Indonesia’s eclipse of Australia?

Author: Peter Drysdale, Editor, East Asia Forum

Already Indonesia has become an economy larger than that of Australia, with GDP measured in purchasing power parity terms.

For many years after Independence, Australia was the dominant economy and the dominant political power at the end of the Indonesian archipelago, despite the immense disparity in relative population numbers.

With the resumption of solid economic ground after the Asian financial crisis, the economic numbers have turned and, as many have it, Indonesia is on the way over the next three or four decades to becoming one of the four to six biggest economies in the world. Of course, things could go wrong. Indonesia, like other economies on the way to catch up with the industrially rich economies, could get stuck in what is now widely called ‘the middle income trap‘. With income per capita at just under $3000 a head in 2010 and ranked 107th in the World Bank’s table, Indonesia is barely a middle-income country yet, so there’s plenty of room to catch up. But its population base means that it will be a big economy before it is a very rich economy.

As observed recently, Indonesia’s economic fundamentals are strong. Foreign investment is playing a major role in the economy’s growth. This reflects Indonesia’s attractiveness as an investment destination, given its large market of 240 million people, rapidly expanding middle class, wealth of natural resources, and strategic location. The ratings agencies have recently upgraded Indonesia’s long-term and local currency ratings to ‘investment grade’, a move that further boosts Indonesia’s standing among global investors. The A.T. Kearney FDI confidence index — which involves a series of surveys of companies with annual global revenue of more than US$2 trillion and provides an assessment of the prospects of international investment flows — ranked Indonesia 21st in 2007 but amazingly the 9th most-attractive investment destination in 2012. Although handicapped by its weak legal system and poor infrastructure, Indonesia is a popular destination for investors in the manufacturing industry.

The Indonesian government has worked hard to ensure macroeconomic stability. Building the financial and physical capital to complement its young and dynamic workforce is one requirement. Developing stronger capital markets, to intermediate domestic saving and to ensure capital inflows are well used, while the government provides the right incentives to promote investment in priority sectors, are others. The government’s reform program will be crucial to strengthening its macroeconomic fundamentals and the projected trajectory of high longer-term growth.

Nothing is perhaps more likely to truncate Indonesia’s transition through low middle income to economic prosperity than failure to get the structure and scale of investment in human capital right. Low education quality afflicts all education levels. There is still huge under-achievement in secondary and tertiary education — essential to income upgrading as they are. The performance of eighth grade Indonesian students in international science and mathematics assessments lags far behind the performance of students in neighbouring countries and countries with similar economic and health conditions. Indonesian students have consistently been performing between 0.4 to 1.9 standard deviations lower compared to Malaysia, Singapore and Thailand from 1999 up to the latest available data. Surveys of employers suggest that 23 to 30 per cent of firms in manufacturing and non-education services are handicapped by skill shortage in the labour market caused by low quality secondary education.

Problems with the quality and structure of national investment in education and skills might be a reality check on dreams of the transition of Indonesia and the eclipse of the Australian economy and national power that Hugh White projects in this week’s lead essay, but they make it no less relevant.

White argues that, while ‘Indonesia’s economy remained much smaller than Australia’s, and its security concerns remained inwardly focused, Indonesia had little money to spare for air and naval forces, and little need for them as long as US primacy in Asia remained uncontested. It has therefore never built the maritime forces without which an archipelagic nation can exercise little strategic weight. Australia, on the other hand, spent relatively large sums on maritime forces, making it for many years the most capable air and naval power south of China and east of India. Over the next few decades this is very likely to change. As its economy grows Indonesia will have more money to spend on increasing its air and naval forces, and it will have more need for them as Asia’s old US-led order is challenged by China. This could be bad news for Australia because it will increase Indonesia’s weight as an adversary’.

But, as White makes clear, it could also be very good news because it will increase Indonesia’s weight as an ally. Most Australians might yet find it difficult to see Indonesia in this light, but the simple facts of geography mean that against any threat from the existing great powers of Asia, a strong Indonesia would be Australia’s greatest strategic asset. The remarkable political transformation in Indonesia, though still a work in progress, has greatly enhanced the chances of building this kind of partnership between the two, once querulous, neighbours. If, as is clearly possible, the US plays a smaller role in Asia, there is a real chance that Indonesia could become Australia’s most important strategic partner. This was Paul Keating’s insight when he sought a security treaty with Jakarta during his prime ministership.

Hence, as White argues, the time to invest in the Australia–Indonesia relationship is now. That is more likely to ensure amity in the long term and it could also just raise the chance — through sharing policy experience and intensified cooperation between the two countries in the area of human capital formation — that Indonesia negotiates the middle-income trap more successfully than might currently seem possible.

Peter Drysdale is Editor of the East Asia Forum.