the effects of free trade zones on indonesian workers an examination of theory, the labor market,...
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Introduction
This Honors Thesis describes Free Trade Zones and their effects on the
Indonesian people by considering wages and employment, focusing on the
Indonesian labor market, and evaluating Batam Island as a test case.
I begin by evaluating the theoretical models of free trade zones and what
they predict. I focus on the different assumptions made by each model, and how
outcomes differ based on what assumptions are made. Because my interest in
Free Trade Zones stems from their role in the export-oriented development
strategies of developing countries, I have chosen to focus specifically on the
implications of Free Trade Zones on the labor markets of host countries. Most of
the theories make predictions about the impact of Free Trade Zones on
employment, so I move from a general description of the theoretical bases of the
zones to what their predictions regarding employment are based on what
assumptions are made. My overview of the theoretical work on Free Trade Zones
concludes with an analysis of what assumptions must be true in order for the
theory to predict positive results for host countries’ labor markets, specifically,
what must be true in order for the zone to alleviate unemployment.
I then turn to Indonesia by describing the current economic situation in
Indonesia, and how high levels of corruption and state control inhibit
development and global integration. I provide an overview of the factors that
have contributed to the corruption that contributes to Indonesia’s current
economic situation, and then turn to an in-depth overview of the Indonesian labor
market. I evaluate the labor market first by explaining the shift of the economy
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from a rural, agrarian base to an urban, manufacturing base and how that has
caused a physical migration from rural areas to urban areas. I then examine the
wage differences that exist between the two areas, and the unemployment
differentials that exist. I describe the Indonesian government’s labor policies, and
show how minimum wage rates and increased implementation have affected
unemployment, and the impact this has had on workers. I briefly describe the
Indonesian government’s response to unemployment problems, and provide my
own analysis of what policies designed to alleviate unemployment should
emphasize.
I then examine a number of empirical studies on extant zones within
Southeast Asia that bear similarities to zones in Indonesia and draw conclusions
on their effects on the workers in their respective locations. I focus first on the
zones in general and their shared traits and characteristics. I examine various
zones and the nature of the industries located within them, and the impact the type
of industry has on labor. I consider wages within zones and outside of zones,
focusing on wage differentials. I examine the implications free trade zones have
on employment levels, speculating in both the long and short run. I finish the
empirical overview of Free Trade Zones by evaluating their possible use in
development policy.
I then focus on the Batam Island Free Trade Zone in Indonesia and
provide an in-depth analysis of its function, its policies, and the results. I have
selected the Batam Island free trade zone because it the best zone in Indonesia to
evaluate, partially because its relationship with Singapore gives it characteristics
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that permit the application of models and partially because of the availability of
comparatively superior data due to its relatively recent establishment and
international location. I provide a brief overview of the history of Batam Island,
and its significance as a Free Trade Zone. I explain the importance of Singapore,
and the joint venture between the Singaporean and Indonesian governments in
establishing the BatamIndo Industrial Park as an enclave that combines
Indonesia’s low-cost abundant labor with Singapore’s reputation and ability to
provide internationally competitive infrastructure within the context of Batam
Island’s special status as a Free Trade Zone. I describe the high levels of
migration instigated by the establishment of BatamIndo, and the extent to which
these migrants are absorbed into Batam Island. I discuss the massive social
problems that have resulted from the high levels of migration coupled with little
to no community building, and how these problems create social costs that hinder
further development and deter further investment and expansion within the
region. I finish my discussion of Batam Island by highlighting the areas in need
of remedy, and the likelihood that such changes will be made.
I conclude by attempting to place Batam Island and specifically the
BatamIndo Industrial Park within the context of the theories on the effects of Free
Trade Zones, and explore to what extent the models explain observed phenomena.
I compare the Batam experience with those of other zones in Asia, and see if the
models describe Batam Island and adequately explain the impact the Batam Island
enclave has had within the region, focusing specifically on changes in wages and
employment and their effects on Indonesian workers. I illustrate the inherently
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short-term nature of the models I selected, and how they cannot incorporate all
important social aspects that are necessary to create sustainable employment, not
merely briefly alleviate unemployment by absorbing surplus labor. I hope to
show that in order to use free trade zones to assist development, labor must not be
viewed as simply an input, the same way commodities and intermediate goods
are, if only because of the additional institutions and facilities that must be
provided for long-run sustainability. Furthermore, I hope to show the role of
simple economic models in evaluating real world phenomena as an important tool
that must be combined with additional considerations.
My work is relevant because Free Trade Zones are controversial methods
of pursuing export-oriented development strategy by attracting foreign direct
investment. Both the theoretical literature and empirical analyses reach divergent
conclusions on whether the zones promote development and are beneficial to
laborers, or permit corrupt and ineffective governments to continue ineffective
policies while simultaneously exploiting laborers. I seek to use Batam Island and
the BatamIndo Industrial Park to illustrate where, if ever, Free Trade Zones will
succeed in alleviating unemployment and thus aiding the development of the
country.
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Chapter 1: Survey of Theoretical Evaluations of Free Trade
Zones
Introduction
The establishment of Free Trade Zones is an interesting component of the
larger strategy of export promotion pursued by a number of developing countries.
The theoretical literature evaluating Free Trade Zones produces divergent and
often contradictory conclusions regarding whether or not these zones will produce
positive effects. This initially daunting outcome does not render the theoretical
models useless; it merely highlights the important considerations to be made
when attempting to implement a policy based on the application of an economic
model. The theories’ divergent conclusions are primarily a result of different
initial assumptions about the environment and conceptions of the role of free trade
zones. Successful economic outcomes are a combination of the policy decisions
made and the environmental factors that exist. Generally, free trade zones are
established in an effort to create jobs, increasing employment, increase exports
and solve balance of payments problems, increase national income, and gain
access to foreign technology. By exploring theoretical models attempting to
describe economic activity associated with free trade zones, I seek to elucidate
which policies could theoretically result in positive results for the host country. I
will then consider what exogenous factors must be present for successful
implementation of these policies.
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The literature associated with modeling free trade zones defines them in
similar terms. Free trade zones are characterized by incentive packages 1 that
typically include some or all of the following: lack of customs duties on
intermediate inputs and imported equipment, freedom from import quotas,
absence of foreign exchange controls, no controls or restrictions on profit
repatriation, low or no taxes on production, low or no restrictions on the extent of
foreign ownership, minimized administrative procedures, lack or suppression of
organized labor movements, and the absence of tariffs on the export of final
goods. Industries within FTZs typically produce export-oriented commodities
and non-traditional manufactured goods not intended for and oftentimes never
entering the domestic markets2. Models necessarily exclude the domestic zone
and the firms operating in it from these benefits and incentives in order to study
the effects of the existence of a FTZ on the country where it is located.
Developing countries establish FTZs as part of wider, export-promoting
strategies. FTZs are essentially an attempt to harness the benefits associated with
a free-market economy while avoiding the detrimental effects of readjusting to a
more liberal economy. In his ground-breaking analysis of duty-free zones,
Hamada states that governments establish FTZs to increase employment of labor
and increase exports, leading to improvement in the balance of payments and the
absorption of advanced technology, while simultaneously retaining a protected
import-competing domestic industry spite of the presence of foreign investments3.
1 Carl Hamilton and Lars E.O. Svensson. “On the Choice Between Capital Import and Labor Export”. European Economic Review 20 (1983) p 168.2 Kaz F. Miyagiwa. “A Reconsideration of the Welfare Economics of a Free-Trade Zone”. Journal of International Economics 21 (1986) p.3383 Koichi Hamada, “An Economic Analysis of the Duty-Free Zone”. Journal of International Economics 4(1974) p. 225
6
These objectives make sense in circumstances where other factors limit more
aggregate liberalization and the establishment of a FTZ acts as a second-best
option. Countries seek to benefit from foreign investment while simultaneously
protecting the interests of domestic industry. Developing nations are also
attracted to the establishment of FTZs for political as well as economic reasons.
During the 1950s and 1960s, many developing countries pursued protectionist
import substitution industrialization policies designed to promote development by
protecting “infant industries”, or newly-formed industries that could not compete
internationally with the more established industries found in industrialized
countries. These policies simultaneously granted import subsidies to domestic
producers and imposed tariffs on foreign producers seeking to export into the
industrializing market in an attempt to create a level playing field. These policies
instead resulted in balance of payments crises, substantial budged deficits, and
inflation that created a legacy of protectionism4. Dismantling these policies by
complete liberalization is often politically unpopular to the point of impossibility,
enticing policy makers to implement FTZs that partially reform policies while
avoiding the stronger objections from powerful individuals with protected vested
interests5 .
Models of Free Trade Zones use elements from other models that describe
international trade. They characterize the actions that take place in terms of
inputs and outputs. Inputs are all factors used in the production of a final good,
including labor, machinery, and any other component needed to produce a good. 4 Jeffrey Frieden, Global Capitalism: Its Fall and Rise in the Twentieth Century. New York: W. W. Norton and Company, 2006. pp 351-356.5 Kaz Miyagiwa, “The Locational (sic) Choice for Free-Trade Zones: Rural versus urban options”, Journal of Development Economics 40 (1993) p 187.
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Outputs are all final goods produced using the specified inputs. Locations specify
where outputs are produced or consumed. Occasionally, an intermediate good is
examined, which can be evaluated as either an input or an output depending on
how it is used. For example, a screw factory would consider screws an output,
while screws are an input to a number of manufacturing or construction outputs.
Models typically refer to these three components by taking them MxNxO, where
M refers to the number of inputs, N refers to the number of outputs, and O refers
to the number of locations. When a model is said to be 2x2x2, that means two
outputs are produced using two inputs in two locations. Likewise, a 3x3x3 model
describes the production of three inputs using three inputs in three locations. A
3x2x2 model describes the production of 2 outputs using three inputs in two
locations, and so on. Models that use a Heckscher-Ohlin framework are using a
2x2x3 model and only considering the interaction between two “countries”, which
in the case of Free Trade Zones refers to the interaction between the Free Trade
Zone (FTZ) and the Domestic Zone (DZ), which refers to the rest of the country
where the FTZ is located. Some models use the concept of industry specific
factors of production, which simply means that one or more of the inputs are only
used in the production of one specific output. Similarly, some models use the
concept of location-specific production, meaning an output is only produced in
one specific location. When the production of an output is said to use an input
intensively, this means the proportion of this input used to other inputs used is
high. For example, consider the production of bibles. If these bibles are hand-
copied and bound by a devout sect of secluded monks, their production would
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certainly be labor intensive, whereas if these bibles were produced in a factory
that used large printing presses, they would certainly be machinery, or capital,
intensive.
Models of Free Trade Zones: Assumptions and Findings
Theoretic modeling of FTZs produces divergent conclusions as to whether
or not the objectives of reducing unemployment, increasing exports to improve
the balance of payments, and absorbing advanced technology can actually be
achieved. The divergence can be partially explained as a result of different initial
assumptions. The first serious analysis of duty-free zones was conducted by K.
Hamada. Hamada uses of a standard 2x2x2 Heckscher-Ohlin trade model and
assumes a small country in order to justify constant world prices. In his model,
Hamada describes the production of two outputs, where the production of output
2 is capital intensive relative to the production of good 1. He finds that the
introduction of an FTZ would attract foreign investments and firms that produce
good 1 to the zone, which would lead to a factor proportion effect. Hamada states
that when considering the effects of an FTZ on the host country, one may focus
entirely on this factor proportion effect, which refers to the process that occurs
when the foreign capital attracts more labor from the DZ into the FTZ, making
labor scarcer and causing the more capital-intensive industry to increase
production. This will result in deteriorated national income at international
prices, and thus a corresponding deterioration in consumption possibilities6.
Hamada’s negative conclusion of deteriorated national income for the host
6 Hamada, Economic Analysis, 233-234.
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country results from the movement of the input Labor from industries in the DZ
into industries in the FTZ, which is contingent on an assumption of full
employment. Hamada’s evaluation is the first of its kind and very simplified. He
concedes that a variety of neglected factors, including positive learning
externalities and unaccounted for unemployment, could significantly alter his
findings7.
L. Young and K. Miyagiwa assert that Hamada’s assumption of full
employment neglects the reality that high domestic unemployment is a common
motive for setting up a duty-free zone and explicitly evaluate the formation of a
FTZ in a country suffering from Harris-Todaro type unemployment. 8 Harris-
Todaro type unemployment, to be discussed at length later, describes a situation
where unemployment persists due to labor market distortions, such as a rigid
wage. Young and Miyagiwa incorporate this assumption of unemployment and
the presence of a rigid wage into a 3x4x2 model where output 1 uses Labor and
domestically produced 1-specific Capital, output 2 uses Labor, domestically-
produced 2-specific capital, and foreign-produced Intermediate, and output 3 uses
Labor, Foreign-produced 3-specific capital, and foreign-produced intermediate.
In their evaluation, the formation of an FTZ would increase the production of
output 3, but without the negative result found by Hamada because the labor
scarcity that causes workers to move out of industries in the DZ would not occur.
They conclude that the formation of a FTZ always increases national income,
rendering the formation of a duty-free zone a sound ‘second-best’ policy in an
7 Ibid, 240.8 Leslie Young and Kaz F. Miyagiwa, “Unemployment and the formation of Duty-Free Zones”, Journal of Development Economics 26(1987) 397.
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economy with Harris-Todaro type unemployment9. Young and Miyagiwa reach a
positive conclusion by using a 3x4x2 model and assuming unemployment that
results from labor market rigidity. They show that if the labor absorbed by the
zone is not otherwise employed, their added contribution will increase national
income because the labor market will not tighten and the factor proportion effect
described by Hamada will not occur.
Alleviating unemployment is not the only reason behind export-oriented
development strategies. Countries seeking to develop stable and diversified
economies often form FTZs to attract foreign investment with the goal of creating
“backward linkages” from the foreign production industries within the zone to the
domestic production activities outside of the zone10. These backward linkages
occur when production of an output within the zone requires an intermediate
domestic input. The establishment of the FTZ spurs foreign investment and the
creation of industries that demand this domestic intermediate as an input, which in
turn causes increased production of the domestic intermediate as an output, which
can benefit the host economy. The development of positive backward linkages
can be evaluated by considering changes in output levels, changes in returns to
inputs, and changes national income of the host country. Din evaluates the
formation of backward linkages using a 3 x 3 x 2 model in which two outputs are
produced in the DZ and the third output is produced exclusively in the FTZ. The
output produced in the FTZ uses Labor, an intermediate input produced in the DZ,
and foreign capital as inputs. Din evaluates two cases, when the intermediate
9 Ibid, 39810 Musleh-ud Din. “Export processing zones and backward linkages”. Journal of Development Economics, 43(1994) 371.
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good (produced in the DZ) is internationally traded and when it is not. When the
intermediate is internationally traded and capital intensive, production of this
intermediate will increase, or positive backward linkages will be established.
Conversely, when the intermediate is internationally traded and labor intensive,
production of the intermediate will decrease, or negative backward linkages will
be created11. As most developing countries produce labor intensive goods for
international trade, this finding implies that establishing an FTZ that requires an
internationally traded, domestically produced input would not create positive
backward linkages and reduce welfare. Additionally, Din finds that if the
intermediate is labor-intensive and non-traded internationally, national income
unambiguously increases12. Din’s research supports the establishment of FTZs
under certain conditions where Hamada’s did not. This apparent inconsistency
exists because Din introduces an intermediate good and bases his evaluation on
the effects of establishing a FTZ on the changes in the output of this intermediate,
and how these changes in turn affect returns to inputs and national income.
The Twin Objectives of Increasing National Income and Generating
Employment
Developing countries establish FTZs as part of larger, export-oriented
development strategies. These strategies seek to accomplish a number of goals,
including the short-term objective of alleviating unemployment and the long term
objectives of economic growth and stability. It follows logically that FTZs are
11 Ibid, 379.12 Ibid, 379.
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often established to accomplish these goals; however, occasionally countries face
a trade-off between these two objectives. Miyagiwa addresses this trade-off using
a Heckscher-Ohlin framework and assuming the existence of Harris-Todaro-type
unemployment and complete labor mobility. His evaluation of FTZs illustrates
the trade-off as a function of the location of the zone, specifically, whether or not
the zone is located in a rural or urban area. Miyagiwa finds that if FTZs are
located in urban areas, can help alleviate the existing unemployment problems,
whereas FTZs in rural areas may serve to broaden the economic base of the rural
region and halt future urban migration13. Miyagiwa uses a Harris-Todaro
framework and conclude that locating an FTZ in a rural region will increase
national income by a greater amount than doing so in the urban area if the
industries located within the zone are labor intensive14. Additionally, under the
assumption of perfect labor mobility, he shows that when the urban sector is
labor-abundant relative to the rural sector, the creation of a FTZ decreases
unemployment regardless of its location. He shows that if the urban sector is
labor-abundant relative to the rural sector, creating an FTZ there will reduce
unemployment more than by doing so in the urban sector15. Miyagiwa’s findings
have highly relevant implications. His work unequivocally states that a country is
better off establishing an FTZ in the rural area because that will simultaneously
increase national income and decrease unemployment.
Miyagiwa suggests that his findings could be skewed by whether or not
the rural area is accessible and by the magnitude of migration costs16. The issue 13 Miyagiwa, Locational Choice, 188.14 Ibid, 195.15 Ibid, 196,197.16 Ibid, 200.
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of accessibility involves the assumption that FTZs function entirely separately
from the DZ. In reality, the FTZ must be integrated into the DZ’s infrastructure.
Large migration costs could negate the assumption of freely flowing labor.
Miyagiwa limits his discussion of accessibility to infrastructural issues such as
poor highways, but in developing countries many other infrastructural problems
could hinder the development of rural FTZs. FTZs typically attract export-
oriented multinational firms that require access to modern amenities, such as
electricity, communications, imports, and export opportunities. This implies that
the initial setup costs in a rural FTZ area may serve as a disincentive for firms that
could possibly outweigh the positive incentive package of low transaction and
labor costs. Miyagiwa argues that the existence of high migration costs supports
his findings in favor of rural areas. High migration costs render rural-to-urban
migration highly wasteful, and welfare reducing17. Miyagiwa explicitly states that
he is considering Harris-Todaro type unemployment, which exists as a RESULT
of excessive migration that has already occurred. With Harris-Todaro type
unemployment and prohibitively high migration costs, the establishment of an
FTZ in a rural area would not serve to alleviate urban unemployment.
Miyagiwa’s assessment suggests an alternative problem not formally addressed in
his model. The establishment of a FTZ could create or exacerbate Harris-Todaro
type unemployment by providing incentives for more workers to migrate to the
zone than jobs are created.
As previously mentioned, Hamada, using a Heckscher-Ohlin framework,
reaches the conclusion that increased foreign investment does not necessarily
17 Ibid, 201
14
improve consumption possibilities and unequivocally decreases welfare18.
Hamilton and Svensson extend upon Hamada’s work by accounting for location
of production, different trade barriers, considering the differences between
allowing foreign investment only in the DZ, in both zones, and only in the FTZ
and explicitly incorporating repatriation of income19. Hamilton and Svensson
use the same 2x2x2 Heckscher-Ohlin model used by Hamada and make the same
assumptions of complete employment, non sector-specific inputs, and a labor
abundant host country. Although both studies find that the increased foreign
investment decreases welfare, Hamilton’s and Svensson’s findings differ from
Hamada’s. They find that capital invested in the FTZ decreases welfare by more
than the same amount of capital invested directly into the domestic zone20. This
finding suggests that the establishment of an FTZ could be a very poor decision
indeed, because although the FTZ can attract foreign investment that would not
have occurred otherwise, the benefits derived would not outweigh the costs. In a
subsequent study, Hamilton and Svensson, still working with a 2x2x2 model, find
that with suitable tax policy that prohibits mobile capital flow, the establishment
of FTZs and shift of labor to the zone will be beneficial to welfare21. These
findings are interesting, but the concept of a suitable tax policy is contradictory to
the understanding of the incentives that define FTZs.
Wong seeks to explain the discrepancies between Hamada’s and
Hamilton’s and Svensson’s findings by considering which outputs are produced in
18 Hamada, Economic Analysis, 225-241.19 Carl Hamilton and Lars E.O. Svensson. “On the Welfare Effects of a ‘Duty-Free Zone’”. Journal of International Economics 13(1982) 45.20 Ibid, 63.21 Hamilton and Svensson, On the Choice, 167- 192
15
the FTZ, what kind of good is used for repatriation, and whether the repatriation,
which includes wages paid to zone employees and earnings by foreign companies
within the zone, is taxed or subsidized upon leaving the FTZ22. He uses the same
2x2x2 Heckscher-Ohlin model and assumes that the country exports the labor-
intensive good. Wong finds that if only the labor-intensive output is produced in
the FTZ, establishing an FTZ and allowing domestic labor to flow into it is
superior to introducing foreign capital into the host country. He also determines
that establishing an FTZ is equivalent to allowing foreign investment in the host
country if all repatriation is in the form of the good produced in the zone. Finally,
he determines that regardless of the production pattern in the FTZ and how
repatriation occurs, taxing the repatriation could not deteriorate the welfare of the
host country and subsidizing this repatriation as an incentive could not improve
the welfare23. These findings demonstrate that establishing an FTZ does little for
the country in the way of increasing welfare. His results strengthen the negative
findings of Hamada, Hamilton, and Svensson by suggesting that FTZs in a small
economy with tariffs and other barriers can cause an inflow of the foreign factor
used intensively in the importable sector or an outflow of the domestic factor used
intensively in the exportable sector, both of which are detrimental to welfare24.
This means that before the introduction of the FTZ, the assumptions show that the
economy will export a labor-intensive output and import a capital-intensive
output. The establishment of an FTZ will attract large amounts of foreign capital,
causing an outflow of labor from the FTZ to the DZ, decreasing production of the 22 Kar-yiu Wong. “International Factor Movements, Repatriation, and Welfare”. Journal of International Economics 21 (1986) 32823 Ibid, 333.24 Ibid, 334.
16
exportable to the detriment of welfare. This conclusion is very similar to
Hamada’s, but incorporates a wider span of variables.
Young extends his work with Miyagiwa to consider the case of an
intermediate good, similar to Din’s evaluation. In contrast to Din, Young does
not find the creation of positive backward linkages that act to strengthen the
domestic economy; instead, he finds that FTZs can create or exacerbate the
existence of a small foreign-owned sector where labor and resources are
concentrated25. This occurs assuming that the incentive package that defines the
FTZ attracts all foreign investment that otherwise would have been invested in the
host country, and in turn attracts labor from the DZ into the FTZ. The result of
the concentration of labor and resources within the FTZ is lower national income
when there is less substitutability between the intermediate and labor than
between these factors and capital, and when the FTZ is small relative to the
domestic zone and production there is intensive in labor but not in the imported
intermediate input26. Young’s findings are particularly striking, because they
suggest a possible trade-off between decreasing unemployment and increasing
national income. His work suggests that the worst effects on national income
occur from zones that attract firms that use labor intensively, yet these zones
would also be most efficient at absorbing surplus labor.
Miyagiwa models a free trade zone by first assuming two outputs,
agriculture and manufacturing, and then splitting the manufacturing sector into
what he describes as “a miniature Heckscher-Ohlin world”27. He assumes the 25 Leslie Young. “Intermediate Goods and the Formation of Duty-Free Zones”. Journal of Development Economics 25(1987) 369.26 Ibid, 370.27 Miyagiwa, A Reconsideration, 340.
17
input labor is used in both sectors, but land is agriculture-specific and capital is
manufacturing-specific. He creates a third output to be produced solely in the
FTZ, and evaluates the effects of the FTZ on welfare. Using this model, he finds
that the establishment of an FTZ in a tariff-ridden economy increases national
welfare regardless of the relative factor intensity of the new FTZ specific
industry, but only with a host of additional subsidies to the domestic industries28.
Miyagiwa’s findings demonstrate that FTZs can theoretically generate welfare
increasing results, but not on their own. They must be accompanied by a system
of subsidies and redistribution mechanisms, a contingency that is theoretically
easy to include but could prove impossible in practice, specifically in developing
countries that have poor governance.
Labor Market Effects as a Method of Evaluating Free Trade Zones
Free Trade Zones are established by developing countries with a series of
positive goals in mind, including creating jobs, increasing exports to alleviate
balance of payments problems, increasing national income, and gaining access to
foreign technology. While each of these goals is desirable, many would prove
difficult to evaluate or implement. Any method that incorporates transfers or
subsidies to increase welfare necessitates a functioning government body to carry
out these subsidies and transfers. Many developing nations are plagued with
inefficient public sectors and corrupt government bodies that are often the
incentive to establish a FTZ. In the presence of such corruption, these transfers
28 Ibid, 346.
18
would be near impossible to implement. Similarly, the formation of backward
linkages would be difficult to evaluate when considering a diverse economy with
far more than two or three sectors. The increase of exports would be possible to
evaluate, but it would be difficult to show whether or not an improvement in the
balance of payments resulted in an improvement for average citizens.
The most useful method of evaluating free trade zones from the point of
view of improving the well-being of the general population of a developing
country is to consider their effects on the labor market. Many of the negative
assessments of FTZs rely heavily on the assumption of full employment and the
assertion that the FTZ will draw workers away from the domestic zone into the
FTZ. Additionally, these evaluations conclude by suggesting that unemployment,
a persistent problem in many developing countries, could change these results.
Whether improvements in national income or increased exports actually improve
the well-being of workers is difficult to assess because it involves a system of
transfers or evidence of aggregate economic growth. These transfers, or whether
or not growth positively affects a worker, are extremely difficult to monitor and
evaluate, whereas if a worker goes from being unemployed to having a steady job,
he is almost certainly better off. The literature that addresses unemployment
specifically mentions Harris-Todaro type unemployment, a common problem in
developing countries that are industrializing and experiencing high levels of
urban-rural migration. A survey of the theoretical literature of free trade zones
suggests that the best way to evaluate their effectiveness in assisting development
is to consider their direct effects on the labor market.
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Chapter 2: The Theoretical Impact of Free Trade Zones on the
Labor Market
Introduction: Assumptions and Techniques
The theoretical analyses of free trade zones and the different modeling
techniques employed yield divergent results regarding welfare effects, yet these
divergences result from different assumptions. The effects of the free trade zone
are evaluated using a variety of measures, from effects on unemployment to
effects on national income. Indonesia, like many developing nations, is
20
characterized by corruption and ineffective government practices, which strongly
suggests that benefits in the form of increased national income or improvement in
the balance of payments would merely benefit the well-connected elite and never
reach the working class. The effects of free trade zones on Indonesia can be most
effectively evaluated by the effects on the Indonesian labor market, because these
effects would be directly experienced by Indonesian workers. The labor market is
characterized by wages, employment, and characteristics of the workforce.
Theoretical analyses of FTZs assume labor mobility, implying that workers can
move relatively effortlessly from one job or location to another and illustrating
that migration must be considered. The impact of FTZs will be experienced most
directly in the form of changes in wages or unemployment rather than in the form
of changes in national income. Wage and employment effects will also have the
greatest influence on the perceived success of failure of the FTZ within the host
country because it will be directly experienced by the workforce. The workforce
is also the most visible indicator to international groups seeking to ascertain the
viability of FTZs. If zones improve employment and wages to the benefit of
workers, the workers and in turn observers will view them as a success.
Models consider labor as an input to production of an output and inputs
are evaluated based on mobility between sectors, and whether or not they are
specific to one industry. All of the models consider labor to be perfectly mobile
between sectors and used in the production of all outputs, but the mobility and
industry specificity of other inputs vary between analyses. The two base models
most commonly used in the evaluation of FTZs are the Heckscher-Ohlin and
21
Ricardo-Viner models.29 The Heckscher-Ohlin model assumes two goods, two
countries, and two inputs that are both perfectly mobile between sectors but
immobile between countries30. In the case of an FTZ, the base model is slightly
altered so that labor is perfectly mobile between the FTZ and the DZ, and capital
is perfectly immobile. This model is applicable to the analysis of FTZs because
they can accurately be considered small economies, they can acquire labor nearly
solely from the host country, and in many cases they are established in tariff-
ridden countries that limit foreign direct investment and other forms of
international capital mobility. In contrast to the Heckscher-Ohlin model, the
Ricardo-Viner model, or the specific-factors model, introduces the concept of
inputs that are used in the production of some goods but not all goods. The
Ricardo-Viner model is used to explain investment in FTZs as the input of capital
that is specific to the industry within the zone. Analyses that follow a Ricardo-
Viner framework also assume perfect labor mobility between zones, but explore
to what extent other factors are mobile between industries. Because the good
produced within the FTZ necessarily uses labor and one or more other inputs, the
mobility of additional inputs will affect the use of labor by acting as substitutes.
Furthermore, the consideration of mobility between industries and substitutability
illustrates the inherent differences between firms found in the FTZ and industries
found in the DZ. Because industries in the FTZ are typically foreign and export-
oriented, their outputs can differ greatly from those produced in the host country.
29 Heckscher-Ohlin: Hamada (1974), Hamilton and Svensson (1982), . Ricardo-Viner: Young (1992), Miyagiwa (1986), 30 Robert Feenstra and Alan Taylor, International Trade, New York: Worth Publishers, 2008 p 97-99.
22
Factor Mobility, Intensity, and Substitutability
Inter-sector factor mobility and substitutability are crucial to determining
the labor effects of an FTZ. Hamilton and Svensson find that capital import into
the FTZ can be treated as a labor export from the DZ, which increases welfare in
the case of sector-specific capital and decreases welfare in the case of inter-sector
capital mobility31. In the case of an FTZ, capital is typically sector-specific
because tariffs and barriers deter investment in the host country, meaning the FTZ
would increase welfare in this case. When considering the effects on labor, a
welfare increase does not necessarily translate into workers being better off.
Hamilton and Svensson’s findings change with the introduction of an intermediate
good, meaning a good that is produced as an output in the DZ and used as an
input in both the FTZ and the DZ, that is mobile between sectors. When such an
intermediate exists, welfare effects are contingent on relative substitutability.
Young finds that an FTZ will increase welfare when labor and the intermediate
input are more substitutable than the intermediate input and capital or labor and
capital32. A welfare increase does not necessarily entail positive effects for
laborers; contrastingly, when the elasticities of substitution between labor, a
sector-mobile intermediate, and sector-specific capital are as described above, an
FTZ will increase unemployment, and vice-versa33. This occurs because the
introduction of capital will cause an increase in the production of capital-intensive
goods and a decrease in the production of labor-intensive goods, which will raise
the returns to capital, decrease wages, and decrease employment by a Rybczynski
31 Hamilton and Svensson, On the Choice, 173.32 Young, Intermediate, 369.33 Chaudhuri and Adhikari, Free Trade Zones, 160.
23
effect34 Taken together, these findings show that in situations where the
establishment of an FTZ is welfare improving, it will be simultaneously
employment decreasing. A welfare increase that is accompanied by increased
unemployment will not directly benefit the workforce.
Miyagiwa extends the consideration of the sector-specific Ricardo-Viner
model by examining the role of relative factor intensity in determining the welfare
effects of the FTZ. He finds that if the industry in the FTZ is capital intensive,
the FTZ will lower the wage rate and raise the returns to capital and land, while if
the industry within the zone is labor intensive, it will raise the wage rate and
lower the returns to capital and land35. These findings imply that the owners of
factors of production stand to gain from FTZs that attract capital-intensive
industries, while laborers stand to gain from FTZs that attract labor-intensive
industries. Considering factor-mobility and substitutability illustrates potential
trade-offs between welfare, national income, wages, and employment that are
made when governments determine where to establish FTZs and how to regulate
the firms that are located there. Trade-offs made to favor increases in wages and
employment will directly benefit the workforce, whereas decisions made in favor
of welfare and national income gains could be made at their expense if the result
is a decrease in wages.
The Role of Wage Rates
34 Ibid, 162.35 Miyagiwa, A Reconsideration, 342.
24
The subject of wages is of interest both to potential employers in the FTZ
and to laborers. Models that assume labor mobility necessarily incorporate wage
equalization between industries. Wong addresses the subject of wages and
taxation of repatriated income by comparing policies that regulate consumption
and repatriation. If workers are assumed to consume solely in the DZ, the wage
can be considered as being paid in a good whose price differs between the DZ and
the FTZ and will be taxed upon reentry to the DZ36. This implies that the workers
and employers can face a different wage rate, where the employer can take
advantage of the benefits of the FTZ while the workers cannot. This finding also
assumes that wage earners must consume in the DZ, an assumption that is not
necessarily true. If workers do consume in the FTZ, and their wages were paid in
the form of a good whose price differs between the zones, workers would
experience the same benefit as the employer. These findings could lead one to
believe that when the host country can tax the repatriated wages of workers, the
welfare of the host country cannot be deteriorated37 because the tax would act to
transfer the benefits given by the host government back to the host country, yet
the worker would not gain an additional benefit from working in the zone in the
form of a higher wage. This situation demonstrates a trade-off for the government
who establishes an FTZ. If they seek to benefit the worker, they can permit
consumption within the zone or not tax the repatriated wages, both of which
would result in deteriorated welfare. Contrastingly, they can forbid consumption
36 Hamada, Economic Analysis, 228.37 Wong, International, 333.
25
within the zone and tax the repatriated wages, which may benefit workers through
increased employment but not higher wages.
Wong’s findings in favor of taxing repatriated wages and prohibiting
consumption within the zone imply that payments to the host government are
equally as beneficial as increased payments to workers in the form of wages. This
implication can be shown theoretically, but requires a system of redistribution of
some form facilitated by the government. Wong inherently assumes that workers
will benefit from an increase in welfare, but with high levels of corruption and an
inefficient state sector, this system of redistribution may not exist. In this case,
the workers may be better off with higher wages and lower aggregate welfare
because they will derive more direct benefits. Indonesia exhibits high levels of
wasteful government corruption, and could benefit more from higher wages and
increased employment than from increased aggregate welfare.
Industries are often attracted to FTZs in developing countries because of
access to inexpensive labor in the absence of labor union activity38. Even when
labor unions have had some effect, in developing countries, it is possible for
wages to be “artificially” lower than the world price for labor because the
presence of capital protections can decrease wages below and increase returns to
capital above the free trade levels 39. This evaluation explains low cost labor as a
result of protectionist laws that shield the developing country from forces that
would bring their wage and rental rates to global equilibrium. These protectionist
barriers serve to subsidize foreign capital by allowing them access to the
38 Miyagiwa, Reconsideration, 338.39 Hamilton and Svensson, On the Choice, 168-169 and On the Welfare Effects, 63.
26
artificially low cost labor40. Low wages act like a beacon to attract foreign
investment to the FTZ41. Additionally, FTZs are often characterized by freedom
from labor laws and union activity, permitting foreign investors to take advantage
not only of the artificially low wages, but also to abstain from providing
additional benefits that unions may have won in the host country42 . Although
FTZs are typically characterized by lack of unionization, in order to attract
laborers from the DZ to the FTZ, industries must offer competitive wage rates or
comparable employment packages. Low wage rates in developing countries help
to attract foreign investors, but wages in the FTZ are unlikely to be lower than
those in the DZ simply because if labor is mobile, workers would simply leave the
FTZ and reenter the DZ. While the promise of freedom from union activity may
serve to entice foreign investors, it will not permit them to pay workers less than
they would be paid in the DZ. While wages between the developing country and
the world may differ due to protectionism, wages between zones must be equal if
the assumption of labor mobility is true.
When considering the interest of Indonesian workers, it is essential to
determine what effect the introduction of an FTZ has on wages. In a 2 x 2 model
assuming no local factor-price equalization and full employment, the formation of
an FTZ will increase the wage rate by a factor terms-of-trade effect43 because the
export-oriented nature of the zone will increase the value of exports relative to
imports and increase the demand for labor. Miyagiwa found that the impact of
the FTZ on wages depends on whether or not the industry is labor intensive, in 40 Ibid, 63.41 Jones and Marjit, Labour-Market, S77.42 Young, Employment, 369.43 Chen and Devereux, Export, 708.
27
which case the FTZ will raise the wage rate while simultaneously lowering the
returns to capital and land44. An FTZ can also potentially raise wages by training
workers to possess higher skills, either driving wages up to the world wage rate
even though local workers cannot emigrate to world markets45 or permitting
foreign investors to capture the returns to skilled labor in the form of rents due to
lack of competition from other industries46. This increase in wages would reflect
the fact that by training workers to possess higher skills, the workers would be
able to produce outputs more efficiently, or the marginal product of labor would
increase. Workers in the developing country would then reap the benefit of their
increase in productivity by an increase in the wage rate. Contrastingly, if workers
were unable to access the world labor market or other employers were unable to
access them, their wages would remain stagnant and then increased productivity
would be captured by their employers. These findings implicitly assume the wage
rate will be set by market forces, an assumption that fails regarding industries
with minimum wage laws or other policies that regulate the labor market.
Rigidities within the labor market greatly influence employment levels.
The Role of Employment
Employment levels are crucial to the study of FTZs. As early as 1974,
Hamada acknowledged that his results could be skewed by neglected factors such
as unemployment, which would result in the FTZ absorbing unemployed labor
rather than reallocating the labor currently employed in the host country47. 44 Miyagiwa, Reconsideration, 338.45 Jones and Marjit, Labour-Market, S78.46 Ibid, S91-S92.47 Hamada, Economic, 240.
28
Baseline models assume a fixed endowment of labor within a country, full
employment, and equalized wages. The assumption of full employment must be
called into question because unemployment is often the reason a developing
country establishes an FTZ48,49. Increasing employment is often a priority of a
host country, leading LDC governments generally to prefer that the zone-based
firms to be relatively labor intensive50. The introduction of an FTZ can
theoretically increase employment and mitigate unemployment caused by factors
such as a rigid wage.
Developing countries frequently exhibit high levels of urban
unemployment while simultaneously exhibiting rural-to-urban migration. This
phenomenon is described by the Todaro model of migration, and in its
equilibrium is known as the Harris-Todaro model51. In the model, individuals
face the incentive to migrate from lower income, rural areas to higher income,
urban areas even when these areas are characterized by high levels of
unemployment because expected income in an urban, manufacturing job exceeds
expected income in a rural, agricultural job. The Harris-Todaro model
incorporates the concept of expectations instead of certainty to describe what
initially appears to be the irrational behavior of migrating to an area with high
levels of unemployment in order to procure employment. This can be best
illustrated with a simple mathematical evaluation.
48 Young and Miyagiwa, Unemployment, 39749 Young, Intermediate, 383.50 Miyagiwa, Reconsideration, 338.51 Michael P. Todaro and Stephen C. Smith, Economic Development: Ninth Edition. (New York: Pearson Addison Wesley, 2006) 339.
29
Let Wr = rural wage, Wu = urban wage, Pr(u) = probability of being hired
in the urban zone, and Pr(r) = probability of finding work in the rural zone = 1.
Then, the individual will migrate to the urban area if
Wu x Pr(u) > Wr x Pr(r) = Wr
even though the individual may be unemployed or underemployed in non-wage
employment for a period of time before finding official work. Theoretically, this
migration would lead to a reduction in urban wages and an increase in rural wages
until the wage differential reached zero and the incentive to migrate disappeared.
In the context of developing nations, this is not the case because often urban
manufacturing sectors are characterized by rigid wages that result from
government-mandated minimum wage rates. In the presence of such rigid wages,
equilibrium would occur when the probability of finding a job in the urban zone
reached a sufficiently low level so that
Wu x Pr(u) = Wr.
Depending on how high the urban wage is relative to the rural wage, the
migration and increasing unemployment can carry on for some time and the
unemployment problem can become increasingly detrimental to the developing
country.52 Although Todaro migration and the existence of Harris-Todaro type
unemployment reflect rational actions undertaken by migrants, the resulting
unemployment has deleterious effects on the society as a whole.
In the presence of Harris-Todaro type unemployment, an FTZ can help
mitigate the problem by balancing out the existing economic barriers that cause
the unemployment. An FTZ can act as a “second best” option to flexible wages in
52 Todaro and Smith, Economic, 339-343.
30
economies with a minimum wage by alleviating the effects of other distortions,
such as high tariffs or other barriers to trade53. The FTZ can compensate for the
rigid wage by eliminating other rigidities, and is preferable to no liberalization at
all. In this case, the FTZ not only alleviates unemployment, but also reduces the
losses from the distortion by a greater margin than lost tariff revenue. Although
the location of the FTZ affects the increase of national income, location in an
urban area can reduce unemployment by absorbing excess labor and location in a
rural area can broaden the economic base and halt urban migration54. With
Harris-Todaro unemployment in a labor abundant country, location in an urban
location will reduce unemployment more effectively, while location in a rural
location will increase national income55. The consideration of rigid wages and
employment introduces yet another tradeoff between increasing national income
and increasing employment.
Conclusion: A Series of Trade-Offs
The establishment of FTZs presents planners with a series of trade-offs
between national objectives. Planners must decide between higher employment
and higher national income56. This decision is made in the form of where to
locate the FTZ (urban versus rural) and what industries to permit within the zone
(labor versus capital intensive). By examining where planners have placed extant
FTZs, it is possible to determine whether these zones are an effort to decrease
53 Young and Miyagiwa, Unemployment, 39854 Miyagiwa, Locational, 189, 193.55 Ibid, 195-19656 Young, Intermediate, 383., Chaudhuri and Adhikari, Free Trade Zones, 157, 161, Miyagiwa, Locational, 198.
31
unemployment or increase national income and also evaluate whether or not the
theory accurately predicts the effects of introducing a FTZ. If a zone is found in
an urban location and the industries within it are labor intensive, the zone should
alleviate unemployment problems by absorbing the surplus labor from Harris-
Todaro migration. If a zone is found in a rural location, it should increase
national income and perhaps decrease rural to urban migration by broadening the
nation’s economic base.
Additionally, planners must decide between increasing wages and
attracting foreign investment or increasing tariff revenue57. Free trade zones exist
because of the special concessions granted by the government of the host country,
and the nature and detail of these concessions determine which model and set of
assumptions will accurately predict and describe the outcomes. The perception of
FTZs by the citizens of a host country is of utmost importance to their success. If
workers perceive gains to foreign investors in lieu of tangible gains to themselves
in the form of employment opportunities or higher wages, they are likely to
chastise the FTZ and the government that established it. If workers perceive gains
to themselves, they are likely to favor the implementing government. Because the
establishment of an FTZ is a market liberalization, this could make future, more
aggregate liberalizations possible.
Developing countries have historically tended to view foreign involvement
as exploitive, imperial intrusions. This is especially relevant to the establishment
of FTZs because foreign employers are granted concessions that directly affect
laborers, such as freedom from union pressure and sometimes minimum wage
57 Miyagiwa, Reconsideration, 342., Young, Unemployment, 369.
32
requirements. Although national income can be maximized by permitting the
establishment of capital intensive industries in FTZs located in rural areas, this is
rarely observed empirically because of the political power of the urban workforce.
If the gain in national income is at the expense of the interests of the urban
workforce, the urban workforce can conclude that the government makes policies
to seek personal gain rather than to assist them. By making decisions that benefit
workers, governments can “alleviate accusations that the government is
impoverishing its own citizens for the benefit of foreign capitalists”58. Using
national income as an indicator of welfare implies the existence of some
redistribution mechanism such that citizens of the host country could reap the
benefits of increased returns to capital, land, and tariff revenue. This implicit
assumption ignores the social and political realities that exist in many developing
countries, including Indonesia. Indonesia is characterized by rampant corruption
and lacks effective social programs. In the case of Indonesia, FTZs that benefit
workers by increasing wages and decreasing unemployment at the expense of
foregone tariff revenue and loss of national income may in reality increase
welfare more effectively.
In order to evaluate FTZs in Indonesia, the economy must be evaluated to
determine which assumptions best apply. Labor mobility is crucial to every
model, but mobility requires sufficient infrastructure to allow workers to
physically move between industries. Models differ on whether or not capital or
additional intermediate inputs are sector specific. In order to determine the extent
to which intermediate inputs are sector specific, the similarity and differences
58 Young, Unemployment, 383.
33
between industries within and industries outside the zone must be evaluated.
Regarding capital, the differences between laws governing foreign investment
within and foreign investment outside the zone must be evaluated. Wage
equalization is a major difference between models. The wage rigidity within
industries in Indonesia must be evaluated to determine whether or not Harris-
Todaro type employment exists. Finally, the location of the FTZ reflects whether
the benefits should be in the form of increased employment or increased national
income. If the FTZ is located in an urban area, unemployment should decrease
because the zone should absorb the surplus labor that results from Harris-Todaro
migration.
In addition to characterizing the Indonesian labor market, the
implementation of an FTZ must be justified in the first place. FTZs are viewed as
a second-best option to aggregate liberalization; therefore, the reasons the first-
best options are not available must be determined. If the zone is located in an
urban area instead of a rural area, reasons why increased employment is preferred
at the expense of national income are necessary. The need for a second-best
option to aggregate liberalization can be justified by showing that it would be
politically impossible to implement better reforms and more aggregate measures
of liberalization. The preference for more direct benefits to workers in the form
of increased wages or decreased unemployment can be justified by showing a
corrupt and inefficient government sector. Increases in national income must be
accompanied by competent and reliable redistribution mechanisms for them to
benefit workers. If the government is sufficiently corrupt and stagnant that
34
aggregate liberalization is not possible and redistribution methods would not
function, the establishment of a FTZ in an urban location is a theoretically
beneficial strategy and should decrease unemployment to the benefit of workers.
Chapter 3: Governance Problems and the Indonesian Economy
Introduction
Indonesia is a remarkable country to consider when examining developing
countries. Although its history as a sovereign nation is comparatively brief,
Indonesia has experienced first-hand many of the economic events that shaped the
economic history of the second half of the twentieth century. Indonesia was a
member of the Organization of Petroleum Exporting Countries (OPEC), the group
that initiated the price hikes on oil that shook the global economy in the 1970s.
Indonesia was also counted among the rapidly developing East Asian nations the
experienced explosive growth during the 1980s and the first half of the 1990s.
Likewise, Indonesia was one of the economies most affected by the financial
35
crisis that wreaked havoc on the East Asian economies in 1997, causing currency
devaluation and devastation of underdeveloped financial markets that quickly
spilled into real markets. Indonesia’s experience during and following the crisis
is of great interest to understanding the economy, because it illustrates the extent
to which corruption has seeped into nearly every aspect of the economy. By
1999, most affected countries were on their way to recovery and structural
adjustment with one notable exception: Indonesia. In 2000, the World Bank
noted that Indonesia was still faltering with barely positive growth, displayed
graphically in the plot of quarter-on-quarter growth measured by percent59 60.
Indonesia’s failure to recover is further demonstrated by the deeper depreciation
of the Rupiah compared to the currency depreciations of other crisis countries61.
Indonesia’s failure to recover as rapidly as other countries in the region suggests
that it possesses fundamental structural differences in the areas of governance and
corruption. Indonesia has largely failed bring about sound governance, structural
stability and strong institutions. Indonesia’s economy is crippled by corruption in
nearly every aspect, preventing deregulation and economic liberalization.
Furthermore, Indonesia’s continued inability to thrive economically displays not
only the excessive presence of these structural inefficiencies and corrupt
governance, but also the government’s unwillingness to address and remove them.
History of Governance Problems in Indonesia
59 East Asia: Recovery and Beyond. Washington D.C.: The World Bank, 2000: pp 5-6. 60 See Figures A1 and A2 in appendix61 See Figure a3 in appendix
36
Indonesia gained independence from Dutch colonial rulers in 1949 and
was established as a Republic under President Sukarno, and was to function as a
guided democracy. Sukarno attempted to structure the economy around socialist
goals in the attempt to become self-sufficient in basic necessities such as food and
clothing. Sukarno’s plans failed and the economy deteriorated under his policies,
resulting in hyperinflation and aggregate economic stagnation62. In 1966, General
Soeharto forced Sukarno to relinquish to him full authority to restore order to the
nation. General Soeharto became president in 1968 an authoritarian “New Order”
that abolished many of the economic controls utilized under Sukarno, such as the
extensive price control system, and initiated more liberal policies towards
privatization and foreign technology63. Soeharto took definitive steps to eliminate
the communistic nature of his predecessor by banning all communist
organizations, but did not move towards a political system of increased personal
freedom64. Indonesia’s political system is intended to be a republic that is guided
by democracy, yet in reality consists of heavy concentration of power in the hands
of a president who is not democratically responsive to the will of the people.
Indonesia was a member of the Organization of Petroleum Exporting
Countries (OPEC) during the 1970s. The oil booms of 1973/74 and 1978/79 were
precipitated by a promising period of global integration, economic openness,
reduction of trade and investment barriers, and tight fiscal and monetary policy.
Following the oil booms, Indonesia’s exports increased drastically, resulting in a
sizeable balance of payments surplus. This surplus led to an increased role of the
62 Hill, Indonesian, 2-3.63 Dick, Emergence, 194.64 Ibid, 196.
37
public sector of the economy and an end to the relatively liberal preceding trend
towards global integration and economic openness. By 1986, central government
revenues as a share of GDP and government expenditures had risen to 22.1%,
from 4.2% and 9.3%, respectively, in 1966. This shift invigorated latent strains of
nationalism and induced the government to enact policies that favored domestic
businesses65. The post-oil boom era of the 1980s and 1990s was marked by shifts
towards deregulation and renewed liberalization in an effort to expand the
economy and escape absolute dependence on oil revenues, but these movements
were held back by “vested interest groups [that] waged an effective rearguard
action against further reforms”66. This period shows the rise of a large, powerful,
corrupt, and inefficient government sector as a result of the prosperity enjoyed
during the oil booms. Corruption took root and became so entrenched that
although attempts were made at reform, they were effectively held back.
Indonesia’s efforts to liberalize the economy were marked by irresponsible
deregulation of the financial sector coupled with continued corruption and a lack
of transparency in all sectors of the economy. The late 1980s and 1990s
experienced “burgeoning corruption at all levels of the government bureaucracy,
collusive relationships between political powerholders (sic) and their business
cronies, and the proliferation of policy-generated barriers to domestic
competition” 67. This trend resulted in an enormous number of large businesses
owned and controlled by powerful individuals related to or well-connected to
65 Thee Kian Wie. “The Soeharto Era and After: Stability, Development, and Crisis, 1966-2000.” The Emergence of a National Economy: An Economic History of Indonesia, 1800-2000. Honolulu: University of Hawaii Press, 2002. pp 203-208.66 Ibid, 211.67 Ibid, 213
38
President Suharto68. These barriers to competition inevitably created incentives
for rent-seeking behavior at the expense of profit-seeking, economically
beneficial behavior. The deeply corrupt nature of industry influenced the
financial sector, as the businessmen who controlled the rapidly expanding weak
banks did not follow banking rules designed to foster a stable financial market69.
Indonesia enacted a series of reforms to liberalize trade markets and financial
markets, and although these led to increased industrial and agricultural
development, an increase in non-oil exports70, and a steep reduction in absolute
poverty71, these reforms occurred under the auspices of detrimental and increasing
corruption. The policies aimed at aggregate growth and poverty reduction
succeeded at the expense of “strengthened crony capitalism and the
conglomerates”72. Although absolute poverty declined, Indonesian
industrialization and liberalization occurred at the expense of increasing relative
inequality, evidenced by an increase in the Gini coefficient from 0.32 in 1993 to
0.37 in 199673 74. The Gini coefficient measures relative inequality on a scale
from 0 to 1, where a value of 0 would reflect perfect equality and 1 would reflect
perfect inequality, or all wealth concentrated with one individual75. For
contextual sake, the current Gini coefficient of Japan is .249, that of the United
68 Ibid, 21369 Ibid, 21370 See Figure A4 in appendix71 See Figure A5 in appendix72 Francisia S.S.E. Seda. “Petroleum Paradox: The Politics of Oil and Gas”. The Politics and Economics of Indonesia’s Natural Resources. Washington, DC: Resources for the Future, 2006. p 186.73 Wie, Soeharto, 227.74 See Figure A6 in appendix75 Measuring Inequality, The World Bank, <http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTPOVERTY/EXTPA/0,,contentMDK:20238991~menuPK:492138~pagePK:148956~piPK:216618~theSitePK:430367,00.html?> Accessed 28 April, 2008.
39
States is .408, and Haiti is .59276 This increase in inequality, along with
economic instability caused by market distortions and an underrepresented
population, suggests the possibility that greater problems lurked beneath the
surface of apparent economic success. Increases in GDP during the oil booms
and immediately following occurred at the expense of the population as a whole.
As the nation appeared to develop and thrive, the benefits were reaped by corrupt
individuals and vested interest groups. This accumulation of wealth in the hands
of the few created an endemic cycle of corruption that has proven impossible to
dismantle, preventing Indonesian development.
The East Asian Crisis: Exposure of Corruption
The East Asian crisis exposed the problems of the Indonesian economy
that lurked beneath the façade of development. Immediately preceding the crisis,
the World Bank Country Report “identified a number of domestic risks …
[including] persistently high inflation, a weak banking sector, a slowdown in non-
oil exports, a widening current account deficit and a rapidly rising private external
debt”77. Following the crisis and rapid capital outflow, the Indonesian
government attempted to manage the crisis by floating the Rupiah and tightening
monetary policy, but this did not stem the crisis and on 13 October 1997,
Indonesia accepted financial assistance from the IMF contingent on a pledge to
implement a comprehensive reform program to address problems with
macroeconomic policy, the financial sector, and the structure of the government.
76 Human Development Report 2007/2008: Inequality in Income or Expenditure, United Nation Development Reports, < http://hdrstats.undp.org/indicators/147.html> accessed 28 April 2008. 77 World Bank 1997a: xxvi in Ibid, 232.
40
The contingencies of the IMF demonstrate the degree to which Indonesia’s
corruption reached. They reveal that without fundamental reform and drastic
restructuring that addresses corruption, aid packages and international
intervention could not assist the struggling economy. With sound governance,
state institutions could be trusted to facilitate the distribution and investment of
aid. The contingency demonstrates the lack of such governance. Additionally,
the fact that aid was contingent on addressing corruption shows that corruption
prohibits Indonesia from being a desirable investment location. If a country is
deemed necessary of fundamental structural reforms, it will fail to attract foreign
investment.
Even after receiving direct instructions and assistance from the IMF to
carry out structural reforms and address the issue of corruption, the Indonesian
government either failed to or was unable to act. “Indonesia did not seem fully
committed to implementing the reform program”78 and continued to support
corrupt policies that prevented aid from being channeled into economically
productive industries, hindering growth and preventing macroeconomic stability.
Corruption continued to plague the economy at every level, worsening the cycle
and dragging the economy deeper into a quagmire of underdevelopment and
isolation from international investment and integration. Indonesia was unable to
shed the structural problems that led to catastrophic consequences following the
crisis, preventing recovery and straining the economy.
Necessary Changes: Failure to Act
78 Ibid, 233
41
Successful development requires a combination of macroeconomic policy
changes, structural adjustments designed to facilitate investor confidence, and
global integration to capture the benefits of strong external demand coupled with
an attractive export market caused by the currency depreciation79. Members of
the Indonesian government have failed to do so and continue to support leaders
and policies that were discredited by the financial crisis and the events leading up
to it. The Indonesian government has displayed not only entrenched corruption,
but that it lacks a serious commitment to implementing economic reforms80. The
government has clung desperately to power, transforming the endemic corruption
that has persisted since the oil booms and the financial crisis into a “full-blown
political and social crisis”81. In Indonesia, evidence suggests that the corruption is
intertwined with the economic, political and social spheres where it became
entrenched and cripples the nation by benefiting vested interests at the expense of
development. The problems in the social and political spheres are illustrated by
the differences between governance in Indonesia in 1999 and governance in other
high-performing Asian economies82. Note that Indonesia is far behind other crisis
countries in nearly every aspect of governance.
Indonesia’s rampant and firmly-rooted corruption is a result of the
explosive capital accounts surplus augmented by the OPEC oil shocks, which led
to an extensively corrupt background upon which development and
macroeconomic restructuring took place, failure to quickly remove and replace
faulty governance with good governance, and the magnification of these problems 79 East Asia, p 7.80 Wie, Soeharto, 23681 Wie, Soeharto, 236.82 See Figure A7 in appendix
42
by the financial crisis. The solution to Indonesia’s failure to develop lies in
correcting these problems, which requires deviation from pure economic theory
and incorporation of the realities of the situation, centralization of power in the
hands of an elite few, the resulting corruption, and the cyclical, reinforcing nature
of the relationship between the two. Considering Indonesia’s situation, Joseph
Stiglitz noted that although “ideology would posit … that privatization always
works, … efficiency requires private property and competition” 83, without which
privatization will most likely result in the creation of a private monopoly, rather
than create a more dynamic, competitive market. Between 1999 and 2004, with
the fall of General Soeharto, Indonesia shifted from an authoritarian state to a
relatively democratic state, yet the political change and accompanying
decentralization alone was not enough to destroy the legacy of patrimonialism and
reduce the corruption levels in the country84. Rather than reduce corruption,
decentralization has fragmented the national economy, increased corruption, and
augmented the misuse of local authority85. This implies that without fundamental
institutional changes, decentralization fails to capture the gains of the free-market
model, including efficiency and marginal pricing determined by market forces.
Instead, Indonesian decentralization has resulted in increased corruption at local
levels, further hindering economic grown and stability. Traditional methods of
liberalization have failed to achieve the desired results, and acted to further hinder
development.
83“Speakers Explore Range of Development Issues and Appropriate Responses to Financial Crises”. IMF Survey: IMF Executive Board Completes First Review of Indonesia’s Economic Program. International Monetary Fund: Volume 27, Number Nine, May 11, 1999. p 6.84 Francisia S.S.E. Seda. “Petroleum Paradox: The Politics of Oil and Gas”. The Politics and Economics of Indonesia’s Natural Resources. Washington, DC: Resources for the Future, 2006. p 18885 Ibid, p 188.
43
The Persistence of Corruption: Facilitators
Indonesia’s peculiar geographic structure and cultural make-up permits the
current corrupt system to thrive. As an archipelago of 17,508 islands with eight
distinct ethnic groups and 29.9% of the population belonging to an unspecified
ethnic group, Indonesia is a vastly decentralized nation both geographically and
culturally86; thus, regional corruption hinders not only aggregate economic growth
but also national unity and confidence in the central government. Regions are
culturally as well as economically distinct, as evidenced by the divergent income
per capita of the provinces in 200087. Many regionally specific issues, such as the
laws unfairly governing the fishing of shallow lagoons in South Sumatra or the
harvest of valuable swallows’ nests, have been addressed by the democratic
governments, but in each case changes in existing institutions merely divert
resources from one external elite power to another88. Indonesian elections at local
levels exhibit the endemic corruption. In 1999, the elected district head of Musi
Rawas, a South Sumatran district, won the election by meeting with legislators,
and “at the end of the meeting, offered money”, which “was not a bribe, … but a
way to ‘help the legislators conduct a very important election for MURA
society’”89. Indonesian legislatures have also appropriated public funds for
personal use, sold contracts for government projects, and supported corrupt NGOs
86 The World Factbook: Indonesia. Central Intelligence Agency. https://www.cia.gov/library/publications/the-world-factbook/geos/id.html (accessed 19 November 2007). 87 See Figure A8 in appendix88 Elizabeth Fuller Collins. Indonesia Betrayed: How Development Fails. Honolulu: University of Hawaii Press, 2007. pp 117 – 120. 89 Ibid, 121.
44
allegedly dedicated to the alleviation of poverty90. These government betrayals of
public trust thrive in the absence of institutions to enforce laws and prosecute
powerful individuals.
Indonesia’s weak judiciary not only hinders the development of the real
sector of the economy by preventing growth at the community level, it also
prevents the Indonesian banks from functioning properly. A strong judiciary is
indispensable to the existence of property rights, which in turn are indispensable
to investor certainty. Investor confidence is essential to attract foreign
investment, and without property rights foreigners face no incentive to invest for
fear their investment will be abused or improperly managed. This lack of investor
confidence is partially caused by the poorly functioning banking sector, which is
also plagued by corruption. Indonesia’s legal system is both inefficient and
highly corrupt and lacks a mechanism to enforce loan contracts, which heavily
disadvantages the finance industry by casting doubt on whether or not loans will
be repaid91. A prerequisite to financial growth and attracting investments is for
the government to provide a reliable legal system to facilitate interaction between
banks, financial institutions, businesses, and individuals92. Superficial efforts
towards privatization, deregulation, and restructuring of the financial sector do not
lead to results in the absence of sound governing institutions to prevent corrupt
behavior. Without radical reform, Indonesia will be unable to attract significant
investment and remain globally isolated and economically stagnant.
90 Ibid, 123-125.91 Ross H. McLeod. “The Economy: High Growth Remains Elusive”. The Politics and Economics of Indonesia’s Natural Resources. Washington, DC: Resources for the future, 2006. p 46.92 Ibid, 46.
45
Current Prospects and Suggestions for Action
Indonesia’s development lags behind the development of other similar
developing countries in the region. Compared to other Asian emerging markets,
Indonesia is one of the least integrated into world trade93. The IMF suggests that
structural impediments have prevented international integration and hindered
economic growth. Data from the World Bank, coupled with surveys of the
International Institute for Management Development and the World Economic
Forum’s Global Competitiveness Report, explicitly state that “infrastructure [is]
seen as the most important obstacle”, along with other specific constraints
including business and government inefficiency, policy instability, and restrictive
regulations94 95. Additionally, the financial sector demonstrates weakness caused
by heavy state-ownership and fear of government interference, illustrated by weak
financial performance and loan quality96. The private sector suffers from
problems with transparency, illustrated by insufficient disclosure of cross-
ownership, concentrated ownership, and financial statements that are not
consistent with international standards97. The economic sector is still plagued by
corruption at far higher levels than other former crisis countries98, perpetuating
Indonesia’s inability to develop and creating the case for alternative strategies.
Although apparently unsuccessful in facilitating development, movements
towards deregulation and liberalization in the Indonesian economy are important
93 “Indonesia: Selected Issues” IMF Country Report no. 07/237. Washington, D.C.: International Monetary Fund, 2007. p 4.94 Ibid, 12.95 See Figure A9 in appendix96 Ibid, 22.97 Ibid, 22.98 See Figure A10 in Appendix
46
economic and financial developments because they highlight the structural
problems that hinder Indonesia’s successful economic development. Economic
growth in Indonesia must be accompanied by the divestiture of economic and
political power to the population to increase accountability and combat
corruption. Such divestures would entail job creation to raise the poor out of
poverty, greater transparency, and improved property rights. The relationship
between the two is illustrated by a dilemma that although the most successful
campaigns against corruption were a result of public outrage at reports in the
press99, in 1999, Indonesia trailed dreadfully behind every other high performing
Asian economy regarding information infrastructure100. Economic growth models
rely on specific assumptions, and when these assumptions fail, so will the model.
Indonesia provides an example of entrenched corruption so widespread that it
prevents the free-market forces created through liberalization and privatization
from harnessing individual action and competition to create wealth and stimulate
growth. Indonesia’s geographic, cultural, and socioeconomic climates allow
corruption to continue relatively unchecked. In order to achieve significant
growth, the Indonesian government must seek to alleviate income disparity and
divest political power from the hands of an elite few to the hands of a stable and
diversified population.
Indonesia’s economic situation reveals the failure of efforts towards
aggregate liberalization through privatization. Indonesia’s persistent corruption,
lack of reliable system of law, and inefficient state sector provide support for a
99 Collins, Indonesia, 122.100 See Figure A11 in appendix
47
“second-best” method of liberalization. A free-trade zone can serve to attract
investment in otherwise undesirable locations by providing additional concessions
and guaranteeing contracts that would be unreliable in the host country. In order
achieve aggregate liberalization and development, Indonesia must address the
crippling issues of transparency and corruption. In the absence of such initiatives,
Indonesia’s economic situation warrants the introduction of a free-trade zone as a
second-best policy to mitigate other existing barriers that cause inefficiency.
Moreover, this overview suggests that the Indonesian Government lacks the
ability to effectively implement redistribution programs. This inability is
demonstrated by contingencies for aid following the crisis. Indonesia’s corrupt
government sector supports the introduction of free-trade zones that directly
benefit workers in the form of higher wages or increased employment, rather than
improve welfare by increasing national income.
48
Chapter 4: The Modern Indonesian Labor Market
Introduction
In order to evaluate the effects of a Free Trade Zone in Indonesia, it is
most effective to examine the effects on the labor market. One of the common
policy goals of establishing FTZs is alleviating unemployment, a common
problem plaguing developing countries. This chapter examines the structure of
the Indonesian labor market. I have chosen to examine wage levels, government
policy dictating wage levels, migration patterns, unemployment trends, and
composition of the workforce, and examine the interplay between these factors
within Indonesia’s development and apparent shift from an agricultural base to
the sort of export-oriented manufacturing industries that are found in Free Trade
Zones. It is logical to begin with an examination of wages within the country,
specifically wage policy and the existence of a minimum wage. Because
Indonesia is a vast and diverse nation, it is essential to examine regional wage
differentials and examine which wage levels correspond with higher levels of
unemployment. It follows to examine which industries exhibit higher levels of
unemployment, and the location of these industries. Finally, I will examine the
characteristics of the workers by explaining the composition of the workforce,
specifically the composition of the workers likely to migrate to areas with higher
wages and face potential unemployment.
49
An economic evaluation of unemployment involves comparing the supply
of labor with the demand for labor. When labor markets do not clear, meaning
that the supply of labor exceeds demand for labor, a surplus of labor can occur,
which can result in unemployment. When a country exhibits high levels of
unemployment, a possible cause is that the price of labor, or the wage rate, is set
too high for the market to clear. The existence of a minimum wage that is set
higher than the equilibrium wage creates a surplus of labor. With more than one
industry that seeks labor from the same market and in the absence of minimum
wages, theory predicts that the wages will equalize; however; when one or both of
the industries face government intervention in the form of labor policies such as a
minimum wage, this equilibrium wage will not be reached.
The Harris-Todaro model of rural-urban migration explains this migration
as a result of higher urban wages. In the model, workers make the rational
decision to migrate from rural sectors to urban ones based on an evaluation of
relative benefits and costs, both financial and psychological. Financial incentives
include the opportunity to earn higher wages, while psychological factors include
expected benefits derived from urban life such as social institutions and more
diverse opportunities. Workers decide to migrate based both on wage rate
differentials and the probability of obtaining employment in the urban sector. If
the urban wage rate is significantly high to offset a lower probability of finding
employment, workers will continue to migrate to urban areas even in the
existence of high rates of unemployment, worsening the problem101. The model
101 Michael P. Todaro and Stephen C. Smith, Economic Development, Chapter 7: Urbanization and Rural-Urban Migration: Theory and Policy (New York: Pearson/ Addison Wesley, 2006), 339-443.
50
describes the situation in many developing countries whereby wage rates do not
equalize between sectors, either as a result of government minimum wage rates102,
far higher productivity and thus wages in increasingly more modern industries103,
or a combination of the two. Harris-Todaro-type unemployment inhibits
development by creating a socially unstable urban labor market and augmenting
problems that result from surplus labor.
I assert that the Harris-Todaro migration model accurately describes the
Indonesian labor market because the Indonesian manufacturing sector, which is
concentrated in urban areas, is regulated by government policies including a
binding minimum wage. This explains the migration from rural to urban areas
and the higher levels of unemployment in urban areas.
Economic Shift from Rural to Urban
Since the 1970s, Indonesia has been shifting from an agriculture-based
economy to a more diversified economy strongly oriented towards labor-intensive
manufacturing104. From 1983 to 1994, manufacturing grew at far higher rates than
did agriculture. From 1983 to 1987, manufacturing grew by 12.0 percent, while
agriculture only grew by 3.3 percent. From 1987 to 1993, manufacturing grew by
11.8 percent, while agriculture continued to grow at 3.3 percent. The sectoral
shift became more pronounced in the nineties, when from 1993-1994
manufacturing grew by 12 percent, compared to agriculture, which grew by only
102 Ibid, 342.103 Ibid, 343.104 Alejandra Edwards. “Labor Regulations and Industrial Relations in Indonesia”. Policy Research Working Papers Issue 1640, The World Bank Poverty and Social Policy Department (1996) p 2.
51
0.3 percent105. From 1987 to 1997, manufacturing accounted for approximately
ten percent of GDP growth per annum, compared to agriculture, which only
accounted for approximately 2 percent of GDP growth per annum, declining each
year106. By 1995, the World Bank estimated that manufacturing contributed 25
percent of Indonesia’s GDP, compared to 21 percent in 1992 and a mere 12.2
percent in 1981107. These results not only demonstrate the decline of agriculture
and the rise of manufacturing, but also show the importance of manufacturing to
GDP growth and development. Manufacturing’s importance to growth is
magnified by the dominance of labor-intensive manufactured exports.
The growth of manufacturing and the decline of agriculture were marked
by a shift of employment from agriculture into manufacturing as the surplus labor
from agriculture flowed into manufacturing jobs associated with the
industrialization process108. In 1971, 75.2 percent of the Indonesian labor force
was employed in agriculture, compared to only 5.1 percent that were employed in
manufacturing109. In the same year, changes in the market from agricultural
orientation to manufacturing orientation were already underway and employment
in nonagricultural industries was growing far more rapidly than employment in
agriculture. In the period of 1971-1980, the increase in employment in the
agriculture sector accounted for 24 percent of the total increase in employment,
compared to the nonagricultural sector, which accounted for 76 percent of the
105 Chris Manning, Regional Labor Markets During Deregulation in Indonesia: Have the Outer Islands Been Left Behind?”. The World Bank, Policy Research Working paper Series, 1728 (1999) p. a1106 Manning, Indonesian, 246. 107 Vedi R. Hadiz, Workers and the State in New Order Indonesia, New York: Routledge (1997) 111.108 Chris Manning, “Approaching the Turning Point?: Labor Market Changes Under Indonesia’s New Order”. The Developing Economies, Vol. 33, No. 1 (1995) p 66109 Chris Manning. “Indonesian Labor Markets: Adjusting to Crisis and Slow Recovery”. The Indian Journal of Labor Economics, Vol. 43, no. 3 (2000) p 246.
52
total increase110. As development continued, agriculture continued to decline as
nonagricultural sectors continued to expand, with manufacturing emerging as the
major non-agricultural sector for employment from the mid 1980s onward111.
During the 1990s, the labor market exhibited a simultaneous slow-down in
employment in agriculture and acceleration and strong growth in employment in
manufacturing, consistent with the structural shift of the economy112. Most of the
new manufacturing jobs were in labor-intensive industries, including textiles,
clothing and footwear. Industrialization and development shifted workers from
agriculture into industrial and manufacturing jobs, which caused a steady increase
in wage employment as a percentage of total employment113.
Growth in manufacturing occurred as Indonesia simultaneously adopted
more technology-intensive methods in agriculture while simultaneously pursuing
a strategy of export-oriented growth. By the 1980s, Indonesia’s new export-
oriented manufacturing industries were composed of almost entirely labor-
intensive activities, mirrored by large shifts in employment from the agricultural
sector into the footloose labor-intensive sector fueled by the export push114.
Between 1980 and 1992, manufactured exports grew at an annual average rate of
20 to 30 percent, and labor intensive exports increased from 287 million US
dollars and 57% of total exports to 9,963 million US dollars and 62% of total
exports. These large shifts are evidence of the physical shift of labor that
necessarily accompanied the economy’s shift towards greater industrialization.
110 Manning, “Regional. a2111 Ibid, 5.112 Manning, Regional, 5.113 Edwards, Labor, 11114 Hal Hill, The Indonesian Economy, Cambridge: The Cambridge University Press (2000) p 157-162.
53
Rural to Urban Migration
The economic shift from agriculture to manufacturing was mirrored by a
physical shift in the labor market from a rural to an urban concentration as
workers moved to fill jobs created in the manufacturing sector. The period was
marked with improvements in both transportation and communication that
widened the labor market both for workers and for employers. Employers were
able to rapidly expand manufacturing industries, which induced workers to move
to urban areas in the hope of securing work115. Between 1990 and 1997, the urban
labor force grew by 7.0 percent as urban employment grew by 6.8 percent, while
the rural labor force shrank by .2 percent and rural employment shrank by -.4
percent. The years 1997-1999 displayed a similar urban bias, with urban labor
force growth of 6.2 percent and urban employment growth of 4.7 percent,
compared to rural labor force growth of 1.1 percent and rural employment growth
of 0.6 percent116. Note carefully that the urban labor force growth outstrips the
growth of urban employment. This urban workforce was characterized by 5
percent agricultural workers, compared to 42 percent manufacturing workers117,
showing the prominence of manufacturing in the urban sector.
This physical shift is evidence of not only industrialization, but also the
increased ease with which workers can move from rural to urban locations.
Migration depends not only on the existence of incentives to migrate, but also on 115 Edwards, Labor, 10.116 Manning, “What Has Happened to Wages in the New Order?”. The Economic Development of Southeast Asia, Vol. 2 (2002) p 553.117 Manning, Approaching, 68.
54
the ability to do so. As a vast archipelago, in the absence of modern technology
and adequate infrastructure, rural-urban migration would be prohibitively
expensive and simply not feasible for low-skill workers. By 1990, transportation
had progressed to the point where it was possible to travel with ease by bus from
the northern tip of Sumatra to Java, Bali, Lombok, and beyond by vehicular
ferry118. By 2000, Indonesia was integrated to such an extent that people and
goods could move quite easily and with high intensity between Java and
Singapore and from Sumatra and Kalimantan to both Java and Singapore119.
Especially in labor intensive industries, workers’ mobility was found to be very
high120. The ease of transportation and evidence of high mobility demonstrates
that the Indonesian labor force is both willing and able to perceive and respond to
changing incentives in the labor market.
The urban areas that experienced industrialization and high levels of in-
migration included not only traditional urban centers such as Jakarta, but also
some Outer Island provinces classified as relatively resource abundant, including
the province of Riau on Sumatra121. These resource abundant provinces
experienced far more rapid growth in manufacturing and industry than did poorer
regions, which remained agriculturally based122. It is not surprising and follows
logically that these same resource-rich provinces also recorded particularly high
rates of net in-migration123. Riau experienced high levels of industrialization as a
118 Hill, Indonesian, 219.119 Howard Dick, Vincent J. H. Houben, J. Thomas Lindblad, Thee Kian Wie. The Emergence of a National Economy: An Economic History of Indonesia 1800-2000. Honolulu: University of Hawai’i Press, 2002 p 12. 120 Edwards, Labor, 12121 Manning, Regional, 7.122 Ibid, 11.123 Ibid, 9.
55
result of Batam Island, a special economic zone that attracts both industry from
Singapore and significant volumes of foreign investment124. Recall that the urban
labor force was expanding at a more rapid rate than urban employment. This
suggests that workers were not merely migrating to fill new jobs created in the
manufacturing sector after losing jobs in the agricultural sector, but responding to
an additional incentive to relocate to an urban area.
Wages: History, Differentials, and Government Policy
Wages in urban manufacturing increased more quickly and remained
higher than those in rural agriculture. Real wages in agriculture in 1977 exceeded
those in textiles, which were 618 Rp a day and 410 Rp a day, respectively125.
From 1972 to 1990, the real wage rate of labor in agriculture increased by a mere
1.3 percent with many periods of negative growth, while that of textiles, a labor-
intensive industry, increased by 5.0 percent with only positive growth126. By
1993, real wages in agriculture were only 885 Rp a day, compared to 1424 Rp a
day in textiles127. This differential shows that urban, manufacturing wage rates
were far higher than those in rural agriculture. Additionally, urban manufacturing
wage rates continued to grow in comparison to those in agriculture, instead
diminishing in comparison and reaching equilibrium. Wage rates in Indonesia
tended to be “skewed by region … and on average much higher in urban that in
rural areas”128. Both nominal and real wage rates were nearly double and grew far
124 Hill, Indonesian, 174, 219.125 Chris Manning, “What has Happened to Wages in the New Order?”, The Economic Development of Southeast Asia, v2 (2002) p 411.126 Manning, Approaching, 70.127 Manning, What, 411.128 Manning, Approaching, 60.
56
more quickly in the urban areas of Jakarta and resource-rich provinces than in
agricultural rural areas129. This differential progressed to the point that by 1993,
“urban incomes were 92% higher than rural incomes”130.
The persistent rise in wages would be consistent with basic economic
principles if the expansion of labor-intensive manufacturing combined with the
labor-intensive export-oriented strategy were sufficiently large to more than
absorb the surplus labor released from agriculture and demand additional labor, in
which case the labor market would tighten, demand would exceed supply, and the
equilibrium wage rate would increase. This absorption would serve to alleviate
unemployment and the job creation would tighten the labor market and increase
wages. Unfortunately, all evidence is to the contrary. Indonesia consistently
exhibits labor surplus conditions, in which real wages for the unskilled would not
be expected to rise131. Given Indonesia’s current situation, Hill predicted in 2000
that Indonesia was at least ten to twenty years away from a point at which the
labor market will tighten to the point that real wage increases are to be
expected132. Although export-orientation acts to increase demand for labor-
intensive products and thus labor, which in turn hastens the tightening of the labor
market, the Indonesian manufacturing sector has still not absorbed all of the
surplus labor. Furthermore, the persistence of unemployment in the rural,
agricultural sector shows the surplus labor problem is not unique to the urban,
manufacturing sector. Manning also noted in 1995 that Indonesia had still not
reached the turning point in economic development that would mark the transition 129 Manning, Regional, 19, 21130 Dick, Emergence, 228.131 Hill, Indonesian, 205.132 Ibid
57
from a labor surplus to a labor scarce economy133. These findings imply that some
other factor must have acted to drive wages up past an equilibrium point
characterized by neither a labor surplus nor a labor scarcity.
The Indonesian government has established labor policies that affect the
labor market, including a minimum wage. Labor policies have existed since the
1950s, when the government established a 40 hour working week, the right to
menstruation and maternity leave for women, and laws regulating industrial
accidents, child labor, and the rights of workers to form unions134. Although labor
regulation has existed since the 1950s, evidence suggests that in the early years of
industrialization in the 1970s and 1980s, minimum wage legislation did not
greatly affect the labor market. Until the 1990s, Indonesian labor markets
appeared to operate relatively efficiently, with weak or poorly organized labor
unions and a large percentage of the population still employed in non-wage, rural
sectors135. This changed in the 1990s, when the Indonesian government was faced
with a combination of internal pressure from urban unrest accusing the
government of pandering to the interests of foreign business interests and external
criticism from the US demonizing labor rights and working conditions136.
The 1990s were marked by a series of labor regulations that introduced
greater rigidity into the labor market, primarily through increases and
enforcement of minimum wage mandates. Minimum wages doubled in real
terms between 1988 and 1995 in response to a series of policy changes137. In
133 Manning, Approaching, 52134 Edwards, Labor, 7.135 Hill, Indonesian, 209.136 Ibid, 210.137 Edwards, Labor, 9.
58
September of 1992, Cosmas Batubara, then Minister of Manpower, attempted to
assuage labor unrest by promoting the idea of periodic minimum wage increases
and the introduction of a new regulation that stipulated a rise in the minimum
wage. Batubara was replaced in 1993 by Abdul Latief, who also emphasized
periodic increases in the minimum wage138 as well as revoked a decree that
allowed employers to call upon the military to break up strikes and initiated
stricter enforcement of labor regulations, including the minimum wage139.
Additionally, the expansion of the manufacturing sector and the resulting shift in
employment from rural agriculture to urban manufacturing has resulted in a far
larger proportion of the population working as official wage laborers who are
covered by minimum wage legislation140.
Evidence shows that the increased minimum wage, stricter enforcement,
and increased percentage of wage laborers did in fact make the minimum wage
binding. This is especially apparent regarding youths, females, and low-educated
workers. Studies show that “less skilled workers and youths are more likely to
lose their jobs from minimum wage hikes” and that “a one percent real increase in
the minimum wage reduced employment of low educated workers as much as 0.2
percent”141. Employers are faced not only with rising minimum wage costs, but
also with disproportionately high unofficial costs of doing business in Indonesia,
which have skewed the labor market. These unofficial costs reflect the
underlying problem of corruption and involve difficulties obtaining permits, the
unreliable legal system, and difficulties obtaining necessary infrastructural 138 Hadiz, Workers, 163-164.139 Edwards, Labor, 9.140 Edwards, Labor, 36.141 Bird and Manning, Minimum, 5, 15
59
components to running a successful business. When examining the labor market
in the context of the effects of the establishment of a Free Trade Zone, the most
important impact of a rigid labor market caused by policies including a minimum
wage is the effects such policies have on unemployment.
The Problem of Unemployment
Indonesia demonstrates persistent and increasing unemployment rates.
The problem of unemployment is worse in the manufacturing sector found in
urban areas, evidenced by the fact that unemployment rates tend to be higher in
urban areas142. Unemployment in the 1990s was generally characterized by
considerable stability coupled with some tendency for overall rates to increase, a
trend that is partially explained by increasing minimum wages. Unemployment in
Indonesia is a very serious concern, and can be viewed as a genuine structural
problem that results from some combination of insufficient labor demand or
excess labor supply143. Unemployment, like wages, differs regionally and shows
extremely low rates in rural areas144. In 1992 in urban areas, 5.3 percent of the
male labor force and 6.6% of the female labor force were unemployed, compared
to only 1.4 percent of the rural male labor force and 1.6% of the rural female labor
force. This shows that as early as 1992, before minimum wage legislation was
increased and more strictly enforced, urban areas already displayed a far more
striking problem with unemployment than their rural counterparts. Additionally,
142 Armida S. Alisjahbana and Chris Manning, “Labor Market Dimensions of Poverty in Indonesia” Bulletin of Indonesian Economic Studies, Vol. 42, No. 2 (2006) 238.143 Chris Manning and P. N. Junukar, “Choosy Youth or Unwanted Youth? A Survey of Unemployment”. Bulletin of Indonesian Economic Studies, v34.n1 (1998) 55-56144 Ibid, 62.
60
there is a bias introduced by the fact that there is a large unofficial sector in urban
areas and many workers who seek non-wage employment in both sectors.
Accounting for this bias, the overall unemployment rate in Indonesia in 1992 is
estimated to be 8.7 percent, and over ten percent in urban areas145. These
strikingly large rates demonstrate the magnitude of unemployment in Indonesia.
Before the increases in minimum wage mandates and enforcement,
Indonesia’s official unemployment rates were relatively low compared to those in
other developing countries. From 1971 until 1993, the official rate was between 2
percent and 4 percent. This changed in 1994, when the national unemployment
rate began to rise, reaching 7 percent in 1995 and perplexingly falling back to 4
percent in 1996146. The rise in unemployment that coincided with stricter
government labor policy disproportionately affected urban areas. From 1996 to
1997, urban unemployment rose to 4.8 percent, coinciding with only a 1.9 percent
growth rate in manufacturing147. In 1997, urban unemployment was 8.0 percent,
compared with only 2.8 in rural areas. In 1998, urban unemployment rose to 9.3
percent, compared to only 3.3 percent in rural areas. In 1999, urban
unemployment rose to 10.5 percent, while rural unemployment rose to a mere 3.9
percent148. These rather large differentials suggest that increases in minimum
wage rates and stricter enforcement exacerbated labor problems in urban areas
and were correlated with increases in unemployment. Of the urban areas most
afflicted by unemployment, from the late 1970s through the 1990s,
145 Ibid, 66.146 Ibid, 76-77147 Chris Manning and Kurnya Roesad, “Survey of Recent Developments”, Bulletin of Indonesian Economic Studies, v42.n2 (2006) 165148 Manning, Indonesian, 552.
61
unemployment rates were highest in resource-rich provinces, including Riau.
This is because the resource-rich provinces were home to resource-based
industries bound by minimum wages and thus were an attractive destination for
migration from rural areas of Java and Sulawesi149. Unemployment in Indonesia
rose to 5.8 percent by the end of 2001, and 6.5 percent by the end of 2005150 and
remained “stubbornly high” at just over 10% in February 2006151. There is no
doubt that unemployment is a persistent and relevant obstacle facing Indonesia’s
development. Although a great deal of this data was during and immediately
following the financial crisis of 1997-1998, Manning finds that the relative
increases in the unemployment rates had little to do with the crisis152.
Unemployment rates and their increase reflect structural problems with the
Indonesian labor market and coincide with increases in minimum wage rates,
suggesting that surplus labor conditions were exacerbated by these policies.
Unemployment and policies that intensify it adversely affect the low-
skilled workers that are generally attracted to wage labor in labor-intensive
industries because these industries can shift to more capital intensive techniques.
This group tends to include large numbers of young and unmarried laborers, and
an increasing proportion of females. Indonesia’s workforce mimics that of other
similar labor surplus countries in the region, yet it exhibits a higher degree of
“segmentation by occupation, gender, and region”153. Logically, minimum wage
increases that influenced unemployment were borne by less-skilled workers and
149 Manning, Regional, 10.150 Manning and Roesad, Survey, 165. 151 Ibid, 143152 Chris Manning, Globalization, Economic Crisis, and Labor Market Policy: Lessons from East Asia, East-West Center Working Papers: Economic Series No. 23 (2001) 12153 Manning, Approaching, 58-59.
62
youths most likely to be found in low wage jobs154. This is partially attributable to
the fact that industrialization and urbanization were most likely to weaken
traditional institutions and eliminate unofficial jobs that would have been
performed by this group. Women who would have worked hours to hand-pound
rice or other unskilled workers who had performed labor intensive rural tasks now
entered the labor market, a shift difficult to quantify but that certainly affects the
transition from a rural to an urban base155. These young, low-skilled, often female
workers would be more likely to seek employment with large labor-intensive
manufacturing firms that were under pressure to implement minimum wages.
Even though workers often had to wait in unemployment queues for jobs in these
sectors, it was still preferable to rural life156. Thus, workers faced incentives to
migrate to urban areas in search of labor-intensive manufacturing employment
regardless of the fact that these areas were marked by high levels of
unemployment. This fits the Harris-Todaro model of rural-urban migration and
provides evidence that the resource-rich urbanized province of Riau did exhibit
Harris-Todaro-type unemployment.
Conclusion: Policies Governing the Indonesian Labor market
Analysis suggests that Indonesia’s labor market policies and regulations
inhibit modernization and development. Critics of Indonesia’s labor market
154 Bird and Manning, Minimum, 14-15.155 Hill, Indonesian, 24-25.156 Manning and Junakar, Choosy, 79.
63
regulation point to the impact of minimum wages on Harris-Todaro processes that
create high urban unemployment in response to minimum wages and expected
incomes157. In order to facilitate development and alleviate poverty in Indonesia,
the government should focus on policies that support job creation and ease
unemployment. Because data indicate slow growth in the formal job sector as “a
major obstacle to reducing the incidence of poverty”158, the government should
implement policies designed to stimulate job creation, such a promoting private
investment and output growth. Evidence show that policies that seek to utilize
unemployed surplus labor are more important for poverty alleviation than other
policies that seek to enhance labor mobility or regulate wages and labor
conditions159. Indonesia should enact policies designed to absorb surplus labor as
an essential component of their development plan. Policies that could
successfully absorb excess labor would be politically viable and economically
beneficial because they would be simultaneously popular with both labor and
business interests.
The Indonesian government has taken steps to enact policies designed to
alleviate problems, but these reforms have largely failed to address the problems.
Attempts to reform the problems plaguing the labor market are overshadowed by
the controversy that exists between union leaders and government officials that
attempt to enact labor policy. When the government attempts to liberalize the
labor markets, union leaders accuse officials of asking labor to make sacrifices in
the interest of employers. This has contributed to the public perception that the
157 Manning, Globalization, 3. 158 Alisjahbana and Manning, Labor, 258.159 Ibid, 258.
64
government is trying to cut worker benefits in the interests of employers, rather
than in the interests of labor in general, by reducing labor costs in order to create
more jobs and reduce unemployment160. Although the government may
acknowledge the need to reduce unemployment, to do so through more flexible
wages would be politically unviable. The Indonesian government has had to seek
alternative methods of expanding employment in order to alleviate problems and
facilitate growth. One alternative method of attracting investment, leading to
employment creation, is the establishment of Free Trade Zones in areas that
exhibit Harris-Todaro-type unemployment. These zones have been established in
many Southeast Asian countries, often with the goal of alleviating unemployment.
Chapter Five: Empirical Survey of the Effects of Free Trade Zones in Asia on the Labor Market
Introduction: Free Trade Zones as a Part of Export-Oriented Strategy
160 Manning and Roesad, Survey, 168-168.
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The establishment of free trade zones has been a controversial component
of many developing countries’ export-oriented development strategies that
marked the final quarter of the twentieth century. Export-oriented development
strategy emerged following the failure of earlier import substitution
industrialization strategies and accompanied general trends towards greater
market liberalization. Free trade zones seek to harness the benefits of economic
liberalization and attract foreign direct investment without fully liberalizing all
sectors of the economy. These zones represent a second-best type solution for a
country seeking to profit from greater and more efficient integration with the
global economy, benefiting from higher world prices in activities in which the
country has comparative advantage while simultaneously not subjecting the entire
economy to trade liberalization and deregulation161. Indonesia is an example of a
country that implemented Free Trade Zones as a second-best option to aggregate
liberalization. Indonesia’s inward orientation induced policy-makers to introduce
Free Trade Zones to create some areas free from the distortions that affect the rest
of the economy162. These zones have been created in attempts to achieve a
variety of development goals, including improving the labor market.
Export-oriented development strategies and thus the establishment of free
trade zones were employed by many Southeast Asian developing countries. East
Asian economies provide the best observed examples of free trade zones because
they have shown to be the most successful163. Asia contains the most successful
161 Dean Spinanger, “Objectives and Impact of Economic Activity Zones – Some Evidence from Asia” Weltwirtschaftliches Archiv. v120.n1 (1984): 65.162 Kankesu Jayanthakumaran, “Benefit-Cost Appraisals of Export Processing Zones: A Survey of the Literature”, Development Policy Review 21 (2003) 52.163 Hooshang Amirahmadi and Weiping Wu, “Export Processing Zones in Asia” Asian Survey, v35.n9 (1995): 829.
66
zones because the countries that established these zones contain the mix of factors
necessary to facilitate successful export-oriented strategies within zones: a
combination of low-cost labor and access to sufficiently reliable infrastructure.
The developing East Asian economies’ labor markets share many similarities with
that of Indonesia, making the evaluation of free trade zones’ successes and
failures within this region an essential prerequisite to evaluating the success or
failure of zones in Indonesia.
Characterizing Free Trade Zones found in Asia
East Asian free trade zones seek to attract foreign direct investment in the
form of multinational companies who in turn seek to exploit the abundant factor
of labor present in these developing countries. In order to operate efficiently
these MNCs require access to sufficiently complementary infrastructure and
facilities, a need that can only be met in more urban areas164. This runs contrary
to Miyagiwa’s theoretical findings that suggested location in a rural sector could
alleviate unemployment more effectively by broadening the economic base and
halting rural-urban migration that contributes to unemployment in the first
place165. Adequate infrastructure is an essential prerequisite to attracting
multinational companies to free trade zones because these companies seek to
manufacture goods to be exported and sold on the world market. These industries
combine modern technology and foreign capital with domestic labor. This
technology needs reliable access to infrastructural components including but not
164 Spinanger, Objectives, 84.165 Miyagiwa, Locational, 21.
67
limited to electricity, transportation, and communication comparable to that
available in more developed countries. Reliable and high quality infrastructure
cannot be effectively established in rural areas, inducing governments to establish
Free Trade Zones in urban areas.
The majority of zones in Asia specialize in labor-intensive light
manufacturing such as garment production, the assembly of light electrical goods,
and electronics. These industries share the ability to be easily relocated because
they involve the combination of standardized, highly mobile production
technology with low-skilled workers, a practice called “footloose
manufacturing”166. As the name and definition imply, this variety of investment
could potentially have negative long-term effects on a developing nation, as it
does not provide opportunities for workers to gain skills and progress to higher
wage and skill jobs. Furthermore, its inherently transient nature may have short-
term positive effects for workers by absorbing surplus labor and alleviating
unemployment, but as unemployment abates and the labor market tightens,
increasing wages, firms engaging in footloose manufacturing will surely relocate
to markets with relatively lower labor costs. If footloose industries are the only
industries located within a free trade zone, their long-term propensity for success
appears bleak.
Zones in Indonesia contain a large proportion of these labor-intensive
footloose industries. Indonesian zones that were studied in the late 1980s and
early 1990s appeared to be highly reliant on the garment industry167, a highly
166Jayanthakumaran, Benefit-Cost, 52.167 Ibid, 60.
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labor-intensive industries whose technology has changed very little in over
time168. Indonesian zones were similar to other Asian zones in the types of
industries they attracted. This suggests Indonesian zones are likely to follow
similar patterns and reach similar results as other zones in similar countries.
Workers in free trade zones in Asia share many common traits. Because
the zones attract predominantly low skill labor, the majority of zone workers are
young, unmarried females between the ages of seventeen and twenty four169. In a
1998 study of zones in Indonesia, South Korea, Malaysia, the Philippines, and Sri
Lanka, unskilled female workers accounted for the majority of jobs in the
zones170. More specifically, in 1995 an estimated seventy to eighty percent of the
total work force employed in Asian free trade zones consisted of unskilled women
between sixteen and twenty-five who would not have otherwise joined the labor
force; thus, employment opportunities in these zones may have helped to facilitate
new opportunities, values, and social responsibility for women171. Conversely,
zones tended to be located in urban areas that exhibited far higher rates of
unemployment than rural areas. Furthermore, these unemployment rates were
consistently higher for women than for men. The attraction for women of
employment in free trade zones may increase rural to urban migration and thus
contribute to Harris-Todaro type unemployment.
168 Peter G. Warr, “Export Processing Zones: The Economics of Enclave Manufacturing” World Bank Research Observer. v4.n1 (1989): 65.169 Peter Warr, “Export Processing Zones”, Export Promotion Strategies: Theory and Evidence from Developing Countries. (New York: New York University Press, 1990), p 144.
170 Jayanthakumaran, Benefit-Cost, 59.171 Amirahmadi and Wu, Export, 836-837.
69
Due to the nature of work available in Free Trade Zones, laborers
generally exhibited high levels of job mobility and experienced high rates of
turnover. Employers are able to hire workers that can be easily and quickly
trained. These workers then undertake tedious and exhausting work172, often with
approximately half of all zone workers working overtime with an average
working week of 54 hours. By law, 54 hours is the maximum work permitted and
these workers are to be compensated for overtime173. These conditions, coupled
with the nature of the work, contributed to an average duration of zone
employment of approximately three years174. This evidence suggests that Free
Trade Zones may have short-term employment benefits, but are marked by
transience and impermanence. Workers do not appear to derive long-term
benefits such as valuable training or management experience. They appear to act
as little more than an input to foreign, export-oriented manufacturing, and derive
little to no spillover benefits from the presence of the zone or their employment
within it. The characteristics of the nature of work within free trade zone was
common to all zones examined in East Asia regardless of structural and
differences, suggesting that the prevalence of labor-intensive industries within
zones is a function of the zone and factor availability in a host country rather
government policies175. The characteristics of the workforces within Free Trade
Zones are a result of the industries that locate within the zones and the locational
172 Ibid, 845173 Armes Gross, “Human Resources in Indonesia,” Pacific Bridge Incorporated: Recruiting and HR Consulting in Indonesia. 2007< http://www.pacificbridge.com/publication.asp?id=29> accessed 5 May 2008.174 Warr, Export Processing Zones, 144175 Xiangming Chen, “The Changing Roles of Free Economic Zones in Development: A Comparative Analysis of Capitalist and Socialist Cases in East Asia”, Studies in Comparative International Development, V.29n.3 (1994): 12.
70
choice for the zone rather than country-specific policies or labor market
characteristics.
Wages in Free Trade Zones
Workers are induced to seek employment within Free Trade Zones by
competitive wage rates offered as compensation for their work. The wages
accrued by workers are of utmost importance to the consideration of the effects of
Free Trade Zones because they are the most tangible form of benefits flowing
from the zone to the country hosting it. The industries that locate in free trade
zones choose to do so primarily for access to inexpensive, low-skilled labor.
Many incentive packages include absence of labor unions to entice foreign firms
into the zones. Zones typically have very lax regulations, tariffs, or other barriers
to imports as a major part of their attractive package to investors. Zones typically
import most non-labor inputs and pay little to no taxes to the domestic zone.
Considering the final manufactured product is to be exported and in the zones
examined most other inputs are imported, the most important component of
domestic value-added in the FTZ is that added by the low-skilled laborer. This
value is reflected by the wage paid to low-skilled laborers within the zone176. The
wage takes on even greater significance in developing countries, including
Indonesia, because in many of these cases, the implementation of EPZ strategy is
usually not accompanied by additional plans for regional development177. In this
case, responsibility for regional development and benefits to the surrounding
176 Amirahmadi and Wu, Export, 842.177 Ibid, 846.
71
areas falls upon the outflow of wage earnings, and to a limited extent, growth of
local suppliers in cases where firms within the zone require some additional local
input that cannot be acquired more cheaply from abroad. Many times, local
additional in puts are minimal and the wage remains the primary domestic benefit.
Wage rates within the zones have been shown to be quite competitive with
their counterparts prevailing outside the zone. In a survey of zones in Malaysia,
the Philippines, and Indonesia undertaken in the late 1980s, Peter Warr
determined that wages paid in the zone are normally equal to, or slightly above,
wages paid in comparable employment outside the EPZ178. In a more recent
study, Kankesu Jayanthakumaran found that wage rates within the Asian zones
tend to be slightly higher on average than those paid outside the zone179.
Although zones are characterized by freedom from union activity and sometimes
labor laws, these findings are consistent with what would be assumed given the
assumptions of rationality and labor mobility. Firms locate within zones to
combine abundant, low-skilled labor with modern technology and foreign capital
and produce exportable manufactured products. Access to internationally
relatively inexpensive labor is a major priority for firms, so they will locate in
zones that provide access to such labor. In order to induce workers to leave
comparable jobs outside the zone or migrate from more rural areas, wage rates
offered in the zone should be equal to or slightly higher than those to be earned in
a competing job. The internationally relatively low wages paid to workers in free
trade zones is a point of international controversy and criticism, and many critics
178 Warr, Export Processing Zones, 148.179 Jayanthakumaran, Benefit-cost, 57.
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from industrialized countries assert that “EPZ firms ‘exploit’ their workers and
enjoy big profits, at the expense of jobs back home in the industrial countries”180.
The second part of this assertion is a different subject for a different study, but
regarding the exploitation of workers within the zone, the point can be addressed
by comparing opportunities in the zone to the workers’ opportunities in other
available professions. The argument remains that unless workers were better off
being ‘exploited’ in FTZ, workers would choose to remain outside the zone and
firms within the zone would find it impossible to hire employees181.
The benefits accrued through wage transfers are best illustrated by
comparing the wage rate paid as compensation for work in the zone with the
economic opportunity cost of working in the zone, that is, what opportunities a
worker has foregone by taking a job within the zone. The social opportunity cost
of employment within the zone is called the ‘shadow wage rate’. This is
especially relevant in the case of zones in Asia, which employ a large proportion
of young women and other workers who otherwise may have worked unofficial
jobs whose values are difficult to quantify. In this case, the shadow wage rate is
not the wage rate prevailing in non-zone employment, but an estimation of the
social opportunity cost of other tasks that would have been performed. The
citizens employed in the zone will generate benefits when the actual market value
of their wages paid in the zone exceeds this shadow wage rate. When this is
true, the social benefits derived from generating an additional job outweigh the
costs182, justifying the establishment of the zone and the transfer of labor to it.
180 Warr, Export Processing Zones: The Economics, 75.181 Ibid.182 Jayanthakumaran, “Benefit-Cost, 54.
73
In the free trade zones studied in Asia, the wage rates within the zones
tended to exceed the shadow rates that prevailed outside the zones. In a cost-
benefit analysis of zones in Indonesia, this was also found to be true. The zones
considered in Indonesia are located in urban areas that exhibit rates of
unemployment far higher than those in rural areas and in Indonesia as a whole,
implying that many workers in Indonesian zones were drawn from the
unemployed. For the unemployed, the shadow wage rate approaches zero. This
contributes greatly to the findings that in Indonesia, the shadow wage rate was
found to be .75 times that of the wage rate within the zone183. These findings
show that workers employed within the zone experienced, on average, the benefit
of receiving compensation twenty five percent higher than would have been
received otherwise.
Recalling the importance of government labor policies in Indonesia,
especially those establishing minimum wage rates, it is essential to consider the
effects of such policies on Free Trade Zones. These zones receive a great deal of
freedom from laws that regulate the rest of the domestic economy, including
generous tax holidays and some freedom from minimum wage legislation. Some
zones incentive packages directly specify freedom from union activity and other
regulations184. Although specific information regarding the zones considered in
this chapter is not available, the fact that the majority of assessments of free trade
zones specify freedom from labor laws as this as a definitive incentive warrants
its consideration. Regardless of technical freedom from such regulations, in order
183 Ibid, 58.184 Miyagiwa, Reconsideration, 338.
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to attract workers to the zone, compensation must be comparable to that available
in other available jobs. Empirical findings suggest that in order to do so, firms
within the zones appear to generally adhere to minimum-wage laws, where they
exist185. Additionally, multinational firms face a great deal of international
scrutiny and find themselves in highly visible and politically sensitive positions
that render violations of minimum-wage restrictions more difficult than for their
domestic counterparts186. Firms within the domestic zone are not subject to
international scrutiny and tend to be regulated by more corrupt governing
structures; thus, firms operating within the domestic manufacturing sector often
avoid minimum wage regulations187. Having established the benefits derived from
wages within the zone, it follows to examine the employment opportunities and
patterns that operate within zones.
Employment and Asian Free Trade Zones
Promotion of employment is a major aspect of Free Trade Zone policy.
Although free trade zones’ policies and characteristics vary by country, all of the
economic zones in Asia aim to generate employment188. In the 1970s, the United
Nations Conference on Trade and Development compiled a list of benefits that
developing countries could expect from free trade zones that includes “creation of
employment opportunities”189. Evaluations that exhort the positive benefits of
185 Warr, Export Processing Zones, 144186 Ibid, 144.187 Warr, Export Processing Zones: the Economics, 76.188 Amirahmadi and Wu, Export, 829.189 Ibid, 834.
75
establishing free trade zones stress their positive effects in generating
employment190. Employment effects are most useful to evaluate because
employment generation is the most noticeable economic impact of the zones191.
There are many theoretical benefits predicted by the establishment of a
Free Trade Zone. In a cost-benefit analysis, potential benefits and negative results
were explored in the categories of employment, foreign-exchange earnings,
domestic raw materials, domestic capital equipment, taxes and other revenues,
domestic profit, electricity use, infrastructure and administrative costs, and
domestic borrowing. Of the expected benefits predicted to result from the
establishment of Free Trade Zones, in Asia these benefits were realized in
employment, but not in other predicted areas192. In order to fully evaluate the
employment effects of free trade zones, it is essential to fully consider the impact
on both generating and sustaining employment. This involves considering the
rapid turnover experienced by employees and the prospects for employment over
time. It also must involve a consideration of the zones impact on aggregate
employment in the region where it is located, not simply the impact on workers
who find employment within the zone.
Asian free trade zones have proven particularly successful in short-term
employment generation193 because Asian developing countries exhibited a large
surplus of cheap, unskilled labor that attracted a great deal of labor-intensive
manufacturing industries. In 1975, total employment in Asian FTZs was only .13
190 Xiangming Chen, The Evaluation of Free Economic Zones and the Recent Development of Cross-National Growth Zones. (??: Blackwell Publishers, 1995): 594.191 Ahmirahmadi and Wu, Export, 830192 Jayanthakumaran, Benefit-Cost, 62.193 Amirahmadi and Wu, Export, 836.
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million, but it reached over .3 million in 1986 and was nearly .4 million in 1990.
Of the Asian economies considered, by 1990, Indonesia was included along with
India and Sri Lanka as having experienced the fastest growth in employment194.
In Indonesia specifically, employment in free trade zones grew from 13,000
workers in 1986 to 50,000 in 1990195, compared to an aggregate employment
growth in Indonesia from 68,338,000 to 85,702,000 in the same period196. When
considering the impact of free trade zones solely on the grounds of employment
generation, analysis shows unambiguously that zones in Indonesia are
economically efficient, generate returns well above the estimated opportunity
costs, and act as an important source of employment197. These results are based
on short-term evaluations that consider only workers actually employed within
these zones, and are evidence that the free trade zones can function efficiently as
tools to absorb surplus labor in the initial stages of development198. These short-
term findings are temptingly promising when ascertaining the effects of FTZs on
the labor market, as Indonesia exhibits a high degree of surplus labor. In order to
fully evaluate the impact of free trade zones on the labor market, it is necessary to
consider the long run implications as well.
Conclusion: Potential Uses for Free Trade Zones
Disappointingly, long-run evaluations of free trade zones in Asian
developing countries show poor prospects for sustainable development. Benefits
194 Ibid195 Ibid, 837.196 Indonesia: Employment – 2A Employment, General Level. International Labour Organization: Laborsta Statistics <http://laborsta.ilo.org/cgi-bin/brokerv8.exe>: Accessed 29 April, 2008.197 Jayanthakumaran, Benefit-Cost, 63. 198 Ibid
77
derived from increased employment and higher wages have been found to be
limited to very short-term effects, suggesting the need for deliberate government
action to diffuse positive social benefits and facilitate development199.
Developing countries usually lack reliable government structures that would be
vital to successfully implementing deliberate diffusion initiatives. Although
evidence strongly shows that free trade zones successfully attract labor-intensive
manufacturing industries that generate employment and can absorb surplus labor,
there is little prospect for long-term development, given the footloose nature of
the industries within the firm and their need for a constant supply of low-skill,
low cost labor. These predictions have been suggested by empirical work done on
zones in East Asia, where evidence shows that in Taiwan and South Korea, two
countries where zones have operated and been effectively monitored, free trade
zones successfully created jobs in their formative and expansion stages, but
subsequently lost momentum200. This suggests that zones established in East
Asian countries to attract foreign investment, generate employment, and absorb
surplus labor will experience the same problems of declining numbers of firms
and thus dwindling employment over time as a result of zones’ inherent
vulnerability to the highly mobile and footloose practices of international
capital201. If this decline occurs accompanied by aggregate development and the
creation of better jobs, as occurred in South Korea and Taiwan, the zone can be
considered a success, but this demonstrates the need for broader, more
comprehensive strategies, not unilateral establishment of FTZs. Indeed, as South
199 Amirahmadi and Wu, Export, 847.200 Chen, Changing, 12.201 Ibid, 19.
78
Korea and Taiwan experienced tighter labor markets resulting from successful
development, many of the foreign firms formerly located in zones in Kaohsiung
and Masun have relocated to lower wage countries202.
Although free trade zones have positive short-term effects, their long-term
prospects for the labor market are not promising. Free Trade Zones generate
employment, but they generate jobs that are oriented toward export markets203 and
do not provide spillover benefits, such as backward linkages, to the local
economy. Additionally, if the free trade zone is large in comparison to the region
where it is located, the zone has the power to restructure the economy, causing
adverse effects on poorer, traditional sectors such as agriculture. Economic
restructuring and migration can cause unemployment outside the zone to actually
rise by attracting unemployed rural workers to the zones and not generating
sufficient employment to absorb the additional attracted workers204.
The benefits derived by free trade zones in developing countries in Asia
are incredibly limited. For the most part, zones have definitely not acted as
“engines of development” 205; instead, they have shown to provide little more than
efficient and productive means of absorbing surplus labor for countries in the very
earliest stages of development. This isolated survey of the specific effects of the
zones shows little evidence of spillover benefits from higher wages and increased
purchasing power to the local economy, but does not evaluate the necessary
literature to fully evaluate these benefits. While there is little direct evidence of
negative effects on labor, even in the very best of cases, “the zones could never be 202 Ibid203 Amirahmadi and Wu, Export, 842.204 Ibid.205 Warr, Export Processing Zones, 159.
79
expected to provide more than a modest part of the solution to the vast
employment problems of these countries”206.
These results imply that while free trade zones may be incorporated as a
small component of larger development strategies to address surplus labor and
unemployment problems, unaccompanied by other large programs, they are
unlikely to provide anything more than a proverbial band-aid to the gaping wound
of social problems inflicted on society by large-scale unemployment.
Furthermore, the establishment of zones can exacerbate the problem by
temporarily mitigating the adverse effects of industrialization and permitting
officials to leave real problems unattended. These zones can also increase the
problem of unemployment by generating further surplus labor by generating
increased migration to regions where zones are located.
Chapter Six: Examination of Batam Island as a Free Trade Zone
Introduction to Batam Island, Indonesia
206 Ibid.
80
Batam Island is located on the north-western tip of the island of Sumatra
and is considered part of the Riau province. Riau is 3300 square kilometers207 and
classified as a relatively resource-abundant province208. Batam is 415 square
kilometers, which is about two-thirds the size of Singapore, and separated from
Singapore by only twenty kilometers. This distance can be easily traveled in a
thirty to forty minute ferry ride. The Riau islands and Batam have a unique place
in Indonesia’s development history that dates back to the late 1960s, even before
export-oriented development initiatives, when it was identified as a potential
logistics and operational base to support offshore oil and gas fields209. Batam
gained greater significance for development in the 1970s as Indonesia began to
implement export-oriented strategies.
207 Siow Chia, “Subregional Economic Zones: A New Motive Force in Asia-Pacific Development”. Pacific Dynamism and the International Economic System (1992) p 248.208 Manning, Regional, 7.209 Caroline Yeoh, Darren Lim, Adeline Kwan, “Regional Co-Operation and Low-Cost Investment Enclaves: An Empirical Study of Singapore’s Industrial Parks in Riau, Indonesia”, Journal of Asia-Pacific Business. v5.n4 (2004): 46
81
In 1971, the Batam Island Development Agency (BIDA) was established
and given responsibility for the development of the island. In 1978, Batam was
given special status as a tax-free bonded zone for export industry210.
Responsibility for the development of the island laid with B.J. Habibie, the
Minister of Research and Technology for BIDA. Habibie sought to develop the
zone under a 1979 Master Plan for Batam by to developing trans-shipment
facilities, establishing industrial states, increasing exports, and providing
infrastructural support211. Habibie entertained a “balloon theory” regarding the
development of Singapore. He asserted that Singapore’s economy had a limited
capacity for growth, and would burst like a balloon if it did not have safety valves
release the pressure by drawing off the excess growth. Habibie recognized the
strategic location of Batam, and attempted to position Batam to absorb this
growth 212. In this early stage of designation, the Free Trade Zone of Batam Island
offered potential investors free importation of all goods intended to be used on the
island, including goods to be processed for export outside of Indonesia213. The
importance of export-oriented initiatives for the development of Indonesia gained
importance in the early 1980s following the collapse of oil prices.
The collapse of oil prices in the early 1980s highlighted the need for
Indonesia to develop a more broad-based strategy that diversified the economy
away from reliance on commodities. The government granted a series of
additional deregulatory concessions intended to stimulate the non-oil sectors of
210 Karen Peachey, Martin Perry, and Carl Grundy-Warr, Boundary and Territory Briefing Volume 2 Number 3: The Riau Islands and Economic Cooperation in the Singapore-Indonesian Border Zone: (Durham: International Boundaries Research Unit, 1998), 9. 211 Yeoh, Lim, and Kwan, Regional, 47.212 Peachey, Perry, and Grundy-Warr, Boundary,1.213 Ibid, 9.
82
the economy to the Batam Free Trade Zone. Policies were designed to improve
infrastructural facilities and liberalize investment to mobilize private sector
investments, including foreign investments214.
These additional unilateral actions on the part of the Indonesian
government largely failed to attract significant foreign investment or enact
developmental changes. A possible explanation is that the infrastructural
development was still focused on supporting the oil and gas industry. The
stagnant nature of the economy is evident in the rudimentary social and economic
infrastructure; for example, in 1989 there was still no centralized power supply
and no international direct dial telephone capacity215. Due to the capital intensive
nature of petroleum refining that supported Batam, the manufacturing sector did
not act as a generator of employment before and thus did not contribute
significantly to development before 1989216.
The Relationship Between Indonesia and Singapore
In 1989, political and economic circumstances were ideal for Habibie’s
balloon theory to come to fruition. Singapore faced a need for an additional
overspill location217 and the Indonesian governments revisited the possibility of
Singapore’s participation in the development of the Riau islands, resulting in an
agreement that entailed joint development of industrial infrastructure on Batam 214 Yeoh et al, Regional, 47. 215 Peachy et al, Boundary, 25.216 Ibid, 5.217 Ibid, 10
83
Island218. This agreement was reached in an effort to assure that Batam not
become a competitor location to Singapore; rather, the highest political levels in
both states endorsed its rapid development as a complementary and cooperative
location to Singapore. Indonesia and Singapore each contributed essential
components to establish a cooperative investment project.
Indonesia granted further concessions to businesses located within the
zone. These concessions included permitting one hundred percent foreign
ownership, subject to divestment of five percent to local ownership after five
years, as compared with the need to divest fifty one percent in fifteen years in the
rest of the country, and a lower minimum capital investment for foreign countries
of US$250,000, compared to US$1 million in the rest of the country. BIDA
opened a Board of Investment office on Batam Island that had the authority to
make autonomous decisions from the head office in Jakarta, and duty payments
were restricted to only the value of the imported raw materials rather than the
value of finished products. Theses laws were designed to make Batam more
viable as an export base, compared to other locations in Indonesia219. Unilaterally,
however, Batam’s potential was hindered by poor infrastructure for business;
namely, poor telephone service, limited capacity and unreliability of energy
supply, congested roads and seaports, and an underdeveloped network220. In order
to overcome Indonesia’s reputation for an inefficient state and a lack of
infrastructure, a partner was needed. The success of Batam Island in attracting
foreign investment depended greatly on its relationship with Singapore.
218 Ibid, 13.219 Ibid, 14.220 Ibid, 8.
84
Since Batam Island’s inception as a Free Trade Zone, its proximity to
Singapore has played an indispensable role. The Singapore-Indonesian border
zone and especially the Riau islands including Batam has long been recognized as
capable of attracting labor-intensive industries, and activities with extensive space
requirements that are closely linked with Singapore-based activity221, as alluded to
by Habibie’s “bubble theory”. Although the 1989 agreement included vast
liberalization and deregulation on the part of the Indonesian government, the
Singaporean government’s decision to develop as self-contained industrial estate
on Batam Island in partnership with Indonesian investment interests provided the
direct stimulus to the investment boom and rapid change of Batam Island222. By
1989, Singapore had gained a unique place within Asia as an important
distribution, testing, design and administrative center for production that was
dispersed across a of lower wage countries in the region223. Batam’s unique
geographical location, Indonesia’s economic comparative advantage in low-skill
labor-intensive manufacturing, and Singapore’s position in Asia resulted in a
seemingly ideal combination for rapid development.
BatamIndo Industrial Park: The Best of Both Worlds
In January of 1990, Singapore and Indonesia decided to construct the
BatamIndo Industrial Park on Batam Island as a joint venture. The land allotted
to BatamIndo consists of 80 percent of the industrial space on the entire island of
Batam224. This park was intend to act as an enclave that could benefit from the 221 Yeoh et al, Regional, 44222 Peachy et al, Boundary, 1. 223 Ibid, 13.224 Ibid, 16.
85
concessions granted by the Free Trade Zone on Batam island coupled with
Singapore’s infrastructural ability to attract foreign investment and rapidly
develop labor-intensive manufacturing industries. This approach offers a unique
combination of competitive labor costs and excellent infrastructural facilities,
which were the two most frequently cited factors that determined multinational
companies’ decisions to invest225. The strategy for marketing the joint venture
was to promise the efficiency of Singaporean infrastructure and management,
combined with the much lower operating costs of Indonesia226. The BatamIndo
Industrial Park attempted to combine savings on labor and land in Indonesia with
confidence in the delivery of a high quality and efficient operating environment
provided by Singapore227. The project’s outcome has depended greatly on the
specific roles delegated to each party and the resultant arrangement that attempts
to maximize the resources and connections of each partner228.
Singapore’s role in the development of Batam has been to increase
investor confidence. Singapore Technologies Industrial Corporation and Juron
Environmental Engineering are responsible for forty percent of the BatamIndo
project. They have designed, physically constructed and developed the industrial
park, and continue to manage it. BatamIndo is designed to be entirely self-
contained, and as such has established economic linkages through Singapore, not
Indonesia, by function of design, construction, and maintenance. BatamIndo has
an independent power supply, water treatment plant, sewerage system, a
commercial center with a market and shops, a bank, a mosque, and a 24-hour 225 Yeoh et al, Regional, 51226 Peachy et al, Boundary, 1.227 Ibid, 23.228 Ibid, 16.
86
medical center. Singaporean developers built dormitories for workers and pre-
constructed factories of various sizes for rent or purchase by investors229.
BatamIndo’s telephone and communications system is linked into Singapore’s,
which provides a high quality service for tenants, but does not permit integration
into Indonesia’s domestic telephone network230. Singapore’s involvement in the
project brings “a reputation for fair and efficient management”231, proximity to
modernized and globally integrated facilities, and business confidence in
Singapore’s reputation in industrial development232. Singapore acts to elevate the
quality of the joint venture of BatamIndo Industrial Park.
Indonesia has provided low-cost labor and land to the BatamIndo
Industrial Park project. Indonesian investors led by the Salim group control sixty
percent of the project. The Salim group is responsible for labor recruitment233, a
job that is undertaken by the Tunas Karya subsidiary. Tunas Karya has branches
in Java and Sumatra, works closely with the ministry of labor to attract eligible
candidates, and is the only group officially permitted to recruit employees for the
BatamIndo park.234 In 1998, Tunas Karya was reported to have recruited between
8000 and 10,000 new recruits a year235, predominantly young females from the
main Indonesian islands to work two year contracts236. Indonesia contributes low
cost labor and land and government commitment to the success of BatamIndo
Industrial Park, but relies heavily on support from Singapore.
229 Ibid, 16.230 Ibid, 26.231 Ibid, 16232 Ibid, 22.233 Ibid, 16234 Ibid, 38235 Ibid, 37236 Ibid, 16.
87
BatamIndo Industrial Park began allowing investment in 1991, officially
opened in 1992, instigating a surge in investments by Singapore companies and
foreign multinational companies based in Singapore237. Batam’s first investors
were multinationals who were operating in Singapore and moved their assembly
plants to Batam. These companies included AT&T, Philips, Sumitomo, Smith
Corona, Seagate, Sanyo, and Thompson238, who opened factories that used young,
low-skilled predominantly female labor in assembly operations of labor-intensive
products such as electronics operations, component assembly processes, and
supporting activities to the electronics sector including plastic molding and
packaging239. Other companies chose to establish their labor-intensive activities
in the park to be combined with capital intensive activities located on Singapore;
for example, Seagate and Thomson established factories employing 450 and 1000
workers respectively to assemble parts to be used on Singapore240. The
establishment of the BatamIndo Industrial parks caused an economic boom,
marked by an eight-fold increase in the value of its exports and a fifteen-fold
increase in annual private investment241.
The BatamIndo joint project was rapidly successful in attracting foreign
investment. In 2002, cumulative investments were valued over US$1 billion and
export value topped US$2 billion. The number of factories operating in the park
increased from seventeen in 1991 to 88 in 2002242. Taken alone, these figures
237 Chia Siow Yue, “Sub-regional Economic Zones in East Asia” in International Trade and Migration in the APEC region : (New York: Oxford University Press, 1996), 144.238 Peachey et al, Boundary, 22.239 Ibid, 23.240 Ibid, 24.241 Ibid, 1.242 Yeoh, et al, Regional, 48.
88
appear simultaneously impressive and successful; however, one must carefully
consider the nature of the park’s impact on Indonesia. Recall the high degree of
foreign ownership permitted on Batam Island that was included as part of the
government’s incentive package of concessions. This foreign ownership
translates into the capital gains being accrued to the foreign firms, not being
reinvested in the Indonesian economy, highlighting the overwhelmingly important
position of employment and wages on ascertaining the social benefit of
BatamIndo Industrial Park. Indonesia’s major contribution to the success of the
park is the provision of low-skill, low-cost labor to act in combination with
Singaporean inputs and create labor-intensive outputs. For Indonesia, evaluating
the success of the zone based on the impact on the workers in the park and on the
labor market of the region is logical because the high levels of foreign ownership
and control suggest they are the most direct recipients of benefits.
BatamIndo: An Incentive for Migration
The rapid economic growth of BatamIndo and the surrounding Batam
Island caused a massive population influx to Batam Island and Riau province.
The population of Riau was approximately 3.3 million in 1990 and reached four
million in 1995 mainly as a consequence of the development of Batam243. This
shows that the massive influx of migrants was a function of the establishment of
BatamIndo and is unlikely to have occurred otherwise. The population on Batam
expanded from 7000 in the late 1970s to over 146,000 in 1993. Immediately
preceding the joint venture of BatamIndo, the workforce on Batam only expanded
243 Peachey et al, Boundary, 5.
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from 9800 in 1988244 to 16,330 in 1990245. Between only 1990 and 1993, the
workforce exploded and grew to 44,000246. This shows that although Batam
Island had been a designated Free Trade Zone since 1978, the establishment of
BatamIndo drastically increased the workforce. Although increased population is
to be expected from the establishment of an enclave specifically created to utilize
and recruit low-skill labor, the massive migration associated with the
establishment of BatamIndo is of great concern to establishing the impact of the
zone on Indonesia.
The establishment of BatamIndo on Batam Island reflects an attempt to
utilize geography to manage population in-migration compared with a mainland
setting in a low-income developing country with high levels of labor mobility and
unemployment247. Planners hoped to control massive unofficial immigration by
exploiting the Batam’s position as an island and sought to control quality and
characteristics of migrants by establishing official recruitment systems. In reality,
the ‘Batam boom’ attracted large flows of legal and illegal migrants, or migrants
not officially recruited by Tunas Karya to legally fill new jobs. This massive
population added to the challenges already faced by the island248. These migrants
were attracted from a variety of backgrounds and locations in Indonesia by the
investment boom on Batam Island.
BatamIndo Industrial Park and the employment it generates attract
migrants to Batam from all over the Indonesian archipelago, with the majority
244 Yue, Sub-regional Economic Zones in East Asia, 149245 Peachey et al, Boundary, 5.246 Yue, Sub-regional Economic Zones in East Asia, 149.247 Peachey et al, Boundary, 1.248 Ibid, 3.
90
migrating from West Java, West and North Sumatra, and neighboring areas in
Riau249. These migrants were generally found to be young, of productive working
age, and initially predominantly unmarried young men, although as development
progressed, many industries targeted young, unmarried female employees250.
These young women are recruited by Tunas Karya to work in low-skill labor-
intensive manufacturing jobs in the BatamIndo industrial park under very strict
stipulations. Eligibility for factory jobs is restricted to single females ages
eighteen to twenty four. As an official policy, “the BatamIndo Industrial Estate
does not hire women over the age of twenty four and pregnancy is just cause for
dismissal”251. Although only Tunas Karya officially has the authority to recruit
and hire migrant workers, the reality of the situation is that in 1996, “only about
50% of the workers at BatamIndo were recruited by Tunas Karya”252. This shows
that at least half of the workers at BatamIndo migrated to Batam without a pre-
arranged contract and found work. Migrants were attracted to the region in an
effort to better themselves and attain a higher standard of living.
Batam Island is a part of the Riau, a resource-rich province that as such
had higher minimum wage rates. In 1996, Batam’s per capita income and wage
levels were higher than other peripheral areas of Indonesia253. Minimum wage
rates are regulated by the Ministry of Labor, called the DEPNAKER, that takes
into account regional variability when setting minimum wage. Batam’s 1996
minimum wage was Rp7350, compared to Rp 5,2000 in Jakarta, and was the
249 Ibid, 32.250 Ibid.251 Ibid, 32.252 Ibid, 40.253 Yue, Sub-regional zones in East Asia, 151.
91
highest in Indonesia254. This massive wage discrepancy, coupled with BatamIndo
and Batam Island’s constant expansion, clearly provides large incentives for
migration even in the presence of unemployment, in which case time spent
unemployed waiting for employment would be worth the eventual payoff of
gaining employment within the zone. Although the local newspaper reported in
September of 1996 that “up to 50% of companies were violating the minimum
wage”, the fact that “for every person that leaves a job there are ten others waiting
for the work”255 demonstrates that migrants perceived benefits from relocating
from rural areas or other urban areas to Batam island. The excess migration and
increasing surplus of labor is a threat to BatamIndo’s future by way of creating
social costs, and has important implications regarding the impact of BatamIndo on
labor in Indonesia.
Migration to Batam has outstripped job creation, sustaining and increasing
unemployment. The firms in BatamIndo seek to hire predominantly young,
single, low-skilled females, yet migrants are comprised of a diverse cross-section
of the population. Many of these migrants lack special skills or expertise, and
face difficulty finding employment in the formal sector256. In addition to new,
unofficial migrants, official employees are employed on a contract of generally
two years. Policy states that “after the completion of the contract, workers are
expected to return to their place of origin, unless the employer offers and
extension”257. Initial contracts and migration are facilitated by Tunas Karya, yet
contract extension or expiration takes place on a bilateral level between the 254 Peachy et al, Boundary, 38255 Ibid, 39.256 Ibid, 32.257 Ibid, 38
92
employee and the employer; thus, the official migrant faces no incentive and is
unlikely to leave BatamIndo and Batam. Although Batam initiatives have
unquestionably created employment, it appears they have contributed more
significantly to unemployment, based on the fact that unemployment rose the
most in the resource-rich provinces of Sumatra, including Riau258, and the massive
in-migration to Riau and Batam Island were a result of the establishment of the
BatamIndo Industrial Park259. This unemployment coupled with Batam Island’s
unique status as a Free Trade Zone has created a slew of social problems that
hinder further development.
Social Costs: Insufficient Housing
Many of the social problems on Batam Island stem from housing
problems. Housing opportunities available to unskilled workers on Batam Island
can be divided into three categories: officially provided dormitory housing
managed by BatamIndo, officially constructed and BIDA sanctioned Rumah
Sanagat Sederhana (RSS) units, and unofficial, illegal squatter settlements known
as Rumah Liar, or “wild houses”, and abbreviated as ruli. An evaluation of where
workers live and what future housing opportunities are available to them is
illustrative of long-term development prospects for Indonesian workers on Batam
as a result of the establishment of BatamIndo.
By far the most troublesome housing variety is the Ruli. Ruli units are
illegal squatter settlements that provide squatters with abysmal housing that lacks
258 Manning, Regional, 9.259 Yue, Sub-Regional, 151-152.
93
access to public services such as water, sewage, drainage, local roads, electricity,
or telephones260. These conditions suggest the existence of common problems
afflicting overpopulated, dirty areas such a disease, malnutrition, and other
deleterious effects not conducive to healthy employees. Ruli have developed to
house the sizeable and increasing group consisting of low-income and unskilled
migrants that have come to Batam unofficially in search of employment. For this
group of migrants, Ruli are the only accessible source of housing due to housing
policies in the region261. These policies explicitly stipulate who has the authority
to build and where they may do so, preventing entrepreneurs from entering the
market and providing affordable housing. In 1996, 20,000 ruli units were
estimated to be scattered across Batam island in anywhere from fifty nine to
eighty locations, housing approximately 100,000 people262. Locations for units
include forested areas of Batam that have been designated as reserve or water
catchment areas, and other currently undeveloped land that is otherwise
designated263. For example, squatters established ruli units along a new highway
that was built to link Batam with other islands despite strict prohibitions and
official warnings. These squatters ignored prohibitions and warnings, hoping that
their well-located plots would bring lucrative business opportunities or eligibility
for land compensation when development occurred264. As BatamIndo attracts
more investment, migration increases and more ruli units are established on land
already designated for other, industrial uses265. An estimated 4000 ruli units are
260 Ibid, 38.261 Ibid, 30.262 Ibid263 Ibid, 32.264 Ibid, 34-35.265 Ibid, 32.
94
constructed each year, consuming four square kilometers already officially
designated for other purposes266. Ruli units pose significant investment, social,
and policy challenges to Batam Island.
Ruli units house workers in various degrees of poverty and squalor.
Batam planners attempt to market the island as the next Singapore, touting high
quality infrastructure and competent management. In this light, the ruli units are
often described as the greatest challenge currently facing Batam’s planners
because developers attempting to market their properties find it nearly impossible
to make potential investors feel securely removed from the uncomfortably
polarized development taking place on Batam267. Ruli units threaten the
sustainability of Batam’s investment attractiveness to multinational companies by
exposing investors to perspectives and dimensions that planners do not want
associated with the parks268. Because the ruli units are often located on previously
allocated land, officials must clear these settlements rather than officially sanction
them and assist their improvement269.
Government clearings of ruli settlements are frequent, disruptive, and
often fruitless in achieving the long-term goal of eliminating such settlements.
When these settlements are cleared, displaced residents are responsible for
rebuilding their homes on temporary resettlement sites and transitioning into the
formal property market within a two-year time frame. If a worker fails to meet
this legal housing requirement, they are expected to leave Batam, although in
1998, this policy had yet to be enforced. The constant clearing of ruli settlements 266 Ibid267 Ibid, 30.268 Ibid, 32-33.269 Ibid, 33).
95
simply entices residents to relocate to other illegal settlements as close to urban
services and employment opportunities as possible270. It does not remove their
unsightly blemish on Batam Island’s marketability, nor does it facilitate
movement into the formal housing market. Additionally, the constant relocation
has detrimental effects on the workers by inhibiting community building. There
is no confidence in tenure in ruli settlements because people live under the
constant pall of the threat of clearance. This inhibits squatters from making either
psychological or financial commitments to Batam that are considered “vital to
stabilize Batam and transform it from a transient place of temporary migrants to a
place with identity, a sense of community, and a shared sense of social norms”271.
Lack of community development suggests lack of long-term stability and
progress.
Some workers are fortunate enough to inhabit official Rumah Sangat
Sederhana (RSS) units. RSS units are small and relatively inexpensive housing
units built by BIDA that are intended to benefit new workers. Approximately half
of new units are stipulated for allocation to those who have never owned a
property or who are living in squatter settlements and meet a set of seemingly
basic requirements including a ten percent down payment and proof of a reliable
source of income272. In reality, this rarely occurs due to eligibility problems and
the deeply corrupted system of allocation. The majority of workers (an estimated
seventy-five percent) who have never owned property or who live in ruli
settlements do not have a reliable source of income and are rendered ineligible in
270 Ibid, 33271 Ibid, 36.272 Ibid, 33-34
96
a bafflingly Catch 22-like situation that perpetuates many workers’ inability to
join the formal sector. This leaves developers available to allocate these homes to
those who offer the highest price rather than demonstrate need. Additionally, the
rate of clearance of Ruli settlements far exceeds the rate of construction of RSS
units. In 1996, 500 RSS units were built over four months, while between 500
and 600 ruli units were dismantled in only six weeks273. As a strategy intended to
solve or at least mitigate the Ruli problem, the RSS program appears to be a
failure.
The final housing opportunity for workers on Batam island are the
dormitory-style housing units provided by employers within the BatamIndo
Industrial park to contracted workers. Although BIDA has attempted to mandate
that all major employers provide accommodation, only BatamIndo has done so
and only to a limited extent. In 1996, BatamIndo provided dormitories with only
26,000 beds, accounting for only half of their industrial workforce274.
Furthermore, only workers recruited and hired through Tunas Karya are eligible
to be housed in on-site dormitories275. The remaining workers are forced to seek
their own housing, often in Ruli settlements. BatamIndo requires that employers
support the housing of their recruits, whether they do it through dormitories or
payment of housing allowances276. In 1997, BatamIndo expressed plans to build
additional dormitories to address the problem of homeless employees, but their
commitment to do so was questioned277. Many employers in BatamIndo “prefer
273 Ibid, 34274 Ibid, 34275 Ibid, 40.276 Ibid, 38277 Ibid, 41.
97
their workers to stay in the dormitories” and assert that the controlled
environment maintains worker productivity, whereas outside habitation puts it at
risk278. Regardless, the current housing system is dismally inadequate to
accommodate Batam’s growing population.
Some employers prefer to hire workers that seek out and maintain their
own housing in lieu of providing dormitories. With an ever expanding workforce,
the constant expansion of dormitories is costly, and some employers would rather
use the capital and land to expand industrial activities279. Workers that are not
housed on site typically can be obtained at far lower costs and hired on shorter,
more flexible contracts280, making them more attractive to employers seeking
cheaper, temporary labor. From a social standpoint, problems reported among
residents of dormitories do not suggest that they foster a stable and healthy
environment for long-term development. Instead, the problems suggested “stress,
frustration, homesickness, and monotony in their new situation”281. Contrastingly,
workforces that possess appropriate housing have access to a social environment
that encourages permanent settlement are more viable and sustainable, as they
demonstrate a greater long-term commitment to Batam than those living in the
dormitories282. Batam lacks such housing and environment, suggesting the lack of
community development and social infrastructure that poses high social costs on
Batam Island.
278 Ibid, 39.279 Ibid, 34.280 Ibid, 34.281 Ibid, 40.282 Ibid, 48.
98
The housing dilemma on Batam Island is indicative of the plethora of
social woes that stem from the unemployment and underemployment that result
from large flows of legal and illegal migrants. These woes impose high social
costs on the community and contribute excessively to planning challenges on
Batam. Unlike the Batam Island Free Trade Zone and the BatamIndo Industrial
park, these problems are not geographically contained and can have deleterious
effects on the surrounding areas. In Riau, there is evidence of social problems
arising from the massive in-migration from other parts of the country283. Riau has
experienced traffic congestion, environmental pollution, a rise in crime and vice,
and general pressure on its local infrastructure as a result of the influx of labor
seeking employment on Batam island284. From the perspective of long-term
development and stability for workers, these issues are problematic because they
will not foster healthy and sustainable environments. From the perspective of
increasing foreign investment and maintaining high levels of growth, these
problems spell disaster, and if left unaddressed they threaten to undermine the
investment attractiveness that Batam has managed to establish285. Besides the
housing problem, Batam island is plagued with prostitution, crime, and increased
evidence of community disintegration.
The Social Costs of Rapid Expansion
The rapid expansion and development of Batam Island has spawned a vast
and shocking sex industry. Organized prostitution was observed in over twelve
283 Yue, Sub-Regional Economic Zones in East Asia, 152.284 Ibid.285 Ibid, 35.
99
settlements in 1998286. Residents of the island face extraordinarily high costs of
living, pressure to send wages home to families, and sometimes insurmountable
difficulty in securing stable employment. These difficulties, occurring within the
context of a fractured and largely absent community structure, have fostered
prostitution as a common solution to economic troubles. Many girls moonlight as
prostitutes by night, while working low-skill labor-intensive manufacturing jobs
by day. The industry is fueled by male migrant workers, expatriate management,
and weekend visitors from Singapore, who finance this market. The government
has taken a peculiar approach to ‘solving’ (used loosely) this problem: “in an
attempt to contain and monitor prostitution, the local government has directed
some of these prostitution activities onto targeted legal settlements on Batam and
on islands just off the coast” 287. The Department of Social Affairs has supervised
this move, and indicated that plans for other such “enclaved prostitution areas”
were currently in the works. In addition to widespread prostitution, a number of
syndicates in the illegal sex trade of women exploit the ease of export offered on
Batam island by selling young girls to work as prostitutes in Johor Bahru and
Kuala Lumpur in Malaysia’s thriving sex trade288. These developments do not
suggest that Batam Island possesses the adequate opportunities for employment
necessary to sustain development.
Unemployment and underemployment have contributed to community
disintegration that hinders stable development. Employment on Batam island is
difficult to come by, and even when attained it is inherently transient in nature.
286 Peachey et al, Boundary, 35. 287 Ibid, 35.288 Ibid, 36
100
These factors have given rise to a high crime rate, composed primarily of theft
and violent theft, but also including rape, weapons charges, and gambling
offences. The difficult conditions endured by workers have created such a
“highly competitive and hostile atmosphere”289 that foreign workers who have the
choice predominantly choose to work from Singapore rather than live or stay
unnecessarily on Batam290. These conditions persist and worsen as what little
community there is on Batam continues to unravel.
The population of Batam is composed nearly entirely of recent migrants
from all over Indonesia, a peculiarity that renders achieving social stability
formidably challenging291. The community is marked by a severe lack of social
infrastructure, evidenced by a complete lack of schools, health units, training
centers, day care centers, and recreation spaces292. The current generation of
workers on Batam is the first, but as they continue to have children, the demand
for education and health services will rise. In 1995, 30,000 children under the age
of five were immunized on Batam293, indicating that the population is growing
and diversifying by age. Although workers in the formal sector officially are on
short contracts, they have often migrated from rural villages in search of greater
opportunities or to escape a relative paucity of opportunity. These migrants view
the opportunities on Batam as far greater than those in their villages of origin and
will stay and establish their lives there294 rather than return to their places of
origin. In this light, it is crucial that they be provided with basic infrastructure,
289 Ibid, 35290 Ibid, 36.291 Ibid, 36.292 Ibid, 37.293 Ibid, 37.294 Ibid, 37.
101
services, and opportunities to maintain and foster the development of stable,
productive, and healthy communities295. Such communities are desirable to all
interests, especially attracting long-term foreign investment.
Prospects for Change
Regrettably, it appears that these pressing issues will be remain
unchanged, resulting in further community disintegration. BIDA is the
governmental authority on Batam Island, and it would logically fall to them to
address these high and rising social costs. BIDA has chosen to concentrate its
planning efforts on economic development, because “social planning and
governance concerns have not been viewed as their responsibility”296. These
social problems stem from the massive unemployment generated by high levels of
migration coupled with the gaps in community as a result of the speed at which
transformation has taken place. These issues must be addressed in order to
maintain Batam Island as an investment destination and thus a generator of
employment. When surveyed, firms within BatamIndo indicated that “shortage of
skilled labor” and “significant problems recruiting R&D personnel” were “major
constraints” to their manufacturing operations297. This curious result indicates that
although low-cost labor is an important component and a significant initial
attraction, further development of labor is needed to sustain development from
both the point of view of employers needing labor and workers needing healthy
communities. 1998 saw a “slowdown in investor interest in the Park” that was
295 Ibid, 37.296 Ibid, 35.297 Yeoh et al, Regional, 58.
102
most pronounced by a “notable decline in European and American
multinationals”298, indicating that although Batam still offers low-cost labor
combined with Singaporean infrastructure, a deteriorating community may act as
a disincentive for investment. This combination is not sustainable in the absence
of a commitment to the long-term development of workers.
The Indonesian government’s approach of establishing BatamIndo and
cooperating with Singapore to achieve rapid results to expedite development by
creating enclaves of investment, protected from the diseconomies and constraints
of the surrounding environment299. Social costs arose as negative externalities
associated with the speed of Batam’s economic development and were especially
created by massive flows of migrants300. These problems must be addressed to
develop a committed and responsible workforce that would be capable of taking
Batam’s development further.
298 Peachey et al, Boundary, 47.299 Peachey et al, Boundary, 46.300 Ibid, 48.
103
Chapter Seven: Conclusions
Theoretical Predictions for Indonesia, Batam Island, and BatamIndo
Industrial Park
All of the theoretical analyses of free trade zones make basic assumptions
about the host country that must exist to consider applying the models. The
theories that follow a 2x2 Heckscher-Ohlin model, from Hamada onward, use
host countries that are labor abundant and export their labor intensive good in the
absence of the zone. Miyagiwa’s approach, usinga 3x3 model that acts as a
“hybrid of the Ricardo-Viner and the Heckscher-Ohlin models”301 shares this
quality, with the host country exporting their labor intensive output before the
introduction of the free-trade zone. In this model, the third sector is created along
with the establishment of the zone and is export-oriented by definition. The
consideration of a third sector and third input introduces the concept of possible
positive backward linkages established by generating demand for the domestically
produced intermediate input and the transfer of technology to the nation and skills
to the workers302. These models all proceed from the assumption of a developing
country that is labor abundant.
Indonesia fits many of the theoretically established criteria of a nation
where the establishment of a Free Trade Zone is a viable option as a part of an
export-oriented development strategy. Indonesia is a labor abundant country and
since the export-oriented development push has exported labor-intensive goods
301 Miyagiwa, Welfare, 340302 Din, Export.
104
such as textiles and garments. Indonesia’s transportation infrastructure is
adequately developed to allow for intra-Indonesian mobility, which supports the
assumption of labor mobility. Indonesia’s industrialization process created a
significant split between rural and urban areas that has resulted in rural areas that
are neither modernized nor sufficiently well-integrated to support modern
industries. This supports locating a free trade zone in an urban location that has
access to adequate infrastructure, even though locating the zone in a rural location
would more adequately address employment and migration problems, because
establishing the zone in a rural area is simply not feasible. Indonesia is afflicted
by significantly high levels of corruption to negate the possibility of creating a
zone to raise welfare by increasing national income. In order for the increase in
national income to result in a benefit for workers, some sort of transfer
mechanism must exist and be administered at the government level, which is
simply not feasible in the case of Indonesia because of high levels of corruption
and inefficiency. Indonesia’s persistently high levels of unemployment illustrate
the existence of surplus labor, suggesting a labor market failure. Additionally,
Indonesia’s industrialization process has been marked by a massive rural to urban
migration with the highest unemployment levels located in the urban areas that
had higher, rigid minimum wage rates. This migration can clearly be
characterized as Harris-Todaro migration, and the resulting unemployment can be
described as Harris-Todaro type unemployment.
Indonesia’s economic characteristics and background support the
establishment of a free trade zone. The government has demonstrated a desire to
105
implement export-oriented development strategies by encouraging
industrialization. A theoretically successful Indonesian zone must be located in
an urban area and should attract labor-intensive industries to absorb surplus labor
and alleviate the Harris-Todaro-type unemployment. Such a zone should
theoretically alleviate unemployment to the benefit of workers and ease social
costs associated with high levels of unemployment to the benefit of Indonesia as a
whole.
The assumptions that define theoretical free trade zones apply very closely
to Batam Island and the BatamIndo Industrial park. The Indonesian government
has designated Batam a free trade zone and granted businesses located there
nearly every concession that defines the incentive structures that create zones.
Businesses on Batam Island are granted partial freedom from customs duties on
imports of inputs and capital used in the production of exportables, restricted only
to the value of the raw materials rather than the value of the finished products.
They do not face any quotas on imports or exports and are not subject to foreign
exchange controls. There are few restrictions on profit repatriation for workers or
employers, as workers are free to consume within the zone and employers have
close to no restrictions on profits earned in the zone. Businesses are granted
generous tax holidays. The restrictions on foreign ownership are minimal,
permitting 100 percent foreign ownership with five percent divestment to
Indonesian ownership within five years, compared to the restrictive policy of
fifty-one percent divestment within fifteen years that dominates the rest of the
country. Administrative procedures are minimal and completely separated from
106
the notoriously inefficient Indonesian state by devolvement of full management to
the autonomous Batam Island Development Agency. Administrative procedures
are additionally facilitated and simplified by the Singaporean management of the
infrastructure of BatamIndo. Based on its incentive structure, Batam Island and
the BatamIndo Industrial Park should behave like a theoretical zone.
Batam Island’s unique relationship with Singapore permits the BatamIndo
Industrial Park to behave more like the enclaved zone described by the models.
BatamIndo is designed to be almost entirely enclosed from its surroundings,
comprised entirely of efficient, modern infrastructure from Singapore and low-
cost labor from Indonesia. This mimics models almost perfectly by isolating the
zone from the host country except for access to labor as an input. The BatamIndo
Industrial Park uses the incentive package of concessions granted by the
Indonesian government on the island to define itself as an FTZ, and combines
these with structural aspects from Singapore that create the necessary
infrastructure to actually function as an FTZ. It is the combination of Indonesian
labor and host country status with Singaporean infrastructure that define the
BatamIndo Industrial Park as a zone that theoretically should behave like the
FTZs described in the models.
The Batam Island Free Trade Zone and the BatamIndo Industrial Park
specifically fit the assumptions in the models sufficiently and thus theoretically
should have alleviated Harris-Todaro type unemployment. The firms located in
the park produce mostly intermediate components for electronics or assemble
simple electronics. These industries are the low-skill, labor-intensive industries
107
that models predict should generate benefits to workers in the form of jobs created
and additional wages paid. The Park is located on Batam Island, an urban
location characterized by a relatively high minimum wage rate that has caused
Harris-Todaro migration. This migration has resulted in high levels of Harris-
Todaro type unemployment, a necessary prerequisite for the success of the
models seeking to use zones to alleviate unemployment303. Although these
models predict different results regarding the affects on national income and other
welfare indicators, they all predict that the establishment of a free trade zone in
an urban area that specializes in labor intensive manufacturing should alleviate
unemployment and generate benefits to Indonesian workers.
The BatamIndo Industrial Park most closely resembles a 3x3 model
similar to that used by Miyagiwa when considering the effects of free trade zones
on welfare and employment304. The majority of industries located within the Park
produce labor-intensive, export oriented electronic components. These outputs
require the inputs of foreign capital, Indonesian labor, and other technologically-
advanced intermediate inputs. If the industries in the zone produced less
technologically advanced outputs such as garments or footwear, there could be
backward linkages created by the demand generated for Indonesian textiles or
other commodities; however, this is not the case given the information available
on the industries located in the Park. Miyagiwa’s model best describes
BatamIndo because it considers the sector within the zone as an export-oriented
diversification of the manufacturing sector that would not have existed without 303 Young and Miyagiwa, Unemployment, 397-405; Miyagiwa, Locational, 187-203; Jones and Marjit, Labour-Market, S76-S93; Chaudhuri and Adhikari, Free, 157-162.304 Young and Miyagiwa, Unemployment, 397-405; Miyagiwa, Locational, 187-203; Miyagiwa, Reconsideration, 337-350.
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government intervention and the existence of the zone305. Miyagiwa uses and
expands upon this model to explain cases for rural versus urban locations306 and
incorporate Harris-Todaro type unemployment307. These models all predict that
the establishment of an urban, labor-intensive zone will result in increased
employment, to the benefit of workers.
Reality: A Comparison of Results to Predictions
The evidence available on the performance of the BatamIndo Industrial
Park does not reveal success in alleviating urban Harris-Todaro type
unemployment as predicted by the models. BatamIndo became operational in the
early nineties and immediately attracted formerly Singapore-based multinational
companies seeking to gain access to low cost labor while simultaneously enjoying
modern infrastructure and the incentive package available on Batam Island.
BatamIndo grew rapidly, reporting a fifteen-fold increase in annual private
investment between 1991 and 1998308 and an increase in factories from seventeen
in 1991 to 88 in 2002309. This rapid increases in investment and firms were
accompanied by an increase in jobs, as these industries are labor-intensive and
hire workers from Indonesia. BatamIndo actively recruited workers from urban
areas of Indonesia, including Java and Jakarta. The rapid increase in jobs coupled
with location in an urban setting and active recruitment of workers from other
urban settings theoretically should have, all else equal, led to decreases in
305 Miyagiwa, Welfare, 341306 Miyagiwa, Locational, 187-203.307 Miyagiwa, Unemployment, 397-405.308 Peachey et al, Boundary, 1.309 Yeoh et al, Regional, 48.
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unemployment in both Riau and other urban areas. Even though the number of
workers employed on Batam increased, a decrease in unemployment did not
occur.
The period following BatamIndo’s establishment during its rapid growth
and expansion was marked by notable increases in unemployment in urban areas.
Between 1993 and 1999, unemployment in urban areas increased from between 2
and 4 percent to 10.5 percent310. Although rural unemployment rates rose as well,
urban unemployment rates outstripped them. Unemployment rates were highest
in resource rich provinces including Riau starting in the late 1970s. Theoretically,
the introduction of the BatamIndo Industrial Park in Riau should have absorbed
some of this surplus labor and possible decreased this differential, but Riau
continued to exhibit among the highest unemployment rates through the 1990s311.
Empirical results suggest that BatamIndo Industrial park did not alleviate
unemployment and may have actually exacerbated the problem by providing
incentives for Harris-Todaro migration based on expectations.
Explanations for Differences between Observations and Predictions
One possible explanation for the model’s failure to predict the impact of
the BatamIndo Industrial Park on unemployment is that Indonesia’s problem of
unemployment is far too massive to be affected by one small zone that houses less
than 100 firms. Indonesia’s urban areas demonstrate high levels of presumably
partially Harris-Todaro type unemployment. Even if the 100 firms in the Park
310 Manning, Choosy, 76-77; Manning, Indonesian, 552311 Manning, Survey, 143.
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employed huge numbers of employees, they could not feasibly generate enough
jobs to significantly affect the unemployment rates of the urban areas. Rural to
urban migration has been occurring in Indonesia since the push towards export-
oriented industrialization development strategies began in the 1980s. This
migration is part of a larger demographic shift from an agrarian base to an
industrial base, a transition that necessarily caused changes in employment. Too
much unemployment may have already existed when the BatamIndo Industrial
park was established, so that the surplus labor that was absorbed by the zone was
either too small to impact the rates or immediately offset by larger rural to urban
migrations that contributed to additional unemployment.
Additionally, the establishment of the BatamIndo Industrial Park
coincided neatly with an increase in enforcement of minimum wage rates as
laborers were increasingly employed in wage employment and gained influential
abilities as a group. Minimum wage rates introduce rigidities in the labor market
and provide incentives for rural-to-urban migration, even in the presence of
unemployment. Between 1988 and 1995, the minimum wage rate doubled in real
terms and these rates were more strictly enforced312. Increases in minimum wage
can increase unemployment in two ways: by giving employers the incentive to
substitute capital and other inputs for labor and by increasing the incentive for
Harris-Todaro migration. Recall that workers will migrate from a rural area with
assured employment to an urban area with unemployment when
(rural wage)x(probability of finding rural sector job) < (urban wage)(probability
of finding urban sector job). Viewed in this context, a minimum wage increase
312 Edwards, Labor, 9.
111
simultaneously raises the urban wage and reduces the probability of finding an
urban sector job. If the minimum wage increase is larger than the probability
decrease, the increase in minimum wage will result in more Harris-Todaro
migration and higher unemployment levels. These minimum wage increases may
have been one factor that caused the higher rates of unemployment and migration
that overshadowed observable effects the BatamIndo industrial park had on the
labor market.
The empirical research available that describes conditions on Batam island
suggests that the Park may have exacerbated unemployment by encouraging high
levels of in-migration. The creation of jobs in BatamIndo increased the
probability of finding a job within the urban sector at the higher urban wage,
which may have contributed to increased migration to the area. This increased
migration is suggested by the vast levels of unofficial housing and unemployment
observed on Batam Island. BatamIndo has not been able to grow as quickly as the
population within the area, so employment opportunities are exceeded by the
number of migrants seeking employment within the zone. Unemployment in
Indonesia is a massive problem in all urban areas, not just Riau, and Indonesian
labor is very mobile. BatamIndo created jobs, but simultaneously attracted rural
to urban migration from traditional sectors and urban to urban migration of
unemployed workers.
The observed situation on Batam Island as a result of the introduction of a
Free Trade Zone can not be evaluated as positive when considering the well-being
of the workforce as a whole over time. The colossal social costs of large levels of
112
migration and high rates of unemployment threaten the future of Batam island.
Recall that BatamIndo faced a decline in investor interest towards the end of the
1990s313, a sign of decreased foreign interest and confidence. This suggests that
perhaps even Singaporean infrastructure and management, devolution of authority
from the Indonesian government to BIDA, and an attractive incentive package do
not suffice to overcome Indonesia’s negative investment reputation. Free Trade
Zones are theoretically supposed to maintain adequate separation from corrupt
reputations and stigmas associated with the host country, and BatamIndo has
taken every possible step to do so. BatamIndo’s inability to generate and
maintain high levels of foreign income suggests that establishing Free Trade
Zones cannot overcome these problems without occurring in conjunction with
improvements in the host country.
The available evidence on Batam Island shows little indication of long-
term promise or stability. Unemployment rates remain persistently high and
increasing, and what little official work there is highly transient in nature.
Consider the official hiring practices of firms within BatamIndo. Firms recruit
young women between the ages of 18 and 24 from urban areas. These women
have usually not been previously employed and leave their homes, communities,
and family for the duration of two years, renewable at the discretion of their
employer. These women face termination upon pregnancy and must compete
with younger, new recruits to keep their jobs after two years. These jobs alone
clearly will not result in long term development for migrant workers as the
conditions do not offer future opportunities. Even if these women are able to
313 Peachey et al, Boundary, 47
113
renew their contract twice or three times, they will eventually be faced with
unemployment. Furthermore, they have no opportunity to settle down by starting
a family, as pregnancy is grounds for termination. This shows that even official
positions promote transience and instability that will not foster long-term growth
and development.
The models’ inability to predict and fully explain Batam island
demonstrates a weakness of the static nature of the models that I chose to
evaluate. Even if the employment opportunities generated by the establishment of
BatamIndo has been sufficiently large to alleviate unemployment caused by
Harris-Todaro migration, the existing social problems would most likely still
exist. Two-year contracts that favor young women do not suggest long-term
development opportunities. Additionally, inadequate housing, the thriving sex
trade, and the utter lack of services and community institutions would likely still
exist even if more people were employed. The high social costs that may result
from the transient and fickle job opportunities offered by the footloose industries
the incentive packages succeed in attracting. These industries do not offer
workers any sort of upward mobility or long-term options, and in the case of
Indonesia, this suggests that acting alone, BatamIndo Industrial Park will not
promote viable opportunities for workers over time.
Recommendations for Future Success
In order to use free trade zones to promote development, they must be
structurally changed to promote long-term goals. Labor abundant countries are
right in promoting employment as a development strategy, and logically should
114
seek to attract industries that will employ surplus labor. When modeling labor
solely as an input, the theoretical analyses I selected necessarily ignore the reality
that the labor market is made up of people in order to describe the function and
operation of FTZs. While this is absolutely necessary to constructing a model, it
must be addressed if attempts are made to apply the theory to a “real world”
situation. In reality, people are a fundamentally different input than any other.
They require more than short-term employment; they require housing, food,
water, communities, access to medical care, and a host of other institutions and
services. When these needs are not available, as on Batam Island, the labor
market can deteriorate because the people who make it up do not thrive. To
promote development, free trade zones cannot be considered independent, short-
run quick fixes. They must be acknowledged as small, possible transient
components to long-run strategies that can work with other components to
promote aggregate development. One way to facilitate this may be to change the
nature of incentives over time in response to changing development needs,
attracting industries initially and exposing the host country slowly to liberalization
while simultaneously not allowing the zone to operate entirely independent of the
development of the country. This would give firms in the zone incentives to
consider the long-term prospects of the country. Another possibility would be to
attract firms at different stages of production, thereby broadening the employment
base and giving workers the prospect of employment over time and upward
mobility. The survey of employers within the zone showed that seventy nine
percent cited lack of access to skilled labor as a problem, while another thirty
115
three percent reported difficulty finding workers to undertake research and
development314. This shows a willingness on the part of firms to widen
production operations to incorporate a more sustainable employment base. The
same survey showed the majority of firm owners experienced the most difficulty
with procuring quality products and inputs locally315. This shows that host
countries could establish free trade zones and simultaneously promote industries
within the domestic zone that would supply inputs, creating the positive backward
linkages considered by Musleh-u al-Din. These needs further support the case for
more aggregate development strategies that incorporate FTZs rather than zones
that stand alone and are isolated from the host country.
Overall, the existing theoretical analyses I chose to examine do not predict
the performance of free trade zones because they do not account for the
components that labor needs to sustain development over time. The theories use
static modeling techniques that do not describe the very fluid interplay between
wage rates, migration, employment, and foreign investment. The theories provide
an essential starting point for evaluating whether or not to implement a free trade
zone as part of a larger, export-oriented development strategy by exposing
necessary pre-conditions for and providing guidance for location and construction
of the zone, but rely on assumptions that cannot be expected to take account of all
relevant factors and accurately predict results. Success of the zone depends on
success of the host country, and cannot function independently. BatamIndo
illustrates this, because even with direct intervention by Singapore, Indonesia’s
314 Yeoh et al, regional, 58.315 Ibid, 59.
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stagnant development process and corrupt nature appear to have overshadowed
the investor confidence that Singapore has provided. In order to effectively
develop the economy and reduce unemployment, Indonesia must take greater
steps towards aggregate liberalization and increased transparency. Only then can
they use small, short-term tools like free trade zones to mitigate problems like
unemployment. Free Trade Zones should be established only as components of
larger, long-term strategies and must include incentives that promote long-term
goals of development.
117
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