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Jakarta Post

Indonesia needs institutional reforms to boost growth

  • Nanang Hendarsah

    The Jakarta Post

Jakarta   /   Fri, August 7, 2015   /  06:10 am

Over the last five years, Indonesian gross domestic product (GDP) growth peaked at 6.5 percent in the first quarter of 2011 and has steadily fallen to 4.71 percent in the first quarter of 2015.

Growth slid further in the second quarter to 4.67 percent, underlining the challenge for the government to revitalize the economic structure to make it strong and balance.

The end of the commodity boom is severely affecting Indonesia, causing a big current account deficit and sharply cutting incomes in producing areas, mainly in Kalimantan and Sumatra. Worse still, the commodity price will likely continue to decline due to weaker demand from China.

Of notable concern for Indonesia is the agricultural sector, which relies mainly on tree crops such as palm oil and rubber. These plantation commodities and coal account for 51.8 percent of total exports, and employ a substantial number of workers.

In 2015, the international prices of eight of Indonesia'€™s major export commodities are envisaged to drop by 16.1 percent. As export prices continue to decline, we have seen a fall in income generated from the external sector and a blow to private consumption derived from this source, particularly outside of Java.

In fact, a number of high-frequency indicators have already suggested downside pressure to private consumption i.e. weaker consumer confidence, falling vehicle sales, lower than expected earnings and slowing consumer lending growth.

Overall consumer confidence, as indicated by the confidence index published by Bank Indonesia, AC Nielsen and Danareksa, has continuously fallen and reached its lowest point in April 2015. There are likely a number of reasons behind this slip in confidence.

However, the most likely factor is that the new government'€™s honeymoon period is over and the people would like to see results instead of another announcement of plans.

People have patiently awaited government spending to kick-start investment growth.

As a matter of fact, fiscal spending has been extremely weak with only 6.1 percent of the capital expenditure budget spent through May. In contrast, the amount of government funds in commercial bank accounts increased after the increase in transfers to the provinces, indicating a sharp decline in investment expenditure.

The lack of government spending has had significant spillover effects, resulting in reduced employment and private consumption.

We still need a clear demonstration of the administration'€™s ability to move quickly '€” and more importantly, an affirmation of its intent. Specifically, investors will be looking for noticeable signs of the government'€™s ability to deliver on its promises.

The completion of government projects in the second quarter of 2015 only reached 48 percent of the target, as shown by the continued slump in cement sales.

On the other side of the coin, the good news is that the current account deficit narrowed to 1.76 percent of GDP in the first quarter 2015 and is expected to remain muted at below 2.5 percent in the second quarter.

However, this improvement masks a concerning underlying trend, which is a markedly weaker ability to consume imports and the unintended delay in infrastructure projects which suggests that capital equipment import needs are likely to fall short.

With growth slowing, the crux of the debate right now is whether the slowdown is temporary, reflecting one-off negative shocks, or long-lasting as the initial growth spurt from undertaking '€œlow-hanging fruit'€ reforms dissipates and the transition toward a more sophisticated growth model is not yet accomplished.

Amid the slow pace of structural reforms, Indonesia has to tolerate lower economic growth in the range of 4.5 to 5.5 percent as the new normal, except proceeding at a higher pace by accelerating structural reforms.

Otherwise, growing above 5.5 percent will magnify the current account deficit and instigate overheating in the economy, given the still inadequate supply-side capabilities to balance the surging domestic demand.

The rigidity of the supply side of the economy to balance out the increase in domestic demand points out that Indonesia lags behind in implementing structural reforms compared to its peer countries in the region.

Structural reforms have repeatedly turned out to be a meaningless slogan from one administration'€™s regime to another. For years, the window of opportunity has again and again closed simply because of the lack of guts to take the decisive step.

Indeed, Indonesia is endowed with diverse natural resources as the most fundamental domestic factor for economic growth. And perhaps this is the endowment which makes every administration in power become self-righteous.

Endowments certainly do give some countries a head start compared to others. But the long-term prosperity of nations is not bound by their endowments while natural and geographical constraints can be overcome. Critical to long-term growth is how one makes use of and develops resources. Japan, Korea and Taiwan spring to mind as countries that have made much of their limited resources.

Doing so requires constant reshuffling of production factors. Workers, capital and land have to be devoted to activities that generate the most added value for the economy. In other words, growth requires structural change.

Development entails more than just aggregate growth. It requires significant transformation in the productive structure of the economy.

Thus, sustaining growth going forward hinges on the continuation of this process of change and upgrading. For Indonesia, with such tremendous endowment, industrializing the agriculture sector through the adoption of modern methods and the development of agribusinesses will be a key source of productivity growth. Similarly, the composition of the services sector, which is also increasing, has to shift from low-productivity activities to modern, high value-added services.

Countries that have achieved sustained growth are those that are better at removing the supply side bottlenecks that impede such transformation.

This by and large requires a number of key fundamental capabilities, such as macroeconomic stability, rule of law, good education, strict enforcement of contracts, a competent bureaucracy, good governance and low tolerance of corruption.

These are often encapsulated under the rubric of '€œstrong institutions'€. Good institutions encourage growth; bad institutions stifle it. Entrepreneurship, a critical driver of structural change, relies heavily on the institutional environment.

The contrast between North and South Korea serves as a striking example of how institutional differences can lead to wildly divergent paths between two countries that were initially very similar culturally and geographically.

Indonesia is currently at a critical juncture. Much has been accomplished and much potential remains. This is the key transition point. How successfully Indonesia manages this transition will depend primarily on domestic factors, specifically its ability to instigate structural change and implement institutional reforms.

Big strides can be achieved if we can push through our individual glass ceilings.

The writer is a senior economist at Bank Indonesia. This is a personal opinion.

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