Indonesia risks falling into the middle-income trap

In recent years, Indonesia has done better than many expected. The economy has been robust and resilient, expanding an average of 6 percent over the past five years — and that was despite a minor dip in 2009 as a result of the global economic crisis.

More so than its neighbors, its growth has been generally balanced, with strong domestic demand allowing the economy to weather the subprime crisis well. Core inflation has declined since price spikes in 2008. Rising merchandise exports and foreign direct investment have bolstered the current account surplus.

The fiscal deficit has been contained and the government debt burden has fallen, helping Indonesia regain investment-grade status for its foreign currency debt after nearly 15 years. Despite the slowdown in advanced economies, Indonesia’s superb performance is expected to continue — 6.5 percent growth is forecast for 2012.

These positive trends, however, merely underline the critical importance of facing the long-term challenge of graduating from middle- to high-income status. Indonesia became a middle-income economy in 2003. It actually attained middle-income status in 1993, but fell back after the 1997-98 Asian financial crisis. It took six years to jump back to the middle income bracket. Now it needs to battle the so-called “middle-income trap” — where an economy is unable to move up to more value-added production. Indonesia is not unique to this problem.

Typically, countries trapped at middle-income level have: (1) low investment ratios; (2) slow manufacturing growth; (3) limited industrial diversification; and (4) poor labor market conditions.

Indeed, since the Asian financial crisis, Indonesia’s recovery in investment and manufacturing has been slow. From about 30 percent of GDP until 1997, its investment rate plunged to 11 percent in 1999 before gradually turning around.

Growth in manufactured exports fell to an average of 11 percent in 1996-2000 and dropped a further 2 percent in 2001-05. Industrial diversification has been limited. Underemployment remains high, at three times above the unemployment rate.

Creating decent jobs — particularly for an expanding, increasingly young workforce — is a critical issue.

Yes, Indonesia has done well, particularly in comparison with its neighbors. And its prospects remain good. But Indonesia needs to set itself more lofty goals. It needs to shift gears to reach higher income levels — so its policy priorities must be realigned.

A recent Asian Development Bank publication, “Diagnosing the Indonesian Economy — Toward Inclusive and Green Growth,” describes what needs to be done and offers policy options for how to do it. The book acknowledges the wide range of reforms being pursued to get to high-income status. But more needs to be done to avoid the middle-income trap.

A key priority is structural transformation. Large-scale manufacturing needs to be ramped up to add new jobs, particularly for young workers. This is critical for poverty reduction. So is the drive for more inclusive and green growth, expanding opportunities to narrow the urban-rural divide and reduce inequalities without endangering the environment and natural resources.

New and better infrastructure is essential — and this includes both physical “hard” infrastructure such as transport and energy, and the so-called “soft” infrastructure — boosting education and training to give the young workforce the skills they need.

Doing this requires money, an adequate budget and good governance. Indonesia’s revenue base is too low. It’s clear that transparency and better governance improve tax collection.

But even with that, the budget alone cannot fund the country’s infrastructure requirements. Deeper and more diverse financial markets can help. So can a better business climate that promotes public-private partnerships to help fund large, often complex, projects.

The private sector cannot transform industry on its own, whether it is in agriculture, manufacturing or services. It needs government help. Developing new industries and new products is always risky. There are many costs with no guaranteed returns.

The private sector alone rarely takes such large risks or provides the necessary coordination across component sub-sectors. The government must provide guidance. This does not mean government should pick “winners” under traditional industrial policy.

In middle-income countries like Indonesia, there is no guarantee the government has an advantage over the private sector. But with the private sector, the government can help choose the best mountain to climb, clear a path, provide essential gear and then let the private sector make the trek.