Research and analysis

Indonesia: avoiding the middle income trap

Published 1 July 2014

0.1 Summary

World Bank’s quinquennial Development Policy Review of Indonesia shows the nation has made impressive progress but faces formidable economic challenges over the next two decades. Will it realise potential and climb the income ladder or miss this opportunity and “float in middle”, as others countries have done? Indonesia has an abundance of natural resources, favourable demographics and the world’s most dynamic markets in its neighbourhood. However, the stakes are high, and without wide-ranging structural reforms, Indonesia could struggle to escape from the “middle income trap”.

0.2 Detail

Since 2001 Indonesia has almost doubled its GDP, maintaining an average growth rate of 5.7%. It weathered the global economic downturn with healthy public finances, demonstrating impressive macroeconomic resilience. The Bank suggests that Indonesia will need to sustain or even exceed this growth rate if it is to deliver on its aspiration to become a high-income economy.

A number of trends will shape Indonesia’s economic prospects including demographics, urbanisation and the rising middle class. Compared to other emerging countries, it has abundant labour due to its favourable demographics. More than 50% of population are below 30 and nearly 15m people will enter the labour market by 2020. Today, there are 45m in the middle class and more than 2m join their ranks every year, creating strong demand for goods and services. In addition, Indonesia is one of the most rapidly urbanizing countries, with its urban population rising from 52% in 2012 to 68% by 2025. All of these have the potential to boost Indonesia’s prosperity. Indonesia has abundant natural resources and benefits from its position in the most economically dynamic region of the globe.

The Bank suggests that economic growth must be greater than 5% every year just to avoid serious unemployment problems. Growth considerably higher than 5% is required for Indonesia to escape the threat of a middle income trap. Growth of 9% would position Indonesia to become a high-income economy by the year 2030. Indonesia’s demographic dividend will last only another decade, so it needs “to grow rich before it grows old” – to use the words of the Deputy Trade Minister who spoke at the launch event.

The Bank identified a number of threats to sustained growth: low levels of investment, slow manufacturing growth, limited industrial diversification, heavy reliance on commodities (65% of exports and rising), widening income inequality and poor labour markets. The country also has weak infrastructure and poor skills, resulting in Indonesia lagging far behind neighbouring countries in key areas: Indonesia has half the ASEAN population but only accounts for 15% of the region’s exports, Malaysia’s labour productivity is five times higher.

The Bank set out key elements of a strategy for strong growth: boosting labour productivity and closing the skills gap; investing in infrastructure; and improving the functioning of product, labour, capital and land markets. The Bank also highlights the need to pay more attention to inequality to ensure that the benefits of growth are shared more widely. Better local governance to deliver public services (health, waste management, sanitation, water), enhanced social protection, and improved management of natural risks are key elements.

These reforms would require significant expansion and redirection of public finance. Enhancing tax revenues and reducing energy subsidies would enable additional spending on infrastructure, health and social protection. Overarching all of these, the Bank identified the need to focus on implementation, which will require strengthened institutional capacity in public administration.

The report is available at the world bank website.

0.3 Comment

These recommendations align well with the focus of the UK’s prosperity-focused partnership with Indonesia. We should continue to support Indonesia to open its markets to attract more inward investment. We have seen Indonesia tend towards greater protectionism over recent years – the stronger Negative Investment List for example. Following its successful hosting of the Bali WTO Summit, it will be important to continue to encourage Indonesia to be aligned with the WTO on anti-protectionism and the G20 on transparency.

With a change of government later this year, we wait to see how the new administration develops its economic approach. Both presidential candidates have promised to increase protection for local businesses. Commentators have noted that the next president will need to increase the pace of growth, and that in turn will demand an investment climate that is favourable for foreign businesses Disclaimer The purpose of the FCO Country Update(s) for Business (”the Report”) prepared by UK Trade & Investment (UKTI) is to provide information and related comment to help recipients form their own judgments about making business decisions as to whether to invest or operate in a particular country. The Report’s contents were believed (at the time that the Report was prepared) to be reliable, but no representations or warranties, express or implied, are made or given by UKTI or its parent Departments (the Foreign and Commonwealth Office (FCO) and the Department for Business, Innovation and Skills (BIS)) as to the accuracy of the Report, its completeness or its suitability for any purpose. In particular, none of the Report’s contents should be construed as advice or solicitation to purchase or sell securities, commodities or any other form of financial instrument. No liability is accepted by UKTI, the FCO or BIS for any loss or damage (whether consequential or otherwise) which may arise out of or in connection with the Report.