“Operationalising Pro- Poor Growth” A joint initiative of AFD, BMZ (GTZ, KfW Development Bank), DFID, and the World Bank A Country Case Study on Indonesia Peter Timmer October 2004 This paper belongs to a series of 14 country case studies spanning Africa, Asia, Latin America and Eastern Europe. The series is part of the ‘Operationalising Pro-Poor Growth (OPPG)’ work programme, a joint initiative of AFD, BMZ (GTZ, KfW Development Bank), DFID and the World Bank. The OPPG work programme aims to provide better advice to governments on policies that facilitate the participation of poor people in the growth process. Other outputs of the OPPG initiative include a joint synthesis report, a note on methodological approaches to analysing the distributional impact of growth, cross-country econometric work, literature reviews, and six synthesis papers on: macroeconomics and structural policies, institutions, labour markets, agriculture and rural development, pro-poor spending, and gender. The country case studies and synthesis papers will be disseminated in 2005. The entire set of country case studies can be found on the websites of the participating organisations: BMZ www.bmz.de, DFID www.dfid.gov.uk, GTZ www.gtz.de, KfW Development Bank www.kfw- entwicklungsbank.de/EN/Fachinformationen and the World Bank www.worldbank.org. For further information, please contact: AFD: Jacky Amprou [email protected] BMZ: Birgit Pickel [email protected] DFID: Manu Manthri [email protected] and Christian Rogg [email protected] GTZ: Hartmut Janus [email protected] KfW Development Bank: Annette Langhammer [email protected] World Bank: Louise Cord [email protected] and Ignacio Fiestas [email protected] This draft: September 15, 2004 Operationalizing Pro-Poor Growth Country Study Indonesia This country study, prepared primarily by Peter Timmer, Senior Research Fellow at the Center for Global Development, Washington, DC, has drawn heavily on the work of many collaborators and scholars. Louise Cord and Ignacio Fiestas have been especially helpful from the World Bank offices in Washington, and Ignacio prepared three of the annexes in this report. Vivi Alatas, Jehan Arulpragasam, and Neil McCulloch in the Jakarta offices of the World Bank have been generous with their time, data, and analytical skills. I absolve them of any responsibilities for the arguments I make here. Wally Falcon, my long-time colleague on matters Indonesian and agricultural, provided very helpful comments on the penultimate draft. Gunilla Petterson was able to figure out how to draw the figure in Annex 1 in Word. My daughter, Ashley provided badly needed econometric skills for an earlier, related paper published in the Bulletin of Indonesian Economic Studies in August, 2004. My wife Carol has come out of retirement to edit the entire manuscript, and readers who know her transformational skills on my earlier work will certainly cheer. My collaborators on the other country studies, and on the background papers for the pro-poor project, have stimulated my thinking more than they realize. To all, a “thank you” is small pay, but I offer it sincerely nonetheless. The main message from this study is succinct but powerful: The poor in Indonesia have been very closely connected to economic growth in the country, benefiting differentially when the economy was growing rapidly, and suffering disproportionately when the economy is not growing, or suffers a major crisis, as in 1998. Of all the country experiences in this project, Indonesia’s record from the late 1960s to the mid-1990s was one of the most “pro-poor,” and from the late 1990s to the present, one of the most traumatic. 2 Page Outline 2 Executive Summary 3 Chapter 1. Introduction 5 Chapter 2. Historical context and the political-economy origins of the strong link between growth and poverty reduction 12 Chapter 3. Why economic growth in Indonesia has been so pro-poor 22 Chapter 4. Connecting the macro economy to markets and to the capabilities of the poor 38 Chapter 5. Tradeoffs cause tough choices for analysts and policymakers alike 47 Chapter 6. Political economy and governance 55 Chapter 7. Looking forward: Optimism or pessimism? 63 References 65 Annexes !. Regression coefficients for calculating the Index of Pro-Poor Growth, and the analytical framework linking income distribution to the average income elasticity of demand for food energy 73 2. Sources of economic growth and labor force trends 78 3. Sources of productivity growth for agriculture and the overall economy 86 4. Poverty characteristics, growth incidence curves, and rates of 87 poverty reduction (prepared by Vivi Alatas, Jehan Arulpragasam, and Neil McCulloch) 5. Gender issues in Indonesia (prepared by Ignacio Fiestas) 93 6. Non-monetary measures of welfare (prepared by Ignacio Fiestas) 95 7. Social safety nets (prepared by Ignacio Fiestas) 98 8. Data for the debate over rice price policy and poverty 100 3 Executive Summary: Indonesia and Pro-Poor Growth Economic growth in Indonesia has been the main source of sustained poverty reduction, which has been dramatic since the late 1960s. There have been growth episodes when income inequality increased and episodes during which it decreased. Indonesia has experienced both “relative” and “absolute” pro-poor growth, and there have been no episodes in which the poor were absolutely worse off during sustained periods of economic growth. During economic decline and crises, the impact on the poor has been severe. The pro-poor performance from the late 1960s to the mid-1990s was based on a conscious strategy that combined rapid economic growth with investments and policies that insured the growth would reach the poor. This strategy integrated the macro economy with the household economy by lowering the transactions costs of operating in the markets—factor markets and product markets—which provide links between the two levels of the overall economy. This strategy was designed and implemented by highly skilled economic planners (the “technocrats”) at the direct urging of President Suharto. The success of the strategy also depended on good luck, as powerful new agricultural technology became available in the late 1960s, just as the country was putting in place the economic strategy and rural investments to make it effective. In the 1980s, foreign direct investment arrived from Northeast Asia just as Indonesia needed to restructure its manufacturing sector to be more labor intensive and export oriented. There has been relatively little long-run change in the overall distribution of household expenditures in Indonesia, with the average Gini coefficient about 0.33 (compared with about 0.32 for India, 0.45 for Thailand and the Philippines, and 0.50 for Malaysia). The Gini does change somewhat during short periods, reflecting changes in variables that affect how well the poor connect to economic growth. This short-run variance in the “poverty elasticity of growth” is caused mostly by changes in real rice prices, but these in turn are largely driven by macro economic policy, especially control of inflation and management of the real exchange rate. Over the long run, income growth of the poor has depended almost entirely on overall income growth. The interaction between macro policy and poverty reduction is especially important in Indonesia because of the relatively smooth interface between the tradable and non- tradable sectors (and between the formal and informal economies). Rapidly rising demand for the goods and services produced by the non-tradable, informal sector, especially in rural areas, has been an important short-run mechanism for pulling people out of poverty. The close integration of rural and urban labor markets, facilitated by rural financial market intermediation, especially on Java, has made economic growth pro-poor. Investments in agricultural infrastructure have also had a major impact. When productivity-enhancing agricultural technology was available and profitable—from the late 1960s through the mid-1980s--growth could be “strongly” pro-poor. Much of the rural infrastructure was built using labor-intensive techniques. The jobs created were “self-targeted” to the poor because of the low wages paid. Thus investments in rural infrastructure were doubly pro-poor. 4 The financing for these projects came mostly from the Central Government, whose budget until the early 1980s depended very heavily on two sources of revenue: donor funding in the early years (especially from the World Bank), and oil revenues after the mid-1970s. The decade of the 1970’s was the era of the most massive rural investments, and these provided the foundation for broadly-based rural development. Important tradeoffs emerged between overall economic growth and growth in the incomes of the poor. Micro- and sectoral policies, often implemented in the name of poverty reduction or improved income distribution, caused economic growth to be slower than the macro policy environment would have permitted. Only the interventions in the agricultural sector have a claim to poverty reduction. In other areas—minimum wage legislation and specific industry protection, for example—the dead-weight losses hurt the poor as well as economic growth. Trade protection for inputs into labor-intensive manufacturing—sugar, tinplate, yarn and textiles, and leather, for example—slowed the development of small and medium enterprises. Tradeoffs might also have existed in public investments, as investments in infrastructure had a more immediate impact on the poor than investments in human capital, which were the long-run route out of poverty. Indonesia was unusual in being able to invest heavily in both dimensions—infrastructure and human capital—in the early stages of its development because of financial support from donors and then from oil revenues. “Pro-poor” public expenditures and targeted subsidies to the poor have played a minor role in poverty reduction in Indonesia. Only the labor-intensive public works programs might claim to be large enough, targeted well enough to the poor, and productive enough in the creation of rural infrastructure, to have linked public expenditures for poverty reduction to pro-poor economic growth.