1

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
 2

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

 3

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

 4

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.
 5

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.

 6

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.338
3
Koichi Hamada, “An Economic Analysis of the Duty-Free Zone”. Journal of International Economics
4(1974) p. 225
 7

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.
 8

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
 9

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.
 10

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.
 11

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, 398
10
Musleh-ud Din. “Export processing zones and backward linkages”. Journal of Development Economics,
43(1994) 371.
 12

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.
 13

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.
 14

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
 15

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
 16

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) 328
23
Ibid, 333.
24
Ibid, 334.
 17

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.
 18

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.
 19

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.

 20

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

characterized by corruption and ineffective government practices, which strongly

 21

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
 22

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.
 23

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.
 24

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.
 25

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.
 26

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.
 27

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.
 28

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.
 29

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, 397
49
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.
 30

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.
 31

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, 398
54
Miyagiwa, Locational, 189, 193.
55
Ibid, 195-196
56
Young, Intermediate, 383., Chaudhuri and Adhikari, Free Trade Zones, 157, 161, Miyagiwa, Locational,
198.
 32

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.
 33

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.
 34

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

 35

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
 36

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 appendix
61
See Figure a3 in appendix
 37

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.
 38

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
 39

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, 213
69
Ibid, 213
70
See Figure A4 in appendix
71
See Figure A5 in appendix
72
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 appendix
75
Measuring Inequality, The World Bank,
<http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTPOVERTY/EXTPA/0,,contentMDK:2023
8991~menuPK:492138~pagePK:148956~piPK:216618~theSitePK:430367,00.html?> Accessed 28 April,
2008.
 40

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.
 41

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
 42

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, 236
81
Wie, Soeharto, 236.
82
See Figure A7 in appendix
 43

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 188
85
Ibid, p 188.
 44

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 appendix
88
Elizabeth Fuller Collins. Indonesia Betrayed: How Development Fails. Honolulu: University of Hawaii
Press, 2007. pp 117 – 120.
89
Ibid, 121.
 45

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.
 46

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 appendix
96
Ibid, 22.
97
Ibid, 22.
98
See Figure A10 in Appendix
 47

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
 48

“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.

 49

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.

 50

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.
 51

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.
 52

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. a1
106
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 66
109
Chris Manning. “Indonesian Labor Markets: Adjusting to Crisis and Slow Recovery”. The Indian
Journal of Labor Economics, Vol. 43, no. 3 (2000) p 246.
 53

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. a2
111
Ibid, 5.
112
Manning, Regional, 5.
113
Edwards, Labor, 11
114
Hal Hill, The Indonesian Economy, Cambridge: The Cambridge University Press (2000) p 157-162.
 54

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.
 55

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, 12
121
Manning, Regional, 7.
122
Ibid, 11.
123
Ibid, 9.
 56

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.
 57

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, 21
130
Dick, Emergence, 228.
131
Hill, Indonesian, 205.
132
Ibid
 58

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, 52
134
Edwards, Labor, 7.
135
Hill, Indonesian, 209.
136
Ibid, 210.
137
Edwards, Labor, 9.
 59

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
 60

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) 55-56
144
Ibid, 62.
 61

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, 76-77
147
Chris Manning and Kurnya Roesad, “Survey of Recent Developments”, Bulletin of Indonesian
Economic Studies, v42.n2 (2006) 165
148
Manning, Indonesian, 552.
 62

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, 143
152
Chris Manning, Globalization, Economic Crisis, and Labor Market Policy: Lessons from East Asia,
East-West Center Working Papers: Economic Series No. 23 (2001) 12
153
Manning, Approaching, 58-59.
 63

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.
 64

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.
 65

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.
 66

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.
 67

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.
 68

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

166
Jayanthakumaran, Benefit-Cost, 52.
167
Ibid, 60.
 69

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.
 70

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, 845
173
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, 144
175
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.
 71

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.
 72

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.
 73

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.
 74

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.
 75

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, 144
186
Ibid, 144.
187
Warr, Export Processing Zones: the Economics, 76.
188
Amirahmadi and Wu, Export, 829.
189
Ibid, 834.
 76

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, 830
192
Jayanthakumaran, Benefit-Cost, 62.
193
Amirahmadi and Wu, Export, 836.
 77

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
Ibid
195
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
 78

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.
 79

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
Ibid
203
Amirahmadi and Wu, Export, 842.
204
Ibid.
205
Warr, Export Processing Zones, 159.
 80

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.
 81

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
 82

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.
 83

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
 84

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.
 85

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, 44
222
Peachy et al, Boundary, 1.
223
Ibid, 13.
224
Ibid, 16.
 86

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, 51
226
Peachy et al, Boundary, 1.
227
Ibid, 23.
228
Ibid, 16.
 87

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, 16
232
Ibid, 22.
233
Ibid, 16
234
Ibid, 38
235
Ibid, 37
236
Ibid, 16.
 88

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.
 89

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.
 90

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, 149
245
Peachey et al, Boundary, 5.
246
Yue, Sub-regional Economic Zones in East Asia, 149.
247
Peachey et al, Boundary, 1.
248
Ibid, 3.
 91

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.
 92

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, 38
255
Ibid, 39.
256
Ibid, 32.
257
Ibid, 38
 93

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.
 94

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
Ibid
263
Ibid, 32.
264
Ibid, 34-35.
265
Ibid, 32.
 95

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
Ibid
267
Ibid, 30.
268
Ibid, 32-33.
269
Ibid, 33).
 96

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, 33
271
Ibid, 36.
272
Ibid, 33-34
 97

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, 34
274
Ibid, 34
275
Ibid, 40.
276
Ibid, 38
277
Ibid, 41.
 98

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.
 99

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.
 100

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
 101

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, 35
290
Ibid, 36.
291
Ibid, 36.
292
Ibid, 37.
293
Ibid, 37.
294
Ibid, 37.
 102

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.
 103

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.
 104

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, 340
302
Din, Export.
 105

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

 106

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

 107

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

 108

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.
 109

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, 341
306
Miyagiwa, Locational, 187-203.
307
Miyagiwa, Unemployment, 397-405.
308
Peachey et al, Boundary, 1.
309
Yeoh et al, Regional, 48.
 110

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, 552
311
Manning, Survey, 143.
 111

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.
 112

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
 113

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
 114

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

 115

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
 116

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.
 117

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.
 118

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