Indonesian Economic Outlook

Indonesian Economic Outlook
2008-2012
ASEAN Economic Integration and the
National Economic Outlook
January 2008
Economic Research Bureau

Directorate of Economic Research and Monetary Policy
Indonesian Economic Outlook
ASEAN Economic Integration and

the National Economic Outlook
January 2008
Economic Research Bureau

Daftar Pustaka
Editors-in-Chief:
Made Sukada
Editorial Team:
Wijoyo Santoso
Endy Dwi Tjahjono
Harmanta
Hidayah Dhini Ari
Ferry Kurniawan
Haris Munandar
Oki Hermansyah
Myrnawati Savitri
The editorial team would like to thank the following members of the Focus Group Discussions
for their participation, information and suggestions: Ministry of Finance, Ministry of Trade, National Development Planning Agency (BAPPENAS), Institute of Economic and Social Research of
the University of Indonesia (LPEM-UI), Bogor Agricultural Institute (IPB), Indonesian Institute
of Sciences (LIPI), the Centre for Strategic and International Studies (CSIS), Indonesian Chamber of Commerce and Industry (KADIN), Indonesian Association of Automotive Manufacturers
(GAIKINDO) and the Indonesian Textile Industries Association (API).
This assessment is the result of analysis and research by the economic research team at the
Directorate of Economic Research and Monetary Policy (DKM). The assessment represents solely
the opinions of the team and does not necessary present or reflect the official opinions of Bank
Indonesia.
ii
Indonesian Economic Outlook 2008 - 2012, January 2008 Edition
Table
Daftar
of Contents
Pustaka
TABLE OF CONTENTS
LIST OF TABLES .....................................................................................................................
LIST OF GRAPHS .....................................................................................................................
LIST OF DIAGRAMS ...................................................................................................................
CHAPTER 1 - GENERAL REVIEW .................................................................................................
v
vii
viii
1
1.1 The World and Indonesian Economy ........................................................................

1.2 Indonesian Economic Outlook, 2008-2012 ..............................................................
1.3 Implications for Macroeconomic and Sectoral Policy .................................................
CHAPTER 2 - UPDATE OF THE WORLD AND INDONESIAN ECONOMY .......................................
1
4
5
7
2.1 Overview of the World Economy ..............................................................................

2.2 Overview of the Indonesian Economy ......................................................................
2.2.1 Indonesian Economic Indicators .....................................................................
2.2.2 Sectoral Developments in the National Economy ............................................
2.2.3 Real Sector and Macroeconomic Policy ..........................................................
CHAPTER 3 - GEARING FOR THE ASEAN ECONOMIC COMMUNITY (AEC) 2015:
IMPLICATIONS FOR THE INDONESIAN ECONOMY ......................................................................
7
10
10
14
17
Background to Establishment of the ASEAN Economic Community ..........................

Dynamics of the ASEAN Economy ............................................................................
Conceptual Review of Economic Integration Theory .................................................
AEC and Implications for Welfare .............................................................................
3.4.1 Impact on Trade in Goods ..............................................................................
3.4.2 Impact on Investment, Growth and Poverty ...................................................
3.4.3 Impact on Labour Conditions .........................................................................
3.5 AEC and Post-Integration Distribution of Output ......................................................
3.6 AEC 2015 and the Monetary Authority Role ............................................................
3.7 Policy Implications ....................................................................................................
3.7.1 Improvements to the Investment Climate and Institution Building ..................
3.7.2 Preparation at the Sectoral Level ....................................................................
CHAPTER 4 MEDIUM-TERM ECONOMIC OUTLOOK ...................................................................
19
20
22
25
28
28
29
30
32
34
35
35
36
41
4.1 Assumptions for the Global Economy, 2008-2012 ....................................................

a. World Economic Growth ......................................................................................
b. World Commodity Prices ......................................................................................
c. International Interest Rates ...................................................................................
d. Global FDI Inflows ................................................................................................
4.2 Assumptions for the Indonesian Economy, 2008-2012 .............................................
a. Government Financial Condition ..........................................................................
b. Domestic Interest Rates ........................................................................................
c. FDI Inflows ...........................................................................................................
41
41
42
43
43
44
44
44
44
3.1
3.2
3.3
3.4
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4.3 Projection for the Indonesian Economy, 2008-2012 .................................................
4.4 Policy Implications ....................................................................................................
4.4.1 Macroeconomic Policy (Monetary and Fiscal) ..................................................
4.4.2 Microeconomic (Structural) Policies ................................................................
CHAPTER 5 - TOPICAL ISSUES ...................................................................................................
45
47
47
47
49
5.1 Mobility of Production Factors, Distribution and Regional Economic Integration .......
5.1.1 Background and Motivation ...........................................................................
5.1.2 Economic Modelling ......................................................................................
5.1.3 Policy Implications ..........................................................................................
5.1.4 Epilogue ........................................................................................................
5.2 Regional Economic Integration, Investment and the Role of Monetary Authority ......
5.2.2 Data and Analysis Method .............................................................................
5.2.3 Short Run Analysis .........................................................................................
5.2.4 Long Run Analysis ..........................................................................................
5.2.5 Conclusions ...................................................................................................
5.3 Impact of Proximity on Provincial Commodity Exports: Gravity Model Approach .......
5.3.1 Overview of Exports by Indonesias Provinces .................................................
5.3.2 Model and Estimates .....................................................................................
5.3.3 Estimate Results .............................................................................................
5.3.4 Conclusions ...................................................................................................
5.4 Human Capital Formation, Income Inequalities and Economic Integration:
49
50
52
53
54
54
55
55
57
57
58
58
60
60
61
62
A Meta-Analysis .......................................................................................................
5.4.2 Education, Openness and Income Inequalities ................................................
5.4.3 Overlapping Generation Economic Model, Heterogeneity and Economic
Integration .....................................................................................................
5.4.4 Role of Human Capital in Conditions of Equilibrium .......................................
BIBLIOGRAPHY .....................................................................................................................
62
62
62
iv
64
65
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Tables
LIST OF TABLES
Table 1.1
Projections ..............................................................................................................
Table 2.1
Table 2.2
Table 2.3
Table 2.4
Table 2.5
Table 2.6
Table 2.7
Table 2.8
World Commodity Consumption ............................................................................

Global FDI Inflows, 1997-2006 ...............................................................................
Policy Changes in FDI Destination Countries, 1992-2006 ........................................
WEF Competitiveness Ratings .................................................................................
Competitiveness Ratings by IMD .............................................................................
Ranking of Competitiveness Components ...............................................................
Findings of Survey on Doing Business .....................................................................
Progress, Implementation of Presidential Instruction No. 6 of 2007 .........................
8
9
10
11
12
12
13
17
Table 3.1
Table 3.2
Table 3.3
23
23
Table 3.6
Table 3.7
Table 3.8
Table 3.9
Table 3.10
Table 3.11
Table 3.12
Table 3.13
Economic Indicators for ASEAN* ............................................................................

Labour Productivity in ASEAN .................................................................................
Intraregional Exports from Exporting Countries as Share of Total Exporting Country
Trade ......................................................................................................................
Total Exports from Exporting Countries to Export Destinations as Share of Total
Exporting Country Trade .........................................................................................
Export Commodities from Exporting Countries to Export Destinations as Share of
Total Exporting Country Trade .................................................................................
Intra-Industry Trade (IIT) Index for ASEAN-5 by Sector over 5 Years ..........................
Intra-Industry Trade (IIT) Index for Indonesia by Sector over 5 Years .........................
Migrant Workers in ASEAN, 2006 (thousands) ........................................................
FDI Outcomes and Employment ..............................................................................
Basic Indicators for ASEAN ......................................................................................
Human Development Indicators for ASEAN .............................................................
Competitiveness Components, Selected ASEAN Members ......................................
Condition of ASEAN Infrastructure .........................................................................
24
25
25
31
32
33
33
33
34
Table 4.1
Table 4.2
Table 4.3
Projection of Global FDI Inflows, 2008-2011 ...........................................................

Basic Domestic Assumptions ...................................................................................
Projections ..............................................................................................................
44
45
47
Table 5.1
Table 5.2
Table 5.3
Table 5.4
Investment Growth and Macroeconomic Performance in Thailand ..........................

Investment Growth and Macroeconomic Performance in Indonesia ........................
Investment Growth and Macroeconomic Performance in Cambodia .......................
Investment Growth and Macroeconomic Performance in Singapore ........................
56
56
56
56
Table 3.4
Table 3.5
24
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Table 5.5
Table 5.6
Table 5.7
Table 5.8
Table 5.9
Table 5.10
Table 5.11
Table 5.12
vi
Investment Growth and Macroeconomic Performance in Malaysia ..........................

Investment Growth and Macroeconomic Performance in the Philippines .................
Investment Growth and Macroeconomic Performance in Vietnam ..........................
Inward FDI and Macroeconomic Performance - 2006 Reference Year ......................
Inward FDI and Macroeconomic Performance 2002-2006 Reference Period .........
Contribution by Province to Non-Fuel Exports and Imports ......................................
Major Export Commodities and Exporting Regions ..................................................
Gravity Model Estimates .........................................................................................
56
56
56
57
57
58
59
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List of Pustaka
Graphs
LIST OF GRAPHS
Graph 2.1
Graph 2.2
Graph 2.3
Graph 2.4
Graph 2.5
Graph 2.6
Graph 2.7
Graph 2.8
Graph 2.9
Graph 2.10
Graph 2.11
Graph 2.12
Graph 2.13
Graph 2.14
Graph 2.15
Graph 2.16
Graph 2.17
Graph 2.18
Contributions to World Growth ..............................................................................

Contributions to World Growth ..............................................................................
Oil Prices, Demand and Production Capacity ...........................................................
Non-Fuel Primary Commodity Prices .......................................................................
World Commodity Supply .......................................................................................
Global FDI Inflows and Mergers & Acquisitions .......................................................
GDP Growth 1989-2007 ........................................................................................
Inflation 1989 2007 .............................................................................................
The Most Problematic Factors for Doing Business ....................................................
Time Required for Business Licensing (days) ............................................................
Most Attractive Venues for FDI (number of responses) ............................................
Risk Indices .............................................................................................................
Criteria for Determination of FDI Venues (Percentage of Responses) ........................
Sectoral Share of GDP ............................................................................................
Sectoral Investment ................................................................................................
Sectoral Dynamics of Capital Stock .........................................................................
Sectoral Growth of Capital Stock ............................................................................
BI Rate and Inflation ...............................................................................................
7
7
8
8
9
9
10
11
12
13
13
14
14
15
15
15
15
18
Graph 4.1
Graph 4.2
Graph 4.3
Graph 4.4
World Economic Growth and Volume of World Trade .............................................

World Oil Price History and Projections ....................................................................
World Commodity Prices, 1906-2006 .....................................................................
Trend in Fiscal policy ...............................................................................................
42
42
43
44
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of Diagrams
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LIST OF DIAGRAMS
Diagram 4.1 Structural Reforms, Aggregate Supply and Performance of the Indonesian Economy
viii
45
Daftar
Foreword
Pustaka
FOREWORD
DEPUTY GOVERNOR OF BANK INDONESIA FOR MONETARY POLICY
FOR PUBLICATION
OF THE INDONESIAN ECONOMIC OUTLOOK, JANUARY 2008 EDITION
The Directorate of Economic Research and Monetary Policy has completed an in-depth study on
the medium-term outlook for the Indonesian economy (2008-2012). The findings of this study have
been carefully organised for presentation in this January 2008 edition of the Indonesian Economic Outlook.
My congratulations for this achievement.
The Indonesian Economic Outlook is a regular semi-annual publication by Bank Indonesia forming
a vital component of a wide range of analyses by many units at Bank Indonesia. The description of the
constellation of the economy, the main study themes, projections and topical issues all serve as a strategic
window on the future condition of the Indonesian economy.
The main topic chosen for this edition is: ASEAN Economic Integration and the National Economic
Outlook. As the monetary authority in this republic, Bank Indonesia has the statutory obligation of
working consistently for low, stable inflation. This low, stable inflation will bring improvement to the
investment climate, which in turn will stimulate greater investment and bring significant expansion in
the stock of capital. This book describes how prudent monetary policy is proven to be a pro-investment
policy, particularly in gearing for the ASEAN Economic Community (AEC) in 2015.
However, investment is hampered by various issues that unfortunately still beset this nation. It is
essential that policy makers, including Bank Indonesia, make use of the dynamics of the global and
domestic economy in the creative design and earnest implementation of a range of policies for
improvement of the investment climate. In the medium-term, the most relevant and effective policy for
the Indonesian economy is a structural policy for strengthening aggregate supply.
The effects of structural flaws will undeniably have a negative impact on inflation and
macroeconomic stability, and therefore the design and implementation of structural policies is not
only the domain of the Government, but also represents a concern of Bank Indonesia. Significant
strengthening in aggregate supply is not only intended to create opportunities and build capacity
among the poor, but is also a prerequisite for high economic growth without sacrificing price stability.
To build the productivity and efficiency of the economy, determined, unswerving effort is necessary to
incorporate FDI-led investment growth, improvement in the quality of our nations human capital and
broader, more intensive transfer of technology into the spirit of each and every policy at the national,
regional and sectoral level.
ix
Daftar Pustaka
Foreword
Finally, on behalf of the Board of Governors of Bank Indonesia, I would like to express my sincere
appreciation to the Editorial Team. May the Almighty God always bestow His Blessing on our work and
lighten our steps on the journey to a better future.
DEPUTY GOVERNOR OF BANK INDONESIA
Hartadi A. Sarwono
Preface
PREFACE
Let us offer our praise and thanksgiving to the Almighty God, by Whose pleasure the book on the
Indonesian Economic Outlook 2008-2012, edition IV January 2008, has successfully reached completion.
In departure from past publications of the Outlook, this edition examines opportunities and challenges
as Indonesia gears for the ASEAN Economic Community (AEC) in 2015 and the relevant implications for
the Indonesian economy. The issue of economic integration has been given special focus in view of the
agreement reached by Indonesia and nine other ASEAN members in November 2007 on the blue print
for establishment of the ASEAN Economic Community in 2015. This represents a joint commitment to
building a stable, prosperous and highly competitive region with balanced economic growth and reduction
in poverty and socio-economic disparities. There is a growing need for assessment of Indonesias economic
fundamentals and the economic integration of ASEAN to support medium to long-term analyses and
projections on the direction of the economy over the coming five years. For this reason, the Indonesian
Economic Outlook has been developed as a regular product of the Economic Research Office of the
Directorate of Economic Research and Monetary Policy at Bank Indonesia.
The economic projections in this Edition IV of the Indonesian Economic Outlook are intended for
use as internal reference for the units at Bank Indonesia in their medium-term analyses and projections,
including assessments and formulation of Destination Statements in the Strategic Forum (FORSTRA) held
each year, and as a source of information for Bank Indonesia stakeholders. Information and data in these
projections is updated on an ongoing basis. The publication of the Indonesian Economic Outlook is the
culmination of a sincere desire to help place the Indonesian economy on a better course for the benefit
of all who call this country their home.
Jakarta, January 2008

MADE SUKADA
Director
Outlook Ekonomi Indonesia 2008 - 2012, Edisi Januari 2008
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Chapter 1: General Review

In the last five years, the world economy has
been marked by a high growth above the historical
average (more than 4%), steadily expanding global
FDI inflows and soaring prices for oil and non-oil
commodities, all leading to added world
inflationary pressure. During the same period, the
Indonesian economy has also seen accelerated
growth, albeit at a moderate level, a low
investment-to-GDP ratio in comparison to the precrisis period despite rising net FDI inflows, and
average inflation slightly above that of the pre-crisis
years triggered mainly by the fuel price hikes in
2005.
In 2008-2012, growth in the world economy
and volume of world trade is predicted to remain
strong, while oil and gas and non-oil commodity
prices will hold above their historical averages. In
the domestic economy, macroeconomic stability
is forecasted to continue with Indonesias fiscal
condition within safe limits accompanied by
steadily rising inflows of FDI. Based on these
assumptions for the world and domestic economic
conditions, the Indonesian economy is predicted
to see further improvement in 2008-2012, with
more vigorous, higher quality economic growth
and falling inflation. This economic outlook is
based on optimism for policy synergy between
Government and Bank Indonesia in maintaining
macroeconomic stability and steady
improvements in the investment climate,
infrastructure, employment and business certainty
through real sector policies. Indonesias
macroeconomic stability and vast market potential
represent two major attractions for international
investors, and for this reason, FDI is predicted to
keep pouring into Indonesia and support strong

investment growth. With investment on the rise,
the economy is expected to chart higher, better
quality growth alongside reduced inflation. A
further benefit will be improvement in real public
purchasing power, which augurs for continued
high growth in consumption. At the same time,
conducive external conditions reflected in the
sustained high volume of world trade is predicted
to strengthen the performance of Indonesias
exports. Growing exports and flourishing
investment activity will be followed by a surge of
imports of goods and services that in turn will
diminish the current account surplus. However,
mounting global FDI inflows will provide a safety
valve for the downward pressure on the balance
of payments, thus maintaining relative exchange
rate stability.
For Indonesia to achieve 7.4%-8.0%
economic growth in 2012, stable macroeconomic
conditions will require support from robust
sectoral policies, such as improvement in the
investment climate (including construction of
infrastructure), greater competitiveness and
productivity, and improvements in the quality of
human resources. These conditions are key to
overcoming supply-side limitations and
stimulating global FDI inflows in support of high,
better quality economic growth.
1.1 The World and Indonesian Economy
The dynamics of the Indonesian economy are
very closely interlinked with the global and regional
economy and influenced by progress improvements
in the investment climate, infrastructure,

productivity, competitiveness and domestic supply
constraints. The world economy has maintained
above 4% growth during the past five years,
surpassing the historical average.1 Key to this
performance is the brisk pace of economic growth
in developing countries (led by China and India)
and Europe. This vigorous growth in the world
economy has been accompanied by surging
volume of world trade volume beyond the longterm trend.2 Consistent with these developments,
global inflows of foreign direct investment (FDI)
flows have seen rapid expansion. However, this
impressive performance is daunted by burgeoning
world prices for oil and non-oil commodities. The
combination of soaring commodity prices amid
continued strong world economic growth has
fuelled world inflationary pressures.
Central banks have responded in varying
ways to mounting world inflationary pressure as
commodity prices remain stubbornly high. This is
explained by the move by some central banks to
consider financial market stability and the outlook
for their domestic economies, in addition to
inflationary pressures. The United States Federal
Reserve has given high priority to recovery from
the financial market crisis and stimulus for the
domestic economy, as demonstrated by aggressive
cuts in the Fed Funds Rate to 3.00% in January
2008. On the other hand, the European Central
Bank (ECB) and Bank of Japan (BOJ) appear to give
greater priority to control of domestic inflationary
pressures and have therefore kept interest rates
on hold.
On the domestic front, while Indonesia is able
to maintain macroeconomic stability, higher, better
1
2
In 1970-2006, world economic growth averaged 3.7%.

Average growth in volume of world trade during the 19702006 period came to 6.1%.
quality growth continues to be hampered by the

array of structural problems such as the investment
climate, infrastructure, productivity and
competitiveness (supply side). Part of this is
explained by the post-crisis structure of the
Indonesian economy, supported more by
consumption and exports while investment has had
a much less significant role. The lack of recovery in
investment is demonstrated by the diminishing
share of investment to GDP, particularly in key
sectors of the Indonesian economy such as
manufacturing, agriculture and mining. In all of
this, inflation behaved differently before and after
the crisis with considerably increased volatility in
the post-crisis period. This condition of lower postcrisis economic growth alongside slightly higher
inflation is an indication of supply-side constraints
impacting aggregate supply, 3 rendering the
Indonesian economy more sensitive to price
pressures.
In spite of the problems described above,
international investors generally see promise in
the business outlook and Indonesia is still
regarded an attractive venue for FDI. In an
UNCTAD survey in 2007, Indonesia ranked
among the top 15 most attractive countries for
FDI. In addition, Indonesias rating on FDI
performance and potential has seen steady
improvement. 4 This is consistent with the
progressive improvement in perceptions of risks
in Indonesia over the years, as show in the
International Country Risk Guide (ICRG).
BIs analysis using the SVAR Blanchard-Quah approach

indicates a steeper post-crisis supply curve compared to the
pre-crisis period. For further analysis, see Nugroho (2007):
Review of the Pre and Post-Crisis Aggregate Supply Curve,
Indonesian Economic Outlook, July 2007 edition.

World Investment Report 2007.

Furthermore, Indonesia is seen as having a large
potential market and healthy business climate.
In the constellation of the Indonesian and
world economy over the past five years, external
factors have contributed in increasingly significant
ways to economic developments in Indonesia. This
is related to Indonesias growing openness to both
the world economy and the region. A noteworthy
development of significance at the regional level is
the plan to move forward the establishment of the
ASEAN Economic Community (AEC) from 2020 to
2015 with the objective of creating a stable,
prosperous and highly competitive zone with
balanced economic growth and reduction of
poverty and socioeconomic disparities. This is
because economic integration promises greater
prosperity for participating nations through
increased market access and incentives for higher
levels of efficiency and economic competitiveness,
including opportunities for more extensive
absorption of labour.
As a region in its own right, ASEAN offers
vast economic potential. In analysis of intraASEAN trade, the Intra-Industry Trade (IIT) index
calculations point to linkages among the various
ASEAN industries that offer strong support for the
ASEAN economic integration process. Using
gravity model applied for five ASEAN nations over
the 1989-2006 period found that the AFTA
agreement is one factor spurring intra-ASEAN
trade.5 In all of this, liberalisation of trade, services
and investment and mobility of labour will affect
labour conditions. For Indonesia, the opportunity
for labour migration is potentially advantageous
5
More complete information on the study findings is

presented in the Box titled Impact of AFTA on ASEAN-5
Export Performance: A Gravity Model Approach in
Chapter 3.
in view of the relatively high rate of

unemployment in Indonesia compared to other
ASEAN nations. 6 However, the FDI trend in
Indonesia over the past five years indicates a shift
in FDI industry orientation from the secondary to
the tertiary sector. Concerning absorption of
labour, this shift in orientation calls for close
monitoring given that the secondary sector
(manufacturing) has traditionally been the largest
provider of employment.
To optimise the benefits of economic
integration, each country is demanded to expand
production capacity. In this regard, the central bank
has a significant role through monetary policy in
promoting higher levels of investment in order to
accumulate physical capital. Empirical evidence
from data from Thailand, Indonesia, Cambodia,
Singapore, Malaysia, the Philippines and Thailand
(ASEAN-7) for the 1992-2006 period points to a
strong relationship between inflation and
investment in those countries. 7 A positive
correlation was also identified between
macroeconomic stability and investment growth.
Both findings indicate that a country with low
inflation and stable macroeconomic conditions will
tend to attract high levels of investment. Central
bank policy aimed at achieving and maintaining
low inflation and stable macroeconomic conditions
can be fittingly described as pro-investment
monetary policy.
According to statistical data taken in 2006, Indonesia and

Myanmar are the two largest labour exporting nations,
accounting for 23% and 27% of total migrant workers in
ASEAN.
More complete study findings are presented in Chapter V,
Topical Issue 2 under the title, Regional Economic
Integration, Investment and the Monetary Authority Role.

1.2 Indonesian Economic Outlook, 2008-2012
The overall forecast is for further improvement
in the Indonesian economy in the coming five years
with growth in the range of 7.4%-8.0%. This
projection assumes that world economic growth and
volume of world trade remain strong alongside
sustained high prices for oil and natural gas and
non-oil commodities, relative stability in world and
Indonesian monetary policy, robust fiscal conditions
in Indonesia and rising inflows of FDI in Indonesia.
The major sources of this growth will be significant
inflows of FDI stimulated by improvements in the
investment climate with FDI reaching 1.5% of GDP
in 2012, bringing the share of investment to about
30% of GDP that year. In addition, intraregional
trade in the ASEAN and Asia-Pacific is predicted to
become a significant source of economic growth in
the medium-term. On the domestic front, disciplined
monetary policy aimed at safeguarding
macroeconomic stability and a continued fiscal
stimulus will have a vital role in bolstering Indonesias
medium-term economic prospects. The above
economic growth forecast is clearly contingent on
robust structural policies such as improvement in
the investment climate, empowerment of MSMEs,
financial sector reform and improvement in
infrastructure.
These conducive external and domestic
conditions are expected to generate higher
economic growth accompanied by subdued
inflation. Macroeconomic stability in combination
with vast market potential represents a vital draw
card for international investors to keep investing in
Indonesia.8 Steadily expanding inflows of FDI will
be followed by buoyant investment growth, set to
8
UNCTAD survey findings state that market size and growth

alongside the quality of the business environment are the
major determining factors in decisions on venues for FDI.
climb from about 9.3% in 2008 to 13.0%-15.0%

in 2012. The brisk investment growth will build
greater economic capacity (read: improvements in
production and distribution) on the supply side,
paving the way for improvement in economic
growth from 6.2% in 2008 to 7.4%-8.0% in 2012
alongside reduced inflation. Low inflation
accompanied by the planned increases in minimum
wage levels will strengthen public purchasing power,
with private consumption predicted to maintain
vigorous growth reaching 5.6%-6.0% in 2012.
With external conditions still conducive,
Indonesias exports are predicted to improve further
alongside mounting global FDI inflows to Indonesia.
This will keep the balance of payments in strong
shape with a stable trend in the exchange rate.
The various structural improvements launched by
the Government, dealing with areas such as
infrastructure, licensing, customs and taxation, will
provide significant support for Indonesias export
competitiveness. In addition, the high volume of
FDI will be accompanied by technological
advancements benefiting productivity and
efficiency. However, export growth and flourishing
investment activity will be followed by increased
imports of goods and services, which in turn will
diminish the current account surplus. However,
mounting global FDI inflows will provide a safety
valve for the pressure bearing down on the balance
of payments. The relatively secure condition of the
balance of payments, supported by improving
economic fundamentals, is forecasted to keep the
exchange rate stable.9
9
This is borne out in survey findings published by UNCTAD

and the Economist Intelligence Unit (EIU) at The Economist,
stating that FDI inflows in Indonesia will remain positive,
particularly because of the size of the domestic market and
considerable potential for expansion seen as adequately
compensating for risks.

Table 1.1 Projections
Projections
Component Growth (%)
Gross Domestic Product
- Private Consumption
- Government Consumption
- Investment
- Export on Goods and Services
- Import on Goods and Services
Others
Income per Capita (USD)
Unemployment (%)
Inflation taget (%)*
2007
2008
2009
2010
2011
2012
6.3
5.0
3.9
9.2
8.0
8.9
6.2
5.4
3.8
9.3
7.9
9.4
6.2-6.8
5.6-5.9
4.0-5.0
10.5-10.8
8.1-9.1
10.4-10.7
6.8-7.4
5.6-6.0
7.0-9.0
11.0-13.0
10.5-11.5
12.5-13.5
7.2-7.8
5.6-6.0
8.0-10.0
12.0-13.0
11.5-12.5
13.5-14.5
7.4-8.0
5.6-6.0
8.0-10.0
13.0-15.0
12.5-13.5
14.5-15.5
1.947.1
9.1
6.01%
1980
9.0
5.01%
2145-2180
9.0-10.0
4.51%
2375-2410
8.5-9.5
4.01%
2650-2685
8.0-9.0
2950-3000
7.5-8.5
*) Pursuant to Decree of the Minister of Finance No. 1 of 2008.
Higher economic growth, subdued inflation,

a stable exchange rate trend and supply-side
improvements are predicted to contribute to higher
levels of public prosperity. Robust economic growth
driven by expanding production capacity will
generate employment for the growing workforce,
with unemployment projected to ease to 7.5%8.5% in 2012. The increased employment of the
workforce accompanied by falling inflation will also
reduce poverty levels. These medium-term
improvements in the economic outlook will in turn
boost prosperity levels with per capita income
expected to climb from USD 1,980 in 2008 to USD
2,950-3,000 in 2012.
1.3 Implications for Macroeconomic and Sectoral
Policy
The envisaged 7.4%-8.0% economic growth
calls for strong support from macro and sectoral
policies as follows:
a.
Monetary policy must maintain a prudent
stance, guiding public expectations of
inflation towards the inflation target while
carefully taking account of the dynamics of
the world and domestic economy.
b. Continuation of the fiscal stimulus for the
economy at the central and regional level over
c.
the next five years without sacrificing longterm fiscal sustainability. The fiscal stimulus
must be targeted at improving infrastructure,
promoting industry capable of generating high
levels of employment, maintaining public
purchasing power, alleviating poverty and
improving income distribution. A steady
reduction is predicted in the fiscal deficit to
1.4% of GDP at end-2012.
Given the importance of physical investment
and human resources to long-term economic
growth, creation of a conducive climate for
investment, infrastructure development,
improved competitiveness and improvement
in human capital will be crucial to building
quality, sustainable economic growth and
readiness for the launching of AEC in 2015.
Concerning this, Presidential Instruction
(Inpres) No. 6 of 2007 concerning Policy for
Accelerated Development of the Real Sector
and Empowerment of Micro, Small and
Medium Enterprises (MSMEs), which covers:
1) Improvements in the Investment Climate,
2) Financial Sector Reform, 3) Accelerated
Construction of Infrastructure and 4)
Empowerment of MSMEs, needs to be fasttracked for optimum implementation.
Chapter 2: Update of the World and Indonesian Economy

The long-term outlook for the world
economy remains positive, despite the turbulent
dynamics of recent months. Reinforcing this is high
world economic growth accompanied by
expanding volume of world trade and growing
international capital flows. Nevertheless, these
positive developments are clouded by persistently
high levels of world commodity prices (fuel and
non-fuel) and the ongoing turmoil on world
financial markets. Domestically, the Indonesian
economy has shown steady progress even though
daunted by weak supply-side response, low
investment role and still inadequate quality of
economic growth reflected in high rates of
unemployment and poverty.
trade, with volume growing at an average of 9.2%

in the past three years, ahead of the long-term
trend.2
(Based on PPP weights, percent of world growth)
35
30
2006
Contributions to Real GDP Growth
2007
25
20
15
10
5
0
China
India
United
States
Euro area
Russia
Japan
Brazil
Source: IMF: Survey Magazine-IMF Research
Graph 2.1 Contributions to World Growth

(Based on PPP weights, percent of world growth)
35
2.1 Overview of the World Economy

In the last five years, world economic growth
has forged ahead at more than 4% per annum,
surpassing the historical average (3.7% for 19702006). This impressive performance has been driven
2006
Contributions to Real GDP Growth
20
2007
15
10
5
by buoyant growth in developing countries and

Europe (unprecedented levels in the last five years).
Rapid economic growth in developing economies,
led by China, India and Russia, has filled the gap
created by the US economic slowdown in the wake
of financial market woes triggered by the subprime
mortgage crisis. For the first time, China and India
have become engines of world growth, as shown
in Graphs 2.1 and 2.2. 1 These impressive
developments in the world economy have also
been accompanied by steady expansion in world
However, these impressive developments are

prices.
overshadowed by spiralling oil prices
Fundamentally, the surging prices are the result of
pressing world demand amid tight supply (see
Graph 2.3). Soaring world oil consumption,
especially in emerging markets like China
In 2006, contributions of growth from China (11.5%), India

(9%) and Russia (8%) accounted for half of world economic
growth.
0
United
States
Euro area
China
Japan
India
United
Kingdom
Russia
Source: IMF: Survey Magazine-IMF Research
Graph 2.2 Contributions to World Growth
In 1970-2006, growth in volume of world trade averaged

6.1%.

accounting for more than one third of growth in
world oil consumption, has not been matched by
adequate supply. In fact, since 2003, spare
production capacity among world oil producers
tend to decline. This has led to an upward spiral in
oil prices beginning in 2003, with prices reaching
a record high of USD100 per barrel in early January
2008. Furthermore, non-fundamental factors, such
as geopolitical conditions in oil-producing
countries, climatic factors and expectations also
influence movement in oil prices.
100
80
77
78
80
82
84
85
69
86
5
67
4
57
60
40
3.1
34
43
28
33
2
2.1
1.9
20
1.3
1.5
1.0
0
2001
2002
2003
2004
2005
160
25
140
20
120
2006
10
100
80
60
-5
40
-10
0
2000
30
15
4.1
29
5.6
77
historical average (see Graph 2.5). Soaring prices

for metal commodities have also been followed
by mounting food prices. This has resulted not only
from supply constraints, due to harvest failures for
example, but has also been spurred by growing
demand for foodstuffs in biofuel production. The
combination of spiralling commodity prices and
robust world economic growth has fuelled world
inflationary pressures. In the second half of 2007,
inflation surged ahead in industrialised nations and
developing nations alike.
2007
20
-15
-20
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Oil Demand - Million Barrel per Day (left)

Oil Price WTI - $ per Barrel (left)
Spare Capacity - Million Barrel per Day (right)
Non-Fuel Primary Commodity Price Index - RHS
Non Fuel Primary Commodity Growth

Source: IMF Database
Source: Energy International Agency (EIA)
Graph 2.3 Oil Prices, Demand and

Production Capacity
Non-oil and gas primary commodities have

also shown a steady upward trend. Before 2000,
these commodity prices were relatively stable (see
Graph 2.4). However, after 2003, primary
commodity prices mounted significantly, with price
escalation reaching as much as 28% in 2006. Prices
have spiralled mainly in response to high world
demand amid tight supply. Table 2.1 below shows
the size of Chinas contribution to consumption of
some non-fuel commodities, such as aluminium
and copper. Supply has tightened because of low
levels of investment in basic metal production and
lack of new discoveries of reserves. Since 2004,
metal inventories have remained below their
Graph 2.4 Non-Fuel Primary Commodity Prices

Table 2.1 World Commodity Consumption
(% Growth)
Projections
2008-2012
Oil
Alumunium
Metals
Copper
Zinc
Agriculture food (c)
Wheat
Maize
Soya beans
Memo:
Share of wprld GDP (percent) (d)
2000 - 04
2005 - 07 (a)
Contribution of (b)
Contribution of (b)
United
United
World States China World States China
1.7
5.2
0.3
-0.4
0.6
2.8
1.4
6.6
0.1
0.2
0.5
5.5
3.4
4.4
-0.9
-0.5
2.5
3.3
2.7
2.4
-0.8
-0.4
3.1
2.4
0.5
2.5
4.4
-0.1
1.0
0.0
-0.2
0.5
1.9
1.2
3.5
5.0
-0.1
1.4
0.9
-0.1
0.8
1.6
20.8
12.3
19.6
15.1
Source: Bank of England, Inflation Report November 2007

(US$ bn)
(number of standard deviations)

1,600
2.0
Wheat. maize and
soya beans (b)
1.5
FDI inflows
M & As
1,400
1.0
1,200
0.5
+
0.0
0.5
1,000
800
600
Metals ( c )
1.0
400
Oil (d)
1.5
200
0
2.0
1997
1999
2001
2003
2005
1992 93
2007
Source: BoE, Energy Infromation Agency, London Metal Exchange, The Economist, Thompson
Data Stream and US Department of Agriculture
94
95
96
97
98
99 2000 01
02
03
04
05
Source: National Statistics, Economist Intelligence Unit, IMF, UNCTAD
Graph 2.5 World Commodity Supply
Graph 2.6 Global FDI Inflows and Mergers &

Acquisitions
In keeping with the impressive performance

in the world economy over the past 4 years, global
inflows of foreign direct investment (FDI) have
seen rapid expansion. Following a period of
The sharp rise in global FDI is explained in

part by higher corporate profits worldwide, which
have driven up share prices and fuelled a wave of
cross-border mergers and acquisitions. The close
substantial negative growth, global FDI charted

significant gains in 2004-2006. The negative
growth in 2001-2003 resulted mainly from
slowing world economic growth and the end of
the previous boom in mergers and acquisitions
(M&A). However, with the improving condition
of the world economy, FDI inflows climbed sharply
with growth in 2004, 2005 and 2006 at 26.6%,
33.1% and 37.4%. In 2006, FDI inflows almost
touched the previous high in 2000 at about USD
1.3 billion (as shown in Table 2.2 below). In 2007,
FDI inflows remained strong although not as high
as in the 2004-2006 period.
link between global FDI inflows and cross-border

M&A is depicted in Graph 2.6 below. This rise in
corporate earnings has caused reinvested earnings
to be an important component in FDI inflows,
accounting for 30% of global FDI inflows in 2006.
In developing nations, this ratio can reach as much
as 50% of total FDI inflows. Government policy in
FDI destination countries has played a role in the
upward trend in global FDI inflows. In 2006, a total
of 147 policies were launched to make FDI host
nations more attractive and conducive venues for
investment. Significant examples include corporate
tax cuts in Brazil and India.
Table 2.2 Global FDI Inflows, 1997-2006

(USD billions)
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Word total
491,8
712,9
1.113,8 1.408,3
851,1
618,1
563,4
730,2
971,7
1.335,1
Developed countries
279,0
493,8
853,0 1.125,0
563,4
421,1
354,6
379,5
546,8
824,4
56,7
69,3
76,6
79,9
66,2
68,1
62,9
52,0
56,3
61,7
212,8
219,1
260,9
283,3
287,8
197,0
208,9
350,7
424,9
510,7
43,3
20,7
23,4
20,1
33,8
31,9
37,1
48,0
43,7
38,8
% of world total
Emerging markets
% of world total
Source: National Statistics, Economist Intelligence Unit, IMF, UNCTAD

Table 2.3 Policy Changes in FDI Destination Countries, 1992-2006
Item
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Number of Countries that

Introduced Changes
43
56
49
63
66
76
60
65
70
71
72
82
103
93
93
Number of Regulatory Change
77
100
110
112
114
150
145
139
150
207
246
242
270
205
184
More Favorable to FDI
77
99
108
106
98
134
136
130
147
193
234
218
234
164
147
Less Favorable to FDI
16
16
14
12
24
36
41
37
Source: UNCTAD, World Investment Report 2007
2.2 Overview of the Indonesian Economy

From long-term perspective, the constellation
of world economic developments, marked by
sustained high economic growth and volume of
world trade, substantial global FDI inflows and
unabated high commodity prices, will continue to
influence the dynamics of the Indonesian economy.
in aggregate demand.4 This has been accompanied

by structural change in the economy, with
investment, once representing 30% of GDP,
hovering at only about 20% of GDP in the postcrisis period. Private consumption has experienced
the reverse, increasing from the pre-crisis share at
less than 60% of GDP to a consistent post-crisis
level at more than 60% of GDP.
2.2.1 Indonesian Economic Indicators

Domestic economic indicators show
improvement, although still overshadowed by a
range of structural problems that could prevent
Indonesia from achieving faster economic growth.
Macroeconomic stability, a prerequisite for
sustainable economic growth, can be maintained
through collaboration by the Government and the
monetary authority in their various policies.
However, in the drive for faster, higher quality
economic growth, Indonesia remains beset by a
range of structural problems.
Since 2002, Indonesias economic growth
has gathered momentum, albeit slowly, with
growth still below the pre-crisis level (see Graph
2.7).3 Economic growth in the post-crisis period
has averaged about 5% per annum, well short of
that in the pre-crisis period indicate a weakening
9
7
5
The analysis is based on the following periodisation: 19891996 for pre-crisis; 2000-2007 for the post-crisis period.
10
Average 2000 - 2007 5.0%
1
-1
-3
-5
1989
1991
1993
Economic Growth
1995
1997
1999
Average 1989-1996
2001
2003
2005 2007*)
Average 2000-2007
Source: CEIC
Graph 2.7 GDP Growth 1989-2007
Inflation has behaved with different

characteristics in the pre-crisis and post-crisis
periods. While the inflation rate in the two periods
only slightly different, its volatility has soared in
4
3
Average 1989 - 1996 7.3%
According to research by BI, the long-term trend in

Indonesias economic growth during the 1981-2007 period
came to 4.9%. This long-term trend is a constant in the
GDP equation derived from macroeconomic models.

the post-crisis period (see Graph 2.8). Post-crisis
economic growth is below that of the previous
period, but despite this, the average post-crisis
inflation is slightly higher than it was in the precrisis period. Theoretically, this occurs only when
aggregate demand softens alongside a
commensurate slowing in aggregate supply. This
interaction in supply and demand is indicative of
supply constraints. 5 Accordingly, resolution of
various structural issues, which will bring
improvement to the investment climate and the
supply side, in conjunction with stimulation of
demand will be key to creating sustainable, quality
growth.
compared to 2005 (see Table 2.4).6 A similar

situation was identified in the International Institute
for Management Development (IMD) survey
published in the World Competitiveness Yearbook
for 2007, which states that Indonesias economic
competitiveness has not improved (Table 2.5). In
2007, Indonesias competitiveness slipped from
52nd spot in 2006 to 54 out of 55 countries.7
Indonesias position was only one notch above
Venezuela and right below that of below
Argentina, Poland and Croatia. When compared
with other ASEAN countries, such as Singapore,
Malaysia, Thailand and the Philippines, Indonesia
lags far behind.
Table 2.4 WEF Competitiveness Ratings
20
Peringkat
15
Negara
10
Indonesia
Singapore
Malaysia
Thailand
Phillippines
Vietnam
Kamboja
Timor-Leste
5
Average 1989-1996 = 8.2%
Average 2000-2007 = 8.7%
0
-5
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
Source : CEIC
Graph 2.8 Inflation 1989 2007
2005
2006
2007
69
5
25
33
73
74
111
113
54
8
19
28
75
64
106
120
54
7
21
28
71
68
110
127
Source: World Economic Forum, Global Competitiveness Report 2006 & 2007
Various indicators and survey findings point

to the continued slow pace of improvement in
economic conditions in Indonesia. According to the
Global Competitiveness Report 2007-2008,
Indonesias economic competitiveness is still ranked
in the 54th position out of 131 countries, following
the significant improvement achieved in 2006
5
Using the Blanchard-Quah SVAR, a research by Bank

Indonesia indicates a steeper post-crisis supply curve
compared to the pre-crisis period. For further analysis, see
Nugroho (2007): Review of the Pre and Post-Crisis
Aggregate Supply Curve, in Indonesian Economic Outlook,
July 2007 edition.
The poor condition of Indonesias

infrastructure, institutions and basic education has
contributed to the lack of improvement in
economic competitiveness. The 2007 WEF (World
Economic Forum) survey also states that the most
important factor hampering business in Indonesia
6
7
Publication by the World Economic Forum (WEF), based on

survey findings.
The IMD criteria in evaluating a countrys competitiveness
include indicators such as economic performance,
government efficiency, business legitimacy, business
efficiency and infrastructure.
11

Table 2.5 Competitiveness Ratings by IMD
Negara
2007
2006
USA
Singapore
Hongkong
China
Taiwan
Malaysia
India
Korea
Thailand
Philippines
Brazil
South Africa
Argentina
Poland
Croatia
Indonesia
Venezuela
1
2
3
15
18
23
27
29
33
45
49
50
51
52
53
54
55
1
3
2
18
17
22
27
32
29
42
44
44
47
58
59
52
53
Total
55
55
2005
Table 2.6 Ranking of Competitiveness

Components
2004
2003
1
3
2
31
11
28
39
29
27
49
51
46
58
57
59
60
1
2
6
24
12
16
34
35
29
52
53
49
59
57
58
60
1
4
40
29
17
21
50
37
30
49
52
47
58
55
57
59
60
60
59
Indonesia
2006
2007
Indonesia
Overall index
Basic requirements
Institutions
Infrastructures
Macroeconomic stability
Health & primary education
Efficiency enhancers
Higher education and training
Goods market & efficiency
Labor market efficiency
Financial market sophistication
Technological readiness
Market size
Innovation & sophistication factors
Business sophistication
Innovation
69
54
75
60
78
73
93
44
70
33
51
58
75
15
41
41
39
54
54
82
63
91
89
78
37
65
23
31
50
75
15
34
33
41
Source: International Institute for Management Development (IMD)
Source: World Economic Forum, Global Competitiveness Report 2006 & 2007
is poor infrastructure, followed by inefficient

government bureaucracy, as shown in Table 2.6 and
Graph 2.9. The quality of Indonesias institutions is
also rated low based on the Transparency
International survey on perceptions of corruption,
in which Indonesia is rated 134th on the list of
corrupt countries worldwide (out of 163 countries).
Meanwhile, a World Bank survey has identified
a number of barriers to commencing business in
Inadequate supply of infrastructure 20.50

Inefficient government bureaucracy 16.10
Access to financing 10.80
Policy instability 10.70
Restrictive labour regulations 8. 50
Tax regulations 8.00
Inadequately educated workforce 5.60
Inflation 5.50
Corruption 4.20
Foreign currency regulations 3.70
Government instability/coups 2.20
Tax rates 2.00
poor work ethic in national labour force 1.80
Crime and theft 0.50
Indonesia, which include the number of procedures

to be completed and the costs involved in business
startup. In general, Indonesias ranking by ease of
startup
starting business ventures improved from 133 in
2006 to 123 in 2007 (see Table 2.7). However,
Indonesias ranking also suffers badly when
compared to other ASEAN countries. Indonesias
position in the 123rd spot is ahead only of countries
like Lesotho, Algeria and Egypt. The most important
barrier to doing business in Indonesia is the process
for starting a business venture, which normally
requires 105 days. This is far longer than the time
12
0
5
10
Source: World Economic Forum. Global Competitiveness Report 2007
15
20
25
Graph 2.9 The Most Problematic Factors for

Doing Business
required in neighbouring countries in ASEAN, such

as Singapore (5 days), Malaysia (24 days), Thailand
(33 days), Vietnam (50 days) and even the Philippines
(58 days) (see Graph 2.10). In this category, Indonesia
holds 168th position out of 178 countries.
Even so, Indonesia is still regarded as an
attractive location for FDI. In a 2007 survey by
UNCTAD, Indonesia ranked among the 15 most
attractive countries for FDI (see Graph 2.11).8
8
UNCTAD, World Investment Prospects Survey 2007-2009.

Table 2.7 Findings of Survey on Doing Business
Ease of Starting Business Dealing with Licenses Registering Property Protecting
Investors
Doing
Time
Rank
Time
Rank
Time
Rank
business Rank
(days)
(days)
(days)
Rank
Economic
Year
Indonesia
Indonesia
Malaysia
Malaysia
Thailand
Thailand
Philippines
Philippines
Singapore
Singapore
India
India
Honduras
Honduras
Brazil
Brazil
Lesotho
Lesotho
Algeria
Algeria
Egypt
Egypt
China
China
Korea
Korea
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
2006
2007
133
123
21
24
17
15
130
133
1
1
132
120
126
121
113
122
119
124
125
125
152
126
92
83
27
30
163
168
74
74
27
36
135
144
11
9
93
111
143
135
120
122
120
126
119
131
126
55
128
135
101
110
97
105
30
24
33
33
58
58
6
5
35
33
44
21
152
152
73
73
24
24
19
9
35
35
17
17
117
99
102
105
11
12
75
77
5
5
133
134
98
72
95
107
146
146
104
108
165
163
175
175
16
22
224
196
285
285
156
156
177
177
102
102
224
224
184
125
316
411
601
601
240
240
249
249
349
336
34
34
123
121
65
67
19
20
81
86
13
13
108
112
89
78
109
110
129
132
153
156
147
101
28
29
65
68
42
42
144
144
2
2
33
33
9
9
62
62
36
24
47
45
101
101
51
51
193
193
29
29
11
11
49
51
4
4
32
33
141
141
2
2
32
33
147
147
62
64
141
141
62
64
105
83
81
83
62
64
Enforcing Contracts
Rank
Time
(days)
Cost
(% debt)
142
141
62
63
26
26
113
113
5
4
177
177
126
124
112
106
99
99
120
117
146
145
20
20
10
10
570
570
600
600
479
479
842
842
120
120
1,420
1,420
480
480
616
616
695
695
630
630
1,010
1,010
406
406
230
230
122,7
122,7
27,5
27,5
14,3
14,3
26
26
17,8
17,8
39,6
39,6
30,4
30,4
16,5
16,5
16,6
16,6
17,4
17,4
25,3
25,3
8,8
8,8
10,3
10,3
Source: World Bank
problems, international investors generally still have

a favourable view of the countrys business
prospects. This consistent with the steady
improvement in perceptions of risks in Indonesia
over the years, as shown in the risk index ratings
152
Brazil
Brunei
Indonesia
Timor-Leste
Phillippines
Vietnam
China
Thailand
Malaysia
Korea
UK
US
Singapore
116
105
82
58
50
35
33
24
17
13
6
5
50
100
150
200
Source: World Bank
Graph 2.10 Time Required for Business Licensing

(days)
Another UNCTAD publication states that Indonesia

has achieved steady improvement in rating for FDI
performance and potential.9 This demonstrates
that while Indonesia is still beset with structural
9
World Investment Report 2007.
110
100
90
80
70
60
50
40
30
20
10
0
China
India
United States
Russian Federation
Brazil
Viet Nam
United Kingdom
Australia
Mexico
Poland
Germany
Thailand
France
Malaysia
Indonesia
Singapore
Italy
Ukraine
Japan
Canada
Republic of Korea
Turkey
South Africa
Serbia
Egypt
United Arab Emirates
Czech Republic
Phillipines
Argentina
Marocco
Venezuela
Hungary
Taiwan Province of China
Bulgaria
Greece
Saudi Arabia
Chile
Belgium
Romania
Peru
Nigeria
Time Required for Business Licensing
Sumber: UNCTAD, World Investment Prospect Survey 2007-2009
Graph 2.11 Most Attractive Venues for FDI

(number of responses)
13

issued in the International Country Risk Guide
(ICRG) and presented in Graph 2.12 below.
Another point of attraction is that Indonesia is
regarded as a large potential market, as evident in
the above WEF survey rating Indonesia as the 15th
largest market among 131 nations. The UNCTAD
survey also states that the size of the market and
market growth together with quality of the
business environment are key determinants in
selecting a location for FDI (see Graph 2.13).10
80
40
ICRG
0
1996
1998
2000
Source: International Country Risk Guide
2002
2004
2006
Graph 2.12 Risk Indices

%
25
20
15
10
Market-related factors
Resources-related factors
Efficiency- Quality of business

seeking
environment
Others
Follow the
leader
Stable
investment
environment
Government
effectiveness
incentives
Cheap labour
Access to
capital market
Access to
natural
resources
Skilled labour
Access of
regional
market
Growth of
local market
Size of local
market
Other motivations
Source: UNCTAD Survey , World Investment Prospect Survey 2007-2009
Graph 2.13 Location Criteria of FDI

(Percentage of Responses)
10
Research findings by Kurniati, Prasmuko and Yanfitri (2007)

state that the determinants of FDI inflows in Indonesia and
emerging Asia are market potential, efficiency issues related
to labour and infrastructure, financial stability reflected in
the stability of the exchange rate and availability of
investment incentives that may reflect the involvement of
home and host countries in a bilateral or regional agreement.
14
2.2.2 Sectoral Developments in the National

Economy
Data from the Central Statistics Agency (BPS)
shows that the agricultural sector role remains vital
to economic growth, despite diminishing from
15.2% of GDP in 2003 to 12.9% in 2006 (see
Graph 2.14). The present constraint on agriculture
involves the low level of investment in provision
and improvement of infrastructure. Graph 2.15
shows that capital formation for the agricultural
sector in 2007 came to only Rp 19 trillion (4.3%)
of the total of Rp 438 trillion across all industries.
However, in the past 40 years, growth in Indonesias
agricultural sector has declined. A shift is under
way in which agriculture is declining, giving way
to the expanding share of manufacturing. In
developed countries like Japan and the USA, a
transition is under way with the expanding share
of the business services sector.
Indonesia ranks among the top 20
agricultural exports, but unfortunately lags behind
other countries endowed with even less agricultural
land. Data from 2005 shows that increased volume
of agricultural exports was also followed by even
higher import growth. Despite the deficit in volume,
the balance of agricultural commodity trade
measured by value still charts a surplus from time
to time. Indonesia is currently experiencing a surge
in volume of rubber exports and is now the worlds
second largest rubber exporter after Thailand.
Indonesia is also the second largest CPO exporting
country after Malaysia, but with exports currently
expanding at a faster rate.
Rice production has failed to maintain
consistent growth over time. As a result, the rice
self-sufficiency achieved in 1984 did not last and
Indonesia must now rely on imports. The slowing
growth in rice production is the result of

(%)
0.30
50
0.25
40
0.20
30
0.15
20
0.10
10
0
0.05
-10
0.00
2000
2001
2002
2003
2004
Agriculture
Electricity. Gas and Water Supply
Mining & Quarrying
Construction
Manufacturing Industry
Trade. Hotel & Restaurant
Source: Central Statistics Agency (BPS), 2008
2005
2006
2007
Transport and Communication

Finance. Real Estate and Business Services
Services
Graph 2.14 Sectoral Share of GDP
-20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Agriculture, Livestock, Forestry
and Fishery
Mining and Quarrying
Electricity, Gas and Water Supply
Construction
Trade, Hotel and Restaurant
Finance, Real Estate and Business Services
Services
Graph 2.17 Sectoral Growth of Capital Stock
Billion Rupiah
120,000
100,000
80,000
60,000
40,000
20,000
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
and Fishery
Construction
Services
Graph 2.15 Sectoral Investment

Billion Rupiah
700,000
600,000
500,000
400,000
300,000
200,000
100,000
0
1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
and Fishery
Construction
Services
Graph 2.16 Sectoral Dynamics of Capital Stock
diminishing area of paddy cultivation in Java due

to the conversion of land to non-agricultural use.
Another reason is the stagnation or even
deterioration in land productivity due to the
absence of new innovations, loss of soil fertility
and damage to irrigation networks and water
sources.
The Economic Sector Mapping Survey (SPSE)
of 2005 shows that 12 mainstay agricultural
commodities, the main driving force in the
agricultural sector
sector, accounted for more than 80%
of primary agricultural sector output and were the
dominant input commodities for agroindustry. At
the same time, the 2006 congress of the Indonesian
Economists Association designated palm oil, coffee,
rubber, cocoa and fish and shrimp as Indonesias 5
leading agricultural commodities.
Strong international market prospects for
the estates subsector, covering palm oil (CPO),
rubber, cocoa and sugar, are buoyed by rising
competitiveness. Three fundamental factors
underlie this strength: the successful outcome of
the WTO meeting in Hong Kong with agreement
on rescinding of all export subsidies in the
agricultural sector by 2013; pressure on
15

competitor countries for agricultural reforms
involving substantial cuts in price supports,
subsidies and protection; and the spiralling trend
in fuel prices.
Annual growth in the mining and quarrying
sector has fluctuated widely, most importantly from
growth in oil and natural gas subsector. While the
mining sector accounts for a relatively modest share
of GDP (10.6% in 2006) with expansion lagging
behind growth in the economy (5% in 2006), it
also has a strategic role in providing the energy
necessary for sustained economic growth. In
addition, the oil and natural gas subsector still plays
a major role in state budget revenues.
Investment in the mining sector is relatively
low compared to other sectors (Rp 11 trillion or
2.6% in 2007). This is also confirmed by data on
FDI and domestic investment approvals (Investment
Coordinating Board/BKPM), data on investment
credit and the results of a Price Waterhouse
Coopers survey. Value of FDI and domestic
investment approvals has steadily declined. The
survey claims a downward trend in investment
spending on mineral and coal-mining companies,
with recovery beginning in 2002.
The mining sector represents 10 mainstay
commodities: oil and natural gas in the oil and gas
subsector, and coal, copper, gold, silver, tin, nickel,
bauxite and iron ore in the non-oil and gas
subsector. These commodities not only have strong
linkages, but also call for higher levels of production
because of their robust competitiveness. The oil
and gas subsector remains dominant within the
mining sector (53% in 2007) despite a diminishing
trend. Falling production of oil and gas needs to
be addressed by boosting investment in the mining
sector while reducing domestic consumption of oil
and gas.
16
Indonesias mining resources and reserves,

in particular coal, natural gas and crude oil, still
hold considerable potential for development.
Crude oil production has steadily declined in recent
years due to the many oil wells reaching the end
of their productive life and minimum large-scale
developments. Non-OPEC countries, such as Russia,
Angola, Brazil, Azerbaijan, the USA and Canada
are expected to keep expanding their production
capacity.
The oil and gas subsector still faces some
policy and regulatory constraints, such as taxation,
contractual terms and conditions, labour issues and
social and environmental problems. The non-oil
and gas subsector faces challenges in relation to
overlapping cross-sectoral policy, lack of support
from regional autonomy, imposition of taxes and
non-tax levies, scarcity of bank financing and social
and environmental issues.
On a sectoral level, the largest contributor
to GDP is manufacturing (28% in 2007), but the
highest net capital stock is in fact held by the
services sector (25.3%). This is related to the need
for information and communications technology
in all areas of life in the current era of globalisation,
for example, in financial transactions.
In general, non-oil and gas manufacturing
still has a dominant role in the economy, despite a
downturn during the crisis. In 2007, the share of
non-oil and gas sector reached 22.8% of total GDP,
which compares to only 5.2% for the oil and
natural gas industry. However, this sector is still
sensitive to shocks in external demand and is
fraught with the problems of poor competitiveness
and low investment. From contribution to
economic growth point of view, employment and
equity in development, the non-oil and gas
manufacturing role still suffers in comparison to

the pre-crisis period. This is due to the nature of
Indonesias manufacturing, which predominantly
serves the domestic market but is highly dependent
on imports, in addition to the sensitivity of industry
to ongoing heavy shocks in external demand, low
competitiveness and minimum investment. Some
competitive non-oil and gas commodities
generating significant value added are crude palm
oil (CPO) and some textile products.
Table 2.8 Progress, Implementation of Presidential

Instruction No. 6 of 2007
Agenda
Investment Climate
Enhancement
Financial Sector Reform
Accelerating of
Infrastructure
Development
Small Scale Enterprise
Empowerment
Total
Number of Actions
Finished by
Total to be Finished June 2007
50
40
9
5
7
5
41
34
165
12
28
8
21
Source: Office of the Coordinating Minister of the Economy
2.2.3 Real Sector and Macroeconomic Policy

The policy synergy between the Government
and the monetary authority has succeeded in
creating macroeconomic stability, a prerequisite to
sustainable, quality development.
The Government has introduced a range of
policies to promote economic growth and reduce
unemployment and poverty. In 2007, the
Coordinating Minister for the Economy, acting for
the Government, issued Presidential Instruction
(Inpres) No. 6 concerning Policy for Accelerated
Development of the Real Sector and Empowerment
of Micro, Small and Medium Enterprises (MSMEs).
This Presidential Instruction covers the following:
1) Improvements in the Investment Climate, 2)
Financial Sector Reform, 3) Accelerated
Infrastructure development and 4) Empowerment
of MSMEs. However, in the outcome, the
Presidential Instruction has failed to deliver optimum
results. Mid-year progress in implementation of the
Inpres is presented in Table 2.8.
On the fiscal policy side, in 2006 the Ministry
of Finance changed its fiscal orientation to stimulus
for economic activity in support of economic
growth and poverty reduction. The fiscal stimulus
operates through tax relief, recurrent expenditures
and capital expenditures targeting improvements
in basic infrastructure as a prerequisite for boosting
economic growth. To support the poverty

alleviation programme and more extensive creation
of employment, stimulation is also provided for
regional economies through the Special Allocation
Funds (DAK).
On the monetary policy side, Bank Indonesia
(BI) is consistently engaged in steering policy in
pursuit of price stability under the Inflation
Targeting Framework (ITF). Stable macroeconomic
conditions and subdued inflation have provided the
basis for the monetary authoritys gradual
reductions in the BI Rate. This reduction is intended
to deliver a stimulus for the real sector and provide
greater incentive for banks to lower their loan
interest rates in order to promote further expansion
in domestic demand.
The synergy between the fiscal and monetary
authorities for achieving price stability is
demonstrated, among others, by the adoption of
the inflation target in a joint decision by the
Government and BI. The explicit terms of the
cooperation between the Government and BI are
set out in the Memorandum of Understanding
concerning the Mechanism for Establishment of
the Inflation Target and Inflation Monitoring and
Control in Indonesia dated 1 July 2004.
Furthermore, Finance Minister Decree No. 339/
17

KMK.011/2004 dated 6 September 2004 states
that the inflation targeting period is 3 years, and
the target used is annual CPI inflation (yoy). The
target was first adopted for the 2005-2007 period
at 6.5%, 5.5% and 4.5% in the respective years,
with a deviation tolerance of 1%. Following this
on 17 March 2006, the target was revised to 8.0%,
6.0% and 5.0% with 1% deviation for 20052008 period. The achievement of low inflation is
deemed important to maintaining public
purchasing power.
18
%
20
18
16
14
12
10
8
6
4
Inflation
BI Rate
0
Jul
Sep Nov Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan
2005
2006
2007
2008
Graph 2.18 BI Rate and Inflation
Chapter 3: Gearing for the ASEAN Economic Community (AEC) 2015:

Implications for the Indonesian Economy

Given the constellation of the Indonesian and
world economy over the past five years, external
factors represent an increasingly significant
contribution to developments in the Indonesian
economy. This is related to the growing openness
of the Indonesian economy to both world and
regional economic forces. A noteworthy
development at the regional level is the planned
formation of the ASEAN Economic Community
(AEC) in 2015 with the objective of creating a
stable, prosperous and highly competitive area with
balanced economic growth and reduction of
poverty and socioeconomic disparities. In view of
the importance of this new development in
Southeast Asia, this chapter examines the
implications of the AEC for the Indonesian
economy.
Globalisation has become topic of frequent
discussion in the past two decades, in most cases
with great enthusiasm, but sometimes
overshadowed by concerns and disappointment.
Globalisation, which means none other than
comprehensive economic integration, will soon
assume a visible form for ASEAN countries in the
form of the ASEAN Economic Community (AEC).
In the aftermath of World War II, world trends been
marked by a proliferation of regional economic
treaties in various parts of the world in a movement
towards globalisation. According to the WTO, in
2006 about 200 regional economic agreements
were in effective operation worldwide, with others
still in the negotiation stage. The volume of
international trade taking place under regional
economic agreements now accounts for more than
half of total global trade, up from only 20% in
1960. 1 The largest regional economic treaties

established so far are the North American Free
Trade Area (NAFTA) and European Community (EC).
On a theoretical level, economic integration
promises increased prosperity for participating
nations, among others, through improved market
access and incentives for more robust efficiency
and economic competitiveness, including
opportunities for greater employment. This is also
supported by the many empirical findings pointing
to a positive correlation between world economic
integration and economic growth. Even so, not a
few espouse the contrary opinion, that economic
integration brings positive benefits only to the more
advanced countries.
The signature of the ASEAN Declaration in
Singapore on 20 November 2007 concerning AEC
2015 marks a new chapter in the history of ASEAN
regional cooperation. The adoption of the
declaration, which contains the blue print of the
actions in preparation for AEC 2015, means that
there can no longer be any vacillating over the
commitment to ASEAN economic integration. In
short, AEC calls for the transformation of ASEAN
into a region with free mobility of goods, services
and skilled labour supported by more liberal
movement of capital. The impact of this change
will be the creation of new configurations in the
distribution of production outputs and production
factors within the intra-ASEAN economy.
A very crucial question is therefore to what
extent this change will have implications for
Indonesias economy. This question will be
Indonesia
1
See WTO News & Views, July-September 2006, Vol. 2 No. 3
19

answered by reviewing the impact of the AEC in
various areas, namely trade, labour conditions,
investment, growth and poverty alleviation. Some
areas of the study lend themselves to empirical
approaches, but the study attempts to respond to
other areas, such as impact on labour conditions
and poverty alleviation, on a theoretical, conceptual
level, given the lack of data for empirical
interpretation. In addition, the theoretical review
will also attempt to examine the post-integration
division of the economic pie within ASEAN. Finally,
there will be a discussion of the monetary authority
role in implementing AEC 2015. This will include
an examination of whether the BI monetary policy,
focused on a commitment to low inflation and
macroeconomic stability, will help Indonesia reap
maximum benefits from establishment of the AEC.
for integration in 2010. This would be followed by

an additional priority sector in 2015, namely logistic
services. Nine of these sectors account for more
than 50 percent of merchandise trade within
ASEAN. The full list of priority goods and services
consists of: 1) Agro-based products, 2) Automotive,
3) Electronics, 4) Fisheries, 5) Rubber-based
products, 6) Textiles & apparels, 7) Wood-based
products, 8) Air travel, 9) E-ASEAN, 10) Healthcare,
11) Tourism and 12) Logistic services.
A number of subsequent meetings
deliberated a draft blueprint for the AEC setting
out the characteristics, elements, priority action
plans, targets and schedule for bringing the AEC
into being with four pillars as follows:
3.1 Background to Establishment of the ASEAN

Economic Community
The ASEAN Economic Community (AEC) is
essentially an extension of the regional economic
integration initiated with the formation of AFTA in
1992. The overarching framework for regional
economic integration was then formulated at the
1997 ASEAN Summit in Kuala Lumpur, which gave
birth to the ASEAN 2020 Vision: to create a stable,
prosperous and highly competitive region with
balanced economic growth and reduction in
poverty and socioeconomic disparities.
In 2003, the ASEAN Summit in Bali adopted
three pillars for realising the ASEAN vision: The
ASEAN Economic Community (AEC), the ASEAN
Security Community and the ASEAN Socio-Cultural
Community. The summit also agreed that the AEC
Single market and production base, covering:

free flow of goods, services, investment,
skilled labour and freer flow of capital, Priority
Integration Sectors and food, agriculture and
forestry.
2) Competitive economic region, covering:
competition policy, consumer protection,
Intellectual Property Rights (IPR),
infrastructure development, energy, taxation
and e-commerce.
3) Equitable economic development, covering:
SME development and initiatives for ASEAN
integration.
4) Full integration into the global economy,
covering: coherent approach toward external
economic relations and enhanced
participation in global supply networks.
Following this, the ASEAN Summit in January
2007 agreed to move forward the formation of
the AEC from 2020 to 2015.
2015 Some of the
should come into being no later than 2020.

Significantly, the summit agreed on 11 priority
sectors (7 goods and 4 services sectors) targeted
underlying considerations in this decision are: (i)

potential for reductions of up to 20 percent in
production costs for consumer goods within
20
1)

ASEAN as a result of economic integration,2 (ii)
increased regional capacity through
implementation of international standards and
practices and application of intellectual property
rights, (iii) improved quality of regional
infrastructure with integration of transportation,
telecommunications and energy, and (iv) improved
benefits for the ASEAN private sector. At the ASEAN
Summit in November 2007, the draft blueprint for
the AEC was finally approved and signed by all
ASEAN heads of state.
The four pillars in the AEC will be phased in
with the current focus on building the first pillar of
investment. The
liberalisation of trade, services and investment
first pillar will provide the basis for building the
subsequent pillars, so that eventually ASEAN will
be ready for full integration into the global
economy.
The expectation of becoming fully integrated
into the global economy also attests to ASEANs
confidence in the AEC regional cooperation as a
trade.3 The
building block towards multilateral free trade
regional cooperation will foster the creation of
comparative advantage for the region as a whole,
which will ultimately bring greater opportunities
to individual countries in the climate of global
competition. In addition, the regional cooperation
under way in ASEAN is open, meaning that
alongside the preferential liberalisation involving
tariff cuts and dismantling of trade barriers among
fellow members, ASEAN countries will also pursue
2
Study by A. McKinsey & Company, ASEAN Secretariat

publication, An ASEAN Economic Community by 2015, 23
January 2007.
This relates to the study by Bhagwati (World Trading System
at Risk, Princeton, 1990) noted for the question: will regional
cooperation (preferential trading arrangements) become the
building blocks or stumbling blocks in the process towards
multilateral free trade?
unilateral liberalisation with tariff cuts and removal

of trade barriers with all countries worldwide.4
In merchandise trade, ASEAN has made
significant progress in eliminating tariffs under the
ASEAN Free Trade Area Common Effective
Preferential Tariff (AFTA CEPT) scheme. To illustrate,
only 1.74% remained of the average CEPT tariff
for the ASEAN-6 countries in 2006, while for tariffs
in Cambodia, Laos, Myanmar and Vietnam (CLMV)
were 4.65% and for the entire ASEAN-10 2.82%.5
For this reason, the AEC blueprint for trade in goods
focuses on areas such as reduction of non-tariff
barriers, improvements in customs administration
systems and harmonisation of product standards.
For trade in services, the liberalisation of the
services sector will take place under the ASEAN
Framework Agreement on Services (AFAS),
1995. These actions
declared as far back as 1995
include the compilation of barriers to cross-border
trade in services, formulation of Mutual
Recognition Agreements (MRAs) for architectural
services, accounting, surveyor qualifications and
medical personnel including dentists (targeted for
completion in 2008), further MRAs for other
professional services (deadline 2015) and
expanded foreign participation in four service
sectors (to 51%) and logistics services (to 49%)
in 2008.6
5
6
Soesastro, Hadi, Competition Policy, Competitiveness,

Liberalisation, Globalisation, Regionalisation and All That,
CSIS Working Paper Series, March 2004.
Pangestu, Mari E., AEC Blueprint: Challenges for
Indonesia, CSIS Jakarta, 2 November 2007
A Mutual Recognition Agreement (MRA) is an international
agreement between two or more nations agreeing to
recognise each others assessment of qualification.
Assessment of qualification covers activities determining,
directly or indirectly, whether a process, product or services
satisfies relevant standards and demands.
21

In investment, the actions taken essentially
strengthen the existing Framework on the ASEAN
Investment Area (AIA) adopted in 1998 under the
more all-encompassing ASEAN Comprehensive
Investment Agreement (ACIA). This includes the
lifting of all restrictions on investment (2008-2009),
upgrading of all investment supporting facilities
such as the FDI database, networking among
ASEAN investment promotion agencies and the
database on industry clusters.
Regarding skilled labour, the MRAs for
professionals (including those in priority sectors)
2008. In the AEC
are targeted for completion in 2008
2015 Blueprint, skilled labour is defined as follows:
1) workers with special skills, knowledge or abilities
in their field of work; and 2) graduates from
universities, academies, technical schools or
workers with expertise gained in the course of their
work. Actions related to mobility of labour in the
AEC 2015 Blueprint are outlined as follows:
a.
Regulation of mobility or entry facilities for
labour according to the regulations
customarily applied in the host country.
ASEAN will facilitate the issuance of visas and
worker ID cards for ASEAN professionals and
skilled labour.
b. To facilitate free movement of services in
2015, ASEAN is working towards
harmonisation and standardisation through:
Cooperation among members of the

ASEAN University Network (AUN) for
increased mobility of students and
teaching staff.
Development of index on core

competencies (according to expertise
and qualifications) for jobs and trainer
skills in priority service sectors (2007)
and other service sectors (2010-2015).
22
Redouble research for improvement of

skills, employment and development of
information networking on the labour
market.
3.2 Dynamics of the ASEAN Economy

As a region in its own right, ASEAN offers
vast economic potential. ASEAN has a population
of 567.6 million (compared to the near 500 million
in the European Union) and a total GDP of about
USD1.1 trillion, and is therefore holds enormous
promise as a market. The share of trade to GDP in
each ASEAN country is also high, underscoring the
regions activity in international trade. ASEAN is
viewed as a highly attractive venue for international
capital, as evident from steadily mounting FDI
inflows from year to year. This also points to
ASEANs vast potential as a production base, a
condition supported by the regions abundant
workforce. ASEANs potential as described above
is presented in Table 3.1.
Although ASEAN has vast potential as a
region, it is unfortunately also beset by enormous
disparities. ASEAN countries represent a wide range
of per capita income. On one end of the scale is
Brunei Darussalam with per capita income at USD
30,200 per annum, almost 150 times that of
Myanmar at a mere USD 200. Similarly, the ranking
of individual ASEAN nations by income has
remained practically unchanged since the mid1970s. In one country, inflation is only about 1%
and deflation is also reported, while in some
countries inflation still runs at about 6%-7%. The
workforce profile shows a similar pattern. In
Indonesia, ASEANs most populated country,
unemployment runs at about 10%, well above that
of other countries. Consistent with the
unemployment profile, yawning gaps in the quality

Table 3.1 Economic Indicators for ASEAN*
Population Inflation (yoy)
GDP per capita
million percent
2006
2006
US$
2006
Unemployment Rate
Country
Brunei Darussalam
0.38
-0.7 30,213.6
US$ PPP
2006
25,094.1
percent
2005/2006
Merchandise Trade
FDI Net Inflow (yoy)
Ratio of
Ratio of
exports to GDP imports to GDP
percent
2006
percent
2006
4.0
65.8
12.9
million US$ percent

2005-2006 2005-2006
145.0
50.2
Cambodia
14.16
2.8
512.3
3,226.0
0.8
48.4
40.3
102.0
26.8
Indonesia
222.05
6.6
1,640.4
4,321.3
10.5
27.7
16.8
(2,779.8)
(33.4)
6.14
4.7
574.0
2,332.1
11.4
16.7
159.7
575.8
Malaysia
26.69
3.1
5,880.4
12,184.9
3.0
100.2
81.8
2,094.9
52.8
Myanmar
57.29
208.6
1,958.8
29.4
17.7
(92.9)
(39.4)
Philippines
86.91
4.3
1,351.5
5,332.7
8.1
40.4
44.1
491.0
26.5
Singapore
4.48
0.8 29,499.6
32,379.6
2.7
205.3
180.3
9,053.5
60.4
Thailand
65.23
3.5
9,163.5
1.3
58.8
61.5
1,799.1
20.1
Vietnam
84.22
6.6
723.9
3,373.3
5.3
60.8
66.0
339.2
16.8
ASEAN
567.60
1,890.3
5,210.2
n.a.
70.0
61.0
11,311.7
27.5
Laos
3,167.8
*as of 15 September 2007

Source: ASEAN Secretariat
of the workforce are reflected in the wide disparities

in worker productivity. For example, worker
productivity in Singapore is almost 17 times ahead
of Cambodia, 10.6 times better than in Myanmar
and 10 times that of Vietnam. Concerning
international capital, Singapore leads the way in
FDI inflows, far outperforming other ASEAN
members. All this is consistent with widely varying
condition of the business climate, with business
Table 3.2 Labour Productivity in ASEAN
Negara
1990
Cambodia
2296
Indonesia
5945
Malaysia
13434
Myanmar
1959
Phillippines 6348
Singapore 28191
Thailand
8291
Vietnam
2346
Source: ILO
1995
2000
2003
2004
2005
2297 3037
8205 7588
18473 19254
2328 3017
6195 6952
38888 42888
11871 11984
3094 3803
2732
8321
19953
3819
6797
46235
13135
4328
2714
8656
21128
4172
7164
49457
13541
4553
2845
922
22112
4541
7271
47975
13915
4809
startups in Singapore requiring only 5 days

compared to 105 and 103 days in Indonesia and
Laos respectively.
ASEAN offers tremendous promise for
intraregional trade. At this time, the share of
intraregional trade in ASEAN is still small in
comparison to trade with non-ASEAN partners, but
recent years have seen steady growth in the share
of intraregional trade. In 2006, intraregional trade
accounted for 24.9% of total trade in ASEAN, well
ahead of ASEAN exports to the USA and Europe
at 14.1% and 13.0% respectively (Tables 3.3 and
3.4). Analysed by traded goods, ASEAN
intraregional trade is dominated by intermediate
goods at 65% of total intra-ASEAN exports. Far
behind this are capital goods at 12% and
consumption goods at 9%, see Table 3.5.
According to the Intra Industry Trade (IIT)
index, intraregional trade in ASEAN reflects a
23

Table 3.3 Intraregional Exports from Exporting Countries as Share of
Total Exporting Country Trade
Exports Destination (Share of Total Trade in Domain Country)
Share of Intraregional
Trade to World Trade
Domain
Country
G3
Developing Asia
ASEAN+4
ASEAN
1990 1999 2006 1990 1999 2006 1990 1999 2006
1990 1999 2006
Developing Asia
53.1
50.0
41.6
33.1
37.9
43.6
43.8
44.8
48.5
11.2
12.8
12.9
1.6
ASEAN
54.3
49.0
37.7
34.9
41.2
50.3
48.8
47.7
56.4
18.9
21.7
24.9
9.5
12.1
ASEAN+4
51.7
49.5
41.1
33.3
38.1
43.7
36.6
40.3
46.1
11.6
13.2
12.8
n.a
n.a
Indonesia
67.9
50.7
43.1
25.1
37.5
45.0
63.7
54.0
58.5
10.0
17.0
20.3
1990 1999
2006
4.5
7.1
10.1
0.8
1.4
7.2
n.a
Source: IMF Trade Directions Statistics

As exports destination ASEAN+4, G3 Japan is excluded
Table 3.4 Total Exports from Exporting Countries to Export Destinations as Share of
Domain Country
USA
Euro
Japan
China
India
1990 1999 2006 1990 1999 2006 1990 1999 2006 1990 1999 2006 1990 1999 2006
Developing Asia
ASEAN
ASEAN+4
Indonesia
21.9
19.4
25.1
13.1
21.9
20.1
24.4
14.2
16.9
14.1
18.2
11.5
16.9
16.0
18.2
12.3
17.0
16.5
17.2
15.1
16.2 14.3 11.1

13.0 18.9 12.4
16.0 8.4 7.8
12.2 42.5 21.4
8.5
10.6
6.9
19.4
15.7 17.4 22.2

6.4 8.6 14.8
5.0 7.7 10.8
5.7 6.9 9.3
0.7
1.2
0.7
0.2
1.0
1.7
0.9
1.9
1.6
2.4
1.5
3.2
Source: IMF Trade Directions Statistics
Table 3.5 Export Commodities from Exporting Countries to Export Destinations as Share of
Domain Country
Neg. Berkembang Asia

Capital Goods
Intermediate Goods
Consumptions Goods
ASEAN
Capital Goods
Intermediate Goods
Consumptions Goods
ASEAN+4
Capital Goods
Intermediate Goods
Consumptions Goods
Indonesia
Capital Goods
Intermediate Goods
Consumptions Goods
G3*)
Developing Asia
1995
1999
2006
1995
17
40
42
18
39
39
24
40
32
23
51
25
21
53
23
21
43
29
5
65
30
ASEAN+4
ASEAN
1999
2006
1995
1999
2006
1995
1999
2006
13
67
18
12
67
16
17
66
10
13
63
23
12
62
21
17
64
13
16
67
16
13
68
13
16
62
10
19
58
20
15
68
15
12
69
11
12
69
7
15
66
18
13
67
14
12
70
8
16
67
15
13
69
12
12
65
9
21
40
29
24
40
27
19
66
13
15
68
12
18
66
9
17
63
18
14
64
17
18
65
11
20
66
11
16
68
10
16
64
9
4
61
32
4
67
26
5
80
15
6
77
13
7
82
7
3
80
16
4
79
13
6
83
7
8
70
21
10
68
17
11
72
10
Source: UN Comtrade, processed.

* As exports destination ASEAN+4, G3 Japan is excluded
24

considerable level of linkages
linkages.7 Analysis of UN
COMTRADE trading data for the 2002-2006
periods for five ASEAN countries, Indonesia,
Malaysia, the Philippines, Singapore and Thailand,
points to a high IIT in the priority sectors for ASEAN
integration. The sectors reporting the highest IIT
include electronics, textiles and textile products,
information and communications technology (ICT),
wood-based products and automotive (Table 3.6).
The high IIT is indicative of linkages among ASEAN
industries, offering strong support for the ASEAN
Table 3.6 ntra-Industry Trade (IIT) Index for
ASEAN-5 by Sector over 5 Years
Sector
Total
ICT
Electronics
Healthcare Products
Textile and Garment
Automotive
Agro-based Products
Fisheries
Rubber-based Products
Wood-based Products
92.86
99.92
75.90
93.38
90.12
84.22
78.33
86.02
92.00
Source: UN Comtrade
Intra Industry Trade consists of trading among different

commodities, but still within the same industry. This is
measured by calculating the Intra Industry Trade Index (IIT)
according to the following formula: IIT = 1 X M x100
j
X j +M
j
j
economic integration process. In the case of

Indonesia, the highest IIT was identified in
healthcare products and the automotive sector
(Table 3.7).
3.3 Conceptual Review of Economic Integration
Theory
International trade has long been a subject
of considerable interest in the development of
economic theory. Among the economists exploring
this topic in depth are David Ricardo, renowned
for the theory of comparative advantage (Ricardian
Model), and Heckscher-Ohlin, author of the
Heckscher-Ohlin Model that emphasises differences
in resources as the factor promoting international
trade. Nevertheless, it was Viner (1950) who led
the way by pioneering a study specifically on
economic integration.8 Viner explains the impact
of economic integration on prosperity levels by the
concepts of trade creation and trade diversion.
Trade creation occurs when a nation is able to
import goods at lower prices from another country
within an integrated economic zone, thus bringing
an overall increase in prosperity. On the other hand,
Viner, J. 1950, The Custom Union Issue, New York, Carnegie

Endowment for International Peace
Table 3.7 Intra-Industry Trade (IIT) Index for Indonesia by Sector over 5 Years
2002 - 2006
Sector
Malaysia
ICT
Electronics
Healthcare Products
Textile and Garment
Automotive
Agro-based Products
Fisheries
Rubber-based Products
Wood-based Products
24.67
78.33
49.45
9.23
36.79
31.40
14.42
49.56
18.73
Phillippines
Singapore
31.73
31.14
49.74
5.16
58.16
68.93
20.95
8.01
19.12
5.43
48.31
42.85
26.18
88.72
9.62
5.82
39.22
78.15
Thailand
90.94
86.70
51.59
78.99
43.13
21.52
14.35
86.89
92.85
Total
10.18
74.71
80.80
32.95
79.89
65.80
10.42
47.84
52.87
Source: UN Comtrade
25

trade diversion occurs when imports from a country
outside the region are replaced by those of another
country within the integrated zone, given that the
products from another country inside the zone are
lower priced due to preferential tariff treatment.
The actual form of regional cooperation may
vary according to the level of economic integration.
A Free Trade Agreement (FTA) represents the first
phase in the economic integration process. In an
FTA, member countries agree to lower or eliminate
tariff and non-tariff trade barriers, but are free to
set their own tariffs with non-FTA participating
countries. The next stage in the economic
integration process is a Customs Union (CU). In a
CU, not only are preferential tariffs established for
all members, but the same import tariffs are also
applied by all towards non-members. The next
phase of integration is a Common Market (CM).
In a CM, member countries agree to dismantle all
barriers to mobility of capital and labour and to
harmonise laws and regulations. A significant
example of a CM is the Mercosur of Latin America,
which includes Brazil and Argentina. The most
comprehensive level of regional cooperation is an
Economic Union (EU), in which member nations
not only agree to dismantle all barriers to trade
and guarantee mobility of all production factors,
but also to a common monetary and fiscal policy.
One example of this is the European Union.
The benefits to be achieved through a
regions integration are obviously not restricted to
region
trade. The emerging expectation for the AEC is
that invigorated intraregional trade will strengthen
the growth performance of member countries. The
trade expansion that will foster higher levels of
growth can assist the lesser developed members
of ASEAN to catch up with their economically more
advanced counterparts in the region. As
26
encountered in the European Economic

Community (EEC), there is a tendency towards a
convergence, not divergence, of incomes among
economies joined together through international
trade (Ben-David, 2000). As described in Baldwin
and Wyplosz (2004), the economic impacts from
forming an integrated zone can be categorised as
follows:
1. Allocation effect
2.
Economic integration will encourage business

actors within each country to pursue more
efficient allocation of their resources. This will
take place in two phases as follows:
(1) Pro-competitive effect. The dismantling
of various barriers to trade and mobility
of production factors will foster
competition with the entry of foreign
producers into domestic markets.
Competition will then stimulate a procompetitive effect, in which companies
are forced to lower their price markups.
(2) Industrial restructuring and scale effect.
As a result of tighter competition,
inefficient companies will eventually
exit the market. Surviving companies
will keep working to expand their
market share and ultimately become
profitable.
Accumulation effect
Economic integration will promote
accumulation of physical and human capital
and in turn strengthen output growth. The
accumulation effect is closely related to the
allocation effect that encourages business to
operate more efficiently. Higher efficiency will
create a conducive climate for added
investment, with economic actors given

3.
incentive to increase capital accumulation.

On the other hand, economic integration will
also facilitate mobility of production factors,
and thus strengthen the supply factors in
production.
Location effect
Economic integration will encourage a
country to pursue specialisation in the areas
of comparative advantage. This concept is
commonly known as the Heckscher-Ohlin
comparative advantage. In addition,
economic integration accompanied by
mobility of production factors will also
promote the agglomeration of specific
economic activities in a specific region.
Agglomeration may work through backward
as well as forward linkages. Agglomeration
in relation to forward linkages is the

agglomeration spurred by business interest
in positioning itself closer to a larger market.
In contrast, backward linkage agglomeration
occurs when business wishes to be close to
suppliers in order to minimise costs.
Many empirical studies have been conducted
to assess the benefits of economic integration.
Grossman and Helpman (1991) proved that
opening up to trade will be followed by
transmission of knowledge that on a broader scale
will strengthen economic growth. Rivera-Batiz and
Romer (1991) also demonstrated that economic
integration will impact the level and growth of an
economy, depending on the extent to which the
integration opens doors to the entry of R&D and
information. Devereux and Lapham (1994)
enhanced the Rivera-Batiz and Romer model,
demonstrating that free trade will crate more
balanced economic growth, even in the absence
of knowledge transfers.
Despite this, relatively little research has been

conducted on economic integration in relation to
the relative post-integration position of each
member country within an integrated economic
club. Even so, in recent years this topic has become
an important subject of study in literature on
international trade, as undertaken by Bowen et al.
(1987), Helpman and Krugman (1985) and Leamer
(1984). For the AEC itself, this study is also of great
interest in view of the substantial economic
disparities among ASEAN member countries. These
sizeable disparities lead to the question of whether
the positive benefits of the AEC will ultimately
benefit all member nations on an equitable basis,
or instead flow to certain countries only. In this
regard, a study by Bowen, Munandar and Viaene
(2005)9 offers an equal share relationship concept
that can be used as a guide in predicting output
distribution among countries in a post-integration
economy. 10 The concept of an equal share
relationship states that economic integration will
create a condition in which the share of a countrys
output to total output in the economy will equal
the share of production factors to total production
factors (assuming no barriers to mobility of factors
and homogeneous level of technology). This
relationship can be illustrated by the following
equation:
it
10
H
j=1
jt
it
Y
j=1
jt
it
K
j=1
jt
For full information, see Topical Issue, Mobility of Factors,

Production Distribution and Economic Integration of a
Region.
This research examined 14 countries in the European Union
and the 51 states in the USA using data from 1965-2000.
The study findings support the hypothesis of an equal share
relationship.
27

The consequence of the equal share
relationship is that movement of physical capital
among the integrated economies will be
accompanied by higher output and strengthening
of human capital (through inflows of foreign
human capital or accumulation of domestic human
capital) to restore the equal share. A policy that
increases a nations share of human capital in the
context of an integrated economy will expand both
share of total output and share of total physical
capital (through inflows of foreign physical capital
and domestic capital accumulation).
3.4 AEC and Implications for Welfare
The most difficult challenge in the period
leading up to the AEC lies in predicting the effect
of the AEC on member economies. A study on
this vitally needed, given that foreknowledge of
the impacts will enable the Government and all
national stakeholders to formulate the necessary
strategic actions to reap optimum benefits from
the coming integration. Some aspects in a study
of the impacts of integration can be answered
through empirical study. However, for other
aspects, such as intra-ASEAN mobility of production
factors and the impact of this on the division of
the economic pie among ASEAN members,
answers will be sought using a theoretical
conceptual approach.
3.4.1 Impact on Trade in Goods
Much attention has been devoted to the
measurement of the economic impact of economic
integration, with numerous studies undertaken to
date. Concerning the AEC, while it will not take
full effect until 2015, measurement of its impacts
have been made in view of the implementation
of agreements for tariff reductions in the wake of
28
the signing of AFTA in 1992 (set out in the

Common Effective Preferential Tariff agreement
CEPT). So far, two major approaches have been
applied in empirical studies of the economic
impact. These are:
The ex-ante approach using a partial or
general equilibrium model, such as applied
by Imada et al. (1991), Adams and Par (1995)
and DeRosa (1995).
(2) The ex-post approach using the Gravity
Method, such as applied by Hamilton and
Winters (1992), Frankel (1993), Sharma and
Chua (2000 and Endoh (1999, 2000).
The use of the Gravity Model was initially
pioneered by Tinbergen (1962) and Pyhnen
(1963) to analyse bilateral trade flows between two
different geographical entities. Frankel (1997) then
attempted to reveal the impact of regional
integration by inserting the dummy variable of an
international agreement into the general gravity
equation.
A study using data from five ASEAN countries
(Indonesia, Malaysia, Singapore, the Philippines and
Thailand) for the 1989-2006 period shows that the
AFTA agreement (forerunner to AEC 2015) not only
brought changes in GDP per capita in member
countries, but was also a factor in intra-ASEAN
trade.11
(1)
The above study is consistent with data on

the share of Indonesian exports to ASEAN nations
(Table 3.3), marked by strong growth in the last
seven years (1999-2006). However, efforts to boost
exports to fellow ASEAN countries will face
mounting challenges. This is related particularly to
11
For more complete research findings, see Box, Impact of

AFTA Membership on ASEAN-5 Export Performance: a
Gravity Model Approach.

the homogeneity of traded commodities, for
example agricultural crops, rubber and timber
products, textiles and electronics. In addition, with
the largely effective dismantling of tariffs so far
(only 1.74% remaining for the ASEAN-6 in 2006),
the next stage of trade integration into the AEC
blueprint will focus on the removal of non-tariff
barriers. This will create particular challenges for
Indonesia, the nation with the highest number of
non-tariff barriers.12 Indonesias non-tariff barriers
range from the imposition of the luxury sales tax
on health and automotive products, sole import
agent restrictions and regulations on local language
labelling for certain commodities.
These challenges in the trading arena call for
a broader understanding of the objectives of trade
liberalisation in the ASEAN region beyond that of
merely boosting intraregional trade. The
dismantling of various trade barriers is expected
to spur each business actor to build competitiveness
at the individual level (allocation impact). This will
eventually boost ASEANs position of strength as a
region and thus attract foreign investment. With
this investment, ASEAN will then become one of
the production platforms of the world, a
development ultimately expected to bring greater
prosperity to member countries.
3.4.2 Impact on Investment, Growth and Poverty
Economic integration will spur inflows of
investment, which in turn will stimulate growth
and ultimately bring down poverty levels.
Integration will inevitably compel every business
12
De Dios, C. Loreli : An Investigation into the Measures

Affecting the Integration of ASEANs Priority Sectors (Phase
2): Overview: Non-Tariff Barriers to Trade in the ASEAN
Priority Goods Sectors, REPSF Project 06/001a Final Report,
October 2006.
actor to improve efficiency and competitiveness in

order to survive in the market. Industry will undergo
restructuring, which over time will bring about a
healthier industry structure. Empirical evidence of
this can be found in the European Union, where
the hallmark of the industry structure in the postintegration period is fewer but larger and more
efficient companies. Conditions like this eventually
create an atmosphere conducive to inflows of FDI,
which in turn will stimulate economic growth
through advancements in technology, creation of
employment, development of human capital and
greater access to world markets. Through this effect
on economic growth, FDI will then contribute to
poverty reduction. FDI can also provide a boost to
government revenues that can then be used to
finance a social safety net for the poor through
contributions of taxes and indirectly by stimulating
growth and broadening the tax base. Additionally,
FDI can play an instrumental role in bringing
infrastructure services to the poor. For example,
foreign investors in telecommunications, power
plants and water resources, working under buildoperate-transfer (BOT) partnerships or privatepublic schemes, have improved delivery of services
to millions of households, including the poor. FDI
can exert a positive influence on growth and
poverty reduction within a healthy environment of
a level playing field between foreign and domestic
investors and adequate physical and social
infrastructure (Klein, et al. 2001, Mirza 2002).
In the case of ASEAN countries, Jalilian and
Weiss (2002) identify direct and indirect linkages
between FDI and poverty. A 10 percent increase in
FDI is associated with 0.17 percent rise in per capita
income among the poor in ASEAN. About 40
percent of the poverty alleviation effect of FDI is
generated through economic growth, while 60%
29

comes from the direct impact of training workers
and job creation for the poor.
Even so, the integration of a region can also
have adverse effects on poverty alleviation.
Integration can bring about poverty reduction
reversal through increased prices for tradable
goods, loss of employment and reduced wages
for the poor and diminished government revenues.
Broader economic integration can also worsen the
vulnerability of the poor, who are generally find it
most difficult to protect themselves from income
shocks due to their limited holdings of financial
assets, low education and skills and lack of access
to a social safety net.
3.4.3 Impact on Labour Conditions
Liberalisation of trade, services, investment
and mobility of labour will affect worker
conditions. This impact normally represents the
conditions
most sensitive issue in the formation of an
economically integrated zone, such as experienced
by the European Union. In theory, liberalisation of
the above four factors will boost worker
productivity, as it will create conditions
encouraging companies to allocate resources more
efficiently (allocation effect). The removal of
barriers to labour mobility will open opportunities
for workers to seek work best suited to their skills.
On the other hand, employers will also benefit from
the opportunity to employ the most suitable
qualified workers. Improved labour productivity will
ultimately strengthen demand for labour and
subsequently improve wage levels.
Despite this, empirical evidence related to
the impact of economic integration on labour
conditions tends to be inconclusive
inconclusive. Among the
issues frequently rearing their head in relation to
regional economic integration are:
30
Will liberalisation of labour mobility prompt

migration of workers from one country to
another? In this regard, will Indonesia be able
to reap optimum benefits from this
movement, or instead be disadvantaged?
Will liberalisation of labour mobility lead to

improved wage levels or indeed the
opposite?
Will this liberalisation promote employment

of skilled labour or unskilled labour?
Workers (in certain sectors) of a nation are
more highly paid than workers in the same sectors
in other countries. Liberalisation of labour mobility
will set off a wave of worker migration to that
country. In these sectors, wages will decline due
to the added supply of workers. This will inevitably
disadvantage the workers of that country, who had
previously enjoyed higher wages. On the other
hand, business in that sector stands to gain. The
reverse will happen in the other countries. The
migration of some workers to other countries will
tend to boost local wages, thus working to the
advantage of workers remaining in their home
country, but will disadvantage employers. For this
reason, migration will always work to the benefit
of some and loss of others, but in general both
countries will reap gains.
Empirical evidence shows that economic
integration is not a dominant factor determining
patterns of migration. Research on the European
Union shows that the business cycle remains the
primary factor in worker migration.
For Indonesia, the opportunity this offers for
labour migration is potentially advantageous, given
the relatively high level of unemployment in
Indonesia compared to other ASEAN nations.
According to statistics for 2006, Indonesia and
Myanmar are the two largest sources of migrant

Table 3.8 Migrant Workers in ASEAN, 2006
(thousands)
Domain
Country
Brunei
Cambodia
Indonesia
Laos
Malaysia
Myanmar
Phillippines
Singapore
Thailand
Vietnam
ASEAN
Destination Country
Brunei Cambodia Indonesia
0
0
6
0
68
0
23
3
11
0
111
0
0
0
1
1
0
1
1
129
157
290
0
0
0
0
0
0
0
0
0
0
0
Laos
0
2
0
0
0
0
0
0
3
15
20
Malaysia Myanmar Philippines Singapore Thailand

0
7
1215
0
0
92
353
87
86
86
1925
0
0
0
0
0
0
0
0
0
0
0
1
0
5
0
0
0
0
0
0
1
8
0
0
96
0
994
0
136
0
0
0
1226
0
232
1
257
3
1382
3
2
0
20
1900
Vietnam
ASEAN
0
0
0
0
0
0
0
0
0
0
0
1
240
1323
258
1066
1475
516
92
229
279
5480
Source: ILO
workers, accounting for 23% and 27% of the total

migrant workforce in ASEAN (see Table 3.8).
Despite this, the ability to take advantage of
opportunities for worker migration will be highly
dependent on the qualifications held by Indonesian
workers. Indonesias migrant workforce has
workers
traditionally been dominated by low-skilled or
unskilled labour. Liberalisation of movement of
labour in AEC 2015 is expected to provide greater
opportunity for skilled labour to seek work under
better conditions.
At the same time, empirical research on the
impact of economic integration on wage levels
results. Research on the European
shows consistent results
Union (EU) indicates that economic integration will
not only bring significant change to wage levels.
In the wake of the EU integration, worker wages
changed by only about 0.3% for each additional
1% of workers from migration. This answers the
concerns of some countries that liberalisation of
labour mobility will unleash a flood of workers in
some countries with the ultimate effect of
depressing local wage levels. Even so, other
research demonstrates that the impact of trade
liberalisation on wage levels depends on whether
the industry benefits from the liberalisation

liberalisation. If the
industry expanding in response to liberalisation is
labour-intensive, the wages of lesser skilled workers
will rise. Hartono et al. (2007) show that the impact
on Indonesia from economic integration will be felt
more by non-skilled labour, who will benefit from
higher pay increases than for skilled labour.
Other empirical research points to a
relationship between the four factors of economic
integration, change in technology, global FDI
inflows and industry restructuring and increased
demand for skilled labour. Tan (2000, 2004) found
that higher levels of FDI in Asia led to greater
demand for skilled labour while increasing their
wage levels. Fajnzylber and Fernandes (2004)
believe that economic integration impacts
developing countries in different ways. In the case
of Brazil, economic integration brought increased
demand for skilled labour, while in China, economic
integration has instead diminished this demand.
The FDI trend in Indonesia over the past five
years indicates a shift in FDI industry orientation
from the secondary to the tertiary sector.
Concerning absorption of labour, this shift in
orientation warrants careful attention, given that
31

Table 3.9 FDI Outcomes and Employment
Sector
Primary
Secondary
Tertiery
Value (million USD)

Labor (person)
Value (million USD)
Labor (person)
Value (million USD)
Labor (person)
2002
2003
2004
2005
2006
2007
102.5
2,465
1553.3
73,839
1435.4
12,082
253.4
18,273
1880.6
69,196
3316.6
29,755
308.5
9,677
2804.5
91,728
1489.3
46,996
407.8
23,190
3502.1
97,326
5004.7
35,593
533.0
26,416
3604.5
152,815
1839.5
27,714
502.4
16,741
3622.9
105,141
4419.1
16,910
Source: Investment Coordinating Board (BKPM)
the secondary sector (manufacturing) has

traditionally been the largest source of employment
for unskilled or low-skilled labour. If this persists,
there are early indications that economic
integration will work more in favour of demand
for skilled labour, as was the case in Brazil.
3.5 AEC and Post-Integration Distribution of
Output
The study of post-integration distribution of
output among countries within an integrated
region is a highly relevant topic, given that not a
few opinions claim that economic integration will
ultimately benefit only the more advanced
countries. The concept of equal share relationships
briefly referred to in the above sub-chapter 3.3
states that regional integration will produce a
distribution of economic output that is dependent
on the distribution of production factors,
consisting of the physical capital and human
capital of each of the countries involved. In other
words, a nation endowed with a large proportion
of production factors in the region will ultimately
benefit from distribution of a similarly large share
of economic output. A country that leads in
human capital and therefore accounts for a high
proportion of total human capital will also have
the largest share of physical capital and slice of
the pie of regional economic output. This is easily
32
understandable, as superior quality human

resources become a magnet for and complement
advanced technology-intensive physical capital,
while technology is the component capable of
achieving exponential increases in economic
productivity.
It is not possible to develop a picture of
Indonesias position using empirical means, given
that liberalisation is not fully in place. Even so, by
applying the concept of equal-share relationship
described above, it is possible to ascertain
Indonesias post-integration position from a very
early perspective by studying developments in
production factors, i.e. capital stock and condition
of human capital, for subsequent comparison with
other countries in the integrated region.
In regard to the production factor of human
capital, the ASEAN region is marked by yawning
disparities. This is evident from the Human
Development Index (HDI), which places Singapore
well ahead of the other nine ASEAN members in
the 25th spot compared to 177 countries, while
Myanmar languishes in 132nd place (see Table
3.10). Indonesias own position is hardly cause for
celebration, ahead only of Laos, Cambodia and
Myanmar. This is also borne out in other HR data,
such as relatively low levels of literacy and school
enrollment, and low government spending on
education and health (Table 3.11).

Table 3.10 Basic Indicators for ASEAN
Country
HDI
Singapore
Brunei Darussalam
Malaysia
Thailand
Phillippines
Vietnam
Indonesia
Laos
Cambodia
Myanmar
Life expectancy
0.922
0.894
0.811
0.781
0.771
0.733
0.728
0.601
0.598
0.583
0.907
0.862
0.811
0.743
0.767
0.812
0.745
0.637
0.550
0.596
Education
index
GDP
index
Poverty
index
0.908
0.877
0.839
0.855
0.888
0.815
0.830
0.663
0.691
0.764
0.950
0.941
0.783
0.745
0.657
0.572
0.609
0.503
0.552
0.389
5.2
..
8.3
10
15.3
15.2
18.2
34.5
38.6
21.5
Rank
index
25
30
63
78
90
105
107
130
131
132
Source: UNDP, Human Development Report 2007
Table 3. 11 Human Development Indicators for ASEAN

Country
Literacy rate
(% of age 15+)
Singapore
Brunei Darussalam
Malaysia
Thailand
Phillippines
Vietnam
Indonesia
Laos
Cambodia
Myanmar
Gross enrolment ratio Expenditure on education

(primary-tertiary school)
2002-05 (% of GDP)
92,5
92,7
88,7
92,6
92,6
90,3
90,4
68,7
73,6
89,9
87,3
77,7
74,3
71,2
81,1
63,9
68,2
61,5
60
49,5
Expenditure on health
2004 (% of GDP)
3,7
,,
6,2
4,2
2,7
,,
0,9
2,3
1,9
1,3
1,3
2,6
2,2
2,3
1,4
1,5
1
0,8
1,7
0,3
Source: UNDP, Human Development Report 2007
In regard to the production factor of capital

stock, ASEAN similarly has considerable disparities.
This is evident, among others, from the country
competitiveness ratings issued by the WEF (see
Table 3.12). The table shows how much Indonesia
is still challenged in fulfilling some of the basic
requirements for creating a high stock of capital,
such as condition of infrastructure, government
institutions and human resources. Indonesia
appears to lag far behind several other ASEAN
nations, as indicated by levels of telephone and
internet use as well as electricity consumption
(Table 3.13).
Referring to the equal share concept
described above and measuring by the relative
condition of production factors, it appears that
Table 3.12 Competitiveness Components,

Selected ASEAN Members
Category
Overall index
Basic requirements
Institutions
Infrastructures
Macroeconomic stability
Health & primary education
Efficiency enhancers
Higher education and training
Goods market & efficiency
Labor market efficiency
Financial market sophistication
Technological readiness
Market size
Innovation & sophistication factors
Business sophistication
Innovation
Indonesia Malaysia Singapore Thailand

54
82
63
91
89
78
37
65
23
31
50
75
15
34
33
41
21
21
20
23
45
26
24
27
20
16
19
30
29
19
18
21
7
3
3
3
24
19
6
16
2
2
3
12
50
13
16
11
28
40
47
27
30
63
29
44
34
11
52
45
17
39
40
36
Source: World Economic Forum, Global Competitiveness Report 2007
33

Tabel 3.13 Condition of ASEAN Infrastructure
Country
Singapore
Brunei Darussalam
Malaysia
Thailand
Phillippines
Vietnam
Indonesia
Laos
Cambodia
Myanmar
Telephone mainlines
(per 100 people)
Celluler subscribers
(per 100 people)
Internet users
(per 100 people)
103.4
56.3
75.2
43.0
39.5
11.4
21.1
10.8
7.6
0.17
57.9
15.3
42.4
11.0
5.3
12.7
7.2
0.4
0.3
0.12
43.5
25.57
16.8
11.0
4.2
18.8
5.7
1.3
0.3
0.79
Electricity consumption
(kWh per capita)
8087.0
9133.0
3196.0
1896.0
655.0
503.0
498.0
135.0
9.0
126.0
Source: ITU 2007
ASEAN integration will bring the most important

benefits to only a few countries, namely Singapore,
Malaysia and Thailand. However, Indonesia of
course still has wide open opportunity to take a
slice of the post-integration economic pie, provided
that substantial changes can be accomplished with
improvements in human and physical capital in the
coming 7-8 years.
3.6 AEC 2015 and the Monetary Authority Role
To be able to reap optimum benefits from
economic integration, each country faces the
challenge of building the capacity of its production
factors, comprising both physical capital and
capital. This is related to the concept of
human capital
equal share relationship described in the above subchapter 3.3, which states that regional integration
will result in distribution of economic output
dependent on the distribution of production
factors, including physical capital and human
capital, for each of the countries involved. In other
words, a nation with a large proportion of
production factors in the region will ultimately
receive a sizeable distribution of economic output.
The central bank has a significant role in
exercising monetary policy to encourage higher
levels of investment in order to build physical
34
capital. Empirical evidence using data from

Thailand, Indonesia, Cambodia, Singapore,
Malaysia, the Philippines and Thailand (ASEAN-7)
for the 1992-2006 period demonstrates a strong
positive correlation between inflation and
investment (in this case FDI inflows) in those
countries.13 A positive linkage was also identified
between macroeconomic stability and investment.
Both findings indicate that countries with low levels
of long-term inflation and stable macroeconomic
conditions tend to attract high levels of investment.
Accordingly, central bank policy aimed at achieving
and maintaining low inflation and stable
macroeconomic conditions is a pro-investment
monetary policy.
All of this is tied together by a common
thread: the economic integration of a region means
that investment takes on an even more central role,
directly determining the prosperity level of a
region. Central
country relative to its peers in the region
banks are able to exert a positive influence on
investment through their monetary policies: low
inflation and macroeconomic stability will do much
13
For more complete research findings, see Chapter V, Topical

Issues, Regional Economic Integration, Investment and the
Monetary Authority Role.

to promote significant levels of investment
(monetary policy targeting low inflation and stable
macroeconomic conditions - a pro-investment
monetary policy). It can therefore be concluded that
regional economic integration elevates the
importance of the central bank role in promoting
investment.
3.7 Policy Implications
As described above, in general terms the
formation of the AEC offers opportunities for better
economic prosperity, particularly for Indonesia. In
the area of trade, studies indicate that tariff
reductions have been one factor contributing to
the growth in intraregional ASEAN trade in recent
years. Concerning labour, the liberalisation of
labour markets in the AEC 2015 is expected to
provide greater opportunity for skilled labour to
seek better job opportunities, and therefore
migrant workers from Indonesia will no longer be
dominated by low-skilled labour. There are early
indications that the effect of economic integration
on Indonesia will be to boost demand for skilled
labour. In the area of growth and poverty reduction,
studies also show that economic integration
through increased FDI has a role in strengthening
growth and the incomes of the poor.
However, for all of this to come into being, it
is necessary to pursue a series of actions and a
strategy in support of these objectives.
3.7.1 Improvements to the Investment Climate
and Institution Building
The creation of a macroeconomic
environment supportive of investment, competition
and private sector development is crucial to the
preparations for economic integration. This
includes improvements in matters concerning
government institutions, such as competent,

efficient bureaucracy, a sophisticated legal system
and recognition of copyrights. Furthermore,
financial institutions must also be strengthened for
effective management of more rapid capital inflows
and outflows resulting from economic integration.
An appropriate regulatory framework must be put
into place to ensure that the funds involved are
channelled into productive sectors and to reduce
the likelihood of a repetition of a regional financial
crisis. No less important, as described in an earlier
sub-chapter, it is essential to stay the course with
a prudent monetary policy stance because of the
positive impact on inflation and macroeconomic
stability that also supports investment.
Besides these institutional requirements, the
institutions related to improvement of human
capital are also extremely important. The
disadvantaged condition of Indonesias human
capital means that the government faces a race
against time to close the gap in quality of human
resources. Government budget allocations must be
prioritised for education and establishment of
vocational and skills training centres. Also
important is the strengthening of institutions
directly involved with the management of poverty
alleviation programmes to ensure greater efficiency
and effectiveness in delivery of aid to the poor and
disadvantaged. These institutions, for example, are
active in land redistribution schemes, microcredit
and social welfare programmes. The majority of
the poor live in rural areas, and it is therefore
important to build the capacity of institutions with
outreach to rural communities.
Lastly, there is a need for institution building
to assist member countries in developing their
leading industries. Production of a diversified range
of products and services can provide added boost
35

to intraregional trade. This calls for research and
product innovation so that each country will be
able to develop their mainstay products. The
magnitude of support for research and
technological development will affect the trade
performance and growth of member countries. It
is already time to strengthen incentives for
innovation, especially in the less developed
economies to enable these countries to benefit
from the larger market created through integration.
An added purpose in providing incentives for
innovation is to mitigate income inequalities
between high and low income countries that may
otherwise widen because of the ability of advanced,
technologically superior countries to reap greater
benefits from integration.
36
3.7.2 Preparation at the Sectoral Level

Twelve sectors have been designated for
liberalisation, leaving Indonesia with no alternative
other than to make the necessary preparations in
those sectors. The possible short-term negative
effects of liberalisation must be clearly
communicated to the affected sectors so that they
are able to ready themselves through retraining,
skills development or gradual transfer to other
employment. The government must also
demonstrate the deeper positive effects of
liberalisation in the affected sectors to that those
impacted can have a better appreciation of the
policy. Intensive consultations with the affected
groups may help avoid adverse reactions.

BOX:
Impact of the AFTA Agreement
on ASEAN-5 Exports:
A Gravity Model Approach1
I. Introduction
In Singapore on 20 November 2007,
Indonesia and other ASEAN member nations
convened to sign the ASEAN Declaration
containing the blue print of a series of actions
laying the groundwork for launching the ASEAN
Economic Community in 2015. Preceding this
was the signing of the ASEAN Free Trade Area
(AFTA) agreement in Singapore on 28 January
1992, which paved the way for the creation of
a free trade area. When AFTA became fully
effective on 1 January 2003, the agreement
involved six member nations: Brunei Darussalam,
Indonesia, Malaysia, the Philippines, Singapore
and Thailand. The agreement was envisaged as
a means of bringing greater prosperity to all
member nations through increased trade.
Against this background, a brief study was
performed to ascertain the influence of AFTA
on the export performance of ASEAN countries
represented by five members: Indonesia,
Malaysia, Singapore, the Philippines and
Thailand (ASEAN-5).
II. The Gravity Model
The gravity model used to analyse
bilateral trade flows between two different
Prepared by Oki Hermansyah and Myrnawati Savitri
geographical entities is adapted from Jan

Tinbergen (1962).2 This model depicts the
relationship between bilateral trade flows,
consisting of imports and exports, to the
incomes of each country and the distance
between the two. The general form of this
function can be expressed as follows:
log( Xij) = 0 + 1 log (Yi)+ 2 log (Yj) + 3 log (Dij) (1)
in which:
Xij
: value of exports or imports from
country i to country j
Yi and Yj : size of the economy of the
exporting or importing country,
normally expressed as GDP
Dij
: geographical distance between
the two trading nations
The distance factor is deemed important
in the gravity theory because it serves as a proxy
of various costs, such as transportation,
communications and the essential transactions
in trade. Frankel attempts to discover the
impact of regional integration by inserting a
variable for international agreements into the
general gravity equation. 3 To analyse the
influence of AFTA on bilateral trade in the
ASEAN region, the following function is used:
log (Xij) = 0 + 1 log (GDPPij) + 2 log (Distij)+ 1
AFTA + 2 trend + ij
(2)
The trade flows in this estimation consist
of the value of exports from one ASEAN
member to a group of other members. The
Tinbergen, J., 1962, Shaping the World Economy:

Suggestions for an International Economic Policy, the
Twentieth Century Fund, New York.
Frankel, Jeffrey (1997): Regional Trading Blocs in the
World Economic System
37

difference from the Tinbergen gravity model

is the inclusion of a multiple of GDP per capita
in the exporting nation by GDP per capita in
the trading partner (GDPP). The GDPP
coefficient is expected to be positive, in which
the higher level of a nations GDP per capita is
correlated with stronger public purchasing
power. The coefficient of the distance variable
is expected to be negative, mean that it
operates in an inverse relationship with the
export variable. The greater the distance, the
higher the costs of transportation in trading
links, and therefore the less the trade that is
conducted between the two nations. The AFTA
variable is a dummy indicating the influence
of AFTA on bilateral trade to ascertain the
impact of the agreement at several points. This
dummy variable is set at 1 for the 1995-2006
period. The year 1995 was selected for the
reason that AFTA took a major step forward
that year with the inclusion of the agricultural
sector in the CEPT scheme at the end of 1994
and the establishment in 1995 of the AFTA
Unit, officially designated coordinator and

regulator of AFTA implementation. At the same
time, the trend included in the equation is
intended to capture permanent growth in
exports.
III. Empirical Data and Findings
This study uses annual data for the
ASEAN-5 countries covering the 1989-2006
period. Data on exports among ASEAN
members, expressed in US dollars, was sourced
from UN Comtrade. GDP and population data
was obtained from the IMF International
Financial Statistics CD ROM database, expressed
in individual country currencies and converted
into USD billions. Distance between national
capitals
was
taken
from
the
www.infoplease.com site, and is expressed in
kilometres.
Generally, the gravity model uses the
pooling data method. However, the weakness
of this method lies in the constant value of the
intercept and slope assumptions for each
Table 1 Parameter Estimates for the Gravity Model

Country
Period
Dummy
Indonesia
1989-2006
Singapore*)
1989-2006
1995
(6.93)
1995
Thailand
1989-2006
1995
Phillippines
1989-2006
1995
Malaysia
1989-2006
1995
C
8.16*
(7.83)
9.95*
(17.59)
8.05*
(4.54)
37.37*
(8.22)
8.28*
(12.64)
log (GDPP)
log (Dist)
dum
0.51*
(-2.55)
0.63*
(8.36)
0.51*
(10.03)
0.44*
(11.09)
0.58*
(12.00)
-0.41**
(3.10)
-0.61*
(-10.82)
-0.47**
(-1.99)
-4.32*
(-7.44)
-0.41*
(-4.76)
0.39*
(4.98)
0.18***
(1.81)
0.51*
(2.99)
0.85*
(5.37)
0.18***
(1.72)
Notes: *) Indonesia not included due to limitations of data

Values in parentheses are t-statistics
* significant at 1%
** significant at 5%
*** significant at 10%
38
Trend
0.02*
0.01*
(2.70)
0.02*
(5.04)
0.02*
(5.33)
0.01*
(5.58)

country that inadequately reflect actual

conditions. As an alternative, this study uses
the cross-section method. Unlike the pool
method, the cross-section method has the
advantage of presenting the export
performance of each of the ASEAN-5 countries
differently. The export variable of a country is
estimated using data on GDP per capita and
distance to its four trading partners by
compiling data stacked by date.
The estimations yield significant results
in line with expectations, as presented in Table
1. The results support the hypothesis that trade
increases with higher GDP per capita, and
therefore the distance factor used as a proxy
for transportation costs shows an inverse
relationship.
IV. Conclusions
The overall conclusion based on
processing and analysis of data is that GDP per
capita has a positive and significant influence
on increased export performance. The AFTA
agreement for the free trade area also showed

a similar pattern. Distance, a proxy for costs
incurred in transportation, has a negative
bearing on export growth. Statistically, AFTA
has strengthened the export performance of
member nations in comparison to the period
before implementation, but in reality the
results fall short of optimal. This is evident
from the share of intra-ASEAN exports at only
24.9% in 2006, not markedly different from
the 1999 share of 21.7%. 17 This may be
explained as the consequence of the more
competitive than complementary nature of
ASEAN economies. Competition has
intensified through the non-tariff barriers
instituted to protect local products. Indonesia
needs to press forward with a range of
measures to maximise the benefits of regional
economic integration.
Data sourced from the IMF Directorateion of Trade

Statistics
39
Chapter 4: Medium-Term Economic Outlook

Indonesias economic outlook for 2008-2012
is based on developments in the world economy
and Indonesian economy, represented by volume
of world trade, commodity prices (oil and non-oil),
international interest rates, Government financial
condition and FDI inflows. Volume of world trade is
forecasted to keep growing at about 7%, with
commodity prices easing slightly but remaining
strong. Interest rates are assumed to remain stable
and the fiscal deficit is predicted to decline along
with steadily mounting inflows of FDI. With these
assumptions, over the next five years Indonesias
economic growth is projected to climb to 7.4%8.0% in 2012, amidst a downward trend in inflation
towards the government-set inflation target.
The steady improvement in economic growth
alongside declining inflation is based on optimism
for implementation of a range of structural policies
covering improvements in production, infrastructure,
legal certainty, labour conditions, education, skills
and health, with the objective of strengthening
Indonesias economic competitiveness and
investment climate. This improvement in the
investment climate will be reflected in significant
gains envisaged in FDI (about 1.5% of GDP). In this
way, supply-side policies will have a very strategic
role in the long term for building high, sustainable
economic growth accompanied by low inflation.
Turbulent financial markets, sustained high

commodity prices and the flagging US economy
augur for a slowdown in world economic growth
to 4.1% in 2008, down from the 4.9% growth
of 2007.1 The looming economic slowdown is
primarily linked to the spreading impact of the
financial crisis (which began as the subprime
mortgage crisis in the US) and the sluggish
performance by major world economies.
Although the decline in world economic growth
is predicted to bear down on exports across much
of the world, developing economies are expected
to maintain strong expansion. Developing
countries are forecasted to benefit from continued
strong domestic demand and their good
housekeeping macroeconomic policies.
Commodity exporting countries also stand to
benefit from high energy and foodstuff prices.
For this reason, large developing economies such
as China, India and Russia are predicted to keep
their role as the engines of world economic
growth. In the medium term (2009-2012), the
world economy is set to grow at about 5% per
annum, above the historical average (3.7%). In
keeping with the dynamics of world economic
growth, expansion in world trade will similarly
ease from 7.1% (2007) to 7.0% in 2008 and
2009, before rebounding with 7.2% growth.2
Furthermore, this trend in world trade volume
4.1 Assumptions for the Global Economy,

2008-2012
1
a. World Economic Growth

World economic growth is predicted to cool
but still remains above the historical average.
According to the World Economic Outlook (WEO) published

by the IMF in the Update January 2008 edition. The World
Bank also predicts a slowing in global economic growth
from 3.6% in 2007 to 3.3% in 2008.
Based on the WEO publication, October 2007 edition.
41

%
USD
14
12
10
160
History
Projections
157
High Price
120
6
4
Reference
80
95
-2
60
58
-4
1980
1970 19731976 19791982 19851988 19911994 1997 20002003 2006 2009 2012
World Real GDP Growth (LHS)
World Trade Volume Growth (RHS)
Low Price
30
1990
2000
2010
2020
2030
Source: International Energy Outlook from EIA, November 2007
Source: IMF, World Economic Outlook, October 2007 edition
USD/ barrel
80
Graph 4.1 World Economic Growth and Volume

of World Trade
70
60
50
continues to be positively correlated with world

economic growth, as shown in Graph 4.1.
40
30
20
10
b. World Commodity Prices

Oil prices are predicted to remain high, but
also to ease gradually in response to
strengthening supply and contraction in global
demand brought about by slowing world
economic growth. In the last four years, oil prices
have spiralled in response to burgeoning world
energy demand, low inventories and geopolitical
instability in oil-producing countries. Looking
ahead, oil prices are predicted to stay high,
despite some gradual decline. The Energy
International Administration (EIA) forecasts that
world oil prices will begin to ease in 2008, among
others due to increased oil production.3 This
prediction is consistent with the IMF forecast of
an average fall of 2.2% in oil prices beginning in
2009, as shown in Graph 4.2.4
3
4
See International Energy Outlook, November 2007

These oil prices are averages for Dated Brent (DB), World
Texas International (WTI) and Dubai Fateh (DF). Historically,
these average prices have been on par with Indonesian crude
(MINAS), and therefore the oil prices used in this projection
are consistent with the IMF projection.
42
0
1991 1993 1995 1997
1999 2001
2003 2005 2007 2009
Average DB, WTI, DF
2011
MINAS
Source: IMF, World Economic Outlook, October 2007 edition
Graph 4.2 World Oil Price History and Projections
Non-oil and gas primary commodity prices

are forecasted to stay high despite gradual easing
prompted by increasing global supply. The price
cycle for primary commodities over the past 100
years indicates at following a period of high prices,
commodity prices subsequently lapse into gradual
decline (Graph 4.3).5 This occurs because of the
stronger incentive for investment in primary
commodities in response to high prices. For this
reason, production of primary commodities and
particularly metals is projected to rise in the next
few years, which in turn will lower prices for nonfuel primary commodities. 6 However, this
5
6
See Reserve Bank of Australia (2007), The Recent Rise in

Commodity Prices: a Long-Run Perspective.
The IMF predicts that in 2008-2012, prices will come down
by an average of 6.8%.

Index
Index
Manufactured exports
100
100
US GDP
50
50
d. Global FDI Inflows

Global FDI inflows to both developed and
developing nations are predicted to climb further
as business climate improves in many countries
around the world. Continued expansion in these
global FDI inflows is forecasted until at least 2011.7
US CPI
25
1906
1926
1946
1966
1986
25
2006
Source: Global Financial Data: Grill & Yang (1988), IMF: Pfaffenzeller, Newbold & Rayner
(2007), Reserve Bank of Australia
Graph 4.3 World Commodity Prices, 1906-2006
projection depends to a great extent on

developments in world demand. Moreover, the
issue of energy conversion to biofuels could also
trigger spiralling prices for some related
commodities such as corn and wheat.
c. International Interest Rates
Central banks will respond in varying ways
to the expected surge in world inflationary pressure
from sustained high commodity prices. In addition
to inflationary pressure, some central banks also
give consideration to financial market stability and
the outlook for the domestic economies in their
countries. Thus early in the second half of 2007,
when inflation was running high in industrialised
and developing countries alike, central banks
responded in different ways. The Federal Reserve
has given high priority both to recovery from the
financial market crisis and to delivering a domestic
economic stimulus, as demonstrated by the
aggressive cuts in the Fed Funds Rate from 5.25%
in September 2007 to 3.00% in January 2008. On
the other hand, the European Central Bank (ECB)
and Bank of Japan (BOJ) have put greater priority
on the outlook for continued high domestic
inflationary pressure, and therefore kept rates on
hold.
In an UNCTAD survey, almost two-thirds of

respondents expressed optimism for a steady rise
in global FDI inflows until 2009.8 This optimistic
projection is supported by the forecast for
continued conducive conditions in the world
economy; improvement in the business
environment in many countries; advancement in
technology; and the tight global competition that
will compel companies to seek venues offering
better returns on investment.9 However, unstable
macroeconomic conditions, regulations that deter
investment, geopolitical factors, global imbalances,
oil prices and unabated turbulence on financial
markets could potentially hamper future growth
in FDI inflows. In 2008, FDI inflows are predicted
to drop slightly as the world economy enters a
period of slower growth, but are set to rebound
after 2009 with growth at 4.5% until 2011. Like
before, global FDI inflows will originate mainly from
developed countries.
7
8
See World Investment Prospects 2011 published by the

Economist Intelligence Unit, The Economist, 2007
World Investment Report 2007: Transnational Corporations,
Extractive Industries and Development and World Investment
Prospects Survey 2007-2009.
The indicators used for the business environment are:
political environment, macroeconomic environment, market
opportunities, policy towards private enterprise &
competition, policy towards foreign investment, foreign
trade & exchange controls, taxes, financing, labour market
and infrastructure.
43

Table 4.1 Projection of Global FDI Inflows, 2008-2011
2002
2003
2004
World FDI Inflows
618.1
563.4
730.2
% change, year on year
-27.4
-8.8
29.6
2006
2007
2008
2009
2010
2011
971.7
1335.1
1474.7
1406.4
1470.3
1536.8
1604.0
33.1
37.4
10.5
-4.6
4.5
4.5
1.9
1.5
4.4
1.8
2.2
2.8
2.8
2.5
2.5
2.4
2.4
countries
421.1
-25.2
354.6
379.5
546.8
824.4
940.2
879.0
925.5
972.6
1017.3
-15.8
7.0
44.1
50.7
14.0
-6.5
5.3
5.1
4.6
% of National
GDP Statistics, Economist Intelligence1.7
1.3
Sumber:
Unit, IMF, UNCTAD
1.2
1.7
2.4
2.6
2.3
2.3
2.3
2.4
% of GDP
2005
FDI inflows to developed
% of world total
68.1
62.9
52.0
56.3
61.7
63.8
62.5
62.9
63.3
63.4
markets
197.0
208.9
350.7
424.9
510.7
534.6
527.4
544.8
564.2
586.7
-31.5
6.0
67.9
21.1
20.2
4.7
-1.3
3.3
3.6
4.0
2.5
2.4
3.4
3.5
3.6
3.3
2.9
2.7
2.6
2.4
31.9
37.1
48.0
43.7
38.3
36.2
37.5
37.1
36.7
36.6
FDI inflows to emerging
% of GDP
% of world total
Source: National Statistics, IMF, OECD, UNCTAD, The Economist Intelligent Unit
4.2 Assumptions for the Indonesian Economy,

2008-2012
The gains in macroeconomic conditions
achieved in recent years are expected to hold,
despite formidable challenges from the external
sector with high oil prices and slowing world
economic growth.
a. Government Financial Condition
The fiscal authority is expected to maintain
fiscal sustainability over the long-term. In recent
years, the Government has changed its fiscal policy
% GDP
0
-0.5
-0.5
-1
orientation from consolidation to stimulus. This

change in orientation is evident in the growing
fiscal deficit (shown in Graph 4.4), projected to
climb in 2008 to 2% of GDP. Beyond this, however,
the deficit is expected to be eased gradually to
safeguard fiscal sustainability.
b. Domestic Interest Rates
The outlook is for Bank Indonesia to stay the
course with the Inflation Targeting Framework (ITF)
in order to achieve low, stable inflation as an
integral part of a series of macroeconomic and
sectoral policies. To this end, the BI Rate will be set
at a level consistent with the inflation target, but
without holding the economy back from high levels
of quality economic growth.
-0.9
-1.1
-1.3
-1.3
-1.5
-1.7
-2
-2.0
-2.4
Conslidation
Stimulation
-2.5
2001
2002
2003
2004
2005
2006
2007
Graph 4.4 Trend in Fiscal policy
44
2008
c. FDI Inflows
FDI inflows into Indonesia are predicted to
keep expanding. The Government commitment to
safeguard macroeconomic stability through
coordination of fiscal and monetary policy will

create room for Government action to stimulate
the real sector.10 In further actions, the Government
is working persistently for improvement in the
investment climate, construction of infrastructure,
financial sector reform and empowerment of
MSMEs. These actions augur for the creation of
conducive conditions for inflows of FDI in
Indonesia. Surveys by UNCTAD and the Economist
Intelligence Unit (EIU) of The Economist found that
FDI inflows in Indonesia are predicted to remain
positive. These predictions are based primarily on
the size of the domestic market and what is
regarded as considerable potential for growth,
which offsets the risks involved.
The above external and domestic
assumptions form the basis for the following
projection for the Indonesian economy in 20082012:
4.3 Projection for the Indonesian Economy,

2008-2012
In overall terms, the projection for the
Indonesian economy in 2008-2012 relies heavily
the success of the Government in implementing
reforms, as shown in Diagram 4.1. Over
structural reforms
the next five years, progress in the Indonesian
economy will be determined more by factors
providing long-term momentum for economic
activity, such as physical capital, human capital and
productivity.
STRUCTURAL REFORMS:
Investment Climate Enhancement
Small Scale Enterprise Empowerment
Reform and Infrastructure
Enhancement
Health
Skill
Education
Physical Capital
Total Factor
Productivity
Agregate Supply
Distribution
FDI
Table 4.2 Basic Domestic Assumptions
Institution
Production
Human Capital
Investment
Consumption
OUTPUT
INFLATION
Agregate Demand
Export
ASSUMPTIONS
World Trade Volume Growth
Oil Price (USD/brl)
Non Fuel Commodity Price
Growth (%)
Fed Fund Rate (%)
BI Rate (%)
Government Budget Deficit
(% GDP)
Net Foreign Direct Investment
(% GDP)
10
2007 2008 2009 2010 2011 2012

7.1
71
7.0
80
7.0
78
7.2
77
7.2
75
7.2
73
15.4
5.1
8.0
-2.8
3.0
8.0
-2.8
3.0
8.0
-2.8
3.0
8.0
-2.8
3.0
8.0
-2.8
3.0
8.0
-1.3
-2.0
-1.8
-1.6
-1.5
-1.4
1.0
1.25
1.35
1.40
1.45
1.50
The Government has adopted various policies to promote

economic growth and reduce poverty. Through the Office
of the Coordinating Minister for the Economy, the
Government issued Presidential Instruction (Inpres) Number
6 of 2007 concerning Policy for Accelerated Real Sector
Expansion and Empowerment of Micro, Small and Medium
Enterprises (MSMEs). This Presidential Instruction covers the
four areas of: 1) Improvement in the Investment Climate, 2)
Financial Sector Reform, 3) Accelerated Construction of
Infrastructure, and 4) Empowerment of MSMEs.
Diagram 4. 1 Structural Reforms,

Aggregate Supply and Performance of
the Indonesian Economy
Implementation of structural reforms is

assumed to proceed smoothly, bringing significant
improvement in production factors and the
investment climate. A better investment climate
will stimulate FDI inflows on a large scale, reaching
1.5% of GDP in 2012, in turn resulting in
significantly greater accumulation of physical
capital. FDI will also pave the way for
improvements in productivity and production
efficiency (total factor productivity or TPF) as the
result of transfer of technology and management
skills. This improvement in TFP will be key to
building increased production capacity in the long
45

run.11 In addition, quality of human capital is also
predicted to improve with successful
implementation of policies in health, education
and skills training.
The synergy between the commitments of
the Government and Bank Indonesia in
safeguarding macroeconomic stability and curbing
inflation while bringing steady improvement to the
investment climate will produce an upward trend
in economic growth. Macroeconomic stability in
to maintain above 5% growth reaching as much

as 6% in 2012, thus retaining a vital role in the
economy.
Alongside this, stronger competitiveness will
sustain a high level of export performance. The
combination with vast market potential represents

a vital draw card for international investors to keep
investing in Indonesia.12 The forecasted sustained
technological advancements with enhancement of

productivity and efficiency. Despite predictions of
a contractionary impact on Indonesias exports from
slowing world economic growth, high commodity
prices combined with greater diversification of
export destinations are expected to work to the
advantage of Indonesia with export growth
reaching 12.5%-13.5% in 2012. Import growth is
also predicted to be strong (14.5%-15.5%) on the
back of robust domestic demand. Under these
conditions, the current account will remain in
surplus, despite the diminishing magnitude of the
surplus itself. Despite the downward trend in the
current account surplus, the high rate of FDI inflows
is predicted to keep the balance of payments in
strong condition and maintain stability in the
exchange rate.
The synergy between macroeconomic
stability and supply-side improvement is ultimately
predicted to contribute to improved public
welfare. The forecasted high economic growth
expansion in FDI in Indonesia will contribute to

investment growth at 13%-14%, with investment
expanding to about 30% of GDP in 2012. This in
turn will foster large-scale accumulation of capital
that will provide the driving force for expansion of
production capacity. This significant supply-side
improvement will eventually bring a higher
economic growth trend, reaching 7.4%-8.0% in
2012.
Increased production and improvements in
distribution will allow high economic growth to
be achieved without sacrificing price stability. The
expanding capacity of the economy will ease
inflationary pressure with corresponding reduction
in inflation. Low inflation and planned increases in
the minimum wage will boost real public
purchasing power, enabling private consumption
11
The World Development Report (2005) claims that according

to studies from 1960 to 2000, the dominant factor (45%90%) explaining differences in growth between countries
can be traced back to differences in TFP, rather than
differences in capital accumulation or labour.
12 The findings of an UNCTAD survey claim that the size and
growth of the market combined with quality of the business
environment are the main determining factors in selecting
a venue for FDI.
46
various structural improvements launched by the

Government involving infrastructure, licensing,
customs and taxation will do much to boost
Indonesias export competitiveness. In addition,
flourishing FDI will be accompanied by
will absorb larger numbers of workers, thus

reducing the existing level of unemployment.
Unemployment is thus projected to east to about
8% in 2012. Increased employment accompanied
by declining inflation will also reduce poverty
levels. Per capita income will also climb to about
USD 3,000 in 2012.

Table 4.3 Projections
Projections
Component Growth (%)
Gross Domestic Product
- Private Consumption
- Government Consumption
- Investment
- Export on Goods and Services
- Import on Goods and Services
Others
Income per Capita (USD)
Unemployment (%)
Inflation taget (%)*
2007 2008 2009 2010 2011 2012

6,3
5.0
3,9
9,2
8,0
8,9
1.947,1
9,1
6,01%
6,2 6,2-6,8 6,8-7,4 7,2-7,8

5,4 5,6-5,9 5,6-6,0 5,6-6,0
3,8 4,0-5,0 7,0-9,0 8,0-10,0
9,3 10,5-10,8 11,0-13,0 12,0-13,0
7,9 8,1-9,1 10,5-11,5 11,5-12,5
9,4 10,4-10,7 12,5-13,5 13,5-14,5
7,4-8,0
5,6-6,0
8,0-10,0
13,0-15,0
12,5-13,5
14,5-15,5
1980 2145-2180 2375-2410 2650-2685 2950-3000

9,0 9,0-10,0 8,5-9,5 8,0-9,0 7,5-8,5
5,01% 4,51% 4,01%
*) Pursuant to Decree of the Minister of Finance No. 1 of 2008.
4.4 Policy Implications

Achieving the target of quality economic
growth will require the commitment and hard work
of all stakeholders. The following section outlines
a number of policies that offer promise for
achieving optimum results.
4.4.1 Macroeconomic Policy (Monetary and Fiscal)
Monetary policy must retain a cautious bias
accompanied by more detailed monitoring of world
events. Although Indonesia has already adopted
the Inflation Targeting Framework, monetary policy
with the objective of low inflation and
macroeconomic stability should take greater
account of global and domestic financial market
stability and the current state of the external
economy. For example, predictions of falling world
demand that could affect exports and the exchange
rate, as well as the lingering effects of global
financial market turmoil, should be given greater
significance as input in monetary policy
formulation.
Fiscal policy, which is predicted to continue
delivering a stimulus at the central level, should be
accompanied by regional fiscal policies tailored to
local conditions. The fiscal stimulus should seek to
improve infrastructure, promote industries that
enhance local regional competitiveness while
generating large-scale employment, safeguard

public purchasing power and alleviate poverty.
Fiscal and monetary policy coordination needs
to be strengthened so that results are more
complementary (mutually supporting) and not
substitutionary (mutually obscuring). Fiscal stimulus
intended to have an expansionary effect on the
economy should not be accompanied by monetary
contraction, which will have the opposite effect.
Alongside this, cuts in the policy rate by the
monetary authority should also not meet with a
contractionary fiscal policy response.
4.4.2 Microeconomic (Structural) Policies
A key factor in boosting activity in the real
sector is the construction of infrastructure. On one
hand, quality infrastructure will ensure free
movement of capital goods and intermediate inputs
that will create smooth, flexible industrial processes
capable of responding to market demand. On the
other hand, reliable infrastructure also ensures
smooth distribution of commodities and industrial
products, thereby strengthening aggregate supply
within the economy. This in turn will contribute to
higher economic growth while curbing inflation.
In addition, high priority should be given to
revamping of government institutions related to
economic functions, primarily on the supply side.
These improvements are related to investment
(licensing, security and certainty of business),
human capital development (skills, education and
health), efficiency and productivity of production
and distribution of goods and services. Higher
quality institutions will ease the overall costs of an
economy, which in turn will strengthen product
volume and competitiveness. Both have positive
implications for growth, price stability and other
economic fundamentals as a whole.
47
48
Chapter 5: Topical Issues
5.1 Factor Mobility, Distribution of Production and Regional Economic Integration

Haris Munandar (Bureau of Economic Research - Bank Indonesia)
5.1.1 Background and Motivation

At the January 2007 ASEAN Summit in Cebu,
the Philippines, ASEAN leaders agreed to accelerate
an ambitious initiative for integrating their
economies by shifting up the launching of the
ASEAN Economic Community (AEC) to 2015.
Previously, the AEC had been scheduled to start at
2020 in a decision by ASEAN leaders at the 2003
summit in Bali. The primary motivation in the
beginning arose from the need for deeper
integration within the regional economy to enable
ASEAN countries to compete in a new world with
China and India rapidly emerging as engines of
growth. The AEC is envisaged as building a single
market and production base, a highly competitive
economic area, a region with equitably shared
economic development and a club of economies
with the ability to become fully integrated into the
global economy. The AEC blueprint for achieving
this goal was adopted at the ASEAN Summit in
Singapore in November 2007. The blue print is
intended to provide the essential road map for
implementing the AEC in 2015. The blue print
summary consists of a series of action plans, targets
and time frames for implementing a range of
economic initiatives to pave the way for the AEC.
The creation of a single ASEAN market and
production base as outlined in the AEC blue print
requires that participating countries first establish
free movement of goods, services, investment,

capital and skilled workers. To achieve these
objectives, 12 priority sectors have been selected
to have a catalytic role, in which these sectors are
fast-tracked for integration.1 Within this context,
the ASEAN Free Trade Area (AFTA) has become the
most important element of the AEC, providing a
platform to facilitate the agenda for building
towards regional free trade. AFTA was established
in January 1992 at an ASEAN meeting in Singapore.
Now, the majority of ASEAN members have
adopted reductions in tariffs to 0-5% under the
AFTA framework, with full implementation by all
members in 2010. Brunei, Indonesia, Malaysia, the
Philippines, Singapore and Thailand (frequently
addressed as the ASEAN-6) agreed to
comprehensive finalisation of tariff cuts in 2008
and subsequently advanced this deadline to 2002.
Cambodia, Laos, Myanmar and Vietnam (the CLMV
countries) were given more time for finalising these
reductions: Vietnam in 2006, Laos and Myanmar
in 2008 and Cambodia in 2010.
On a conceptual level, the AEC is intended to
resemble a single market along the lines of the
The 12 priority sectors are: electronics, information and

communications technology, health, wood-based products,
automotives, rubber-based products, textiles and garments,
agriculture-based products, fisheries, air transportation,
tourism, and logistics.
49
The purpose of this article is to provide an

overview of what is likely to happen after free
mobility of production factors takes effect after
AEC 2015. At the same time, this analysis is
intended to strengthen the tools to anticipate the
ASEAN Economic Community 2015 . Both
objectives were clearly set out by the Governor of
Bank Indonesia at the annual Bankers Dinner on
18 January 2008. In the presentation of the annual
strategy, the Governor noted as follows:
The third initiative in monetary affairs is to
strengthen policy analysis capability in preparation
for AEC 2015. With the signing of the ASEAN
Charter in Singapore on 20 November 2007, the
programme for ASEAN economic integration
represents a firm commitment . The near
completion of the agenda for intra-ASEAN free
trade will bring significant changes to mobility of
production factors, including mobility of physical
capital through financial investment, for example
FDI or portfolio investments, and human capital
through mobility of skilled labour. The impact of
the free mobility of production factors will be the
creation of a new configuration for distribution of
production within the intra-ASEAN economy. It is
50
mandatory for all of us to understand the

determinants of this new configuration. We must
acquire the capability to predict the characteristics
and determinants of the new distribution of
production within the economy. Of course,
because we are discussing a future event, data that
can be interpreted in an empirical study are not
available. For this reason, research at the theoretical
and conceptual level in keeping with the principles
of economics, while applying a number of plausible
assumptions, is deemed necessary.2
5.1.2 The Economic Model
This section examines an economy (or
economic unit) producing a single product with
the use of a constant return to scale production
function:3
(1) Yt =F (Kt , Ht ).
in which Yt is output level, Kt is the level of physical

capital and Ht is the level of human capital, all at
time t. To facilitate interpretation, we assume that
the production function takes the form of Constant
Elasticity of Substitution (CES):
(2) Yt = {Kt -+ (1) Ht-} -1/
in which is the efficiency parameter, is utilisation

of physical capital and is the substitution
parameter such that elasticity of substitution
between the two inputs is = 1/(1+). Based on
(2), the marginal product of physical capital is:
(3) (FK )t = + (1)
[ HK
t
t
{[
European Union. In the ASEAN context, some

actions are still necessary to eliminate various barriers
and discrimination faced by suppliers of goods,
services and production factors from ASEANs own
member countries. ASEAN still faces a long journey
in building a single market. Fundamental changes
are required in the mindset of ASEAN economic
policymakers, particularly in how they view regional
economic integration. The relatively successful
implementation of AFTA (regional trade
liberalisation) has placed a number of issues related
to mobility of production factors firmly on the
agenda of the AEC implementation programmes.
(1+)/
See Speech by Governor of Bank Indonesia Burhanuddin

Abdullah at the Annual Bankers Dinner: Opening the Path
to Stability, Safeguarding the Nations Economic
Development, 18 January 2008, page 62.
For further discussion, see Bowen, Munandar and Viaene
(2005).

t
t
1+
= t (h)() (1)
[ HK
t
t
1+
1+
Similarly, the expression of marginal product

of effective labor (human capital) is:
where * indicates the variables of the second

economy. The ratio of (7) and (8) gives the ratio of
human capital to physical capital:
(9)
[ HK
t
t
1/(1+)
( t )
{[
(5) (FH )t = (1) (1) +
Ht
Kt
*
t
*
t
[ KH
(1+)/
Yt
Kt
[ HY
(4) (FK )t =
(8) (1) +
By combining (2) and (3) we obtain:
where
t
t
1+
At this point, we introduce a second

economy and analyse the implications of mobility
of production factors between the two economies.
If physical capital and human capital are able to
move perfectly between the two economies, we
can expect that each factor will flow from the
country with the low rate of return to the country
offering a high rate of return until each factors
marginal product is equalized between both
economies. However, if there are barriers to
movement of production factors, the rate of return
will only be partially equalised.4 For simplicity, such
barriers are represented by a time-varying
proportional wedge in rates of return to physical
capital and rated of return to human capital. Given
this, the relationship between the rates of return
for the two economies can be written:
t
t
[ KY
= t (k)()
*
t
*
t
[ KY
(7)
1+
1+
Barriers to mobility of physical capital include political risk,

various forms of capital controls and differences in taxation
regulations that hinder cross-border investment flows.
Barriers to mobility of human capital include various
government regulations pertaining to immigration and work
permits, differences in pension systems and different
languages used.
(10)
Yt
Kt
1/(1+)
= (t (k))
[ KY
t
t
where
= ( / ) 1/(1+)
= [()- ]
1/(1+)
We are now ready to illustrate the

implications of the model for distribution of output
and production factors between two economies.
To see the role of human capital, (8) can be
rewritten as:
(11)
Yt
Ht
1/(1+)
(t (h))
[ HY
t
t
[ HY
(6) (FH )t = (1)
= [ (1)/(1)]1/(1+), resulting in = 1 at
time =;
= (1+) /(1+), resulting in = 1 at time = ;
t = t (k) / t (h), resulting in t = 1 at time t (k) =
t (h).
Using this definition, one can write (7) as:
or
Traditionally, (11) serves as a basis for

productivity calculations and comparisons across
countries. However, unlike other literature in which
productivity is measured by output per worker,
equation (11) expresses (as in literature on
endogenous growth theory) productivity in output
per effective unit of labour. Empirical evidence
points to sensitivity of productivity comparison to
the measure used for human capital.
51

To obtain the first expression from the socalled equal-share relationship, note that (9) and
(10) may be written as follows:
Yt
Kt
= (t (k))
1/(1+)
[ YK
1/(1+)
Ht + (Ht * )
[ KY
t
t
= ( t )
Ht
Kt
(t ) 1/(1+)
Kt + (Kt * )
Yt + (Yt * ) (t (k))
1/(1+)
Kt + (Kt * )
(14)
By combining these two expressions, we

obtain:
Ht
(12)
Ht + (Ht * )
t 1/(1+)
Yt
Yt + (Yt * ) t (k)
1/(1+)
Kt
Kt + (Kt * )
Equation (12) establishes a link between

proportions of total output, physical capital and
human capital in the first economy compared to
the second economy. Differences in technology
between the two economies result only in a scaling
of the initial variables. A difference between * and
indicates a neutral difference in technology that
has no effect on optimum selection of physical
capital and human capital, but has some effect on
output distribution through in (12). Differences
between elasticity of substitution introduces the
power , while differences between other
parameters lead to a multiple rescaling of variables.
Equation (12) contains a number of
proportional linkages dependent on different
assumptions related to technology and mobility of
production factors. If the technology in the two
economies is identical, then (12) simplifies to:
(13)
Ht
Ht + Ht * t 1/(1+)
Yt
Yt + Yt * t (k)
1/(1+)
Kt
Kt + Kt *
In this new form of the equal-share

relationship, some variables for the second
economy are rescaled by the proportional
difference in rates of return. For example, for (13),
52
an absence of barriers to physical capital mobility

(t (k)=1) implies equal output and physical capital
shares that, however, differ from the human capital
share. If it is assumed that both t (k)=1 and t (h)=1
then the equal-share relationship takes the simple
form:
Ht
Ht + Ht *
Yt
Yt + Yt *
Kt
Kt + Kt *
This states that when there are no barriers

to factor mobility and technologies are identical,
each economys shares of total output, total
physical capital and total human capital will be
identical.
5.1.3 Policy Implications
The equal share relationship (14) has three
main implications. First, a relocation of physical
capital between integrated economies
(investment!), i.e. *, must be accompanied by an
increase in output and an improvement in human
capital (through inflows of foreign human capital
or accumulation of domestic human capital) to
restore parity in world proportions. Similarly, a
policy that increases a nations total share of human
capital will increase its share of total output in the
integrated economy and share of total physical
capital (through inflows of foreign physical capital
and accumulation of domestic capital).
Second, this framework can be reltaed to the

broad topic of output convergence by noting that
if (14) holds then the following two equations will
also hold:
(15)
Ht
Ht
Yt + Yt *
Ht + Ht *
(16)
Yt
Ht
Yt *
Ht *
From (16) it is clear that, if the equal-share

relationship holds then the two economies will have

the same output per effective unit of labour. This
implication is the essence of the productivity
convergence hypothesis, here interpreted in terms
of efficiency units of labour and not per capita.
in the pie of regional economic output. This makes

sense since superior quality human resources
become a magnet for and complement advanced
technology-intensive physical capital, while
Third, the equal-share relationship (14) can

be extended to the case of an integrated economy
that comprises j = 1,...,N members. If all members
have the same technology, and there is perfect
mobility of either physical or human capital among
members, then the equalisation of factor rates of
return implies:
technology has the capability of delivering

improvement in economic productivity
exponentially.
In addition, ASEAN countries able to
offer the most conducive atmosphere (read:
policies) for foreign investment have the greatest
opportunities for acquiring the largest share of
physical capital in relation to other ASEAN
countries. Besides this, a more advanced economy
will support a higher rate of domestic investment
by the public, which will also expand the proportion
of physical capital in that country. A nation with
substantial physical capital (financial and nonfinancial) will be able to employ highly skilled
domestic and foreign labours that represent a
powerful source of energy for high quality and
sustainable economic growth.
Each ASEAN member will occupy a certain
ranking among the AEC participating countries in
terms of economic output, human capital and
physical capital, commensurate to that countrys
resources and the economic policies that it chooses
to adopt. Needless to say, there will be great interest
in answering this question: Where will Indonesia
stand?
(16)
Hit
N
j=1
Hjt
Yit
N
j=1
Yjt
Kit
N
j=1
Kjt
for i = 1, , N
This set of equalities expresses the

distribution of output and production factors
among N members of a fully integrated economy.
Like (12), expression (17) can be extended to allow
for differences in technology and factor market
imperfections among member countries.
5.1.4 Epilogue
In the context of the ASEAN Economic
Community (AEC), the equal share relationship can
predict the limiting distribution of production
among ASEAN members after 2015. Countries
with more human capital and therefore have high
proportions of total human capital will have larger
proportions of physical capital and bigger shares
53

5.2 Regional Economic Integration, Investment and the Role of Monetary Authority1
Oki Hermansyah, Ferry Kurniawan and Haris Munandar (Bureau of Economic Research - Bank Indonesia)

In todays global economic environment,
countries frequently decide to join forces by
forming an integrated economic group. One
example is the decision by the ten members of
ASEAN to set up the ASEAN Economic Community
(AEC) in 2015. The establishment of a fully
integrated economic club has potential to change
the distribution of member country economic
outputs. This means that in an integrated economy
where barriers to factor mobility no longer exist
and the production technology is increasingly
uniform, the share of total output, total physical
capital and total human capital of a nation is
becoming more identical. Nations with a small
share of output will have a comparably small
proportion of capital stock (physical and human).2
The implication of this relationship is that
reallocation of physical capital (investment) to a
country will result in an increase in that countrys
output accompanied by inflows of foreign human
capital or accumulation of domestic human capital.
As a result, policies to create a conducive
investment climate and improvement of human
capital are vital not only for a country to become
competitive, but also for national survival. A
reduced share of human capital will also lead to a
This article is a summary of the Directorate of Economic

Research and Monetary Policy Working Paper No. WP/17/
2007, Regional Economic Integration, Mobility of
Production Factors and the Role of the Central Bank.
As described in Topical Issue 1, this condition is referred to
as the equal share relationship.
54
deterioration in economic output and in turn a

decline in the living standards of the people of that
economy.
Considered further, a strategy to build human
capital requires implementation of long-term
policies involving commitment, major budget
expenditures and untiring hard work, particularly
in the world of education, and hence the role of
central bank in this area is very limited. On the
other hand, however, the central bank could do
something in relation to the strategy to accumulate
physical capital. A significant increase in physical
capital requires high investment from domestic
sources (accumulation of private savings) and
foreign sources (FDI inflows).
Some studies have attempted to investigate
the possibility of a linkage between monetary policy
performance (the central bank domain) and
investment levels. At the theoretical level, Barro
(1996) made the conceptual discovery that the
effect of inflation on growth and investment is
negative, while Agenor (2004) claims that improved
macroeconomic stability in response to appropriate
policies leads to increased savings and investment.
In this regard, it is important and interesting to
examine whether empirical evidence can be found
in the case of Indonesia. The search for this
evidence becomes highly important when linked
to the imminent formation of the ASEAN Economic
Community in 2015. It is therefore crucial to study
whether a significant relationship exists between
monetary policy performance (most importantly
inflation) and investment performance in the

ASEAN countries (mainly FDI inflows). If this
relationship is discovered, the monetary authority
can play a role in building a nations physical capital,
which will lead to expansion in that nations share
of economic output (read: prosperity). In other
words, the monetary authority may have a positive
role in the period leading up to the establishment
of the ASEAN Economic Community (AEC).
5.2.2 Data and Methodology
To validate the possible existence of the above
linkages, an empirical study is conducted using
macroeconomic data from the ASEAN-7 countries
(Philippines, Indonesia, Cambodia, Malaysia,
Singapore, Thailand and Vietnam) for the 19912006 period. The first phase of this study involved
a short-term analysis using data on investment,
inflation and real annual GDP for each country
obtained from the International Monetary Fund
(IMF) and Asian Development Bank (ADB).3 In the
short-term, the model specifications used are as
follows:
Model 1: yt = a1 + b1 x1,t-1 + e1,
Model 2: yt = a2 + b2 x2,t-1 + e2,
in which yt is investment growth in year t, x1,t-1 is
inflation in the preceding year and x2,t-1 is real GDP
growth in the preceding year. e1,t is assumed to
have the IID property. The above specifications
attempt to capture the nature of the relationship
between inflation and economic growth in one
period and investment growth in a subsequent
period. A significant b1 or b2 coefficient values will
confirm the existence of this relationship.
Theoretically, the b1 value is negative (high inflation
reduces investment) and the b2 value is positive
The IMF data is the International Financial Statistics (IFS)

covering a number of years.
(economic growth will promote investment

growth).
The long run analysis uses cross-section data
for inward FDI in 2006 and cross-section data for
average inward FDI in the 2002-2006 period for
the above seven ASEAN countries. The use of these
averages is aimed at minimising volatility in the FDI
data. As can be seen, 2006 is used as the reference
year. Long-term inflation is calculated for each
cross-section data using average annual CPI
inflation for the 1991-2005 period, while
macroeconomic instability is proxied by a standard
deviation of nominal GDP growth, also for the
1991-2005 period. Data on FDI inflows from the
International Monetary Fund is used for investment
levels in the long run analysis. The long run
regression model is prepared as follows:
Model 4: yi = c1 + d1 x1,i + e3,
Model 5: yi = c2 + d2 x2,i + e4,
where yi is FDI inflows to country i, x1,i is longterm inflation in country i and x2,i is the level of
macroeconomic instability in country i. e3 and e4
are assumed to have IID properties. The above
specifications attempt to capture the nature of the
relationship between long-term inflation in
combination with macroeconomic stability on FDI
inflows in ASEAN countries. A significant d1 or d2
coefficient value will confirm this relationship.
Theoretically, low long-term inflation will promote
FDI inflows while high levels of macroeconomic
instability will deter inward FDI.
5.2.3 Short Run Analysis
The results of the short run (annual)
regression analysis are presented in Tables 5.1 to
5.7. In some countries (including Indonesia and
Thailand), low annual inflation and real GDP growth
are associated with investment growth. However,
55

this linkage is less convincing in the case of other
ASEAN countries in the study (Cambodia, Malaysia,
the Philippines, Singapore and Vietnam), and results
are therefore inconclusive.
Table 5.5 Investment Growth and Macroeconomic

Performance in Malaysia
Annual Inflation (-1)

Performance in Thailand
Real GDP growth (-1)
Sample: 2002-2006 Sample: 1992-2006

Model 1 Model 2 Model 1 Model 2
0.036
0.019
(0.2049)
(0.6281)
0.011
0.013
(0.1636)
(0.2173)
Note: Dependent variable is investment growth

growth; number in the bracket is p-value

Sample: 2002-2006 Sample: 1992-2006

-0.006
-0.035
(0.8086)
(0.0696)
0.030
0.018
(0.0319)
(0.0354)

Performance in Filipina


Performance in Indonesia

Sample: 2002-2006 Sample: 1992-2006

-0.028
-0.005
(0.0250)
(0.0023)
0.070
0.012
(0.2783)
(0.0124)


Performance in Vietnam


Performance in Kamboja

Sample: 2002-2006 Sample: 1992-2006

-0.028
-0.005
(0.0250)
(0.0023)
0.070
0.012
(0.2783)
(0.0124)


Performance in Singapura

Sample: 2002-2006 Sample: 1992-2006

-0.017
0.038
(0.8380)
(0.1042)
0.014
0.012
(0.2882)
(0.0638)

56
Sample: 2002-2006 Sample: 1992-2006

0.000
0.007
(0.9981)
(0.3104)
-0.017
-0.010
(0.4737)
(0.3992)
Sample: 2002-2006 Sample: 1992-2006

-0.003
0.007
(0.4570)
(0.0000)
-0.024
0.007
(0.2468)
(0.8188)

The findings of the short run analysis must

be treated with caution. On one hand, the results
obtained are dependent on the business cycle in
individual countries, and therefore it is difficult to
identify a uniform pattern within ASEAN. On the
other hand, an interesting aspect of economic
integration concerns its effect in the long run, not
short run. In addition, country investment policies
are generally focused on foreign capital inflows,
given that domestic investment tends to be stable.
FDI is the most desired of all types of foreign
investment because of the more direct implication
it has on the real sector (compared to the effect of

portfolio investment which tends to be confined
to the financial sector). Therefore, attracting the
maximum possible FDI is the goal of many
developing nations, including those in ASEAN. The
long run analysis in the following section attempts
to explain these issues.
5.2.4 Long Run Analysis
The results of a long run analysis appear in
Tables 5.8 and 5.9. Both tables indicate to a strong
correlation between low inflation and high rates
of inward FDI. Countries that succeed in achieving
a consistent level of low inflation will benefit from
Table 5.8 Inward FDI and Macroeconomic
Performance - 2006 Reference Year
Model 3
-0.141
(0.0112)
Long Run Inflation

(1991-2005)
Macro Economy Instability
(1991-2005)
Model 4
-0.061
(0.052)
Note: Dependent variable is Inward FDI 2006

2006; number in the bracket is p-value
Table 5.9 Inward FDI and Macroeconomic

Performance 2002-2006 Reference Period
Model 3
-0.148
(0.0031)
Inflasi Jangka Panjang

(1991-2005)
Instabilitas Ekonomi Makro
(1991-2005)
Model 4
-0.064
(0.0325)
Note: Dependent variable is Average Inward FDI 2002-2006

2002-2006; number in the bracket is p-value
high inflows of FDI. The results also demonstrate a

strong correlation between macroeconomic
stability and FDI inflows. Countries with stable
macroeconomic conditions enjoy high rates of FDI,
and the converse also applies. Both results are valid
for all ASEAN countries under study. The conclusion
from this analysis seems to be that central bank
policy aimed at achieving and maintaining low
inflation and stable macroeconomic conditions is

a pro-investment monetary policy.
5.2.5 Conclusions
Regional economic integration will result in
an economic distribution that depends on
distribution of each countrys production factors,
comprising both physical capital and human capital.
Investment will play an increasingly central role,
directly determining a countrys level of prosperity
in relation to its peers in the region. Central banks
are able to influence investment performance
through their monetary policies: low inflation and
stable macroeconomic conditions contribute
significantly to increased investment. In other
words, monetary policy targeting low inflation and
macroeconomic stability is a pro-investment
monetary policy. With regional economic
integration, central banks will play an increasingly
essential role in promoting investment.
57

5.3 Impact of Proximity on Provincial Commodity Exports: Gravity Model Approach
Yayat Cadarajat and Yanfitri (Bureau of Economic Research - Bank Indonesia)
The formation of the ASEAN Economic

Community in 2015 creates both opportunities and
challenges for Indonesia in building national
prosperity through regional economic and financial
integration. In regard to international trade, the
extent to which Indonesia benefits from the
formation of the ASEAN single market will depend
on the nations ability to build competitiveness and
productivity. Indonesias vast territory with the
relatively wide variation of leading export
commodities among its provinces offers
opportunities for further export diversification to
increase exports to the ASEAN region, other
countries in Asia, and the world. This will enable
Indonesia to be not only a large market for the
exports of other ASEAN countries, but also to avail
market opportunities in neighbouring countries for
Indonesian exports. On a specific level, Indonesias
export performance will be determined by the
economic and trade performance of individual
provinces. For this reason, it is important to devote
attention to trade patterns at the provincial level.
To complement existing research on demand
for Indonesian exports, this study examines
whether distance from production location
(exporter location) to market (importer location) is
also a factor that influences export demand. This
study uses panel data for 15 major commodities
from 24 provinces in Indonesia traded with ASEAN
countries and also Australia, New Zealand, Papua
New Guinea, Bangladesh, India, Sri Lanka, Japan,
South Korea and China. The methodology used is
a panel regression of the gravity model with
58
random effects over an estimation period of 19992006. Before testing the gravity model, this study
begins with an analysis of the pattern of exports
from each province in Indonesia.
5.3.1 Overview of Exports by Indonesias
Provinces
As mentioned earlier, a countrys
international trade can be built up through the
trade conducted by each province. The large size
of Indonesias territory and broad variation of
leading export commodities among provinces can
be harnessed to promote export growth in these
provinces. The most dominant province in export
activity at this time is West Java, followed by Riau,
East Java and Jakarta (Table 5.10). In West Java,
26.2% of exports are shipped to ASEAN, led by
Malaysia, the Philippines, Thailand and Vietnam.
Riau province conducts its export trade mainly
with Singapore.
Table 5.10 Contribution by Province to Non-Fuel
Exports and Imports
PROVINCE
WEST JAVA
RIAU
EAST JAVA
JAKARTA
NORTH SUMATERA
EAST KALIMANTAN
BANTEN
CENTRAL JAVA
IRIAN JAYA
SOUTH KALIMANTAN
EXPORT
2005
2006
23.2
13.6
9.9
8.1
6.6
5.9
7.7
4.2
3.8
3.1
Source : BI, DSM
21.4
13
10.4
7.9
6.4
6.2
7.6
3.9
3.9
3.7
2007
19.4
13.5
11.5
7.8
6.5
5.9
6.6
3.8
4.8
3.8
Average
2001-2007
26.2
14
10.3
9.1
6.0
5.5
5.4
4.1
3.2
3.0

Examined in more detail, each region in
Indonesia has specific leading commodities for
export. Examples are:
- Provinces in Sumatra
: palm oil, natural
rubber,
- Provinces in Kalimantan : mining products
(coal)
- Provinces in Sulawesi
: cocoa, palm oil
and metalliferous
commodities
- Provinces in Java and Bali : industrial products
such as textiles &

garments, paper,
furniture and
wood products
- Provinces in Nusatenggara: metalliferous
- Irian Jaya
: metalliferous
Table 5.11 shows that in most provinces of
Indonesia, the main export products are restricted
to one or two commodities. Only a few provinces
in Java have a more diversified range of mainstay
exports.
Table 5.11 Major Export Commodities and Exporting Regions

FISH,CRUST.,MOLLUSCS AND THEIR PREP
COAL, COKE AND BRIQUETTES
EAST JAVA
JAKARTA
NORTH SUMATERA
LAMPUNG
SOUTH SULAWESI
Total
EAST KALIMANTAN
SOUTH KALIMANTAN
BENGKULU
LAMPUNG
SOUTH SUMATERA
Total
31.9
12.4
10.3
6.9
6.2
67.7
COFFEE, TEA, COCOA, SPICES

SOUTH SULAWESI
LAMPUNG
WEST JAVA
NORTH SUMATERA
EAST JAVA
Total
CRUDE RUBBER
25.8
8.8
8.2
7.9
6.4
57.1
METALLIFEROUS ORES&METAL SCR

IRIAN JAYA
WEST NUSA TENGGARA
SOUTH SULAWESI
RIAU
WEST JAVA
Total
59.1
35.6
1.9
1.6
0.5
98.7
FIXED VEGETABLE OILS & FATS

21.2
17.4
13
11.2
10.9
73.7
SOUTH SUMATERA
JAMBI
RIAU
WEST SUMATERA
WEST KALIMANTAN
Total
OFFICE MACH.& AUT.DATA PROC.
NORTH SUMATERA
RIAU
WEST SUMATERA
SOUTH SUMATERA
NORTH SULAWESI
Total
38.9
36.1
5.5
4.7
3.4
88.6
WEST JAVA
RIAU
JAKARTA
EAST JAVA
CENTRAL JAVA
Total
PAPER,PAPERBOARD&MFD THEREOF
FURNITURE AND PARTS THERE OF
EAST JAVA
WEST JAVA
RIAU
JAKARTA
CENTRAL JAVA
Total
CENTRAL JAVA
EAST JAVA
WEST JAVA
JAKARTA
BALI
Total
WEST JAVA
CENTRAL JAVA
JAKARTA
EAST JAVA
BALI
Total
48
39.4
0.8
0.1
0.0
88.3
TELECOMMUNICATION & REPRO. APP
35.5
34.4
15.3
2.6
0.9
88.7
TEXTILE YARNS, FABRICS&PROD.

36.5
18.0
14.4
1.2
0.6
70.7
RIAU
WEST JAVA
JAKARTA
NORTH SUMATERA
EAST JAVA
Total
66.3
19.4
4.2
1
0.8
91.6
32.9
26.5
21.4
6.4
3
90.2
CLOTHING
61.8
17.3
8.6
6.4
0.6
94.6
WEST JAVA
JAKARTA
CENTRAL JAVA
EAST JAVA
BALI
Total
39.8
39.1
8.9
1.9
1.8
91.6
59

5.3.2 Model and Estimates
In international trade theory, the gravity
model essentially depicts the influence of market
size and distance on levels of trade. The gravity
model applies the assumption that distance reflects
costs and barriers to trade. The model assumes
that each country produces different goods, but
with the same, uniform utility functions. It applies
the assumption of constant elasticity of substitution
(CES), which implies that when several regions
produce the same goods, transportation costs will
be the determining factor in trade.
The basic equations used in the model are
as follows1
Tij = Aij (
Y iY j
Dist ij
(1)
In the study, equation (1) is expressed in linear

form with some adjustments to variables: variable
Yj is replaced with Mj to reflect real demand in the
importing country and an additional variable is
added for the real exchange rate (RER) to capture
the influence of export price competitiveness. This
enables an analytical model to be expressed in
equation (2) as follows:
log Tij= + 1 log Dist ij + 2 log Y i + 3 log M j + 4 log RER +ij (2)
Dist ij where Tij is the level of commodity exports

from region i to j, Y i is the distance between region
i and j, M j is the GDP of the exporting region, ij
represents imports in the trading partner nation,
and RER is the real exchange rate.
Deardorff, V.A. (1995): Determinants of Bilateral Trade:

Does Gravity Work in a Neoclassic World? NBER Working
Paper No. 5377.
60
5.3.3 Estimate Results

Results of estimates using the random effect
method2 indicate that most of Indonesias major
export commodities demonstrate negative elasticity
to distance to export destination (Table 5.11). The
distance coefficient is influenced by the
characteristics of the traded commodity itself and
the condition of the trading partners of the
provinces involved. Heavy, more difficult to
transport commodities demonstrate a high level
of elasticity to distance. Examples are coal, CPO
(with elasticity above 1) and metal ores such as
copper ore, nickel ore and tin (with elasticity
approaching 1). In contrast, easily transportable
commodities, such as electrical machinery,
telecommunications equipment and coffee, tea
and cocoa tend to have a low coefficient of
elasticity to distance.
On the other hand, the low elasticity of some
major commodity exports is also explained by the
similarity of products from countries included in
the sample, so that provinces in Indonesia export
more to other countries such as the United States
and European Union than to the sample countries.
In addition, some exports of wood-based products,
paper, garments, furniture and rubber are not
affected by distance and are exported mainly
through ports in Java.
The estimation results for this gravity model
show that exports are not only influenced by
distance, but are positively influenced by real
demand in Asian trading partners with higher
This study was also attempted with the OLS pool method,
but the results tended to be inefficient (see Wooldridge,
2006).

Table 5.12 Gravity Model Estimates
Commodities
Jarakij
Imporj
PDRBi
RER
Fish, Crust., Mollusc

Coffee, Tea, Cocoa, Spices
Crude Rubber
Wood, Lumber&Cork
Metalliferous ores &scraps
Coal
CPO
Wood&Cork Manufactured
Paper, Paperboard
Textile yarns, fabrics&prod.
Office machinery
Telecommunication app
Electrical machinery
Furniture
Clothing
-0.68***
-0.38*
0.21
-0.03
-0.95*
-1.96***
-1.19***
-0.12
-0.10
-0.04
0.50
-0.41***
-0.28*
0.21
0.43
0.80***
0.56***
1.25***
0.47***
1.27***
0.80***
0.94***
0.80**
0.21**
0.26***
1.25***
0.94***
0.45***
0.36***
0.39***
0.73***
0.62***
1.39***
0.140
1.47***
-0.75*
0.140
0.75***
1.74***
1.65***
0.68***
3.00***
1.82***
0.95***
2.05***
0.00
-0.03*
-0.04
-0.02
-0.07
-0.09
0.01
-0.01
-0.01
-0.03
0.04
0.05
-0.02
-0.02
0.01
Notes: *) 10%, **) 5% dan ***) 1% significance level.
degree of elasticity in exports of primary

commodities and raw materials compared to
exports of manufactured products (paper, textiles/
clothing and furniture).
The gravity model also predicts that export
levels are influenced not only by distance and
trading partner imports, but also by exporter
earnings. Earnings in exporting provinces depict
the supply side of export commodities. Of the 15
commodities, only fish, coffee, tea and cocoa and
office equipment demonstrate relatively high
elasticity in exports to regional GDP (greater than
1). Table 5.12 shows that all major export
commodities are positively influenced by exporter
revenues, with the exception of wood and coal.
The negative correlation of coal exports to
provincial GDP is thought to be partly attributable
to the large size of the domestic coal market, with
the result that regional GDP growth will strengthen

domestic coal demand.
In addition to the three factors described
above, appreciation in the real exchange rate
(factoring in the difference between domestic and
trading partner inflation) is predicted to have a
negative influence on leading commodity exports.
Estimation results show that the real exchange rate
had no significant influence on exports to Asia,
except for coffee, tea and cocoa.
5.3.4 Conclusion
This research shows that in most cases,
provincial trade in major export commodities is
negatively correlated to distance between the
provinces in Indonesia and trading partner
countries, while a positive correlation exists
between regional growth and real demand in
trading partners. However, the exchange rate has
little influence on most exports of leading
commodities. Concerning this, the following
recommendations are put forward:
Manufactured commodities (downstream

industry) need to be developed into leading
exports produced from raw materials based
on the natural resources that have hitherto
served as Indonesias leading exports, thus
reducing the impact of negative elasticity of
distance to exports.
Exports of manufactured goods can be

developed in all regions because distance to
market in Asian export destinations has less
influence on manufactured exports.
61

5.4 Human Capital Formation, Income Inequality and Economic Integration: A Literature
Survey
Oki Hermansyah, Haris Munandar and Myrnawati Savitri (Bureau of Economic Research - Bank Indonesia)

Social mobility and persistent inequality are
important from both a theoretical perspective and
in policy making. How a family can improve its
economic status and what determines the income
level of that family is an interesting and important
question. Research on what creates the conditions
for income inequality in the long run and why
income inequality is different in each country is a
fascinating topic of study. The explanation offered
in past research is that the phenomenon of income
inequality results from the different levels of
technological advancement among nations and
represents the asymmetrical impact of globalisation
of world trade and financial markets. However,
conventional policy and intuition suggest that the
explanation for these two issues must involve
education as a primary factor.
Various international organisations have
successfully prepared a list of indicators that enable
us to compare school graduation levels in a number
of countries. The primary characteristic of these
indicators is that formal education, parental
guidance and other methods for acquiring
knowledge hold different positions in different
parts of the world. The level and efficiency of public
education, parental contribution and utilisation of
new technology is different from one economy to
another, and is marked by enormous variation. If
we agree that the process explaining the formation
of human capital influences economic output and
income distribution, then we need to formalise that
process to ascertain the significance of that factor.
62
5.4.2 Education, Openness and Income Inequality

This section is a meta-analysis of the topic
outlined above. A meta-analysis is a combined
study of the various theses obtained from various
related research. Some literature provides a very
in-depth understanding of the formation of income
inequality. Atkinson (1999), Corneo and Jeanne
(2001) show that social norms are a determining
factor in income distribution. Many different studies
have been performed to analyse the role of
accumulation of human capital in income
distribution within diverse contexts.
There are numerous linteratures linking the
components of education and differences in
income distribution. Becker and Chiswick (1966)
show how income inequality is positively correlated
with disparities in school ratings and negatively
correlated with educational levels. Based on data
from nine countries, Chiswick (1971) claims that
differences in income levels are directly correlated
with differences in educational levels. Using
samples from larger countries, Adelman and Morris
(1973) and Chenery and Syrquin (1975)
demonstrate that higher educational levels reduce
income inequality. Despite this, recent advances in
technology have not influenced human capital
formation in some countries in similar fashion.
Experience in various countries offers
conflicting explanations of the relationship
between openness and income inequality. Wood
(1998) states that trade is blamed for the income
inequality that hit America at the end of the
twentieth century. However, Feenstra and Hanson

(1999) predict that in fact only 15 to 33 percent of
the worsening of income inequality is attributable
to trade competition. Other research findings claim
that income inequality is not linked to globalisation
and economic integration, but in fact stem from
other factors such as reduced growth in supply per
worker and changes in technology that have led
to more dismissals of unskilled compared to skilled
workers (Williamson, 2006). These seemingly
contradictory results offer a hint that economic
integration may not have a significant impact on
income inequlaty.
Until the mid-1980s, only the United States
and Great Britain had seen a worsening of income
inequality, but beginning in the mid-1980s, 20 of
the 21 OECD nations recorded significant increases
in this area (Burniaux et al., 1998). This study reveals
that in most OECD countries, fulltime labor
earnings did not become more unequal. This
indicates that income inequality in many nations
are suffered in the form of mounting
unemployment and reductions in working hours.
The latter finding encourages the inclusion of elastic
labor supply into each model attempting to explain
income inequality.
Despite the limitations of literature on the
relationship between economic liberalisation and
income inequality in developing nations, the
findings of studies that have been made indicate
differing results among these countries. Income
inequality appeared to ease when Japan, Korea and
Taiwan embarked on liberalisation at the end of
the 1960s. However, differences in wage levels
generally widened when six Latin American nations
liberalised their economies after the end of the
1970s (Hanson and Harrison, 1999; Robbins,
1997). This provides further indication of the
importance of answering the question of whether
economic integration is associated with rising or

falling income inequality.
As emphasised by Wood (1998), there is
plausibility in the importance of the historical
context, given the differences in some matters
when various liberalisation processes took place.
One example is the widening of wage disparities
in Latin America, apparently in contradiction of the
Stolper-Samuelson prediction, such as occurred
with Mexicos liberalisation in 1985-1990.
Unfortunately, this pro-globalisation policy action
coincided with the emergence of China and other
Asian exporters on the world market, pitting
Mexico against new competitors in all export
markets. When the three Asian tigers (Japan, Korea
and Taiwan) opened their economies at the end of
the 1960s, there was much less extreme
competition from low-wage countries compared
to the end of the 1970s, when Latin America
lowered tariffs and other barriers to trade.
Although widening income inequality in
China, India and Russia appears to dominate the
global trend in income inequality in the present
generation, this phenomenon is very likely
unrelated to economic integration policies
(Williamson, 2006). Most situations of widening
income inequality during the liberalisation phase
experienced by these countries are related to the
incomplete and selective way in which the opening
of economies took place. The worsening inequality
suggests that the benefits of globalisation did not
flow to the majority of the population. For example,
liberalisation in China appears to have benefited
only those living in coastal areas. Another example
is Mexico. After the GATT-related liberation in 1986
and subsequent liberalisation under the NAFTA
framework in 1994, disparities in Mexico in fact
worsened instead of narrowing as experts had
63

predicted. Hanson (2002) explains that this resulted
from differences in the magnitude of regional
stimulation and the surge in development along
the border with the United States. Robertson
(2001) indicates that the increased wage disparities
began to ease after three to five years.
The effect of economic integration on income
inequality is clearly the subject of frequent debate.
5.4.3 Overlapping Generation Economic Model,
Heterogeneity and Economic Integration
The following section discusses an
overlapping generation economic model consisting
of heterogeneous agents producing a single
product using two types of production factors:
physical capital and human capital.10 Human
capital is represented by interaction between
number of workers and skills. Each individual lives
in one of three periods. During the childhood
period (not making any economic decisions), the
person gains an education. Intergenerational
transfer in an economy takes place through two
channels: (1) public education financed from taxes
paid by workers and (2) investment by parents in
their upbringing at home. Each child is also
endowed with certain inherited abilities from birth.
The second period is the working phase, while the
third period is the retirement stage.
The Government has two roles in an
economy: first, to fund public education by taxing
earnings, and second, to provide the public
education while also regulating quality. Public
education consists of formal education at school
and all education-related expenditures (such as
public libraries and media). Education at home is
This analysis follows a framework developed in Munandar

(2008).
64
provided by the immediate family, firstly by parents

and also in social interaction and learning
technology available at home (such as books and
the internet). In this case, the level of human capital
of the parents and the time they spend teaching
their children are essential factors.
Many economic models employ similar
mechanisms to explain the formation of human
capital. Such processes are usually focused on a
few parameters to ensure tractability. In the model
discussed here, the process for building human
capital has several important characteristics. First,
individuals from families with above average
human capital receive a lower return on investment
in public education compared to those from
families with below-average human capital.
Similarly, the cost of achieving a certain level of
human capital is less for the younger generation
in the case of families with relatively higher levels
of human capital. Other models possessing these
characteristics are, for example, Tamura (1991) and
Fischer and Serra (1996). Second, this model
demonstrates the importance of parental human
capital in the development of the human capital
of their offspring. Burnhill et al. (1990) shows that
the educational levels of parents influence the
ability of their children to obtain higher education.
Barro and Lee (2001) and Brunello and Checchi
(2005) found that family characteristics, including
education of the parents, strengthened the
achievements of their children. The reason is that
the educational level of parents influences the
quality of child education at home.
When analysing the effects of economic
integration, two economies are involved, one
exporting capital and the other importing capital.
This condition will lead to a post-integration
equalisation of return on capital. Some literature,

for example Lucas (1990) and Leidierman and Razin
(1994) discuss differences between countries in
return on capital.
Using the above overlapping generation
model, the usual explanatory factors in income
inequality, such as mobility of physical capital and
technological advances in production, in fact do
not have any role in determining income
distribution in the long run. The initial condition
of human capital turns out to be the relevant factor,
meaning that a nation that begins with a higher
level of human capital has greater opportunity to
eliminate income inequality over time. However,
the mobility of physical capital that results from
income inequality has no impact on income
inequality after economic integration, even though
the effect on welfare can well be substantial. This
finding isolates the human capital formation
process as the most important source of income
inequality. Such result stands in contrast with those
of Viaene and Zilcha (2002) which suggest that
following capital market integration, inewaulaity
in intragenerational income distributions changes
in all dates. This difference is explained by their
assumption of intergeneration transfer of physical
capital (bequest). However, empirical evidence
seems to suggest that among families, bequest is
far from universal (Laitner, 1997).
5.4.4 Role of Human Capital in Conditions of

Equilibrium
The consequences of various processes for
building human capital in income inequality within
an overlapping generation economy with
heterogeneous agents have been studied. The
heterogeneity in models originates from the initial
distribution of human capital among individuals
and from the random inborn abilities. The results
offer some insights concerning a relation between
income inequality and various features of the
human capital building process, including: a) the
international environment, such as mobility of
physical capital; b) initial condition of human capital
stock; c) level and externality of public education;
and d) efficiency from educational technology. This
framework shows that the nature of income
inequality remains unchanged from generation to
generation. According to this characteristic, while
wage levels equalise after economic integration,
inequality remains unchanged because all
individual incomes are affected in the same
proportion. However, between countries,
intergenerational income distribution becomes
more equitable after the opening of an economy.
Even so, poverty traps and positive growth in
human capital may occur, and both are dependent
on the initial level of human capital in the economy.
65
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Indonesian Economic Outlook

Economic Research Bureau

Indonesian Economic Outlook

ASEAN Economic Integration and

Economic Research Bureau

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

1.1 The World and Indonesian Economy ........................................................................

2.1 Overview of the World Economy ..............................................................................

Background to Establishment of the ASEAN Economic Community ..........................

4.1 Assumptions for the Global Economy, 2008-2012 ....................................................

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

World Commodity Consumption ............................................................................

Economic Indicators for ASEAN* ............................................................................

Projection of Global FDI Inflows, 2008-2011 ...........................................................

Investment Growth and Macroeconomic Performance in Thailand ..........................

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Investment Growth and Macroeconomic Performance in Malaysia ..........................

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Contributions to World Growth ..............................................................................

World Economic Growth and Volume of World Trade .............................................

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

DEPUTY GOVERNOR OF BANK INDONESIA

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Jakarta, January 2008

Outlook Ekonomi Indonesia 2008 - 2012, Edisi Januari 2008

this page is intentionally left blank

Chapter 1: General Review

Chapter 1: General Review

keep pouring into Indonesia and support strong

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

In 1970-2006, world economic growth averaged 3.7%.

quality growth continues to be hampered by the

BIs analysis using the SVAR Blanchard-Quah approach

Indonesian Economic Outlook, July 2007 edition.

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

More complete information on the study findings is

in view of the relatively high rate of

According to statistical data taken in 2006, Indonesia and

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

UNCTAD survey findings state that market size and growth

climb from about 9.3% in 2008 to 13.0%-15.0%

This is borne out in survey findings published by UNCTAD

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

*) Pursuant to Decree of the Minister of Finance No. 1 of 2008.

Higher economic growth, subdued inflation,

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 1: General Review

this page is intentionally left blank

Indonesian Economic Outlook 2008 - 2012, January 2008 Edition

Chapter 2: Update of the World and Indonesian Economy

Chapter 2: Update of the World and Indonesian Economy

trade, with volume growing at an average of 9.2%

Contributions to Real GDP Growth

Source: IMF: Survey Magazine-IMF Research

Graph 2.1 Contributions to World Growth

2.1 Overview of the World Economy

Contributions to Real GDP Growth