Two decades have passed since the Asian financial crisis wreaked havoc on Indonesia’s economy and swept from office its authoritarian leader, Suharto.
With the rupiah pegged to the US dollar, Indonesian companies had gleefully borrowed in dollars from foreign banks at 9% or 10% annual interest, a fraction of the 18% or 20% charged in the domestic market. At the end of September 1997, Indonesia’s total foreign debt was $133.3bn, $65.6bn of which was owed by private companies. These dollar corporate loans were mostly unhedged, and had to be serviced out of rupiah revenue. When the rupiah crashed, the foreign investment tide turned, markets swooned, and companies were unable to pay back their borrowings.
By the end of 1997, the rupiah had plummeted from 2,500 to the US dollar to 14,000 and the banking system was on its knees. In 1998, the Indonesian economy shrank by almost 14% and was in the intensive care of the International Monetary Fund.
Notable recovery
Indonesia’s recovery since the crisis has been remarkable. Real (inflation-adjusted) gross domestic product (GDP) growth averaged 5.5% from 2003 to 2016 and is expected to exceed 5% in 2018. This was slower than the pre-crisis (1983 to 1996) average of 7%, but as the World Bank points out, it is more sustainable and Indonesia “weathered the global financial crisis reasonably well”. The World Bank says “prudent fiscal management” has kept the fiscal deficit to within 3% of GDP and government and public debt to within 60%.
Indonesia’s efforts were rewarded in 2017 when Standard & Poor’s lifted its sovereign rating to investment grade. One of the key reforms has been making the exchange rate more flexible.
“They have stopped direct management of the exchange rate in terms of keeping it stable against the US dollar. They do signal from time to time, and intervene in the foreign exchange market, but that is mainly just to ensure that the currency doesn’t fluctuate too wildly from day to day. They still allow the market to set the basic level,” says Khoon Goh, head of Asia research at ANZ.
Mr Goh points out that this year’s depreciation of the rupiah has been less than that of other Asia currencies more sensitive to exports, such as the Korean won, the Taiwanese dollar or the Malaysian ringgit. While Indonesia’s $1000bn economy is often considered to be tied to commodities and resources, the world’s fourth most populous country, with 267 million people, has a large domestic consumer base.
Reducing inflation
The Bank of Indonesia also has successfully tackled “very high and persistent inflation”, says Mr Goh. “It has been one of the reasons why the exchange rate has remained under pressure and it leads to all sorts of distortions in the economy. In recent years, they have been quite successful in bringing the rate of inflation from 8%, or sometimes double digits, down to the 3% to 4% range, which historically for Indonesia is very low,” he adds.
The government has also targeted foreign-owned corporate debt, the source of much financial stress in 1997 and 1998. “A few years ago, the authorities mandated that short-term or external overseas debt had to be hedged in order to manage the exchange rate risk,” says Mr Goh.
Poverty rates halved to 10.9% in the 2000 to 2016 period thanks to “broad macroeconomic stability, commodity-driven growth and structural transformation”, according to the World Bank. “More than 30 million service and industrial jobs were created over this period, replacing less productive agricultural jobs and raising incomes for millions of Indonesians. As real per capita incomes doubled to nearly $4000, an additional 32 million people joined the middle class,” it adds.
Poor world, rich world
Alongside these considerable achievements are troubling weaknesses, particular in the uneven distribution of Indonesia’s economic bounty. The World Bank calls its March 2018 quarterly report on Indonesia ‘Towards Inclusive Growth’ to highlight growing inequalities, with consumption of the poorest 40% of households growing a mere 1.5% a year between 2006 and 2016, while for the richest 20% it increased by 5.1% a year.
The bank highlights major disparities in access to basic services across the 13,466 islands of the archipelago. Less than one-fifth of households in Papua and Kalimantan have access to safe water. Maternal mortality remains well above targets. Life expectancy at birth is only 69 years, five years lower than the average in east Asia and the Pacific. Meanwhile, 37% of children aged under five are stunted; among the poorest children, the proportion is almost one-half.
The past decade has brought growing recognition of the vital role of infrastructure in Asian economic development, and Joko Widodo, a former exporter of furniture, has made boosting Indonesia’s stock of roads, railway, airports, power plants and grids a cornerstone of his presidency since being elected in 2014.
The buildout is needed to fill the hole left by years of underinvestment in infrastructure. The World Bank estimates the infrastructure deficit at $1500bn. “Between 2000 and 2013, Indonesia spent an average of 3.6% of GDP in public investments and public private partnerships in infrastructure per year, compared with 17.7% in China, 11.3% in Malaysia and 6.3% in Thailand,” it says. It is a similar story for public health, on which Indonesia spends 1.4% of GDP or one-third of the global average.
In the aftermath of the Asian financial crisis, government priority changed to shoring up failed banks and trying to regain economic stability by reducing debt. “The incoming democratically elected government talked a good game but unfortunately it failed to deliver, as there was lack of coordination and an absence of political will to follow through with land acquisition for priority projects,” says Raj Kannan, founder of infrastructure advisers Tusk Advisory.
In the absence of eminent domain laws, the Widodo government has shown more political courage in acquiring land in the teeth of public opposition. “Often the president has been directly involved in persuading owners to vacate their land,” says Mr Kannan.
The World Bank has criticised the choice, delivery and maintenance of some projects with ineffective outcomes. A sixfold increase in spending on national roads between 2005 and 2015 “did not lead to a concurrent increase in the quantity and quality of roads”, it says, while despite a sevenfold increase in central government spending on the water supply, “usage of piped water for drinking purposes has fallen by almost one-third”.
Cutting waste
Mr Kannan believes such problems can be overcome by better planning, management and coordination. A central committee, headed by a top civil servant but managed by experts hired from the private sector, now oversees the delivery of priority projects. “This coordination has resulted in more than $100bn currently under construction,” he adds. Still, meeting the government’s target of building $500bn in additional infrastructure by 2020 will require increasing public investment to 4.9% of GDP per year, and raises inevitable questions of where the money will come from.
More efficient spending would clearly help. The World Bank points out that “the private sector can deliver infrastructure more efficiently and at better value for money than traditional government procurement”, yet private investment in infrastructure has declined from an average of 19% during 2006 to 2010 to 9% between 2011 and 2015. State-owned enterprises, especially construction companies, are at the forefront of executing Mr Widodo’s vision, and, as Standard & Poor’s has noted, their balance sheets have weakened as investment has accelerated.
One way the government has managed to adhere to its fiscal rule is by reducing wasteful subsidies and reallocating the savings to capital investment and targeted social welfare. “Until 2015, a large share of the revenue raised during the commodity boom was spent on regressive energy subsidies. In 2012, the government spent a fifth of its budget or 4% of GDP on energy subsidies, about four times the amount spent on social assistance,” says the World Bank. Only about 35% of these subsidies reached poor and vulnerable households, and they made little contribution to economic growth.
In 2015, the government removed petrol subsidies. Total spending on energy subsidies fell from 3.7% of GDP in 2014 to 1.4% of GDP in 2016. In the following year, electricity subsidies were restricted to only poor and vulnerable households.
Nevertheless, there is only so much that can be saved by fiscal housekeeping. If spending is to meet policy objectives – at 14.6% of GDP, Indonesia’s expenditure is less than half the average of other emerging markets – revenue will also have to rise through collecting more taxes. At present, less than 10% of Indonesia’s population, or about 15% of the employed workforce, are obliged to file annual income tax returns.
Tackling tax
A tax amnesty in 2016 raised taxes and fees equivalent to 10.4% of average tax revenues in the 2013 to 2015 period, and prompted declarations of total assets worth Rp4,882,000bn ($344bn), 39.3% of 2016 GDP. Indonesia’s joining in the automatic exchange of financial account information from September 2018, and adoption of an Organisation for Economic Co-operation and Development (OECD)-led framework to tackle base erosion and profit shifting, encouraged high-net-worth tax evaders to own up to Indonesian tax authorities. Much of the untaxed financial assets were in Singapore bank accounts, though some were held onshore.
Thorough reform of the national tax system is needed, including improving record keeping, updating IT systems and rooting out corruption. The World Bank cites estimates of compliance for major Indonesian taxes of about 50% to 60%. It also recommends broadening the tax base to include all of Indonesia’s “current and emerging middle classes who stand to benefit from additional health, education and infrastructure spending, and who, with continued GDP growth, will enjoy higher incomes and thus have higher capacity to pay tax in the future”. For political reasons, this may have to wait until after 2019’s presidential and legislative elections.
Indonesia’s gargantuan ‘shadow economy’ impedes the development of medium-sized firms that dominate the private sector in the world’s advanced economies. Small firms seeking to expand in the ‘formal economy’ must not only contend with difficulty in accessing capital, but compete against firms that pay no taxes or national insurance, and flout laws on minimum wages.
In Indonesia, 90% of workers are employed by 58 million companies with fewer than five people, according to a 2017 report by the now-disbanded Australia Indonesia Partnership for Economic Governance. Each worker at one of these minnows produces only 3% of the output of a worker at a larger firm with 100 or more people, yet together they account for 37% of GDP. The 5000 or so large Indonesian businesses that employ 100 workers or more account for only 3% of employment, but 40% of GDP. Productivity in manufacturing is almost double that of services, and five times that of agriculture. Many of the larger firms are part of conglomerates owned by tycoons who were granted monopoly concessions by Suharto.
Others are state-owned enterprises (SOEs). In 2013, the OECD ranked Indonesia fourth highest in the world (after China, the United Arab Emirates and Russia) in the SOE share of sales, assets and markets values of its top 10 companies. The Ministry of State-Owned Industry Enterprises currently lists 115. An Australian government-funded study estimated that they account for only 6% of GDP and 5% of capital stock.
Although less productive than private enterprises, the SOEs receive preferential access to government contracts and capital. The government plans to create holding companies for each major sector (such as energy, mining, ports, banking and insurance), which will hold stakes in SOEs in the same sector. Details of this vision remain hazy.
How to reach potential?
Winfried Wicklein, country director for the Asian Development Bank in Indonesia, enthuses about the “exciting potential” for digital start-ups, citing the home-grown success of Go-Jek, whose 1 million motorbike drivers respond to app-based demands for shopping deliveries, as well as massages and pedicures.
He is concerned, however, that Indonesia has yet to develop a sizeable manufacturing sector. “They have done a lot of structural reform, but the structural shift seems to have gone from agriculture straight into what is largely very low-value services. If the country wants to reach its potential growth, can it do that without building a solid manufacturing base?” asks Mr Wicklein.
If Indonesia is to have its own productive sector of medium-sized companies, it will need better infrastructure and education (the country remains near the bottom of the PISA rankings for scholastic attainment), as well as reforms that foster entrepreneurship, technology and innovation, according to Mr Wicklein. “GDP growth of about 5% is not a bad number – many countries would like to have that – but Indonesia could do much better, could have much more,” he says.
