Agglomeration and manufacturing activities in Indonesia

 POLICY NOTE 6 73127 Agglomeration and Manufacturing Activities in Indonesia THE WORLD BANK OFFICE JAKARTA Indonesia Stock Exchange Building, Tower II/12-13th Fl. Jl. Jend. Sudirman Kav. 52-53 Jakarta 12910 Tel: (6221) 5299-3000 Fax: (6221) 5299-3111 Printed in September 2012 Agglomeration and Manufacturing Activities in Indonesia is a product of staff of the World Bank. The findings, interpretations and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory, or the endorsement of acceptance of such boundaries. Cover photograph is: Copyright @ Takiko. All rights reserved.  Policy Note 6 Agglomeration and Manufacturing Activities in Indonesia Abstract Contributors: Sjamsu Rahardja and Ari Kuncoro, with the help from Fitria Fitriani, Gonzalo Varela and Mohammad Adhi Dipo The importance of the agglomeration process in facilitating growth and productivity increases in Indonesia’s manufacturing sector cannot be ignored. The agglomeration process is associated with improved productivity as firms enjoy external benefits from either urbanization or from the sharing of inputs available in certain locations. Evidence suggests that Java remains the main corridor for manufacturing activities, with large cities attracting manufacturers that are looking for externalities from urbanization. However, there are signs that some firms are shifting to new locations in other cities and forming new agglomerations in areas that these firms find more favorable. With regional autonomy, issues relating to local governance, infrastructure, and uncertainties in local regulations are increasingly important and can undermine the process of agglomeration. Some programs promoting certain locations as special economic zones (SEZs) are experiencing difficulties in attracting manufacturing investors. Understanding these challenges should help policymakers to strengthen the underlying factors that facilitate manufacturing agglomeration.  Table of Contents 1. Introduction 2. Agglomeration process in Indonesian manufacturing sector 3. Impact of agglomeration on productivity 4. Constraints that can slow down the process 5. Conclusions and Implications for the Policy Framework References Annex IV Agglomeration and Manufacturing Actiities in Indonesia 1. Introduction Agglomeration is one of the key processes for facilitating growth in modern manufacturing activities. Unlike cottage industries that operate using traditional technology and serve small markets nearby, modern manufacturing industries thrive by serving larger customers. Besides adopting measures to improve internal efficiency, such as specialization and better technology, modern manufacturing firms choose to locate in places where they can tap into one of the following external benefits. The first type of external benefit comes from accessing a pool of inputs, such as labor and skills that exist in a certain location, and an exchange of knowledge from other manufacturers in a similar industry (i.e., localization economies).1 The second type of external benefit comes from accessing diverse types of inputs, such as proximity to consumers and opportunities to exchange knowledge from diverse businesses in a certain location (i.e. urbanization economies).2 The process, whereby new manufacturers tap into external benefits by choosing to locate in areas that other manufacturers are already operating in, is defined as agglomeration. The process of manufacturing agglomeration is present in Indonesia. Manufacturing activities across Indonesia often started in certain major cities such as Jakarta, Bandung, and Surabaya. The process seems to reinforce itself as new manufacturers tend to locate in areas where there are already manufacturing activities. The process also seems to be associated with productivity gains and an increase in product variety. Market forces and associated externalities appear to be the main driver of the process. Manufacturing agglomeration, or clustering, of selected industries continues to take place today, such as in garments in the Bandung area, machinery and heavy industries in the Greater Jakarta and Surabaya areas, rattan in Cirebon and Jepara, leather and footwear in Sidoarjo, and ceramics in Plered (West Java). Firm co-location can increase the productivity spillovers from foreign direct investment and exporting. Spillovers can occur through various transmission channels including changing market forces (such as increased competition and demonstration), labor turnover, and supply chains. Such channels are more likely to work when foreign and domestic firms are located close to each other. Empirical evidence suggests that spillovers to domestic firms seem to be constrained to regions where multinational firms are located.3 Empirical evidence for Indonesian manufacturing firms over the period 1990-2005 suggests that a higher share of exporters in a province (export spillovers) has a significantly positive effect on firm-level export propensity. In addition, a higher share of exporters in a province also significantly increases firm-level export intensity.4 In sum, spillovers from foreign direct investment and exporting seem to be more prevalent in agglomerations. This policy note argues that the policy focus should be on facilitating the private-sector-led agglomeration process instead of on mandatory policies that distribute industrial development across regions. Organic growth of manufacturing activities is likely to be most effectively sustained by a private-sector-led agglomeration process. Agglomeration has benefits from the standpoint of production efficiency, as well as improving the general welfare of the population. An optimal strategy should be one that makes use of the forces of agglomeration to facilitate industrial development. 1 Localization, in this respect firms learn about local inputs, output markets and technological conditions from their own industry, which in the dynamic form is often called Marshall-Arrow-Romer (MAR) externalities. 2 These types of externalities are called urbanization or in the dynamic context are termed Jacobs’ externalities (Jacobs [1969]). Firms learn from all firms in a city, whereby the diversity of local industries enhances the local information environment. 3 Girma and Wakelin (2007), Girma, S. and K. Wakelin (2007) “Local productivity spillovers from foreign direct investment in the U.K. electron- ics industry