Indonesia: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
06 Feb 2018
eISBN:
9781484340707
Language:
English
Keywords:
ISCR; CR; Indonesia; IMF staff estimate; VAT; workforce; export; infrastructure investment; streamlining labor market regulation; product market reform; SOEs assets; Structural reforms; Public investment and public-private partnerships (PPP); Commodity markets; Global
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Selected Issues

Abstract

Selected Issues

Indonesia’s Growth Strategy: Boosting Potential Growth with Structural Reforms1

The Indonesian authorities are seeking to accelerate economic growth. Indonesia can achieve stronger inclusive potential growth with structural reforms on infrastructure, regulations, and human capital. An illustrative scenario that includes these reforms shows that potential growth could rise from 5.6 percent to 6.5 percent in the medium term. Structural reforms, together with clear communication and coordination among the authorities, would also help boost confidence in the economy.

A. Introduction

1. Higher growth is needed to address Indonesia’s developmental needs and reap the benefits of the demographic dividend. Indonesia’s economic growth has slowed in the last decade, with the contributions from capital and labor falling and that of total factor productivity (TFP) remaining below peers (Figure 1 and Figure 2). Growth has stabilized at near 5 percent, and exports and imports have declined relative to GDP. Slower growth has made it more difficult to create quality jobs for the near 2 million new labor force entrants each year. Employment varies widely across provinces, and inequality remains somewhat elevated.

Figure 1.
Figure 1.

Real GDP Growth

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: Das, Mitali. 2017, “How has Indonesia fared in the Age of Secular Stagnation?”
Figure 2.
Figure 2.

Contribution to Growth

(In percent, period average)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: Penn World Table; and IMF staff estimates.

2. To boost growth, the authorities have accelerated infrastructure development and improved the business environment. Public investment on infrastructure has increased with several projects currently under construction. The authorities have also implemented 16 economic policy packages since 2015 to streamline regulations and strengthen productivity. The FDI regime was partially liberalized, barriers to entry have been reduced, including on logistics, and the setting of the minimum wage has been made clearer. A single submission system, covering the licenses of both central and 534 regional governments, is being introduced to improve coordination with line ministries and local governments. Reflecting these efforts, Indonesia’s World Bank’s Doing Business ranking improved markedly to the 72nd position in 2018 from the 106th position in 2016.

3. Indonesia can accelerate potential inclusive growth by continuing structural reforms on infrastructure, regulations, and human capital. Previous studies have found that the most binding constraints to growth in Indonesia include infrastructure, regulations, and human capital (OECD, 2016; World Bank, 2015; and ADB, 2013). Previous studies have also found positive effects on growth from reforms on infrastructure, regulations, trade and FDI, labor markets, and education:

  • IMF (2014) finds that the multiplier on output of increasing infrastructure investment by 1 percentage point of GDP ranges between 1 percent and 1.3 percent in the first year, rising gradually to over 2 percent in 10 years.

  • Barnes (2014) finds that a benchmark reduction in the product market regulation (PMR) index could increase TFP by around 2 percent of GDP over 5 years, with larger gains for emerging market economies (EMEs). For example, a 10 percent reduction in the PMR index could lead to gains in TFP of 1.7 percent for BRICS and 1.3 percent for OECD countries. Gal and Hijzen (2016) finds that product market reforms have positive effects on capital, output and employment, with their effects increasing over time. After two years, product market reforms raise capital by 4 percent, output by 3 percent, and employment by 1 percent. Bouis and others (2016) finds that major reductions in entry barriers yield large increases in output and labor productivity over a five-year horizon, and output gains from reforms primarily reflect higher TFP; and that effects become statistically significant two to three years after the reform, as prices start dropping, and productivity and output increase significantly.

  • Dabla-Norris and others (2016) finds that trade and foreign direct investment (FDI) liberalization, as well as labor market reforms to remove excessive rigidities, can significantly boost TFP in EMEs. Moreover, the short-term costs of these reforms are small, while the medium-term benefits are sizable and long lasting. Coady and Dizioli (2017) finds that expanding education would help reduce income inequality, especially in EMEs.

B. Infrastructure Development

4. The government has prioritized several infrastructure projects.

  • The government has selected 247 priority infrastructure projects, with a total cost of US$323 billion (32 percent of GDP), to be implemented in 2015–22 (Figures 3 and 4). The plan centers on improving logistics, power generation, water and sanitation, and oil refineries. These include constructing 3,650 km of roads, 3,258 km of railways, 24 new seaports, and 15 new airports. The plan also includes developing power plants with total capacity of 35 GW, 33 new dams, and new oil refineries of 600,000 barrels per day. Most of the cost is expected to be borne by the private sector (18 percent of GDP) and state-owned enterprises (SOEs) (10 percent of GDP). Out of 247 projects, four have been completed; 131 are being constructed; and 112 are being prepared.

  • Fiscal spending on infrastructure has risen. The authorities have increased infrastructure spending after the fuel subsidy reforms in 2015, which freed fiscal space for development. The central government’s capital spending and transfers to local governments for infrastructure have risen by 1 percentage point of GDP between 2014 and 2017. The funds allocated for infrastructure investment in the 2018 budget is about 6 percent higher than in the 2017 revised budget.

  • The authorities are also seeking to raise infrastructure investment through SOEs and public-private partnerships (PPPs). To support infrastructure investment, the government injected capital to SOEs amounting to 0.6 percent of GDP in 2015–16. The authorities are trying to mobilize foreign investment by having SOEs finance from capital markets, including by domestic and external bond issuances as well as initial public offerings of subsidies. The authorities have improved the schemes for guarantees and PPPs. Government guarantees for infrastructure investment (credit, business viability, and PPP guarantees) stood at 2.8 percent of GDP in March 2017, while the maximum guarantee limit is 6 percent of GDP during 2017–20.

Figure 3.
Figure 3.

Real Public Capital Stock

(In percent of 2011 constant GDP. 2015)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: IMF, Investment and Capital Stock data (2017).1/ General Government.2/ Public-private partnership.
Figure 4.
Figure 4.

Funding Allocation Plan for 247 Projects

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: The Committee for Acceleration of Priority Infrastructure Delivery (KPPIP); and IMF staff estimates.

5. The authorities have also improved the institutional and regulatory framework.

  • Coordination has been strengthened. The authorities established the Committee for Acceleration of Priority Infrastructure Delivery (KPPIP) to coordinate priority projects, including by commissioning or amending feasibility studies. KPPIP coordinates 37 of these projects, including 12 oil refineries, one electricity program, 74 roads, and 23 rail roads. The Investment Coordinating Board (BKPM)’s one-stop service has also helped expedite investment approvals.

  • The land acquisition process has been streamlined and made more flexible. The maximum time needed for land acquisition has been shortened to around 400 days from 518 days. The revised regulations allow for revocation of land rights in public interest and enable businesses to acquire land on behalf of the authorities and be reimbursed later. The State Asset Management Agency (LMAN) was established to facilitate the financing of land acquisitions. LMAN integrates land acquisitions for national strategic projects and carries over unused budget into the following year. The land acquisition process was completed for a toll road project (the Trans-Sumatra) and a rail project (the Java North Line Double track), both of which had been delayed for decades.

  • To attract foreign investment in infrastructure, the Negative Investment List (DNI) has been eased. The foreign ownership limit for toll road operators, telecommunications, and testing companies has risen to 100 percent from 95 percent. The foreign ownership limit of distribution and warehousing has increased to 87 percent from 33 percent.

  • The framework for PPPs has improved, and several important PPPs were launched (Figure 6). The government established a PPP unit and improved financial support schemes, particularly guarantee programs to ensure acceptable market returns for private investors, including the Viability Gap Fund (covering up to 49 percent of the construction cost) and the Availability Payment scheme (annuity payment during the concession period). Several PPPs have been launched, including the Palapa Ring Broadband project (US$0.6 million, supported by Availability-Payment scheme); the Umbulan Water project (US$0.3 million, supported by the Viability Gap Fund); the Central Java Power Plant (US$3 billion); and three toll roads (US$2.2 billion).

Figure 5.
Figure 5.

Private Participation in Infrastructure

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: World Bank, Private Participation In Infrastructure; and IMF staff estimates.
Figure 6.
Figure 6.

Real Public Investment 1/

(In percent of GDP, 2011 constant dollars)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: IMF (2017); and IMF staff estimates.1/ Investment of general government as the average of 2012-15.

6. Notwithstanding these actions, the government is relying on SOEs while investors are concerned with uncertain policy and regulations. Limited fiscal space and low private sector participation have made the government rely on SOEs to jumpstart infrastructure investment. This may crowd out private investment and prevent a sound, sustainable development framework. Investors appear to be concerned with the lack of transparency in the procurement of projects, believing that SOEs receive more commercially attractive projects through direct assignments. Investors are also concerned with the uncertain legal/regulatory framework, particularly regarding policy continuity and land acquisition, given the long-term capital intensive nature of the projects.

7. In developing infrastructure, vulnerabilities and risks should be carefully managed to protect macrofinancial stability:

  • Priority should be given to financing infrastructure development with revenue from a medium-term revenue strategy (MTRS). Despite a recent increase, there is still large room for public investment to expand, aided by tax revenue reforms (Figure 6). This would allow for steady funding for infrastructure investment, while limiting the buildup of external debt.

  • Meanwhile, infrastructure development should be paced in line with available financing and the economy’s absorptive capacity. Given low fiscal space, limited institutional capacity, and shallow domestic financial markets, a too rapid raise in infrastructure investment could increase external debt. A more measure pace of infrastructure development, particularly in the absence of a MTRS, would help preserve macrofinancial stability. Projects with larger impact on production capacity should be prioritized.

  • Infrastructure development should be accompanied by sound risk management for SOEs and PPPs. Financial performance of SOEs, including domestic and external debt, should be closely monitored, as SOEs in the infrastructure sector have continued to leverage. While proper balance between SOEs and the private sector is needed to ensure that SOEs do not crowd out private investment, the burden of financing infrastructure investments could be further shifted to the private sector through PPPs and FDI. Proper design of PPP contract—including on respective rights and responsibilities, risk allocation, and mechanisms for dealing with changes— is important. Overemphasis on the equity aspect of infrastructure projects may undermine feasibility studies. Government guarantees for infrastructure development need to be carefully designed and monitored to avoid a potential increase in contingent liabilities.

8. Attracting private sector financing requires improving the regulatory framework for new financing instruments (debt and equity) and institutional investors.

  • Regulations on structured products should be enhanced, including by clarifying the risk allocation between special purpose vehicles (SPVs) and issuers. Building on the recent successful issuance of asset-backed securities (ABS) for the Jagorawi toll roads (IDR2 trillion), ABS should be further explored, especially on toll roads and power plants, which have more predictable cash flows. Infrastructure investment schemes (e.g., project finance, infrastructure bonds, or IDR-linked global bonds) need to be developed, together with a thorough assessment of potential fiscal risks.

  • Limited concession schemes (LCS) should be explored, which offers concession to the private sector for infrastructure assets that are already operational and generating cash flows. This would help free financial resources for other infrastructure investment, increase management efficiency, and adopt know-how from the private sector.

  • The expansion of the institutional investor base (e.g., insurance firms, social security funds, private pension funds) can be supported by a stronger regulatory and supervisory framework to allow better asset and liability management (see the Selected Issues on “Financial Deepening and Inclusion” for more details).

C. Regulatory Reforms

9. In addition to the 16 economic policy packages, the authorities have implemented other reforms to improve the business environment. The FDI regime was partially liberalized, including on logistics, tourism, and agriculture, and the setting of the minimum wage was made more transparent and predictable. A national single window system to automate export and import permits has been introduced in more than 21 ports. The authorities are also planning to streamline nontariff measures (NTMs), gradually shifting control from border to post border, and open to trade through bilateral and regional trade agreements. Compared with BKPM’s one-stop service that deals with 9 types of licenses, the forthcoming single submission system covers about 100 licenses of both central and local governments, thus helping simplify regulations.

10. Restrictive product market regulations should be reformed to foster competition and productivity growth. The OECD’s Product Market Regulations (PMR) Index suggests that the biggest gains can be realized by reducing state control, easing trade and FDI regulations, and lowering business entry barriers, including antitrust exemptions:

  • The dominant role of SOEs needs to be reduced. With a rise in assets to around 50 percent of GDP and stable revenue, SOE efficiency has declined (Figure 7). This suggest an increase of non-commercial activities and implicit subsidies, including price controls (e.g., gas, electricity, air fares, retail prices of various products) and import or export restrictions. These practices could undermine the financial strength of SOEs, increase fiscal risks from contingent liabilities, and crowd out private investment. SOEs are prevalent in manufacturing, trade and transportation, and financial services (Figure 8). SOEs need to be confined to strategic areas with commercial viability, while those in low strategic areas should be privatized or closed (IMF, 2016; Figure 9). For example, the heavy SOE involvement in the network industries such as electricity and railroads, needs to be rationalized, which would promote private sector participation and help reduce fixed costs, particularly for smaller firms (Gal and Hijzen, 2016). The energy sector, which requires significant investment, merits a review, including on the transmission and distribution of electricity and exploration of hydrocarbons. SOEs should be subject to the competition law and proper bidding procedures, and refrain from exercising dominant power. The governance of SOEs also needs to be improved for proper risk management, including through public listing on the Indonesia Stock Exchange (IDX), which would enhance public scrutiny and transparency of financial information (Figure 10).

  • Lowering trade and FDI restrictions would boost competitiveness and export diversification. Barriers to FDI and trade, particularly NTMs, have led to low integration with global value chains and limited competitiveness, compared to Asian peers (Das, 2017; the Selected Issues on “The Evolution of Merchandise Exports in the New Millennium”; and Figure 11). Imports still require overlapping licensing. Against this backdrop, Indonesian manufacturers, including FDI-affiliated corporates, became less export-oriented in contrast with those in other emerging Asian economies, which increasingly took part in regional production networks (Basri, 2016). Indonesia’s ranking on trading across borders in the World Bank’s 2018 Doing Business Report is still low at the 112th place out 190 countries. The priority is to adopt internationally harmonized standards and certification procedures in major sectors (energy, transport, construction, banking, and business services). Stronger coordination across ministries would ensure coherent regulations. Free trade agreements would help lower trade and FDI restrictions.

  • Easing administrative burdens and entry barriers would help create businesses and jobs. There is still a significant regulatory burden on existing and new corporates due to required licenses and permits under different ministries and local governments, and their procedures.

Figure 7.
Figure 7.

SOEs Assets and Turnover Ratio

(In percent)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: Obis: and IMF staff estimates.1/ Estimated using previous year growth for companies which assets data have not been available.2/ Asset turnover ratio = Operating revenue/total assets.
Figure 8.
Figure 8.

Industry of State-Owned Enterprises

(In number)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: Indonesia, Ministry of State-Owned enterprises
Figure 9.
Figure 9.

Framework for Reviewing the Status of Public Enterprises

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: IMF, Fiscal Affairs Department, 2016, How to Improve the Financial Oversight of Public Corporations, Fiscal Policy Paper.
Figure 10.
Figure 10.

Ownership of State-Owned Enterprises

(Number; as of January 2017)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: Indonesia, Ministry of State Owned Enterprises.
Figure 11.
Figure 11.

Regulations by Category, 2016

(Number of regulations)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: Indonesia, Ministry of National Development Planning.

11. The overall legal and regulatory framework should be also enhanced.

  • The regulation and policy making process should be improved by adopting a systemic, holistic approach. Laws often lack implementing regulations, where regulations are subject to substantial interpretation and prone to rent-seeking, while often conflicting with other regulations. In many cases, implementing regulations are not issued for several years, while law provide only brief guidelines (Devi and others, 2013). For example, when a new Construction Law came into effect in early 2017, implementing regulations were not issued and could take up to two years to issue them, while the regulations under the old Construction Law were still applicable. Environmental regulations and industrial regulations are often at odds, causing confusion to investors. Therefore, greater ministerial coordination and public consultation are needed to avoid conflicting regulations and policies, particularly among line ministries and local governments (OECD, 2012). The regulatory impact assessment should also be strengthened (Intal and Gill, 2016; Table 1). A formal centralized mechanism to simplify and evaluate existing regulations would ensure a holistic approach. The recent presidential decree to strengthen the coordination of policies through coordinating ministries is a welcome first step.

  • Local regulations. Local policies and regulations are often inconsistent with national policies (OECD, 2016). Decentralization without adequate coordination since the early 2000s has resulted in a proliferation of local regulations (Figure 12). Coordination among 405 regional governments has been challenging, with a limited role of provinces. Therefore, a regional government coordination forum, anchored by a clear national strategy, would help nationwide policy coordination. Adopting merits and competition factors into fiscal transfers to local governments would enhance accountability and coordination. Continuing efforts are required to synchronize local with central regulations through standardization. Capacity building for local governments is also critical.

  • Law and contract enforcement. Weak enforcement of laws and contracts has hampered business certainty. Indonesia still ranks low in contract enforcement (145th place) in the World Bank’s 2018 Doing Business Report.2 Addressing these constraints requires upgrading governance in the legal environment, and the transparency and consistency of the judiciary system. The recent decision of the Supreme Court to recruit 1,500 judges and train them for two years would help mitigate the shortage of judges and foster public trust in the judiciary system.

Table 1.

Use of Regulatory Management System Instruments 1/

article image
Sources: APEC; and NZIER via Economic Research Institute for ASEAN and East Asia.

“None” refers to the non-use of any informal instrument.

Figure 12.
Figure 12.

Enacted Regulations During 1998–2017

(Number of regulations; as of April 2017)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Source: Indonesia, Ministry of National Development Planning.

D. Human Capital

12. The authorities are trying to improve the performance of education and labor markets. The government has allocated 20 percent of the annual budget to education, and is focusing on improving the efficiency of education spending. Efficiency savings will be channeled to a sovereign wealth fund to finance future education needs. The authorities are also considering labor market reforms to enhance flexibility and align wage growth with productivity growth. Improving education and labor market outcomes would support inclusive growth and job creation.

13. Further efforts are needed to improve the quality of education and reduce labor market segmentation:

  • Education. Enrollment rates in primary schools vary widely across districts, while those in higher education are low, with fewer than one-third of Indonesians completing secondary education. Educational quality is also low, with many of graduates not meeting international standards due to unqualified teachers and unaccredited higher education institutions (Figure 13). Corporates face persistent skill shortages.

  • Labor market. The transition from employment in agriculture to services has continued, although wage earning employment has slowed and non-agricultural self-employment has risen. The labor market continues to be segmented, with a large fraction of workers employed on short-term contracts. Rigid labor regulations have led to high informal employment (58 percent of total employment) and low on-the-job training. Youth unemployment is high at around 20 percent, hindered by inadequate education. Female labor participation has stagnated at around 50 percent, much lower than that of males (83 percent).

Figure 13.
Figure 13.

Government Education Spending and Outcome 1/

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: World Bank: and IMF staff estimates.1/ Latest data available.

14. The priority is to improve the quality of and access to education.

  • Enhancing the quality of education spending (OECD, 2016; ADB, 2015; and World Bank, 2017). Expenditure on teacher salaries and allowances has risen substantially in recent years. The priority now is to improve the efficiency and quality of spending by strengthening the link between compensation and performance in education sector in terms of competency, classroom performance, and professional development. The teachers’ skills should be improved through training and periodic recertification. The monitoring of the local government’s budget spending and schools’ performance should be also improved.

  • Improving access to education. Efficiency savings and additional resources should be directed to ensure equitable access to quality education, especially in rural areas. A strong role of the central government on resource allocation across regions would help alleviate the imbalance on teacher distribution across regions. Opening the education market to foreign investment would help strengthen education quality, particularly in higher education institutions, while greater availability of student loans would help increase enrollment in higher education. Early childhood education should also be developed (Jung and Hasan, 2014).

  • Tailoring education to labor market needs. Vocational training can be improved by strengthening the coordination with employers, with the education process closely linked to the needs of the corporates, including by improving soft skills (computer, language, and thinking skills).

15. Strengthening active labor market policies and streamlining labor market regulations would support job creation.

  • Active labor market policies, including job placement services and vocational training, would help labor mobility (Allen, 2016). Youth employment can be boosted by targeted training in regions. Female labor participation can be enhanced by providing affordable childcare and flexible work arrangements, as well as better education opportunities. However, these initiatives should be subject to a cost-benefit test and ex-post evaluation given potential fiscal costs (Mckenzie, 2017).

  • Easing stringent job protection, such as dismissal procedures and severance payments, while improving vocational training and job placement services, would promote youth employment and reduce the use of short-term contracts. In particular, streamlining administrative procedures, including on mediation by the administration and judicial settlement, would be important, as administrative procedures are more distortive and disruptive than severance payments (Mckenzie, 2017). Adopting a more open immigration policy for skilled labor, and improving the quality of domestic education, can lower skill mismatches, including in professional services. The minimum wage formula introduced in 2015 should continue to be implemented, which would help foster business certainty.

E. Structural Reform Scenario

16. A comprehensive and properly sequenced package of fiscal and structural reforms would be self-reinforcing. Given limited fiscal space, the priority should be on reforming product markets to promote entry and reduce state control, streamlining complex regulations, and fostering financial deepening and inclusion. An increase in revenue from tax reforms would create fiscal space for development spending on infrastructure, education and health, where policy gaps remain large.

17. Complementarities between reforms should also be exploited. Product market reforms, including relaxing FDI and network industry regulations, can promote private participation in infrastructure. Stronger property rights through regulatory reforms can improve access to credit, while financial inclusion, such as student loans, can expand education opportunities. Financial deepening can help mobilize financing for infrastructure, while infrastructure development can improve education access in remote areas.

18. The IMF’s Global Integrated Monetary and Fiscal (GIMF) model is used to estimate the macroeconomic effects of fiscal reforms in Indonesia. GIMF is a multicountry general equilibrium model that includes a detailed specification of fiscal policy, including different taxes (consumption, labor, and corporate) and expenditure items (government consumption, public investment, general and targeted transfers, and interest payments) (Kumhof and others, 2010).

19. The main properties of the GIMF model calibrated for Indonesia are as follows (Anderson and others, 2013; and Curristine and others, 2016):

  • Tax increases. The multipliers on output in the first year from a 1 percent of GDP permanent rise in revenue due to higher taxes are −0.2 percent for consumption taxes, −0.3 percent for labor taxes, and −0.5 percent for corporate taxes. The negative impact on output from higher consumption taxes declines over time to nearly zero after 10 years, while that from higher labor taxes rises increases to 0.5 percent in the second year, remaining at that level for the following eight years. The negative impact on output from higher corporate taxes increases gradually over time to 1.5 percent after 10 years.

  • Infrastructure investment. The multiplier on output from a 1 percent of GDP permanent increase in infrastructure investment is 1 percent in the first year, rising gradually to over 2 percent in 10 years. The rise in the multiplier in the medium term is driven by the increase in private investment, as the higher stock of public capital raises the productivity of private capital.

  • Social transfers. The multipliers on output from a 1 percent of GDP permanent rise in social transfers are modest in the first year, ranging between 0.15 percent for targeted transfers to the poor and 0.05 percent for untargeted general transfers. The medium-term impact is slightly negative as taxes are raised or spending is cut to keep the fiscal deficit unchanged.

  • Other structural reforms. As the GIMF model cannot estimate the impact of other structural reforms directly, these are estimated indirectly in the GIMF model through an estimated impact of these reforms on TFP based on previous studies (Barnes, 2014; Dabla-Norris and others, 2016; Gal and Hijzen, 2016; and Bouis and others, 2016).

20. The reform scenario includes higher spending in infrastructure and targeted transfers financed mainly by higher consumption taxes, reduced barriers to trade and FDI, and structural reforms to the product and labor markets (Table 2).

  • Revenue. About 2 percentage points of GDP of the extra revenue from a medium-term revenue strategy (MTRS) would come from consumption taxes such as VAT and excises on fuel, vehicles, and plastic bags, which have low negative multipliers. The other 1 percentage point of GDP would come from taxes with larger negative multipliers.

  • Expenditure. This extra revenue would be used to increase spending in infrastructure (1.3 percentage points of GDP) and targeted transfers in education, health and social programs (1.5 percentage points of GDP), which have larger multipliers.

  • Other structural reforms would center on reducing restrictions to trade and FDI, and streamlining product and labor market regulations to promote entry, rationalize the role of SOEs, and foster employment. The reform scenario assumes a 10 percent reduction in the OECD’s product market regulations (PMI) over 5 years, to the level comparable to the average of the BRICS economies. This includes rationalizing the role of SOEs through enhancing the governance of SOEs and reducing price controls; removing FDI and trade restrictions; and easing entry barriers and administrative burdens to businesses. These would be accompanied by reforms on the legal and regulatory framework. The effects of reforms on education and the labor market would take longer to realize, but would be conducive of inclusive growth.

Table 2.

Indonesia: Illustrative Effects of Fiscal and Structural Reforms 1/

article image
Source: World Bank; Indonesian authorities; and IMF staff estimates.

The estimate impact of the reforms included in staff’s active scenario are based on Nozaki and Shin, 2015, “Infrastructure Development in Indonesia,” IMF Country Report No. 16/82; Dabla-Norris and others, 2015, “Structural Reforms and Productivity Growth in Emerging Market and Developoing Economies,” IMF Working Paper No. 16/15); Bouis, Duval and Eugster, 2016, “Producer Market Deregulation and Growth: New Country-Industry-Level Evidence,” IMF WP/16/114; Gal and Hijzen, 2016, “The short-term impact of produt market reforms: A cross-country firm-level analysis.”; Chapter 3, Time for a supply-side boost? Macroeconomic effects of labor and product market reforms in advanced economies, IMF WEO April 2016.

21. Potential real GDP growth would increase gradually to 6.5 percent by 2022, 0.9 percentage point higher than the baseline scenario (Figure 14). Most of the gains in potential growth in the initial years would come from public and private investment on the back of fiscal reforms and improved efficiency, while gains in TFP from other structural reforms would play a bigger role in the outer years. Higher infrastructure investment and lower trade and FDI regulations, which would also catalyze private investment and employment, would be the main growth drivers in the first two years, raising potential growth by 0.2–0.3 percentage point. Implementing the medium-term revenue strategy will help contain the fiscal deficit and government debt, while allowing greater social and infrastructure spending. While infrastructure spending would stabilize in the medium term, higher private investment partly due to improved efficiency, and employment growth would play an increasing role over time, raising potential growth by additional 0.5 and 0.2 percentage point relative to the baseline by 2022, respectively. Gains in TFP from regulatory reforms including on product market regulations would raise potential growth by 0.1 percentage point in 2020-21 and 0.2 percentage point in 2022. Gains in TFP would become larger in a long term, benefiting from enhanced competition, improved labor skills, and greater integration with global value chains.

Figure 14.
Figure 14.

Growth Under Reform Scenario

(In percent)

Citation: IMF Staff Country Reports 2018, 033; 10.5089/9781484340707.002.A003

Sources: Penn World Trade; and IMF staff estimates.

22. The reform scenario also assumes continued macroeconomic stability:

  • Inflation would rise to around 4 percent (y/y) in the initial years due to the demand stimulus and higher consumption taxes, but it would moderate afterwards due to a tighter monetary stance, stronger domestic competition and expanded production capacity.

  • The current account deficit would widen to around 2.3 percent of GDP due to higher public and private investment-related imports (or a lower saving-investment gap in the private sector), which would be partly offset by higher exports due to enhanced competitiveness.

  • With a medium-term revenue strategy in place, the fiscal deficit would be contained at around 2.2 percent and government debt below 30 percent of GDP in the medium term.

F. Conclusion

23. Indonesia can achieve stronger inclusive potential growth with structural reforms on infrastructure, regulations, and human capital. Growth remains constrained by a large infrastructure gap, low institutional quality, and inadequate human capital. Indonesia can achieve stronger inclusive potential growth by developing infrastructure, streamlining regulations, and strengthening human capital. An illustrative scenario that includes fiscal and structural reforms shows that potential growth could rise to 6.5 percent in the medium term due to permanent supply shifts, around 1 percentage point higher than the baseline scenario. Together with a clear communication strategy, these structural reforms will help boost confidence in the economy.

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1

Prepared by Jongsoon Shin (APD)

2

It takes 498 days to enforce contracts in Indonesia with sizeable costs during the process. Weak property rights are also reflected in low rankings of starting a business (144th place), and registering property (106th place).

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Indonesia: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2018: Issue 033
Publisher:
International Monetary Fund
ISBN:
9781484340707
ISSN:
1934-7685
Pages:
64
DOI:
https://doi.org/10.5089/9781484340707.002

Real GDP Growth

(In percent, year-on-year)

Contribution to Growth

(In percent, period average)

Real Public Capital Stock

(In percent of 2011 constant GDP. 2015)

Funding Allocation Plan for 247 Projects

(In percent of GDP)

Private Participation in Infrastructure

(In percent of GDP)

Real Public Investment 1/

(In percent of GDP, 2011 constant dollars)

SOEs Assets and Turnover Ratio

(In percent)

Industry of State-Owned Enterprises

(In number)

Framework for Reviewing the Status of Public Enterprises

Ownership of State-Owned Enterprises

(Number; as of January 2017)

Regulations by Category, 2016

(Number of regulations)

Enacted Regulations During 1998–2017

(Number of regulations; as of April 2017)

Government Education Spending and Outcome 1/

Growth Under Reform Scenario

(In percent)