Building a more equitable and productive Indonesia

At the beginning of 2013 Indonesia’s economy looked to be in good shape. Growth was still over 6 per cent; inflation was manageable at below 5 per cent. Then on 22 May 2013 came a signal from the US Federal Reserve that it would begin to scale back its quantitative-easing program. In Indonesia, in an attempt to reduce budgetary burdens, the government reduced the subsidy (thereby increasing the fuel price) on 22 June. These two events, combined with increases in the minimum wage and food prices, as well as the continued slowdown in many advanced countries, have contributed to a rather different picture of the Indonesian economy in the second half of 2013.

The net inflows of portfolio investment that were so strong in the first quarter have now started to slow — in some cases they have even reversed — in response to US stimulus taper talk. The rupiah has come under pressure. And the inflationary effect of food and fuel price changes has started to kick in. Capital formation has also slowed down. By September Indonesia’s growth rate had gone down to 5.6 per cent, inflation exceeded 8 per cent, and the rupiah had fallen by more than 15 per cent against the US dollar.

Of course the country has seen worse. The situation following the 1997–98 Asian financial crisis was much bleaker. Yet, slowly, the country managed to recover and the economy was surprisingly resilient amid the 2008–09 global financial crisis. The recent episode in 2013 is but a small hiccup if seen through the longer-run trajectory of Indonesian economic dynamics. It is therefore important not to lose sight of long-term structural reforms. In this regard, two issues are of particular relevance to Indonesia: productivity and inequality.

With a total GDP of US$878 billion, Indonesia is among the 20 richest countries in the world. In per capita terms, however, this translates to around US$5,000 at purchasing power parity, which places Indonesia above India and the Philippines but well below China, Thailand and Malaysia. Indonesia’s relatively small output per capita can be partially explained by technological productivity. Indonesia’s total factor productivity, relative to US levels, dropped significantly after the Asian financial crisis. It has yet to recover, despite a period of quite stable growth. Currently,Indonesia’s productivity level is below most other countries in the region.

Furthermore, the wage employment elasticity of growth has gone down from 0.56 in 1991–2001 to 0.45 in 2001–11. This indicates that a higher rate of output growth is needed for every percentage of employment growth. But the change in wage employment elasticity may also imply one or both of the following: that technological progress has been more labour-saving or, given that the measure mostly captures the formal sector, that the informal sector has grown bigger. In fact, the number of unpaid and own-account workers (those in ‘vulnerable employment’) in Indonesia’s labour force has reached 60 per cent, compared with, for example, 40 per cent in the Philippines.

The second area in need of attention is inequality. Indonesia’s economic growth and poverty-reduction programs have been impressive. But increasing income inequality could constrain the effectiveness of growth in reducing poverty. Indonesia fares better than China, the Philippines and Thailand — and is far above Malaysia—in its Gini ratio (or in other measures of inequality, such as the ratio of income shares held by the highest 10 per cent compared to the lowest 10 per cent). Nevertheless, Indonesia’s inequality has deteriorated from 0.33 in 2007 to 0.41 today, with urban areas showing higher inequality (0.43) than rural areas (0.33).

But inequality is not just about income differences. What matters more for future prosperity is access to education and healthcare. In 2010, the literacy rate in Indonesia was 95 per cent for males and 90 per cent for females. In the meantime, 18 per cent of Indonesians still used rivers, lakes, unprotected springs or unprotected dug wells as their main sources of drinking water. Worse yet, 46 per cent of the population could only access unimproved sanitation (sanitation facilities that do not ensure the hygienic separation of human excreta from human contact) — and 36 per cent of the population in rural areas practiced open defecation.

These conditions vary across regions in Indonesia, but the case of one of the least developed provinces, East Nusa Tenggara, as compared to Jakarta, is illustrative. Income per capita in Jakarta was close to US$9875 in 2010, while in East Nusa Tenggara it was only US$650 — a 15-fold difference. Close to 9 per cent of the population aged 10 or above in East Nusa Tenggara did not go to school, and 9 per cent of households had undernourished babies. The numbers in Jakarta, on the other hand, were 1.7 and 3 per cent, respectively.

Improving equality in access to basic education and healthcare is therefore key. There are many ways to do this, but one of the most important prerequisites is budgetary support. Only 5 per cent of government expenditure goes towards health, while 15 per cent goes to education. This is in stark contrast with Thailand, for example, which spends 14 per cent of government expenditure on health and 30 per cent on education. Perhaps not surprisingly, both malnourishment and illiteracy rates are higher in Indonesia than in Thailand.

The recent fuel subsidy adjustment in Indonesia is commendable. But it is not enough. In fact, in the proposed 2014 budget, the fuel subsidy still crowds out education and health spending: the amount allocated to these two sectors is around 66 per cent and 6 per cent, respectively, of that allocated to the fuel subsidy. Getting the funding right, along with other issues such as curriculum improvements and access to universal healthcare, is critical to reaping the benefits of the so-called demographic dividend — which will start to subside in around 10 years’ time.

Finally, an enabling environment that connects the outcomes from better education and health conditions to increased productivity is necessary. This includes a more flexible labour market and a strong social protection system. In an economy that is undergoing structural change, higher labour mobility would be beneficial. The role of manufacturing is now gradually decreasing, while the importance of the services sector is increasing. In 2012 services value added represented 40 per cent of GDP, which was still among the region’s lowest levels. While employment in services has reached 44 per cent of total employment, the sector is still primarily made up of informal workers and small- and medium-sized enterprises. A more flexible market would help the transition from low- to high-productivity services and would go some way in securing Indonesia’s future prosperity.

Arianto Patunru is a fellow at the Arndt-Corden Department of Economics and policy engagement coordinator at the Indonesia Project, Crawford School of Public Policy, The Australian National University.

This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Indonesia’s choices’.