Client: World Bank

In 2016, Svara Institute (formerly Presisi Indonesia) with World Bank and Ministry of Trade conducted a study on import substitution. Indonesia views the development of a thriving intermediate inputs industry, including processed raw materials and capital goods, as a cornerstone of its industrialization process. As laid out in the master plan (MP3EI) for 2011-2025, the government aims to promote policies that can turn raw materials into semi-processed materials and from semi-processed materials into components and to increase value-addition at home instead relying too much on imports. It is therefore important to be able to evaluate the possible impact of an import substitution strategy (ISS) on the development of the intermediate inputs industry. This study aims to examine how intermediate sectors in the Indonesian manufacturing sector have performed to date, in order to gain insight of the feasibility of ISS as a part of the overall industrialization strategy.

IS policy in Indonesia has been implemented since 1970s. Although it helps to reduce the dependence on imports of intermediate inputs, there seems to be misallocation of resources toward production for the domestic market rather than exports and toward capital-intensive industries rather than labor-intensive ones. Since 1985, the trade policy in Indonesia has been oriented more towards exports. The crisis period of 1997 to 1999 was highlighted with the International Monetary Fund (IMF) intervention to stabilize the Indonesian macroeconomic situation. The IMF’s economic recovery and reform program pushed the Indonesian economy to be an open economy through its unilateral liberalization. There was a sharp decline of protection across sectors in 2008 compared to 1996. However, in 2009, down streaming program was launched by the government to focus on sectors, namely mineral and coal mining. It aims to enhance value added, strengthen the industrial structure, as well as provide jobs and expand business opportunities.

Examining plant-level and trade data of Indonesian manufacturing in the past two decades or so provides a different perspective in respect to implementation of ISS. The most important message is that, there has been a rather healthy natural development of intermediate-input sectors during the time, especially for parts-and-components industry.

Overall, the decision of applying import substitution to local intermediate input industries is not likely be optimal. In fact, it may not achieve the objective of greater domestic supply or more developed intermediate industries. Instead of protecting these industries, the better approach may be to keep, or intensify, the extent of foreign presence in the industries. It is clear from the analysis that intermediate input sectors with the growing presence of foreign investment grew rapidly in the past decades or so.