By 2014 Indonesian output reached nearly 1.3 million vehicles, with exports expected to be around 200,000. Foreign direct investment (FDI) has driven this impressive performance, but now Indonesia’s rising middle class is the main reason for optimism in the automotive industry.

While slow to start, Indonesia’s automotive industry has a history of vehicle assembly going back to the 1920s. Growth was rapid in the 1970s, but in the 1980s production stagnated at around 200,000 vehicles annually. Only in the 1990s did growth resume, though it was interrupted by the 1997 Asian financial crisis.

As in other ASEAN countries, early growth in Indonesia was heavily based on import substitution, with the import of complete cars banned from 1974 to 1993. The domestic vehicle assembly of imported kits has historically been protected by high tariffs, which are still quite substantial.

Inward FDI has driven recent output growth. This has mainly come from Japanese automotive producers, who now account for some 90 per cent of Indonesian production and domestic market sales. The protected domestic market has been one attraction. But, since 2010, under the ASEAN Free Trade Area (AFTA) Indonesia has had to remove the barriers to imports from other AFTA members — including Thailand, a major vehicle exporter. Yet since Japanese cars dominate domestic sales, Japanese motor manufacturers can decide which of their own models to import, and this gives them some control over import competition.

Today, the large size and growth of the Indonesian domestic market is the main driver of optimism for automotive producers. Indonesia is reaching an income level at which many urban dwellers can begin switching from riding motorbikes to driving cars. And the incentives to switch will only become stronger if Indonesia can improve its highly congested road system.

Incentives to expand car production were strengthened by the Yudhoyono government’s support for a fuel-efficient and environmentally friendly vehicle — the low-cost green car (LCGC) — with tax incentives for consumers. This is somewhat like Thailand’s eco-car, which was developed as a ‘product champion’. Even though economic growth in Indonesia has slowed since 2012, local sales of LCGCs have continued to increase rapidly.

Between 2011 and 2012, new automotive investment in Indonesia more than doubled. Most of this investment came from foreigners. This foreign domination is not unusual, even in developed countries, due to the world motor industry’s concentration into a small number of giant companies like Toyota or Volkswagen. Yet some domestic participation in the industry remains important if local firms are to develop the technological capacity to stimulate other industrial development in the long run.

There is still scope for Indonesian firms to act as component suppliers to foreign assemblers, but there is much to be done. Indonesia has only about a third as many auto-parts suppliers as Thailand. Most of the large, first tier component suppliers are Japanese firms with some local joint-venture participation. While these joint ventures may offer technology transfers, there is often heavy foreign control over how the Indonesian partner can develop.

Many developing countries have tried to increase the local content of automotive production by imposing local-content requirements, and Indonesia is no exception. Such requirements have been banned by the WTO since the early 2000s, although some countries — including Thailand — have used tax policy to circumvent the bans.

Some vehicle brands in Indonesia appear to have high local content, but the indirect import content is often high. To increase genuine local content, Indonesia has charged lower levels of duty, or no duty, on imported subcomponents since 2006. This is to encourage local assembly of major components rather than their direct importation.

Some countries, notably South Korea, have been able to develop their own indigenous motor industries. Malaysia has also tried to do so, but Proton — its national car — is generally regarded as a failure. Only the Malaysian government has been able to keep Proton in business. Indonesia’s attempts in the 1990s to develop a national car, with Korean participation, failed because they were so blatantly anti-competitive that other WTO members were able successfully to protest.

Given the problems Malaysia has had with Proton, Indonesia’s failure to establish a national car may have been a blessing in disguise. Yet Indonesia’s President Joko Widodo visited Malaysia and witnessed the signing of an agreement between an Indonesian company and Proton to investigate the possibilities of a new Indonesian national car.

Indonesia’s growing domestic market is the strongest incentive to increase production, but Japanese manufacturers also see further export potential. LCGCs are already being exported to the Philippines. The Indonesian government hopes to develop the country as a regional centre for vehicle production in ASEAN. Recent growth is encouraging, but there’s a long way to go.

Kaoru Natsuda and Kozo Otsuka are Associate Professors at Ritsumeikan Asia Pacific University in Japan. John Thoburn is a Visiting Professor at APU and Emeritus Reader in Economics in the School of International Development at the University of East Anglia, UK.

This article is a digest of a paper originally published here in the Bulletin of Indonesian Economic Studies.