I. Overview: Economic Policies for Growth and Employment Creation1
1. Indonesia has made significant progress in establishing macroeconomic stability and reducing vulnerabilities since the crisis, and growth has been picking up. Economic growth reached 5.1 percent in 2004, the highest annual rate since the crisis, increasingly bolstered by investment and exports besides private consumption. Meanwhile, inflation and interest rates have declined from their post-crisis peaks. Following the major cleanup of the banking sector after the crisis, banks’ performance has improved as net interest margins and profitability have increased. Public and external debt ratios have declined and international reserves have, until recently, risen, reducing domestic and external vulnerabilities.
2. Despite this favorable record, the recovery in Indonesia has been slower than in other crisis-hit countries in Asia, and employment creation has fallen short. Indonesia stands out as having experienced a slower recovery in investment and exports than other countries hit by the Asian crisis. Moreover, the increase in economic activity has not been accompanied by job creation, although there are some recent encouraging signs, and registered unemployment has increased every year since the crisis.
3. Recognizing the challenge, the new government has adopted a sound medium-term strategy focused on boosting economic growth. The strategy is built on a continuation of macro-economic stability and reforms in the financial sector, coupled with a reinforced effort to improve the investment climate.
4. This paper takes an in-depth look at selected aspects of the government’s growth strategy. The first chapter sets the stage by examining Indonesia’s growth experience in a longer-term perspective, seeking to draw lessons for the future. Each of the following chapters deal with a specific topic that is central to the government’s growth strategy: the role of public debt in affecting vulnerabilities and growth; the state of the banking system and key issues going forward in ensuring that the system can effectively mobilize and channel saving for investment, and not be the fulcrum of crisis; Indonesia’s external competitiveness, which will be key in sustaining the recovery in exports; the potential role of the petroleum sector, and in particular the policies needed for Indonesia to benefit from its considerable petroleum resources; and, finally, how the labor market functions and what could be done to translate higher GDP growth into employment creation. In summary:
The paper starts out with An Empirical Analysis of Long-Term Growth in Indonesia. The chapter examines Indonesia’s long-run growth performance in an effort to understand the factors behind the favorable record in the decades before the Asian crisis. Using a growth accounting framework, the analysis suggests that productivity growth was the major driving force in the 1960s, while capital accumulation has played a complementary role in later decades. A cross-country analysis of long-term growth underscores the importance of the quality of institutions and fiscal prudence for Indonesia.
The next chapter assesses Indonesia’s Public Debt Level, starting out from a recognition that the level of public debt, while greatly reduced since the immediate aftermath of the crisis, remains relatively high for an emerging market country like Indonesia. This is the case both from the point of view of vulnerabilities and crowding out. Using different approaches to assessing the appropriate upper debt level, the analysis concludes that a reduction in public debt towards the 35–42 percent of GDP range or below would be considered an appropriate medium-term target for Indonesia.
The following chapter reviews Recent Developments and Future Issues in the Banking Sector. The chapter concludes that, the recent strong credit growth notwithstanding, there is considerable scope for the sector to expand. Indeed, the ratio of bank credit to the private sector and the loan-to-deposit ratio are both relatively low in a regional comparison. By the same token, going forward, a strengthening of the banks’ capacity to manage risks and further improvements in prudential regulations and supervision, as planned by the authorities, will be key to ensuring a sound banking sector that can play a successful role in supporting investment and growth.
The paper then turns to a discussion of Indonesia’s External Competitiveness. While the evidence is mixed, the chapter concludes that, on balance, external competitiveness is not an immediate concern. Real effective exchange rate indicators and estimates of the equilibrium real exchange rate suggest that Indonesia’s competitive position has improved since mid-2003 and that it is adequate. On the other hand, an analysis of the post-crisis export performance underscores the need for caution in assessing competitiveness. Indeed, the real effective exchange rate indicators may not capture the full story, as the weak non-oil export growth in recent years suggests that structural shortcomings have been hampering export performance.
The following chapter reviews the potential contribution of the Oil and Gas Sector to Indonesia’s growth prospects. Following an overview of the sector’s role in the economy, the chapter discusses Indonesia’s regulatory and fiscal arrangements for the petroleum sector in a regional context, the government’s energy reform strategy, and policies for attracting investment. The sector’s overall role in the economy is likely to decline over time, and the chapter underscores the need to diversify exports and improve competitiveness, optimize energy use, and develop the base for non-oil and gas revenues. All of these are important elements of the government’s medium-term economic strategy.
Dealing with Indonesia’s pervasive unemployment problem is among the most important objectives of the government, and this is the focus of the last chapter, Labor Market Policies and Job Creation. In seeking to explain the lack of job creation in the post-crisis period, the chapter focuses on real wage growth, productivity developments, and the role of labor market legislation. The chapter also compares Indonesia’s regulatory regime for the labor market with those of other countries in the region. It concludes that recent sharp increases in real minimum wages, high severance payments, and restrictions on outsourcing have contributed to increased unemployment and growth of the informal sector. The chapter puts forward a range of policies that could help translate growth into jobs.
Prepared by Nita Thacker (APD).