The future of the Indonesian economy

Author: Anwar Nasution, UI and SEADI

To maintain strong economic growth in a world of high government debt, and in the midst of a global recession, Indonesia needs to revise its development strategy.

It must shift from external to domestic sources of growth, move higher up the value chain and join the global supply chain. Due to the weakness in its tax administration, and the absence of wide-ranging social protections, automatic fiscal stabilisation will not work in Indonesia. Problems that have spilled over from the international economy, as well as domestic difficulties, have begun to hold back economic activity. Indonesia’s positive terms of trade, which were caused by high economic growth in China and India, have come to an end.

Significant changes to fiscal and monetary policies are required to increase domestic-oriented expenditure, which can be achieved through fiscal stimulus, private-sector investment and promotion of household consumption. Resolution of development bottlenecks and strengthening of public institutions are also required. In the short term, Indonesia’s austere macroeconomic policy needs to be relaxed, as it has begun to affect economic growth. Fiscal and monetary policies of the past, and those currently in place, may not suit the current global economic situation. For example, during the Suharto administration, from 1966–1998, the government budget deficit was entirely financed with official development aid (ODA) from a consortium of foreign donors. Elements of the IMF’s short-term stabilisation program of 1997–2003, including monetary policy, fiscal policy and debt rules, are still in place today. Indonesia’s current fiscal rule sets the maximum annual deficit at 3 per cent of GDP, and the ratio of public debt to GDP at 60 per cent.

There are four methods open to Indonesia to finance greater government expenditure: raising taxes; selling state assets; taking on domestic and foreign debt; and engaging in monetary financing. Of these, external debt financing is the most feasible for Indonesia, as its budget deficit has been maintained at around 2 per cent per annum, and debt to GDP ratio is below 30 per cent. The timing is also right because quantitative easing is pushing nominal interest rates in many advanced economies close to zero. Indonesia’s weak administration and legal system limit the government’s power to raise taxes. Monetary financing can also be ruled out due to Indonesia’s traumatic experiences with high inflation prior to 1997 (from 1965–66, the inflation rate was over 650 per cent per annum). Auctioning state assets, including mining rights and other rents and licenses to exploit natural resources and other monopoly rights, has not been properly explored. Such practices are rendered more difficult by the fact that Indonesia’s state enterprises are owned by both central and local governments.

Fiscal expansion should be used to relieve bottlenecks and boost competitiveness and long-term growth, particularly because of the lack of infrastructure, education and health care in Indonesia. Funding for these purposes can be increased by diverting the regressive budget subsidies for electricity and oil to finance these items. In addition to financing, the input markets also need radical supply-side reforms, including to the labour market, land use, the education system and health care, to allow greater participation of the private sector and foreign entities in these industries. To promote private-sector investment, Indonesia needs to improve its business climate by streamlining its complicated regulatory system. To make the market work effectively and efficiently, the country needs to upgrade its legal and accounting system, improve protection of property rights, enforce contracts, provide relevant, accurate and timely market information, and work on eradicating corruption and bribes. Good institutions are the keys to social protection. Only by tacking bottlenecks can Indonesia attract foreign direct investment and be part of the global supply chain.

The appreciation of the Rupiah is also posing challenges to Indonesia’s monetary policy. Until recently, the Rupiah’s appreciation was supported by the boom in the export of raw materials and the surges in short-term capital inflows. The appreciation of the Rupiah produces several results. It artificially makes import prices cheap, and makes it easier for the central bank to achieve its inflation target. On the other hand, it acts as a tax on producers and exporters of non-raw materials, including energy. It thus provides incentives for the allocation of resources away from the relatively efficient trade sector to the inefficient non-traded sector. In addition, it creates regional imbalances, as raw materials are produced in parts of the country with a lower population density than Java.

Indonesian banks must also reduce their lending rates. The gap between deposit and lending rates in Indonesia is, at present, the highest of the ASEAN 5. This is due to inefficiency in the banking system, low domestic savings, segmentation of the banking market (because of the exclusive access state-owned banks have to public-sector finance), weak creditor rights, and failures in contractual enforcement due to weaknesses in the legal system.

Indonesia faces many challenges if it is to continue along the path of strong economic growth. There are many policies that worked in the past which Indonesia can no longer rely on. Reviewing fiscal and monetary policies, strengthening the legal system, and addressing current challenges will assist in improving Indonesia’s development prospects.

Anwar Nasution is Professor of Economics at the University of Indonesia and Senior Institution Specialist at the Support for Economic Analysis Development in Indonesia (SEADI).