Indonesia Growth Diagnostics:
Strategic Priority to Boost Economic Growth
Ministry of National Development Planning/
National Development Planning Agency
Directorate for Macroeconomic Planning and Statistical Analysis
Indonesia Growth Diagnostics:
Strategic Priority to Boost Economic Growth
Ministry of National Development Planning/
National Development Planning Agency
Directorate for Macroeconomic Planning and Statistical Analysis
ii | I n d o n e s i a G r o w t h D i a g n o s t i c s
Indonesia Growth Diagnostics:
Strategic Priority to Boost Economic Growth
Supervisor
Eka Chandra Buana, S.E., M.A.
Authors
Mochammad Firman Hidayat, S.E., M.A.
Adhi Nugroho Saputro, M.Sc.
Bertha Fania Maula, S.E.
Cover Design
Hamdan Hasan, S.Kom.
Data Visualization Bertha Fania Maula, S.E.
Sekar Sanding Kinanthi, S.E.
Ministry of National Development Planning/
National Development Planning Agency
Directorate for Macroeconomic Planning and Statistical Analysis
Jalan Taman Suropati Nomor 2 Jakarta 10310
Tel. (021) 3193 6207 Fax. (021) 3145 374 www.bappenas.go.id
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Acknowledgments
The Growth Diagnostics study, to identify the most binding constraint of Indonesia’s economic growth, started in early 2018. Previously in December 2017, we invited Prof. Ricardo Hausmann from Harvard University to give a public lecture and workshop regarding Growth Diagnostics in Jakarta with funding from the Australian Government through the Department of Foreign Affairs and Trade (DFAT). We would like to thank DFAT for making it possible for us to learn about the tools and mechanics of Growth Diagnostics directly from Prof. Ricardo Hausmann.
The whole research activities and writing process of this report is a joint work between Directorate for Macroeconomic Planning and Statistical Analysis Bappenas and PROSPERA. Therefore, we would like to thank PROSPERA for doing this collaborative research from the beginning until the report is published. We received valuable support from PROSPERA for the analytical process of the study, the preparation of final outputs, and the facilitation of holding a discussion and in-depth interviews with related stakeholders.
We are indebted by many stakeholders that gave us inputs for preparing the study through a series of Focus Group Discussion (FGD) held in 2018.
The cross-directorate discussion in internal Bappenas helped us mapping the initial findings of the study and thus we are thankful for their inputs and supports.
We also want to thank private sector representatives who actively participated in our FGDs sharing their perspective on factors that hindering business activities in Indonesia. We benefited from discussion with Deloitte Indonesia, PWC (Pricewaterhouse Coopers), Bukalapak, Tokopedia, PT GE Operations Indonesia, PT Tira Austenite Tbk, HighScope Indonesia, PT Pacto Ltd, Maersk Line, PT Naku Freight Indonesia, and PT Mayora Indah Tbk. Moreover, we also gained perspectives from the smaller scale business through the SME representatives under the supervision of UKM Center FEB UI, IncuBie IPB, PEAC Bromo, and PT Permodalan Nasional Madani (PNM).
Besides, we also received valuable inputs on several discussion topics from public and research institutions that contributed in our FGDs, namely Ministry of Trade, Ministry of Industry, Otoritas Jasa Keuangan (OJK), the SMERU Research Institute, Lembaga Demografi FEB UI, and Centre for Strategic and International Studies (CSIS).
Most importantly, we would like to thank experts in economics and related field that we approached for in-depth interviews, invited in FGDs, and asked for the feedback to improve our study:
• Prof. Dorodjatun Kuntjoro-Jakti
• Prof. Mari Elka Pangestu, Ph.D.
• Dr. Muhammad Chatib Basri, S.E., M.Ec.
• William Wallace, Ph.D.
• Prof. Geoffrey J.D. Hewings
• Prof. Budy P. Resosudarmo, Ph.D.
• Dr. Asep Suryahadi
• Prof. Arief Anshory Yusuf, Ph.D.
• Faisal H. Basri, S.E., M.A.
• Prof. Dr. Mohamad Ikhsan, S.E., M.A.
• Anton Hermanto Gunawan, S.E., M.A., M.Phil.
• Teguh Dartanto, S.E., M.Ec., Ph.D.
• Haryo Aswicahyono, Ph.D.
• Turro S. Wongkaren, Ph.D.
I n d o n e s i a G r o w t h D i a g n o s t i c s | iii
Table of Contents
FOREWORD ... III FOREWORD ... IV FOREWORD ... V ACKNOWLEDGMENTS ... VI TABLE OF CONTENTS ... III LIST OF FIGURES ... IV EXECUTIVE SUMMARY ... 11. INDONESIA GROWTH STORY ... 3
1.1.DECLINING TREND GROWTH ... 3
1.2.PRODUCTIVITY PROBLEM ... 3
1.3.GROWTH QUESTION ... 4
2. GROWTH DIAGNOSTICS ... 5
3. REGULATIONS AND INSTITUTIONS AS THE MOST BINDING CONSTRAINT ... 6
3.1.INVESTMENT FINANCING:ISSUE WITH INTERMEDIATION ... 6
3.2.GEOGRAPHY:UNDERLINING THE NEED FOR INFRASTRUCTURE ... 7
3.3.HUMAN CAPITAL (FUTURE BINDING CONSTRAINT):SKILLS,BASIC EDUCATION, AND HEALTH IMPROVEMENT IS CRITICAL ... 7
Skills ... 7
Education ... 8
Health ... 9
3.4.INFRASTRUCTURE:LACKING PARTICULARLY FOR CONNECTIVITY ... 10
Connectivity ... 10
Energy ... 11
Digital ... 12
Water and Sanitation ... 12
3.5.MARKET FAILURE:UNREALIZED POTENTIAL ... 12
3.6.MACRO RISK:LOW TAX RECEIPT LIMITS PUBLIC GOODS DELIVERY ... 13
3.7.REGULATIONS AND INSTITUTIONS (THE MOST BINDING CONSTRAINT):BETTER COORDINATED POLICIES TO BOOST GROWTH ... 13
CONCLUSION ... 16
REFERENCES ... 17
APPENDICES ... 19
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List of Figures
Figure 1. Binding Constraint Illustration ... 1
Figure 2. Diagnostic Tree ... 5
Figure 3. Indonesia Economic Growth ... 19
Figure 4. GDP per Capita Trend ... 19
Figure 5. Indonesia Potential Growth ... 19
Figure 6. Total Factor Productivity ... 19
Figure 7. Share of Manufacturing & GDP per Capita ... 20
Figure 8. High-Technology Exports ... 20
Figure 9. Accumulation of Fixed Capital Investment of Machinery and Equipment, 2007-2016 ... 20
Figure 10. Infrastructure Capital Stock ... 20
Figure 11. FDI Net Inflows vs. GDP per Capita, 2017 ... 20
Figure 12. Indonesia Incremental Capital-Output Ratio ... 20
Figure 13. Gross Domestic Savings vs. GDP per Capita, 2017 ... 21
Figure 14. FDI Net Inflows ... 21
Figure 15. Real Lending Rate vs. GDP per Capita, Average 2015-2017... 21
Figure 16. Nominal Lending Rate, vs. GDP per Capita, Average 2015-2017 ... 21
Figure 17. Real Lending Rate and Investment Rate ... 22
Figure 18. Biggest Obstacles in Doing Business in Indonesia ... 22
Figure 19. Indonesia Investment Composition ... 22
Figure 20. Net Interest Margin ... 22
Figure 21. Financial System Interlinkages, Malaysia ... 22
Figure 22. Financial System Interlinkages, Indonesia ... 22
Figure 23. Labour Force Distribution by Education, 2016 ... 23
Figure 24. Labour Force with Tertiary Education... 23
Figure 25. Agriculture Employment vs. GDP per Capita, 2017 ... 23
Figure 26. Informal Employment vs. GDP per Capita, 2017 ... 23
Figure 27. Returns to Secondary Education ... 24
Figure 28. Unemployment Rate by Education ... 24
Figure 29. Returns to Tertiary Education ... 24
Figure 30. Skills of Working Age Population ... 24
Figure 31. Skills Mismatch in Indonesia ... 24
Figure 32. Net Wage Effects of being Skills Mismatch ... 24
Figure 33. Mean Years of Schooling ... 25
Figure 34. Mean Years of Schooling vs. GDP per Capita, 2017 ... 25
Figure 35. Gross Enrolment Ratio ... 25
Figure 36. School Enrolment, Tertiary ... 25
Figure 37. Returns to Education vs. GDP per Capita, 2010 ... 25
Figure 38. Returns to Education, Indonesia ... 25
Figure 39. Trends in International Mathematics and Science Study (TIMSS), 2015 ... 26
Figure 40. Programme for International Student Assessment (PISA), 2015 ... 26
Figure 41. PISA Score Projection, Indonesia ... 26
Figure 42. TIMSS Score Projection, Indonesia ... 26
Figure 43. Indicators Related to Quality of University ... 26
Figure 44. Indonesia University Ranking Classification ... 26
Figure 45. The Global Innovation Index 2018 ... 27
Figure 46. The Human Capital Index 2018 ... 27
Figure 47. Life Expectancy at Birth ... 27
Figure 48. Infant Mortality Rate ... 27
Figure 49. Maternal Mortality Ratio ... 27
Figure 50. Stunting Prevalence vs. GDP per Capita, 2016 ... 27
Figure 51. Immunization Rate, 2017 ... 28
Figure 52. Cause of Death by Communicable Diseases and Maternal, Prenatal and Nutrition Conditions ... 28
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Figure 53. Cause of Death by Non-Communicable Diseases ... 28
Figure 54. Mortality from CVD, Cancer, Diabetes or CRD ... 28
Figure 55. Health Facilities per 10,000 Population ... 28
Figure 56. Trend in Male Smoking Prevalence ... 28
Figure 57. Male Smoking Prevalence vs. GDP per capita, 2016 ... 29
Figure 58. Most Recent Survey of Youth Tobacco Use (Age 13-15) ... 29
Figure 59. Road Connectivity Index, 2017 ... 29
Figure 60. Road Density, 2014 ... 29
Figure 61. Quality of Roads, 2017 ... 30
Figure 62. Quality of Port Infrastructure, 2017 ... 30
Figure 63. Airports per Million Square Kilometre, 2013 ... 30
Figure 64. Quality of Air Transport Infrastructure, 2017 ... 30
Figure 65. Railroad Density, 2017 ... 30
Figure 66. Efficiency of Train Services, 2017 ... 30
Figure 67. Problematic Factors for Doing Business in Indonesia ... 31
Figure 68. Electrification Ratio, Indonesia ... 31
Figure 69. Electrification Ratio, Peer Countries ... 31
Figure 70. Electrification Ratio by Consumption Decile ... 31
Figure 71. System Average Interruption Frequency Index (SAIFI) ... 31
Figure 72. System Average Interruption Duration Index (SAIDI) ... 31
Figure 73. Electrification Ratio (% of Households) by Region, 2017 ... 32
Figure 74. System Average Interruption Frequency Index (SAIFI) by Region, 2017 ... 32
Figure 75. System Average Interruption Duration Index (SAIDI) by Region, 2017 ... 32
Figure 76. Quality of Electricity Supply, 2017 ... 33
Figure 77. Broadband Subscriptions, 2017 ... 33
Figure 78. Broadband Speed, 2017 ... 33
Figure 79. Access to Basic Water Services, 2015 ... 33
Figure 80. Access to Basic Sanitation Services, 2015 ... 33
Figure 81. Access to Water Supply by Quintile 2018, Urban ... 33
Figure 82. Access to Water Supply by Quintile 2018, Rural ... 34
Figure 83. Firms Experiencing Water Insufficiencies ... 34
Figure 84. Indonesia’s Export by Type of Commodity... 34
Figure 85. Export Composition by Product, 1995 - 2017 ... 35
Figure 86. Complexity Outlook Index & Economic Complexity Index, 2016 ... 35
Figure 87. Economic Complexity Index vs. GDP per Capita, 2016 ... 35
Figure 88. External Debt & Reserve Adequacy ... 36
Figure 89. External Debt & Current Account Balance ... 36
Figure 90. Central Government Debt ... 36
Figure 91. Tax Ratio vs. GDP per Capita, 2016 ... 36
Figure 92. Government Expenditure on Education vs. GDP per Capita, 2015 ... 37
Figure 93. Government Expenditure on Health ... 37
Figure 94. The Missing Middle, 2013 ... 37
Figure 95. Regulatory Index, 2017 ... 37
Figure 96. Legal System and Property Right Index, 2017 ... 37
Figure 97. Rule of Law Index, 2017 ... 37
Figure 98. Cost of Redundancy Dismissal, 2018 ... 38
Figure 99. Percent of Firms Offering Formal Training ... 38
Figure 100. FDI Regulatory Restrictiveness Index, 2018 ... 38
Figure 101. Inward FDI Stock, 2018 ... 38
Figure 102. Time Required to Start a Business, 2019 ... 38
Figure 103. Score on Trading across Borders, 2019 ... 39
Figure 104. Rank in the Ease of Paying Taxes, 2019... 39
Figure 105. Cost to Export and Import, 2019 ... 39
Figure 106. Effective Rate of Protection, 2015 ... 39
Figure 107. Most Problematic Factors for Doing Business in Indonesia ... 39
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I n d o n e s i a G r o w t h D i a g n o s t i c s | 1
Executive Summary
Countries need many things to grow, but they are highly complementary, and resources are limited. Hence, the development plan needs to prioritize and resolve the most binding constraint to get the maximum return. The “most binding constraint” is the one constraint that will prevent the economy from growing faster even if other reform needs are addressed. The growth diagnostic is a framework for identifying the binding constraints to growth. It is an iterative process that starts with identifying the growth question and follows a diagnostic decision tree.
This study is produced as a background study for the 2020-2024 National Development Plan. The study itself adopts the original diagnostic tree and seeks to answer a growth question: what the most binding constraint to the low level of innovation and productive investment i.e., how to get investment that delivers higher productivity. This is on the background that Indonesia’s growth has been declining in the past decades. At the same time, Indonesia’s investment to income ratio is one of the highest in the world suggesting that investment effectiveness is low.
The study found that regulations and institutions are the most binding constraint to growth. Existing regulations do not support business creation and development and tend to be restrictive. Institutions here refer to the setting which produces those regulations, in particular: lack of strategic alignment, weak supervision, and overlapping institutional responsibilities. It also points to corruption and bureaucratic inefficiency. This conclusion was a common theme not only with private business but also in social sectors like health and education.
Inefficient regulations create high fixed costs. Therefore, it generates a missing middle phenomenon in Indonesia: large companies can bear high fixed costs, medium companies cannot compete, and small companies choose to be outside of the regulation – causing a large informal sector. Compared to other countries, existing regulations tend to be protectionist and the cost related to labour and taxation is very high. Widespread middlemen practice also indicate regulations and institutions as the most binding constraint as economic agents attempt to bypass it.
Figure 1. Binding Constraint Illustration
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There are three main areas identified as the regulatory constraints: labour, trade, and investment.
First, in labour regulation, the cost of firing workers in Indonesia is high. This means firms employ staff on temporary contracts and do not develop their professional skills through training. Indonesian firms also struggle to navigate costly and complex regulations to hire skilled foreign workers. This places Indonesian firms at a disadvantage.
Second, exporters and importers face high administrative costs owing to excess licenses and regulations. At the same time, “non-tariff barriers” to trade such as licenses and quotas increase the cost of living in Indonesia by 8%.
Third is investment policy, Indonesia is among the most restrictive countries in the world for foreign direct investment.
The negative list discourages foreign firms from setting up businesses in Indonesia that could attract technology, create jobs and boost exports. This issue is not only for the manufacturing sector but even worse for the services sector. There are also skewed competition treatment, for instance, tax exemptions towards small businesses. This discourages Indonesian firms from expanding and becoming more productive through economies of scale. Even more, there are sectors closed for the domestic private competition such as seaports industry which is dominated by less efficient state-owned firms.
The evidence is also apparent across sectors. In the education sector, foreign nationals could not obtain academic tenure in Indonesian universities preventing know-how transfer. In the health sector, there is a lengthy process to obtain BPOM license making some drugs unavailable in Indonesia. Some evidence also points to the weak institutional setting. For instance, in 2018 there were up to 30 ready-to-operate ports with no road access. This is due to weak coordination between central government who built the ports and local government who has the authority to build the roads. Within the central government itself, there is a conflicting role on the budget process between three agencies: Bappenas and Fiscal Policy Agency, MoF and Treasury, MoF resulting in a budget that doesn’t reflect development priority.
The study also identifies human capital as the future binding constraint, particularly given the development of the digital economy and the aspiration to adopt industry 4.0 – the development of high technology manufacturing sector.
Skills and education will become the next binding constraint in the rapid advancement of technology particularly as the quality of education in Indonesia are worrying.
Overall the study suggests that priority should be given to improvements in regulations particularly the ones that hamper business development and productivity growth. And, to the institutional improvement, mainly on the clarity of roles and authority, including the role as the policy conductor and development regulator. In addressing the future constraint on human capital, policy actions need to focus on reforming basic education and teaching, opening investment in tertiary education, incentivizing diaspora engagement and focus on children’s nutrition.
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1. Indonesia Growth Story
Indonesia’s growth story is one of the most impressive in the world. Since the early 1960s Indonesian GDP per capita has grown more than six-fold. Only a handful of other countries have matched this achievement, namely China, India, and South Korea. Indonesia’s poverty rate fell to single digits for the first time in 2018. This is significant because almost half of the population was poor after the Asian financial crisis in late 1990s.
1.1. Declining Trend Growth
The pace of Indonesian economic growth today is slower that it was before Asian financial crisis (Figure 3). During 2000-2018 Indonesia’s economy expanded by 5.3 percent a year on average compared with 7.0 percent during 1980- 1997.
Slower growth means that Indonesia has failed to match the economic advances of its peers in East Asia. During the past decade, Indonesia’s progress in closing the gap in GDP per capita with Malaysia and Thailand has stalled (Figure 4). During the same period, the Philippines and Vietnam managed to narrow the gap in GDP per capita with Indonesia.
China’s GDP per capita doubled during this period.
Indonesia’s slower and stagnant growth stems from structural rather than cyclical issues. The declining growth rate is a result of declining production capacity – potential output. Bappenas (2017) shows that current potential GDP growth is 5.1-5.3 percent and this figure continues to decline (Figure 5).
At the same time, Indonesia aspires to become a high-income country within the next two decades. Bappenas (2018a) shows that Indonesia need to grow at least by six percent each year in order to avoid a middle-income trap.
Sustainable and targeted structural reform is necessary to obtain higher growth and achieve this goal.
1.2. Productivity Problem
Slower productivity growth is the main reason for the declining growth of potential output. Before the Asian crisis, Indonesia’s productivity was one of the highest in the region—above Malaysia, Thailand, Vietnam, the Philippines, and China1 (Figure 6). But Bappenas (2017) estimates show a decline in Indonesia’s total factor productivity growth during the past 15 years. Today Indonesia’s productivity is among the lowest in the region.
Productivity in agriculture and services are especially low. This indicates that the structural transformation of the economy has not gone smoothly. Ideally an economy would advance from being built around agriculture and natural resources to higher value-added activities such as manufacturing then services. However, this does not mean that one sector is more important than the others: the transition from resources to high-value manufacturing would, for example, also require supporting services such as logistics, insurance, and accounting.
In Indonesia, more than 30 percent of the labour force works in the agricultural sector where productivity is low.
Meanwhile, manufacturing’s share of economy activity is declining (although it is still high compared with other countries). Nonetheless, the declining trend is worrying because it is happening at an earlier stage of the economy’s development compared with other countries such as Malaysia and Thailand (Figure 7). In those two countries, the decline in manufacturing’s share of the economy began after peaking at around 30 percent of GDP and at a higher level of per capita GDP.
Indonesia’s manufacturing sector is more productive than other parts of the economy, but it is still not productive enough to compete globally. Indonesia’s manufacturing exports are low compared with its peers. Its exports are dominated by commodities and simple manufacturing products, mainly garments. Indonesia has been left behind when it comes to making more complex products that require more advanced technology (Figure 8). There has been little export diversification in recent decades. In 1970 Indonesia’s exports were dominated by commodities, mainly rubber and oil. The composition is not much different today, with exports still dominated by commodities (palm oil and coal). Fifty years ago, Thailand and Malaysia also exported mostly commodities but since then they successfully diversified. Today their exports are dominated by manufactured products, mainly electronics.
1In this study, when referring to peer countries, it refers to Malaysia, Thailand, Vietnam, the Philippines, and China.
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1.3. Growth Question
Indonesia successfully transformed its economy during the 1980s when it built up the manufacturing sector. However, after the Asian crisis structural transformation has stalled, as evidenced by the failure to develop exports of more advanced manufactured goods.
Lack of innovation is a major obstacle to export diversification. Indonesia ranks 85th out of 126 countries in the Global Innovation Index (2018). Compared with peer countries, Indonesia is wanting in both product and process innovation.
Indonesia introduced only four new export products during 2000-2015, much lower than Vietnam and the Philippines, which created 51 and 27 new export products, respectively. It is widely known that innovation could drive productivity and in turn contribute to higher economic growth.
In Indonesia, the share of investment to GDP is one of the highest in the world. It means that investment has not been directed toward activities that could support higher productivity growth. This is shown by four main observations.
First, the accumulation of machinery and equipment in Indonesia during the past decade has been significantly lower than in peer countries (Figure 9). Without this type of investment, the manufacturing industry cannot grow optimally owing to the depreciation of machinery and equipment as well as outdated technology. Second, Indonesia’s
infrastructure capital stock as a percent of GDP is low compared with peer countries. Massive infrastructure
investment in recent years has managed to stop the decline but more is required to return the capital stock to the level seen before the Asian crisis (Figure 10). Third, foreign direct investment (FDI) is low in Indonesia (Figure 11). FDI is important because it enables the transfer of “know-how”. Fourth, Indonesia’s overall investment effectiveness is declining and low compared with its peers (Figure 12). This points to a declining return on investment.
This study seeks to answer a growth question: what is the most binding constraint to the low level of innovation and productive investment, i.e. investment with high productivity return. This study follows the growth diagnostic method introduced by economists Ricardo Haussmann, Dani Rodrik and Andres Velasco.
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2. Growth Diagnostics
Countries need many things to grow, but they are highly complementary, and resources are limited. Hence, the development plan needs to prioritize and resolve the “most binding constraint” to get the maximum return. The most binding constraint is the one that will prevent the economy from growing faster even if other problems are addressed.
The growth diagnostic is a framework for identifying the binding constraints to growth. It is an iterative process that starts with identifying the growth question and then follows a diagnostic decision tree: posit a hypothesis that can account for the symptoms and search for further testable implications of the hypotheses and repeat these steps until they converge and the most binding constraint is identified.
The method was developed by Ricardo Hausmann, Dani Rodrik and Andres Velasco in 2015 and has been adopted by over 20 countries. If a constraint is binding, then: (i) the (shadow) price of the constraint should be high; (ii)
movements in the constraint should produce significant movements in the objective function (e.g. GDP); (iii) agents in the economy should be attempting to overcome or bypass the constraint; and (iv) “camels and hippos”: agents less intensive in that constraint should be more likely to survive and thrive, and vice versa.
The study itself adopts the original diagnostic tree and seeks to answer a growth question: what is the most binding constraint to raising the low level of innovation and productive investment, i.e. how to get investment that delivers higher productivity.
Poor geography
Low human capital
Bad
infrastructure Micro risks:
regulation, institution i.e.,
legal system, corruption
Macro risks:
financial, monetary, fiscal instability
Information externalities:
“self- discovery”
Coordination externalities Low domestic savings + bad international finance
Low competition
High risk High cost Government
failures
Market failures Low
appropriability Low social
returns
Bad local finance/
intermediation Low return to
economic activity High cost of finance
Problem: low levels of productive investment and
innovation Figure 2. Diagnostic Tree
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3. Regulations and Institutions as the Most Binding Constraint
The diagnostic tree is the guiding framework for this section. First, we look at the right side of the tree on the cost of finance. Once we conclude that the cost of finance is not the main issue, we then move to the left side of the tree, on the return to economic activity. We look at social issues first, starting with geography followed by human capital and then infrastructure. We then move to the appropriability issue, both for the market and the government. The latter encompass both macro and micro risks.2
3.1. Investment Financing: Issue with Intermediation
In this section, we look at the issue of financing investment. First, we look at the supply of financing both from foreign and domestic sources and then examine in more detail domestic financing where government has more power to intervene. We found that investment financing is not a binding constraint for investment. Shopping malls, for instance, are considered to offer higher returns over more productive investments such as factories. This suggests that the issue is more on the appropriability or the social return. Low foreign financing (FDI) is also supportive of this argument because foreign financing is independent of issues surrounding the domestic financial system.
Nevertheless, there is an important caveat here. The size of the domestic financial system in Indonesia is small and it is dominated by banks. More importantly, intermediation is low—thus driving inefficient investment. This is because investors have to compete for intermediated finance and the competition ensures finance is allocated to investments with the highest returns. Without the competition made possible by intermediation, finance flows to less productive investments.
At 31.6 percent of GDP in 2018, domestic savings in Indonesia are higher than most peer countries at similar stages of development (Figure 13). At the same time, non-resident investors’ trust and appetite for Indonesian assets is strong.
Indonesian government paper is considered investment grade by all major credit rating agencies. Nevertheless, foreign direct investment in Indonesia is low compared with other countries (Figure 14)—even with assured access to foreign finance. Therefore, the issue is not the supply of financing but must be something else. Next, we look at access to finance.
Only half of adults in Indonesia have a bank account. This figure is low compared with Malaysia and Thailand where at least 80 percent of people have access to bank. It is a similar story for business where only six out of ten Indonesian companies have a bank account. The cost of finance is also not an issue given that lending rates are low and
comparable to other countries in real and nominal term, respectively (Figure 15 and Figure 16). Changes to the lending rate do not have a meaningful correlation with the investment level. In fact, Figure 17 shows the contrary: investment tends to pick up when inflation-adjusted lending rates increase.
Indonesia also has high investment figures despite financing issues. The latest World Bank Enterprise Survey shows that financing is not considered as the biggest obstacle to doing business (Figure 18).
Nonetheless, most investment is not directed into areas with the highest returns. Figure 19 suggests that the issue is the lack of financial intermediation, as only 15 percent of investment is delivered through intermediation. This lack of intermediation means that the competition that would allocate investment to areas with the highest returns is limited.
The lack of intermediation also came up during our discussion with financial institutions. Indonesia’s domestic savings is high compared with its peers. Yet only a small fraction goes to the formal financial system. Hence deposit-taking institutions (banks) are competing for limited funds by offering high deposit rates. Among others, these three issues were identified as the root causes: low financial literacy, lack of trust in the financial system, and low financial inclusion.
The issue surrounding financial intermediation is exacerbated by inefficiency among banks themselves. Banks are highly segmented, limiting competition. This causes high operational costs and in turn drives the high net interest margin (Figure 20). Risk is another important driver of high net interest margin. Long-term investors such as those involved in insurance and pensions are scarce in Indonesia. This causes a mismatch in maturities where deposits are
2The flow in this report has been adjusted to tell the story in a more coherent way. While it may not reflect the actual process which has many iterations, the findings are consistent.
I n d o n e s i a G r o w t h D i a g n o s t i c s | 7 mostly short term but high-return investments usually require long-term financing. As shown in Figure 21, Indonesia’s financial intermediation is heavily concentrated in banks only. The size is also small and less diversified compared with Malaysia (Figure 22).
Although lack of financial intermediation is a significant shortcoming that needs to be addressed, the financial system overall is not currently a binding constraint. Investment with lower economic returns, such as shopping malls over factories, can thrive in Indonesia. This suggests that the issue is more about appropriability or social return. Low foreign financing (FDI) is also supportive of this argument because foreign financing has nothing to do with the issues surrounding the domestic financial system.
3.2. Geography: Underlining the Need for Infrastructure
Since the cost of finance is not a binding constraint, we look at the left side of the diagnostic tree, starting with geography. On the one hand, Indonesia is a vast archipelagic country with more than 70 percent sea area. This poses huge challenges for transport and communication between locations in Indonesia. Large numbers of remote and isolated areas separated by sea, dense forests, or mountainous terrain contributes to high logistics cost in Indonesia.
Geography could also explain the evolution of economic development that differs between regions. On the other hand, Indonesia’s geography could also be an asset. Indonesia’s has an economically strategic location, situated on major international maritime trade routes.
Further research is needed here. However, we argue that improving infrastructure, especially connectivity, is key for Indonesia to overcome its geographical challenges and reap the rewards of its strategic location.
3.3. Human Capital (Future Binding Constraint): Skills, Basic Education, and Health Improvement is Critical
This section looks at human capital issues, covering skills, education and health. Human capital determines the labour quality which in turn affects productivity. Labour productivity improvement has significant potential to boost
Indonesia’s growth given almost three quarter of its population is of working age.
Although access to education has been improved significantly in Indonesia, the quality of education has been slower to improve. The slow pace of improvement in PISA Assessments, for instance, suggests a wider gap in the quality of education with peer countries. Meanwhile, despite significant improvement, health indicators and facilities are still left behind compared with peer countries. Furthermore, there is a higher risk coming from poor health conditions
indicated by high prevalence of stunting, rising non-communicable diseases, and high smoking prevalence among teenagers. With the rise of disruptive technologies and global competition, we conclude that education and health may constrain economic growth in the future.
We found that skills, in particular the lack of high-skilled labour, to be one of the binding constraints to growth.
Employment is still dominated by those with primary education or less. The proportion of high-skilled workers across industries is also below that of peer countries. Indonesia’s low skills reflect the high rate of agricultural and informal employment. Skills mismatches are also a concern. More than half of Indonesian workers do not have the skills wanted by employers. Although training can significantly increase wages of those who learn the right skills, this itself points to shortages of skills in the labour market.
Skills
Indonesia’s workforce is dominated by those with primary education or less (Figure 23). Compared with its peers, the proportion of labour with secondary education background is relatively high while those with tertiary education is low despite increasing in recent years (Figure 24).
High agriculture and informal employment in Indonesia suggesting that low skilled labour dominate the workforce.
Approximately 30.2 percent of workers are farmers as of 2018 (Figure 25), higher than the average of peer countries.
Moreover, the rate of informality in agriculture is more than 90 percent in Indonesia, based on OECD estimates (2018).
Meanwhile, informal employment in non-agricultural sectors is above 70 percent. The number is significantly higher than other countries (Figure 26). Women, young people, and less educated people are more likely to work in the informal sector (OECD, 2018). The same study suggests that informality exists across regions in Indonesia, typically contributing to lower productivity, lower wages, less training, and poorer working conditions.
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High informality often exists when workers do not possess skills for jobs in the higher-paying formal sector (OECD, 2018). However, strict labour regulation in Indonesia that make it costly to fire workers also discourages employers from hiring low-skilled labour (Allen, 2016) and thus contributes to informality. As the problem of high costs
discourages employers from adding formal or permanent workers, this is also associated with less training (Figure 99).
More on this will be explained in the regulations and institutions section.
Mid-skill, that is labour with secondary education background, comes second in Indonesian workforce demography.
The returns to secondary education are higher compared with peer countries (Figure 27). This indicates a high demand for labour with this level of education. However, unemployment among secondary-educated workers is also higher than other countries and other levels of schooling (Figure 28). This points to the uneven quality of secondary education as well as premise that the high return to the secondary education may be rooted from the minimum wage regulation in Indonesia.
The returns to tertiary education in Indonesia are low compared with its peers (Figure 29), indicating that the economy may not be looking for high-skilled labour. The fastest-growing economic sectors in Indonesia are also those that make intensive use of low-to-medium skills such as agriculture, trade and low-end manufacturing. In other words, despite limited supply, there is also a low demand for high-skilled labour.
It is important to note that the actual skills of labour may not be fully reflected by education level. Pritchett (2016) found that the skills of workers with tertiary education in Indonesia is similar to those of workers with less-than-upper- secondary education in Denmark (Figure 30). Hence the issue could be worse than what the figures suggested as they do not capture the quality of education.
Training is one of the solutions to address mismatches between people’s skills and the skills required for jobs in Indonesia. Horizontal and vertical skills mismatches34 existed for more than half of total workers in Indonesia with no significant improvement from 2008 to 2015 (Figure 31). Moreover, a study by the OECD (2016) found that Indonesia has the largest prevalence of mismatch by field of study, with one in two workers is doing jobs unrelated to their studies.
The skills mismatch keeps wages low (Samudra, 2018) (Figure 32). However, training could compensate for this negative wage effect. Samudra (2018) argues that training acts as a “cushion” for the wage penalty of being
horizontally and vertically mismatched. There is a significant increase in wages from training, indicating a high price of skills owing to skills shortages in labour market. Furthermore, it is crucial that Indonesia’s labour force is able to adapt by improving its skills in an age of automation and other technological disruption.
Education
Indonesia has recorded a significant improvement in educational quantity over the past two decades. The average number of years an Indonesian aged 25 or older has spent in school doubled from four years in 1990 to eight years in 2017 (Figure 33). Although this improvement is impressive, the average years of schooling in Indonesia is still less than peer countries with similar levels of per capita income (Figure 34).
Indonesia’s gross participation rate for primary and secondary education is on a par with peer countries (Figure 35).
Meanwhile, the gross participation rate for tertiary education has improved significantly since 1990, although it is still less than peer countries (Figure 36).
The return on every year of additional education is similar with peer countries (Montenegro and Patrinos, 2014) (Figure 37). Nonetheless, the return has been declining since the mid-1990s (Figure 38). This suggests that education is not the binding constraint to growth.
Even so, the quality of education is still wanting compared with peer countries. Indonesia’s scores in both the OECD’s Programme for International Student Assessment and the IEA’s Trends in International Mathematics and Science Study are evidence education quality is lagging (Figure 39 and Figure 40). Indonesia is in the bottom third of countries, with lowest PISA score in 2015, far behind the OECD average. The World Bank (2018) shows that the improvement in Indonesian education quality is very slow. At the current pace, Indonesia will not match the average PISA score of
3Horizontal Mismatch: the type/field of education or skills is inappropriate for the job.
4Vertical Mismatch: the qualification/education level is lower (underqualified) or higher (overqualified) than the requirement.
I n d o n e s i a G r o w t h D i a g n o s t i c s | 9 OECD countries until 2065—and this assumes there is no improvement in those countries (Figure 41). Indonesia’s TIMSS score points to declining abilities in mathematics (Figure 42).
The Global Innovation Index (2018) shows that tertiary education in Indonesia is shut off from the rest of the world as reflected by the low mobility of home students (Figure 43). Malaysia’s tertiary education is much more open. Three of its universities are ranked among the world’s 25 best institutions. Indonesia’s best university come 37th in the world rankings. That is better than Thailand, the Philippines and Vietnam. Yet there is huge variance in the quality of Indonesian universities. Based on Ministry of Higher Education’s rankings for 2018, only 14 universities across Indonesia (0.7 percent) belong to the first cluster (Figure 44). The rest are not nearly so good.
Although we do not believe that education is a binding constraint at this stage, there is a high probability of it constraining economic growth in the future. The quantity and quality of education in Indonesia is not sufficiently high to prepare the workforce for increased global competition and technological disruption. This is particularly concerning given that education is the main factor to produce skilled labour and innovation that will ensure high productivity in the long term.
The existing skills mismatch may suggest that the education system is poor at teaching the skills needed for work.
Moreover, the World Economic Forum (2016) predicts that science, technology, engineering, and mathematics (STEM), as well as soft skills, will be the skills most sought after by employers in the future (by 2020). Indonesia comes near the bottom of PISA and TIMSS assessments in these areas. But the OECD (2018) estimates that ensuring today’s students are equipped with basic skills by raising the PISA score to Thailand’s current level would increase Indonesia’s average GDP growth by 0.6 percentage points a year from 2020 to 2060. Unfortunately, soft skills are not yet an important part of education in Indonesia. This contrasts with advanced countries such as Singapore and South Korea which put them at the core of their national curriculums.
The Global Innovation Index and Human Capital Index reveal separate concerns about Indonesia’s human capital, including education. Indonesia’s Global Innovation Index score for human capital and research has declined steadily since 2013. The country also scored lower than peer countries in 2018 (Figure 45). This indicates that human capital and research is insufficient to support innovation in Indonesia. Indonesia also ranks below neighbouring countries such as Singapore, Vietnam, Malaysia, Thailand and the Philippines in the Human Capital Index5 (World Bank, 2018) (Figure 46). This could mean that the next generation of Indonesian workers will be less productive than those in other countries.
Considering all the evidence, we categorise education as a future binding constraint to Indonesia’s economic growth.
Health
Indonesia’s health outcomes have improved significantly. Life expectancy at birth has risen sharply although it is still below peer countries (Figure 47). Infant and maternal mortality has also been reduced significantly in the past two decades to rates nearly similar with peer countries (Figure 48 and Figure 49).
However, the quality of children’s health and nutrition is relatively low compared with peer countries. This is reflected in high prevalence of stunting (Figure 50) although in recent years the figure has dropped. Immunisation rates for children below the age of 5, including those for measles and hepatitis B, are still below those of peer countries (Figure 51).
Deaths from communicable diseases, deaths during pregnancy and childbirth, and deaths from poor nutrition are still relatively high in Indonesia (Figure 52). There has been improved in the recent years, however, suggesting that health intervention is working. Nevertheless, the government budget for improving health infrastructure and health workers is lacking compared with peer countries (Figure 93).
Meanwhile, deaths from non-communicable disease have increased, as expected as there are growing middle class (Figure 53). In particular, the prevalence of cardiovascular diseases, cancer, diabetes, and chronic respiratory diseases in Indonesia is higher than peer countries (Figure 54). A higher rate of non-communicable disease will increase demand
5The index is measured in terms of the productivity of the next generation of workers relative to the benchmark of complete education and full health.
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for health facilities. Yet health facilities such as number of doctors and hospital beds per 10,000 people is still far below peer countries (Figure 55).
An important consideration is the high prevalence of smoking in Indonesia. Among adult men, smoking rates continue to increase, in contrast with other countries (Figure 56). In fact, Indonesia is one of the countries with highest rates of male smokers in the world (Figure 57). Recent surveys also suggest that the smoking among teenagers is also
widespread in Indonesia (Figure 58).
Although several indicators show improvements to health, there are still many areas of concern that could impact labour productivity negatively over the long term. Moreover, the Human Capital Index released by the World Bank (2018) based on the current state of health, along with education, shows that Indonesia is being left behind by neighbouring countries. Taking into account the potential impact of current health and education, Indonesia’s long- term labour productivity is predicted to be lower than that in Singapore, Vietnam, Malaysia, Thailand and the Philippines.
Stunting, in particular, could mean that children’s brains fail to develop to full cognitive potential (World Bank, 2018).
This would hinder children’s abilities to perform well at school and in turn make them less productive when they enter the labour market. Meanwhile, the high prevalence of smoking among teenagers heightens the risk of premature deaths from non-communicable diseases. This could lower lifetime earnings.
Improvements to health are essential for a more productive labour force going forward. Human capital itself is categorised as a nation’s productive wealth. Poor health would retard growth in human capital as it affects lifetime earnings (World Bank, 2018). As Indonesia is approaching its lowest-ever dependency ratio, with more than half the population in their productive years, poor health will give penalty to reap the optimal growth.
Looking at current condition of human capital and its possible condition in the future, we categorise health, along with education, as future binding constraints to economic growth.
3.4. Infrastructure: Lacking Particularly for Connectivity
In this section, we look at infrastructure as part of our examination into whether social return is the most binding constraint for generating investment with higher returns. We found that infrastructure, in particular connectivity, is still a major constraint for Indonesia. Spanning almost 2 million square km and spread across 17,000 islands, Indonesia needs a vast amount of infrastructure. However, a lack of investment in the past has led to a decline in the
infrastructure capital stock. Recent government’s effort to boost infrastructure have halted the decline but not enough to return the capital stock to previous levels or to put it on a par with peer countries.
Poor logistics limit opportunities for economic diversification and contribute to price disparities. For example, regions with limited access to markets owing to poor freight logistics (such as Papua) have less diversified economies than well-connected regions (such as West Java). This is because higher value-added goods need to meet tight delivery schedules cheaply, reliably and predictably.
We identify water and sanitation as potential problems in the future. The supply of surface water is projected to decline mainly owing to an increase in economic activity that is not environmentally friendly. The natural carrying capacity, i.e. the ability of natural ecosystem to support continued growth within the limit of abundance of resource and within the tolerance of environmental degradation, is also in declining and so making economic growth
sustainable must be factored in the development agenda.
Connectivity
High logistics costs are a major drag on the economy. In 2016 logistics costs were equivalent to 27 percent of Indonesian GDP.6 High logistics cost drag down firms’ profitability. The World Bank (2015) shows that total logistics costs incurred by Indonesian manufacturers represent 25 percent of sales, higher than both Thailand (15 percent) and Malaysia (13 percent). The World Bank also suggests that poor infrastructure contributes to high logistics costs by generating congestion, inefficiency, and unreliability. It also shows that poor logistics limit opportunities for economic diversification and contribute to price disparities.
6INDii calculation.
I n d o n e s i a G r o w t h D i a g n o s t i c s | 11 The cost of congestion is most relevant for roads. Underinvestment has adversely affected the capacity as well as the quality of the nation’s road network and driven up logistics costs. Travel speeds are relatively low (approximately 40 km/hr) due to a high volume-to-capacity ratio. Only 18 percent of vehicles travel without experiencing jams. To travel 100 km, it takes between 2.5 and 4 hours, which is much longer than in neighbouring countries. Approximately 40 percent of national roads in Java and Bali are congested. Nearly 60 percent of roads are less than seven metres wide.
Indonesia’s road transport infrastructure lags other countries’ in term of connectivity, density, and quality (Figure 59, Figure 60, and Figure 61). Demand for road transport rose by 7 percent a year between 2013 and 2016. This outstrips the supply of new roads, which grew by about 5 percent a year between 2009 and 2016 to 87,800 lane-km. Extensive congestion is prevalent in main areas. This trend is expected to continue as vehicle-ownership increases. Current levels of vehicle ownership in Indonesia are still relatively low, with 87 motor vehicles (excluding motorcycles) per 1,000 people.
The road transport network is struggling to cope with this exponential growth, mainly because of delays building new roads, persistent and substantial underinvestment, and weak planning capability at all levels of government for network expansion. This, in turn, has led to imbalanced growth of the network and uneven access in different regions of the country (especially in rural areas). The sector also faces other major challenges, such as road safety, congestion, and pollution in urban areas. Congestion is concentrated on major roads in arterial corridors—reflecting a lack of high- capacity expressways and dual-carriageways.
Inefficient and unreliable sea transport also increase costs for firms. Indonesia’s ports perform poorly relative to global benchmarks (Figure 62). Average productivity of ports under Pelindo 3 and 4 is approximately 22 containers per hour.
Some ports are much more productive than others, with the worst ports managing to process only 13 containers per hour, and the best dedicated container terminals processing to 29 boxes per hour. The average vessel turnaround time is about 2.1 days. This is much slower than the global average of 1.4 days and is comparable to the slowest tier of ports in South Asia (which do not face much competition). Vessels also spend only around half (54 percent) of their berth time effectively (loading and unloading). World Bank study also found that sea freight costs are driven by the high value of time required for transportation (due to congestion and inefficiency), not the direct tariff or price paid for the transportation service.
Indonesia’s air transport infrastructure—as measured by airports per million square km, and air transport quality (Figure 63 and Figure 64)—is in line with that of other countries at a similar stage of development. The Government aims to develop tourism. Airport investment could support this ambition.
Indonesia’s rail transport infrastructure is slightly below that of other countries at a similar stage of development but similar to other ASEAN countries, measured by railway density and efficiency of train service (Figure 65 and Figure 66).
As an archipelago, railway won’t be freights. Nonetheless, rail development should be the big and fast-growing cities.
Infrastructure is still one of the top constraints for doing business in Indonesia, according to the latest WEF survey (Figure 67), although it is not considered to be as much as a problem as it was in the past. our discussions with large manufacturing companies produced interesting findings. For large players, it is cheaper to build multiple factories to make the same products in different parts of Indonesia than it is to pay the high costs of moving goods around the archipelago. This means the producers do not achieve economies of scale, costing productivity.
Energy
The electrification ratio (the proportion of households with some form of electricity) increased rapidly over 2010-2018 (Figure 68 and Figure 69. Electrification Ratio, Peer CountriesFigure 69) to 97.5 percent. At the same time, access to electricity improved for lower-income households so that the electrification rate is now broadly similar across all income groups (Figure 70). As such, improving electrification is no longer a pressing priority, at least at the national level.
Demand for electricity grew more slowly than expected in recent years, meaning that investment plans exceeded requirements. The largest demand for electricity came from Java where the manufacturing sector is thriving. As a result, PLN was able to maintain electricity reserves close to, or in excess of, its targets in most years.
However, the national electrification ratio masks substantial regional disparities between western and eastern Indonesia. Almost all districts in western Indonesia have electrification rates of more than 80 percent, while there are
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10 districts in Papua where less than 20 percent of households have electricity (Figure 73). Connecting these remaining districts will be challenging and expensive because most of them are in remote areas.
There is also a need to improve the quality and reliability of electricity, as demonstrated by the average duration of power cuts and the number of power cuts per year. Both indicators have worsened in recent years (Figure 71 and Figure 72) and are higher in eastern Indonesia (Figure 74 and Figure 75). Many industries run their own back-up electricity generators, especially outside Java.
Improving access to electricity for remote areas is important. However, Indonesia’s national electrification rate is higher than those of other countries at a similar level of development (Figure 69). However, the quality of electricity supply is still below the average (Figure 76). Given that most electricity demand has been met, electricity is not a pressing constraint for Indonesia, although intervention is still needed to improve reliability and extend coverage to all households.
Digital
ICT infrastructure, as indicated by the number of broadband subscriptions and connection speeds, is below the average of countries at the same level of development (Figure 77 and Figure 78). However, there is a megaproject in place to significantly improve ICT infrastructure: the “Palapa Ring” broadband project. Improved ICT infrastructure is the backbone of the digital economy. At the same time, soft infrastructure, such as technology regulation and skills development, is needed. Even so, digital infrastructure is not currently a binding constraint, given the rapid
development of Indonesian digital start-ups. Unequal access to technology is still the main challenge. At present the digital economy can only grow rapidly in Java and Bali where digital infrastructure is more developed than in other regions.
Water and Sanitation
Access to water supply and sanitation (WSS) services has improved over the past decade. Indeed, Indonesia reached its Millennium Development Goal (MDG) for water supply, with 89 percent of its citizens benefiting from access to improved water supply in 2016 (Figure 79). The MDG for sanitation was missed by a narrow margin (Figure 80). The Government is now targeting universal access to water supply and sanitation services, in line with the new Sustainable Development Goals (SDGs).
However, access to WSS services is unequal between the rich and poor, between rural and urban households (Figure 81 and Figure 82), and between the different regions of Indonesia. For example, in rural areas, 57 percent of the poorest quintile have access to water services compared to 93 percent in the highest quintile. In sanitation, only 66 percent of the poorest quintile have access to improved sanitation compared to 89 percent in the highest quintile.
Improving access to WSS services is particularly important because of the recognized link between poor sanitation, water-borne diseases, malnutrition and stunting (chronic malnutrition).
While improving access to clean water and sanitation to provide basic service for the low-income population is important, access to clean water seems to not be a constraint for firms (Figure 83). Nonetheless, Bappenas study (2018b) shows that water scarcity will become a challenge in Indonesia going forward. Unsustainable business practice has worsened the environment condition. This requires immediate actions to stop the deterioration of water quantity.
3.5. Market Failure: Unrealized Potential
This section looks at market failure—the inability of the market to generate new economic activity. As discussed previously, Indonesian exports have not developed or diversified in recent decades. Also, Indonesia lags behind in term of innovation. Nonetheless, this study sees slow self-discovery as a consequence, not cause, of the growth constraint.
Since the 1980s Indonesian exports have been dominated by resource-based manufacturing products. This peaked during the commodity boom (Figure 84). Low-value industries such as garments and footwear have been established but these have not developed into higher value-added manufacturing exports. As a result, exports remain dominated by resource-based manufacturing (Figure 85) and are heavily dependent on the cycle in commodity prices. Since the end of the commodity boom, export performance has been declining.
I n d o n e s i a G r o w t h D i a g n o s t i c s | 13 The complexity outlook index, an index that shows how easy it is for a country to develop a new product, suggests that Indonesia is actually in a good position. Indonesia has higher potential compared with other countries. However, this potential is yet to be realized, as shown by a low score in the economic complexity index (Figure 86 and Figure 87).
Not only does Indonesia lack high-value-added manufacturing, the services sector is also dominated by the low-end activities such as retails (micro and small kiosk) and tourism (particularly car rental). The modern financial services, business services and logistics services that could support manufacturing are lacking. Limited data on the services sectors means that it is not possible in this study to provide a similar level of analysis for services as for other sectors.
3.6. Macro Risk: Low Tax Receipt Limits Public Goods Delivery
This section examines whether the macroeconomic and fiscal positions are the binding constraint to growth. We found that the macroeconomic condition is relatively stable and supportive of business, despite some risks related to the external balance, i.e. financing the current-account deficit. Macroeconomic stability is also reflected in more manageable inflation, lower exchange-rate volatility, adequate official reserves, and prudent fiscal management.
However, we note that fiscal revenue is low owing to low tax receipts. Compared with peer countries, Indonesia has one of the lowest tax-to-GDP ratios. This translates into low fiscal spending. For instance, even though Indonesia spends at least 20 percent of its annual budget on education, the amount it actually spends is less than peer countries.
Indonesia’s macroeconomic management is good. On the external side, reserves have been built up and are at a safe level (Figure 88). The current account is still manageable although more could be done to attract more sustainable financing, FDI. External debt is also relatively low compared with the peer countries (Figure 89). On the domestic side, inflation is low and manageable, particularly in recent years.
Fiscal sustainability has also improved. Governments have kept to the commitment to keep the fiscal deficit under 3 percent of GDP. Government debt as share of GDP has declined and is low compared with other countries (Figure 90).
The fiscal rule also states that the government must keep public debt under 60 percent of GDP.
Nonetheless, low revenue combined with the commitment to prudent fiscal management have limited the government’s ability to provide necessary public goods. More than 80 percent of revenue comes from taxation but receipts have followed a declining trend. Indonesia collects the equivalent of less than 11 percent of GDP in taxes (Figure 91) compared with 15 percent in peer countries such as Thailand and Malaysia. This represents a significant decline compared with the years before the Asian financial crisis when Indonesia collected as much as 16 percent of GDP in taxes.
Tax collection is largely determined by the performance of commodity-related sectors. In the past five years,
Indonesia’s declining tax receipts were driven by a fall in income tax from oil and gas. from 0.9-1 percent of GDP to 0.3- 0.4 percent of GDP. The tax base is also small owing to low compliance. In 2018, the number of registered taxpayers was 39.2 million. Of that figure, only 18 million earned taxable income, of which only 60 percent filed a tax report.
Nonetheless, the main issue is tax policy. VAT receipt is low compared with other countries, mainly because of multiple exemptions.
Low tax receipts translate into to low public expenditure. This limits the delivery of necessary public goods, such as on education and health (Figure 92 and Figure 93). Indonesia’s capital spending is low compared with other countries.
When the government removed fuel subsidy in late 2014, it created space for more capital spending. This enabled the delivery of many long-awaited infrastructure projects.
3.7. Regulations and Institutions (the Most Binding Constraint): Better Coordinated Policies to Boost Growth
This section examines regulations and institutions. It concludes that they are the most binding constraint to growth.
Existing regulations do not support business creation and development and they tend to be restrictive. Institutions here refer to the setting which produces those regulations, in particular: lack of strategic alignment, weak supervision, and overlapping institutional responsibilities. It also points to corruption and bureaucratic inefficiency. Weak
regulations and institutions were a common complaint not only among private business but also among social sectors such as health and education.
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Inefficient regulations create high fixed costs. Therefore, it generates a “missing middle” phenomenon in Indonesia (Figure 94): large companies can bear high fixed costs, medium companies cannot compete, and small companies choose to be outside of regulation – causing a large informal sector. Compared with other countries, existing
regulations tend to be protectionist, and costs related to labour and taxation is very high. Widespread middlemen also indicate regulations and institutions to be the most binding constraint as economic agents attempt to bypass them.
Compared with peer countries, Indonesia has a low regulatory index score (Figure 95). The index reflects perceptions of the government’s ability to make and implement regulations/policies that support business development. In other business-related regulations, such as property rights, legal system, and rule of law, Indonesia also ranks low compared with other countries (Figure 96 and Figure 97).
Data from Global Trade Alert suggest that the number of new regulations issued by Indonesia is greater compared with other countries. While that figure could mean active participation of government in the international trade and investment, the type of intervention suggests that these interventions are mostly protective. They do not support international trade and investment.
Regulatory constraints cover three main areas: labour, investment, and trade.
First, labour regulation. The cost of firing workers in Indonesia is high. This means firms employ staff on temporary contracts and do not develop their professional skills through training (Figure 99). Figure 98 shows that in order to fire Indonesian workers with 1, 5, and 10 years tenure, it costs 57.8 weeks of salary on average. This is two times more than in Turkey, four times more than in Brazil, and six times more than in South Africa.
Indonesian firms also struggle to navigate costly and complex regulations to hire skilled foreign workers. This places Indonesian firms at a disadvantage. As an illustration, for a firm to be able to hire foreign skills, it needs to acquire RPTKA, IMA, VITAS, KITAS, MERP, and a residence permit. The annual cost to get IMTA is USD 1,200, or 35 percent of income per capita in Indonesia. Foreign skills are also limited into few sectors only with services sector being the most restrictive. With these limitations, only about 74,000 permits were granted in 2016. This is equivalent to just 0.03 percent of the population.
Second is investment policy. Indonesia is among the most restrictive countries in the world for foreign direct investment (Figure 100). Restrictions on FDI through the negative list discourage foreign firms, especially export- oriented firms, from setting up business in Indonesia. The service sector is one example where developed is hindered by highly restrictive regulation. As a result, Indonesia has low foreign direct investment (Figure 101).
Despite recent improvement in investment climate, as reflected in improvements in the ease of doing business rank, Indonesia still ranks poorly in few important areas such as starting a business, trading across border, and ease of paying taxes (Figure 102, Figure 103, and Figure 104). For instance, it takes 19.6 days to start a business in Indonesia compared with only 4.5 and 1.5 days in Thailand and Singapore, respectively. Moreover, Indonesia ranks 112th in the ease of paying taxes whereas Singapore and Thailand rank 3rd and 36th, respectively. It should be remembered that Indonesia is not alone in seeking to improve the ease of doing business. Indonesia is competing with other countries that are undertaking similar reforms.
Regulations do not create right incentives for businesses to grow. For instance, tax exemptions for small businesses discourage Indonesian firms from expanding and becoming more productive through economies of scale.
Third, Indonesian exporters and importers face high administrative costs owing to excess licenses and regulations. It takes longer and is more expensive to export from Indonesia compared with neighbouring countries such Malaysia, Thailand and Singapore (Figure 105). At the same time, “non-tariff barriers” to trade such as licenses and quotas increase the cost of living in Indonesia by 8 percent (Figure 106).
The evidence of regulatory constraints is apparent across sectors. In education, foreign nationals are not permitted to obtain academic tenure in Indonesian universities, preventing the transfer of valuable “know-how”. In health, there is a lengthy process to obtain a BPOM license, making some drugs unavailable in Indonesia.
There are examples of success when Indonesia has pursued more open investment policies. Indonesia recently has recorded a success story in opening its investment policy. The domestic film has grown rapidly since rules on foreign ownership were relaxed in 2016, with 600 new cinema screens opening during the past three years. The number of cinema-goers also grew, from 16 million in 2015 to 43 million in 2017. The larger market has created opportunities that
