Why can't Indonesia be industrialized?

Indonesia faces major challenges

The country's economy is not heavily involved in international supply chains. That was a benefit when the Covid-19 pandemic broke out around the world. Nevertheless, the crisis has left deep marks in Indonesia.

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With over 270 million inhabitants, Indonesia is the largest country in the ASEAN region (Association of Southeast Asian Nations) and its only G20 member. 58% of the population are under 35 years of age, which must be seen as a major demographic advantage. In the past 20 years the economy has grown by an average of more than 5% per year.

According to the World Bank, Indonesia is an upper-middle-income economy with a GDP per capita of USD 4,050. It ranks in the same category as China and Thailand, one notch above its regional neighbors Philippines and Vietnam. However, this classification should be treated with caution because the Indonesian economy is not necessarily on a very solid footing. Industrialization is largely backward. The manufacturing industry is limited to cheap contract manufacturing of imported primary products. The relatively high income is mainly due to the island nation's rich mineral resources, such as copper, nickel, coal and palm oil.

Growth story is interrupted

As of August 31, Johns Hopkins University reports more than 174,000 confirmed cases of Covid-19 in Indonesia. The consequences of the pandemic are considerable: economic life in the country has largely come to a standstill for months. GDP shrank by 4.2% in the second quarter; Negative growth is also forecast for 2020 as a whole.

The dependence on imported intermediate products (mainly from China) and the disruption of national supply chains are problems on the surface. In addition, the island state has even deeper, structural problems. These include the low level of education, poor infrastructure and anti-investment legislation. Overall, this is where the country's major challenges lie.

The government and central bank intervene resolutely

In the past 20 years, Indonesia has basically operated solidly. The national debt at the end of 2019 was just under 30% of GDP. Thus, the Indonesian government and the central bank were able to put together a reconstruction package called “National Economy Recovery” relatively quickly in response to the pandemic. The volume of the package will gradually increase to 1,082 bill IDR (equivalent to around 76 billion USD), which corresponds to around 7% of GDP. The most important components of the package are:

  • Provision of tests and medically necessary care for the infected,
  • Increase of state transfers for the needy,
  • Deferral or restructuring of the debt services of those small businesses that are particularly hard hit by the lockdown, e.g. in the tourism industry,
  • Reduction of the sales tax rate from currently 25% to 22% and by a further 2 percentage points to 20% from 2022.

To this end, the government has suspended the previous ceiling of 3% for the budget deficit. The suspension should apply until 2023. At the same time, Bank Indonesia (central bank) announced an extensive bond purchase program in several stages. Government bonds are to be bought on a large scale in order to depress the yield on debt securities and thereby finance the increased government spending. The measures seem to be working, currently a total collapse in Indonesia can be avoided.

Foreign investment urgently needed

In addition to Singapore, Japan and China are among the largest investors in Indonesia. Both regional heavyweights are now campaigning for more influence on the archipelago. In May 2020, two multilateral development banks, ADB and AIIB, under the leadership of Japan and China, launched a joint aid program with a volume of USD 2.25 billion. The aim of the program is to support the Indonesian government in the fight against the negative consequences of the pandemic. Above all, the poorest part of the population who lives on less than USD 1 a day and those small to micro-enterprises that are directly affected by the lockdown are supported. One of the declared goals is to halve unemployment to the pre-crisis level of 5% by April 2022. The time frame alone indicates how serious the economic consequences actually are.

Because of the global isolation, it was not surprising to see that foreign direct investments (FDI) fell massively in the first half of 2020. For 2020 as a whole, Indonesia wants to attract a good USD 60 billion, despite the false start, which is urgently needed to revive the economy. According to the Indonesian Investment Authority, there are already numerous contenders among large corporations who want to relocate their production from China to Indonesia, including Panasonic and LG Electronics.

The key arguments for relocating to Indonesia are likely to have been the low local wages, on the negative side are the poor qualifications of the workforce and the ruling bureaucracy. If Indonesia gets these two challenges under control, it can play to its demographic advantage as the most populous country in Southeast Asia.

Politics must set priorities

President Joko Widodo, who was re-elected in spring 2019, had already initiated numerous projects in his first term of office to tackle the country's structural weaknesses. The labor market reform is considered to be one of the most important measures to loosen up the strict protection of workers and to create an investment-friendly environment. Education is also a key area in which the Indonesian government desperately wants and needs to improve.

The announcement that a capital in the province of East Kalimantan would be built out of the ground also attracted attention. The plan is to build an area of ​​180,000 hectares of quasi-arable land between the cities of Balikpapan (650,000 inhabitants) and Samarinda (860,000 inhabitants) as the center of the state administration.

According to the current plan, the construction of the government buildings and the necessary infrastructure should be completed by 2024 so that the authorities can move in and are at least able to work. These include parliament, the Ministry of Defense, the Constitutional Court, the Ministry of Foreign Affairs, foreign embassies, etc. All authorities related to the economic sector should remain in Jakarta.

The main reasons given for the ambitious project are the increasing risk of flooding due to the steady sinking of Jakarta's floor area and the over-concentration of economic output on the island of Java. The capacities of road traffic, health and energy supply and the disposal of everyday waste have reached their limits. The total cost of the relocation is estimated at US $ 34 billion, which should be a very conservative estimate.

From today's perspective, it is very questionable whether the budget situation after fighting the pandemic will still allow the project initiated by President Widodo. Politicians must now prioritize what the limited funds should be used for. The experts at ODDO BHF expect the highest priority for investments in the fields of education, healthcare and energy. For German exporters, therefore, increasing business opportunities are seen around medical equipment and in the range of energy solutions.

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