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Indonesia needs a new strategy for securing medium-term growth

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In Brief

The slowdown in Indonesian growth to 4.7 per cent for the first quarter of 2015 follows a steady quarterly slowdown since the 6.8 per cent peak just over four years ago. Is this slowdown simply a post-commodity boom cyclical downturn, or is it the beginning of an extended period of weakness? 


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The answer to this question will be determined by whether the Indonesian government adopts a pragmatic response, or doubles down on an economic course that diverges sharply from the successful path adopted in the post-Asian crisis period.

The predominant view is that this slowdown is a cyclical development. Growth will rebound, led by rising government infrastructure spending, which in turn prompts a revival of private investment and a boost to demand. Some reforms — such as investment licensing — have also gained traction and could help to increase investment.

Nonetheless, there are few signs of an early turnaround. As activity grinds lower, critics will challenge the view that this is a cyclical downturn. Instead they will ask whether the policy foundations of economic activity can explain the slowdown.

The role of government is being recast. The public sector is increasingly seen as the manager of economic activity rather than the creator of an enabling environment for private economic activity. Mainstream Indonesian political discussions accept this view and it is increasingly reflected in the legal and regulatory framework. For example, the 2014 industry law envisages government determining the sectors of focus and establishing upstream and downstream activities in those sectors. Exports and imports are managed using tools from outright bans to local content rules and domestic market obligations.

The 2015 Indonesian budget positions the public sector as the main driver of growth. The re-orientation of the budget towards infrastructure spending and the injection of additional capital into state-owned enterprises both signal this philosophy. Of course, increased public investment in infrastructure is justified by the dramatic failure of the public-private partnership infrastructure model over the last decade. But this breakdown of a balanced public and private investment strategy is explained more by the government’s failure to provide an enabling environment for private investors than a lack of investor finance and interest.

External economic relationships are being reshaped. A plethora of regulatory and non-tariff measures have been introduced. Indonesia features among the G20 countries with the most significant increases in tariff barriers and the most number of trade partners affected by these increases. The 2014 Trade Law, in the same spirit as the Industry Law, grants powers to manage trade directly. Some have suggested that discretionary limits on imports will reduce the current account deficit without setting back the development of the export-oriented manufacturing sector. But both industrial and trade policy fails to grasp the nature and operation of global value chains and technology acquisition.

Key laws framing the post-Asian crisis recovery are being challenged. The constitutional court has recently struck down the 2004 water law, stating that the free-market economy harms the people.

The court has received submissions to consider three other laws. They are: the 1999 law on foreign exchange, which provides the legal basis for convertibility of the rupiah and the use of foreign exchange; the 2007 law on investment that, among other things, is the basis for the ‘negative list’ restrictions on foreign investment; and the 2009 law on electricity, which allows private operation of power plants.

These laws are part of the foundation that has enabled Indonesia’s involvement in the global economy and certainty for domestic and foreign investors. The outcome of these legal actions will send a strong signal about the direction of Indonesian economy.

The internal contradictions of the new model are running into harsh economic realities. The public sector-led model cannot be adequately financed. On the domestic front, the financial sector is small. As a consequence, the funding of significant investments by government and state-owned enterprises will crowd out private activity.

These challenges are increased by the significant state-owned share of the banking sector, which also needs to increase capital to meet medium-term goals. The need for significant financing in the banking sector comes at a time when the thrust of political discussion is to reduce foreign investment in the banking sector.

On the external financing side, Indonesia has seen a necessary resort to greater reliance on short-term capital flows, because the impediments to foreign investment mean that FDI remains low as a share of GDP. A pick-up in multilateral and bilateral official flows is a possibility and this could certainly help. But official flows are not likely to meet funding needs.

Indonesia’s economic slowdown is reducing the degree of freedom afforded to economic policy. The public sector-led model, if it ever were viable, is becoming less so day-by-day. The only ‘get out of jail free’ card is a turnaround in commodity prices, but that does not appear likely in the near future. This means that medium-term growth prospects require a meaningful re-orientation of strategy. Indonesian policy has long responded pragmatically and boldly to economic challenges. It will need to follow that course once again.

David Nellor is an Adjunct Professor in the Lee Kuan Yew School of Public Policy, National University of Singapore.

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