This Selected Issues paper for Indonesia reports that following the major cleanup of the banking sector after the crisis, banks’ performance has improved as net interest margins and profitability have increased. Public and external debt ratios have declined and international reserves have risen, reducing domestic and external vulnerabilities. Indonesia stands out as having experienced a slower recovery in investment and exports than other countries hit by the Asian crisis. Recognizing the challenge, the government has adopted a sound medium-term strategy focused on boosting economic growth.


This Selected Issues paper for Indonesia reports that following the major cleanup of the banking sector after the crisis, banks’ performance has improved as net interest margins and profitability have increased. Public and external debt ratios have declined and international reserves have risen, reducing domestic and external vulnerabilities. Indonesia stands out as having experienced a slower recovery in investment and exports than other countries hit by the Asian crisis. Recognizing the challenge, the government has adopted a sound medium-term strategy focused on boosting economic growth.

VII. Labor Market Policies and Job Creation1

A. Introduction

1. Indonesia’s steady pickup in growth in the last few years, averaging some 4.5 percent since 2000, has not been accompanied by increases in employment levels. In fact, registered unemployment has edged up every year since the crisis, increasing from 4.8 percent in 1997 to almost 10 percent in 2004.2 At the same time, formal sector employment has declined.

2. The new government has made employment creation one of its central tenets. Its medium-term economic program aims to reduce the unemployment rate by half by 2009. Improvements in the business climate to attract investment and create jobs, and programs to improve the skills of the working population, form central themes of the economic program.

3. This chapter discusses employment trends in Indonesia over the last several years and examines the reasons for the rising unemployment. Specifically, the chapter focuses on real wage growth, and the role of labor market legislation in explaining the underperformance of the labor market. The chapter also compares the trends in Indonesia with those in other countries in the region. It finds that labor legislation in Indonesia—which has added to the cost of labor—has played an important role in discouraging formal sector employment and in delinking growth and employment generation.

B. The Indonesia Labor Market—Some Stylized Facts

4. Indonesia’s working age population and labor force have steadily increased, but the new workers have not been absorbed. The labor force has expanded in line with population growth, with the participation rate around 67–68 percent. At the same time, unemployment has shown a steady upward trend. On average 2–2½ million Indonesians have entered the job market annually. However, the number of registered vacancies has declined every year since the crisis up until 2003, and the ratio of registered job applicants to available vacancies has increased two and a half fold. The resulting disappointment of people failing to acquire jobs may explain the decline in new labor force entrants in the last two years, despite an increase in the working age population by 2 percent as in previous years. At the same time, the increase in employed persons in 2004 may signal that the recent pickup in investment is in fact creating jobs (much of the GDP growth until last year was consumption driven). This would be similar to what happened in the late 1980s, when rising investment levels created demand for labor, especially in export-oriented industries.


Registered Vacancies and Unemployment

Citation: IMF Staff Country Reports 2005, 327; 10.5089/9781451818352.002.A007

5. A sectoral analysis of employment trends suggests that informal sector employment has risen since 1997, with the share of workers in this sector increasing from 54 percent in 1997 to about 60 percent in 2003. Thus, most new entrants absorbed have gone to the informal sector, most notably agriculture (Table 2).

Table 1.

Indonesia: Trends in Labor Market

(In millions, unless stated otherwise)

article image
Sources: Indonesian authorities; National Labor Force Survey; USAID; and Fund staff estimates.

Data for 2004 are preliminary.

Defined as population above 15 years of age.

Includes those who work and those actively looking for a job; from 2001 includes transitionally unemployed and discouraged workers.

Defined as the number of people in the labor force as a percentage of working age population.

Table 2.

Indonesia: Sectoral Employment Trends

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Source: National Labor Force Survey.

6. Indonesia’s unemployment rate is considerably higher than rates in other countries affected by the Asian crisis, such as Korea, Thailand, and Malaysia. Unlike the other countries in the region, unemployment in Indonesia has steadily increased since the crisis. In part this is because the faster pace of manufacturing growth in the other countries created a large number of jobs and helped to absorb the growing labor force.3


Unemployment Rate

In percent

Citation: IMF Staff Country Reports 2005, 327; 10.5089/9781451818352.002.A007

C. Elasticity of Employment

Empirical analysis confirms that the elasticity of employment creation has been low in Indonesia. The estimates suggest that a one percent increase in GDP results in 0.4 percent increase in employment.4


Moreover, the dummy variable distinguishing the pre- and post-crisis periods is significant, indicating a downward shift in the elasticity between the two periods, although the shift is not very large.5 The results are consistent with the factor substitution and “induced innovation” theory, which suggests that firms will use/develop technology that substitutes the relatively expensive factor of production with other factors of production. The significant jump in minimum wages combined with increased labor market rigidities since 2000 (see below) could therefore explain the decline in elasticity between the pre-and post-crisis periods.

7. The estimates of the post-crisis elasticity suggest that employment should have increased with GDP growth, but rising labor costs has prevented this (see below). Although the elasticity measure suggests that employment should have increased given that growth has been trending up since 2000, employment has not, until recently, increased. Not only is Indonesia’s recent performance disappointing in terms of job recovery, but it also stands in contrast to the pre-crisis years, when high investment, including FDI combined with export-led growth, was a major source of employment creation. During those years, wages increased as labor moved from low productivity jobs in agriculture to high productivity jobs in manufacturing and services. The unemployment rate during the first half of the 1990s was therefore only about 3–4 percent, while the period since the late 1990s has seen a doubling and tripling of the rate.

D. Explaining Unemployment

8. Since 2000, labor policy in Indonesia has focused on improving workers’ rights and enforcing labor standards to improve working conditions. The Basic Manpower Act No. 13, 2003 is the current legal framework for labor regulations. Moreover, in 2000, Indonesia passed the Trade Union Act, which recognizes the freedom of association of workers. As a result, the largest three trade union federations now have close to 10 million formal sector workers (nearly one-third of those employed in the formal sector) with the number of trade union federations jumping from 11 in 1998 to 86 in 2004 and the number of plant level unions up from 2,836 in 1998 to 18,332 in 2004.

9. Labor market rigidities have been cited as one of the most important causes of rising unemployment. As shown in Table 3, Indonesia ranks least favorably in terms of standard indicators of labor market rigidities used by the World Bank in international comparisons. While Indonesia’s per capita income is less than one-fourth of the region, firing costs are about three times the regional average. In a survey of 700 firms conducted by the World Bank, labor market rigidities, most importantly minimum wages, hiring and firing difficulties, relatively high severance pay, and outsourcing restrictions were cited among the key factors inhibiting investor interest in Indonesia. This section seeks to assess to what extent these elements have indeed hampered job creation. The Indonesian regulations are compared with those in neighboring countries to assess the extent to which they are out of line with the regional norms and with the U.S., which is often cited as the country with the most flexible labor market (Table 4).

Table 3.

Indicators of Labor Market Rigidities - A Regional Perspective 1/

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Source: Doing Business, The World Bank.

The index varies from 0–100, with higher values representing more rigid regulations.

This index is an average of the three indices shown above, that is, indices for difficulty of hiring and firing and for rigidity of work hours.

Table 4.

Labor Regulations and Worker Benefits in Selected Countries

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Minimum Wages

10. While minimum wages (MW) were first introduced in the early 1970s, they have gained importance in recent years. Indeed, MW have risen quite sharply in the post-crisis period, increasing almost four-fold in some provinces. While the philosophy behind MW has been to enable workers to consume a minimum bundle of essential goods and services, like clothing, housing, transportation, and health services, the fact that the MW has outpaced labor productivity has meant rising unit labor costs for enterprises. Studies suggest that this has been a deterrent to wage employment. This situation has been exacerbated by the decline in investment, until recently, especially in labor-intensive export industries.


Indonesia: Labour Productivity and Real Wages

Citation: IMF Staff Country Reports 2005, 327; 10.5089/9781451818352.002.A007

11. When nominal minimum wages tripled in the first half of the 1990s, labor productivity was also rising. In 1998, in the immediate aftermath of the crisis, wages in real terms fell significantly given the high inflation during this period. In an effort to restore worker incomes, MW have been raised substantially since 2000, increasing much faster in real terms than average wages and per capita GDP. As a result, MW in real terms are now significantly higher than their pre-crisis peak in 1997. Indeed, since 2001, real minimum wages (averaged across provinces) have increased by more than 50 percent, while in Jakarta they have increased by over 60 percent. As this has happened against the backdrop of an economy where unemployment is increasing and formal sector employment declining, fewer workers have actually benefited from the new increases.

12. A regional comparison shows that, although MW are not high in absolute terms, they have recently outpaced productivity growth. In most countries, the MW serves as a floor and is the wage earned by the least skilled workers. However, in Indonesia average wages are close to the minimum wage and the MW has been binding on firms. In fact, average real wages have increased far slower than average real minimum wages. As a result, more productive workers in some cases earn the same as less productive ones, limiting the scope for wage differentiations to reflect productivity levels of different workers and undermining incentives. Indeed, surveys of employers suggest that they are unable to give performance-based wages to motivate more productive workers.


Monthly Minimum Wage by Province (thousands rupiah)

Citation: IMF Staff Country Reports 2005, 327; 10.5089/9781451818352.002.A007

13. Studies investigating the impact of MW on employment find mixed results. One of the first studies on the subject for Indonesia was done by Rama (1996), who found that the doubling of the MW in the early 1990s had resulted in a decline in employment in the range of 0–5 percent. Researchers at SMERU have also found a similar impact of MW on employment, with negative impacts stronger for females, youths and low educated workers. However, Islam and Nazara (2000) find that the MW policy has had no impact on unemployment.

14. Our estimates show a negative impact of MW on employment. A multivariate least squares regression of employment, on real minimum wages and GDP (all in log differences) gave the following results (with t-statistics shown in parentheses):


with the adjusted R-squared at 0.50 and the F-statistic at 9.6. Including a dummy variable to distinguish between the pre- and post-crisis period gave broadly similar results. The estimated relation suggests that changes in minimum wages have had a negative impact on employment growth, while real GDP growth is not significant. These results are consistent with developments in the post-crisis period, when growth has not resulted in an accompanying increase in employment. At the same time the R-squared and F-statistic imply that these variables do not capture the full story on employment developments. Other regulations like high severance pay and restrictions on outsourcing are possible explanations.6

Severance Pay

15. Severance pay regulations have been revised twice since the crisis, in 2000 and 2003. Already in 1996, rates of severance pay were increased by about 50 percent for dismissals relating to economic reasons, that is, when a firm laid off workers due to downsizing or if the firm went bankrupt. In 2000, Ministerial Decree No. 150 raised severance rates further for workers with 10 or more years of service although long service pay remained unchanged. However, the decree also extended long service pay to all workers, including those who left voluntarily. For example, a worker with 20 years of more of service was now entitled to 7 months of salary instead of 5 months in severance pay and 7 months of salary in long service pay. In addition, all laid-off workers, regardless of the cause for dismissal, were entitled to a 15 percent gratuity on their severance pay and long service payments. The Manpower Act of 2003 further increased severance to 9 months of salary and long service pay to 7 months. If workers are laid off for economic reasons, severance pay is now 18 months of salary plus 7 months in long service pay adding up to a total of 25 months of salary. Employment in the manufacturing sector has been hardest hit by these regulations, as this sector employs the largest proportion of formal sector workers.

16. Severance regulations act like a “hiring” tax on employment and several studies, both for developed and developing countries have shown that increases in severance pay reduce the demand for labor. Severance pay in Indonesia is the highest in the region as shown in the chart based on labor laws of different countries. Furthermore, in a study done by USAID-GAIT, the authors show that severance pay in Indonesia is now among the highest in the world in relative terms, and similar to rates in Latin American countries, such as Honduras, Colombia, Peru and Ecuador, where unemployment rates are similarly high.


Severence Pay In Monthly Wages in Asia (Employees With 4 Years of Service)

Citation: IMF Staff Country Reports 2005, 327; 10.5089/9781451818352.002.A007

Outsourcing and fixed term contracts

17. Unlike advanced countries, where outsourcing usually relate to jobs being transferred to lower-income countries, in Indonesia it relates more often to intra-industry transfers of jobs. The 2003 Labor Law allows firms to outsource any “non-core” activities, while leaving the definition of what constitutes core versus non-core to negotiation between employers and employees. While this legislation is aimed to give flexibility to enterprises to decide what to outsource, labor unions have claimed that employers use this ambiguity to contract out work to temporary labor to avoid severance payments. While it is difficult to quantify its impact on employment generation, it appears that worker opposition to outsourcing may have resulted in negative investor sentiment toward labor-intensive industry in Indonesia vis-à-vis its neighbors.

18. The regulation on fixed-term contracts now restricts such contracts to 2 years with an additional year of extension allowed, compared to previous regulations which allowed 3-year fixed-term contracts with one time renewal. By limiting the length of fixed-term contracts to three years, including through renewability, this regulation seeks to improve job security for workers by ensuring that firms do not use such contracts as a means of avoiding severance pay by not offering permanent contracts even to workers needed for protracted periods. However, by limiting the enterprises’ flexibility to hire temporary workers and thus reducing their adaptability to changes in product demand or technology, this regulation is viewed as inhibiting by investors.

E. Policies for Employment Creation

19. A principal focus of the government’s medium-term program is to halve the unemployment rate by 2009. Beyond the general strategy to encourage investment through the maintenance of macro-economic stability and a deepening of structural reform, the program underlines three principal initiatives in regard to the labor market:

  • Reducing unemployment through better targeted and active labor market programs.

  • Improving the quality of human resources.

  • Strengthening labor market institutions to promote a balance between employer and employee rights.

20. The discussion in this chapter suggests that the following actions would help increase job creation:

  • Minimum wage to serve as a floor as in other countries, with actual wages decided by collective bargaining. In most developed countries, the government determines minimum wages, with the level set with a view to help protect workers with low skills. Actual wages are then set by negotiation between workers and employers. This system helps to protect low-skilled workers while allowing firms the flexibility to determine the wages they are willing to offer for different types of work based on labor productivity. In this context, the establishment of tripartite councils which bring together employers, employees and the government, acknowledges the need to keep labor productivity in mind when deliberating on minimum wage increases. Looking ahead, it will be important to set minimum wages such that the low skilled workers are protected while allowing a process of collective bargaining between employers and employees to determine wages at the enterprise level. This would facilitate hiring as well as introduce skill and performance based wage setting.

  • Improve worker skills by investing in education. Labor productivity in Indonesia has risen much less than real wages. A recent study by the Ministry of Manpower found that almost 55 percent of the workforce only has an elementary school education and less than 5 percent has post-secondary school education. The new government’s commitment to reprioritize spending to improve the quality and efficiency of spending by redirecting it to health and education could be key to improving education levels and the skills of workers.

  • Improve the social security system while limiting the burden on the budget. An important political rationale for the high severance payments in Indonesia is the lack of an effective social security system. Although there are regulations that require employers with 10 or more employees to provide insurance with employer-employee based contributions, currently these are not strictly enforced. The Social Security Bill aims to improve the safety net, and would provide the basis for scaling back statutory severance payments. When implementing this system, the government needs to avoid the creation of unfunded contingent liabilities and setting payroll taxes at levels that would discourage hiring.


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Prepared by Nita Thacker (APD).


Since 2001, the Statistics Agency uses an internationally accepted definition of unemployment, which includes transitionally unemployed and discouraged workers. If these workers were excluded from the definition of the labor force, the unemployment rates for 2001–2004 would be 3–4 percentage points lower.


Note that for Indonesia the relative performance may appear weaker because of the larger coverage of unemployment statistics since 2001, as explained in footnote 1.


The elasticity was estimated using data for 1991–2004 with all variables in log, including a dummy variable for the two crisis years of 1997–98 and another regression using a dummy variable only for the pre-crisis period up to 1998.


In comparison, Isard and Nazar (2000) found that the elasticity of employment during the pre-crisis period (1977–1996) was in the 0.50.7 range.


Studies have shown these as important in many developing countries.

Indonesia: Selected Issues
Author: International Monetary Fund