Senior lecturer in Development Studies at Western Sydney University
Concerns about de-industrialization again became a hot issue raised during a symposium of 100 Indonesian economists organized by the Institute for Development Economics and Finance (INDEF) last week. The issue is by no means new.
The deindustrialization trend in this country started at the turn of the millennium. It refers to the declining share of manufacturing output and employment in overall gross domestic product (GDP) and total employment respectively.
Reflecting on the trajectory of economic development in the developed world, there is nothing wrong with deindustrialization. It is a natural process of development and a natural consequence of further growth. The main reason for the de-industrialization is the faster growth of productivity in manufacturing than in services, while output growth of the two sectors remains the same. This is labeled as positive de-industrialization.
The problem with the deindustrialization in Indonesia is that it is a premature one. Our economy passed the peak of the manufacturing industry’s contribution to overall GDP just before the collapse the New Order at about 28 percent, which is quite low. In advanced economies, the peak of the manufacturing sector’s contributions to GDP was achieved in the 1960s and the turning points were much higher: e.g., about 36 percent in Japan and 32 percent in the European Union.
More importantly, at the peak of industrialization in advanced economies, the employment share of the manufacturing sector was more or less comparable to the sector’s share of GDP. In Indonesia, the employment share of the manufacturing sector is far lower than its share of GDP, indicating the failure of this sector to absorb surplus labor from the agricultural sector, a la the Lewis model.
It has been identified that a key constraint in the problem of deindustrialization is labor capacity in the industrial sector, as this sector has been losing its competitiveness. In essence, this is about labor productivity. In this regards, a key question is: What drives labor productivity?
This question is answered in our study commissioned by the International Labor Organization. The study utilized the rich dataset of the Large and Medium Manufacturing Survey and the Micro and Small Manufacturing Survey since the advent of the global financial crisis in 2008.
Our study finds that the most important variable at the firm level that drives productivity is wages, echoing the efficiency wage theory. The overall wage elasticity with respect to productivity in large and medium industries is about 13 percent, while the figure in small and micro industries is far higher, about 66 percent.
If large and medium industries are divided into different factor intensities, capital intensive industry has a higher wage elasticity compared with that of labor and resource intensive industries.
In the case of large and medium firms, after wages, the next variable that can significantly drive productivity is capital intensity, which is measured as the value of machinery and equipment per worker. This is consistent with the previous finding about the high wage elasticity in the capital intensive industry.
Not surprisingly, export orientation and foreign investment at the firm level, both, have virtually no significant effect on productivity. This is understandable since the period of study begins in 2008.
Two reasons are in order. First, the manufacturing sector relied more on domestic markets, rather than exports. Second, access to foreign technology is not subject to foreign investment anymore as technology has become widely available through the market.
The two reasons are completely different from the situation in the 1980s and 1990s prior to the Asian financial crisis. At that time, Indonesia was at the peak of its industrialization with labor intensive manufacturing in the leading role. At that time, export orientation and foreign ownership played significant roles in enhancing the labor productivity of the industrial sector.
This tells us that the overall situation confronted by the manufacturing sector has changed. Therefore, policies need to adapt to the changes.
In the case of micro and small firms, after wages, the second most important variable driving productivity is own capital. In micro firms, the elasticity of own capital with respect to productivity is marginally negative, while in small firms the elasticity is marginally positive.
What could all these findings possibly imply?
First, Indonesia needs to reindustrialize, reversing the nearly two decade trend of deindustrialization. As the domestic and global environments have changed, Indonesia needs to upgrade its industrial sector by placing subsectors characterized by high productivity and high wages in the leading role. This is because wages can drive productivity. This seems to direct our attention to capital intensive industry. In this regard, using wages for industrial upgrading should be explored. Longing for the good old days of labor intensive manufacturing with cheap labor seems to be useless.
Second, related to the above point, policies that help firms to increase their capital intensity are another avenue for improvement. Third, the importance of domestic markets and domestic financing cannot be underestimated.
It has to be noted, however, the above three implications are based on firm-level analysis. While these are micro to internal firms, the scope of policies needed to improve manufacturing productivity is far more than that.
It is concerned with overall macro environments: adequate supply of skilled workers, regulatory certainty and efficiency, macro stability, infrastructure provisions and so on.
Last, the problem with the manufacturing sector is not on the demand side. With such a large population, growing middle class and globalized consumers, there has been no shortage of domestic demands.
The problem lies on the supply side for not being able to cope with such large domestic demands and we tend simply turn to a quick fix: imports. A lot can be done about this.
The writer is a senior lecturer in Development Studies at Western Sydney University, Australia, currently on sabbatical leave as visiting academic at SMERU Research Institute and Bogor Agricultural University.
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