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Indonesia’s Economic Outlook Post 2014 Elections

An Interview with Gunawan Wicaksono

By Noelan Arbis
July 22, 2014

As the results of Indonesia’s July 9 presidential election remain in heated contention, the biggest challenge facing the incoming president is the country’s economy. Once seen as a beacon in Asia, Indonesia’s economy grew by less than 6% in 2013, its lowest level in four years. The country’s rising deficits, underdeveloped infrastructure, and protectionist measures have also caused grave concerns for foreign investors, as reflected by slowing FDI. In light of these challenges, NBR spoke with Gunawan Wicaksono (Harvard University) to get his thoughts on what the incoming president could do to turn the tides and jump-start more robust economic growth for Indonesia.

The new president faces the enormous task of restoring Indonesia’s economy. GDP growth has slipped over the past three years, FDI growth is slowing, and the country’s current account is projected to remain in deficit, as it has been since 2012. What has caused these trends and what steps could the new government take to improve Indonesia’s economic outlook?

Indonesia during the last several years, especially after the 1997 crisis, has restored somehow its economy growth though not as high as pre-1997. However, this has been done mainly on the backbone of its booming commodity trades. The more recent slowing of Indonesian economic growth was mainly due to the slowing growth of these commodities caused by higher competition and stagnant demands. Other than that, the production of oil and gas has been stagnant or even declining during the past few years mainly due to the declining of the current production capacity and no significant additional new oil and gas explorations. In recent presidential debates, both candidates proposed to reduce the consumption of oil and gas through energy diversification, reducing imports, and increasing the overall production capacity. All of these are feasible but each requires more than a short time period to implement, especially with energy diversification and capacity expansion. Related to the slowing growth of FDI and the current account deficits, there are several factors that might be causing these, but it's all down to the weakness of the foreign demand for our export products and stronger domestic demand for imports.

The question is then how could that happen? Is Indonesia’s competitiveness stronger or weaker? If you looked at the statistics for exports, you would notice that manufactured products have not been the backbone of the growth of Indonesian exports, due to lower demands for Indonesian manufactured products. Several things might cause this. One is related to the characteristics of the products themselves, such as their quality and prices. Since most Indonesian products are low-end products, quality might not be the main concern of the buyers, especially if quality differences are not significant but prices are. Looking at the real effective exchange rates (REER), Indonesia has experienced the real appreciation of its currency relatively to other member countries of the Association of Southeast Asian Nations (ASEAN), especially during the last few years prior to the middle of 2013, before the sharp depreciation of rupiah. The relative higher export price might contribute to the lower competitiveness of Indonesia’s manufactured products, especially its low-end products.

Other than that, the investment climate itself has not improved much. These may explain the slowing FDI and the current account deficits. The new government needs to enhance the competitiveness of the country’s products. Streamlining the bureaucracy, reducing transportation costs, improving and stabilizing the quality of the power supply, maintaining the competitiveness of the rupiah, and preserving socio-political stability, among other things, are important to boosting investment, exports, and Indonesia’s overall economic outlook.

Indonesia’s fuel subsidies remain a hot-button issue for the country. Many analysts agree that subsidies should be phased out to ease constraints on the fiscal deficit, but doing so remains politically unpopular and has led to nationwide protests in the past. How should the new president tackle this issue?

First of all, I agree that the size of fuel subsides in the Indonesian government’s budget has been substantial, and this surely needs to be reduced. But this action is particularly unpopular and would initiate widespread protests around the country. I think the root of the problem is not about the fuel subsidy itself but about the trust that the people put in their government. For decades, the government’s actions have only been symbolic actions to calm the people without providing real results. There have been a lot of problems in each government program to replace the subsidy. How can the people believe in their government when what they can observe is a big price increase and more unemployment?

This is very important: when the people observe that there is a lot of improvement in their healthcare, in their transportation costs, in their wellbeing—which can be reflected in less criminality, better social indicators, better distribution of goods and services—then anything the government would do to reduce the subsidies will have less resistance from the people. It is this trust that should be built up by the new government: that the intention of the government is the improvement of the wellbeing of the people and not just the cronies of the incumbent. When the actions of bureaucrats just become a showcase to the people of how the bureaucrats think only about themselves, then how could anybody trust them to think and care about the people? As a result, many of the policies produced are thought of as dishonest and believed to not bring much improvement to the people’s wellbeing.

I remember the argument that many of the fuel subsidies are enjoyed more by the rich than the poor. Well, while that is correct in absolute terms, it is totally wrong with respect to the percentage of wealth. Poor people would react to any disturbances in prices than rich people because the proportion of transportation costs and basic needs in their budget are simply much larger than for rich people. The poorer the people are, the bigger their transportation and basic-need cost shares are. Therefore, there should be a way to manage the increase in transportation costs and prices for basic needs that would minimize the negative impact. I believe that when the government can do this sincerely, there will be much less resistance and more support from the people for having greatly reduced or no fuel subsidies.

Indonesia dropped four spots to 120th out of 189 economies in the World Bank’s 2014 Doing Business report. What can the new president do to improve the business environment in Indonesia? Where should infrastructure spending rank in the government’s priorities?

The new government should focus on slimming down the bureaucracies and overhauling the old system of monitoring, as well as creating new systems that would reduce the loopholes for corruption and unnecessary spending. In the past, presidential candidate Joko Widodo, who was the governor of Jakarta at the time, had to be directly involved in the monitoring process to make sure that policy could be implemented fast and correctly. I think the need for this will be reduced when the monitoring system is ready and functioning well. The previous successfulness of such direct involvement in the monitoring process proves by itself the lack of a proper monitoring system. Something about our monitoring system has to be fixed there.

With regards to improving the business environment in Indonesia, it should be based upon the existence of adequate support. Two important sources of support are the right laws and regulations and the right infrastructure, both in terms of hard and soft infrastructure. I will only explain the second one regarding infrastructure. Infrastructure development should be the government’s priority. Without sufficient maintenance, our current infrastructure will deteriorate overtime and its value will diminish faster than it should. On top of that, power supply generators should be the first priority, followed by building transportation hubs across the country. Many factories will require a lot of efficient energy to make them viable to operate and compete. Insufficient supply of electricity would essentially hinder the development of manufacturing industries. Of course, the soft infrastructure—the people who run these systems—should have adequate skills and be sincere and trustworthy. Without them, even a perfectly designed system would fail to operate well. Besides that, right now transportation costs could eat up as much as 40% of the cost of production, and that is not small. To make Indonesia’s products more competitive, the transportation costs should be smaller. Currently, many inter-island shipments stop in Singapore, Jakarta, or Surabaya before reaching other islands in the country. This is not efficient and puts an unnecessary burden on ports in Jakarta and Surabaya. While I am talking about the end results, the process to establish these results needs to be managed in a way that can be synergized with regional development. Surely, that’s another challenge to face.

Both presidential candidates touted a more nationalistic and protectionist approach to the economy during their campaigns. Will this have a lasting impact on Indonesia’s economy and FDI levels? How big of an impact will the president-elect’s efforts against corruption have on foreign investments?

It is not the case that having a nationalistic and protectionist approach is necessarily bad. It is about how you implement it. There are some pro and cons to this approach, and both sides have some grounds for support. When you want to apply this approach, one important thing to be concerned about is the international reaction to and repercussions of the policy. When it involves international law regarding contracts related to foreign investments, the downsides might be overwhelming and exceed the benefits. You can secure few bucks but lose a lot of possible future streams of foreign investments. It is easier to make foreign investors run away from a country than to make them believe in the prospects for investment in a country and to invest in it. Again, there should be a deep analysis of the possible international reactions to and repercussions of such policy on a specific industry, and so that leaders can apply it when they know that the benefits would exceed the costs. I think that renegotiating contracts based on bilateral agreements might have fewer repercussion effects than blanket protectionist measures. The costs might not seem inherent at first sight, since this involves investors’ confidence. So, sometimes, the benefits and the costs are not so simple to describe, and you have to be really careful about this.

Now, about the second question, I would say that corruption has become a significant problem in Indonesian economic development. Everyone talks about this especially when the budget is tight and you want to achieve a lot. Now, put yourself in the boots of foreign investors. Which one is more important: the corruption problem or the guarantee of the return of your investment and its profitability? There will always be some amount of corruption, whether small or large. The concern is when this corruption becomes so rampant that the efficient allocation of resources is distorted so much and that productive investment is hindered. I can assure you that in the past some complicated bureaucracies have hindered some important manufacturing industries to invest in Indonesia. Complicated bureaucracies will always invite corruption due to their nature. Slimming down the bureaucracies and overhauling the systems is needed, especially regarding the monitoring of implementation, so that direct involvement by executives in the monitoring process will not be needed.

What challenges and opportunities could arise for Indonesia’s economy due to ASEAN’s increased integration in 2015 through the ASEAN Economic Community (AEC)? Which industries are expected to gain and lose? How can the president-elect support implementation of the AEC in Indonesia, and what should the country prioritize for the next phase of ASEAN integration?

I believe that ASEAN integration in 2015 will bring more opportunities and challenges for Indonesia’s economy than we previously thought. With the population well over 250 million, Indonesia contributes more than 40% of ASEAN’s population. The country is a huge market for ASEAN products but also a potentially huge supplies of human capital, providing a big competitive edge for industries if can it can be developed. However, without sufficient inter-island transportation, instead of becoming a whole, huge market, Indonesia can only be several fragmented markets, and likewise with its industries.

A large population can be a burden, but it can also be a benefit. One important thing to remember is that not only goods can be traded freely; there is also the movement of skilled workers. The current argument is that Indonesia’s workers would hardly compete with other ASEAN countries’ workers due to the lack of skills. I don’t agree with that. In the short run, it might be right, but in the medium and long run that would not be the case, provided that political stability in Indonesia can be maintained. This is where national unity should be put to the forefront, regardless of religion, cultures, ethnicity, skin colors, and races. When Indonesians are more productive and are led by Indonesians rather than foreigners, then companies will prefer to have skilled labor from Indonesia instead of foreigners, especially when those who these skilled workers work with are also Indonesians. When we think about what industries are expected to gain and lose, the answer will not be simple. Several factors such as the availability of skilled and unskilled workers, infrastructure, materials, and technical know-how should be considered, as well as the time frame of the analysis. In the short run, we would expect that high-tech products as well as products that are currently difficult to produce domestically will flood the market. Since many of the country’s products are low-end in nature, those kinds of products have chances to spread more into other ASEAN countries. Eventually a new equilibrium will be formed and, in that process, the government can do more to make adjustments.

The country should also push the free flow of unskilled and low-skilled workers between ASEAN countries. Currently, only limited categories of skilled workers are allowed to work across the borders. I know resistance would be great, but meanwhile I think we could get around it by widening the classification of what is called a skilled worker toward much lower levels. This may be the next step the country needs to negotiate. On top of that, among other things, the country, as mentioned before, should prioritize building the infrastructure across the country in order to attract more investors. We have to do something about this or we will lag behind the progress of other ASEAN countries. I believe Indonesia will not only become an attractive market, but also a productive producer and exporter.

Noelan Arbis is an Intern at NBR.

Gunawan Wicaksono ("Gimel") is a Research Fellow in the Indonesia Program at Harvard Kennedy School. As a Research Fellow, he will expand on his research topic “Is Economic Development in Indonesia on the Right Track? Examining the Direction of Indonesian Strategic Economic Development Toward Poverty Reduction and Inequality Past, Present and Future.” He holds a PhD in regional science from Cornell University.