INDONESIA: GROPING FOR A NEW INDUSTRIALIZATION STRATEGY

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP86T00590R000200210001-0
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 15
• Document Creation Date: December 22, 2016
• Document Release Date: January 18, 2011
• Sequence Number: 1
• Publication Date: April 1, 1985
• Content Type: REPORT

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Con-ffdmft
Indonesia: Groping for a
New Industrialization Strategy
eunfidential
EA 85-10072
April 1985
Copy 357
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Directorate of Confidential
Intelligence 25X1
Indonesia: Groping for a
New Industrialization Strategy
This paper was prepared by
Office of East Asian Analysis. Comments and queries
are welcome and may be directed to the Chief,
Southeast Asia Division, OE
Confidential
EA 85-10072
April 1985
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Indonesia: Groping for a
New Industrialization Strategy
Key Judgments The sluggish performance of Indonesia's economy since the world oil glut
Information available emerged in 1982 is spurring President Soeharto and his chief economic
as of l April 1985
was used in this report. policy makers to gradually shift the country's development away from
dependence on oil to a more labor-intensive, export-oriented approach
emphasizing light manufacturing. Although debate within the government
about an appropriate industrialization strategy continues, we do not expect
dramatic restructuring of the economy during the rest of this decade.
Institutional inertia, competing domestic interest groups, and the modest
economic growth we expect in the next few years will undercut incentives
for radical policy shifts. Marginal improvements in bureaucratic efficiency
and reductions in redtape, however, are likely and, we believe, will
encourage increased private domestic and foreign investment.
Even if Soeharto undertakes far-reaching trade or investment reforms-an
unlikely prospect in our view-their effect would be felt only gradually
because potential investors would probably move slowly until they were
sure of the government's commitment to reform. Thus, by the end of the
decade, Indonesia's manufacturing output will probably remain oriented
primarily to the domestic market, and the economy will continue to depend
on oil exports for most of its foreign exchange earnings.
We believe Jakarta will continue to restrain spending until its financial
position improves, and will not choose a clearcut growth strategy even then,
but will try to balance the competing demands of a rapidly expanding labor
force for jobs against the proponents of large industrial projects. The
debate over growth strategy, however resolved, will have political over-
tones. Infighting among interest groups will intensify as the senior
technocrats continue to hold the line on development spending while other
factions-such as the Research and Technology Ministry and the backers
of large industrial projects postponed in 1983-push for increased spend-
ing. A substantial increase in spending would require foreign borrowing
and risk an external payments crisis because Indonesia's prospects for
boosting foreign exchange earnings are being dimmed by the soft world oil
market. On the other hand, continued austerity risks escalating domestic
social and political discontent-a factor that Soeharto must consider with
parliamentary and presidential elections approaching in 1987 and 1988.
iii Confidential
EA 85-10072
April 1985
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Indonesia: Groping for a
New Industrialization Strategy
Pressures on the Traditional Development Strategy
Jakarta's development strategy has been a predomi-
nantly resource-based, government-controlled pro-
gram financed by oil exports and emphasizing large
projects that depend on imports. The financial moti-
vation for such an approach is not hard to find. The
oil and gas industry earns about 70 percent of Indone-
sia's foreign exchange and supplies over 50 percent of
government revenues. Oil exports, benefiting from the
oil price hikes of the early 1970s, rose from less than
$1 billion to about $5 billion during 1971-75 and
reached about $15 billion in 1981 following the
second round of OPEC price hikes. On the expendi-
ture side, public investment through the 1970s con-
centrated on infrastructure and human resource de-
velopment, but much of the increase since 1979 has
gone to heavy industrial sectors serving the domestic
market such as petrochemicals, fertilizer, cement,
paper, and steel. Although most use domestic natural
-resources, all depend heavily on imported capital
equipment.
The sudden sharp turnaround in oil export earnings in
1982, however, slowed economic growth to -0.4
percent compared with 7.1 percent the year before
and nearly brought Indonesia's industrialization pro-
gram to a halt, forcing the government to reevaluate
its policy options. Falling exports and rising imports
caused the current account to deteriorate from a
surplus of about $2 billion in fiscal year 1980 (1 April
1980-31 March 1981) to a deficit of $7.3 billion in
1982. Previously manageable foreign debt suddenly
became worrisome for foreign lenders as falling oil
export revenues pushed the country's debt service
ratio from a favorable 10.6 percent in FY 1980 to
19.2 percent in FY 1982.
Jakarta adopted the following package of austerity
and reform measures to avoid an untenable further
deterioration in its current account and foreign debt
position:
? Budget austerity, including cuts in subsidies.
? A 28-percent devaluation.
? Postponing or shelving major industrial projects to
cut capital goods imports by some $10 billion over
several years.
? Financial reforms, including deregulation of bank-
ing operations.
? Income tax reforms, particularly simplification of
the tax system and broadening of the tax base.
Although the austerity program nearly halved the
current account deficit in 1983 and 1984, helped
restore the country's foreign exchange reserves to
about $10 billion, and held inflation below 9 percent
in 1984, efforts to spur growth through diversification
of exports have had only limited success. The finan-
cial and tax reforms initially caused potential inves-
tors to postpone investment decisions until they can
assess whether Jakarta is really committed to imple-
menting basic reforms. Furthermore, Indonesia's 5-
percent growth rate in 1984 was due largely to factors
that will not be repeated. New production facilities
boosted LNG (liquefied natural gas) output more than
30 percent and good weather helped produce another
record rice crop.
Policy Options
Each of the options under consideration by Jakarta's
economic planners entails risks. Maintaining the cur-
rent austerity program would protect Indonesia's fi-
nancial standing with foreign bankers, but will slow
the country's growth, intensify the unemployment
problem, and weaken some of Soeharto's financial
backers. Resumption of the traditional strategy of
concentrating public investment in heavy industry and
encouraging the private sector to develop consumer
goods industries aimed at the domestic market would
maintain the government's dominance of the econo-
my, protect the financial interests of the elite, and
utilize key natural resources. This approach, however,
would require increased foreign borrowing, which
would risk Jakarta's standing with foreign bankers
and reduce incentives to cut costs and improve
efficiency.
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Alternatively, the Soeharto government has stated its
intent to encourage increased privatization to make
up for the shortfall in public investment funds and to
emphasize an export-oriented, labor-intensive devel-
opment strategy. Such a program holds the promise of
increasing employment prospects and creating a more
diversified economy able to cushion itself against
downturns in individual commodity markets. This
option, however, would reduce the government's abili-
ty to control the economy and threaten inefficient
domestic firms with stiff new competition from both
domestic and foreign investors. It would also run into
protectionist barriers in industrial country markets
and meet stiff competition from more advanced Third
World countries that have already gained access to
markets.
Failure to choose an appropriate growth strategy
could be costly because population pressures are
intensifying the demand for job-creating investment.
Jakarta needs to create jobs for nearly 2 million new
jobseekers annually and to alleviate unemployment
and underemployment of the existing labor force.
Modernization of agriculture-which employs about
two-thirds of the labor force-while contributing to
national self-sufficiency in rice production, has also
reduced the demand for rural labor and accelerated
the flow of landless laborers into the cities.
The manufacturing sector, which is primarily oriented
to selling in the domestic market, is characterized by
inefficiency and high costs, which hurt its competi-
tiveness in world markets and limit its job-creating
capacity. The combined effect of public and private
investment from 1971 to 1978 tripled employment in
manufacturing from 1.3 million to 4.5 million people,
but industrial workers still accounted for only 10
percent of the labor force, and manufacturing cur-
rently accounts for only 12 percent of national output
and an even smaller share of exports (see figure 1 and
table 1). In industry, the bulk of public investment
since 1979 has gone to heavy industries such as
petrochemicals, fertilizer, and cement, which create
fewer jobs and require greater investment per job than
light industry. The private sector has been encouraged
to invest in consumer goods manufacturing, but is still
constrained by the growth of domestic demand.
Figure 1
Indonesia: 1983 Gross Domestic Product,
by Industrial Origin
Electricity, gas. and water
0.6
Banking and finance
2.5
Other
5.4
Construction
6.1
Public administration
7.2
Manufacturing
12.3
Commerce. hotels, etc.
I5.I
Mining and quarrying
(including oil and gas)
20.2
Other mechanisms have absorbed only limited
amounts of surplus labor. The 1982-83 economic
slowdown has forced increasing reliance on the infor-
mal economy for jobs as street vendors, hawkers,
pedicab drivers, and suppliers of other personal ser-
vices-outlets that up to now have not offered a
satisfactory long-term solution to the unemployment
problem. Indonesia's transmigration program, which
calls for resettling 750,000 families to the outer
islands during 1984-88, offers only partial relief be-
cause of the magnitude of Java's population growth.
Indonesia thus remains highly dependent on the ex-
port of oil, natural gas, and primary products. And
the end of the oil boom has presented Jakarta with
two key tasks it has long expected, but is still not fully
prepared to undertake:
? To reduce dependence on oil by diversifying nonoil
exports.
? To carry out a development program that empha-
sizes manufacturing industries that employ relative-
ly large amounts of labor.
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Table 1
Indonesia: Exports by Commodity
Group, 1983
16.4
2.9
Rubber 4.9
Coffee 2.5
Palm oil 0.4
Other 5.7
4.0
1.5
0.8
0.8
0.4
0.5
2.9
3.5
Conventional approaches to promote exports of manu-
factured products to supplement traditional commod-
ity exports, however, have met tough obstacles. Rising
foreign sales of textiles and plywood, for example,
leveled off in 1984 as foreign demand sagged. Soaring
apparel exports to the United States have resulted in
quota limitations under the Multifiber Agreement,
and Japanese tariffs have hurt sales of Indonesian
plywood.
Nonconventional approaches have fared no better.
Jakarta has expanded trade ties with the USSR and
Eastern Europe, has begun to prepare openly for the
resumption of direct trade with China, and has adopt-
ed such troublesome expedients as countertrade.' In
' Countertrade is a barter-type mechanism recently adopted by
Indonesia and other Third World countries to compensate for
foreign exchange shortfalls resulting from the world oil slump and
the Third World debt crisis
our view, these measures are unlikely to produce
dramatic results because Indonesia can purchase
higher quality, lower priced imports from its major
trading partners-Japan, the United States, and
Western Europe-and find more lucrative markets
for its exports.
Debate Within the Government
Implementing a coherent policy program to cope with
financial and population pressures is complicated by
the fact that different factions within the government
have conflicting agendas. The original group of
Western-trained economists, known as the techno-
crats or the Berkeley Mafia, are Soeharto's leading
economic advisers and head the key economic and
financial ministries (see table 2). Many have been
associated with Soeharto since he came to power in
the 1960s and remain responsible for devising the
government's development strategy and implementing
overall financial and economic policies. A younger
faction of engineering-oriented specialists exhibits less
concern than the older technocrats for balancing
competing demands for resources within overall finan-
cial constraints and tends to push for a high-technol-
ogy strategy-this would encourage metalworking
industries and the development of manufacturing
capabilities in such industries as aircraft, ships, vehi-
cles, and machinery. A third faction includes the
ministries representing heavy industries and their
backers in the military and the bureaucracy. They
exert influence in favor of both state-owned industries
such as petrochemicals, cement, paper, and fertilizers
and the privately owned consumer-goods manufactur-
ing sector.
The original technocrats have sought to promote job
creation in Indonesia's rural areas through govern-
ment-sponsored construction programs and transmi-
gration. They have repeatedly asserted the need to
encourage the development of efficient, labor-
intensive firms able to compete with foreign firms in
domestic markets and abroad. Nonetheless, they have
accepted a statist approach to development and have
authored the government's series of five-year develop-
ment plans. They have not been able to open the
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Soeharto, the Chief Executive
President Soeharto, in power for nearly two decades, is the final arbiter of all ma-
jor decisions in Indonesia. His longstanding goals have been to bequeath the
nation a legacy of political stability, economic growth, and an equitable distribu-
tion of income. Strongly aided by the OPEC oil price windfalls of the 1970s,
Soeharto's government has made remarkable gains under the guidance of his
team of Western-trained economic technocrats.
people.
Although the sluggish world economy and soft oil market have prevented
Soeharto from restoring vigorous growth following the 1982 slump, he demon-
strated his willingness to take tough political steps by introducing a package of
stiff austerity and reform measures in 1983, which have succeeded in averting afi-
nancial crisis. He has continued to respond vigorously to the country's economic
problems by replacing managers of key government agencies with more competent
foreign exchange expenditures.
Despite his demonstrated willingness to make major personnel shakeups, we
believe Soeharto is unlikely to permit existing manufacturing firms to be
bankrupted by more efficient new competition. He seems quite willing to tolerate
continuing factional struggles within the bureaucracy as long as they do not get
out of hand. Thus, he probably will continue to encourage Habibie to pursue a
high-technology approach to development-in Indonesia's context, a strategy
emphasizing the absorption of metalworking capabilities and the mant(facture of
aircraft, ships, vehicles, and machinery. At the same time, Soeharto will continue
to give Wardhana the authority to approve or deny requests involving significant
economy to greater competition because such a move
poses major financial risks for many existing firms
backed by high-level officials in the military and the
bureaucracy. The current concern with averting a
financial crisis and adjusting to the reality of lower oil
income, however, has strengthened the resolve of the
technocrats to impose restraints on public investment
and to seek a greater role for competitive private
investment.
Opposed to the technocrats are groups that have
invested in production facilities to serve the domestic
market.
Military officers are also among those
backing Jakarta's statist approach to development of
heavy industry. This group includes active and retired
officers whose careers have been devoted to industrial
management-an option that arose originally during
the struggle for independence because the military
was the only national institution that had prepared
Indonesians for leadership positions. Protectionist bar-
riers have enabled them to prosper despite inefficiency
and corruption, and they will continue to oppose
moves to open the economy to freer competition.
The freewheeling Minister of Research and Technol-
ogy, B. J. Habibie, more interested in developing
technological capabilities than in living within current
financial constraints, is pushing the high-technology
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can begin for any significant industrial project.
All Wardhana, one of the original Berkeley Mafia, served 15 years as Minister of
Finance before succeeding his mentor, Widjojo Nitisastro, as Coordinating
Minister for Economics, Finance, and Industry in 1983. Wardhana and his fellow
technocrats were the architects of the market-oriented development strategy
followed by Soeharto since he came to power in the mid-] 960s. As Minister of Fi-
nance, Wardhana oversaw the preparations for the tax law revisions introduced
by Soeharto in 1983 and was a key designer of Soeharto's financial austerity and
reform program. Soeharto has entrusted Wardhana with the responsibility for
avoiding excessive foreign debt, and he is determined to avoid the pitfalls of the
major LDC debtor countries. Under Presidential Directive No. 8 of 1984, for
example, Wardhana must grant prior approval before export credit negotiations
front against groups that would undercut Soeharto's austerity program.
Wardhana earned a reputation for his ability to say no during his tenure as
Finance Minister. Armed with the authority granted by Soeharto, Wardhana has
been able to resist pressures from many fronts to restore canceled projects.
Wardhana and his colleagues in the financial and economic ministries remain
closely attuned to the need for external financial balance and maintain a united
strategy. He views the absorption of technology as the
key element of economic development and is deter-
mined to push Indonesia into the front ranks of the
Third World in at least some areas of metalworking
and machinery manufacturing.
Wrestling With the Tradeoffs
Each of Jakarta's factions is counting on increased
investment in manufacturing to diversify the econo-
my, but the government needs to continue restraining
public spending for at least the next several years
because it has no alternative revenue source compara-
ble to oil exports. Even with solid gains in nonoil
exports, soft oil prices will be the chief determinant of
Indonesia's foreign exchange receipts for the foresee-
able future. Continuing softness in oil prices thus is
forcing Jakarta to choose between cuts in investment
spending to maintain financial balance and foreign
borrowing to spur economic growth. Jakarta cut
imports by $3 billion in 1984 by postponing, cutting
back, or canceling major industrial projects. The
rephasing program is expected to reduce planned
expenditures by as much as $10 billion over the next
few years. We believe any further drop in oil prices
would trigger additional cuts in imports of machinery,
equipment, and semiprocessed materials, which ac-
count for more than 85 percent of total imports.
Although such reductions in capital goods imports
help relieve balance-of-payments strains and avoid
excessive foreign borrowing, they also tend to slow job
creation and economic growth.
The rephasing program, by stretching out investment
in electric power and transportation systems, is slow-
ing the growth of labor-intensive industry in the
countryside because manufacturing facilities cannot
operate effectively without such infrastructure. Even
though the government is continuing a $1.5 billion
investment program in the nation's road network and
is planning to spend hundreds of millions on port
improvements, railroads, and shipbuilding in the cur-
rent five-year plan, the program is lagging earlier
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A key policymaker with close ties to President Soeharto, Habibie exerts major in-
fluence on economic policy making through his personal participation in such
bodies as the Pertamina Board of Commissioners and the role of BPPT
(Department of Research and Technology) in decisions involving technology.
Habibie exercises influence on both civilian and military programs, and he or one
of his representatives plays a decisive role in establishing technological standards
throughout Indonesian industry. He carefully cultivates ties with advanced
industrial countries through frequent travel abroad and includes on his personal
staff several foreign advisers, including an American.
without the constraints imposed on other ministries.
Habibie has no peers in the Indonesian hierarchy who match his understanding of
advanced technology, and few can match his energy level in carrying out his
functions. Both his close personal ties to Soeharto and his unchallenged
technological capability have helped him to gain favored access to funding
future, but not before tarnishing Habibie's reputation.
Habibie almost singlehandedly has created an aircraft manufacturing industry in
Indonesia by expanding a small government firm, P. T. Nurtanio, from an airline
service operation employing about 600 workers in 1976 to a full-fledged airframe
producer employing over 12,000 people in less than eight years. The showcase
firm, however, has had problems in building a small passenger aircraft under
license from a Spanish firm. The company probably will succeed in correcting
technical deficiencies and will sell at least some aircraft abroad in the near
technological advance.
More recently, he initiated a program to scrap older ships in order to improve the
efficiency of Indonesia's merchant fleet. Replacements are to be built in Indone-
sian shipyards by P. T. Pal, the national shipbuilding company, even though
steamship company officials have complained that work at Indonesian yards costs
substantially more than in South Korean, Taiwanese, or other foreign shipyards.
Despite the high cost, Habibie sees this program as a means of spurring
plans. And, because of insufficient job opportunities,
landless peasants continue to migrate to the cities,
intensifying social strains in urban areas.
Although powerful groups within the military and the
bureaucracy are exerting influence for the resumption
of major projects and their associated imports, the
technocrats are holding the line; Presidential Instruc-
tion No. 8 of 1984 gives Economics Minister Ward-
hana authority to approve or deny applications for
new foreign credits. We believe any sharp recovery in
foreign exchange earnings will intensify pressure on
the government to resume its earlier investment pro-
gram quickly. For their part, the technocrats are
concerned that any such resumption would risk
balance-of-payments problems and hurt the country's
good international credit rating, especially if the
recovery were only temporary. Thus, for the time
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Table 2
Indonesia: Key Economic Policy Makers
Ali Wardhana Coordinating Minister for Economics, Favor a market-oriented development strategy, favoring
Finance, and Industry foreign investment, free convertibility of currency, flexi-
ble exchange rate, prudent external debt management,
J. B. Sumarlin Chairman of the Central Planning Com- and use of fiscal and monetary policy to maintain price
mission (Bappenas) stability.
Radius Prawiro Minister of Finance
Rachmat Saleh Minister of Trade
Arifin Siregar Governor of Bank of Indonesia
Subroto Minister of Mines and Energy
B. J. Habibie Minister of State for Research and Favor high-technology industries.
Technology
level military and bureaucratic elite; maintain control
Chairman, Capital Investment over key heavy industrial sectors.
Coordinating Board
Chairman, State Logistics Board and
Minister of Cooperatives
being, Jakarta is restraining public investment but, we
believe, will increase spending as soon as financial
conditions permit.
Tinkering With the Existing Strategy
We have no evidence that the debate within the
government on moving ahead with a new industrial
strategy will be resolved in favor of sharp policy shifts
soon. More than likely, in our view, Soeharto will not
opt for a clear-cut strategy, but will follow a cautious,
middle ground approach shifting between the demand
for labor-intensive investment and the development of
heavy industry. Jakarta is taking some initiatives to
improve the economy's performance. For now, these
moves are aimed primarily at improving management
and introducing some financial and regulatory re-
forms. The key will be whether the tax and financial
reforms are decisively implemented and produce visi-
ble benefits, thus paving the way for a new industrial
policy.
Banking reforms adopted in 1983 were aimed at
encouraging the private sector to take up some of the
slack caused by shortfalls in government funding. By
freeing interest rates on deposits and eliminating
many of the investment regulations originally de-
signed to protect ethnic Indonesian entrepreneurs, the
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government sought to mobilize domestic savings and
encourage private investment. Government officials
realized the move probably would benefit the ethnic
Chinese business community, but President Soeharto
apparently was willing to risk the political conse-
quences to protect the country's financial position.
Thus far, although the effect on investment is incon-
clusive, the effect on savings apparently has been
favorable. Furthermore, there has been no major
political criticism of the move, and the government
has not had to reverse itself.
Jakarta introduced a new value-added tax on 1 April
and is trying to broaden the income tax base. With
less than 750,000 registered taxpayers in a nation of
about 170 million people, Indonesia's income tax base
is among the lowest in Asia. As one of the major
income tax revisions introduced last year, Jakarta
offered a pardon for new taxpayers to register by
December 1984 and has now extended the amnesty to
June 1985. Given the past performance of Indonesia's
cumbersome bureaucracy and the lack of trained
personnel to administer the income and value-added
tax programs, we believe the government is likely to
achieve only marginal improvements in tax equity and
efficiency and modest gains in tax revenues-and this
only if Soeharto persists in using the authority of his
office to implement the new tax structure.
Soeharto is pushing for better economic management
by replacing top managers of important government
entities with more competent leadership. Dissatisfac-
tion with Pertamina's financial performance, for ex-
ample, led to the dismissal of Pertamina President
Sumbono and the ouster of Director General of Oil
and Gas Wijarso last year. Foreign oil company
officials thus far have found the new leadership more
competent and cooperative. In late 1984, rumors
began circulating widely in Jakarta that a shakeup in
BKPM (the Capital Investment Coordinating Board)
was impending, spurred largely by the country's
dismal investment performance. And, early this year,
Soeharto replaced the top management of BKPM.
The new investment chief is a protege of State
Secretary Sudharmono, Soeharto's top aide in charge
of the civil bureaucracy, and he has a reputation for
management skill as well as powerful political clout.
The move might improve BKPM's management, but
we believe it will do little to increase investment in the
near term because of factors beyond Jakarta's control.
More recently, Soeharto fired the Director General
for Customs and Excise, who headed one of the
traditionally most corrupt organizations in the Indo-
nesian bureaucracy. According to the US Embassy,
Soeharto acted because Customs Service corruption
threatened to undermine plans to promote domestic
products, nonoil exports, and private investment.
Whether the changes in management reflect a long-
term commitment to encouraging efficient private
investment remains to be seen. Part of the problem is
Jakarta's reluctance to assure improved financial
incentives for foreign investment or to relax its regula-
tory controls-moves that would signal a welcome to
foreign investors. Despite the government's oft repeat-
ed claims of openness to foreign investment, many
Indonesians-including high-level officials-remain
opposed to foreign investment
Foreign investors pulled back sharply in 1984
ecof uncertainty about the implementation of
new tax laws and signs of growing nationalism evi-
dent, for example, in the Manpower Ministry's tight-
ened restrictions on employment of expatriates. The
soft world oil market and a wave of domestic political
unrest reflecting Muslim discontent later in 1984
created additional disincentives.
Despite the recent changes, Jakarta's complex invest-
ment approval process and manpower policies still
discourage new foreign investors. Manpower Minister
Sudomo, a former intelligence chief and longtime
associate of President Soeharto, alarmed potential
investors in 1984 with a series of well-publicized
investigations of expatriate employees. In our view,
Sudomo tightened restrictions on expatriates at least
in part to spur the transfer of jobs to indigenous
Indonesians. The dismal investment figures for the
first half of 1984, however, led President Soeharto to
halt Sudomo's actions and to return control over
expatriate work permits to BKPM, according to US
Embassy reporting. He also ordered the elimination of
duplicate licensing requirements and unnecessary reg-
ulations-moves that probably will not be fully imple-
mented, even though such action would be very
attractive to foreign investors.
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 Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0
Confidential
Looking to the Late 1980s
More of the Same. We believe Indonesia will adhere
to the senior technocrats' conservative approach to
financial management over the next several years to
avoid a debt crisis-a choice that will protect the
balance of payments but constrain investment in
industry. Memories of the economic chaos of the late
Sukarno years and the aftermath of the 1975 Perta-
mina debacle still inhibit Soeharto and his top eco-
nomic advisers from excessive foreign borrowing.
Jakarta's hopes for a rise in foreign exchange earn-
ings, however, are being dampened by the soft world
oil market, which has seen a steady erosion of OPEC's
pricing power over the past three years and promises
continuing austerity for the next few years.
The Indonesians are counting on growth in industrial
country demand for nonoil exports and gradual recov-
ery in domestic demand to achieve 4- to 5-percent
annual growth rates in the next few years. As long as
the economy achieves such growth-a target we
consider likely-we believe Soeharto will opt for
policies aimed at improving efficiency and employing
more labor and will avoid radical departures from the
existing growth strategy. As he approaches a period of
heightened political tension before parliamentary
elections in 1987, we believe he will seek to avoid
unsettling important groups among his supporters or
giving political ammunition to opposition elements by
initiating a risky or potentially painful new growth
strategy.
At least for the next few years, Jakarta will continue
to press for better access to markets in industrial
countries, especially the United States and Japan, for
such labor-intensive products as textiles, plywood, and
other light manufactures. Pressures to boost foreign
exchange earnings will spur continuing efforts to
reduce bureaucratic inefficiency and corruption. Even
if the technocrats were to eliminate internal barriers
to an export promotion strategy-redtape, inefficien-
cy, corruption, and high costs-exports in the 1980s
offer less promising growth prospects than during the
past few decades. Market opportunities for
Indonesian-manufactured exports will be constrained
both by protectionism in developed-country markets
and by competition from other Third World countries
that have already gained access to the most lucrative
markets. Accordingly, Indonesia's manufactured ex-
ports in 1990 will probably continue to consist mainly
of traditional goods such as textiles, wood products,
processed food products, and other light
manufactures.
Would Soeharto Surprise Everyone? Although we
believe the probability is low, we cannot rule out a
move by Soeharto to follow up the recent financial
and tax changes with a far-reaching trade reform
program in the next few years, particularly if the
economy is hit by a severe global downturn or a
slumping oil market. A major trade reform designed
to restructure the manufacturing sector by eliminat-
ing protective tariffs or the maze of investment regu-
lations that now insulate domestic firms from compe-
tition would risk financial damage for many of
Soeharto's supporters, including high-level govern-
ment officials and his own family members. More-
over, the initial impact almost certainly would intensi-
fy unemployment, and the long-term growth in jobs
for Indonesians would occur only gradually. During
the 1983 oil market slump, however, Soeharto placed
national interests before parochial interests when he
postponed or canceled major industrial projects and,
in our view, would take equally drastic actions if the
country's economic situation deteriorated sufficiently.
Political Costs of Slower Growth
The Soeharto government, in our view, is keenly
aware of the political risks 2 of failing to generate
enough jobs, but is more likely to resort to authoritar-
ianism to contain any dissent than to introduce radical
reforms. Although we believe the austerity program
represents a necessary step to avoid a foreign debt
crisis, we remain skeptical that Jakarta will be able or
willing to reorient its development strategy sufficient-
ly to ease the expected worsening in the country's
unemployment problem later in the 1980s. Given the
expected shortfall in investment funds over the next
several years and the steadily rising demand for jobs,
Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0
 Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0
Confidential
If Jakarta were to aggressively pursue deregulation
and privatization, two key elements about which we
know little could significantly influence Indonesia's
long-term growth prospects:
? The growth of the informal or underground
economy.
? The emergence of small-scale unregulated entrepre-
neurial activity.
Indonesia's informal economy traditionally has been
perceived as a labor-absorption mechanism-provid-
ing jobs such as street vendors and pedicab drivers-
with little or no data available on its output or
growth. We do not know whether it has expanded
from processing activities such as food preparation
for sidewalk stalls into operations such as bicycle or
auto repair, manufacturing of simple textiles or
building materials, or similar small-scale operations.
Furthermore, we do not know what the prospects are
for moving beyond simple subsistence to more dy-
namic entrepreneurial growth or the government's
likely reaction to such a development. As it is, the
government is suspicious of the private sector and,
according to the US Embassy, is unwilling to disman-
tle the excessive regulations thar'stifle private invest-
ment and efficiency.
the government will be hard pressed to alleviate social
discontent arising from growing unemployment and
underemployment.
We do not know how the growing number of unem-
ployed will respond to their predicament, but we
believe the government's first response to unrest stem-
ming from economic hardship-or any other reason-
will be stern. Soeharto has never hesitated to crack
down on opposition elements when riots or demonstra-
tions have occurred in the past, and he shows no sign
of changing his approach. This suggests that political
initiatives-probably growing authoritarianism-will
precede any radical shift in Indonesia's economic
policy.
Nonetheless, financial and tax reforms enacted in
1983 could be the first steps in a textbook case of
deregulation and encouragement of small-scale entre-
preneurial growth. Not surprisingly, the initialfinan-
cial and political costs of the reforms have been
high-the pullback in investment in 1984 and the
risk of alienating important segments of Indonesian
society if the Chinese business community appears to
be the greatest gainer from the financial reforms.
If the government continues to eliminate unproduc-
tive regulations, however, Indonesia could see the
emergence of dynamic new industries headed by
entrepreneurs responding to market incentives. The
emergence of the informal economy or a successfully
deregulated private sector characterized by small-
scale entrepreneurs would signal a dramatic shift
toward a free market economy and a promising start
on a new growth path. Information on these and other
emerging developments, however, is badly lacking,
and reporting on newly emerging trends is likely to
become as important as reporting on the oil industry
and agricultural performance is now for assessing
Indonesia's long-term growth prospects.
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Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0
 Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0
Confidential
Confidential
Declassified in Part - Sanitized Copy Approved for Release 2011/11/17: CIA-RDP86T0059OR000200210001-0