 Chapter 5
Indonesia: The Surfacing of Structural Problems—The Pressing Issue of Infrastructure Development
Miki Hamada
Senior Research Fellow, Development Studies Center
Institute of Developing Economies
Key Points


The announcement of a step-down in quantitative easing by the US resulted in capitaloutflows, and structural problems, such as current account and trade deficits, havesurfaced in Indonesia.



Infrastructure development is the pressing issue, especially distribution infrastructuredevelopment, which is crucial to expand trade and resolve trade deficit. .

Exports depend heavily on natural resources and primary goods. Development of
the manufacturing industry is crucial in terms of increasing value-added, but hasty
policy turnarounds could negatively influence overseas investments. .

Institutional weaknesses in terms of governance, including the formation andenforcement of regulations, stand out. Legal opacity is still high, and legal
predictability is still low.

Shrinking manufacturing industry in Indonesia(change in % of GDP by industry)
30.0%

1986
1994
2002
2007
2010
2012

25.0%
20.0%
15.0%
10.0%

5.0%
0.0%

Source: Created by author based on Indonesian Central Statistics Agency

Japan Center for Economic Research, 2013 ―Asia Research‖ Report61

1. Introduction—Increasing attention after the global financial crisis
After the global financial crisis in 2008, the global economy stagnated, and the neighboring
countries of Thailand, Malaysia, and Singapore recorded negative growth.

Amidst thesedeclining economies, Indonesia showed steady economic growth of 4.6% (Figure 1) and hassince garnered attention. As a result of the plunge in the rupiah due to the Asian currency
crisis in 1997 and the collapse of the Suharto administration the following year, Indonesia fell
into chaos politically, socially, and economically. As a result, foreign businesses, which had
tapped into markets in Indonesia during the 1990s, were forced to withdraw or contract theirpresence.

Afterwards, due to the political chaos and continual terrorism, Indonesia posed too

great a risk for investors; investments from abroad did not return, not for about a decade.
Thus, the strength of the Indonesian economy in 2009 brought Indonesia to international
investors’ attention.

Figure 1: GDP growth rate
10.0%

5.0%

Suharto Administration (32 years)
0.0%

-5.0%

~7% economic growth-10.0%-15.0%

Source: Indonesian Central Statistics Agency

Furthermore, 2009 was the year President Yudhoyono won the election for a second time.
The achievements of the Yudhoyono Administration’s first term, which began in 2004, hadearned a good reputation, and in this year the world recognized that a period of politicalstability had arrived.

62

The Indonesian economy thereafter had a tailwind from a variety ofJapan Center for Economic Research ―Asia Research‖ Reportfactors and experienced four years of smooth sailing.

The successive upgrades to Indonesia’s

sovereign ratings supported the upswing in the Indonesian economy, and further propelled it
forward.

The upgrades continued from the beginning of 2010, reaching investment grade at

the end of 2011.

2. The path towards a middle-income country

2.1

The awareness of a middle-income country

The GDP per capita of Indonesia exceeded $3,000 in 2010. The local media also reported
largely on this fact, and it can be said that this was a period in which the awareness within
Indonesia of itself as a middle-income country began to develop.

Indonesia became alower-middle-income country in 1995, and its per capita GNI in 2012 was $3420; it istherefore poised to become an upper-middle-income country soon.1

2.2 Facing fluctuations
The steady economic growth was driven by vigorous domestic consumption and highinternational commodity prices.

Furthermore, increasing investment in Indonesia was

supported by stable macroeconomics, or in other words, a stable rupiah exchange rate, acurrent account balance and trade balance surplus, and a steadily increasing foreign exchange
reserve.

The inflation rate was within the target range of the central bank, and the interest

rate was maintained at a low level for a long time.

Meanwhile, in the labor market, wages

continued to rise, and, coupled with low lending rates, domestic consumption was increased,
which resulted in an increase in imports.

Following the latter half of 2011, the trade surplus

continued to shrink, and the current account balance also deteriorated.
trade and current account balance on a quarterly basis.

Figure 2 shows the

The current account surplus in 2011

was $1.69 billion, or one third of the value of the previous year, and became a large deficit of$2.44 billion in 2012.

1

The deficit has continued to expand in 2013.

According to the World Bank’s income classification, low-income countries’ GNI per capita (2012) is less than $1,035;
lower-middle-income countries range from $1036-$4085; upper-middle-income countries range from $4,086-$12,615; andhigh-income countries exceed $12,616.

Chapter 5 | Indonesia: The Surfacing of Structural Problems

63

Figure 2: A deteriorating current account balance and trade balance (on a quarterly basis)＄Millions(＄Millions)
15,00010,000

経常収支
Current
account balance

5,000

Trade
balance
貿易収支

0-5,000-10,000

March-04
September-04
March-05
September-05
March-06
September-06
March-07
September-07
March-08
September-08
March-09
September-09
March-10
September-10
March-11
September-11
March-12September-12
March-13-15,000

Source: Bank Indonesia, Indonesian Financial Statistics

The current account deficit put pressure on aggressive international investors to review their
Indonesian strategy.

Since the US suggested a step-down in quantitative easing in May 2013,

international funds began to flow out of emerging countries, and the Indonesian economy also
fluctuated.

The prices for natural resources, which constitute a majority of Indonesian

exports, were affected by the slowing Chinese economy, and began to decline in theinternational markets.

While exports dropped continuously, the depreciation of the rupiah

and the increase in imports due to vigorous demand overlapped, and the trade balance also
continued to deteriorate.

The stock market had been continuously recorded high, and further

capital inflow was expected as of May 20, 2013, when it reached a record high of 5,214.976,
but it dropped due to the US announcement of a step-down in the quantitative easing program.
Since foreign investors dominate–they are responsible for approximately 30% oftransactions–the stock markets stagnated due to the sell-off by foreign investors. Expectationsof capital inflow turned into concerns about capital outflow.

3. Avoiding the middle-income trap
In response to signs of fluctuation, concerns about a ―middle-income trap‖ have arisen inIndonesia as well.

President Yudhoyono, who had submitted a 2014 fiscal budget to thelegislature, gave warning against the middle-income trap and emphasized the expanding

64

Japan Center for Economic Research ―Asia Research‖ Reportinfrastructure expenditures in order to avoid it.

Abundant natural resources and a large

population have been the natural endowments of Indonesia, and the sharp rise in internationalcommodity prices was a strong tailwind. However, resource prices are unstable, and pricefluctuation has a negative effect on the economy, which has been experienced since the oilboom of the 1970s.

The large population does not always have a positive effect, andwithout the support of economic growth, it causes the opposite effect, including unemployment
and a poverty problem.
The biggest problem in the Indonesian economy is its undeveloped infrastructure.

In

October 2012, Anoop Singh, Director of the Asia and Pacific Department at the IMF, also
noted Indonesia’s danger of falling into the middle-income trap if the infrastructure is not
improved.2

Moreover, unceasing corruption is a major obstacle to growth, and problems withindustrial structure have been made clear through the current account deficit are profoundissue.

3.1

Infrastructure development

In ―Doing Business in Indonesia: 2012 Country Commercial Guide for U.S. Companies,‖
which was produced for US companies by the US Commerce Department Commercial Service,
the Indonesian infrastructure and service network were noted to not have caught up with theeconomy, and the undeveloped infrastructure was an obstacle to business.
The importance of infrastructure development has been consistently noted. During thedecade following the Asian currency crisis, there was a negative spiral in which insufficientinvestment impeded infrastructure development, and deteriorating facilities resulting from theinvestment shortfall became an obstacle to foreign direct investment. The biggest problem of
all was how to obtain funds.

In January 2005, directly after the presidential inauguration, the―Indonesia Infrastructure Summit 2005‖ was held on a large scale as an initiative of President
Yudhoyono, who called for the world to invest in the Indonesian infrastructure sector.
Declaring that during the five years between 2005 and 2009, infrastructure investment totaling$145 billion would be necessary to achieve an annual economic growth rate of 6.6%, heexplained that the majority of this would derive from overseas private funding. However, of
the 91 projects presented by the government, only six had concretely actualized after one year,3
and the development of laws in all kinds of fields pertaining to infrastructure development
became an urgent task for introducing private capital.
2
3

Jakarta Post article, ―RI risks falling into middle-income trap,‖ October 13, 2012.
Sato(2011)

Chapter 5 | Indonesia: The Surfacing of Structural Problems

65

3.2

A resource-dependent economy

Indonesia is the world’s second-largest exporter of coal, and in terms of reserves, ranks
fourth for nickel, sixth for copper, and seventh for bauxite (and fourth in production volume).
Natural gas reserves stand at 165 tcf (trillion cubic feet), of which the annual production is 3
tcf. Also ranking second in the world in tin production, Indonesia has abundant natural
resources that are an important factor supporting the growth of its economy.
Indonesian natural resource exports expanded rapidly in the latter half of the 2000s thanks torising international commodity prices and expanding demand from China. Natural resources
and primary goods exports accounted for 34.8% of total exports in 2005 but reached 47.6% in
2012; nearly half of all exports came to rely on natural resources. Crude oil and natural gas,
which for many years had been the primary export items of Indonesia, declined, respectively,from 8.3% to 6.7%, and from 11.8% to 9.4%, while coal rose rapidly from 4.8% to 13.9%.
Many studies have suggested that if resource-rich countries rely too much on resource
exports, there is a negative effect on economic performance, and in recent years, therelationship between economic growth and the quality of institutions in resource-rich countries
has been debated.4 In Indonesia as well, instead of selling resources piecemeal, economic
direction has aimed at high added value in resource exports. In 2009, the Law on Mineral andCoal Mining was enacted, forbidding the export of unprocessed mineral resources starting in
2014.

The objective was to expand exports and promote the fostering of downstream

industries by requiring high added value for mineral resources domestically.
This policy is important in promoting a higher-level industrial structure, but the suddenchange in direction for the mining business, which require time before profits are recovered,
has a strong nationalistic coloration, and so could be avoided by foreign companies. Also,
prohibiting exports at a stage when the structure of domestic industry is still not in order could
invite a loss in revenue, and hasty policy turnarounds could negatively influence overseas
investments.

3.3

The task of improving the industrial structure

In Indonesia, where reliance on resource exports heightened, de-industrialization began
proceeding before industrialization was complete.

Since 1994, when the GDP per capita ofIndonesia exceeded $1,000, the manufacturing exports5 exceeded 50% in 1994 but steadily
declined thereafter to 35.3% in 2010, when the GDP per capita exceeded $3,000.
4566

At 32.6%,

Mehlum(2006)
Based on the first digit of the HS code (Harmonized Commodity Description and Coding System) export item classification.

Japan Center for Economic Research ―Asia Research‖ Reportit currently represents less than one third of the whole.

It declined after peaking in 2007, as

indicated in Figure 3.

Figure 3: Fractions of GDP by industry over time
30.0%

1986
1994
2002
2007
2010
2012

25.0%
20.0%
15.0%
10.0%

5.0%
0.0%

Source: Produced by author based on the Indonesian Central Statistics Agency

In order to become an upper-middle-income country or an advanced country, it is necessary
not only to master existing technologies, but also to be innovative in one’s own right. 6
Industrial development is indispensable as a forum for fostering such technological strength,
but comparing the value-added by the industrial sector during 1985-1993, when the per capita
GDP was at the $1,000 level, to the period of 1994-2004, when it was at the $2,000 level, it
can be seen that the increase has been slackening (Figure 4).

6

Aiyar et al. (2013).

Chapter 5 | Indonesia: The Surfacing of Structural Problems

67

Figure 4: Value-added of industrial sector (as % of GDP)

Source: Created by author based on World Bank data.

During the Suharto Administration in the 1960s, Indonesian industrialization was pushedforward by an import-substituting industrialization policy under a full-set principle. 7
Following the oil boom in the 1980s, export-oriented industrialization was promoted, and thenefforts were made for the structural reform of an oil-dependent economy into a
post-oil-dependent economy. 8

The Suharto Administration, which had been promoting

industrialization, met its demise in 1998, and Indonesia experienced a long period of politicalturmoil and has been transformed amidst rapid changes in the international economic
environment.

A government-led industrialization policy could not be adopted anymore, andthe industrial structure of Indonesia changed greatly.
The current state of de-industrialization can be considered a result of the absence ofindustrialization policies and the resource-export-dependent economic structure.

In the 2000s,

terms of trade began to rise and have been improving since 2005, with natural resources prices
increasing.

During this period, the value of the rupiah against the US dollar had been stable

thanks to the efforts of the central bank, which called for a strong rupiah.
effective exchange rate tended upwards throughout the 2000s.

Meanwhile, the realThis appreciation of the realeffective exchange rate was unfavorable for manufacturing exports, while imports became
easier due to the continued improvement in terms of trade; the increase in imports of low-cost

7

8

68

Under the ―full-set principle‖ industrialization, the goal was to create a ―full set‖ of finished product, component, and raw material
industries in the country, all the way from light industry and resource processing to heavy industry.
Mihira and Sato (1992).

Japan Center for Economic Research ―Asia Research‖ Reportforeign products such as Chinese goods might lead to a stagnation in Indonesian
manufacturing.
Upgrading industry is a prerequisite for becoming an advanced country, but for Indonesia,
just aiming at becoming an upper-middle-income country, by using the manufacturing sector
as a source of job creation, is also important.

The percentage of workers in manufacturing

was 11.8% in 2004, and has been gradually rising to 12.7% in 2007 and 13.9% in 2012, but
productivity is declining.
Increasing productivity and international competitiveness while absorbing an expanding
labor force is a challenge for the manufacturing sector.

To achieve this, a variety of policy

efforts are required, including reforming the rigid labor market where it is difficult to lay off
workers, nurturing human resources, developing infrastructure for the facilitation oftransportation and trade, improving access to funding, increasing the transparency andefficiency of policies, and the like.9

4. The fragility of the Indonesian economy

4.1

Weak governance and administration

The surfacing problems arise from the common fragility of the economic system ofIndonesia.

In a survey by the World Bank comparing the state of the business environment in

the world (―Doing Business 2013: Comparing Business Regulations for Domestic Firms in 185
Countries‖), Indonesia ranked 128 out of 185 countries.

This indicates that the institutions

and the capabilities of the administration are still those of a developing country.
The need for infrastructure development is absolutely certain, but financing is also a vital
issue.

Infrastructure investment requires that a huge amount funds be covered from various

sources.

Although the government’s development investment budget is 10% of the whole,

one large problem is not the amount, but the ability to sufficiently enforce the allocated budget.
The problem has been noted that every year towards the end of the year, a significant
fraction of the budget allocated to many ministries and agencies is unused.

For the 2013

budget as well, as of October, only 67% of the total expenditures had been spent.

Based onthe distributed amount to each ministry, agency, and national body, excluding personnel
expenditures, the executed amount was only 58%, which means that the remaining 40% or somust be spent in two months.

9

Farole (2012).

Chapter 5 | Indonesia: The Surfacing of Structural Problems

69

4.2

The small financial sector

The Indonesian economy has been steadily growing since the latter half of the 2000s, but it
is difficult to say that it has been financed by the domestic financial market. 10

Figure 5 plots

the outstanding loans of commercial banks and deposit balances as a percentage of GDP from1970 to 2012.

From 1970 until the Asian currency crisis of 1997, bank loans/deposits

expanded relative to GDP.

Loans, which stood at 65.8% of GDP in 1997 just prior to thecurrency crisis, fell to 20.3% in 1999 due to debt that had gone bad after the crisis wastransferred to the Indonesian Bank Restructuring Agency (IBRA).
Loans began to increase in 2002, and from 2010, loans and deposits finally resumed
increasing together.

However, the current loans/deposits ratio to GDP remains at pre-1990

levels, and so the Indonesian banking sector had been set back by over 20 years.

Furthermore,at least approximately 30% of the bank loans are for consumption, including housing loans andautomobile loans, which exceeds the approximately 20% that are long-term investment funds.
The domestic banking market is a place for financing short-term operating capital, and has areduced intermediate function of long-term production funding.

Figure 5: The development of the banking sector

Source: Bank Indonesia, Indonesian Financial Statistics

1070

Hamada (2013).

Japan Center for Economic Research ―Asia Research‖ ReportAs source of funds, other financial markets also cannot be said to be sufficient.

While bankloan balances as a percentage of GDP is 33%, stock market capitalization is 50% of GDP, andbonds are around 10% (in 2012). The private companies’ financing from the capital markets isonly around 100 trillion rupiah, combining stocks and bonds. This is less than 5% of the bankloan balance, equivalent to 2,731 trillion rupiah (in 2012).

If the net increase in bank loans from2011 to 2012 is equivalent to 514 trillion rupiah, these funds, which are regarded as fundraisingfrom banks, are equivalent to five times the new financing from the capital markets.
Indonesia’s financial sector has not reached a sufficient scale to support not only infrastructure
investment but also future economic growth.. According to the World Bank, the percentage ofadults 15 years or older who had an account at a formal financial institution in 2011 was only 20%.
In order to develop the Indonesian economy to grow from the bottom, providing comprehensive
and inclusive financial services is crucial.

4.3

Lack of human capital

To evade the middle-income trap—namely, achieving sustainable growth—there is no high road,and it is important to enhance human capital adaptable to high-level technology and technologicalinnovation. To this end, the importance of education goes without saying, and there is a need toenhance educational institutions.

Indonesia has a 95% primary education enrollment rate, which

is high just in terms of the numbers, but there is also the question of quality. Enrollment in middle
school (pre-secondary education) became required in 1994, but complete implementation at anational level has not yet been reached.
According to the population census in 2010, the national average number of years of educationof the citizenry was 7.9, which is shorter than the required education period of 9 years, and theaverage value exceeded 9 years only in certain urban areas such as Jakarta and Yogyakarta.

Thehigh school enrollment rate was 45%, and the tertiary education enrollment rate was 11%.

From

the recent steady economic growth and the size of the population, the rate of advancement totertiary education is expected to rise. While management-class human resource training is an
issue, the enhancement of secondary and tertiary education, including high school, is important.
Meanwhile, in Indonesia, which has many workers, the maintenance and expansion inlabor-intensive industries that can absorb unskilled workers who have completed only primary andsecondary education is also important. Worker wages in recent years have largely continued toincrease.

In 2013, the minimum wage in Jakarta and similar cities in the capital region was raisedby 44% year-over-year, and it was decided to be increased by 11% in 2014, but there is a worker

Chapter 5 | Indonesia: The Surfacing of Structural Problems

71

backlash.

Raising wages without an accompanying productivity could become a factor decreasing

Indonesia’s international competitiveness.

5. Towards sustainable development

5.1

A blueprint for 2025.

In May 2011, the Indonesian government released a ―Master Plan for Acceleration andExpansion of Indonesia’s Economic Development (MP3EI) from 2011 to 2025.‖ MP3EI upholds
the target of expanding GDP from the previous year value of $700 billion more than six fold to $4.5
trillion by 2025, to become one of the top 10 economies in the world.

A total amount of 4,012

trillion rupiah are planned, of which 45% are for infrastructure investment.

The government

intended to provide a quarter of the total amount; the remainder would take advantage of domestic
and foreign funds including private funds. The plan specified projects and clarified the necessary
investment amounts.
The promotion of six Indonesian Economic Development Corridors (IEDC) is a key element.
The connections between domestic and overseas elements as well as the connections among the
economic corridors and domestic development bases must be increased.

Furthermore, the plan

aims to strengthen human capital and scientific technology for carrying out the economic program.
The economic program plans eight programs (agriculture, mining, energy, manufacturing, shipping,tourism, communication, and the development of special economic zones) comprising 22 importantfields.11 It is extremely broad in scope and contains many fields, and suggests the Indonesian
government’s intentions rather than specifying the primary industries for promoting economic
growth; instead it redefines broadly the industrial base on which Indonesia stands.‖12

5.2

The 2015 establishment of the AEC and the Indonesian economy

Further economic growth should be achieved while taking advantage of the two strengths oflarge domestic demand and abundant natural resources, and taking into consideration theinternational markets.

Since Indonesia was not incorporated into the global production networks,

the effects of the global financial crisis in 2008 were less serious than for neighboring countries.
However, without taking part in the global networks, it will not be able to become an
upper-middle-income country.

11

The 22 important fields are coal, nickel, copper, bauxite, petroleum/gas, tin, livestock, cacao, rubber, palm oil, defense equipment,
iron, food and beverage products, textiles, shipping, ICT (Information Communication Technology), transportation devices, theSunda Strait Strategic Area, the Jakarta capital region economic zone (Jabodetabek), food/agriculture, tourism, and fisheries.
12
Sato (2013).

72

Japan Center for Economic Research ―Asia Research‖ Report

The Indonesian government has been emphasizing the importance of nurturing nine industries in
preparation for establishing the ASEAN Economic Community (AEC) in 2015. 13 They areadvantages to Indonesia in the ASEAN single market, and meanwhile seven industries14 arerequired to increase competitiveness against imported products from ASEAN countries. While
being wary of imports from other countries, it is starting to invest in the AEC single market; forexample, the state-owned cement company, Semen Indonesia, is expecting to increase exports toneighboring companies alongside the launch of the AEC, and plans to build a cement factory inEast Kalimantan by 2015.
Meanwhile, the size of the domestic Indonesian market is attractive to the other ASEAN
countries.

Indonesia’s Industry Minister and Chamber of Commerce and Industry emphasized thenecessity of strengthening competitiveness because the AEC will bring about great opportunities
for Indonesia, but at the same time the Indonesian manufacturing industry will be tested by a large
inflow of import goods. Behind this lies the lessons from the China-ASEAN FTA (ACFTA) in
2010.

The launch of the ACFTA resulted in massive inflows of low-cost products from China at

the beginning of 2010, and domestic industries were heavily damaged.

5.3

A year of politics in 20142014 is an election year. The elections for the national legislatures will be held in April, andthe presidential election will be held in July. 15

Each political party debates over selecting

presidential candidates. Since presidents are not allowed to serve a third term according to theconstitution, the Indonesian people will select a new president in this next election.
The economic policy of the second term of the Yudhoyono Administration puts emphasis on
growth, as seen in the MP3EI.

However, ―growth‖ vs. ―distribution‖ is a constant political issue.

Although the poverty and unemployment rates have decreased to 11.6% in 2012, the former is stillin the double digits of 11.6% in 2012 and the latter is still 6.1%.

The young working population isa strength of the Indonesian economy, but it works both ways. Every year two to three million
people enter the labor market.

If job creation fails to absorb these young workers, theunemployment rate will quickly rise.
No matter who becomes the next president, the problems that must be faced are the same.With
the changing economic environment for emerging economies, amid the global attention being paid

13

Agricultural products include crude palm oil, cacao, rubber, fish and processed fish, textiles, textile products and footwear,
leather goods, furniture, food and beverage, fertilizers and petrochemical products, steel, and machinery.
14
Automobiles, electronic components, cement, clothing, footwear, food and beverage, and furniture.
15
If no candidate receives a majority in the first round of voting, a run-off election will be held in September between the top two.

Chapter 5 | Indonesia: The Surfacing of Structural Problems73

to whether the Indonesian economy will keep on growing, Indonesia should devote effort to resolve
the surfacing structural problems.

5.4 Moving on to further development
Indonesia’s honeymoon period with global investors, starting in 2009, showed changes in 2013.
With capital flows changing greatly in an instant, the foreign exchange markets and stock markets
fluctuate in the short term.

The view of Indonesia becomes far stricter than one year prior.

However, policy efforts tackling capital outflow and the fall in rupiah were well received, foreign
currency reserves returned to a growth trend in August, and purchases by foreign investors ofcentral bank certificates (SBI) and government bonds have started to increase.

It is necessary todifferentiate between short-term changeable market problems and structural problems such as thosein industrial structure and economic institutions.
Furthermore, after foreign companies rushed to enter, a variety of business risks might emerge inthe future while maintaining and expanding business.

Aside from macroeconomic issues like thecurrent account deficit, problems resulting from differences in business customs and values
between trade partners or joint venture partners in Indonesia, as well as labor problems, areexpected to arise, one after another. In Indonesia legal opacity is still high and legal predictability
has been low; for instance new laws and regulations are suddenly introduced in fields such as labor,
taxation, and customs, and then in-operation corrections are made due to requests fromstakeholders.
In the second term of President Yudhoyono, comprehensive business environment reform was
expected under favorable conditions. It is important to closely examine what worked and what did
not work during this period. In order for Indonesia to become an upper-middle-income country, it isnecessary to consider sincerely the next reforms on the basis of the examination results.

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Chapter 5 | Indonesia: The Surfacing of Structural Problems

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