempt to obtain as large a share of this growing market as it posssibly can. Moreover, countries such as Brazil, Mexico, Japan and most recently Singapore, have continued to progress along the scale of comparative advantage as their exports have become more capital- and skill-intensive, making room for countries producing labor-intensive products. For example, through the late 1960s and early 1970s, Japan's declining share of labor-intensive products in the world markets was fully accommodated by the quantum increase in the share of Hong Kong, Korea, Taiwan and Singapore/2; these countries maintained rapid export growth in the 1970s despite setba-1Ts in the world trade situation. 7.22 Now, with rapidly rising labor costs, the structural trans- formation of these countries away from labor-intensive manufactures enhances the propects of Indonesia to emerge as the successor. The recent rapid growth of Indonesian labor-intensive exports in textiles, electronics and wood-products, discussed in Chapter 3, should be the precursor of strong export growth in other industries as well, provided appropriate policies are followed. A related benefit of these policies, as mentioned earlier, will also be an efficient allocation of resources which will lead to a more dynamic /1 World Development Report, 1980. /2 See H. W. Arndt and Ross Garnaut (1979), "ASEAN and the Industrializa- tion East Asia," Journal of Common Market Studies, vol. XVII, No. 3. - 99 - and flexible industrial sector, which is essential in a world of uncertain and rapidly changing trading environments. Such a flexible sector will not only permit rapid redirection of exports away from the quota-imposing countries towards those with more open trade policies, but it will also encourage the growth of efficient import-substituting industries that are essential for industrial growth. If, however, Indonesia maintains the current bias towards import-substitution policies which have, in the past, encouraged the growth of some inefficient industries, then the prophecy of poor manufactured exports will become a self-fulfilling one and the manufacturing sector will be ill-prepared to cope with the uncertainties of international trade. Financial Policy Reforms 7.23 As discussed in Chapter 5, the provision of credit in Indonesia has constrained industrial development. The shortage of long-term borrowing instruments, the nonallocative role of interest rates and the ineffectiveness of the financial intermediation process have greatly restricted the avail- ability of credit to the private sector. The financial policy framework, therefore, needs to evolve into one that can be adapted to the needs of the 1980s. In many ways, the long-run reforms suggested are similar to the policies undertaken by the Government prior to 1974. The changing environ- ment suggests the importance of controlling inflation and managing liquidity, not through the current exclusive reliance on credit ceilings except under conditions of emergency, but through the domestic expenditure budget - which, in the recent past, has been the most important source of inflation - and appropriate interest rate policies. 7.24 This, in turn would permit more effective use of interest rates in the allocation of financial resources in determining an appropriate choice of technology in the manufacturing sector and in containing liquidity growth. The use of sectoral ceilings to allocate credit should, therefore, be abandoned; their perpetuation will only introduce uncertainties and raise administrative costs. The key problem in Indonesia today is not the overall adequacy of resources, but the allocation of resources. Any reform in the interest rate structure should reflect that fact. The existing fragmentation of the financial market means that borrowers who have access to credit from the state banks must pay one rate of interest, while those who must borrow from private banks or in the international market must pay much higher rates of interest. As noted before (para. 5.09), some private borrowers, particu- larly new firms and small firms, have no access to external funding, while at the same time, the public sector has a large surplus. Specifically, real /1 See H. W. Arndt and Ross Garnaut (1979), "ASEAN and the Industrializa- tion East Asia," Journal of Common Market Studies, vol. XVII, No. 3. - 100 - positive rates, which need not necessarily imply high nominal rates if inflation control is succesful, would reduce the fragmentation of the financial market and ease the existing supply constraints by encouraging greater real savings and investment. Given Indonesia's open access to international capital markets, the level of the lending rate would then be set by expectations of inflation and exchange rate changes. However, in so far as the weaker economic group is concerned, the Government should continue to provide credit at subsidized interest rates to this group until indigenous entrepreneurship develops to the desired level. 7.25 To support real positive deposit rates, the Government should also consider the re-establishment of the rediscount mechanism as a tool of monetary policy to control the reserve money base. With adequate rates of return to financial institutions, the current use of the rediscount window to subsidize these institutions can be abandoned. Furthermore, to reduce the intermediation costs and to improve the efficiency of state banks, the degree of competition faced by these institutions needs to be increased. Such a policy is essential if the desired expansion of services and financial intermediation is to be achieved. 7.26 As noted in Chapter 5, the use of financial policies to attain social objectives may have economic costs which are higher than anticipated; these policies have not only constrained industrial growth, but also have had only limited success in achieving their goals. A realignment of policies which explicitly uses budget subsidies rather than the rediscount window to provide subsidized credit, and emphasizes business education, on-the-job training, and employment creation in the manufacturing sector provides an attractive alternative to the current exclusive focus on regulations to develop the entrepreneurial talent of the weaker economic group (paras. 8.38 to 8.41). Nevertheless, the Government may choose to pay a high cost for objectives that transcend economic considerations; the social benefits of these policies - to the extent that they are effective - only the Government can evaluate. 7.27 Institutional reforms are also essential to expedite the process of financial intermediation. But without the long-range changes in the policy environment mentioned above, administrative reforms, such as training, recruitment and streamlining procedures, will have only limited, short-run benefits. A financial policy climate that encourages the growth of the banking sector is a sine qua non for industrial growth. Moreover, improvements in the legal framework for debt collection within Indonesia and across international boundaries, reduction in the variance in administrative interpretation of regulations related to debt intermediation, and improvements in accounting practices, company law and tax regulations will further enhance the evolution of an efficient financial sector. Policies Toward Private Foreign Investment 7.28 The potential for direct private foreign investment with significant benefits for the Indonesian economy is very high. The central problem for the Indonesian economy is to transform available resources into investments with - 101 - high rates of return. The most important element in achieving this objective is the need for entrepreneurial, technical, and managerial expertise. The major benefits of private direct foreign investment lie in its efficiency in the international transfer of such expertise relative to alternative processes based on licensing, consulting arrangements, or local research and develop- ment. Private foreign investment can also aid in attaining the Government's objective of creating indigenous Indonesian enterpreneurship, but the process would be more of a long-term nature rather than one that would confer immediate benefits. Private foreign investment can not only contribute to the broad objective of improving the economic position of such lower income groups through its impact on wage rates and skill development, but also to the narrow objective of developing commercial expertise and the economic power of specific indigenous groups; constant exposure to efficient and modern business techniques is one of the best training grounds for enterpreneurial skills. 7.29 Given the objective of the Government to attract foreign investment into Indonesia, the incentives for these firms to locate there, rather than in other Southeast Asian countries, must be provided. This implies that the general investment climate needs to be improved to overcome the reluctance of new foreign investors to make investments in Indonesia. Despite recent restrictions, foreign investors still believe that Indonesia with its large potential domestic market makes it an attractive place for long-term investment, but there is less unanimity as to whether it will remain so if current trends continue. 7.30 The intent of the reforms outlined earlier in this chapter is to eliminate the distortions in the economy so that a close correspondence can be achieved between private and social profitability. Many of the investment controls and restrictions placed on foreign firms are, in fact, responses to existing distortions. As these distortions are gradually eliminated, there will be little reason to favor or discriminate against specific sectors and foreign firms. Thus, these long-run reforms would also contribute significantly to improving the economic climate for and the social profitability of foreign investment. 7.31 Specifically, this implies that, over the long-run, existing invest- ment controls for foreign firms in the manufacturing sector can be relaxed. Licenses could be maintained for firms in the capital-intensive extractive sectors of the economy, but, in the long-run, foreign firms in other sectors should not be subject to investment controls; they should, however, be expected to register with the Ministry of Industry or the BKPM. As with domestic firms, detailed, sector-specific investment incentives should also be replaced by general incentives. The elimination of special incentives should be carried out in conjunction with the elimination of restrictions as these policies currently tend to work at crosspurposes. Once price distortions, such as tariff protection, that lead to net losses to the Indonesian economy are eliminated and if the previous suggestions for long-run reform are under- taken, then there is no compelling reason to either restrict or differentiate the incentives to any type of investment in the manufacturing sector. - 102 - 7.32 As part of a move towards eliminating or reducing the use of special incentives of the type administered by BKPM, the Government of Indonesia should propose an agreement within ASEAN aimed at both moderating and creating more uniformity in incentives systems for foreign investment. It is to be disadvantage of the ASEAN economies to bid up the cost of foreign investment to each other; this is one area of economic policy where mutual cooperation would be both feasible and beneficial. 7.33 Furthermore, as part of an overall policy reform, the restrictions on the use of foreign workers might be relaxed. Such a relaxation would be part of a process of achieving efficiency in production; this may lower returns to Indonesians in executive positions, but it is to the advantage of the Indonesian consumer and worker. A clear long-run policy of access to high level personnel from abroad, combined with a cooperative effort between the Government and firms to replace such workers would eliminate the high costs of uncertainty in the investment process. A few key personnel can make the difference between success or failure and any uncertainty created by Government restrictions on hiring practices of the firms will be reflected in a larger risk premium attached to the operation of foreign firms. 7.34 There is also little evidence to support economic arguments that current ownership regulations are effective in permitting Indonesians to excercise local control, to develop entrepreneurship or to increase Indonesia's share of profits. There is also little evidence demonstrating that foreign firms behave significantly different than domestic firms. In fact, there are grounds to believe that foreign firms operate closer to the legal norms with respect to tax payments and business operations in general than do domestic firms. Thus, ownership control policies that are currently generating considerable uncertainty must be carefully evaluated by the Government with clearly identified long-run economic and noneconomic objec- tives in mind. The Role of the Government 7.35 The primary focus of this report has been on analyzing the invest- ment climate for the private sector. No attempt has been made to analyze the issues relating to public sector industrial investment planning. Given the key role of the Government in the industrial sector, the remainder of this chapter briefly addresses this issue. The Government currently plays a dual role in the industrial sector. The first one involves the formulation of policies and incentives/disincentives to production and exports; the appropriate policies to be formulated by the Government over the long-run have already been discussed in the preceding sections and the specifics are outlined in the next chapter. The second is direct intervention in the pro- duction process through Government investments which have been predominantly, but not exclusively, in the capital-intensive sectors. 7.36 The reasons for such investments and for the resulting establish- ment of state enterprises are similar to those in other developing countries: there is believed to be a shortage of entrepreneurial and managerial talent - 103 - in the private sector; the capital market is not well developed, so private business firms find it difficult to raise sufficient funds for large projects; the private sector is too cautious and risk averse to undertake "appropriate" investments; the Government considers it essential to own and control the "commanding heights" or the "key sectors" of the economy so that prices and marketing channels can be directly administered for basic products in order to achieve equitable growth; and, as noted earlier, there is widespread concern that private sector involvement in important industries would streng- then the economic power of minority entrepreneurial groups. To the extent that the Government is involved in investing in the industrial sector, great care must be taken to ensure that individual projects are carefully evaluated and selected, since once they are initiated, the practical possibilities of reversing such mistakes appear to be limited in Indonesia. There is, however, little economic justification for continued public sector ownership and control of labor-intensive industries. To further the goals of Repelita III and to increase the participation of the private sector, the Government should consider selling the existing firms to the private sector through public offerings on the Jakarta stock exchange. 7.37 Regarding the capital-intensive industries, there is little ques- tion that the Government has an important role to play in the investment process and will continue to do so in the foreseeable future; as indicated in para. 2.25, over the period 1977/78, 68% of all industrial investments have been made in the public sector. Government investment in large-scale capital-intensive projects such as petrochemicals, fertilizers, LPG and other such industries in which Indonesia has a comparative advantage must be carefully undertaken. This is because, if due to an incorrect evaluation, a high cost "upstream" industry is established by the Government, to maintain its financial viability, the Government may be forced to impose import tariffs to protect this industry from more efficient imports. "Downstream" industries using the domestic high cost input will now themselves be unable to compete efficiently with imports, thus, necessitating increased tariffs on a range of such input-using industries. These measures would constitute retrogressive steps given the Government's current plans to move towards a lower overall tariff structure. Consequently, it becomes extremely important that the selection of projects in the public sector be carefully undertaken and that considerable emphasis be placed on quality project preparation and implementation; otherwise the ripple effects of an incorrect "upstream" decision could be quite far reaching. 7.38 The Government's current objectives of encouraging foreign equity participation in large projects without Government guarantees are likely to prove beneficial for the industrial sector. One hundred percent government equity in these projects may be justified if it can be demonstrated that the social profitability of the project exceeds its private profitability, and private domestic or foreign investors are unprepared to undertake the investment. This appears to be the case because, as mentioned earlier (para. 2.25), due to delays in project implementation and the external - 104 - resource position of Indonesia, the Government is considering financing some of the large petrochemical complexes entirely from domestic resources. In Chapter 3, it was shown that Indonesia had a potential comparative advantage in certain capital-intensive sectors, such as fertilizers and petroleum products, whereas others, such as iron and steel and motor vehicles, would impose large economic costs to the society. To the extent that, in the short- and medium-run, direct Government investment is deemed to be socially desirable, only the profitable sectors should be considered; no investments should be undertaken in the unprofitable ones./I Rather, domestic demand should be met through imports which would be cheaper. 7.39 There is, however, little reason to protect new or existing state enterprises from domestic or foreign competition. The efficiency of both public and private firms can be enhanced by permitting both types of firms to operate in the same sector and by creating an environment in which both are subject to competitive pressures from each other and from imports. The Government should, therefore, permit private sector activity in any industrial subsector provided it is private capital that is at risk. This implies that the current policy of demarcating industries between the private and the public sectors should be abandoned, and, contrary to the present situation, public firms should not receive more favorable treatment than private firms. This, in turn, has important implications for and places further urgency on the reform of the licensing procedures, financial policies and the incentive system, all of which currently add significantly to the costs of operations of private firms. 7.40 Furthermore, given the scarcity of skilled manpower and managerial resources in the public sector, care must be taken to ensure that these scarce resources are not spread too thinly across too many projects. Thus, the Government should also consider utilizing, in state-owned firms, management skills from the private sector. This is not inconsistent with public equity or with meeting social objectives; it may also serve to insulate the operations of these firms from political influence. 7.41 In the long-run, as the domestic capital market develops and domestic entrepreneurial skills and abilities are in increasing supply, the Government could ensure continued efficient operation of these capital- intensive firms by selectively selling them to the domestic private sector utilizing the Jakarta stock exchange. The arguments for this divestiture arise from the finite limits to the state's managerial abilities and from the fact that this policy makes available a "revolving fund" which can be used to pioneer other efficient state ventures in monopolistic or oliogopolistic markets to promote competition in specific industries, or to invest in the social sectors in which the private sector is unlikely to enter. This policy has been adopted by several countries such as Japan, UK, Singapore, Korea, Argentina and Brazil, in the belief that the efficiency of continued production would be ensured by private investors risking their own resources rather than by managers of public enterprises. /_ Annex 2 shows the relative rankings and the social profitability of several manufacturing sectors. - 105 - 8. AN AGENDA FOR POLICY ADJUSTMENTS Introduction 8.01 The previous chapter outlined a general framework for long-term industrial development in Indonesia. It provided the broad directions towards which various industrial policies should move if Indonesia is to achieve a structural transformation that would provide the basis for efficient industrial growth and the expansion of exports, productive employment and increased income-earning opportunities and equity. The industrial policies of the 1960s and the 1970s have served Indonesia well as witnessed by the high growth rate of manufacturing in 1970s. This, however, should not be viewed as the sole parameter of success. It is essential that any high growth rate be accompanied by the evolution of an efficient industrial base that can make Indonesian manufacturing internationally competitive by the end of the decade. As para. 3.14 (and Table 13 in Annex 2) indicate, there are, at the moment, several subsectors that cannot compete on the international market without substantial explicit or implicit subsidies. Therefore, to facilitate the desired evolution of the sector, reforms would have to be undertaken now and continued throughout the 1980s to ensure that the Indonesian manufacturing sector does not fall into the quagmire of a high growth rate accompanied by the creation of an inefficient industrial structure as in the case of some other developing countries such as Turkey. 8.02 The above suggests that policy reforms need to be undertaken in the near future so that their effects can be visible by the mid-1980s. Moreover, the current period is particularly opportune to begin the process given Indonesia's large foreign exchange reserves and the relatively small size of the industrial sector. In this context, Indonesia is far more fortunate than many developing countries that have either undertaken major policy reforms under crisis conditions or when a relatively large and inefficient industrial sector has been firmly established. 8.03 The focus of this chapter is, therefore, to provide specific recommendations necessary to move towards the long-term industrial develop- ment framework described in Chapter 7. Clearly, the suggested reforms cannot and should not be implemented overnight. Apart from the existence of vested interests, social and political considerations and the possibility of industrial dislocation suggest the adoption of a gradual approach. In order to reduce uncertainty, and to provide opportunities for existing firms to adjust to the new environment, a phased schedule of changes is outlined in this chapter. Such an approach would assure a smooth adjustment and also provide the opportunities to coordinate the different policies with one another, thus, laying the foundations for improving private sector incentives for industrial expansion. Therefore, by their very nature, these recommend- ations are not of the "first-best" variety; they are, rather, transitional policies designed to provide the basis for developing a much improved economic environment. Furthermore, there is no unique optimal sequencing of these policy adjustments. The recommendations made below represent best - 106 - judgments made within the Indonesian context. The recommendations made are designed to attain the Government's objectives of growth, improved income distribution and equity. Many of them can be considered without making fundamental decisions on overall policy directions. These recommendations involve a time phasing which extends over a ten-year period; the period beyond ten years is considered to be the long-run and has already been discussed./I Simplifying Administrative Controls Establishing a Deregulation Commission 8.04 The analysis provided in Chapters 3 to 6 suggests that the most serious obstacles to increased industrial activity in the private sector are the variety of controls imposed on such activities. To begin the process of simplification, it is recommended that the Government establish a Deregulation Commission that gives serious consideration to the suggestions made below and treats them as an initial terms of reference for its task. The broad mandate of this Commission would be to undertake a major review of the system in order to disentangle the existing procedures for issuing licenses. On a periodic basis, the Commission may wish to consider preparing and publishing reports which discuss the various phases of reforms as they are undertaken. The following seven actions provide examples of what would constitute a first step towards their task; these would apply to a broad range of licenses: (a) all the forms in use need to be revised to eliminate superfluous questions and requirements. This is a very detailed and sensitive assignment and assistance should be sought from consultant firms proficient in management techniques; (b) to the extent possible, multiple copies of documents should not be required of applicants; this, however, can only be decided on a case-by-case basis; (c) brochures clearly explaining different licensing requirements for different firms and applications for various licenses should be available free of charge from all Government offices which issue licenses; where service charges are necessary they should be publicly posted; (d) applications should be approved or rejected within specified time periods and the reasons for rejections should be given; (e) until significant reforms take place, the evaluation of all projects for investment licensing purposes should be based on careful cost-benefit analyses performed by trained staff within the BKPM; (f) formal procedures should be established for businessmen to appeal against rejected applications; and /1 Annexes 2, 3, 4 and 5 discuss the specific recommendations in much greater detail. - 107 - (g) all offices responsible for issuing major licenses should be required to report annually and make public the time taken to process applications. Resolving the Ambiguity in the DSP List 8.05 The simplification of procedures also involves a reform of the DSP system for allocating investment licenses. A useful step would be to resolve the existing ambiguity in the 1980 DSP regarding those sectors that "may be open for investment, closed or not yet classified". It is suggested that these sectors be open for new investment with no conditions of approval and no special investment or taxation incentives. Only their registration should be required which would make them eligible for general fiscal incentives available to all firms. Modifying tl'e DSP List 8.06 This step should be followed by modifying the current DSP list;the detailed 866 subsectors in the latest lists should be reduced to about 50 (or any reasonably small number determined by the Commission). One criterion that the Commission may wish to consider in determining this set of subsectors would be to preserve in the DSP list those few subsectors that would be subject to significant economic disruptions as a result of the delicensing procedures. Another criterion would be to identify certain sub- sectors in which the Government may wish to give preference to the economically disadvantaged groups of society. In applying this criterion, great care must be taken to ensure that, as a result of such a preference policy, the development of the particular subsector is not retarded. But using the current DSP list and the associated licenses to achieve, in the short-run, objectives other than the support of the weaker economic group (such as regional balance, and preventing excess capacity) not only has limited success in meeting these goals, but as discussed earlier (Chapter 4) also discriminates against the economically disadvantaged groups and succeeds, albeit unintentionally, in thwarting the equity goals of the Government. 8.07 In conjunction with the above suggestion, detailed tax and investment incentives specified at the subsectoral level may be substituted with incentives that differentiate only between broad categories of industries. For example, incentives (such as tax holidays) which least distort the choice of technology may be used to encourage labor-intensive industries. There is, however, considerable evidence indicating that tax and investment incentives given by the BKPM are not a significant factor in affecting domestic or foreign investment decisions, nor do they provide adequate encouragment for domestic firms to obtain licenses through the BKPM; these incentives are relatively unimportant given the existing levels of protection. Consequently, many domestic firms have chosen to bypass the BKPM and the T)SP system and forego these incentives. There is, therefore, a strong argument for reducing administrative costs by eventually moving towards a uniform set of tax and investment incentives as suggested in Chapter 7./I /1 Annex 5 discusses the economic principles that the BKPM should consider in providing special incentives to domestic and foreign firms. - 108 - 8.08 Subsequent steps could be taken, in the short-run, to eliminate the many categories of project modification for which reapproval from the BKPM is necessary; simultaneously, the detailed documentation required with each modification can also be minimized. Moreover, the interdependence of various licenses should be abolished; procedures should be established to permit non-BKPM investors requiring licenses such as health, environment and labor, to apply simultaneously for these licenses at the regional and at the national level. This would significantly reduce the current delays in obtaining these licenses. Relaxing Restrictions on Second-Hand Machinery 8.09 The Government has already taken some steps to relax the regulations precluding investors from importing second-hand machinery; these regulations should be further liberalized. Since this principle has already been accepted for a small range of equipment, the process could begin immediately - as it is particularly easy to implement - and could be done in stages until the ban is eventually eliminated. This conforms with other recommen- dations made regarding quantitative restrictions on trade (para. 8.19). Shortening the Master Lists 8.10 In the same vein, the extensive difficulties associated with the master lists for equipment, machinery and raw materials suggest that steps could also be taken to shorten these lists. Since the detailed information required for each item of machinery and raw material cannot be effectively supervised, they serve little purpose. Such requests should, therefore, be minimized. Furthermore, specific tariff exemptions, granted by the BKPM on a firm-by-firm basis, and which encourages the use of capital relative to labor, should be replaced by an alternate tariff structure, discussed in para. 8.20, that applies to the entire manufacturing sector. Gradual movement in these directions would make the master lists eventually superfluous; they could be eliminated over the same time frame as the short-run reforms in the tariff structure are implemented; viz., within five years. Moreover all of the suggestions made above, including the aggregation of the DSP sectors, should also be accomplished within five years; this would now set the stage for the three-way classification of the industrial sector discussed in Chapter 7. Controlling Environmental Pollution 8.11 Although the size of the industrial sector is still small, the impact of industrial pollution on some densely populated areas surrounding an industry has been known to be quite significant. This is particularly true of the impact of industrial pollution on water; consequently, this is of great concern to the Government. As the sector grows, the need to address industrial pollution and environmental issues in a systematic manner will become increasingly important and measures to control pollution will need to be applied more vigorously. Consequently, clear procedures and regulations are required covering the treatment of - 109 - waste and effluent through a system of effluent taxes and penalties (which may be recycled into the system to improve the ecological processes of the environment), tariff concessions on imported equipment required to control pollution, tax incentives for industries that succeed in reducing the damage to the environment, and industrial zoning and other environmental instruments that allow for substantial differences between the regions of the country. Furthermore, it is suggested that an environmental impact assessment be an integral part of project design and choice of technology. Such an assessment should specify the type and level of environmental change (e.g. pollutants) expected from the firm-s production activities, and the control mechanisms necessary to keep the change within a tolerable level. This would be particularly useful if the project involved a type of pollutant not accounted for in the effluent tax, zoning or regulatory system. The objective of the above would be to ensure that due consideration is given to the proper choice and use of energy, natural resources and technology in order to minimize environmental destruction, optimize the recycling of materials and maintain the essential ecological process and life support systems. The above system of tax incentives and penalties should equate private costs with social costs and the incremental burden of the social costs should be borne by the producers and the consumers of the relevant product. Moreover, within a particular industrial zone, tolerable levels of pollution may be maintained by the automatic allocation of an environmental license specifying, for each firm, the permissible level of pollution. In addition, the Government should also permit the existence of a market that facilitates the trading of these licenses between firms. This will ensure that the maximum tolerable level of pollution is not exceeded in that particular zone. However, for small-scale industries, particularly those involving the weaker economic group, the Government should provide tax relief or even straight subsidies to control environmental pollution, particularly for those located on mini-industrial estates. 8.12 Environmental factors must also be incorporated into the large industrial projects undertaken by the Government such as power, mining and pulp and paper. For example, in the planning of all hydroelectric projects a thorough analysis of the effects of building dams on the people and the environment of the area must be undertaken. In the design of thermal plants measures to control air pollution should be included in the project design as should instrumentation to monitor pollution levels. In addition, forest industries projects should be designed to prevent over or underharvesting of trees, or damage to remaining stands. They should also provide for commen- surate reforestation and should use all felled trees either for sawwood, pulp, or fuel to provide electricity and steam for the sawmills and pulp factory. 8.13 Environmental standards at the provincial level should be set by the provincial governments in consultation with the Ministry in charge of the environment. Moreover, the control and implementation of these standards should also be decentralized to the provincial governments. Furthermore, in cases of conflicts between the industry and the public at large, settlement of disputes should be attempted at the provincial level with the right of appeal to the Ministry of Environment. However, the successful implementation of an appropriate environmental policy will also - 110 - necessitate considerable training and education in the field of pollution control and environmental impact assessment. Therefore, a large program of training and education of public officials is of urgent priority. In addition, the development of laboratories for field research on environment, especially in the Environmental Study Centers at the universities throughout Indonesia should be given serious consideration. Improving Customs and Port Procedures 8.14 Customs and port procedures also continue to need reform. This recommendation has been made in past World Bank reports, but much more progress needs to be made. It is suggested that the Government inquire into the reasons why previous attempts to improve procedures have not had the expected effect and that it establish a specific deadline to complete the study regarding the streamlining of these procedures for which funds were allocated in Tanjung Priok Port Project (Loan 1337-IND). The current status of this study is in some question; as a first step, this status needs to be clarified if the objective of reducing the costs to importers and exporters is to be achieved. Reforming Tax Laws and the Legal Infrastructure Establishing a Tax Board 8.15 The current difficult relations between company taxpayers and tax officials suggests that substantial problems continue to exist with the company tax system, particularly for smaller firms. It is, therefore, proposed that a Tax Board be established composed of Indonesian lawyers and accountants and foreign advisers experienced in taxation law and accounting practices. This group should look into a wide range of matters including a review of the Corporate Law system, simplification of the corporate tax system and incentives, clarification of ambiguities and the establishment of effective procedures for appeal. The recent decision to reactivate the Court of Appeals will improve the current situation, but proper staffing, facilities and judgements perceived to be fair by the aggrieved party will be necessary to reestablish faith in the tax system. The March 1979 reforms undertaken by the Government, in particular the use of public accountants in preparing corporate tax returns, are good examples of the type of steps required to improve the institutional environment. Improving the Legal Framework 8.16 The weakness in the legal infrastructure for the industrial sector manifests itself in the numerous regulations that overlap with one another, that are inconsistent between one another and, in some cases, are out of date. Furthermore, there is no organized system for circulating and publicizing laws related to the industrial sector. A Legal Group should, therefore, be established to conduct a codification of all industrial laws and regulations. This could begin with laws and regulations enunciated by the Ministry of Industry, but could then be extended to those issued by the Ministries of Trade and Finance. The Pusat Dokumentasi Hukum (Center for - lii - Legal Documentation) at the University of Indonesia would be a suitable organization that could be involved in this undertaking. The codification process, at a minimum, should ensure that outdated regulations are eliminated from the books, recent regulations that supersede old ones clearly identify those that are no longer legally valid, and the language of these regulations should be carefully constructed to avoid, to the extent possible, ambiguity and confusion. To provide firms with adequate security against the proliferation of contradictory decisions, a legal mechanism also needs to be established that would protect firms against prosecution for ignoring instructions from a "lower" (regional) level if they differ from those legally issued by a "higher" (Central Government) authority. Distribution of Information 8.17 There is also an urgent need to establish a well-organized system of making public the numerous government laws and directives. The first steps can be taken by the Ministries of Industry and Trade and by the Directorate General of Taxation. An official publication should be issued, at least monthly, by these agencies containing the text of recent regulations, laws and decisions made at the national and provincial levels. These publications should be on sale throughout Indonesia and also be made available on a subscription basis. Furthermore, regulations and formal decisions made by the Government and affecting the industrial sector should not become effective until announced in such a publication. All related official material on industrial policy should also be distributed through Government stores and distributors throughout Indonesia. The current system of combining private and public sector initiatives by the Government's use of a reputable pribumi company, Cafi, and the Government gazette, Berite Negara, are excellent examples of how the system of publishing regulations should be undertaken (para. 4.03). To build on this system and to facilitate the distribution of these bulletins, the Government may wish to consider their large-scale purchases for national distribution. Reducing the Import-Substitution Bias Expanding the Export Certificate Scheme 8.18 The extent to which domestic firms become internationally competitive is of paramount importance in affecting industrial growth, employment and exports. Therefore, in conjunction with the gradual deregulation of the economy, steps should also be taken to reduce the current inward-looking bias of the trade regime. To facilitate this process, the Government can begin by improving the operation of the export certificate system. These certificates should be provided for more broadly defined groups of commodities rather than for specific items only, as at present. The Government may, therefore, consider making eligible all groups of manufactured goods, including those that are currently not being exported. Furthermore, as a rough initial guideline, the export certificate rates should be set at a level which, at a minimum, provides an average of zero effective protection for export sales for every group; this can be done for sets of commodities at the two or three-digit SITC level rather than at the current six-digit level. Any firm that chooses to export a commodity would - 112 - now be guaranteed this export certificate rate without having to provide detailed documentation on tariffs paid on inputs. Currently, there is some consideration being given by the Government to increase the coverage of goods eligible for the export certificate scheme. The Government also recognizes the increased administrative burden that will be imposed by the expanded coverage and by the detailed current six-digit level of commodity specificiation. It is, therefore, also considering grouping commodities into more aggregated sets and specifying these sets at less than the six-digit level. Providing Increased Incentives to Exports 8.19 In order to improve the efficiency of the manufacturing sector, the current bias towards production for the domestic market may be reduced by providing positive incentives (protection) to exports. However, export certificate rates necessary to achieve these subsidy levels may raise the question of international acceptability and to the imposition of countervailing duties under GATT rules. One alternative, therefore, would be to establish a "wastage allowance" system which permits duty-free imports of input beyond that necessary for export production. Firms could use the excess inputs for domestic production or resell this amount to other firms. A second alternative would be to develop an "export-import link" system which provides exporters with a "duty-exemption" certificate which qualifies the holders for duty-free imports of any number of listed intermediate (or final) commodities. Thus, for example, for every $100 worth of exports, the exporter would obtain a certificate worth Rp 10,000 at customs in lieu of customs duties, in addition to the export certificate rebate. In the early 1960s, under the then existing stringent exchange controlled trade regime, the Government attempted an "export-import link" system which resulted in some administrative problems. These may have been exacerbated by the exchange control regime whiich now no longer exists. This system may, therefore, be worth some consideration as a potential approach if the need arises. Export credit subsidies provided for working capital can also aid exporters, but subsidized export credit for investment capital should be avoided as they tend to distort the choice of technology and lead to a misallocation of resources. The provision of positive protection to exports through subsidies on energy (gas, fuel oil and electricity) distorts significantly the allocation of this scarce resource; such measures, are, therefore, not appropriate instruments for protection. Reforming the Export Check-Price System 8.20 The export check-price system for commodities on the export certificate list should also not be used as a policy instrument to alter the effective rate of export rebate as is the current practice. These check-prices should reflect real f.o.b. prices and be set by customs using the same foreign sources now used to set import check-prices. These prices should continue to be adjusted at least semi-annually, as is the current practice, except in cases of unusual international price movements. Once the smooth operation of the redesigned export certificate system has been established, the export check-prices can be eliminated and the export rebates should then be provided on actual realized f.o.b. prices. - 113 - Maintaining Real Incentives to Exporters 8.21 Furthermore, to ensure that, in the short-run, the real incentives to exporters provided by the export certificate scheme are maintained, increases or decreases in export certificate rebates should be provided, at least every quarter, to reflect changes in the domestic price level relative to international inflation. This will ensure that the effective exchange rate for manufactured exports will be indexed so as to prevent its real deterioration and, thus, dissuade further expansion of export capacity. Replacing Export Quotas with Export Taxes 8.22 Except for special circumstances such as adjustment periods after devaluation or for goods whose domestic price stability affects those at the lower end of the income distribution scale or when price stability is considered to be essential by the Government to ensure political stability, the continued use of export quotas is not in the long-run interest of improving industrial efficiency. Consequently, export prohibitions which are currently still in force could be replaced by a 5-10% export tax which could be phased out over five years. Such a level of protection will be sufficient to encourage the domestic processing of raw materials if Indonesia has a genuine long-run comparative advantage in these activities. Higher rates of export taxes, however, can be justified (on optimal tariff grounds) for those commodities, such as timber, in which Indonesia has monopoly or quasi-monopoly power. To facilitate the proper exploitation of this instrument and to reduce the associated administrative costs, the legislation restricting export taxes to only three levels - 5%, 10% and 20% should be replaced by a more flexible one that permits the Government to replace export quotas with appropriate export taxes. Thus, the current policy of imposing export quotas in addition to export taxes on commodities can be abandoned. The Development of Export Processing Zones / 8.23 Throughout the transition process, the emphasis on the encourage- ment of exports through appropriate policy instruments mentioned above can be supplemented by strong political commitment to this goal and high level official support to expedite the needs of export-oriented manufacturing through the creation of private trading houses that facilitate international marketing and exports and through the establishment of export-oriented industrial complexes. The formation of export processing zones would be particularly beneficial to Indonesia in its early phase of an export-oriented strategy and can form part of Indonesia's overall strategy for the expansion of manufactured exports. The benefits include increased employment for the country, the additional sales of raw materials and services and the resulting increase in export value-added. The benefits to firms would arise from the low cost of available labor, the proposed infrastructure and plant facilities, and the visible assurance to domestic and foreign investors that they will be free to export and import without any institutional constraints; this "extraterritorial" status is a special characteristic of such industrial complexes. The benefits to Indonesia would arise from the progressive development of backward linkages and by the channelling of capital, management and know-how which can have significant demonstration effects on the industrial sector. - 114 - 8.24 Such zones have been established in many developing countries. In the 1960s, they formed part of the industrial development programs of Korea, Singapore, Malaysia, and Taiwan. Since then, they have spread to several other countries such as Barbados, Haiti, India, Mexico, Morocco and Senegal. It is, however, important to point out that the most dramatic expansion has taken place in countries where the general economic policies have favored exports. In countries that have continued to adopt policies biased towards import-substitution, export processing zones have been merely established to by-pass the entire system. Therefore, without a genuine change in policy bias to one favoring manufactured exports, the long-run benefits derived from such zones will be lost to Indonesia. It is, therefore, suggested that the pilot project at Pulo Gadung be expedited, that the reasons why the zone at Tanjung Priok does not operate as a true export processing zone be investigated, and that potential sites be identified for future zones in Indonesia. Replacing Quantitative Restrictions with Import Tariffs 8.25 Shifting the focus to imports, quantitative restrictions and total bans on imports may be needed at times when indirect measures to restrict imports are too slow. But the occasions to resort to such measures are likely to be infrequent. Furthermore, protection by quotas does not provide a criterion for the selection of activities to protect and there is no discipline provided by import competition. Quotas also tend to create monopoly situations since they eliminate import competition, and insulate the domestic economy from foreign developments. Given the urgency to improve the efficiency of the industrial sector, any use of bans and quanti- tative restrictions should be made very judiciously. It is, therefore, suggested that the existing quantitative restrictions and bans be phased out over five years and be replaced by tariffs. The Government is currently reviewing the list of quantitative restrictions with a view to eliminating such restrictions and replacing them by tariffs. A few months ago, the Government lifted the import quotas on checkered sarongs and replaced them with relatively low import tariffs. Making Import Tariffs the Sole Source of Protection 8.26 Before the tariff structure can be properly reformed, it is important to ensure that tariffs are made the sole source of protection; a number of steps may, therefore, be taken. First, the import sales tax and the domestic sales tax could be harmonized; this implies that these two taxes should adopt the same nomenclature and rates; this "sales tax" would then apply equally to all sales of a commodity whether it originates at the factory-gate or at customs. Simultaneously, the current 1% rate of sales tax should be abolished as the associated administrative costs far exceed the revenues collected. These actions can be undertaken in the near future. 8.27 Second, discriminatory protection afforded through the import pre- payment scheme, sales tax, MPO rates, import check-prices and quantitative restrictions should also be eliminated. The import of a commodity should bear the same duty rate regardless of who the importer is, or what sector will make - 115 - use of the commodity. Protection for specific sectors should be provided via tariffs on outputs - which should preferably be ad valorum rather than specific - or through production subsidies which are superior instruments to discriminatory taxes and tariffs on inputs. Restructuring the Tariff Schedule 8.28 In order for the Government to move gradually towards a more uniform and lower tariff structure, the entire tariff schedule needs to be reviewed. As mentioned earlier (para. 7.12) such a review is currently underway. It is, however, suggested that a Tariff Board be established to consider such a review and the suggestions made below. At the moment, the ndcleus of such a Tariff Board already exists and is made up of only Government officials. One more step needs to be undertaken to incorporate the private sector into this group and establish its permanence in overseeing the tariff situation. A primary objective of this Board would be to lower the average effective protection and its variance. In certain situations a combination of ad valorem and specific tariffs may be practical if protection is desired for a particular quality range. But as a general rule it is suggested that initially ad valorem rates not to exceed 50% be established for all final and intermediate goods whose nominal tariffs currently exceed this amount. These rates should be slowly reduced to a uniform ceiling of 20% within five years with annual targets set and announced in advance. Higher tariff rates may be justified to protect firms on infant industry grounds. But great care needs to be taken to ensure that legitimate and credible grounds have been first established to justify these higher rates. Furthermore, these industries should not be given more than a 15% margin over the 20% afforded to other sectors, and these rates should be set for a finite period not exceeding five years to permit the infant industry to mature; over this period, the incremental protection should decline to the 20% level. It is also important that this decline in protection be announced in advance to prevent expectations of continued protection; such expectations, in other countries, have often turned infant industries into senile industries. To ease the adjustment process for firms, the Government may wish to provide some industrial adjustment assistance to those firms who, with a little bit of support, could operate efficiently under the new tariff regime. The difficulty would lie in making the appropriate selection of firms because most firms, including the extremely inefficient ones, would apply for such assistance. If the administrative machinery required to undertake the selection and provide the necessary assistance proves to be too cumbersome, the Government may wish to consider lengthening the transition phase from the five years suggested above to permit firms to undertake their own adjustment programs. 8.29 The Tariff Board will also have to modify the system of uniform tariffs for the entire industrial sector in cases where the eventual result of the tariff reform is very non-uniform effective protection; given the uniformity objective, there will inevitahly be a conflict between uniform nominal rates and uniform effective rates. In practice, the Board will have - 116 - to make a final judgement on the best compromise./l The restructuring of tariffs will not only encourage the growth of efficient domestic firms, but it will also dissuade "tariff-jumping" by foreign firms seeking refuge and high profits behind high tariff walls in Indonesia; once appropriate changes are made, only those foreign firms that are prepared to compete efficiently on the domestic and international markets will have the incentive to invest in Indonesia. However, the Government should develop a program, as in many other countries, to safeguard against short-term dumping policies that contravene GATT regulations. Consequently, a mechanism needs to be developed that identifies genuine cases of dumping and imposes appropriate countervailing duties. 8.30 It is, however, important that the Tariff Board avoid piece-meal reforms and temporary exemptions. This Board should also oversee the formulation of import check-prices. These should be proper estimates of c.i.f. prices and should continue to be published at least twice a year, as is the current practice, and be kept in line with international price movements. The reductions in import tariffs suggested above would also permit the eventual elimination of the import check-prices; now the incentives for importers to under-invoice their goods will be signifcantly reduced as will the incentives to make illegal payments that arise from the current high tariff rates and the check-price system. Equalizing Tariffs and Export Rebates 8.31 The reductions and uniformity in the import tariffs structure also permits an opportunity to introduce uniformity in the export certificate scheme. Once the tariff structure is reformed as suggested above, the export certificate rates could also be made uniform across all groups of manufac- /1 This conflict arises from the fact that non-uniform nominal rates are required to yield uniform effective rates and vice-versa. Uniform nominal rates will yield uniform effective rates only if all inputs of manufactured goods are always themselves manufactures with no basic material input at any stage. But when some inputs are basic materials or exportables, then the nominal tariff for one activity becomes the input tariff for another in a multistage production process where the semi-manufactured components are inputs into further processes. It should also be noted that tariff reductions will, of course, have implications for tax revenues. It is not, however, obvious that reduc- tions in tariff rates will necessarily lead to a loss in revenue; this would depend upon the import elasticities of demand. Furthermore, the Government's ability to raise revenue from mineral exploitation makes the use discriminatory excise and customs taxes questionable policy instruments as revenue raising devices given their negative impact on the manufacturing sector's efficiency, output and exports. Improving the incentive mechanisms will not only lead to increased manufacturing output, exports and imports, but also, ceterus paribus, to increased tax revenues from several sources. - 117 - tured goods. As a final step, which can most likely be taken in about ten years, the Government should attempt to equalize tariffs and export rebates. Since it is likely that import tariffs will exceed the export rebates at this stage, the equalization should be achieved by lowering the tariffs to reduce the domestic market bias. Since the long-term goal would be to provide an approximately neutral trade regime, the Tariff Board should continue to oversee the equalization of the export rebates and import tariffs in an attempt to achieve the above objective. Sequencing Adjustments in Financial Policy The Control of Inflation 8.32 The movement towards a more outward-looking trade policy also suggests a movement towards a more viable financial policy for the 1980s to accommodate an expanding economy and a growing industrial sector. This implies that a series of steps be undertaken to gradually transform the current system of controlling liquidity and allocating financial resources. To facilitate this transformation, a sequencing of policy adjustments, which may be undertaken over the next decade, is given below. It is, however, recognized that political and administrative constraints may indicate an alternate sequence of steps. As a start, it is suggested that the major task of controlling liquidity in the economy be assigned to the budget which should be used to sterilize the expected increase in foreign resources due to increased oil revenues; moreover, greater reliance on fiscal policy for monetary stability requires, under current circumstances, a surplus in the rupiah budget. In recent years, the Government has achieved a budget surplus, but this surplus has not been adequate to sterilize the increases in foreign resources. Once this task is properly assigned to the budget, the dismantling of administrative controls on credit can begin and measures to make interest rate policies more effective for inflation control and resource allocation purposes can be introduced. Elimination of Credit Ceilings 8.33 The use of the budget to control liquidity growth and an increased use of the reserve requirement ratio will aid in reducing the dependence on credit ceilings for monetary control and will permit the substitution of current policies with effective interest rate policies. Consequently, the reliance on credit ceilings can be gradually diminished and synchronized with reforms of the interest rate structure. Reforming the Interest Rate Structure 8.34 Indonesia is today pursuing a policy of being an open economy with an effectively fixed exchange rate. With such a policy, Indonesia must continue, as it has in the past, to keep its interest rates, suitably adjusted for expected exchange rate changes, in line with world interest - 118 - rates in order to prevent destabilizing capital flows. In the long run, that will mean paying positive real interest rates on deposits. Changes in interest rate policy needed to ensure real positive deposit and lending rates imply that nominal rates be adjusted to conform with long-run expectations of inflation. This, however, does not imply that interest rates be constantly adjusted to reflect short-term changes in the inflation rate. Under present world conditions of high inflation, slack economies, and large reservoirs of international liquidity, interest rates in world markets and correspondingly Indonesian interest rates may be below the rate of inflation. Thus, short-run negative real interest rates can exist so long as there is movement towards eventually establishing a real positive interest rate structure. As an example, a 5% real return on deposits implies that nominal rates be set at 20% for 12-month time deposits, if inflation, over the longer term, is expected to be reduced to 15% per year from 1981 onwards. For 24-month deposits, a similar adjustment must be made, but it must also include the transaction costs of redepositing for another 12 months. If expectations of inflation are on the rise, the Government may wish to consider "twisting" the deposit rate structure which rewards deposits longer than 12 months with higher interest rates. This will aid with inflation control and permit banks to transform their portfolio of assets towards longer term ones than at present. 8.35 The establishment of real positive deposit rates necessitates real positive lending rates. A competitive banking industry would permit a decontrol of the deposit rate and the lending rate would then be established by a competitive margin that accounts for the costs of intermediation. Given that such a competitive structure will emerge only after some time and after a variety of institutional reforms have been implemented, the real lending rate will have to be set. But banks should be given the authority to charge differential loan rates corresponding to the risk associated with different borrowers./l It should be recognized, however, that given Indonesia's access to the international capital markets, the real domestic lending rate cannot deviate significantly from real international rates; the extent of this deviation would be determined by the relative costs of intermediation, relative inflation rates, expected changes in exchange rates and the different risks associated with lending to prime borrowers in other countries relative to those in Indonesia where the legal framework and the provision of collateral are less advanced. 8.36 Such a reform of the interest rate structure need not be at the expense of the weaker economic group. To meet the objectives of the Govern- ment to increase equity in the country, the weaker economic group should continue to have access to subsidized interest rates and credit programs (paras. 8.39 to 8.42). There is, however, little economic argument to provide subsidized credit to those who do not need it, such as the economically strong group of entrepreneurs, and who currently obtain short-term credit at subsidized rates. Such groups and joint ventures /1 In the short-run, subsidized lending for essential areas such as the BIMAS program should, however, continue. - 119 - should be encouraged to pay market rates for investment and for short-term credit (para. 8.42). Over the long run, such a policy will benefit the financial intermediation process in Indonesia, as opposed to the current situation where such groups borrow, at market rates, Indonesian funds deposited offshore by the state banks and then invest these funds in Indonesia. 8.37 The elimination of subsidies on short-term credit for the economically strong segments of society and joint ventures will reduce their demand for such credit, a significant amount of which is currently being rolled over and used for investment purposes (para. 5.04). On the other hand, because of existing restrictions on long-term credit, increased access to such credit at market or international rates will result in an increased demand from such groups for long-term credit from the domestic banking system; this will, at most, result in a commensurate decline in demand for such credit from offshore capital markets. In an open exchange economy such as Indonesia's, there is litte reason to believe that, as a result of the policy recommendations made, there will be a net increase in total (i.e. domestic plus offshore) demand for long-term credit from the economically strong group. In fact, in the short-run, until the domestic banking system develops, given the current high costs of intermediation and the inefficiency of the state banks, the shift in demand, from offshore banks to domestic banks, for long-term credit at international rates may not be significant. Given the above, the ratio of firms owned by the economically strong and weak groups is not likely to change significantly, particularly since the economically weak groups will continue to have access to domestic credit at subsidized rates. Furthermore, the recommendations made above, along with those made in the areas of foreign trade, licensing and foreign investment policies will lead to increased employment and income earning opportunities of the weaker segments of society, thus improving income distribution and contributing to the equity goals of the Government. The Role of the Rediscount Rate 8.38 Once real positive deposit and lending rates have been implemented, attention can be focused onto the proper role of the rediscount mechanism. The current policy of providing subsidies to commercial banks through the rediscount system would no longer be necessary as the interest rate structure would provide adequate returns to these institutions. Subsidies to commercial banks to encourage them to undertake loans to the weaker segments of society should be continued, but this should be done through the budget (para. 8.40) or through a special development fund (para. 8.41) rather than through the rediscount mechanism. The current policy of using the rediscount rate as a mechanism of transferring subsidies to the commercial banks robs the Indonesian economy of a major tool of monetary control. Rediscount rates could, therefore, be raised to reflect the cost of credit which, in turn, would influence the growth of liquidity. This implies proper control over the reserve money base, particularly since, at this stage, credit ceilings would no longer be in use. Differential rediscount rates may also be considered to influence resource allocation among sectors; but this is clearly a second-best policy to letting resource allocation be determined by the profitability of each sector as perceived by the borrower. In either case, the entire structure of rediscount rates needs to be raised from its present levels to ensure control over liquidity expansion. - 120 - Supporting the Economically Weak Entrepreneurs 8.39 The rediscount mechanism is currently also used to subsidize specific borrowers. In keeping with the thrust of the previous recommenda- tions, and to further the Government-s objectives to promote equity among the different economic segments of society, it is suggested that such subsidies be granted directly from the budget rather than through the rediscount window. Thus, long- and short-term credit to the economically weak firms should be continued at subsidized rates; they should, however, be financed by direct subsidies to all banks, not only to state banks. Attractive returns to loans made to economically weak investors through this mechanism would encourage state as well as private domestic and foreign banks to seek out such enterprises and provide them with expertise and advice regarding financial management and exports. This approach would also provide incentives to develop skills required for retail banking; these, at the moment, are inadequate. 8.40 These subsidies, however, would probably create an excess demand for funds. This makes it important for the Government to earmark a fixed quantum amount in the budget, on an annual basis, to be allocated for the development of the economically weak entrepreneurial class. The Government, should also continue the present arrangements regarding the KIK/KMKP credits targetted to the small entrepreneurs. Despite certain weaknesses in these schemes, the amounts involved are small, and with time, the benefits can be expected to exceed the costs. But it may be desirable to encourage all banks to provide these credits - not only state banks - by assuring them adequate margins through the budget subsidy. An alternative approach to the budget subsidy would be for Bank Indonesia to establish a special development fund for the weaker economic group and subsidized credit to this group may then be financed from this fund. As a distinctly second-best approach, the rediscount system may be used to transfer subsidies, but this should be restricted only to investment and short-term credit designed to aid the economically weak groups of society. Neither equity nor allocative efficiency objectives are served by the use of the rediscount mechanism to encourage lending to specific sectors or activities as is the current policy. The Government may also wish to permit institutional equity funds to be treated as surrogate capital with the intention that these shares could be later sold to individual economically weak investors. The state commercial and development banks can play an effective role in this process and should be encouraged and strengthened to do so. 8.41 More effective support for small enterpreneurs may be provided by coordinating the above credit schemes with other programs such as the development of mini-industrial estates, cottage industry projects and the development of industrial extension services throughout the country. The possibilities here include assistance to weak entrepreneurs in completing application forms and in obtaining licenses, advise on the appropriate choice of technology, establishment of district industry centers where assistance from Bank officials and extension officers can be provided, and the creation of provincial committees on which bank extension agencies and local government officials would be represented. The Government may also wish to - 121 - consider providing tax incentives to private foreign and domestic firms to employ and provide training to the weaker economic groups. This will provide increased exposure to efficient and modern business techniques. A graduated tax incentive system could also be considered in order to encourage private domestic and foreign firms to increase their share of management and ownership of firms by the economically weak groups. Tax incentives of the above kind are superior to current incentives provided through the credit system because, as noted in Chapter 5, the latter distort significantly the allocation of credit with undesirable consequences for the industrial sector. Additional policies that may be undertaken simultaneously to promote econom- ically weak enterprises include Government support for on-the-job training, special training facilities and business schools. 8.42 Once adequate credit at subsidized rates is made available to the economically disadvantaged groups of society, the Government may be able to begin to relax the restriction on extending investment credits to the rest of the society including the joint-venture firms. Restricting investment credit to the weaker economic groups, as is the current policy, does not ensure their participation in the industrial sector; it merely precludes access to long-term funds by the economically advantaged segments of society. In this way, such restrictions like investment licenses, act as one-edged swords; they preclude access, but do not ensure participation of the weaker groups. Since investment credit is made available at subsidized rates to the economically disadvantaged segments, access to investment credit at international or market rates can be made available to all who seek it (paras. 8.37 and 8.38). At these non-subsidized positive real rates, such restrictions will not be necessary. If the Government, however, feels that significant social and political costs are associated with the removals of these restrictions, then, as an interim measure, it may wish to consider a positive (rather than the current zero) ceiling level that will restrict the demand for credit to a level lower than that determined by the real rates of interest. Improving the Efficiency of State Banks 8.43 The sequencing of the above reforms in a phased manner will ensure a smooth adjustment as the substitution from an administratively determined allocation system to a price determined system takes place. These reforms can be implemented over a ten-year period so that they can begin to provide the foundations of an efficient financial intermediation system. This process will be enhanced if the protection afforded to state banks is gradually reduced with all relevant policy changes announced well in advance to permit these banks to make adjustments. Such reforms would have to address the various regulations that shelter state banks, such as those that exempt interest earnings from deposits held with state banks from taxes, restrict state enterprises to holding deposits only with state banks, restrict the opening of branches by nonstate banks, impose borrowing ceiling on private domestic and foreign banks, include interbank call money as liabilities against which reserve requirements have to held, geographically restrict the lending operations of foreign banks, and those that place - 122 - limitations on private banks to undertake foreign exchange business. All these restrictions could be gradually dismantled in a phased manner and as rapidly as is politically feasible. 8.44 At the same time, support could be provided to the state banks through various means. For example, the long-term lending capability of these banks could be developed and state bank officials could be trained through technical assistance from large foreign banks; this has worked extremely well in the case of one national private bank and a major international bank. This example is well worth emulating by state commercial banks. Major international banks can bring to bear their experience in the areas of retail banking, investment analysis, portfolio selection and information handling capabilities. This will constitute an important transfer of technology to the commercial banking system in Indonesia. In addition, the restrictions on the expansion of the fixed assets of state banks could be removed, bad debts should be written off on a once-and-for-all basis and systems procedures could be introduced to speed up the loan processing schedule. Furthermore, with regard to the KIB program, decisions should be decentralized from Bank Indonesia to the state banks and within the state banking system; this will permit greater access to the KIB rediscount facilities. These actions should, over time, increase the efficiency of the state banking system and permit these banks to compete on the basis of increased service capability. Enhancing Financial Intermediation 8.45 To further enhance the intermediation process, the development banks should be permitted to open branches in different parts of Indonesia, and the focus of the Regional Development Banks should be shifted from their present concentration on commercial banking activities towards specialization in development banking. This would enable these banks to play a larger role in the financing of small and medium economically weak enterprises in the rural areas. Thus, the training of loan officers in appraisal and supervision techniques, and the streamlining of their operating procedures and internal administration are of very high priority. 8.46 Other institutional policy measures that the Government may wish to consider would be the creation of a deposit insurance scheme for domestic private and foreign bank deposits; the liberalization of the regulations on the issuance of bank guarantees to foreign lenders for suppliers' credit; the encouragement of the development of long-term savings instruments and bonds through minimizing issuance criteria; the provision of tax incentives (or the removal of disincentives) to the provision of institutional equity capital; and the encouragement and/or the creation of leasing companies and of NBFIs to set up secondary brokerage services. All the institutional reforms suggested here could be undertaken simultaneously with reforms in the policy environment mentioned earlier; the interdependence of the institutional and policy reforms is such that one without the other will severely hinder the development of an efficient financial sector. - 123 - Stimulating Private Foreign Investment Providing Optional Incentives for Foreign Firms 8.47 The reforms in the regulatory environment, trade and financial policies would have an effect on stimulating both domestic and foreign investment. But, there are also specific actions which would stimulate foreign investment that can be undertaken. As a first step towards the long-run goal of a system of general incentives suggested in Chapter 7, special incentives that are currently offered to foreign firms could be made optional. This would permit foreign firms with an option already available to domestic firms; viz., that of going through the BRO process and of bypassing the incentives and the restrictions administered by the BKPM. While all foreign investment applications should continue to be processed by the BKPM, this should be done routinely as a way of assisting foreign firms in quickly satisfying various registration requirements, hopefully in a matter of days or weeks, while allowing these firms the option of bypassing an evaluation process tied to the provision of special incentives that would reasonably be expected to take several months. The result of the current procedures has been that many of the benefits to the foreign firms are presently being whittled away by time delays and other costs imposed on them. This policy would, therefore, also provide some mechanism for eliminating incentives that are not only very costly to Indonesia, but which are also of relatively minor importance for foreign firms. 8.48 The main reason for providing any special tax incentives to foreign (or domestic) firms would be to take account of distortions brought about by say, trade restrictions. Thus, special incentives would still be made available for sectors subject to unfavorable discrimination, such as the export sectors, where the effective rate of protection is less than zero; this group of activities does not currently account for a large proportion of industrial investment in Indonesia and would become progressively smaller as the policy reforms outlined earlier are carried out. 8.49 In those cases in which the BKPM extends special incentives to investors, it should be required to calculate the projected costs of these incentives and to provide subsequent reports to the Government on actual costs once projects are undertaken. Under the present system, costs of special incentives are reflected in foregone tax income and this is effectively hidden in a complex system of tax exemptions and rebates; estimates of the costs of these incentives are currently not available at the BKPM. Furthermore, these special incentives should take the form of direct subsidies paid in the form of specific tax credits that could be used by the firm in settling corporate tax payments or tax payments for any imports subject to duty. - 124 - Improving the Quality of Labor and the Transfer of Technology 8.50 To enhance the quality of labor and to facilitate the transfer of technology, the Government should also undertake joint efforts with foreign firms to develop educational and training programs. Many other countries have been able to achieve substantial benefits from public sector activity to stimulate labor training in the industrial sector. Public sector financial support for vocational and business-oriented educational institutions could be augmented by schemes to share costs with foreign firms in programs aimed at providing training and assistance in the transfer of technology. This might take the form of a fellowship program for business studies, financing programs in which industrial or business experts are brought to Indonesia, and financial support for well-defined training programs carried out by foreign firms. A section concerned with training and technology transfer should also be established within the BKPM which should solicit the desired aid from foreign firms. The Use of Foreign Workers 8.51 Furthermore, there is a shortage of sufficiently well-trained or experienced Indonesians to fill middle and higher management levels. This is most acutely felt in the marketing, accounting, engineering and personnel management areas. This, in turn, hinders the rapid promotion of Indonesians into managerial positions. Consequently, restrictions on the use of foreign personnel should not be increased from their present levels. As part of an overall policy reform, restrictions in several areas should, in fact, be relaxed and there are several ways in which these could be achieved in the short-run. For example, specific skills that are in short supply in Indonesia, and the supply of which is not expected to increase significantly in the near future may be made exempt from the current restrictions. In addition, the current process of obtaining entry documents entails costs and time delays. The Government could provide multiple entry visas at the same time as the work permits are issued to foreign nationals. Furthermore, if Government efforts to decrease the use of foreign nationals are found to be insufficient, then rather than placing restrictions which entail significant administrative costs, the Government should impose an annual fee for working permits; this fee can be varied, depending on labor market conditions, in order to increase or decrease the incentives to use foreign workers. Policies Towards Lower Skilled Workers 8.52 Current policies with respect to lower skilled workers also need to be reconsidered. The restrictions on dismissing workers employed for more than three months discourage an efficient selection of low skilled workers for training and promotion to higher positions; this policy encourages foreign and domestic firms to rely instead on casual workers. The interests of such workers are better protected if a severance fee - say, a half-months severance payment for every six months of employment - tied to the length of employment is instituted. - 125 - 8.53 The reforms suggested here, combined with specific actions designed to improve the investment climate in Indonesia will stimulate the growth of both foreign as well as domestic investment in sectors in which Indonesia has a long-run comparative advantage; this approach, would therefore, form the basis for increased production, exports and employment in the manufacturing sector in Indonesia.