Development Discussion Papers

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1 Development Discussion Papers Dutch Disease and Agriculture in Indonesia: The Policy Approach C. Peter Timmer Development Discussion Paper No. 490 June 1994 Copyright 1994 C. Peter Timmer and President and Fellows of Harvard College Harvard Institute for International Development HARVARD UNIVERSITY

2 HIID Development Discussion Paper no. 490 DUTCH DISEASE AND AGRICULTURE IN INDONESIA: THE POLICY APPROACH C. Peter Timmer Abstract Indonesia's experience with the impact of booming oil revenues on its agricultural sector is now recognized as a classic case of Dutch Disease. The "treatment" administered in 1978, a dose of exchange rate protection, almost certainly explains much of the divergent path of agriculture in Indonesia compared with the experience of Nigeria or Mexico. The specific concern for rural profitability and incomes reflected in macroeconomic decision making after 1978 complemented (and incorporated) commodity-specific pricing policies, and thus contributed to rising agricultural productivity. The paper reports on a model constructed to test the importance of oil imports and exports on the agricultural sector. The structure of the model contains important lessons about the role of macro prices in agricultural growth and the mechanisms by which this role is felt. The share of oil imports or exports is a significant variable in nearly all aspects of the model. For Indonesia, an oil exporter, an increase in oil export revenues (caused by a rise in oil prices), led to more rapid income growth, larger investment, an appreciation of the real exchange rate, and a deterioration in the rural-urban terms of trade. The model shows how growth in agriculture might be stopped altogether in oil-exporting countries if differential inflation (relative to that of the United States) was combined with a fixed nominal exchange rate that was defended using large dollar earnings from oil exports. The model fit the Indonesian experience particularly well and explained the concerns of macro policymakers in 1978 over the deteriorating health of the rural economy. The combination of stagnant growth in the overall agricultural sector in the mid-1970s, following the increase in oil prices, with problems of pests and disease in the rice economy, led to a major reappraisal of food policy. The conclusion was controversial at the time but is now widely accepted: for agricultural projects and programs to be effective in generating sustained growth in output, they must be inserted into a favorable agricultural and macro price environment. There is nothing in the Indonesian record to suggest, however, that this favorable price environment alone generates a dynamic rural economy. For this, an active research and investment program on behalf of agricultural producers (and consumers) is also needed. C. Peter Timmer is Thomas D. Cabot Professor of Development Studies, At Large, Harvard University, and a Faculty Fellow at the Harvard Institute for International Development (HIID). He was a resident advisor in Indonesia in with the Harvard Advisory Group and has returned several times each year since then. In 1992 he was awarded the Bintang Jasa Utama (Highest Merit Star) by the President of Indonesia. His current research is on how markets value the role of agriculture in economic development.

3 HIID Development Discussion Paper no. 490 DUTCH DISEASE AND AGRICULTURE IN INDONESIA: THE POLICY APPROACH C. Peter Timmer Indonesia's experience with the impact of booming oil revenues on its agricultural sector is now recognized as a classic case of Dutch Disease. The "treatment" administered in 1978, a dose of exchange rate protection, almost certainly explains much of the divergent path of agriculture in Indonesia compared with the experience of Nigeria or Mexico (Corden and Warr; Warr; Gillis, et al., and Timmer, 1984). The specific concern for rural profitability and incomes reflected in macroeconomic decision making after 1978 complemented (and incorporated) commodityspecific pricing policies, and thus contributed to rising agricultural productivity. Indonesia's macroeconomic and trade policies that are the ultimate determinant of incentives facing agriculture reflect a curious blend of liberal market approaches and high tariff and quota barriers for most industrial products. Although efforts have been made since 1980 to privatize the management of the many state-owned trading and industrial companies, ownership and the boards of directors remain largely in public hands even in the early 1990s. From the point of view of the agricultural sector, three aspects of these policies are crucial: the impact of trade policy on the costs of agricultural inputs and rural household purchases from the urban sector; the net result of foreign exchange rate policy directly, and trade policy indirectly, on the effective exchange rate; and the impact of other macro prices, especially interest rates, on decisions about choice of technique in both the rural and urban sectors. Budgetary and fiscal policy, as they affect investments in agriculture, also play an important role which is beyond the scope of this paper. 1

4 Trade Policy.-- Roughly speaking, Indonesia's macro prices have been determined by a market orientation that reflected basic scarcity values for capital, labor, and foreign exchange. This approach has been consistently advocated by the Western-trained economists who have held key cabinet positions in the New Order government since Trade policy, on the other hand, has consistently been determined by a more nationalistic force within the cabinet, which has wished to pursue a path of import substitution and self-sufficiency, even at high costs, in a broad range of industrial products. The accommodation of both approaches under President Suharto's role as final arbiter of cabinet disputes on policy has produced the curious blend of policies that seems to tug the economy in opposite directions simultaneously, often to the considerable confusion of private and foreign investors. The balance between market forces and statism at the level of central policy has always been delicate. Profound implications for the direction of macroeconomic policy have been read into every cabinet appointment. Divining the ascendancy or decline of key individuals and the approaches they espouse has been a minor industry in Jakarta; the profitability of individual factories, of entire industries, and of the urban as opposed to the rural sector depends critically on which approach is implemented. The mechanisms by which these key economic strategy choices ultimately affect the profitability of agricultural production are complicated and only roughly understood. When domestic industry was protected and high cost, most industrial inputs into the agricultural sector were also high cost. An exception, however, has been fertilizer, the most important industrial input into agriculture. Indonesian factories using domestic natural gas have produced nearly all the nitrogen fertilizer (mostly urea) used by farmers. The plants tended to embody modern technology and were well-managed; their costs of production were competitive with most producers in other countries except in periods of surplus supplies when the marginal costs of Arab 2

5 Gulf producers were below those of all other suppliers. But no matter what the real costs of production were, fertilizer was heavily subsidized since the mid-1970s. This key industrial input was not responsible for any deterioration in the rural-urban terms of trade before subsidies began to be phased down in the late 1980s. Virtually every other rural input, however, had its costs raised directly or indirectly by trade policy. Tools and implements, for example, were made from high-cost iron and steel. Diesel engines from domestic manufacturers cost twice their import cost; for some models there was negative value added in domestic assembly. Although this would seem to be impossible, the knocked-down kits of imported parts indeed cost more than the assembled engines themselves because of high-volume manufacturing efficiencies in Japanese factories. Trucks, the mainstay of the rural marketing sector, have been heavily protected by high tariffs. The high cost of manufactured consumer goods also weighed against the rural sector, as would be expected unless it shared equally in the protection afforded industry. Such protection was clearly not the case for most commodities for most of the time. The rice sector received significant protection only after 1984, and all traditional export crops, plus cassava and corn, have been exported without subsidy even when the exchange rate was somewhat overvalued. In 1973 and 1974, the Ministry of Trade banned exports of cassava and corn to keep their domestic prices below world levels. For most of the 1968 to 1984 period, when high oil prices might have caused problems, the food crop sector received negative protection; the only significant exception was soybeans, whose domestic price 1 has been kept well above the world price since the late-1970s. In net, trade policy provided high 1 Sugar is another important exception. Prices of sugar in Indonesia have been roughly comparable with those in the United States, often four to five times the world price. 3

6 protection to the industrial sector and negative protection to agriculture, thus biasing the ruralurban terms of trade against the rural economy. While input subsidies compensated partially for this direct anti-rural bias, and rice prices in particular were held more or less constant in real terms after 1969, the overall terms of trade declined by 2.3 percent per year from 1970 to 1983, the period when oil prices rose on two occasions, thus putting pressure on rural incomes and reducing incentives to increase output. Where new, low-cost technology was available, or price supports for specific commodities meshed with input subsidies, incentives faced by farmers were substantially positive, as for rice. More neglected crops, such as cassava, did not fare as well. Hence the overall direct impact of trade policy on agriculture was negative; its indirect impact through the equilibrium value of the foreign exchange rate was probably just as negative. The Foreign Exchange Rate.-- The foreign exchange rate is the most important macro price influencing the profitability of agricultural production specifically and the health of the rural economy generally. From April 1970 until the devaluation of November 1978, Indonesia maintained a fixed exchange rate that was devalued as necessary (in August 1971) to maintain equilibrium in the balance of payments. After 1978, the government allowed the rate to float in a highly controlled manner. Major devaluations were announced in March 1983 and again in October 1986 when oil prices fell. The rate floated in a controlled manner in the interim periods. Market forces clearly influence the value of the rupiah, especially by determining the pressures on the rate of depreciation via the float, but macro policymakers also set the level from which the market can exert its influence. Most devaluations and the rate of float have been determined by basic market forces, but the 1978 devaluation came as a complete surprise to the market and is 4

7 seen as one of the first and clearest applications of "exchange rate protection" on behalf of the sectors lagging in adjustment to high oil prices. An empirical study of the link between oil prices, the foreign exchange rate, and the ruralurban terms of trade in Indonesia provides direct evidence of the importance of macro price policy to agriculture (Timmer, 1984). This study builds on a model of structural transformation developed by Chenery and Syrquin (1975) to explain the declining share of agriculture in gross domestic product from 1960 to 1980 as a function of incomes per capita and country size for a 2 sample of seven Asia-Pacific countries, including Indonesia. As shown in Figure 1, the model has separate equations to explain income per capita (LX1), the purchasing power foreign exchange rate (PPFEX), investment (INV), and the rural-urban terms of trade (TT). The predicted value of the terms of trade is then added to the basic Chenery-Syrquin model explaining the share of the agricultural sector in GDP (AGSHR) to see if relative prices affected the process of structural change. The results provided powerful confirmation of this impact. 2 The sample included Indonesia, Mexico, and Malaysia as oil exporters, and Thailand, Philippines, Sri Lanka, and South Korea as oil importers. 5

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9 In the model, the rural-urban terms of trade--defined as the GDP deflator for the agricultural sector divided by the GDP deflator for the rest of the economy--are determined by five exogenous variables in addition to commodity-specific price and trade policy: the foreign exchange rate (lagged), the relative share of oil exports or imports in GDP (OILMSHR), the current account balance as a share of GDP (CABAL), world prices for cereal grains (DCERPR), and world prices for noncereal agricultural commodities (DANC). The impact of changes in the rural-urban terms of trade on the agricultural sector can be analyzed in several ways. In the model the impact was captured via influence on the share of agriculture in gross domestic product, holding incomes per capita and population size (LPOP) constant. This influence was large and robust: an increase of one standard deviation in the rural-urban terms of trade raised the share of agriculture by 10 percent (for example, from 30 to 33 percent), other things held constant. Raising the share of agriculture for a given level of per capita income not only means the agricultural sector is better off. Because most poverty in low-income countries is in rural areas (or is linked to rural-urban migration), increasing the share of agriculture also has dramatic effects on poverty alleviation and income distribution. The structure of the model itself also contains important lessons about the role of macro prices in agricultural growth and the mechanisms by which this role is felt. The share of oil imports or exports is a significant variable in nearly all aspects of the model. For Indonesia, an oil exporter, an increase in oil export revenues (caused by a rise in oil prices), led to more rapid income growth, larger investment, an appreciation of the real exchange rate, and a deterioration in the rural-urban terms of trade. The model shows how growth in agriculture might be stopped altogether in oil-exporting countries if differential inflation (relative to that of the United States) 7

10 was combined with a fixed nominal exchange rate that was defended using large dollar earnings from oil exports. The model fit the Indonesian experience particularly well and explained the concerns of macro policymakers in 1978 over the deteriorating health of the rural economy. The combination of stagnant growth in the overall agricultural sector in the mid-1970s, following the increase in oil prices, with problems of pests and disease in the rice economy, led to a major reappraisal of food policy (Afiff, Falcon, and Timmer). The result was a threefold strategic redirection: new efforts to diversify the food economy away from rice; new incentives for rice producers through a higher (nominal) floor price and subsidized fertilizer price; and a major shift in macro prices via the 50 percent devaluation of the rupiah in November 1978, at a time when many observers felt a 3 revaluation might be announced because of rising foreign exchange reserves. Although this modeling approach to determining the impact of changes in the rural-urban terms of trade on the agricultural sector has the advantage of generating many broad lessons about the impact of oil shocks on the dynamic relationship between the agricultural and nonagricultural sectors, it does miss some of the specificity of the Indonesian experience. Fortunately, it is also possible to measure the impact of the terms of trade on agricultural growth directly. While this is somewhat more difficult because many other factors also influence agricultural output, Figure 2 shows how agricultural gross domestic product at constant prices 3 See Gillis, et al., especially pp , for a more complete description of this episode. 8

11 compared with the rural-urban terms of trade in Indonesia from 1968 to 1983, the period of most interest for understanding the relationship between oil exports and agriculture. The rapid rise in agricultural GDP and the uneven but dramatic fall in the terms of trade are obvious, but more subtle patterns can also be discerned. In Figure 3, the 1969 to 1983 time period is divided into three sub-periods when the rate of growth in agricultural GDP varied substantially: 8.2 percent per year between 1969 and 1974; 4.3 percent per year between 1978 and 1983; and only 0.8 percent per year between 1975 and These growth rates were matched against the average rural-urban terms of trade for the same sub-periods, but lagged one year (to allow agricultural producers time to respond to changed incentives). Although Figure 3 has only three observations, the positive response of agricultural growth to the terms of trade is fairly clear. A regression model using annual data with the same specification and lags also shows a positive and significant coefficient for the impact of the terms of trade on agricultural growth. A 10 percent change in the terms of trade leads to a change in the agricultural growth rate of 3 percentage points. Since the fitted trend growth rate in agricultural GDP for the entire period was 4.58 percent per year, the large relative influence of the terms of trade is obvious. The equation in which this result was obtained also has a marginally significant time trend of 0.7 percent per year, implying that actions taken to alleviate the declining terms of trade, especially investments in rural infrastructure and new agricultural technology, were having an increasingly positive effect on agricultural growth. Many of these investments were financed from oil revenues accruing to the national budget. 9

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14 Other Macro Prices.-- Macro prices other than the foreign exchange rate have had relatively little distorting effect on agriculture. The availability of subsidized credit in the rice intensification program (BIMAS) probably helped spur fertilizer demand, but as noted, such increased demand appeared to reduce distortions rather than increase them. The widespread availability of cheap unskilled labor has prevented agricultural mechanization, even though the Asian Development Bank made some subsidized credit available for this purpose. Consequently, the major influence of macro prices on agricultural output has been through the foreign exchange rate, and this influence has been dramatic indeed. Because of the large increases in oil prices in the 1970s, Indonesia's rural economy was severely buffeted by declining terms of trade. Price policy for rice, the fertilizer subsidy, and a more rural-oriented macro policy after 1978 helped overcome the pressures exerted by these exogenous changes on Indonesia's macro economy. The lessons learned from these experiences have not been painless, but the pragmatic search for policies that improved rural welfare by countering the negative effects of other policies, and doing so without imposing high costs on industrial development, paid off in the early 1980s in the form of a highly dynamic rural and urban economy. The experience is especially noteworthy when compared with the experience of other oil exporters such as Mexico and Nigeria. Their management of oil revenues and macro policy led to steep declines in the health of their rural economies, in direct contrast to the Indonesian experience (Gillis, et al.). For example, between 1971 and 1991, real agricultural output per capita increased 1.5 percent per year in Indonesia, while it fell 0.5 percent per year in Mexico and 2.0 per cent per year in Nigeria. By contrast, real agricultural output per capita increased

15 percent per year in Colombia during those years. In other words, agricultural production increased in Indonesia, an oil exporter, by nearly as much as in Colombia, an oil importer. Despite this success in stimulating agricultural productivity, the rural-urban terms of trade continue to be a problem for Indonesian policymakers. Although all the issues already discussed contribute to the value of this indicator, broader strategic decisions dominate its determination. In particular, trade orientation for the manufacturing sector, oil exports, and exchange rate policy are the three main factors that ultimately determine the relative profitability of production and incomes in rural areas. Since three-quarters of Indonesia's population live in rural areas and are directly or indirectly dependent on the health of the rural economy for their well-being, how these three factors work out is crucial to the standard of living for the vast majority of Indonesians. Policymakers can do relatively little about oil prices. With a strong determination to maintain a competitive exchange rate, policymakers allowed the rupiah to follow the dollar down in value after early 1985 and then devalued it sharply in October, 1986 because of the massive loss in export earnings due to price declines for oil and other primary commodities. One intent of the devaluation was to stimulate rural incomes and spur additional exports, especially for crops such as cassava and corn, which were within the c.i.f.-f.o.b. nontradable band. In addition, the higher price for foreign exchange would reduce imports through market pressures, thus allowing the government to rely less on tariffs and quotas as a way of bringing balance to the current account. 13

16 This approach permits a less protective approach to manufactures; historically, industrial protection seems to have been an important factor in turning the terms of trade against the rural sector. A "state-managed" approach to restoring balance in the trade account, rather than a "market-induced" approach, places a heavy burden on the rural economy. In addition, the historical record indicates that protection has not turned the Indonesian industrial sector into an alternative "engine of growth," and the prospect that such a trade strategy might prevail remains worrisome. Only part of the impact of interventions into macro prices and other key signals is picked up directly in the rural-urban terms of trade and its effect on sectoral output. The dynamic allocative efficiency of the entire macro economy has an additional impact on agriculture through the growth linkages first spelled out by Johnston and Mellor (1961). If interventions create distortions that slow the growth of total economic output, they will also tend to impede the development of these linkages and hence have a doubly dramatic effect on agricultural growth. Using data from the World Development Report 1983, it is possible to carry out an interesting, if rough, test of the impact the overall level of price distortion in an economy has on agricultural growth. The results, which show a strong inverse relationship between distortion and growth in agricultural output, are striking and surprisingly robust given the limited sample (30 countries, with 8 in Sub-Saharan Africa) and the obvious difficulty in specifying a single measure of price distortion that would be applicable to all 30 countries. Distortions in the World Bank analysis were measured in a fairly crude and impressionistic fashion. Price distortions in foreign exchange pricing were measured for the exchange rate, degree of protection of manufacturing, 14

17 and protection or taxation of agriculture. Distortions in factor pricing were measured for capital and labor prices. Distortions in product prices were measured for power tariffs and through the rate of inflation. All of these elements were weighted equally into a three-step measure of overall price distortions--high, medium, and low--which took on the value of 3, 2, and 1, respectively, in the statistical analysis. In all cases, deviations from free-market prices were recorded as distortions. In this simple model, the rate of growth in agricultural output is a function of independent variables including population growth, a regional dummy, and the distortion index. The distortion index is meant to capture the impact of "bad" pricing policies. It ranges from a low of 1.14 for Malawi to a high of 2.86 for Ghana; the Indonesian value of 1.86 is roughly in the middle of the sample. A dramatic policy shift from "bad" to "good" might realistically involve a change in the distortion index of one full point. Consequently, the highly significant negative coefficient of about 2.4 attached to this distortion index implies that the difference between bad and good economic policy accounts for 2.4 percentage points of agricultural growth per year. Since the average agricultural growth rate for the entire sample of countries was only 2.9 percent per year, price distortions clearly play a major role in explaining differential rates of agricultural growth. A simple equation with the rate of growth in agricultural output from 1970 to 1982 as the dependent variable and with population growth, the distortion index, and a dummy for the Sub- Saharan African countries as independent variables, showed that about 80 percent of population growth is directly reflected in aggregate agricultural growth. When the equation is then specified in per capita terms, a dummy variable equal to one when population growth rates are in excess of 15

18 2.5 percent per year has a negative coefficient of about 0.7, which is marginally significant even in the presence of the other two variables. Holding all other variables constant, the dummy variable for Sub-Saharan African countries is consistently negative and significant with a coefficient in the range of 1.0 to 1.4, thus confirming that Africa's poor performance in agricultural growth stems from more than just bad policies. The Indonesian economy in the mid-1960s must have been among the worst distorted in recent comparative history, perhaps rivaling the 2.86 distortion index measured for Ghana during the mid-1970s. This starting point implies that Indonesia's economic policies within these definitions improved by a full point, from 2.86 to 1.86, thus contributing perhaps 2.4 percentage points per year to the agricultural growth rate over this period. (Indonesia averaged 3.8 percent per year during the time period of the World Bank sample and 4.6 percent per year from 1968 to 1983.) Some of this impact is transmitted through improved commodity price policy and in better rural-urban terms of trade, and it would be double counting to add this entire 2.4 percent to the 2 to 3 percent accounted for by those price factors in order to find the total contribution of price 4 policy at all three levels. But there was also likely to have been some additional contribution from the vastly improved macro and trade policy environment. The implication is that micro and sectoral projects and programs, independently of both the specific and overall price environment, can explain relatively little of aggregate growth performance for agriculture. 4 It should be noted, however, that in the World Bank definition of distortions the fertilizer subsidy in Indonesia would count as a distortion. In fact, the subsidy helped to remove a distortion (the failure of farmers to equate the marginal cost of fertilizer with its marginal revenue due to a lack of knowledge and the private risk of losing their investment), as the empirical evidence presented in Timmer (1985) indicates. 16

19 Indonesia's story of agricultural development has a conclusion identical to that reached in 1973 with respect to choice of technique in rice milling on Java: "`Getting prices right' is not the end of economic development, but `getting prices wrong' frequently is." [Timmer (1973), p. 76] For agricultural projects and programs to be effective in generating sustained growth in output, they must be inserted into a favorable agricultural and macro price environment. There is nothing in the Indonesian record to suggest, however, that this favorable price environment alone generates a dynamic rural economy. For this, an active research and investment program on behalf of agricultural producers (and consumers) is also needed. But the Indonesian evidence is quite powerful in suggesting that there is little return to such programs for research and investment in the absence of a favorable price environment. Even more powerful, perhaps, is the implication that the favorable price environment itself is defined to a large extent by macro price policies which are heavily conditioned by oil revenues, and not just by commodity and sectoral price policies. Agricultural development is thus the joint responsibility of macroeconomic policymakers and the Ministry of Agriculture. 17

20 References Afiff, Saleh, Walter P. Falcon, and C. Peter Timmer. "Elements of a Food and Nutrition Policy in Indonesia" in Gustav Papanek, ed., The Economy of Indonesia, (New York: Praeger, 1980), pp Chenery, Hollis B. and Moise Syrquin. Patterns of Development, , (Oxford University Press, London, 1975). Corden, W. M., and Peter G. Warr. "The Petroleum Boom and Exchange Rate Policy in Indonesia," Ekonomi dan Keuangan Indonesia/ Economics and Finance in Indonesia, vol. 29, no. 3 (1981), pp Gillis, S. Malcolm, Dwight H. Perkins, Michael Roemer, and Donald R. Snodgrass. Economics of Development, (New York: Norton, 1983). Johnston, Bruce F., and John W. Mellor. "The Role of Agriculture in Economic Development," American Economic Review, vol. 51, no. 4 (September 1961), pp Timmer, C. Peter "Choice of Technique in Rice Milling on Java," Bulletin of Indonesian Economic Studies, (Canberra), vol. 9, no. 2 (July), pp "Energy and Structural Change in the Asia-Pacific Region: The Agricultural Sector," in Romeo M. Bautista and Seiji Naya, eds., Energy and Structural Change in the Asia- Pacific Region: Papers and Proceedings of the Thirteenth Pacific Trade and Development Conference, (Manila: Philippine Institute for Development Studies and the Asian Development Bank), pp "The Role of Price Policy in Rice Production in Indonesia, " HIID Development Discussion Paper no. 196 (Cambridge: MA: Harvard Institute for International Development, May 1985). Warr, Peter G. "Exchange Rate Protection in Indonesia," Bulletin of Indonesian Economic Studies, (Canberra), vol. 20, no. 2 (August 1984), pp