Information about Asia and the Pacific Asia y el Pacífico
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Indonesia

Author(s):
International Monetary Fund
Published Date:
October 2011
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Information about Asia and the Pacific Asia y el Pacífico
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I. Estimating Indonesia’s Potential Growth Rate1

In the recently unveiled Master Plan, the Indonesian government targets a growth rate of 7–8 percent after 2013 and aims to become one of the world’s largest economies by 2025. This growth target is much higher than the growth rate achieved in 2006–2010 (5.7 percent) as well as the short-term consensus growth forecast (around 6.4 percent). This study estimated Indonesia’s potential growth rate and examined its underlying determinants. According to the growth accounting method, we expect Indonesia’s potential growth rate in the baseline scenario to gradually rise to 7 percent, mostly reflecting the increase in capital accumulation and productivity. For a downside scenario, moderate investment growth and slow progress in structural reforms would result in a slower growth rate of about 6 percent. Raising Indonesia’s potential growth to 8 percent would require substantial enhancements in capital and efficiency. This implies the need for greater efforts to address many long-standing constraints to growth.

A. Introduction

1. Potential output provides a useful measure of the productive capacity for an economy and plays an important role in policymaking. Using growth accounting methods,2 we have estimated Indonesia’s potential growth rate and decomposed the change in output into the contributions of capital, labor accumulation and the efficiency with which the factors are combined. Estimating potential growth, however, is highly dependent on the quality of underlying data, especially in Indonesia where the economy has been undergoing many structural changes.

2. Indonesia’s potential growth and its main sources have fluctuated in the past two decades. Prior to the Asian crisis (1991–1997), estimated potential growth was robust at 6.5 percent and predominantly input-driven, specifically by capital accumulation. After becoming negative immediately after the Asian crisis, estimated potential growth recovered to 4 percent during 2000–2005 with productivity gains dominating contributions to growth owing to institutional reforms and growth enhancing policies. Since 2006, potential growth resumed its structural momentum and picked up to around 6 percent, again being driven by higher labor and capital inputs.

Table I.1.Indonesia: Contribution to Potential Growth Under Three Scenarios, 2016(In percent)
Delayed ReformBaselineIntensive Reform
Potential growth6.07.28.2
Capital services4.45.25.5
Stock of capital4.14.85.2
Capacity utilization0.30.30.3
Labor services1.31.41.5
1-NAIRU0.20.20.3
Labor force participation rate0.30.30.4
Average hours worked0.00.00.0
Working age population0.80.80.8
Total factor productivity0.20.71.1
Sources: IMF staff estimates.
Sources: IMF staff estimates.

3. We estimate Indonesia’s potential growth rate in the baseline scenario to gradually rise to 7 percent, mostly reflecting the increase in capital accumulation and efficiency. Although the chance of a significant slowdown or reversal in the reform process is minimal, if the pace of progress does not advance, growth would stagnant around 6 percent over the medium term. Alternatively, a bigger than assumed increase in private and foreign investment on improved growth prospects, along with greater public infrastructure spending, and higher productivity growth from faster structural reforms could boost potential growth by 1 percentage point to around 8 percent.

4. To achieve a higher potential growth rate, Indonesia must try harder to reduce long-standing constraints to growth. It needs to implement more fundamental reforms to address the key impediments to higher investment and productivity growth. Structural reforms to enhance efficiency and supportive policies to promote infrastructure development will be crucial to translate the current favorable demographic trend and buoyant investment demand to an even higher potential growth rate.

B. Determinants of Potential Growth: Capital, Labor and Productivity

Capital and Investment

5. Capital accumulation is the fundamental determinant of growth. As a dominant contributor to potential growth, increasing the investment-GDP ratio and/or reducing the relative price of investment goods can speed up the capital stock. It is also clear from Asia’s own experience that capital accumulation has been a key driver of fast growth. Despite an increase from the post-Asian financial crisis low in 1999, the current rate of investment is inadequate to meet official long-term growth objectives. To achieve the similar growth trajectory of China and India, Indonesia would need to boost its investment spending.

Figure I.1.Real Gross Fixed Capital Formation

(In percent of GDP)

Sources: IMF, WEO database; and staff calculations.

6. Investment returns in Indonesia are expected to be high, supported by favorable terms of trade and strong regional demand for commodities. Despite some correction during the global crisis, Indonesia enjoyed a sizable gain in its terms of trade (TOT) (of an average about 3 percent over 2002–08). In fact, the favorable TOT in Indonesia is one of the driving factors for the recent investment pick up, especially in the commodity sector where high returns are expected. In a neoclassical model, higher TOT could offset diminishing returns to capital, boosting investment. Moreover, Indonesia’s export destinations have shifted from slow-growing advanced economies to fast-growing emerging market economies like China and other developing Asia countries, which will further boost Indonesia’s investment and growth prospects.

Figure I.2.Indonesia: Weighted Growth of Major Trading Partners

(In percent)

Sources: IMF, World Economic Outlook; and staff estimates.

Table I.2.Indonesia: Exports by Destination(In percent of total)
20062010
Singapore8.868.70
United States11.179.06
Euro Area (aggregate)9.889.16
China, P.R.: Mainland8.279.95
Japan21.5516.34
Developing Asia22.9030.27
Others25.6526.48
World100.00100.00
Sources: DTTS database; and staff calculations.
Sources: DTTS database; and staff calculations.

7. A lower cost of capital may further facilitate investment. Indonesia’s cost of capital is on a structural decline, with a prudent and stable macroeconomic environment leading to an improved credit rating.3 As a result, the credit default swap (CDS) spread has been falling and Indonesia’s long-term government bond yield has also declined remarkably. Improved public finances would also enable the government to undertake a more active role in providing funds to support infrastructure investment.

8. Pressing infrastructure bottlenecks and a slow pace in improving the investment environment, however, are widely viewed as impeding investment. Since the Asian crisis, the infrastructure sector has suffered from protracted under investment, leading to inadequate as well as poorer quality infrastructure in Indonesia than in regional peers. In the latest World Economic Forum global competitiveness index (GCI) (2010–11), Indonesia ranks 82 out of 139 economies in infrastructure.4 The key issues holding back infrastructure spending include land acquisition and funding. Indonesia’s infrastructure spending5 is considerably lower than China’s 10.4 percent of GDP in 2010 and India’s 7.5 percent of GDP. This in turn points to a need to speed up reforms such as improving the investment climate and reducing barriers to entry, including barriers to foreign investment in key sectors.

Population and Labor

9. Endowed with the fourth largest population in the world, Indonesia enjoys favorable demographics. Indonesia has enjoyed a demographic premium since the 1970s as the dependency ratio has declined. This is likely to continue in the next decade as the working-age population is projected to start peaking and the dependency ratio bottoms out. However, this demographic premium needs to be accompanied by more job creation and better quality education to produce high skilled workers and to productively absorb the additions to the workforce.

10. Inflexible labor market policies, however, hinder a more productive use of Indonesia’s labor and are detrimental to higher long-term growth. For most emerging market economies with a huge population and a large labor force, the labor constraint is not usually emphasized as restraining growth. That being said, an efficient labor market could boost potential growth through productivity gains. The current labor law was originally introduced to protect formal-sector workers, in the absence of unemployment insurance, through generous severance payments and high minimum wages. However, such protection is a deterrent to hiring workers on formal contracts and encourages informality.6 Indonesia ranks a low 84 in this pillar in the Global Competitive Index (GCI), a position that has been continually deteriorating since 2007, when it ranked 34. Indonesia’s labor markets now are assessed as less efficient than those of Thailand (24), Vietnam (30), Malaysia (35), and China (38).

11. Policies that enhance labor force participation would also help employment and boost potential growth. The participation of women in the labor force remains very low, with a participation rate of 52 percent compared with 86 percent of working age men. Expanded social safety nets and better education and health service would help to increase labor force participation, employment and potential growth.

Productivity

12. Improvements in efficiency are crucial to increase Indonesia’s potential growth. Efficiency, or total factor productivity (TFP), is an unexplained residual in the production function. It not only represents a measure of technical progress; it also captures the effects of many other determinants of the efficiency of factor usage: government policy, institutions, structural reforms, etc. It is therefore best interpreted as a measure of gains in the efficiency with which the factor inputs are used. Increasing the factor inputs (capital stock or labor) has a diminishing return. So it is desirable to increase output through improvements in the quality of labor (education), or institutional changes and structural reforms. There are also sizable gains from reforms that allow the existing factors of production to be utilized more effectively. For example, problems with land acquisition in Indonesia has long been viewed as constraining the use of land for more productive uses (such as infrastructure).

13. Infrastructure, labor and general regulatory reforms are recognized as critical to higher efficiency in Indonesia. There was a slight drop in Indonesia’s ranking in the 2011 Doing Business Report7 from 115 in 2010 to 121 in 2011. Indonesian firms are currently constrained by infrastructure bottlenecks, which increasingly affect their efficiency. Indonesia’s infrastructure, ranked 82 in the latest GCI, requires improvements across many areas. It is well behind other ASEAN members Singapore (5), Malaysia (30), and Thailand (35), and also less developed than China (50) and India (62). In the latest GCI, Indonesia ranks 98 for the flexibility of wage determination, a sharp drop from 2007. Moreover, Indonesia must continue strengthening its institutional framework (ranks 61).

C. Estimation Results8

14. After falling during the Asian crisis and its immediate aftermath, potential output growth gradually recovered after 2000. It has been little affected by the global crisis and achieved an average growth rate around 6 percent over 2006–10. Capital accumulation and labor input growth have been the main drivers of potential output during this period. In contrast, gains in TFP accounted for less than 5 percent of potential output growth before the Asian crisis. The TFP component appears to have deteriorated steadily since 2006, contributing only 0.2 percent to growth in the 2006–10 period.

15. Capital accumulation is the dominating contributor to Indonesia’s growth (Figure I.3). This was evident even before the Asian crisis. Following the Asia crisis and the decline in the investment, the contribution of capital accumulation, not surprisingly, declined to negative. The contribution of growth in capital has steadily increased over the past five years owing to strong investment growth, especially to the commodity sector.

Figure I.3.Indonesia: Potential GDP Growth Rate by Growth Accounting

(In percent)

Source: IMF staff calculation.

16. Various assumptions are necessary to estimate future potential growth. In the baseline, higher investment, employment and efficiency gains can lead to 7 percent growth in the medium term. Our baseline assumptions include: infrastructure spending will accelerate, easing infrastructure constraints and drive investment growth to 12 percent in 2016; the rate of labor force participation growth is expected to increase moderately because of various structural reforms; the unemployment rate is assumed to come down to 5.0 percent, consistent with the government’s medium term development plan; and TFP is assumed to increase by about three fold from the recent average of 0.2 percent to 0.7 percent. This set of assumptions would lead Indonesia to a higher potential growth rate of around 7 percent by 2016, with the investment to GDP ratio increasing from 24 percent in 2010 to 29 percent in 2016, and labor and capital contributing respectively 1.4 percentage points and 4.4 percentage points to growth.

Figure I.4.Indonesia: Potential Growth under Three Scenarios

(In percent)

Source: IMF staff estimates.

17. Both upside and downside risks exist, mainly depending on different assumptions on investment growth and efficiency improvement. In the “downside” scenario, infrastructure development proceeds slowly and there is little progress with structural reforms compared with the baseline. We take roughly the historical averages for investment and TFP growth and assume the unemployment rate stabilizes at about 6 percent. This produces growth of around 6 percent (roughly in line with the recent trend), with the investment to GDP ratio rising slightly to 26.6 percent in 2016 and the respective growth contributions of labor and capital of 0.9 percentage points and 2.4 percentage points. In the “upside” scenario, most of the infrastructure and other structural reforms are implemented and drives investment growth up to 14 percent and, together with structural reforms, leads to higher TFP growth (1.1 percent) and lower unemployment (4.5 percent). Potential growth in this scenario would reach 8 percent by 2016, with an investment to GDP ratio of 30 percent, and labor and capital contributing 1.6 percentage points and 5.3 percentage points to growth.

Table I.3.Indonesia: Contribution to Potential Growth Under Three Scenarios(In percent)
Downside ScenarioBaseline ScenarioUpside Scenario
1991–971998–992000–052006–102011–132014–162011–132014–162011–132014–16
Potential growth6.5-1.64.05.86.16.06.57.16.87.9
Capital services5.1-2.10.84.44.44.44.55.04.65.3
Stock of capital5.7-0.60.74.14.14.14.24.74.35.0
Capacity utilization-0.5-1.50.10.30.30.30.30.30.30.3
Labor services1.21.30.81.21.41.41.51.41.61.6
NAIRU-0.3-0.3-0.40.30.30.20.30.20.40.3
Labor force participation rate-0.10.30.51.00.30.30.40.30.40.4
Average hours worked0.00.0-0.10.10.00.00.00.00.00.0
Working age population1.61.30.7-0.30.80.80.80.80.80.8
Total factor productivity0.3-0.72.40.20.20.20.40.70.61.1
Sources: Statistics Indonesia; Haver Analytics; IMF, WEO database; IMF staff estimates.
Sources: Statistics Indonesia; Haver Analytics; IMF, WEO database; IMF staff estimates.

D. Conclusions and Policy Implications

18. According to our estimates, rising investment and productivity would lead to a baseline potential growth rate of 7 percent for Indonesia in the medium term. The estimates are filled with considerable economic uncertainties: in an upside scenario, we expect Indonesia’s potential growth to gradually rise to around 8 percent—about 1 percentage point higher than the baseline scenario, with the increase mostly reflecting higher capital accumulation, increasing labor participation and productivity. In contrast, slow progress in structural reforms and infrastructure development would reduce the baseline projection by about 1 percentage point, and lead to potential GDP growth remaining around 6 percent.

19. For Indonesia to achieve the upside scenario, it will need greater efforts to address long-standing constraints to higher investment and efficiency growth. Indonesia has achieved an impressive growth performance recently as a result of solid fundamentals through prudent macroeconomic policies pursued over the last decade. This study shows, however, that a number of challenges remain, which must be addressed to ensure that Indonesia sustains the current positive momentum and reaches a higher growth path in the future. Ample investment is needed so that growth in the capital stock can contribute to raising potential growth. Supportive policies for infrastructure development, such as a more effective fiscal policy through improved budget execution would be crucial to this effort.

20. In sum, Indonesia’s outlook for a high and sustainable potential growth appears favorable. A sound and stable macroeconomic and political environment, together with resilient growth prospects, provide Indonesia a unique opportunity to pursue its reform agenda and achieve higher, sustainable, and more inclusive growth in the medium term. Nevertheless, the pace of structural reforms will have to accelerate considerably to achieve the government’s Master Plan targets. Limited progress has been made since 2006 in establishing public private partnerships (PPP) to fund infrastructure investment. In this regard, subsidy reform and revenue mobilization will be needed to provide the fiscal space necessary for higher public infrastructure and act as a catalyst for private investment.

References

Prepared by Sarah Zhou.

The standard growth accounting approach is extensively used by industrial countries for estimating potential growth and doing cross-country comparisons; and is the chosen approach of the U.S. Congressional Budget Office (CBO), the European Commission, and the OECD. Despite all its flaws, it is a simple and internally consistent intellectual framework for organizing data. And as stated by CBO, is preferable to any of the alternatives so far to gain valuable insights into the process of economic growth.

All the three rating agencies (Moody’s, Fitch, and Standard & Poor’s) are now rating Indonesia just one notch below investment grade now. And both Standard and Poor’s and Fitch have positive ratings outlooks.

Despite notable improvements, its roads and railroads remain in poor condition, and the capacity of seaports remains limited (Geiger, 2011).

Prior to the Asian crisis, total public and private infrastructure spending reached 7 percent of GDP but declined to 2.5 percent in 2000. It has only partially increased since, to around 3.8 percent in 2008.

The informal sector represents around 70 percent of total employment and women have a higher probability than men to be employed in the informal sector.

Descriptions of the model and the detailed path of variables will be included in a forthcoming working paper and are available from the author by request.

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