The International Monetary Fund’s June 2023 assessment of Indonesia’s export ban policy has reignited debate on Indonesia’s downstream industrial policy.
Advocates emphasize its substantial impact on export revenues and value addition, while critics pinpoint the fiscal cost and the market distortions caused by the policy. A more nuanced assessment suggests the merits of both perspectives.
Indonesia’s experiment with downstream industrial policy began with the 2009 Mining Law signed by former president Susilo Bambang Yudhoyono, which mandated the domestic processing of all mineral commodities mined in the country.
But the policy was only implemented in 2014 for nickel and bauxite amid widespread opposition from the mining sector. It was in nickel that Indonesia found its success.
Before banning nickel ore export in 2014, Indonesia predominantly exported raw nickel ore, which is minimally processed into nickel matte. The country’s nickel-related exports were a modest US$6 billion in 2013.
By 2022, this figure had skyrocketed to nearly $30 billion, propelled by the exports of higher value-added products such as stainless steel and battery materials.
The most crucial factor to this success appears to be Indonesia’s exploitation of its “market power” in nickel production through an export ban.
Chinese firms that were large players in the downstream nickel-based production had no choice but to expand their operations within Indonesia to secure access to its abundant nickel resources.
The rapid growth of the nickel sector was facilitated by concessional financing under the Belt and Road Initiative. Chinese state-owned banks financed the construction of coal power plants and basic infrastructure, integral components of the industrial areas that fostered economies of scale and agglomeration.
But while the export revenue gains are evident, the extent to which this revenue is retained and equitably shared within the country remains uncertain.
This is mostly due to the capital-intensive nature of the nickel sector, the high share of foreign equity and the sector’s limited linkage with other parts of the economy beyond the primary sector.
Growth in gross domestic product may not directly translate into gross national product as export earnings by foreign investors may be entirely repatriated out of Indonesia. Yet the downstream industrial development strategy has contributed significantly to structural transformation.
Nickel-based manufactured products now stand as the third-largest export commodities behind coal and palm oil. The impact on regional economic development is also significant as the industrial areas are concentrated in eastern Indonesia, which generally lacks a large formal manufacturing sector.
A balanced evaluation necessitates weighing these benefits against the costs. Basic trade theory suggests that an export ban will depress domestic prices relative to global prices, resulting in winners and losers within the economy.
The nickel mining sector has borne the brunt of subsidizing the downstream industries, which may affect the incentive to explore new reserves.
The fiscal costs of tax holidays and forgone royalties may also be substantial. The environmental and social costs associated with nickel processing should also be considered. Nickel smelting tends to be emission-intensive due to a reliance on coal-fired power plants. Industrial expansion has also been associated with deforestation and water pollution.
In terms of social cost, labor rights violations have been amply documented. The building of industrial areas has also been associated with the displacement of local communities traditionally dependent on agriculture and fishing.
As Indonesia contemplates extending the policy to other commodities, it is imperative to note that its nickel-based export success was highly contextual and whether comparable outcomes can be realistically expected for other commodities.
This underscores the necessity for the downstream industry development strategy to move beyond export bans and tariffs.
While harnessing market power through export restrictions has attracted investments, there is an inherent risk to this strategy due to its impact on global prices and supply. It potentially incentivizes the innovation of substitutes and provokes retaliatory trade measures from other countries.
Indonesia needs better policies to internalize the social and environmental externalities associated with nickel processing. Better enforcement of labor and environmental regulations will be key. Indonesia could also draw inspiration from certain aspects of the US Inflation Reduction Act.
While Pigouvian taxes remain the optimal way to internalize externalities, linking fiscal incentives to broader social and environmental objectives — such as reducing carbon intensity and creating quality middle-class jobs — can be another method to achieve similar goals.
Also, as natural resource advantage diminishes the more downstream a sector is, a more holistic approach that focuses on ecosystem development through the provision of key public inputs will be essential.
Developing human capital and subsidizing public research and development will amplify positive spillovers as well as support downstream industrial growth, promoting more inclusive and shared prosperity.
Finally, increasing the share of value-add that stays in Indonesia will require financial market deepening and removing foreign direct investment barriers. These will incentivize the reinvestment of export receipts in the country.
There is reason for cautious optimism and with the implementation of better evidence-based policies, Indonesia can expand on its initial success and achieve the intended goals of its downstream industrial policy.
Faris Abdurrachman is a Master’s student in Quantitative Economics at New York University Stern School of Business and Graduate School of Arts and Science and a former Research Analyst at the Australia-Indonesia Partnership for Economic Development.
This article was originally published by East Asia Forum and is republished under a Creative Commons license.