How Indonesia Can Rev Up Its Faltering Economic Growth

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https://carnegieendowment.org-Trinh Nguyen

Trinh Nguyen is a nonresident scholar in the Asia Program at the Carnegie Endowment for International Peace.

Source: Getty

Summary:  To sustainably plug its funding shortfall and bridge its income gap, Indonesia must tap more into global value chains and capitalize on its greatest asset: its people.

Indonesia has two major advantages that few countries can boast: it has the largest population in Southeast Asia and a population of citizens who will remain youthful well into the future .

But the archipelago’s demographic potential has not yet been fulfilled. Indonesia is highly dependent on commodity exports, places limited emphasis on manufacturing, and is heavily reliant on volatile portfolio investment—foreign investors buying stocks and bonds in Indonesian companies—to cover its current account deficit. The government also spends more than it receives in revenue, so it relies on foreign investors’ appetite for risk to cover this fiscal shortfall too.

Since President Joko Widodo came to power in 2014, Indonesia’s GDP has grown on average 5 percent per year, short of the 7 percent growth rates he promised during his first campaign .

In 2020, that growth rate has been bogged down as the coronavirus pandemic impacts tourism, trade, and investment. To compound matters further, measures that Jakarta itself has taken to combat the virus—restricting the movement of people and temporarily shutting down businesses—have also devastated domestic demand.

Indonesia’s perennial fiscal and current account deficits are not likely to cause problems in the short term because the collapse in domestic demand has curtailed demand for imports and caused the country’s trade balance to grow. Few Indonesians are buying things, so there is less need to stock the stores with expensive foreign goods. But in the longer term, Indonesia will have to pay a high price: weak growth and rising debt and poverty, unless the country changes course.

Indonesia’s Government Offers Support, But Financing Is a Challenge

In response to these dual challenges, the government recently unveiled a fiscal package valued at 4.2 percent of the country’s overall GDP. According to the authors’ calculations, this plan funnels 0.8 percent of the country’s overall GDP to help small- and medium-sized enterprises (SMEs). Additionally, 3.2 percent of GDP will go toward supplementing existing government budgets, bolstering social safety programs, and offering corporate financing. An additional 1.2 percent of GDP is discretionary support, like tax incentives and healthcare outlays, which are not direct spending but function more like tax cuts.This package, together with an earlier announced package worth of 0.2 percent of GDP, brings Indonesia’s total fiscal support to 4.4 percent of GDP.

This support will help jump-start Indonesia’s GDP growth after the pandemic. But it is nowhere near enough to offset the decline of the country’s private sector and the drop in tax revenue that businesses generate. And as such, given Jakarta’s reliance on income taxes, value added taxes, and excise duties, the government’s revenue streams have fallen rather sharply. Falling state revenue and rising expenditures to offset declining growth likely will mean a fiscal shortfall of nearly 7 percent of GDP in 2020. The country’s central bank, Bank Indonesia, has also helped not just by lowering the price of money via interest rate cuts but also by purchasing government bonds outright.

Even if financing is not an issue in the short term—as foreign investors return to Indonesia thanks to the high yields on its government bonds and large injection of liquidity by central banks in developed markets like the Federal Reserve and the European Central Bank—both the government’s fiscal boost and the central bank’s monetary support are only helpful to the country’s floundering economy at the margins. The bigger problems are shrunken growth and uncertainty about future income flows.

Indonesia should seize this opportunity to roll out fundamental reforms to reenergize its growth. The decline of domestic demand—which drives most of Indonesia’s growth in ordinary times—highlights that the country is too dependent on domestic sources of income. This vulnerability also shows Indonesia’s weak funding foundation, as the country heavily relies on income from portfolio investments that can be very volatile due to foreign investors’ fluctuating appetites for risk.

Indonesia Should Capitalize on Its Greatest Asset: People

Global demand is staging a recovery in the second half of 2020, but Indonesia will likely benefit less than other countries in Asia because exports make up too low a share of its GDP. As such, it cannot rely on pulling in money from overseas. That means Indonesia’s recovery is contingent on its ability to revive domestic activities and sources of income for consumption and investment. The reality is that Indonesia needs to move beyond resources, which it has focused on for quite some time, and instead move up the value chain by enacting policies to promote more investment in complex and lucrative commodity processing at home in Indonesia rather than just selling its raw materials abroad. Now is the time for the country to focus on moving up the value chain in manufacturing to leverage its inherent advantages—a huge, young, and energetic workforce that is eager to learn new skills—to raise its capital base and diversify its sources of national income.

Studies have shown that trade linkages to the global value chain (GVC) raise incomes and reduce poverty. The idea is that a country trades its comparative advantage (cheap and abundant labor) to gain what it lacks (capital and skills to produce higher value-added goods).

Unfortunately for Indonesia, its exports as a share of GDP declined to 17.3 percent in 2018 from 20.7 percent in 2012, thanks to a manufacturing slump and the country’s reliance on commodities, for which prices sank. The decline is both relative and absolute, in that gross exports peaked in 2011 at $203 billion, then fell to $180 billion in 2019 . Indonesia’s global market share in merchandise exports is now stagnating at around 0.9 percent, partly due to less money flowing in via manufacturing-focused foreign direct investment (FDI) . With fierce competition from neighboring countries like Vietnam, which aggressively offers investment incentives to foreign businesses and has liberalized its trade policy with the recent ratification of the EU-Vietnam free trade agreement, Indonesia has fallen behind. Its FDI is held back by restrictions as well as cumbersome labor laws that include some of the world’s most generous severance pay rules, which have put off some overseas investors. Vietnam’s global export market share has risen to 1.3 percent of GDP while Indonesia’s has stagnated .

As the world’s pandemic-induced economic contraction continues, exports will shrink even more in 2020. That is a worrying trend, as Indonesia’s participation in the GVC has declined since 2010 from 54 percent of its exports to 50 percent .

This means that Indonesia is falling behind both on the absolute value of its gross exports and its value added in terms of global supply chains. And that decline is coming from two avenues: first, fewer foreign parts are making their way into Indonesia’s gross exports, and second, fewer Indonesian-made intermediate goods (the component parts that go into a final product, like wheels for a bike) are going into the rest of the world’s exports.

But all is not lost. Indonesia is the largest economy in Southeast Asia, both in terms of population and economic size. And most importantly, the archipelago’s demographic transition will still be favorable to economic growth for the next thirty years, according to UN Population Statistics projections. Widodo’s push to invest more in infrastructure is a move in the right direction. Earlier in 2020, the president reformed labor laws to open the economy after his government received World Bank reports that raised concerns regarding the country’s economic attractiveness for firms looking to diversify away from China.

These steps forward will help Indonesia capitalize on its endowment of favorable demographics to attract manufacturing FDI. The playbook is straightforward: Indonesia should target sectors it wants to develop and introduce incentives to attract multinational firms to invest.

Going the manufacturing FDI route would kill at least five birds with one stone. It would provide stable funding in new factories rather than less stable portfolio investment in existing Indonesian companies. This strategy would diversify Indonesia’s sources of income and would also bring in foreign technological advances. Such an approach would increase access to foreign markets as well. And, finally, it would help increase the country’s share of high value-added exports vis-à-vis lower value-added ones, helping Indonesia rise up the global supply chain. Such long-term reforms are critical for Indonesia to hasten its economic development and realize its potential to achieve a GDP growth rate above 7 percent.

 

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