Challenges abound for Indonesia’s economy

In the middle of Jakarta stands a statue of Krishna and Arjuna, central characters in the Mahabharata, the Indian epic. They are on a chariot pulled by 11 horses in full gallop. It is an appropriate metaphor for the Indonesian economy, which has surged forward to its highest level in years. While growth is expected to be 6.1% in 2012, on June 7 the Jakarta Globe reported the Government believes it to be 7.2% next year. (World Bank estimates previously had suggested 6.4% growth in GDP in 2013.)

That’s not all. By the end of this year or early next year, Indonesia may join the club of 15 countries with an annual GDP of more than $1 trillion. In 2011, foreign direct investment reached a record $19.3 billion and exports grew by 29%, reaching $203.62 billion. Fitch Ratings in December granted Indonesia an investment-grade credit rating after 14 years of junk status, and Moody’s Investors Service followed in January.

Indonesia’s net foreign debt is now less than 10% of GDP, and a real possibility exists that the country might become a net creditor by the end of next year. Moreover, Indonesia’s stock market is booming. It was one of Asia’s best-performing markets, gaining 3.2% at a time when other exchanges suffered due to the global financial crisis. In April, the World Bank noted that “despite both domestic and international risks, Indonesia’s economic fundamentals are solid”.

Indonesia has seen rapid economic growth before – but the country also faces several risks and challenges. Experts at Wharton and elsewhere wonder whether this growth is sustainable. Philip M. Nichols, a professor of legal studies and business ethics at Wharton, is upbeat. He believes Indonesia’s large internal market has enabled the country to weather the global economic crisis relatively unscathed. According to him, Indonesia is finally beginning to climb out of the “institutional hole” that it found itself in pre-1997 when rapid growth papered over deep faults and eventually led to a crash. Indonesia’s large internal market – two-thirds of its consumption is internal – makes its economy resilient. Furthermore, the country has better institutions, less distortion and greater reliance on markets.

Indonesia is in the middle of an unprecedented consumer boom. Scooters, cars, smartphones, ice-creams and skincare products are all in demand. The middle class is growing, and newly affluent Indonesians are spending. Big brand names are visible on televisions, bill boards and on Jakarta’s streets. When it comes to commodities, the growth of China and India has given a fillip to the Indonesian economy. Both demand coal and gas while the entire world is hungry for palm oil.

Dutch disease?

While commodities are driving growth, they are also creating the risk of a Dutch disease for Indonesia. The Dutch disease refers to the fact that an increase in exploitation of natural resources leads to a decline in the manufacturing sector in the economy due to exchange rate appreciation. Manufacturing has lagged behind almost every other sector of the Indonesian economy. This is unhealthy in the long term, according to Richard J. Herring, co-director of the Wharton Financial Institutions Center, who believes Indonesia should focus on infrastructure and human capital formation to wean itself away from its resource base. Other regional competitors, such as Vietnam, have been focusing on education and infrastructure while Indonesia has been lagging behind on both fronts.

Indonesia ranks 124^th out of the 187 countries surveyed by the 2011 Human Development Index. Apart from the University of Indonesia, its universities have slipped in the 2011 World University Rankings. The overall level of educational attainment is relatively low; some 50% of the labor force has an elementary school certificate or lower. Only 40% of the labor force has secondary education and a little more than 5% has diplomas and university degrees. This leads to a problem of labor underutilization, such as unemployment and underemployment.

These challenges are compounded by a shortage of infrastructure. Indonesia desperately needs ports, roads, railways, power and broadband. Broadband use is only about 18% of all internet users in Indonesia. More importantly, while its neighbors are busy building new ports or expanding old ones, Indonesia appears to be lagging behind. The World Bank’s Logistics Performance Index ranked Indonesia at 75^th out of a total of 155 countries surveyed. Malaysia, Thailand, Philippines and Vietnam are all ranked above it, and the differential is only likely to increase as they are all investing in infrastructure.

Role of government

As a young democracy, Indonesia’s government institutions are still evolving. The highly decentralised political system makes decision-making arduous and protracted. Forging institutions for a sprawling archipelago with a population of 240 million people from more than 300 ethnic groups speaking 737 languages is tough. This is made tougher because of the legacy of Dutch colonial rule followed by decades of authoritarian rule after independence in 1945. Indonesia has a gargantuan bureaucracy that is often criticised for acting too slowly.

To add to Indonesia’s woes, its political system is fragmented. President Susilo Bambang Yudhoyono is the head of a six-party coalition who seeks to rule by consensus, but this is often difficult to achieve because of conflicting agendas. Politicians draw their power from patronage, which means that there is an incentive to create policies that benefit wealthier segments of the population.

Consider fuel subsidies, for example. According to the 2009 household survey conducted by the World Bank, 40% of the direct benefits to households from fuel subsidies go to the richest 10% of households, and less than 1% of the subsidies go to the bottom 10%. Further, with the price of Brent crude oil topping $105 a barrel, fuel subsidies are costing the exchequer a huge sum. Recent attempts to cut back the subsidies have resulted in street protests and parliamentary rebellion. As a result, fuel subsidies remain unchanged. In light of the continuing high price of oil, Shubham Chaudhuri, the World Bank’s lead economist in Indonesia, remarked last month that the government would end up spending between $20 billion and $30 billion every year on subsidies instead of using funds “for roads, health care, alternate energy sources and helping poor households”.

Corruption poses another challenge for growth. For instance, Muhammad Nazaruddin, the former treasurer of the ruling party, was convicted in April of defrauding the exchequer to the tune of $365 million by inflating construction tenders for the 2011 Southeast Asian Games. He claims that he did this to raise funds for the party and not for personal gain. Senior party members and even ministers are now suspects in this scandal, which, according to The New York Times, has “riveted the nation and shaken the party of President Yudhoyono”.

What will this combination of growth potential and serious challenges mean for Indonesia’s future? According to Herring, “Indonesia could be one of the leading economies in the world,” but to get there, the country will need to implement reforms. At the moment, the International Financial Corporation and World Bank rankings for doing business place Indonesia at number 129 out of a total of 183 countries. The same index ranks Indonesia at 155^th for starting a business, at 156^th for enforcing contracts and at 161^st for getting electricity.

With reforms, over time, things are likely to get better. A new land acquisition act was passed in December. This is likely to increase spending on infrastructure, and already there are signs that this is beginning to happen.

One of Indonesia’s greatest strengths is its culture of tolerance. No other Islamic country has a statue of Krishna, who is revered by millions of Hindus, in the middle of its capital. If the country can build upon such strengths while also being mindful of its challenges, there is a strong chance that the metaphorical chariot will continue to speed forward without faltering.