Indonesia, a country with 250 million inhabitants, recently elected a new President of the Republic in July 2014 – Joko Widodo – who is described as being a reformer. For several decades, Indonesia’s economic activity has been very dynamic and has led to a marked increase in the level of per capita wealth, as well as the emergence of a middle class. However, despite strong macroeconomic fundamentals, Indonesia’s economy is experiencing structural changes that affect its growth potential. The medium- and long-term challenge for this country will be to overcome the structural difficulties of its productive sector. Will Indonesia, which is now one of the emerging economies alongside Brazil, Russia, India, China and South Africa (BRIICS), manage to overcome the structural difficulties of its productive sector in the medium/long term?
Economic growth dynamic but not inclusive
Indonesia’s robust economic growth in the aftermath of the 1997 crisis led to a marked increase in the level of per capita wealth, which saw a twofold increase between 1998 and 2012, and the emergence of a middle class, which could double by 2020. It currently accounts for 20% of the population, i.e. some 45 million people.
However, this remarkable increase in Indonesia’s GDP per capita did not lead to a reduction in inequalities in the aftermath of the shock of the crisis. In fact, it was rather the opposite, as these inequalities increased: the Gini index rose from 29.9 to 38.1 between 1999 and 2011, reflecting an increase in income inequalities. The wealthiest 20% of Indonesians saw their relative wealth rise between 1999 and 2011. As for the poorest 20% of Indonesians, their wealth declined and accounted for 7% of GDP in 2011, after 10% of GDP in 1999. Finally, regional inequalities continue to be prevalent, despite decentralization, with a very important share of activity concentrated in Java.
The poverty rate (at the threshold of USD 2 a day in purchasing power parity) is high and concerned 43% of Indonesia’s population in 2011 – which is among the average for countries in the same income bracket –, but has declined considerably since the Asian crisis (82% of the population was poor in 1999). A significant proportion of the poverty and social difficulties that prevail in Indonesia has been caused by the financial crisis which hit the archipelago in July 1997. The lack of social protection nets explains why the most vulnerable communities are exposed to the turnarounds in economic activity. In addition, improving health services poses a major challenge for the country, since public health expenditure only accounts for 1% of GDP. Both health indicators and mortality rates (child, maternal, total) are the most negative in the region. This is due to the poor quality of basic healthcare and access to hospitals for the poorest, as well as the low level of preventive health measures.
Structural weaknesses affect growth potential
Highly capital intensive industries (steel, electrical equipment, chemicals…) and highly labor-intensive industries, such as the textile industry, have declined in added value in relation to GDP due to a lack of investment, which has contributed to accelerating the aging of equipment. In addition, there is a lack of infrastructure, especially in the electricity sector. At the same time, industry has experienced a boom in the plantation sector – mainly for palm oil and rubber – and mining sector (especially coal), fuelled by increasing international demand for these products. Overall, there has been a marked increase in the dependency of Indonesian industry on natural resources over the past decade (58% of the manufacturing industry), at the expense of other branches. This increase in the dependency on natural resources may be a source of vulnerability for the country in the long term, due to the constraints on the reserves related to these resources, and of greater exposure to the volatility of international prices in the exporting sector.
The development of the manufacturing industry is stagnating, in particular due to the lack of infrastructure. The country has the least infrastructure compared to its regional peers and it is of low quality. More specifically, it is the density and quality of roads, the capacity of ports and the quality of the power generation supply which show the greatest weaknesses for connectivity in Indonesia and with the countries in its region. According to IMF research, if infrastructure caught up with the average level of developed economies in terms of quantity and quality, the Gini index in Indonesia would fall by two percentage points. However, the investments to remedy these structural deficiencies, which affect competitiveness and therefore Indonesia’s growth regime, are grossly inadequate. In addition, they focus more on natural resources sectors.
At the same time, the primary state of the productive sector means it is unable to meet the dynamic domestic demand, which has contributed to creating new external imbalances since 2011. The latter are exacerbated by the sharp depreciation of the rupiah against the dollar since May 2013, which was triggered by the announcement of the phasing out of the US unconventional monetary policy, and reveal vulnerability in Indonesia’s external financing.
Furthermore, the shock of the Asian crisis in 1997 was so strong that a series of restrictions was introduced, which limits the banking sector’s financing of the economy, as well as the possibility for the State to borrow. These measures may be virtuous, but they also pose a constraint for Indonesia’s economy in general, and for the State in particular, in terms of addressing the structural challenges faced by the archipelago.
Overcome structural difficulties in the productive sector
Macroeconomic balances are changing in Indonesia and hamper its growth potential. The medium- and long-term challenge for this country will be to overcome the structural difficulties of its productive sector. The first challenge is infrastructure development (particularly for transport and electricity) and the State’s capacity to implement the required investments despite legal constraints (which limit recourse to the budget deficit and borrowing), the lack of fiscal resources and the high level of expenditure, which is constrained, as is the case with subsidies (for energy and food). The largest archipelago in the world holds considerable potential and Indonesia will need to meet these challenges in order to realize its own ambitions, in an increasingly uncertain international environment.
FMI (2013), Infrastructure and Income Distribution in ASEAN-5 : What are the Links? Seneviratne, D. et Y. Sun, Washington, D.C.
 The downward trend for the Indonesian rupiah against the dollar has stopped since early 2014.
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