Stuck in the Middle with You – and Indonesia

Indonesia became a middle-income country in 04. Indonesia’s growth rates — while superior to those of most developing countries — remain below those of East Asia’s most powerful economies. So why hasn’t the nation grown faster still as well as why does growth appear reduced in the democratic era than that of Suharto?

Few countries have experienced such dramatic changes in economic fortunes and political governance as Indonesia. The ‘chronic economic dropout’ in the mid-1960s, this took a remarkable turnaround as well as three decades for Indonesia to join East Asia’s miracle economies in the 1990s. However, getting graduated to middle-income status — whenever rapid, East Asian style economic development seemed assured — Indonesia experienced another discontinuity: the Asian financial crisis (AFC). This particular collapse was accompanied by, and indeed triggered, a political crisis, with the sudden end from the 32-year rule of President Suharto within 1998. The economy seemed in free fall.

However, as with the mid-1960s, the doomsayers were incorrect. The economy quickly bounced back and Indonesia quickly emerged as Southeast Asia’s most vibrant democracy, in which ‘big bang’ decentralisation devolved much administrative, financial and politics power to sub-national governments. It was one of the most comprehensive and rapid reconstructions of a country’s political institutions and procedures in recent times, with only a brief loss of economic momentum.

With this record of economic and political anticipating the waves, the notion of a middle-income trap in Indonesia hardly appears related. If growth rates from the last 15 years continue, Philippines will graduate to the high-income team within half a century.

At the same time, there are several key, if unquantifiable, challenges keeping back stronger growth in Indonesia.

The Indonesian public has long been reluctant to accept liberalism and globalisation. On this issue, the pendulum swung from global disengagement in early 1960s to an open regime in the late 1960s to growing state intervention throughout the 1970s oil boom prior to major deregulation from the mid-1980s. With persistently pro- and anti-reform currents, Indonesia has always been reasonably open since this period.

But the country’s rising economic nationalism has intensified protectionist pressures. This policy stance, combined with declining item prices since 2012, has resulted in indifferent export performance in recent years. Meanwhile, Indonesia continues to underperform in the crucial area of connecting to global value stores. These account for almost half associated with trade within ASEAN, but Philippines remains a relatively minor participant.

The reasons for this under-performance are well known and amenable to coverage intervention. Participating in these chains requires open trade as well as investment regimes, highly efficient logistics infrastructure and aggressive labour inputs. In these three key areas, Indonesia lags.

In education, Indonesia has achieved impressive gains since the 1970s. The country is now close to reaching universal literacy for its school-aged population and there’s a general commitment to funding, having a 20 per cent mandate on the government’s budget. Nevertheless, the nation lags in terms of high post-primary dropout rates and according to most comparative ‘quality’ indications, such as international examinations.

Major problems in higher education will become much more pressing as Indonesia advances through the ranks of the middle-income team. This sector is growing rapidly, but the government only usually spends 0.3 per cent of GDP on its in the past state-operated universities. While most of the growth must thus come with private involvement, the government remains ambivalent regarding deregulating and internationalising the system. The quality of tertiary training is highly variable, with no institutions featuring prominently in international comparisons.

Educational challenges are compounded by related labour market problems of weak formal sector employment and skill mismatches. During 1966–96, formal field employment and modern field wages grew strongly. The AFC resulted in a sharp fall in formal employment as well as real wages. Democratisation unleashed powerful ‘pro-labour’ sentiments. Increased labour marketplace regulation and slower development resulted in anemic formal sector employment growth, especially in the manufacturing sector, which had been a key source of dynamic growth. As a result, Indonesia misplaced competitiveness in international markets for labour-intensive manufactures.

Then there is infrastructure. Here Indonesia’s problems are intensively analyzed and of high political concern. The problem is that inter-island transport costs are high. This pushes up the common cost structure, particularly for distant areas, leading to large inter-regional price differences. On logistics performance, Indonesia lags all ASEAN neighbours club the Philippines.

Underinvestment has led to the low quality and quantity of facilities. As a percentage of GDP, Indonesia’s infrastructure expenditure is about half of that in the Suharto era as well as in other high-growth East Asian economies. Regulatory constraints on competitors and efficient service provision compound these problems, as does a powerful post-AFC aversion to foreign borrowing, meaning successive governments have not acquired themselves of much of the long-term concessional financial on offer.

From a longer-term perspective, Indonesia is in the early stages of establishing the democratic consensus around the institutions required for a prosperous, equitable and worldwide oriented economy. Substantial problems remain in the country’s legal system, which are closely tied to battling corruption, increasing bureaucratic efficiency and improving local-level governance.

Indonesia has only recently graduated to middle-income status. In addition, while moderately strong financial growth means that is not in any sense ‘trapped’, it will have to overcome the problems holding back its growth as it moves up through the middle-income ranks. Fortunately, all of these problems are amenable to fairly straightforward policy reforms.

Is Indonesia trapped in the middle? is republished with permission from East Asian countries Forum