Why Widodo must act now or risk failing Indonesia for generations to come

ASEAN’s biggest economy is struggling to make the jump to a higher-income country because of poor education, ageing infrastructure and a lack of opportunities.

By Oliver Ward, edited by Francesca Ross

The ASEAN region’s largest economy is on a path to stagnation as Indonesia walks further into an income trap which could keep wages low for generations to come.

The problem is unsustainable and unbalanced governmental economic policy which is driving the economy into a middle-income trap. This is where a country becomes stuck at a certain income bracket because it has lost its competitive edge due to higher wages.

This means it is unable to make the transition to a high income nation. These countries suffer from limited investment, slower economic growth and limited economic diversification.

Indonesian GDP growth is slowing and stagnating. It currently hovers at 4.8%, down from 6.2% in 2010. Current projections expect it to reach 5.2% over the next 12 months and stay around this rate until 2020.

Indonesia needs to look to other nations for a solution

South Korea is a good example of a country which escaped the trap. In 1970, the Gross National Income (GNI) per capita in the Republic was just US$260, a similar level to Indonesia’s at that time. South Korea’s income had leapt to US$21,530 by 2009, but Indonesia’s is still just US$3,440.

The South Korea government boosted manufacturing industries thanks to low-cost labour and exported cheap manufactured goods. The authorities then promoted investment in high-tech industries and the GNI per capita began to soar. Indonesian President Widodo could learn lessons from this approach.

South Korea & Indonesia GNI per capita, Atlas method (current US$)

Source: World Bank

Indonesia has the perfect conditions to climb the income ladder

Indonesia has a natural abundance of resources and favourable working demographics yet still finds itself fighting to raise its income level. More than 50% of the population are currently under 30 years old. Indonesia is expected to have a workforce of 15 million people by 2020.

This creates a demographic bonus where the number of people at a productive age outnumbers those requiring state support. This will only be a bonus if there are jobs to fill. Indonesia has the population to fill huge manufacturing industries but these operations have not been established.

The population is also urbanising at a fast rate. The number of people living in urban areas rose to 52% in 2002 and is expected to reach 68% by 2025. Employment and industry needs to adapt to this new opportunity with more jobs, training and opportunities.

Current economic policies are not creating a manufacturing economy

The nation is currently in a good situation. There has been consistent growth of around 5.7% every year since 2001. The economy has also been resistant to the shocks of the global economic downturn thanks to strong public finances.

In these circumstances, Indonesian income levels should be sky rocketing but it remains stubbornly low. There are a number of reasons for this.

National export structures do not favour high value manufacturing. Raw materials still account for the largest amount of exports and 65% of all goods leaving the country are commodities.

Coal accounts for 8.7% of Indonesian exports, palm oil 7.6%, petroleum gases 5.9%, crude petroleum oil 3.7% and rubber 2.6%. These low-value exports make it impossible to take the leap to a higher-income economy.

Export Value (US$ billion)
Coal Briquettes 14
Palm Oil 12.3
Petroleum Gas 9.5
Crude Petroleum 5.9
Rubber 4.2

Source: OEC

Countries, like Japan, South Korea, Taiwan and Israel escaped the trap by transitioning to higher value, technological industries. Government policies have focused on increasing foreign direct investment in manufacturing. Education and infrastructure were also made a priority.

Enny Sri Hartati, Director of the Institute for Development of Economics and Finance complained “we were focused on natural resources, that is where the economy is concentrated. Small and micro industries never ascend to medium and large industries.”

Indonesia’s human capital is poor

Indonesian citizens have not been put in the best situation to make the leap from low-wage labour-based industries to high-wage skilled production. Young people have suffered from poor education and a lack of funding that means as much as 20% of those aged 15-25 are not in formal work or education.

Mathematics scores decreased between 2002 and 2012. During the same ten-year period the Organisation for Economic Cooperation and Development (OECD) saw a decelerated reading performance in Indonesia of 0.4. Countries like Thailand accelerated their scores in this period, reaching 0.7.

The Indonesian government needs to steer the economy towards manufacturing industries

It is up to Widodo to set a new course. It is essential to close the infrastructure gap to move to a manufacturing economy. Inadequate roads and port facilities are hampering Indonesian competitiveness in the global market.

The cost of logistics in Indonesia is equivalent to 24-27% of the total GDP. Other Asian countries average between 19-22%. This means Indonesia could be losing as much as 3-4 percentage points in GDP every year because of ageing, substandard infrastructure.

Widodo also needs to attract more investment. The level of cash coming into the country is creeping up at 0.9% year-on-year, but could be far higher with a more liberal economic policy. Singapore once took this road and adopted open door policies and created an attractive business environment for investors. This was a significant success; the country received US$65 billion in investment in 2015.

Indonesia could do the same but needs to remove the legal obstacles standing in the way of foreign investment. Bureaucracy is dissuading overseas companies and individuals to put their cash into the country. Promoting high-tech industries will create new opportunities for the workforce but investment in the country’s education system is needed to provide a skilled workforce for these industries.

An analysis by The World Bank suggests a complete overhaul of the product, labour and capital markets is needed. A coherent and sustainable industrial strategy also needs to be adopted which includes training centres across the country. These measures would support the growth of 9% per year Indonesia needs to become a high-income country by 2030.

It is a race against time

Widodo cannot wait. His 12-point economic reform package showed him to be a cautious and gradual reformer. Unemployment is rising and economic growth is still below its potential. The country needs a visionary reformer; not someone content to tweak the work of others and hope for economic growth and diversification. There simply is not time.

Indonesia’s demographic dividend of a large working population will not last forever. Estimates suggest the current demographic advantage will last for just another decade. The Indonesia leadership needs to capitalise on its large working demographic before they become old.

If this is not done then the people of Indonesia will be reduced to a middle-income limbo for a generation at least as the government struggles to pay for an ageing population. The demographic bonus that Indonesia is enjoying now, will turn into a demographic nightmare when they grow old and require state support.

In the words of the Deputy Trade Minister, Indonesia needs to “grow rich before it goes old”. The race is on for Widodo. He must develop a progressive economic policy which diversifies Indonesian exports, supports developing skills, and establishes higher value industries. If he does not he is letting down the country for many generations to come.