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Chapter 1. Realizing Indonesia’s Economic Potential: An Overview

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Regional Office for the Asia and the Pacific
Published Date:
May 2018
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Author(s)
Luis E. Breuer and Tidiane Kinda 

Home to more than 260 million people, Indonesia is the fourth most populous country in the world and the largest economy in Southeast Asia. With GDP of about US$1 trillion, the country is the world’s sixteenth largest economy and the seventh largest in purchasing-power-parity terms. It has played an increasingly prominent role in the global policy debate, including as a member of the Association of Southeast Asian Nations (ASEAN) and the Group of 20 (G20), an international forum bringing together 20 of the world’s largest advanced and emerging market economies.

Indonesia’s modern economy has been long in the making, shaped by periods of extended prosperity, a major socioeconomic and political crisis in the late 1990s, and a strong and sustained recovery during the past 20 years. Despite this rich history and the large size of the economy, the economic literature on Indonesia remains limited, and studies that provide a comprehensive and integrated macroeconomic analysis are particularly scarce. There are some exceptions. Booth (1998) takes stock of macroeconomic changes in the Indonesian economy during the 19th and 20th centuries.1Hill (2000) analyzes Indonesia’s remarkable economic transformation between the mid-1960s and the mid-1990s. Basri and Hill (2011) provide an analytical narrative of Indonesian economic growth over two decades, with particular attention to the Asian financial crisis of the late 1990s and the global financial crisis of 2007–09. Ananta, Soekarni, and Arifin (2011) and Wie (2012) provide a historical overview of economic development in Indonesia until the global financial crisis. Basri (2013) studies Indonesia’s political economy and factors underlying the country’s resilience during the global financial crisis. Ing, Hanson, and Indrawati (2018) provide a more recent analysis, with a focus on trade and industrial policies. Notably, even though Indonesia has made impressive socioeconomic progress during the past two decades, including in recent years, much of the existing literature focuses on the periods leading into either the Asian financial crisis or the global financial crisis.2

This book has three main goals. First, it complements the existing literature by providing a comprehensive and integrated macroeconomic analysis covering recent years, including the aftermath of the “commodities supercycle” that began in the early 2000s, during which the global prices of energy, metals, and food rose rapidly. Second, it surfaces underlying forces that are likely to shape the future of the economy and provides some recommendations on how to strengthen the policy frameworks and toolkits—the country’s critical “soft infrastructure”—to help ensure that the Indonesian economy and the Indonesian people continue to prosper. Finally, it investigates the main constraints to growth and proposes options for raising resources, in particular domestic revenues, to overcome those constraints and boost potential economic growth.

The rest of this chapter is organized as follows. The first section summarizes Indonesia’s social, economic, and political achievements during the past two decades. Major trends that could profoundly affect the Indonesian economy are then discussed, including demographic trends, reflected in a young and growing labor force; the rise of the digital economy, facilitated by the young tech-savvy population; and the rise of Asia, particularly China, in the global economy. As the global landscape continues to evolve and shift, Indonesia’s policy frameworks and toolkits must be adapted to ensure that the economy continues to prosper in this new environment. The 12 thematic chapters of the book explore some of the key economic issues policymakers will likely face in the coming years. The final section of this chapter summarizes the key findings from the thematic chapters.

Achievements During the Past Two Decades

Indonesia has made remarkable political, economic, and social progress during the past two decades. In the aftermath of the Asian financial crisis, the country adopted a wide range of political and economic reforms (reformasi) that served the country well. In the political sphere, the military-led political system was replaced by a democratic multiparty system with term limits for the president. A deep decentralization program replaced the system of centralized government and development planning, giving greater direct authority, political power, and financial resources to regencies and municipalities. Local governments’ responsibilities were expanded in health, primary and middle-level education, transport, agriculture, manufacturing industry and trade, capital investment, land, and infrastructure services. Although decentralization aimed to improve the delivery of public goods and satisfy regional interests, the process was hampered by the fact that there was no corresponding increase in subnational governments’ capacity to deliver public goods (Nasution 2016).

A wave of reforms reduced the dominant role of the government in the economy—a legacy of the postcolonial period—and began a shift toward a more market-based economy. Policy frameworks and toolkits were upgraded, including adoption of a floating exchange rate, fiscal rules that limited the deficit and capped public debt, and an inflation targeting regime. The banking sector was also restructured, and regulation and supervision were overhauled (see Chapter 2, Twenty Years after the Asian Financial Crisis). As a result, the economy became much more resilient, benefiting from comfortable external positions, low public debt, and ample international reserves (Figure 1.1).

Figure 1.1.Selected Macroeconomic Indicators: Growth, Inflation, Current Account, Reserves, Fiscal Deficit, Public Debt

Various sectoral reforms were implemented to open up the economy and improve the business environment, including privatization of some state-owned enterprises, elimination of monopolies in some sectors, and reduction of general subsidies. More recently, fuel and electricity subsidies were more effectively targeted to low-income households; the land acquisition process for infrastructure projects was streamlined and made more flexible; the foreign direct investment (FDI) regime was partially liberalized, including for logistics, tourism, and agriculture; and the setting of the minimum wage was made more transparent and predictable (see Chapter 3, Boosting Potential Growth).

The Indonesian economy is benefiting from these far-reaching reforms and performing well, even after the end of the commodities supercycle. Growth has stabilized at about 5 percent since 2013. At about 3 percent, inflation is contained and within the official target band (3.5 ± 1 percent). The current account deficit is modest (less than 2 percent of GDP) and remains manageable, and the fiscal deficit has been kept below the statutory deficit ceiling of 3 percent of GDP (see Figure 1.1).

Supported by an expanding economy and entrenched macroeconomic stability, Indonesia has also made strong progress in various social areas. Between 1996 and 2016, poverty was reduced by half, to 11 percent, and infant mortality was halved to 22 infant deaths for every 1,000 live births (Table 1.1). During the same period, life expectancy at birth increased by 4 years, to 69 years. Access to clean water, electricity, and sanitation also improved significantly as did educational attainment, although access to sanitation and education attainment are both still relatively low. The use of the internet more than doubled between 2010 and 2016, even though it is still limited and unequally distributed across the country. Although there has been some progress, gender disparities remain prevalent. For example, the proportion of seats held by women in the national parliament more than doubled since 2000 but was still below 20 percent in 2017. The gender gap in labor force participation declined slightly between 1996 and 2016 but is still substantial, with the female labor force participation rate at 51 percent compared with 82 percent for men.

Table 1.1.Selected Social Indicators, 1996–2016
19962000200620102016
Extreme Poverty: Poverty Headcount Ratio at $1.90 a Day (2011 PPP) (% of population)45.939.828.015.96.8
Poverty Headcount Ratio at $3.20 a Day (2011 PPP) (% of population)79.080.266.248.431.4
Poverty Headcount Ratio at National Poverty Lines (% of population)17.523.417.813.310.9
Infant Mortality Rate (per 1,000 live births)48.641.132.227.522.2
Life Expectancy at Birth, Total (years)65.366.267.468.269.0
Educational Attainment, at Least Completed Lower Secondary, Population 251, Total (%)19.143.342.348.8
Improved Sanitation Facilities (% of population with access)42.347.153.157.060.8
Improved Water Source (% of population with access)74.577.981.984.587.4
Access to Electricity (% of population)72.486.390.694.297.0
Individuals Using the Internet (% of population)0.10.94.810.925.4
Proportion of Seats Held by Women in National Parliament (%)8.011.318.019.8
Labor Force Participation Rate, Female (% of female population ages 151), ILO Estimate49.050.650.351.950.8
Labor Force Participation Rate, Male (% of male population ages 151), ILO Estimate82.784.784.983.982.0
Income Gini Coefficient36.637.839.7
Sources: World Bank, World Development Indicators; and Statistics Indonesia.Note: Last column is 2016 or latest available data. For the proportion of seats held by women in national parliament, the latest data point is 2017. ILO = International Labour Organization; PPP = purchasing power parity.

Looking Ahead: Trends that Could Transform the Economy

Three major trends are likely to transform the Indonesian economy in the future: favorable demographics, the emergence of the digital economy, and the increasing role of Asia, particularly China, in the global economy.

Demographic Dividend

Indonesia’s population continues to expand rapidly. It grew at 1.3 percent a year on average during 2000–16, reaching about 261 million in 2016. The fertility rate, currently at 2.4 children per woman, while declining, is projected to remain above the replacement rate of 2.1 children per woman until 2030. As a consequence, despite a declining trend in the population growth rate, the total population is projected to reach 296 million by 2030, also supported by a marked improvement in life expectancy (Figure 1.2).3 As for population growth, urbanization has been rapid in recent decades. The urban population grew at 3 percent a year during 2000–16, while the rural population declined by 0.2 percent.4

Figure 1.2.Fertility, Population Growth, and Life Expectancy

(Percent, left scale)

Source: IMF staff estimates based on United Nations (2015) (medium fertility scenario).

The labor force is projected to increase substantially. Indonesia is undergoing a demographic transition with a sizable decline in infant mortality and a reduction in fertility rates (Table 1.2). This has led to an increase in the working-age population, defined as persons 15 to 64 years old, of 1.6 percent, or 2.5 million people a year, during 2000–16.

Table 1.2.Indonesia: Demographic Indicators
20002005201020161
Population Growth (percent)1.41.41.31.1
Working Age (15–64 years old)2.11.61.41.2
Rural20.720.120.320.4
Urban4.33.12.92.5
Percent of Total
Working Age (15–64 years old)64.665.366.267.2
Rural58.054.150.145.5
Urban42.045.949.954.5
Population <30 years old58.055.753.751.9
Total Population (million)211.5226.7242.5261.1
Life Expectancy at Birth, Total (years)66.267.268.169.1
Fertility Rate, Total (births per woman)2.52.52.52.4
Sources: World Bank, Health Nutrition and Population Statistics; and Statistics Indonesia.

These favorable demographic trends provide a unique window of opportunity for economic growth. In particular, the number of workers is growing faster than the number of dependents, a demographic dividend that has provided strong tailwinds to growth and productivity in many other countries (IMF 2015).

Demographic trends are expected to increase Indonesia’s annual real GDP growth by close to 1 percentage point during 2020–50.5 This boost is substantial and positions the country relatively well compared with peers in Asia, many of which are set to endure a reduction of real GDP growth as a result of adverse demographic trends (Figure 1.3). Indonesia is among a few comparable Asian countries set to benefit from a boost to GDP per capita owing to favorable demographics. During 2020–50, demographic trends are expected to increase the growth of Indonesia’s annual GDP per capita by close to 0.2 percentage point.

Figure 1.3.Growth Impact of Demographic Trends

(Percentage point impact; average over 2020–50)

Sources: IMF (2017) based on IMF staff projections; Amaglobeli and Shi (2016); UN (2015), medium fertility scenario; and Penn World Tables 9.0.

Note: The baseline estimates are based on the assumptions of unchanged labor force participation by age-gender cohort, constant capital-to-labor ratio, and total factor productivity growth unchanged from historical average.

McKinsey and Company (2012) estimates that Indonesia’s consumer class could grow by 90 million by 2030. Such an increase would represent the third-largest expansion of consumers in the world (after China and India), providing unique economic opportunities.

An Emerging Digital and Technology-Driven Nation

With the third-largest youth population in the world and 130 million active social media users, Indonesia is poised to have the largest digital economy of all Southeast Asian countries. According to McKinsey and Company (2016), digitalization could expand Indonesia’s economy by 10 percent by 2025. The economic gain would materialize mostly through a combination of higher productivity and labor inputs. Digital technologies also have the potential to add 3.7 million jobs, including through enhanced job-matching schemes and flexible on-demand work via online platforms.

Indonesia’s digital landscape has expanded rapidly in recent years—ranging from increased use of big data and mobile internet to the rise of digital financial services and e-commerce (Figure 1.4). The use of big data and advanced analytics increased by 60 percent between 2014 and 2015, while the number of mobile internet users grew by 13 million (more than 20 percent) between 2015 and 2017.

Figure 1.4.Indonesia’s Digital Landscape: Selected Indicators

Sources: CEIC Data Co. Ltd.; McKinsey and Company (2016); and Statista.

1 1 petabyte = 1 million gigabytes.

There has also been a large shift toward digital financial services. This is a promising development in support of greater financial inclusion given the country’s unique geographic challenges and the fact that it houses the third-largest unbanked population in the world. For instance, an Indonesia Banking Survey performed by PricewaterhouseCoopers (2017) found that the number of people who mostly banked through traditional branches (more than 50 percent of their total transactions) dropped from 75 percent in 2015 to 45 percent in 2017. Digital transactions are growing rapidly. E-money, which is mostly used by lower-income individuals, almost quadrupled between 2014 and 2017, while revenues from e-commerce grew by 22 percent between 2016 and 2017.

Indonesian youth are ready adopters of these technologies and comprise a sizable customer base for the digital economy. There also is a vibrant environment for digital startups. A recent survey by the Economist Intelligence Unit (2017) ranked Jakarta as the eighth best city in the world for digital companies and particularly praised it for developing new technologies and for innovation and entrepreneurship.

The Rise of Asia, Particularly China

The economic rise of China has been a key driver of global and Asian growth in recent years. During 2000–17, Asia accounted for about two-thirds of global growth, with China alone accounting for nearly one-third (Figure 1.5). Spillovers from China have increased as China’s economy has grown and integrated more closely within the region and with the world in both trade and finance (IMF 2016). Initiatives to foster regional cooperation in the areas of trade, investment, and finance, such as the Belt and Road Initiative, could help enhance infrastructure provision and further boost regional growth.

Figure 1.5.Contribution to Global Growth, 2008–16

(Percentage points)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

Indonesia lies at the heart of rising Asia. McKinsey and Company (2012) predicted that 75 percent of the 1.8 billion people projected to join the global consuming class by 2030 will likely be in Asia. This unique dynamism means higher external demand for Indonesia’s products, ranging from agricultural goods to energy, commodities, tourism, and manufactured goods. Indonesia’s exports to other Asian economies, particularly China, accelerated strongly in recent years. Rapid economic expansion in China fueled demand for raw materials from Indonesia, leading to a quadrupling of export values to China during 2000–16. From fifth in 2000, China has emerged as Indonesia’s top export destination in 2016, mostly driven by commodity products (see Chapter 9, Diversifying Merchandise Exports).

The Chinese economy is undergoing a structural transformation, rebalancing from an investment- and export-driven model toward a consumption- and services-driven model. China’s economic transformation reduces the long-term risks of a sharp adjustment and thus benefits not only China but also the rest of Asia, including Indonesia. But there are some challenges. China’s rebalancing is expected to negatively affect countries with higher exposure to Chinese domestic investment, including commodity exporters such as Indonesia (IMF 2016; Mathai and others 2016). However, China’s consumption is expected to increase, including for agricultural products and tourism, which can greatly benefit Indonesia.

Some Challenges

Indonesia is well positioned to benefit from these favorable trends, but there are vulnerabilities and challenges. Inequality is an important one. Income inequality rose sharply between 2002 and 2013, a period of rapid growth associated with the commodity boom, although it has declined in recent years (Figure 1.6). There are also gaps across income groups in access to health services and higher education.

Figure 1.6.Income Inequality, 2002–17

(Gini coefficient)

Sources: Statistics Indonesia; and IMF staff estimates.

In addition, youth unemployment remains stubbornly high, and reaping the demographic dividend requires creating sufficient quality jobs to absorb the expanding labor force. Rigid labor legislation has been associated with a large informal labor market. Institutional, regulatory, and structural constraints hamper the business environment and hinder growth and job creation. Low tax revenues and thin domestic financial markets constrain the authorities’ ability to implement needed reforms, including scaling up infrastructure provision and improving public services such as health, education, and social safety nets. Indonesia’s relative low exposure to cross-border trade and financial flows since the Asian financial crisis has also limited productivity-enhancing spillovers associated with global economic integration, which hampers competitiveness. For instance, the low level of FDI and low participation in global and Asian value chains may hinder Indonesia’s ability to tap the growing Asian consumer market and complicate the transition from a commodity-dominated economy to a more innovative, services-oriented economy. With one of the lowest internet penetration rate in the ASEAN region, the digital divide can slow the rise of the digital economy.

Indonesia may struggle to seize the many opportunities presented by the digital economy, a young population, and a rising Asia if it does not implement needed structural reforms. These include raising tax revenues to enhance infrastructure, upgrading education, further opening product markets and service sectors to support more efficient allocation of resources and economic diversification, and deepening financial markets.

The chapters in this book analyze how Indonesia can tackle these challenges by answering the following questions: How have Indonesia’s economic policy frameworks evolved since the Asian financial crisis? What are the country’s main structural constraints to raising productivity and growth? How should the country go about financing priority spending and structural reforms to support competitiveness and inclusive growth while preserving stability? In essence, where should the priorities be placed in the next wave of investment in the country’s soft infrastructure? Answering these questions is important for Indonesia but could also provide lessons for other large commodity exporters in their quests for economic diversification.

Organization and Main Findings of the Book

This book consists of 13 chapters grouped into five parts. Part I reviews the strong foundations of the Indonesian economy. Part II analyzes the main structural constraints to improving productivity and raising potential growth. Part III proposes options for raising government revenues for priority spending and structural reforms to support growth. Part IV examines Indonesia’s links to the world economy, including exposures to trade and capital flows, and examines the country’s competitiveness. Part V concludes by highlighting the role of financial deepening and financial stability in supporting inclusive growth.

There are three key messages:

  • Indonesia has done well during the past two decades, including by building a more resilient economy and achieving remarkable socioeconomic progress.

  • As the world economy shifts, policies and institutions need to adapt to ensure that Indonesia’s economy continues to prosper.

  • To lift productivity, support competitiveness, and boost growth, raising government revenues, complemented by prudent financial deepening, would help finance needed reforms, including enhancing infrastructure, regulations, and human capital.

Chapter 2, Twenty Years after the Asian Financial Crisis, by Muhamad Chatib Basri discusses how reforms undertaken since the Asian financial crisis have improved the resilience of the Indonesian economy, helping it successfully face the global financial crisis and 2013 taper tantrum episode.6 The author outlines critical reforms that contributed to lowering inflation and increased investor confidence, including the overhaul of banking regulations and oversight, banking sector restructuring, and central bank independence, along with the adoption of inflation targeting and a flexible exchange rate. Fiscal reforms, including the adoption of fiscal rules, supported a reduction in public debt and a buildup of fiscal buffers, which facilitated countercyclical fiscal policy during the global financial crisis. Although the economy is currently much more resilient than in 1998, the heavy reliance on nonresident financing, in part due to a small domestic revenue base, creates a source of vulnerability for the financial sector, public finances, and the corporate sector.

The next two chapters examine key structural constraints in the Indonesian economy that hamper higher productivity, growth, and job creation and could prevent the country from reaping the demographic dividend. In Chapter 3, Boosting Potential Growth, Jongsoon Shin highlights the recent achievements of an improved institutional and regulatory framework, which has contributed to an increase in much-needed public infrastructure investment. Nonetheless, growth remains constrained by a large infrastructure gap, still-low institutional quality, and inadequate human capital. The author estimates the macroeconomic effects of an illustrative fiscal-structural reform package in Indonesia that comprises higher infrastructure spending and targeted transfers in education, health, and social programs, financed mainly by higher consumption taxes. The reform scenario also includes structural reforms that center on reducing restrictions to trade and FDI, easing entry barriers and administrative burdens on businesses, rationalizing the role of state-owned enterprises, and fostering employment. Combined, these reforms could raise potential growth to 6.5 percent in the next five years, or about 1 percentage point higher than the baseline scenario. Investing in infrastructure, including digital infrastructure, and human capital while streamlining regulations, nontariff measures, and FDI restrictions would help the country capitalize on the digital economy and facilitate the development of competitive sectors, which could, in turn, help absorb the large and growing young labor force.

Chapter 4, Developing Infrastructure, by Teresa Curristine, Masahiro Nozaki, and Jongsoon Shin focuses on structural issues surrounding infrastructure development, including in the regulatory and institutional framework. The authors find that multiyear capital budgeting could be improved and that there is scope to enhance coordination across ministries, for example, by establishing central guidelines and oversight for feasibility studies for infrastructure projects. Also, central-local coordination could be improved in the areas of land acquisition and regulations. The authors also note that the increasing role of state-owned enterprises and public-private partnerships could help reduce the infrastructure gap while keeping fiscal risks at manageable levels. However, they also suggest close monitoring of potential fiscal risks and paced implementation of the ambitious infrastructure development plans, given limited execution capacity and reduced fiscal space. Through a macro-fiscal simulation model, the authors highlight that financing a large infrastructure push by raising higher tax revenues would maximize the growth impact while safeguarding macroeconomic stability.

In this context, the subsequent two chapters examine how fiscal policy can help raise revenues to finance priority spending, including on infrastructure, and support structural reforms. Chapter 5, Supporting Inclusive Growth, by Hui Jin, examines Indonesia’s overall fiscal policy strategy. The author highlights that Indonesia has demonstrated strong fiscal discipline since the early 2000s, anchored by statutory fiscal rules. General government debt was reduced from about 90 percent of GDP in 2000 to less than 30 percent in 2016. The author proposes a fiscal strategy that centers on a medium-term revenue strategy (MTRS) to finance priority spending on infrastructure, education, health, and social assistance and support critical structural reforms while reducing inequality. Because implementing an MTRS will take time, the chapter discusses some near-term policy actions to arrest the recent drop in the tax-to-GDP ratio. These actions include removing tax exemptions and lowering the value-added tax and corporate income tax thresholds. Because much of the inequality in Indonesia is associated with unequal access to social services and infrastructure, the author stresses that revenue from the structural tax reform, as well as savings from better targeting of the existing program, could finance the expansion of social assistance programs to reduce inequality.

Given Indonesia’s low tax-revenue-to-GDP ratio, at close to 10 percent, Chapter 6, Implementing a Medium-Term Revenue Strategy, by Ruud de Mooij, Suahasil Nazara, and Juan Toro, elaborates on the design of the MTRS, which combines tax policy and tax administration measures to achieve an ambitious but realistic plan to increase the tax-to-GDP ratio over a five-year period. Tax policy reforms could potentially generate up to 3.5 percent of GDP, including through the introduction of new excises on vehicles and fuel and the removal of most incentives and exemptions in the value-added tax and corporate and personal income taxes. Tax administration measures can potentially add another 1.5 percent of GDP in revenue, provided that a comprehensive compliance improvement program is implemented and institutional reforms are successful. The MTRS also strengthens reform governance through a multiyear commitment and an appropriate mandate and monitoring to ensure effective implementation.

With a continually changing global landscape, the following three chapters examine Indonesia’s links to the global economy, particularly trade and capital flows, and explore the country’s competitiveness. In Chapter 7, Spillovers from the International Economy, Jaime Guajardo analyzes potential spillovers to Indonesia and other ASEAN–57 economies from two shocks emanating from two main trading partners: first is a growth slowdown in China as the country rebalances away from investment and toward consumption, and lower growth in the United States as demographic pressures and slow productivity growth weigh on output in the medium term. Second are financial shocks such as spikes in global financial volatility and higher global interest rates. Spillovers from these shocks could be transmitted through three channels: trade, commodity prices, and financial markets. The author finds that spillovers to other ASEAN–5 economies from a slowdown in China are large, while those from a slowdown in the United States are relatively smaller. Spillovers to Indonesia are smaller than those to other ASEAN–5 economies and are transmitted mostly through the commodity price channel. Countries that have closer trade links to China and the United States (such as Malaysia, Singapore, and Thailand) have larger spillovers and are mostly affected through the trade channel. Spillovers could be larger if the growth shocks in China or the United States are accompanied by spikes in global financial market volatility.

In Chapter 8, Linkages to the World Economy, Mitali Das highlights that since the Asian financial crisis, compared with the rapid expansion of domestic demand, Indonesia’s trade openness has declined. The country’s low exposure to global economic and financial developments has partially insulated the economy from global shocks and supported stable output growth. However, low exposure to global developments has also limited the diffusion of technological advances and productivity-enhancing spillovers associated with global economic integration. Indeed, the author shows that despite strong demographic tailwinds and steady capital accumulation, lower productivity growth has led to a decline in potential output growth in recent years. The author identifies a slowdown in human capital accumulation, a rise in protectionism, and some weakening of the regulatory environment as potential contributors to the slowdown in productivity growth.

Against this background, Chapter 9, Diversifying Merchandise Exports, by Agnes Isnawangsih and Yinqiu Lu takes a closer look at trade developments to explore the composition of Indonesia’s merchandise exports and their competitiveness. The authors find that coal and palm oil have replaced oil and gas as the top two export products, and China has replaced Japan as Indonesia’s top export destination. Indonesia has remained a basic commodity exporter subject to global price swings. Five key traditional commodity products (gas, oil, coal, palm oil, rubber) accounted for about 60 percent of total exports to China in 2016. With increased competition from neighboring countries, the shares of key noncommodity exports, such as electrical appliances and textiles, declined during 2000–16. The authors stress that Indonesia has yet to improve its competitiveness in products with higher technology content to improve its low export sophistication and economic complexity. The country’s comparative advantage still lies in mineral fuels and low-technology industries, and its participation in regional and global value chains remains low, limiting opportunities to tap into the growing Asian consumer market.

In Chapter 10, Determinants of Capital Flows, Yinqiu Lu examines capital inflows to Indonesia. The author shows that the volume of capital inflows has increased, which has helped finance Indonesia’s current account and fiscal deficits, especially in the aftermath of the commodity supercycle. FDI and portfolio inflows have dominated capital inflows. Government bonds, especially those denominated in rupiah, have increasingly attracted foreign investors. Indonesia has experienced several episodes of reversal or sharp declines of capital inflows since the global financial crisis, affecting bond markets but also equity and foreign exchange markets. The author’s empirical analysis shows that cyclical push and pull factors have influenced capital inflows to Indonesia. Growth and interest rate differentials between Indonesia and the United States, as well as global risk sentiment, account for an important portion of capital inflows. Exchange rate expectations, interest rate spreads, and global risk aversion are also important factors behind short-term fluctuations in capital inflows. Although Indonesia’s resilience to external shocks has improved, deepening the domestic capital market would help further accommodate the volatility of capital inflows.

The final three chapters of the book analyze avenues to deepen financial markets in Indonesia while preserving financial stability. The development of Indonesia’s financial markets since the Asian financial crisis has been slow, and financial access remains low. The size and depth of financial markets dropped sharply after the Asian financial crisis and have not recovered since. Banks dominate the financial system, and the domestic institutional investor base is narrow. To help meet demand for financial services, Chapter 11, Advancing Financial Deepening and Inclusion, by Heedon Kang, proposes options for furthering financial deepening and greater inclusion. These options include strengthening the credit culture and financial infrastructure, upgrading the supervisory and regulatory framework alongside financial market development, establishing a liquid benchmark yield curve, promoting long-term financing using new financial instruments, expanding the domestic investor base, supporting financial innovation, and enhancing financial literacy. The use of digital financial services has rapidly increased, offering a promising channel for overcoming Indonesia’s unique geographical barriers to financial inclusion.

In Chapter 12, Managing Macro-Financial Linkages, Elena Loukoianova, Jorge Chan-Lau, Ken Miyajima, Jongsoon Shin, and Giovanni Ugazio investigate macro-financial links and corporate vulnerabilities in Indonesia. Although risks from the corporate sector remain manageable, the authors indicate that the corporate sector’s exposure to foreign funding can be one of the key channels for transmitting negative external shocks to the rest of the economy. The authors conclude with options for containing corporate vulnerabilities, including close monitoring of firms with rupiah income and foreign currency debt, as well as those with unhedged, nonaffiliated, or maturing foreign currency debt, together with bank linkages; and upgrading the framework for interagency coordination of corporate surveillance. In the medium term, deeper financial markets will help reduce the costs of hedging and develop the corporate bond market.

The final chapter of the book, Chapter 13, Reinforcing Financial Stability, by Ulric Eriksson von Allmen and Heedon Kang, explores how financial deepening can be achieved without endangering financial stability. The authors find that systemic financial risk is currently low and the banking system appears generally resilient to severe shocks. Various measures have been taken to strengthen financial oversight and crisis management, including the establishment in 2011 of the Financial Services Authority (OJK), an integrated regulator to oversee the entire financial sector. However, the authors point to further improvements that are needed. The mandates for the OJK and Bank Indonesia should be amended to give clear primacy to financial stability over development objectives. The OJK also needs to promote a more intrusive supervisory approach across sectors, including rigorous evaluation of financial institutions’ risk management and internal audit functions. Crisis management and safety nets also need to be strengthened, including by adjusting emergency liquidity assistance to ensure its effectiveness.

Following two decades of socioeconomic progress, Indonesia is well positioned to continue its remarkable transformation. However, important reforms remain needed to lift growth, make growth more inclusive, and provide employment opportunities for the growing labor force. These reforms, discussed at length in the book, include raising tax revenues to enhance infrastructure and human capital, streamlining complex regulations, opening up to FDI, and deepening the financial sector while preserving stability.

References

To download the complete publication in a digital format, visit the IMF eLibrary www.elibrary.imf.org

To purchase a copy of the complete book or for additional information on IMF publications, visit www.bookstore.imf.org

The Bulletin of Indonesian Economic Studies, hosted by the Australian National University, has been publishing various articles focused on the Indonesian economy and society since 1965.

A number of authors have also written on the economic history of Indonesia, analyzing developments from as early as the 14th century. These include Papanek (1980), Robison (1986), Cribb (1995), Dick and others (2002), Ricklefs (2008), and Marks and van Zanden (2012).

Population growth has been declining in recent years, from 1.4 percent in 2000 to 1.1 percent in 2016.

About 55 percent of the population lives in urban areas.

This estimate could be viewed as a lower bound given the relatively high youth unemployment rate and existing room to improve labor force participation, particularly for women. The estimate rests on a number of assumptions: (1) unchanged total factor productivity growth (based on the historical average), (2) unchanged age- and gender-specific labor force participation rates (and employment rates), and (3) a constant capital-to-effective-labor ratio. See IMF (2017) for more details. The methodology follows the approach of Aiyar, Ebeke, and Shao (2016), building on work by Feyrer (2007). The baseline model fits the growth in real output per worker on the share of workers ages 55 and older and the combined youth and old-age dependency ratios, with decade (10 years) and country fixed effects.

“Taper tantrum” refers to the 2013 surge in US Treasury yields that resulted from the Federal Reserve’s use of tapering to gradually reduce the amount of money being fed into the US economy.

The ASEAN–5 are Indonesia, Malaysia, Philippines, Thailand, and Vietnam.

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