Indonesian economy -- what next?

The Indonesian economy was floored by the 1997/98 Asian financial crisis. Then as recovery began, it hitched its wings to the 2001/2010 commodity price boom. Now that commodity prices have fallen back again, the Indonesian economy faces new challenges.

No-one imagined that Indonesia would become a high-flying democracy, when the corrupt, authoritarian regime of President Suharto crumbled under the weight of the Asian financial crisis. Indeed, there was much bleating at the time by the three crisis-affected countries, Indonesia, Korea and Thailand, about the harsh reform measures imposed on them by IMF.

But all three countries bounced back quickly from the depth of the crisis. And they all enjoyed a subsequent decade of high-flying growth, in no small part thanks to the structural reforms undertaken. In sharp contrast, Japan has been protected from an externally-induced financial crisis, due to its mammoth foreign exchange reserves. Thus, Japan has unfortunately been relieved from external pressure to implement serious structural reforms, which has contributed to its long economic stagnation. A similar stagnation risk exists for China, due to the temptation to avoid difficult reforms and their unavoidable creative destruction.

Indonesia and the commodities boom

Back to Indonesia, and it was the commodities boom, one of the greatest of all time, driven by rapid growth in China and India, that pushed the Indonesian economy forward in the 2000s. Indonesia is a commodity rich country, and it benefited greatly from the threefold increase in prices for coal, crude palm oil, and rubber, all of which it has in abundance.

Indonesia's GDP grew at an annual rate of 4.7% from 2000/05, rising to 5.7% in 2006/10, and further to 6.0% in 2011/12, according to the World Bank. Thus, total GDP almost doubled between 2001 and 2012, from $580 billion to $1.1 trillion, making it the 15th largest economy in the world. Its GDP per capita jumped from $2,737 to $4272 in purchasing power parity terms. And the share of people living in poverty was cut from 24% in 1999 to 11% in 2013. This was also a period of low public deficits, declining public debt and healthy balance of payments.

But not all was rosy during this high-growth decade. Inequality grew sharply, as high-income households benefited much more from the boom than did low income households. About 65 million people still live in near poverty (between $1.25 and $2 a day), and are thus highly vulnerable to food price increases, health shocks (like a sudden serious illness) and natural disasters -- especially since large numbers have no social protection.

All together, this means that some 40% of the Indonesian population lives in poverty or near-poverty. And large numbers who would not be considered poor in income terms, are poor in terms of access to decent housing, transportation, water, sanitation, health and education. Poor nutrition and stunting remain serious problems among the poor. Public health spending in Indonesia represents only 1.2% of GDP, the fifth lowest in the world.

The Indonesian government also squandered the sharp rise in public revenues during this period, with much of the windfall being consumed via fuel subsidies which benefited higher income families disproportionately, thereby exacerbating inequality. At the same time, public investment in infrastructure lagged economic growth, with the result that Indonesia's terrible infrastructure deficit is now worse than ever, thereby cutting the potential for growing productivity. Fuel subsidy expenditure has been double that on infrastructure.

Growing reliance on commodity exports may also have harmed Indonesia's longer term development prospects. They now account for over two-thirds of total exports, with seven of Indonesia’s top ten export products being commodities. In contrast, manufactured exports have slipped back in importance, especially in the high technology area. And commodity-driven growth this past decade has been accompanied by further environmental degradation and rapid deforestation, along with illegal logging and fishing.

Indonesia at a critical juncture

Today, the Indonesian economy stands at a critical juncture. Commodity prices have been falling since 2011, and Indonesia's oil and gas production is in long-term structural decline. More recently China, an important trading partner, has moved to a lower growth trajectory. At the same time, Indonesia has the potential to exploit a demographic dividend, as the working age population could increase by 15 million to 190 million from 2013 to 2020. Already some 43% of Indonesia's population is below the age of 25.

Navigating this critical juncture will not be easy.

Indonesia’s new President, Joko Widido (“Jokowi”) is a breath of fresh air after years of policy drift under President Susilo Bambang Yudhoyono. A self-made businessman, Jokowi is now is a reform-minded politician, who is untainted by accusations of corruption.

But Jokowi has his work cut out for him. His political allies do not hold a majority in the parliament. The pace of reform has slowed since the Asian financial crisis. And protectionist tendencies have been evident, such as in the ban on the export of unprocessed mineral resources.

Indonesia is not an easy country in which to do business. It ranks only 114th in terms of the ease of doing business among the 189 countries surveyed by the World Bank. Indonesia ranks even worse than the Philippines (95th), China (90th) and Vietnam (78th). And for some criteria, its rank is simply appalling, such as the 153rd for dealing with construction permits, 155th for starting a business, and 172nd for enforcing contracts.

The OECD estimates that Indonesia has the fourth most restrictive policies towards FDI of the 58 countries it surveyed. Inflows of FDI are lower than in Indonesia’s ASEAN peers. Corruption is endemic in Indonesia, with Transparency International placing it at 107th out of 174 countries, way behind problem cases like China (100th), the Philippines (85th) and India (also 85th). In particular, corruption is widespread in the judiciary and law enforcement, according to the World Justice Project.

Indonesia’s poor infrastructure is legion, with the World Economic Forum ranking it 61st out of 144 countries surveyed. It is hardly surprising that Jakarta should have the worst traffic in the world. Indonesia road length only grew by 35% over the past decade, while vehicle growth was 300%! The country’s infrastructure deficit has been a significant drag on economic and productivity growth.

Logistics bottlenecks are also preventing better integration into global value chains. Poor inter-island transportation prevents Indonesia from being an effective single market. It is often more expensive to ship goods from one Indonesian island to another than it is to ship from Indonesia to Singapore, China and even Rotterdam.

Access to financial services is very limited according to the OECD. A large proportion of poor households, micro-businesses and SMEs are excluded from formal banking and lending services. Overall, only 20% of adults have an account at a formal financial institution, compared with 35% in India and 64% in China.

If only Indonesia could improve its business and investment climate, it has great opportunity to unleash the productivity potential of the economy, and become an industrial power. China, which became the factory of the world in the 1990s and 2000s, has been suffering from rising wage costs, and a declining workforce due to population aging -- thereby creating a window of opportunity for countries like Indonesia.

But to exploit this window of opportunity, Indonesia needs not only a more business-friendly environment. It also needs a massive improvement in the quality its workforce to lift its productivity and GDP per capita. In the 2012 OECD PISA study, which focused on the education abilities of 15 year old students in 64 countries, Indonesia had the second lowest score (in contrast, fast-growing Vietnam, which still has a lower GDP/capita, ranked 17th). Over 50% of Indonesian 15-year olds do not even master basic skills in reading or mathematics.

The fact that the equivalent of almost six years schooling separates the highest and lowest average scores in PISA 2012, highlights how far behind Indonesia is. Indeed, some 70% of Indonesian manufacturers indicate that it is very difficult to fill skilled positions. Regrettably, a familiar refrain emerges in the education sector -- around one-third of Indonesia's education budget is misappropriated according to Indonesia Corruption Watch. And some 20% of Indonesian teachers are absent from the classrooms every day.

Improving economic opportunity for women could also greatly improve Indonesia’s economic prospects. It ranks a lowly 97th out of the 142 countries surveyed in the World Economic Forum’s global gender gap index. Female participation in the workforce is relatively low, and many of those with jobs have part-time employment in the informal sector.

Another group regrettably deprived of economic opportunity is Indonesia's indigenous peoples. They number some 50-70 million, out of a total population of 250 million, and suffer terrible human rights abuses, especially in West Papua. Close to 40% of the West Papua population lives in poverty.

One factor holding Indonesia back has been the decentralisation of government administration since the early 2000s. This may have brought government closer to the people. But it has also led to many inefficiencies in service delivery, and increased local level corruption.

President Jokowi's challenges

President "Jokowi" has made an impressive start to his presidency since he took office in October 2014. His decision to abolish most fuel subsidies was a courageous decision, even if it was facilitated by the sharp fall in world oil prices. These savings will hopefully contribute to tackling poverty, and improving education and infrastructure.

But Indonesia's "oligarchic democracy", with its vested interests of rich business and military elites, will make it difficult for President Jokowi to advance his reform agenda. Indonesia is perhaps the classic case of an oligarachy -- government of the "few", by the few and for the few, the very antithesis of the ideals of Abraham Lincoln. Government has always been dominated by a small group who seek to distort government decision-making to favour or protect their financial and other interests -- at the expense of the general population.

Indonesia has a very high concentration of material wealth power, according to American academic Jeffrey Winters. The total wealth of Indonesia's forty wealthiest citizens, $71.3 billion, is very much higher than those of Malaysia ($51.3 billion), Singapore ($45.7 billion), or Thailand ($36.5 billion), even though these latter countries are much richer overall.

The combined wealth of this handful of Indonesian oligarchs equals some 10% of GDP. A majority of Indonesia's oligarchs live semi-permanently in Singapore, where much of their wealth is also stashed away.

It is true that outside of Asia, countries like the US are also becoming oligarchic democracies, as wealth is concentrated in ever fewer hands, and is then converted into political power through “buying” the political system. But as disturbing as the trend is in the US, it pales into insignificance compared with Indonesia and many other Asian countries.

Most of today's Indonesian oligarchs grew up under President Suharto, through the corruption, licenses and privileges of his regime. As a practitioner of "sultanistic oligarchy", Suharto limited their influence and kept his oligarchy under control. But with the demise of the Suharto regime in 1997, Indonesia's oligarchs proceeded to buy up the political system.

Indonesia’s oligarchs now finance all the major political parties, and can influence decison making. Both candidates in Indonesia's presidential elections had their election campaigns bankrolled by oligarchs, with the winner incurring immense post-election debts.

Further, the flawed state of Indonesia’s democracy was highlighted by the fact that Jokowi’s contender for the Presidency, ex-general Prabowo Subianto, ran such a close race in the election. Too many Indonesians have a naive nostalgia for the authoritarian stability and strong leadership of Suharto's days.

Prabowo is a former son-in-law of President Suharto and was a central figure within his security apparatus. He “is a reactionary nationalist, whose commitment to democracy is half-hearted at best”, in the words of Andreas Ufen from the University of Hamburg.

Indonesia has an immense policy agenda for it to continue a path of strong economic growth and poverty reduction, and to exploit the opportunities of the ASEAN Economic Community. Investments in infrastructure, education, health and social security all require public revenues for financing. But government spending represents a paltry 15% of GDP, and must be increased by raising more government revenues. But oligarchs and many others are reluctant to pay their taxes. Only half of the Indonesian population file tax returns.

Moreover, over the coming decade, Indonesia will need economic growth rates of over 5% to avoid serious unemployment problems and the risks to social and political stability that this entails. Already, more 20% of the youth population is unemployed. To make serious progress in climbing the development ladder would require growth rates around 10%.

Indonesia has great potential to succeed in its development challenge. But for a country burdened by an oligarchic democracy, and many other political and social hurdles, it will not be easy to make the necessary difficult decisions.

Author

John West
Executive Director
Asian Century Institute