Industrial development and economic growth: Implications for poverty reduction and income

5.5 Indonesia
From the late 1960s until the Asian economic crisis of 1997, economic
growth in Indonesia was very rapid, averaging 7 per cent per year (Hofman
et al., 2004). During that 30-year period, the country moved from a predom-
inantly agricultural production base to a more industrialized base – the share
of agriculture in GDP declined from 56 per cent in 1965 to 16 per cent in
1997, and the share of industry increased from 13 per cent to 44 per cent
(Figure 7). In the 1970s and 1980s, oil production had a high importance –
e.g., in 1980 the share of mining and quarrying (including crude oil) in GDP
was 25.7 per cent (Ishida, 2003). From the mid-1980s onwards, manufactur-
ing has been the driving force behind economic growth. Agriculture remains,

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however, a very important sector in terms of employment: in 2004 it
accounted for 43 per cent of total employment, whereas industry’s share was
13 per cent (World Bank, 2006). Rapid growth of the economy has benefit-
ed a large share of the population, as poverty fell from more than 70 per cent
in the mid-1960s to 11 per cent in 1996 (Hofman et al., 2004). The Asian
economic crisis in 1997, however, caused an increase in poverty rates. 
In the mid-1960s, Indonesia was still one of the least industrialized of the
large developing countries (Feridhanusetyawan, 2000), poverty was wide-
spread and society in economic and political chaos. In 1966, after a regime
change, thorough reforms were started. The first phase of economic liberaliza-
tion involved a shift away from a closed economy and heavily interventionist
policies to a more market oriented economy (Feridhanusetyawan, 2000).
Liberalization entailed the restoration of external stability, fiscal constraints,
restoration of the banking system, liberalization of the investment regime, and
agricultural support programs aiming especially at self-sufficiency in rice pro-
duction. Liberalization of the investment regime included incentives and
assurances to new foreign investors, and the return of previously nationalized
foreign-owned industrial and trading properties. Preferential treatment for
state enterprises was reduced. New investment laws provided the same incen-
tives to domestic and foreign investors. Export and import procedures were
simplified. Indonesia also moved to a unified, fully convertible fixed exchange
rate, which gave a boost to exports and foreign direct investment. Most of the
price controls were eliminated, and a balanced budget policy was adopted.
Restoration of the banking system included creation of a national central
bank, improved access to credit, authorized establishment of foreign bank
branches and of private domestic banks (Hofman et al. 2004). Chosen poli-
cies fostered broad-based industrial growth in the country (Hofman et al.
2004), but the liberal policy period did not last long. During the 1970s,
Indonesia experienced a rapid growth of income due to an increase of oil pro-
duction. Oil revenues made it possible for the government to finance capital-
intensive investments and engage directly in production, and there was less
need to rely on external sources of capital (Feridhanusetyawan, 2000).
Furthermore, the open door policy at the end of 1960s and beginning of the
1970s had already brought vital foreign investments to the country. As a
result, Indonesia reverted to a public sector-dominated economic strategy
emphasizing import substitution and public financing (Hofman et al., 2004).
State-owned banks provided subsidized credits to favoured clients, the state
was the owner of strategic capital-intensive industries, and barriers to imports
were erected (Feridhanusetyawan, 2000). State-owned factories operated
especially in such areas as oil refining, fertilizers, cement and basic metals.
Exports were mainly of oil and gas, mining and quarrying sector products –
e.g. in 1980, 70 per cent of Indonesian exports were products of this sector
(Ishida, 2003). However, once the oil boom ended at the beginning of the
1980s, the import-substituting pattern of industrialization, financed by oil

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Industrial development and economic growth
revenues, could not be sustained, and the government shifted towards an
export-promoting strategy. Indonesia moved from government-led growth to
greater private sector participation. A series of deregulation measures were
introduced to improve the investment climate. Trade reforms were intro-
duced, including exemption of export-oriented firms from all import duties
and regulations on imported inputs. Investment controls, including invest-
ment licensing, were relaxed. Also, financial sector reforms were started in the
early 1980s and major reforms were carried out at the end of the 1980s
(Hofman et al., 2004). Reforms eased restrictions on the opening of new pri-
vate banks, allowing e.g. foreign banks to open offices. Freedom for banks to
mobilize deposits in support of new lending was increased.
As a result of the improvement in the investment climate, foreign and
domestic direct investments started rising rapidly in the late 1980s (Hofman
et al., 2004), and exports of manufactures started to increase at a remarkable
rate (Figure 8). In 1980, the share of manufacturing exports in merchandise
exports was only 2.3 per cent, but by 1996 the share had expanded to 51.4
per cent. Oil-based exports remained important, however, with the share of
fuels in merchandise exports at the beginning of 2000s still amounting to
approximately one-fourth. Food exports are also of importance. Within the
category of manufacturing exports, the importance of resource-based manu-
factures diminished in the 1980s and, by the early 1990s, they had been
overtaken by low- and medium-technology manufactures (Aswicahyono and
Feridhanusetyawan, 2004). Since the mid-1990s, the share of low-tech prod-
uct exports has declined and that of medium and high-tech products
increased (see Aswicahyono and Feridhanusetyawan, 2004). This trend can
also be seen in the structure of manufacturing production, as the share of
machinery and transport equipment production in manufacturing value-
added increased from 13 per cent in 1980 to 22 per cent in 2002 (World
Bank, 2006). Over the same period, the share of the food sector (food, bev-
erages and tobacco) decreased from 32 per cent to 23 per cent (65 per cent
in 1970), while the share of textiles and clothing, which is also a low-tech
industry, has been relatively steady – between 15 per cent and 21 per cent
during the 1990s. 
Rapid and persistent economic growth, which continued until the late
1990s, had a significant impact on poverty. In the late 1960s a large part of
the population was still living in poverty, but in 1996 the share was only 11
per cent (Hofman et al. 2004; according to World Bank figures, the share was
15.7 per cent). From 1967 to 2002, the income of the bottom 20 per cent
of income earners grew at the same pace as the overall average per capita
income (Timmer, 2004), and growth was thus on average pro-poor during
that period, even if there was considerable variance between sub-periods.
Changes in inequality were relatively minor during the 1964-1996 period,
and the Gini coefficient fluctuated between 0.32 and 0.38 (see
Feridhanusetyawan, 2000).
4
Investment of the oil rents in the financing of

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the green revolution caused a decline of inequality, especially in rural areas,
as employment and production opportunities increased in the rural sector
(Cornia and Kiiski, 2001). Oil revenues allowed large investments in infra-
structure, education and health, all of which also benefited the poor. The
period from the mid-1970s to the late-1980s can in particular be considered
a successful example of fast and equitable growth accompanied by rapid
poverty reduction. However, from the late 1980s until the economic crisis of
the late 1990s, during the period of rapid globalization, the development of
the urban-based manufacturing, financial and other sectors was emphasized,
and there was a slowdown in agricultural growth, which caused a widening
of the rural-urban gap and an increase of overall inequality (Cornia and
Kiiski, 2001). Rural development programs were also retrenched during that
period. As the overall growth was rapid, however, the poverty rate declined
during that period as well. 
Rapid economic growth has significantly decreased poverty in
Indonesia. Growth has been built on strong macroeconomic policies, sup-
port for agriculture, investment in physical and human capital, and increas-
ingly liberal policies in the financial sector, trade, and foreign investment
(Hofman et al., 2004). Rapid growth has tended to be based on labour-
intensive production; thus, growth has in general been pro-poor. As in
China, Taiwan or South Korea, development of and increased productivity
in the agricultural sector have contributed significantly to the reduction in
poverty. The oil boom of the 1970s caused a significant increase in export
income and made possible investments in infrastructure and public goods
that also benefited the poor. Following the oil boom, an increase of manu-
facturing exports has been the driving force of growth. Private sector manu-
facturing has been highly labour-intensive and sectors like textiles and cloth-
ing, wood processing, and the food industry have created employment
opportunities for the poor.