Making the Most of High Commodity Prices for Indonesia's Development

March 14, 2011

Sjamsu Rahardja

By: Sjamsu Rahardja, a senior economist at the World Bank office in Jakarta

This is the last in a series of articles by Indonesia-based World Bank economists drawing on analytic work done by the World Bank in collaboration with local partners on the impact of commodity prices on the Indonesian economy. This article looks at Indonesia’s future growth trends assuming a world of higher commodity prices and how those higher prices can best be used to serve Indonesia’s development.

Following the 2008 surge in commodity prices and given the likelihood that commodity prices will remain high for the foreseeable future, economists have started to rethink the role of commodities in the development of natural-resource abundant countries like Indonesia. One of the many questions this raises is whether Indonesia should remain focused on developing its relatively lackluster manufacturing sector, or should it encourage increased commodity production.

As the World Bank research already discussed in the previous three articles shows, the increase in commodities prices over the past decade has been net positive for Indonesia’s poor, helping to reduce the overall national poverty rate. There is no doubt that commodities are hugely important to Indonesia’s economy, accounting for one fourth of GDP and more than one fifth of total government revenue in 2007. It is also worth remembering that Indonesia is one of the largest commodity exporters in the world, a position that it can continue to expand upon given the large reserves that undoubtedly remain to be discovered and exploited.

However, the desirability of commodity-driven development has long been controversial and there is little doubt that in some cases over-reliance on commodities can have adverse consequences, such as price volatility, governance effects linked to corruption, ‘Dutch disease’ (where an increase in revenues from natural resources boosts wealth, appreciating the real exchange rate and drawing production away from the non-resource tradable sector towards the resource tradable sector and non-tradable sector), and low levels of job creation. This has led to the view of some economists that Indonesia should encourage the development of the labor-intensive manufacturing sector. Conversely, others argue that it makes better economic sense to use the commodities sector to create development opportunities, especially in view of the window of opportunity that higher commodity prices provide Indonesia. This would also serve to help Indonesia’s poorer and less-well connected outer islands, where most of Indonesia’s commodities are found.

Although Indonesia has been a major beneficiary of rising commodity prices in recent years, the government has so far missed the opportunity to take full advantage of them. On one hand, the government has used the commodity prices windfall to a large extent on unproductive public spending, such as excessive fuel subsidies that have mostly benefited non-poor Indonesians. On the other hand, it has failed to make the most of the potential supply response to higher commodity prices as a result of a poor investment climate in Indonesia.

High commodity prices going forward provide Indonesia with a new chance to develop a comprehensive strategy for long-term sustainable high and broad-based growth, if well managed. There is much evidence that exploitation of natural resources can lead to prolonged periods of growth and does not preclude the development of manufacturing: Australia, Canada, Sweden and the US all show that rich natural-resource endowments can underpin a successful strategy for broad-based economic growth. Therefore, it makes good economic sense for Indonesia to rely on the revenues generated by the natural-resource sectors to develop the rest of its economy.

It is a golden opportunity for Indonesia but at the same time a challenging one. One challenge for Indonesia in seizing the opportunity, however, can be seen in its poor investment climate. For example, in the potentially highly lucrative mining sector the 2009 Law on Mineral and Coal Mining appears to continue the legal and regulatory uncertainty that has prevented significant foreign investment for several years despite the booming sector globally. Using the prospect of continuing high commodity prices as an opportunity to improve regulatory clarity in the mining sector could trigger a more enthusiastic response by domestic and foreign investors. This in turn could help the government utilize the windfall resources generated in the sector to implement an ambitious broad-based development strategy.

Doing so would be an important element in avoiding Dutch disease, first by helping to create jobs to absorb some of the 1.5 million or more of young people entering into the workforce every year, while diversifying the economy to avoid over-exposure to damaging boom-and-bust cycles in commodity prices. Dutch disease could also be prevented by increasing the competitiveness of the non-resource tradable sectors and avoiding excessive appreciation of the real exchange rate. A comprehensive strategy would ideally aim at increasing competitiveness and dynamism in Indonesia’s tradable sectors, with particular focus on improving logistics chains and infrastructures, nurturing FDI inflows to develop the skills and knowledge needed, and promoting the development of knowledge industries, particularly those in which Indonesia has a comparative advantage.

Meanwhile, exchange rate volatility could be reduced through the creation of a sovereign wealth fund to sterilize surging revenues from high commodity prices. Other negative impacts of commodity price volatility on the poor could be mitigated by well-targeted cash transfer measures and measures to decrease transaction costs and encourage supply, including addressing the bureaucratic obstacles that constrain the swift and cheap transportation of goods.

Inequity and governance issues generally associated with greater commodity production can also be mitigated by the government through redistributing resource windfalls in ways that promote social and political stability. A natural resource boom could increase disparities between Indonesia’s regions, leading to tensions and also increasing opportunities for corruption. Rebalancing revenue-sharing between regions, reforming the public sector to deliver better public services, and establishing a social welfare system to support the poor would make growth more inclusive and help to reduce the potential for increased political instability.

Taking all of these factors into consideration, with a comprehensive strategy to make the most of higher commodity prices Indonesia could have the best of both worlds: it could maximize revenues from increased production of natural resources while using part of the windfall to develop a broad-based competitive economy that would serve to provide long-term employment for Indonesians moving out of poverty.