Indonesia: The great ascent?

Since the 1960s, Indonesia has emerged from a poor developing country to one of the world’s most attractive emerging markets for global investors. Can it continue its ascent during the next decade to become a global economic power?

Indonesia: The great ascent? AFP Photo/Bay Ismoyo

When Susilo Bambang Yudhoyono became president in 2004, Indonesia was still a low-income, developing country. Indonesian gross domestic product per person was just $1,200, still stagnating at a similar level to 1995. Yudhoyono had inherited a legacy of economic stagnation during the decade from 1995 to 2004. Indeed, GDP per person had fallen sharply during the Asian economic crisis of 1997-98, with Indonesia in political and economic turmoil.

However, in the decade Yudhoyono held office, between 2004 and 2014, GDP per head in Indonesia almost tripled, rising from $1,250 in 2004 to around $3,500 in 2014, reflecting the remarkable economic transformation that took place under his leadership. During his presidency, the nation moved into the ranks of the lower middle-income developing countries. During this period, Indonesia’s total annual GDP also tripled, increasing from $280 billion in 2004 to $890 billion in 2014.

Under the current president, Joko Widodo, Indonesia’s GDP has risen further, to an estimated $970 billion for this year. By 2018, Indonesia is expected to join the elite ranks of the world’s nations whose GDP exceeds $1 trillion. In the Asia-Pacific region, only China, Japan, India, Australia and South Korea are currently in this grouping.

The macroeconomic achievements of Yudhoyono’s presidency included substantial achievements in reducing the twin burdens of high government debt and external debt during the 2004-2014 period. Government debt as a share of GDP was reduced from 56 percent of GDP in 2004 to an estimated 25 percent as of 2014, putting Indonesia’s government debt burden in a very favorable light compared with the fiscal plight of most Organization for Economic Cooperation and Development countries today. As of 2016, the government debt to GDP ratio had edged higher, to an estimated 28 percent of GDP, but still remained very low by international benchmarks for both developed and developing countries.

Indonesia’s own external debt position has also improved substantially, with external debt as a share of GDP having been reduced from 54 percent in 2004 to around 33 percent in 2014, another substantial achievement that has helped to reduce its vulnerability to external financing. Indonesia’s external account position has also been strengthened by a significant rise in foreign exchange reserves. In 2004, its FX reserves were around $35 billion, and since then have tripled, reaching the $100 billion mark in 2011 and hitting $112 billion in 2016.

The improved macroeconomic and external account indicators for Indonesia have helped the nation to secure an investment grade rating from the international rating agencies Fitch (2011), Moody’s (2012) and Standard & Poor’s (2017). This is important for lowering international borrowing costs for the Indonesian sovereign as well as Indonesian currently in this grouping. corporates, as well as making its capital markets more attractive for international investors.

With Indonesian GDP currently growing at a pace of around 5 percent per annum, and projected to sustain growth momentum at around 5 percent to 6 percent per year during the next decade, the size of its GDP is projected to reach $3.7 trillion by 2030, according to IHS Markit forecasts, or around half the size of Japan’s GDP in that year. This is expected to place Indonesia as the Asia-Pacific region’s fourth-largest economy after China, Japan and India, and exceeding the size of the Australian and South Korean economies.

On a global scale, Indonesia’s GDP is projected to be larger than the GDPs of Italy, Canada, Brazil and Russia by 2030. This is expected to place it as the eighth-largest economy in the world by 2030. The ascent of Indonesia as a global economic power during the next decade will transform its role in the global geopolitical and economic landscape. This will have many implications for its foreign policy and its role in international relations, bringing new duties and responsibilities as one of the world’s most powerful nations, economically speaking.

The changing structure

First and foremost, Indonesia’s ascent as a global economic power will be a tremendous positive factor for Indonesian society. Despite its tremendous economic progress since 2004, it remains a country facing significant further challenges in achieving fundamental human development goals. Although there has been substantial progress in poverty reduction since 2004, the World Bank estimates that 28 million Indonesians, or around 11 percent of the total population, still live in poverty, with around 40 percent of all households close to the national poverty line.

Rural poverty remains a burgeoning problem, with the rural poor accounting for around 63 percent of the total numbers in poverty. Similarly, although there have been large improvements in access to basic health care since 2004, with health insurance coverage for the poor having roughly tripled to cover around 43 percent of the population, this still leaves half of the poorest segments of society without access to basic health care cover.

The projected expansion of GDP by around $2.7 trillion between 2017 and 2030 will

transform the domestic economy, bringing tremendous improvements to national living standards and largely eradicating poverty in both urban and rural areas. Indonesian per capita GDP measured in nominal dollar terms is projected to rise from $3,700 in 2017 to $12,400 by 2030, pushing Indonesia into the ranks of the upper middle-income nations of the world.

This rise in per capita GDP will fuel rapid growth in household incomes, making Indonesia one of the fast-growing large consumer markets among the world’s emerging markets. This will create strong momentum for rapid growth in domestic industrial production for a wide range of consumer goods, such as autos, white goods, home furnishings and fast-moving consumer goods, as well as manufactured products required for the construction sector such as steel, cement and glass. The rapid growth in household incomes will also drive growth in demand for services such as health care, retail banking, insurance and communications. E-commerce is projected to be one of the fastest-growing sectors, bringing with it rapid growth in demand for the logistics sector.

The rapid growth of domestic consumer demand for a wide range of goods is expected to drive industrial development, helping to underpin sustained rapid growth in industrial output of a wide range of products, such as autos, electrical and electronic products, household goods, food products and construction-related manufactured products.

This should accelerate the development of Indonesia’s industrial companies, creating large domestic industrial firms that will eventually begin to expand into other markets in Asia as well as worldwide. The emergence of Indonesian multinational brands will be an important aspect of Indonesia’s long-term industrial development and its emergence as a manufacturing exporter. A number of Malaysian, Singaporean and Thai multinationals have already developed regional and international brands, and as Indonesia becomes a regional economic power, a growing number of firms will become more global in their business operations. This will also be a crucial step for the future development of its manufacturing exports.

Transforming the export economy

One of the biggest economic challenges that Indonesia faces during the next decade will be to transform its export sector by reducing the dominance of commodity exports and increasing the share of manufactured products and services in total exports. During the past two decades, Indonesia’s export structure has continued to be heavily dominated by exports of primary commodities, notably oil and gas, coal and agricultural commodities. This has kept its economy vulnerable to volatile global commodity prices and rapidly changing terms of trade for its exports. This vulnerability has been further compounded by Indonesia’s gradual shift from a net oil exporting nation to a net oil importer since 2004, as rapidly growing domestic oil consumption has not been matched by sufficient growth in oil supply.

Indonesian oil production in 2016 was 820,000 barrels per day, approximately half the

AFP PHOTO/ROMEO GACAD

level of oil production of 1.6 bpd achieved in 1981. Meanwhile, domestic oil consumption grew from 455,000 bpd in 1981 to 1.7 million bpd by 2013, creating a growing net oil import requirement since 2004. Indonesia is also confronting a similar situation with its liquefied natural gas exports, as rapidly growing domestic demand for natural gas is reducing the country’s long-term capacity for sustaining its level of LNG exports.

Indonesia’s deteriorating net oil import position, the slump in world thermal coal prices between 2011 and 2012, and declines in world prices for other mineral ore exports such as copper and nickel have contributed to a significant deterioration in its terms of trade and its current account balance. As a result, after a protracted period of current account surpluses between 1998 and 2011, it has run significant current account deficits every year between 2012 and 2016.

While exports of mineral commodities have been adversely impacted by falling world prices for commodities, the rapid growth of domestic demand has continued to drive rapid expansion in imports, creating potential long-term imbalances for Indonesia’s trade balance if the nation is not able to transform the structure of its export economy. The key challenge will be to develop a more competitive manufacturing export economy, which will be able to generate rapid growth in exports as well as employment growth. Therefore, a key strategic priority for economic policy will be to develop major manufacturing export industries that will help to mitigate the impact of deteriorating net oil and gas exports and volatile commodity prices.

With Indonesia’s urban population set to continue to rise rapidly during the next two decades, sustained job creation in the manufacturing and service sectors will also be important for social stability and to avoid inner-city problems related to high unemployment and urban decay. However, Indonesia is facing tremendous competition from other emerging markets that are also competing to attract foreign direct investment and create manufacturing export hubs. Member states of the Association of Southeast Asian Nations (Asean) such as Vietnam, Thailand and Cambodia are among the competitors, with Myanmar likely to also emerge as another competitor to Indonesia.

A key factor that is helping to build the competitive advantage for these countries is their proximity to China, with the Belt and Road initiative helping to boost road and rail connectivity among these countries during the next decade. In contrast, Indonesia faces logistical challenges due to relatively inefficient transportation infrastructure and the need to significantly upgrade its ports to reduce logistics costs and shipment times.

Building a competitive advantage

To accelerate the pace of development of the manufacturing and service sectors, strategic policy reforms are required to create a dynamic, entrepreneurial economy that is capable of generating a wide range of jobs in many sectors of the economy, including skilled professionals, vocationally qualified blue-collar workers and unskilled labor.

While the Indonesian mineral resources sector – notably, minerals and energy – has a vital role to play in Indonesia’s future economic development, it is, generally, relatively capital intensive and unlikely to generate sufficient direct and indirect employment growth in the economy to match the pace of growth of the work force. Therefore, a crucial element of its future economic development toward a well-diversified economy is to build a strong, competitive manufacturing sector that can generate substantial growth in employment. Creating the enabling business environment to encourage the growth of manufacturing through investment by both domestic and foreign entrepreneurs is an important role for government. Indonesia has in many ways been a laggard compared to many East Asian countries in terms of creating a competitive business culture that encourages both large multinationals and small- to medium-sized enterprises to establish operations and compete in domestic and international markets.

A key priority for the Indonesian government is to accelerate the pace of economic reform for business, to create a more competitive environment that allows privately owned, small- to medium-sized enterprises to become an important force for job creation. At the same time, barriers to international investment and foreign competition need to continue to be lowered. This will not only help to generate more private sector jobs in both the manufacturing and service sectors, but also will gradually lift productivity and the long-term potential growth rate of the economy.

The Joko administration has accelerated the pace of regulatory reform, reflected in

a significant improvement in Indonesia’s ranking in the World Bank’s Ease of Doing Business report for 2017. Indonesia improved its ranking from 106th out of 189 countries ranked globally in 2016 to 91st out of 190 countries in the 2017 report. Despite this, however, Indonesia still ranks poorly in key areas including procedures required to start a business, for which it ranks 151st in the world despite an improvement of 16 places compared to 2016. Another area where it ranks very low by international standards is in enforcing contracts, at 166th among 190 countries in the 2017 World Bank survey.

The Joko administration recognizes the importance of such reforms and has made significant efforts to liberalize foreign direct investment limits in a number of key sectors of the economy in a series of liberalization reforms that were introduced after President Joko took office in late 2014. Sectors that have been liberalized for foreign direct investment include cold storage, warehousing, toll road operators, tourism operators, pharmaceutical companies and health care services. These reforms have been a contributory factor to the strong investment inflows during the past two years. In 2015, Indonesia had the highest foreign direct investment in the Asean region.

A very important focus for future reforms will need to be accelerating the pace of microeconomic reforms, to deliver sustained improvements to economic competition within the Indonesian economy. This includes major reforms of state-owned enterprises, to ensure they are operating in a more transparent manner and that key sectors they operate in are liberalized and opened up to market competition.

Second, the pace of infrastructure investment needs to increase substantially. The government has already identified this as a key policy objective, having set a target of catalyzing around $120 billion of infrastructure investment during the current five-year national development plan, requiring around $24 billion of infrastructure investment per year. The government has estimated that it has the capacity to fund around 30 percent of this, with much of the remainder coming from private investment and public-private partnership projects. As a significant portion of the private sector financing will need to be externally financed, creating an attractive longterm environment for foreign direct investment is essential. While the process of legal reform is under way, substantial further liberalization of the investment environment is also important.

Third, major new initiatives are required to develop human capital. For the manufacturing and service sectors to flourish, creating a modern and skilled work force is critical. This requires substantial efforts to build up tertiary and vocational training institutions in the major urban centers around Indonesia, assisted and catalyzed by joint ventures and partnerships with foreign institutes. This will be a critical component of increasing the international competitiveness of Indonesia as an attractive destination for foreign direct investment, as well as enabling domestic firms to compete more effectively in international markets.

AFP PHOTO/BAY ISMOYO

Geopolitical implications

As the Indonesian economy rapidly expands, the size of total GDP will increase from around $1 trillion in 2018 to around $3.7 trillion by 2030. This will result in significant changes in Indonesia’s geopolitical importance in the Asia-Pacific region, as well as globally. The large increase in size will make it an increasingly significant voice in global international governance through international institutions such as the United Nations, International Monetary Fund, World Bank and G20. At the regional level, Indonesia will become a linchpin for the rising political and economic importance of Asean in global international relations.

After decades of being a recipient of overseas development assistance, Indonesia’s rising importance as a major global economic power will also transform it into an aid donor nation that plays an increasing role in providing South-South development aid flows to least-developed countries around the world. This has the potential to transform Indonesia into a development assistance donor nation, becoming an important positive force for assisting the development of other Asian countries that still remain in the group of low-income or lower middle-income nations. As Indonesia’s development assistance capacity grows it will gradually extend its assistance to other developing countries.

From a defense perspective, the tripling of Indonesian GDP between 2017 and 2030 will imply that its defense budget will also increase by a similar proportion, assuming that the share of defense spending of total GDP remains constant. This will increase Indonesia’s military capabilities substantially, allowing sustained modernization and making the country a more significant regional military power.

A key strategic focus of a growing military budget is expected to be the development of Indonesia’s naval power, in order to protect the vast archipelago that comprises more than 17,000 islands. With competing territorial claims by a number of countries in the South China Sea, developing Indonesia’s naval capabilities is likely to remain a strategic priority for Jakarta to protect its sovereign territory.

Risks and opportunities

While the growth prospects for Indonesia during the next decade remain favorable, with GDP growth forecast to average around 5 percent per year, there are significant risks that could impact the mediumto long-term economic outlook. A key risk to the outlook would be if the pace of economic reform were not sustained. A retreat from trade and investment liberalization could slow foreign investment inflows and reduce the pace of industrial development. Indonesia needs to significantly improve its business competitiveness in a regional landscape where other developing Asian countries are not standing still, but are also trying to improve their own competitiveness. As infrastructure remains

a key bottleneck to Indonesia’s long-term growth, another risk would be if the pace of infrastructure development should slow down. Indonesia needs to invest heavily in the development of critical infrastructure such as power stations, ports, highways and airports to enable the economy to grow at a sustained pace of 5 percent or better during the next decade.

Another key risk to the outlook is if Indonesia is unable to create sufficient new jobs for its youth entering the labor market. High rates of unemployment or underemployment could generate social unrest, as occurred during the political and social turmoil that shook the Middle East during the Arab Spring. As the manufacturing sector needs to play a significant role in generating new employment growth, a strategic priority for economic policy is to make Indonesia a more dynamic manufacturing export hub. Human development will be critical for its economic competitiveness, and strengthening tertiary and vocational training systems will be essential for creating a skilled work force with sufficient qualified workers for technical professions. If Indonesia does not train sufficient numbers of skilled professionals in key industries, this will become a significant bottleneck to industrial development.

Despite the numerous risks and challenges facing Indonesia over the next decade, there are also important opportunities that favor its future economic development. One of the most important opportunities is the rapidly growing domestic middle class, which is creating strong growth in demand for goods and services. This will provide a significant driver for the growth of a wide range of manufacturing and service industries.

Indonesia’s position at the center of the world’s fastest-growing region, the Asia-Pacific, also provides strong growth opportunities for its exports to other Asean economies as well as the world’s two largest emerging markets: China and India. This creates considerable trade and investment opportunities for Indonesian companies in the Asia-Pacific Economic Cooperation region in a wide range of industries, such as agricultural products and food processing, garment manufacturing, industrial equipment, construction services and tourism. Indonesia remains one of the most attractive emerging markets in the world and should be ranked among the BRICS economies to reflect its growing economic weight and significance among the world’s developing countries.



Rajiv Biswas is Asia-Pacific chief economist for IHS Markit. He is based in Singapore.

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