Indonesia Requires The Right Policies For Rough Times To Lift Its Middling Growth – Analysis

By M. Chatib Basri

‘Good, but not exceptional’. This captures the essence of Indonesia’s current economic performance. Though the nation’s 5 per cent growth rate is solid by global standards, it falls short of countries like India, Vietnam and the Philippines.

Indonesia faces significant hurdles.

By 2050, the country will be in the throes of an aging population. But unlike Japan, South Korea, Taiwan and Singapore, Indonesia has rarely experienced double-digit economic growth and even those countries now struggle with thecomplexities of aging populations. With its steady 5 per cent growth, there is a risk that Indonesia may become ‘too old to get rich’.

Three key challenges await President Prabowo Subianto’s new administration.

First is how to accelerate economic growth to 6-7 per cent, let alone achieve Prabowo’slofty 8 per cent goal. That would require an investment rate of 41-48 per cent of GDP. Currently, Indonesia’s Gross Domestic Savings are 37 per cent of GDP, leaving a significant savings–investment gap. To close this gap, Indonesia must increase savings by boosting the tax-to-GDP ratio, enhancing productivity through improved human capital, innovation, infrastructure development and better governance. Indonesia must also attract foreign direct investment into export-oriented sectors.

The second challenge is fiscal space. The COVID-19 pandemic scarred many countrie, and fiscal policies worldwide need to be inclusive. Social protection programs, education, health and nutrition initiatives — such as those championed by Prabowo — are critical. But how to fund them?

Indonesia’s debt-to-GDP ratio has increased, though it remains within safe limits. What requires attention is the rising debt service ratio (DSR) — the proportion of government revenue spent on interest and debt repayments. Since 2015, the DSR has been climbing, reaching a peak of 46.7 per cent in 2020. And though it has decreased tojust below 35 per cent, it is markedly higher than that of other emerging economies. This means nearly 35 per cent of state revenue is used for debt servicing, leaving less for social spending infrastructure and other needs.

If debt increases, it must be balanced by an increase in state revenue. The higher the DSR, the less funds can be allocated for infrastructure and social protection. Increasing debt does not automatically expand fiscal space unless state revenue rises.

To improve this situation, the government needs to increase revenues, particularly through tax reform — something Indonesia has previously found difficult. This includes enhancing tax administration, reducing the scope of tax exemptions and reviewing existing tax incentives. On the expenditure side, improving the quality of spending is crucial, including reallocating fuel subsidies to direct subsidies, education and healthcare spending.

The third challenge relates to the middle class. The World Bank defines the middle class as those whose expenditure is 3.5 to 17 times above the poverty line. Yet many in this group are at risk of slipping down the economic ladder. Indonesia’s Bureau of Statistics data show the middle class steadily increasing from 2004 to 2018, but then dropping from 23 per cent of the population in 2018 to only 17 per cent in 2023.

This downward trend began even before the COVID-19 pandemic. To address this, the government needs to expand social protection in a more inclusive manner, especially for the middle class. Creating decent-paying jobs in the formal sector — particularly in manufacturing, tourism and the creative industries — is crucial.

Formal sector jobs have contributed to nearly 75 per cent of the increase in middle-class jobs. Investments in tourism and creative industries also could create more middle-class employment opportunities.

Unfortunately, high economic costs hinder these industries. In highly competitive, export-oriented manufacturing sectors, producers are price-takers on the global market — they are usually unable to pass high costs onto consumers. As a result, profit margins may shrink, reducing incentives for innovation and further investment.

In contrast, Indonesia’s natural resource sectors, where the country is a global price-setter for some products, can pass high costs onto consumers, allowing higher profit margins. Investors often shift from manufacturing to natural resources — a trend exacerbated by a recentboom in commodity prices. Unfortunately, the natural resource sector is capital-intensive and does not create many jobs, limiting its ability to create middle-class jobs.

Indonesia’s domestic market is large, but its purchasing power is limited. Indonesia must therefore become a global production hub, like Vietnam. Encouraging FDI into export-oriented sectors is critical. Export revenues help avoid balance of payments pressures when profits are repatriated, reducing currency mismatches.

If Indonesia wants to help drive economic growth without jeopardising the stability of the rupiah, FDI must be channelled into export-oriented sectors. Like Vietnam, Indonesia should benefit from the relocation of production bases from China by continuing to improve its investment climate. The data shows, however, that Indonesia’s FDI-to-GDP ratio has declined from 2.8 per cent in 2014 to 1.9 per cent in 2022. This is one reason why Indonesia’s economic growth has been stuck at around 5 per cent since 2014.

The government has implemented a number of policies to support small and medium-sized enterprises (SMEs), but these have been more protectionist than productivity-enhancing. It is important to integrate SMEs into global value chains by providing them with market access. Mentorship, training and technology diffusion are essential to ensure SMEs can produce goods that meet international standards and ensure continuity of supply. Support needs to go beyond credit access alone. With the right support, SMEs have the potential to create middle-class jobs.

Indonesia faces significant challenges ahead. But with the right policies — increasing investment, improving fiscal sustainability, supporting the middle class, integrating into global markets and boosting SME productivity — there is ample opportunity forPrabowo’s administrationto achieve stronger, more inclusive economic growth.

• About the author: Dr M Chatib Basri is Senior Lecturer at the Department of Economics, University of Indonesia, and was formerly Indonesia’s Minister of Finance.
• Source: This article was published by East Asia Forum