Oil-induced growth in Indonesia.

Oil constitutes a major part of Indonesia’s exports (approximately 25 percent). In contrast to many other
resource-rich countries, Indonesia has achieved a rapid GDP growth of 5.6 percent per year in the 1980s.
Although growth rates declined in the 1990s, economic GDP growth is now expanding again. This section
shows how Indonesia made use of its oil endowments to induce economic growth and then diversify into
competitive manufacturing.

1. Introduction.
Indonesia, the ‘archipelago of thousand islands’, is the fourth most populous country in the world after China,
India and the US. Current population is 214.5 million, growing at an annual 1,4% (1990-2003). Although
initially a largely rural economy, industrial development has brought large-scale migration to urban areas -
35.9% of the population lived in cities in 1995, compared with 22.4% in 1980. Population distribution is
highly uneven, concentrated on Java, Bali and Madura where 60.73% of Indonesians live. Although the
national incidence of poverty is low (8 percent of the population lives below the international poverty line of
1 US$ a day), more than 50 percent of the population has to live off less than 2 US$ a day (2005).
After a military coup in 1966, General Soeharto was installed as president. The base of his
government was a coalition of diverse groups rather than a narrow political party. Current presidency is held
by Megawati Soekarnoputri, who continued ruling with a cabinet with representatives from all the main
parties.
Table 1. Key economic ratios of the Indonesian economy.
1983 1993 2003
GDP (US$ billions) 85.4 158.0 208.3
Total exports (US$ billions) … 36.8 61.1

% of GDP
Agriculture 22.9 17.9 16.6
Industry 39.8 39.7 43.6
Manufacturing 12.7 22.3 24.7
Services 37.3 42.4 39.9

Natural resources form the backbone of Indonesia’s subsistence and formal economies. Millions depend on
subsistence farming, fishing, tree crop and cash crop cultivation for a living. In recent years oil palm has
expanded rapidly and Indonesia is now the world’s second largest producer of palm oil after Malaysia. The
country also has a vast range of mineral resources. Rich deposits of oil, gas, coal, tin, copper and other
minerals form part of an important mining and quarrying sector.
The manufacturing sector expanded dramatically since the mid-1980s. More recently the services
sectors have expanded rapidly, and in 2000 jointly accounted for approximately 40% of GDP and employed
about one-third of the working population.
Exports have been the primary engine of growth. Before the mid-1970s exports consisted mainly of
a small number of primary commodities, including natural rubber, coconut oil and copra, tin, and crude oil.
Now, semi-processed and manufactured products are increasingly dominating exports (table 2).
Table 2. Key exports of Indonesia (US$ million, fob)
Export product 2000
Oil & gas
Crude petroleum 6,090
Gas 6,625
Petroleum products 1,652
Export product 2000
Agriculture
Shrimps 1,003
 Coffee 312
Fish 359
Minerals
Copper 1,621
Coal 1,276
Industry
Processed wood 2,320
Clothing and textiles 8,337
Processed rubber 1,320
Palm oil 1,087
Electronics 3,162
Paper & paper products 2,291

2. Intervention
Although initially a poor, largely rural economy, Indonesia has many advantages as a populous country with
a resilient agricultural sector and substantial oil reserves. Indonesia’s successive governments have shown a
strong commitment to economic growth.
A scandal involving Pertamina, the state-owned oil corporation, has significantly influenced
Indonesia’s macro-economic policies. Backed with the huge oil reserves in the 1970s, Pertamina recklessly
expanded its activities to a variety of other areas such as steel plant, real estate, tanker fleet and so on. This
led to an accumulation of foreign debt of more then US$10 million that required servicing. This incident
exerted a strong influence upon the Indonesian foreign borrowing strategy in the following years and led to
the cautious management of external debts by policy makers. It also delayed many government projects that
would probably have been inefficient if they would have proceeded. During the 1978-82 period Indonesia’s
ratio of short-term debts to imports never exceeded 18 percent (while the ratio of an oil-rich country like
Mexico never fell below 30 percent).
The Indonesian government continued her conservative fiscal policy, accumulating oil revenues and
controlling government spending. Resource gains were saved abroad, leading to a gross domestic savings of
approximately 30 percent of GDP in the 1980s. The budget expansion was used to strengthen other tradable
sector (like palm oil and later manufacturing) by expanding infrastructure and investing in social services and
agriculture.
The Indonesian government consistently put a high priority on rural development. A significant
fraction of the oil rent was devoted to rural programmes in order to drive labour-intensive agricultural
growth. Considerable emphasis was placed on research in rice production, investment in irrigation, and
subsidisation of fertiliser. Investments paid off and Indonesia raised farm output and productivity, which
transformed the country’s food deficit into self-sufficiency by the mid 1980s.
Other investments were made in the hydrocarbon sector to diversify both foreign exchange earnings
and tax revenues through liquefied natural gas exports. These projects helped to expand and diversify the
country’s hydrocarbon markets. Additional investments went into metal production (steel and aluminium) and
other industries to broaden the manufacturing sector.

Notwithstanding prudent foreign borrowing and fiscal responses, the Indonesian government did intervene
strongly and inefficiently by protecting the manufacturing sector during the period 1982-85. This accelerated
inflation and caused an appreciation of the exchange rate. Dutch disease threatened the competitiveness of
the efficient food grain sector, reduced efficiency in the manufacturing sector and delayed infant industry
maturation. These trade imbalances were threatening the country’s long-term growth, especially when oil
prices fell in 1985. Fortunately, the Indonesian government stabilised the economy by initialising industrial
policy reform and trade liberalisation. Non-tariff barriers were substantially reduced, the number of tariff
bands was halved and the average level of nominal protection was lowered to 20 percent between 1986 and
1991. In addition, restrictions on foreign investment were eased and financial markets were liberalised. These
measures enhanced competitiveness of the Indonesian economy.
As oil prices fell, Indonesian government did not only cancel investments and made cuts in public
spending and subsidies, it also stabilised its real exchange rate through progressive devaluations. Indonesia
devalued its currency up to three times after oil prices fell. This improved the profitability of exports and lead
to increased investment in the non-oil tradable sector. The government broadened its tax base to non-oil
sectors, thereby boosting the non-oil tax share.

3. Benefits for growth.

Wise use of oil rents have led to diversification of the Indonesian economy into agriculture, manufacturing
and a hydrocarbon sector. This diversification has contributed to the consistent growth of the Indonesian
economy:

■ Annual GDP grew with 4.8 percent between 1965 and 1999.

■ Government investments in rural development and the diffusion of Green Revolution technologies have
raised agricultural productivity dramatically. Indonesia’s agriculture transformed into a self-sufficient
industry in the mid 1980s.

■ Palm oil plantations increased from only 106,000 ha in 1967 to 2.96m ha in 1999, and more than 2m
people are now employed in the sub-sector.

■ Economic reforms have boosted both oil as well as non-oil exports. Between 1965 and 1999, Indonesian
export has grown consistently at an annual 5.6 percent. Oil is one of Indonesia’s major export products,
but the expanded manufacturing sector and processing industry are now increasingly important exports.

4. Benefits for poverty reduction.

Economic growth has had a positive effect on poverty rates in Indonesia. Between 1970 and 1999 the level of
absolute poverty fall dramatically from 60 to 8 percent.

5. Benefits to the environment.

Indonesia is suffering from many environmental problems and environmental benefits from economic
development are scarce. Population pressure, increased conversion of forest lands for agricultural purposes or
development projects and inappropriate logging practices have caused unsustainable resource depletion. In
addition to the exhaustion of non-renewable resources, renewable resources are being depleted as a result of
soil erosion and deforestation.

6. Policies and coalitions for change.

Unlike other oil-rich economies like Nigeria, Indonesia benefited from the continuity of a political regime
which was committed to macroeconomic performance and the pursuit of prudent fiscal and exchange rate
policies.

Several factors contributed to the success of Indonesia’s economic growth. First of all, the base of the
Indonesian government was a coalition of diverse groups rather than a narrow political party. This provided a
vehicle for developing consensus, and reduced rivalries over how resources rents were to be spent. The
overwhelming rural character of the Indonesian economy made rural policies a critical priority. Soeharto’s
government was well aware that rural unrest had caused the downfall of its predecessor. Mindful of not
making the same mistake, the government ensured that significant investments reached the rural communities.
A second important factor was the prudent investments of oil revenues during the windfalls of 1974-
78. Although obviously a scandal, the Pertamina crisis stimulated sensible borrowing and investment by the
government. This facilitated the growths of a tradable sector and stimulated export diversification. By the late
1980s, exports had diversified sufficiently to no longer be dependent on oil alone.
Third, although inefficient government investments did occur and rent seeking and cronyism
proliferated, industrial policies were reformed if they clashed with macro policy. The government promptly
dismantled protectionist policies and reduced trade barriers during the second half of the 1980s. Timely
devaluations of the rupee prevented Dutch Disease effects and improved the profitability of the tradable
sector.
7. Remaining challenges.
Notwithstanding its economic success, the sustainability of Indonesian growth has been criticised. Despite
the importance of natural resources to the economy, much of the exploitation is destructive and depletion of
natural resources, soil erosion and deforestation rates have been high. Poor access to credit and markets
caused small farmers to deplete the forest cover and to grow crops on ill-matched soils. Current reforestation
efforts are insufficient to halt deforestation. Improved government policies are required to direct farm
subsidies to upland farmers, who will then be able to adjust their land use. The government should also
promote assistance to forest loggers and provide incentives that promote sustainable forestry (e.g. forest
concessions and increased certification). Donor aid may be necessary to aid the Indonesian government in
implementing new policies and establishing forest reserves.
Also, due to increasing migration to the cities, Indonesia is suffering from increased water and air
pollution and solid waste disposal and land management have become major problems. It has been argued
that environmental destruction has intensified since Soeharto resigned from office in May 1998. The
following political unrest has led to a breakdown in law an order and subsequently to a surge in illegal
logging, mining and fishing, which have now reached alarming levels.
Although economic growth has had positive effects on reducing poverty (absolute poverty fell to 8
percent in 2005), more than 50 percent of the population is still living off less than 2 US$ a day (2005).
Distributing resources rents to increase the income of the large poor population remains an issue of concern.

8. References.
■ Auty, Richard M. (1995) “East Asia’s development escalator: Malaysia and Indonesia.”. In: Auty,
Richard M. (1995) Patterns of Development: Resource Endowment, Development Policy and
Economic Development, Edward Arnold, London, UK.

■ Auty, Richard M. (unpublished) The Political Economy of Deploying Oil Rent for Pro-Poor Growth in
Post-War Angola. Paper for presentation at the ISS, The Hague, May 25th 2005.

■ Economist Intelligence Unit (2001) Country Profile 2001: Indonesia. The Economist Intelligence Unit,
London, UK.

■ Eifert, Benn, Alan Gelb and Nils Tallroth (2002) The political economy of fiscal policy and economic
management in oil exporting countries. World Bank Policy Research Working Paper 2899.

■ Mikesell, Raymond F. (1997) “Explaining the resource curse, with special reference to mineral-
exporting countries”. In: Resources Policy, vol. 23(4): 191-199.

■ Murshed, S. Mansoob (2004) When does natural resource abundance lead to a resource curse?. EEP
Discussion Paper 04-01. International Institute for Environment and Development, London.

■ Usui, Norio (1997) “Dutch disease and policy adjustments to the oil boom: a comparative study of
Indonesia and Mexico”. In: Resources Policy, vol. 23(4): 151-162.

■ World Bank (2004) World Development Report 2005, A Better Investment Climate for Everyone. The
World Bank, Washington, DC.