The “middle-income trap” was first coined in 2006 by economists to address challenges faced by developing economies to transition from the ranks of middle-income to high-income countries. Today, more than three quarters of the world’s population live in middle-income countries1. In fact very few middle-income countries have become high-income; of the 101 economies in the middle-income category in 1960, only 13 achieved high-income status by 20082.

The move from low-income to middle-income has been quite straightforward with many countries pursuing a labour-intensive manufacturing growth model that produced and exported competitively priced goods. This strategy however has its limitations as soon as another source of cheaper labour emerges – China is a case in point. Throughout 1990-1995, Asean countries collectively enjoyed 66% share of the global merchandise export growth while China tracked 30%. The tables turned during 2000-2005 when China garnered close to 67% share while Asean only managed just over 25%.3

To climb to the high-income league, the textbook theory suggests moving up the manufacturing value chain and transforming into a more knowledge based economy. Practically, however, this is a challenge if the quality of higher education systems, infrastructure, technology and financing capabilities are lacking.

Based on the World Bank’s income classification, Indonesia is currently a lower middle-income country and although gross national income per capita has risen steadily since 2004, it has only hit USD3,540 in 2017, an insufficient level to be classified as upper middle income, let alone high-income4. Range bound growth rate (5% to 5.5% per annum) since 2014 has been cited as one reason for the slow progress.

Scourge of “Dutch disease”

This stagnating growth has been attributed to the hollowing out of the manufacturing sector, allegedly struck by the “Dutch Disease” – a term that originated in the Netherlands during the 1960s, when the high revenue generated by its natural gas discovery led to a sharp decline in the competitiveness of its other, non-booming tradable sector. Ever since any country that benefits from the development of a natural resource discovery is said to be afflicted by this malaise if it experiences a decline in other sectors (such as manufacturing or agriculture).

In Indonesia, the commodity boom in 2000s resulted in a declining tradable sector and rising non-tradable sector. In particular, the contribution of value added from the manufacturing sector towards Indonesia’s gross domestic product has been steadily declining since 2001 (see Fig. 1) and this exacerbates the probability for Indonesia to be trapped in middle-income5  - this argument was reiterated in a research done by a British economist, Angus Maddison6. The 2000s also marked the start of the period when Indonesia began to prioritise exports on mining and agricultural commodities. In contrast, South Korea avoided the trap by maintaining the focus on its manufacturing sector via production and export of high technology-based products. Furthermore the contribution of manufacture exports to total merchandise exports in South Korea has been stable and above 80 percent while in Indonesia it has been fluctuating and way below its peers.

Fig 1: Indonesia’s Manufacturing Woes7

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Realising this need to develop a source of growth that also creates employment, the government has started an industrialisation move which is called Indonesia 4.0 with the hope to increase the manufacturing exports' contribution to 10% of GDP by 2030 and create 10 million new jobs. The five sectors that have been prioritised, based on its potential impact on growth and employment, are food and beverage, textiles, automotive and electronics and chemical.

To support the industrialisation roadmap, the government enacted a new tax holiday regulation while keeping the current account deficit manageable. The support has targeted primary rather than secondary sectors as the latter negatively impacts the current account balance. The regulation covers both new and existing companies and the duration depends on the amount of new investment (see Fig. 2).

Fig.2 New tax holiday scheme8
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To increase the competitiveness of the manufacturing sector, two key areas need to be looked into – improving the country’s infrastructure and raising the education standards.

Constraints of infrastructure

Infrastructure has been one of Indonesia’s main concerns; in Jakarta, an imported orange can cost much less than a home grown one. As bizarre as it sounds, it is unfortunately a consequence of Indonesia’s notoriously high logistics costs arising from inadequate infrastructure. Good infrastructure that facilitates ease of transport and connectivity between manufacturers and consumers is instrumental in determining a country’s international competitiveness. In 2016, the World Bank’s Logistics Perfomance Index (LPI) ranked Indonesia 63 out of 160 countries with an overall score of 2.98, weighed down by a poor infrastructure score (see Fig 3).

Fig. 3: Indonesia’s overall logistics performance index score over the years9
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Recognising this, the Jokowi administration has prioritised infrastructure spending (see Fig. 4). However, there are state budget10 limitations and the funding gap is still one of the largest in Asean11.

Fig. 4: Infrastructure spending on the rise12
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As such private sector funding for infrastructure is a must. In this regard, the country has made a breakthrough via securitisation financing. Indonesia’s biggest toll operator, Jasa Marga is one of the recent success stories; the company securitised about half of its IDR 4tn in revenue over the next five years from its road operation in Java. In fact, the demand for the securities was oversubscribed - two times higher than the target. Going forward, we believe that the government will urge – at least starting from state owned enterprises – to follow suit.

Dearth of skilled labour

Indonesia is currently the world’s fourth most populous country after China, India and the United States. The country’s demographic advantage is not defined by this rank but by the fact that almost half of its population is in the economic productive age group of 25-59 (see Fig 5). To be sure, Indonesia will enjoy this demographic dividend only up until 2030. The opportunity to capitalise and harness this demographic dividend should not be missed as it is one of ways for the country to achieve higher economic growth and in turn avoid the middle-income trap.

Fig 5. Indonesia's population by age groups and sexes in 203013
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To do this, education standards have to be increased. A 2015 study14 showed that Indonesia was ranked lower compared to its neighbours such as Thailand and Vietnam in knowledge and skill performance of 15-yr old students. The lack of competitive human capital in Indonesia is glaring. Currently 59% of the labour force consists of workers with education below high school and only 41% have a high school degree and above (see Fig 6). Within the manufacturing sector, the same profile is repeated; workers with less than senior high school education constitute 57% share.

Fig 6: Indonesia’s labour force based on educational level15
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Improving the education quality is essential if Indonesia wants to become more productive; the more educated and skilled the workers are, the higher the chances of innovating and converting economic activity to new products and profits.

Several efforts have been done by the government to narrow the inequality and improve education, one of which is the Indonesia Smart Program. First implemented in 2015, the programme which is still being developed is dedicated to increase the participation rate of school-aged children (6-21 years) from poor families. Furthermore, the government is also encouraging the use of information technology such as digital learning to achieve a more even distribution of education quality within the country.

The investment perspective

Middle income countries need to embrace a capability-focused strategy to advance innovation, move up the value chain and create decent jobs. Such a strategy will likely underpin the country’s stock market performance and appeal to investors.

Typically, Indonesia’s stock market returns have high correlation with the commodity price cycle given that commodity exports are a crucial earnings growth driver. Fiscal spending is another and the past stock market reaction is proof that investors pay attention to these developments. In 2011, both Indonesia and Vietnam enacted the tax holiday incentives to lure foreign direct investment (FDI). Indonesia’s tax holiday was, however, less attractive than Vietnam in terms of the incentives and the application process, not to mention the political/regulatory risks. As a result, Indonesia’s FDI growth stalled post-2011 while Vietnam’s jumped substantially. The stock market responded accordingly with Vietnam’s re-rating and Indonesia’s stagnating (see Fig 7).

Cognisant of this, the Jokowi government has put in place reforms with a heavy focus on infrastructure development. This has not gone unnoticed. Standard & Poor upgraded the country’s sovereign rating to investment grade in 2017, a clear indication of Indonesia’s improved fundamentals in recent years. The pursuit of continued reforms should benefit the economy and the stock market as the economic multiplier kicks in.

Fig 7: Average forward price-to-earnings (PE) ratio versus the foreign direct investment (FDI)16

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Ari Pitoyo

Chief Investment Officer
Eastspring Investments Indonesia

  • ASIA