World Bank Report: How Can Indonesia Avoid the Middle Income Trap

Robust economic growth in Indonesia has helped to lower the country’s poverty rate from 24 to 12 percent between the years 1999 and 2012. However, 65 million people still live between the national poverty line of USD $1.25 per day and the global poverty line of approximately USD $2 per day.

The country also faces the challenge of a skills gap between available jobs and education opportunities. Employers complain about not being able to fill jobs with skilled applicants, while certain sectors report not having enough graduates in those fields.

Higher economic growth in Indonesia also requires more and higher quality infrastructure. However, total infrastructure investment has remained low at 3-4 percent of gross domestic product (GDP) over the past decade, which is far below the rate of above 7 percent of GDP before the Asian financial crisis in 1997-1998. Meanwhile, China and India spend 10 percent and 7.5 percent, respectively, of GDP on infrastructure. Currently, the lack of quality and quantity of infrastructure in Indonesia results in high logistics costs.

How can Indonesia climb the income ladder (joining the rank of the high-income economies within two decades) while avoiding the middle income trap according to the World Bank? It needs reforms in six priority areas:

1) close the infrastructure gap
2) close the skills gap
3) well-functioning markets
4) access to quality service for all
5) improving social protection
6) natural risk management

“In the absence of critical reforms, Indonesia would float in the middle, as was the case of Brazil, Mexico, South Africa and other middle-income countries from the early 1980s to the mid-2000s,” said Ndiame Diop, World Bank Indonesia lead economist, and lead author of the study.

Indonesia is fortunate to have options in financing these reforms without threatening its long-term fiscal outlook. These options include phasing out the large fuel subsidies, and enforcing spending efficiencies at both the national and local government level. However, the main difficulty is to get these reforms implemented in a complex institutional and decentralized government.

A number of important remarks in the report:

Over the next decade, Indonesia has several factors which good policies can turn into powerful drivers of growth: demographics which will provide abundant labor; the urbanization trend; and developments in China.

Indonesia faces a risk of slowdown in long-term growth, as recent growth was partially driven by a very favorable external environment: the commodity boom of 2003-2011 combined with low global interest rates since 2009.

To avoid risks associated with higher unemployment, growth above five percent is vital. Economic growth considerably higher than five percent is required, for Indonesia to escape the threat of a middle income trap. Growth of nine percent would position Indonesia to become a high-income economy by the year 2030.

Growth has not been inclusive. Between 1999 to 2012, the poverty rate was cut by half, from 24 percent to 12 percent but 65 million people still live between the national poverty line of $1.25 a day and the global poverty line of around USD $2 a day.

Boosting economic growth through increasing labor productivity is very important, as it will bring higher value-addition to the labor force, reduce workers’ vulnerability to job losses, and enhance private sector competitiveness. More jobs should be created in the manufacturing sector and high-end services.

Governments can increase infrastructure investments by improving the quality of budget spending. Phasing out the large fuel subsidy spending frees funds to to finance greater infrastructure investments. Sub-national governments can spend more on infrastructure by reallocating funds from inefficient uses.

Closing Indonesia’s skills gap will require improving education quality at all levels, as well as expanding and improving of training centers. Graduates and workers should be equipped with the right technical skills and also employer-valued behavioral skills (discipline, reliability, teamwork and leadership).

Enhancing productivity growth through structural change or within sectors in Indonesia requires improving the functioning of product, labor, capital and land markets. A consistent industrial strategy is needed, elaborated in partnership with the private sector.

The poor, the vulnerable and some in the middle-class require better access to key services. Improving service delivery requires strengthening accountability through both demand-side and supply-side measures.

Indonesia’s social security system is being built.This reform will have significant impact on the national budget, the labor market, and the macro economy. That and the large number of stakeholders with diverging interests will require strong leadership of these reforms. Strengthening existing social assistance programs is the other essential component of a comprehensive social protection framework.

Indonesia should continue to enhance the management of disaster risks and further improve community resilience to natural disasters. Indonesian cities are particularly vulnerable to natural disasters, due to rapid construction in urban areas and weak enforcement of building codes and zoning regulations.

Further Reading:

• World Bank Report: Indonesia Avoiding the Trap
• Avoiding the Middle Income Trap; a Presentation by Ndiame Diop