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Indonesia Economic Prospects June 2024 Ta bl e of C o n te n ts Contents Table of Summary Executive LIST OF FIGURES, TABLES, AND BOXES IV PREFACE VI Developments A.1. Recent Economic ABBREVIATIONS VII EXECUTIVE SUMMARY 1 A.2. The Policy I. Economic Update 1 Stance II. Unleashing Indonesia’s Business Potential 3 A.3. Structural Trends A. ECONOMIC UPDATE 6 1. Recent Economic Developments 6 A.4. Outlook 2. The Policy Stance 11 and Risks 3. Structural Trends 15 4. The Outlook and Risks 20 A.5. Policy Priorities 5. Policy Priorities 23 B.1. Introduction B. UNLEASHING INDONESIA’S BUSINESS POTENTIAL 27 1. Introduction 27 2. Performance of the Private Sector 30 B.2. Performance of the Private Sector 3. Tackling Regulatory Uncertainty, the Next Challenge 34 4. Takeaways and Policy Recommendations 40 Regualatory Uncertainty, the Next Challenge ANNEX 42 B.3. Tackling REFERENCES 43 Recommendations B.4. Takeaways and Policy CLICK THE SIDE BUTTONS TO GO TO THE SECTION YOU WISH iii TO READ. Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential LIST OF FIGURES, TABLES, AND BOXES Contents Table of FIGURES Summary Executive Figure A.1: GDP growth remains solid, supported by strong private and public demand 6 Figure A.2: Capacity utilization has been increasing 6 Figure A.3: Headline inflation eased, but food price inflation remained strong… 7 Figure A.4: …partly due to challenges in the domestic food supply chain, particularly in rice 7 Developments A.1. Recent Economic Figure A.5: April saw the largest capital outflows in the past two years 9 Figure A.6: Portfolio outflows were larger than those observed in ASEAN EM peers, but situation revered in 9 May after BI policy rate hike Figure A.7: Indonesia’s sovereign yield spread against the US is narrower than for EM peers 9 A.2. The Policy Figure A.8: The Rupiah depreciated modestly in real effective terms among regional peers 9 Stance Figure A.9: The current account deficit widened due to narrower surplus in goods trade 9 Figure A.10: Indonesia’s ratio of reserves to IMF’s ARA metric was the lowest among peers 9 Figure A.11: Banks have adequate buffers to withstand potential adverse shocks 11 A.3. Structural Trends Figure A.12: Lending to the private sector expanded in March 11 Figure A.13: Fiscal balance posted a small surplus… 12 Figure A.14: …as revenues declined with subsiding commodity windfalls 12 A.4. Outlook Figure A.15: At the same time, expenditure growth picked up significantly 13 and Risks Figure A.16: And the government increased its social protection spending 13 Figure A.17: Indonesia’s general government capital stock is among the lowest among peers 13 Figure A.18: Demand for Indonesian government bonds lessened 13 A.5. Policy Priorities Figure A.19: The stability of Rupiah has been parallel with changes in net FX reserves 15 Figure A.20: SRBI yields rose significantly following the April hike in BI Rates 15 Figure A.21: Services growth has been accounting for more than half of GDP growth 16 B.1. Introduction Figure A.22: Post-COVID-19, the manufacturing sector has experienced notable shifts 16 Figure A.23: The services sector growth has been resilient, consistently outpacing manufacturing 16 Figure A.24: The manufacturing sector is becoming less diversified 16 Figure A.25: Subnational income convergence and catch-up have slowed down 17 B.2. Performance of the Private Sector Figure A.26: Income convergence is strongest when excluding Nusa Tenggara 17 Figure A.27: There has also been convergence in subnational capital formation 18 Figure A.28: But GFCF convergence is primarily driven by Java-Bali 18 Figure A.29: Annualized growth rate by percentile of consumption, adjusted for inflation 19 Regualatory Uncertainty, Figure A.30: Gini Index began to slowly rise post-COVID pandemic 19 the Next Challenge Figure A.31: Growth in inflation-adjusted median wage by sector 19 B.3. Tackling Figure A.32: Growth in share of employment by median wage for formal and informal sectors 19 Figure A.33: 5-year migration flows by district income level 20 Figure A.34: Regional convergence in median consumption per capita 20 Figure A.35: Indonesia’s high VAT thresholds narrow the tax base and lower the efficiency of collection 23 Recommendations Figure B.1: Average Indonesian firm labor productivity (2009-2023) 30 B.4. Takeaways and Policy Figure B.2: Labor productivity Indonesia vs. Comparators 30 Figure B.3: Average number of workers per firm 31 iv Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Figure B.4: Average sales per firm 31 Contents Table of Figure B.5: Kernel densities of sales of manufacturing and services firms: Indonesia vs. comparators 31 Figure B.6: Analysis of manufacturing firm sales distribution: Indonesia vs. comparators 32 Figure B.7: Analysis of manufacturing firm sales distribution: Indonesia across time 32 Summary Executive Figure B.8: Relationship between firm sales and employment—Indonesia vs. comparators 33 Figure B.9: Senior management time spent dealing with requirements of government regulation 35 Figure B.10: Bribery depth (percent of public transactions where a bribe was requested) 35 Figure B.11: Bribery incidence (percent of firms that report at least one bribe payment request) 36 Developments A.1. Recent Economic Figure B.12: Efficiency vs uncertainty in regulatory compliance 39 Figure B.13: Average efficiency and discretion across regulatory compliance regimes: Indonesia and 39 comparator countries Figure B.14: Indonesia: Regulatory efficiency and discretion across firm sizes in 2023 39 A.2. The Policy Figure B.15: Indonesia: Regulatory efficiency and discretion over time 40 Stance TABLE A.3. Structural Trends Table A.1: Fiscal needs to reform the social protection program that serves all and across life cycle 24 Table A.2: Selected Macroeconomic Indicators 25 A.4. Outlook and Risks Table B.1: Opinion on top 5 constraints in 2015 and 2023 29 Table B.2: Major constraint to productivity in 2015 and 2023 29 Table B.3: Relationship between bribing and firm productivity 36 A.5. Policy Priorities BOXES B.1. Introduction Box A.1: A deeper look at SRBI: BI’s new instrument to maintain the stability of FX reserves 14 Box A.2: International experience with school meals 22 B.2. Performance of the Private Sector Regualatory Uncertainty, the Next Challenge B.3. Tackling Recommendations B.4. Takeaways and Policy v Indonesia Economic Prospects June 2024 Preface Contents Table of Summary Executive The Indonesia Economic Prospects (IEP) is a bi-annual World Bank report that assesses recent macroeconomic developments, the outlook, and risks, as well as specific development challenges for the Indonesian economy. In doing so, the IEP aims to inform the public policy debate and is geared towards a wide audience, including the general public, Developments A.1. Recent Economic the government, the private sector, civil society organizations, and other domestic and international stakeholders. The IEP is a product of the World Bank Jakarta office and receives strategic guidance from an editorial board chaired by Satu Kahkonen, former Country Director for Indonesia and Timor-Leste, and from Carolyn Turk, Country Director for Indonesia and Timor-Leste. The report is prepared by the Macroeconomics, Trade and Investment (MTI) Global A.2. The Policy Practice team, under the guidance of Lars Christian Moller (Practice Manager), Cecile Thioro Niang (Practice Manager) Stance and Habib Rab (Lead Economist). The report is co-led by Wael Mansour (Senior Economist), Csilla Lakatos (Senior Economist), and Alexandre Laure (Senior Private Sector Specialist). Deviana Djalil provided administrative support and coordinated the organization of the report launch event. The A.3. Structural dissemination is organized by Gb Surya Ningnagara, Jerry Kurniawan and Maulyati N. Slamet under the guidance of Trends Lestari Boediono Qureshi. The report was designed and typeset by Arsianti. Part A was prepared by Wael Mansour and Csilla Lakatos (report leads), Dwi Endah Abriningrum, Indira Maulani Hapsari, Mochamad Pasha, Ratih Dwi Rahmadanti and Rong Qian. Inputs were provided by Anastasiya Denisova, A.4. Outlook and Risks Shreya Chatterjee (social protection and labor markets), Francesco Strobbe, Ou Nie (financial sector), William Hutchins Seitz (poverty), and Sara Giannozzi (Box 2). Part A benefitted from the comments of Habib Rab, as well as Kevin C. Chua and Samuel Christopher Hill as peer reviewers. A.5. Policy Part B was prepared by Alvaro Gonzalez (Lead Economist), Alexandre Laure (Senior Private Sector Specialist), Aufa Priorities Doarest (Economist), and Agnesia Adhissa Hasmand (Private Sector Specialist). Part B summarizes findings from an extended World Bank team for the Indonesia Investment and Competitiveness Program of the Finance, Competitiveness, and Innovation (FCI) global practice. Part B benefited from the comments of Habib Rab (Lead Economist), Francesco B.1. Introduction Strobbe (Lead Financial Sector Economist), Wael Mansour (Senior Economist), and Csilla Lakatos (Senior Economist). Inge Susilo (Program Assistant) provided administrative support. This report is available for download in English and Indonesian via: www.worldbank.org/iep Previous report editions: B.2. Performance of the Private Sector • December 2023: Climate Action for Development • June 2023: The Invisible Toll of COVID-19 on Learning • December 2022: Trade for Growth and Economic Transformation To receive the IEP and related publications by email, please contact ddjalil@worldbank.org. For questions and comments, Regualatory Uncertainty, please contact wmansour@worldbank.org and clakatos1@worldbank.org. the Next Challenge B.3. Tackling For information about the World Bank and its activities in Indonesia, please visit: www.worldbank.org/id instagram.com/worldbank Recommendations @BankDunia #IEPBankDunia www.linkedin.com/company/the-world-bank B.4. Takeaways and Policy   BankDunia vi Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Abbreviations Contents Table of Summary Executive ADR Alternative Dispute Resolution MSMEs Micro, Small and Medium Enterprises AHU Administrasi Hukum Umum Developments MoF Ministry of Finance A.1. Recent Economic AMDAL Analisa Dampak Lingkungan NBFI Bank Financial Institutions ARA EMARA Assessment of Reserve Adequacy NIB Nomor Identifikasi bisnis/Business for Emerging Markets Identifcation Number APBN Anggaran Pendapatan dan Belanja NFA National Food Agency Negara NPL Performing Loans A.2. The Policy ASEAN Association of Southeast Asian Nations NSFR Net Stable Funding Ratio Stance BI Bank Indonesia OECD Organisation for Economic Co-operation BKPM Badan Koordinasi Penanaman and Development Modal OMO Open Market Operation OPEC Organization of the Petroleum Exporting A.3. Structural BPS Badan Pusat Statistik Trends BOS Bantuan Operasional Sekolah Countries BOP Balance of Payment OSS Online Single Submission Bulog Badan Urusan Negara PBG Persetujuan Bangunan Gedung CAD Current Account Deficit PKH Program Keluarga Harapan A.4. Outlook CAR Capital Adequacy Ratio Posyandu Pos Pelayanan Terpadu and Risks CIT Corporate Income Tax Puskesmas Pusat Kesehatan Masyarakat CPI Consumer Price Index Pustu Puskesmas Pembantu EMDE Emerging Market and Developing REER Real Effective Exchange Rate Economy RHS Right Hand Side A.5. Policy Priorities EMBI Emerging Markets Bond Index ROA Return-On-Assets EAP East Asia Pacific ROE Return-On-Equity FDI Foreign direct investment RPDR Regulatory Policy and Delivery Review FX Foreign Exchange RRR Reserve Requirement Ratio B.1. Introduction GDP Gross Domestic Product Sakernas Survei Angkatan Kerja Nasional GEC Global Export Consortium SBN Surat Berharga Negara GOI Government of Indonesia SIUP Surat Izin Usaha Perdagangan GRP Good Regulatory Practice SIMBG Sistem Informasi Manajemen Bangunan GVC Global Value Chains Gedung B.2. Performance of the Private Sector HHI Herfindahl Hirschman Index SLF Sertifikat Laik Fungsi IEP Indonesia Economic Prospects SPHP Stabilisasi Pasokan dan Harga Pangan IFC International Finance Corporation Program IMF International Monetary Fund SRBI Sekuritas Rupiah Bank Indonesia INA Indonesian Investment Authority Susenas Survei Sosial Ekonomi Nasional IT Information Technology SVBI Sekuritas Valas Bank Indonesia Regualatory Uncertainty, JCOL Job Creation Omnibus Law TDP Tanda Daftar Perusahaan the Next Challenge JKK Jaminan Kecelakaan Kerja TFP Total Factor Productivity B.3. Tackling JKM Jaminan Kematian THL Tax Harmonization Law JKN Jaminan Kesehatan Nasional THR Tunjangan Hari Raya KBLI Klafisikasi Baku Lapangan Usaha TPAF Tax Policy Assessment Framework Indonesia VAT Value-Added Tax KKPR Kesesuaian Kegiatan Pemanfaatan Ruang WBES World Bank Enterprise Survey LAR Loan at Risk Yoy year-on-year Recommendations B.4. Takeaways LCR Liquidity Coverage Ratio and Policy LHS Left Hand Side v ii Executive Summary Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential E xe cut i ve Su m m a r y Contents Table of Summary Executive I. Economic Update At 5.1 percent in Q1-2024, GDP growth remains with rising interest payments could crowd out priority Developments A.1. Recent Economic resilient surpassing the middle-income countries’ and pro-growth spending, such as public investment. average. Robust private consumption accounted for Nevertheless, public debt declined to 39 percent of 57 percent of GDP growth. This reflects consumer GDP, with most of the debt stock in domestic currency confidence supported by softening inflation in non- (72 percent) and with maturities above one year (88 food products, the hike in civil servant wages, and percent), reducing currency and rollover risks. A.2. The Policy robust performance in consumer services. Public Stance consumption rebounded in Q1-24 driven by election- Bank Indonesia maintained a “tight interest rate, related and social spending. This rebound outweighs loose macroprudential” policy mix to strike a balance the negative contribution to growth of net exports as in supporting the currency and macroeconomic A.3. Structural weak global demand and commodities price volatility stability. In April 2024, BI raised its policy rate by 25 Trends have dampened exports earnings. bps, bringing it to 6.25 percent—the highest since 2016. The rate hike came as delays in anticipated Inflation accelerated again in 2024, after dipping policy rate cuts in advanced economies triggered throughout 2023, driven by persistent pressures notable portfolio and other investment outflows A.4. Outlook and Risks from food prices. Headline inflation rose to 2.8 causing currency pressures in many emerging markets, percent yoy in May but remains within Bank Indonesia’s including Indonesia. This situation was compounded target of 2.5±1 percent. Adverse climate conditions by rising domestic demand for foreign currency. reduced domestic rice harvests and affected food To soften the impact on the economy, BI is using A.5. Policy Priorities prices more broadly. The government had stepped macroprudential incentives to support credit growth. up efforts to curb food inflation by increasing the This includes expanding the coverage of Reserve quota for rice imports for 2024 to 4.1 million tons (up Requirement Ratio discounts to specific sectors. The from 3.1 million tons in 2023) and extending the rice expanded liquidity incentives are estimated to boost B.1. Introduction aid program to June. Price stabilization policies such private sector credit by an additional 1.6 percent by the as rice price ceilings imposed by the National Food end of 2024. Agency had unintended consequences, compounding temporary supply shortages. Meanwhile, fuel subsidies Going forward, the economy is expected to B.2. Performance of the Private Sector have stabilized transport fares and eased administered benefit from a pick-up in public consumption and services inflation to 1.0 percent yoy. investment but will face headwinds, notably from worsening terms of trade. GDP growth is projected The fiscal stance expanded slightly amid rising social to average 5.1 percent over the period 2024-26. spending and subsiding commodity windfalls. The Consumption will continue to drive growth, supported budget posted a small surplus of 0.1 percent of GDP in by a pick-up in public consumption as new social Regualatory Uncertainty, the Next Challenge Q1-24. Fiscal revenues declined by 4.2 percent yoy as spending programs from the incoming administration B.3. Tackling commodity windfalls subsided and economic activity take effect. Headline inflation is expected to remain moderated. Tax efficiency challenges have reduced stable, averaging 3 percent in 2024 and 2.9 percent the revenue gains from the previous VAT rate hike. thereafter, well within BI’s target band but facing Meanwhile, spending grew by 18 percent due to a rise upward pressure from food an energy prices. With in personnel and material spending as the GoI boosted increased social spending and public investment, the social assistance to mitigate the effects of El-Nino fiscal deficit is expected to be higher but remain within Recommendations B.4. Takeaways climate patterns on food prices. Pressures on energy the 3 percent rule. The external position is expected to and Policy subsidies are re-emerging amid geopolitical tensions, remain challenging due to sluggish recovery in global which raises international oil prices, and currency trade and financing pressures. The current account depreciation. Increasing spending pressures coupled deficit is projected to gradually widen and reach 1.6 1 Indonesia Economic Prospects June 2024 percent of GDP by 2026, as lower commodity prices redeploying resources from less effective programs and global uncertainty hamper exports. The outlook is Contents and subsidies, like energy subsidies, to spend on social Table of subject to multiple downside risks. High interest rates protection that serves all Indonesians across their could weigh on borrowing costs and tighten access to lifecycle. Existing systems such as the national health external financing, raising public debt servicing costs. insurance could also be leveraged. Summary Executive External shocks such as a potential intensification of armed conflicts or geopolitical uncertainty could result Beyond these short to medium-term cyclical in a sharper-than-expected decline in the terms of issues, four structural challenges to growth are trade, resulting in lower revenues and a tighter fiscal emerging and merit closer attention. In addition position. to maintaining macroeconomic fundamentals amid Developments A.1. Recent Economic a more complex global environment, tackling these Social spending packages planned under the structural challenges will solidify development gains upcoming five-year economic program have the of the past two decade and ensure faster and more potential to enhance human capital formation inclusive growth going forward. A.2. The Policy within a sustainable fiscal framework. A gradual Stance implementation of the programs coupled with tax First, a gradual increase in manufacturing reforms, which could bring yearly additional revenues concentration points to competitiveness challenges. of 1-1.5 percent of GDP, would help the government The rising share of food and beverages combined with adhere to its fiscal rules. Those rules have helped build the expansion of several commodity-based industries A.3. Structural a transparent and credible macroeconomic policy have led to a narrowing base for economic growth and Trends framework. reduced diversification in the manufacturing sector. This could be a source of increasing vulnerabilities to The authorities prudent and consistent sectoral downturns and the volatility of commodity A.4. Outlook macroeconomic policy framework has so far been prices. The marked expansion of basic metals and and Risks a cornerstone of Indonesia’s successful economic metal products industries accounted for one-third of performance. Such management was acknowledged manufacturing growth during 2021-23. Conversely, by the markets. For example, credit default swap other priority industries have underperformed relative rate and the JP morgan emerging market bond to their pre-COVID averages. Food and beverages— A.5. Policy Priorities index (EMBI) spread for Indonesia have consistently by far the largest contributor to manufacturing value fallen since the pandemic and are lower than several added—slowed, while textiles and apparel, has faced comparator countries. Credit rating agencies have with increasing challenges, including reduced export B.1. Introduction also maintained investment grade for sovereign credit demand, and tightening import restrictions. including stable outlook. As a result, this enabled the country to successfully navigate external shocks, Second, despite robust growth overall, there attract investment, and boost growth. is scope to accelerate subnational income convergence to sustain inclusion gains. Progress to B.2. Performance of the Private Sector In this context, reforms to boost domestic reduce regional income inequalities since the 1990s revenue mobilization remain a top priority. The slowed during the last decade. There has been also implementation of the Tax Harmonization Law will little improvement in the catch-up of other regions support this effort. However, given a tax gap of 6 with Java-Bali. Further, the divergence in income per percent of GDP, additional reforms to broaden the tax capita in Nusa Tenggara compared to the rest of the base, enhance compliance, and reduce widespread country, has been contributing to the growth inequality Regualatory Uncertainty, the Next Challenge informality among businesses will be important. in eastern Indonesia. The slowdown in convergence B.3. Tackling Specific reforms could include lowering tax thresholds, of investment partly explains the distribution and removing tax exemptions that do not benefit the dynamics of regional growth disparities, particularly poor, and improving audit mechanisms to enhance when considering Java-Bali, which has been driving compliance. In the medium-term, tax collection could investment trends. also be improved through third-party data that helps track and verify incomes/revenues. Along with the Third, post-pandemic labor market trends have Recommendations B.4. Takeaways need to boost revenues, improving quality spending slowed progress in reducing inequality after a and Policy is paramount particularly for social protection, health, decade of improving inclusion. Between 2015-19, and boosting human capital. This could be done by Indonesia made important progress to ensure that 2 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential gains from robust growth are more evenly distributed. reaches 39 percent in some of the world’s most mobile During this period, growth increasingly favored the countries like Australia. Partially because of these Contents Table of poorest half of the population and began reversing the trends, there has been no long-term convergence in trend of increasing inequality of the previous decade. welfare between Indonesia’s island groups over the For the top 10 percent, the pace of consumption growth past two decades. Therefore, enabling mobility will be Summary Executive fell by half, while doubling for the poorest 10 percent of important to match workers with jobs and locations people. In 2015, growth for the bottom half outpaced that offer higher earnings and improved standards of the top for the first time in a decade. A strong labor living. market, increasing returns to skills and a rise in wages in all sectors pushed the Gini Index down by nearly 4 As Indonesia navigates these complex economic Developments A.1. Recent Economic points. However, in the aftermath of COVID-19 the Gini dynamics, the next phase of growth will require Index began to slowly rise again, now at 0.36. After a boost to private sector dynamism. Addressing accounting for inflation, median wages have yet to structural challenges and leveraging potential growth fully recover to their pre-pandemic levels. areas is crucial for sustaining the progress made A.2. The Policy thus far. This calls for a strategic focus on enhancing Stance Fourth, inclusive growth will require mobility to productivity, improving regulatory frameworks, and take on new jobs in higher productivity sectors, and ensuring inclusive growth. Central to this is the role of in higher productivity places. Spatially, Indonesia is the private sector, which is poised to remain a significant one of the least mobile countries in the world, and driver of economic expansion and innovation. As such, A.3. Structural the trends are worsening. The internal migration rate the focus must shift towards unleashing Indonesia’s Trends between provinces was just 2.3 percent in 2023. This business potential and fostering a robust and dynamic is lower than pre-pandemic, lower than the global private sector capable of propelling the country average of 8 percent, and far from the frontier, which towards high-income status. A.4. Outlook and Risks II. Unleashing Indonesia’s Business Potential Indonesia stands at a critical juncture in its economic Philippines, and Türkiye. These industrial giants have A.5. Policy Priorities development, with the private sector poised to played a significant role in Indonesia’s development assume a more pivotal role in driving growth and but have recently begun to exhibit slowing productivity innovation. To transcend its middle-income status, growth. Indonesia must accelerate annual growth to more than B.1. Introduction 6 percent. This would require a productivity increase Reforms to boost private sector development have of 3 percent—one percentage point higher than been notable, but regulatory and productivity gaps recent averages. Attaining the ambitious goal of high- still exist. Indonesia has been on a transformative income status by 2045 demands a significantly more journey since 2015, implementing significant economic B.2. Performance of dynamic and productive private sector. This report reforms to enhance the business environment. Reforms the Private Sector examines the necessary pathways to fostering such a such as the Job Creation Omnibus Law in 2020 and transformation by analyzing private sector dynamics, investment liberalization have yielded tangible evaluating current performance, assessing the impact improvements. Notably, establishing the Online Single of regulatory reforms, and addressing the persistent Submission (OSS) system has harmonized business challenges that lie ahead. registration and licensing processes, significantly Regualatory Uncertainty, easing the operational burden for businesses through the Next Challenge B.3. Tackling Indonesia’s private sector is characterized by many adopting a risk-based approach. Despite the strides small firms, but economic dominance of a few large made, the country’s private sector grapples with firms. Indonesia’s private sector is vast, home to 66 significant challenges. Regulatory unpredictability and million businesses, of which 9 million are formally corruption persist as major hurdles, impeding smooth registered. It is predominantly composed of micro, business operations. Objective measures indicate that small, and medium-sized enterprises (MSMEs), with access to finance and regulatory compliance costs are Recommendations B.4. Takeaways a significant presence in wholesale and retail (54%), substantial productivity constraints. The perceived and Policy accommodation and food services (20%), and the improvement in business licensing is overshadowed processing industry (14.5%). On the other side of the by the increased time required to meet regulatory size spectrum, the enduring dominance of giant firms requirements, posing a significant challenge for sets Indonesia apart from peers like India, Mexico, the businesses. 3 Indonesia Economic Prospects June 2024 The first challenge for Indonesian firms is to improve resource allocation, particularly in the employment labor productivity. The performance of Indonesian of labor and capital resources compared to their Contents Table of firms, particularly in terms of labor productivity, market share. Unlike in comparator economies, such lags that of firms in comparator countries. Labor inefficiencies are less pronounced. productivity declined from US$7,530 per worker in Summary Executive 2015 to US$5,336 in 2023, partly due to the economic The third challenge lies in addressing the underlying impacts of the COVID-19 pandemic. Indonesian firms uncertainty and bias in implementing regulations. also exhibit lower average sales and employment Uncertainty results in discretion from enforcers of figures than those in Türkiye, Mexico, and India. government mandates. Discretion leads to bribery and petty corruption, which continues to hamper firm Developments A.1. Recent Economic Potential growth had been declining due to productivity by diverting resources from investment weaker labor input, human capital formation, and and increasing operational costs. Large firms are better productivity growth. While investment and labor able to navigate these frictions due to higher financial previously fueled growth, the post-pandemic period and administrative resources. Large firms can afford A.2. The Policy has seen a moderation, with total factor productivity specialized legal and compliance teams to interpret Stance (TFP) particularly affected. TFP growth in the 2010s was and adhere to regulations, mitigating compliance half that of the 2000s. The decline in TFP and human costs. In contrast, smaller firms often lack the resources capital aligns with lower labor productivity growth (see and expertise to navigate constantly evolving Indonesia Economic Prospects June 2023 for more regulatory landscapes, leading to comparatively A.3. Structural details). These findings highlight the importance of higher compliance costs. This uncertainty also exposes Trends improving private sector productivity to create jobs all firms to corruption, which is more burdensome for with rising labor productivity. smaller firms. A.4. Outlook The second challenge is the market dominance of Enhancing regulatory consistency and fostering and Risks large firms exhibiting falling productivity growth. access to international markets are key to A significant feature of Indonesia’s private sector is unleashing the potential of the Indonesian private the pronounced firm size and performance inequality. sector and driving sustained economic growth. To A few large firms dominate the market, while most enhance regulatory consistency, establishing a more A.5. Policy Priorities enterprises remain small and less productive. In the predictable regulatory environment is crucial. This past 31 years, the top 5 percent of large manufacturing involves consistently applying rules across regions firms continue to accrue a disproportionately large and sectors to reduce uncertainty and boost business B.1. Introduction revenue share. This is not necessarily a problem if firms confidence. Meanwhile, to foster Access to International are growing large through productivity gains that have Markets, easing access to global markets can enhance strong multiplier effects across the economy through the competitiveness of Indonesian firms and make better jobs, supply chain linkages, innovation, and large firms more productive. Policies integrating other spillovers. local firms into global value and supply chains will B.2. Performance of the Private Sector require upgrades in technology, management, and, Globally, larger firms, defined by annual sales, increasingly, greening production. generate more employment. However, this relationship is notably weaker in Indonesia than in By addressing these key areas, Indonesia can comparator economies. This suggests that sales create a more dynamic and resilient private sector growth in larger Indonesian firms does not translate capable of driving long-term economic growth and Regualatory Uncertainty, the Next Challenge into as much employment as in other economies. improving the quality of life for its citizens. The B.3. Tackling However, large Indonesian firms offer higher wages journey towards a more prosperous Indonesia requires than their smaller counterparts, like trends observed sustained effort and a commitment to reform, ensuring in comparator economies. The analysis also finds that that the benefits of economic growth are widely shared large Indonesian firms demonstrate inefficiencies in across all segments of society. Recommendations B.4. Takeaways and Policy 4 A. Economic Update Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential A. Economic Update Contents Table of Summary Executive 1. Recent Economic Developments At close to double the world average, Indonesia’s consumption accounted for more than 60 percent Developments A.1. Recent Economic growth remained robust. of 2023 growth (Figure A.1). Public spending in 2023 was softened by delays in budget execution but Despite steady recovery, global economic conditions accelerated in Q1-24 with increased election and social remain challenging. Exceptionally weak global trade spending. Weak global demand and commodities price growth in 2023—the slowest expansion outside global volatility dampened exports earnings and normalized A.2. The Policy Stance recessions in the past 50 years—has been exacerbated commodity windfalls. The contribution of net exports by restrictive policies and fragmentation. Commodity to growth remained steady at 0.7 percentage points prices, despite recent volatility, have fallen from their (ppts) in 2023 but turned negative in Q1-24. Capacity 2022 peaks. Nevertheless, geopolitical tensions have utilization has been increasing and averaged 73.6 A.3. Structural sustained pressure on the price of oil and other percent in Q1-24, above the pandemic low of 69.1 Trends commodities even as global growth remained weak percent (Figure A.2). (World Bank 2024c). Delays in anticipated policy rate cuts in advanced economies have led to foreign Inflationary pressures are re-emerging as climate A.4. Outlook capital outflows and the sharp depreciation of several conditions and supply bottlenecks impact food and Risks emerging market and developing economy (EMDE) prices. currencies. After decelerating in 2023, inflation picked up again Indonesia’s GDP growth remains resilient. The in 2024 as pressure from food prices intensified. A.5. Policy Priorities economy grew by 5 percent in 2023 and by 5.1 Headline inflation accelerated to 2.8 percent yoy in May percent in the first quarter of 2024 (Q1-24). This is (from 2.6 percent in January) but remained within Bank close to double the world average at 2.6 percent and Indonesia’s (BI) 2024 target band of 2.5 +/- 1 percent. B.1. Introduction higher than the middle-income country average at The increase was driven by renewed pressures on food 4.5 percent. As consumer confidence remained strong prices (Figure A.3). Basic food inflation rose by 8.1 and supported by declining inflation, robust private percent yoy mirroring escalating prices of staple crops Figure A.1: GDP growth remains solid, supported by Figure A.2: Capacity utilization has been increasing B.2. Performance of the Private Sector strong private and public demand. (percent of total capacity) (percentage points contribution to yoy growth) Private consumption Government consumption Investment Net exports Q4-22 Q1-23 Q2-23 Q3-23 Q4-23 Q1-24 Stat. discrepancy GDP 77 6 5.0 5.1 Regualatory Uncertainty, 75 the Next Challenge B.3. Tackling 4 73 2 71 69 0 Recommendations 67 B.4. Takeaways and Policy -2 65 Mar-22 Sep-22 Mar-23 Sep-23 Mar-24 Agriculture Mining Manufacturing Total Source: BPS, World Bank staff calculations. Source: BI, Business Activity Survey, World Bank staff calculations. 6 Indonesia Economic Prospects June 2024 and basic food items like rice, chicken meat, and eggs, (Figure A.4). In addition to climate shocks, which which were heavily impacted by climate shocks. Drier considerably reduced domestic production for staple Contents Table of than normal conditions brought by the El Niño in 2023 crops especially that of rice (down 17.5 percent in the reduced and delayed rice harvests in early 2024. This first 4 months of 2024), price stabilization policies coincided with the cyclical increase in demand during had unintended and adverse consequences. Price Summary Executive Islamic festivals falling in March and April. Additionally, ceilings imposed by the National Food Agency (NFA) El Niño-induced drought reduced domestic corn had compounded supply shortages as mills reduced production and raised corn farmgate prices in 2023 production to avoid financial losses, and retailers faced until the peak harvest season in April 2024, when prices challenges sourcing subsidized medium-grade rice.² started to decline again. This further caused a rise in Moreover, the GoI through BULOG—the state-owned Developments A.1. Recent Economic the prices of poultry products which rely on corn for food logistics company—prioritized the allocation of feed. The Rupiah depreciation also had adverse effects this subsidized rice to administer the rice aid program. on imported food items including agriculture inputs. As a result, temporary shortages were observed at Meanwhile, fuel subsidies partially stabilized transport the more regulated modern markets, while prices A.2. The Policy costs and kept administered services inflation to 1.0 escalated at the mostly informal traditional markets. In Stance percent yoy (from 0.8 percent in January) despite response to shortages, the NFA had to relax the cap rising demand during holidays period. On the other on mill and retail rice prices, from March till June,³ and hand, core inflation edged up to 1.9 percent yoy partly raised the import quota for other volatile food items driven by a temporary consumption boost and the such as garlic and corn. A.3. Structural early disbursement of employees’ holiday allowances. Trends Overall, core inflation remains subdued and reflects a Tight global monetary conditions are impacting persistent, albeit closing, negative output gap. Indonesia’s external financing, triggering pressure on foreign currency reserves and the Rupiah. A.4. Outlook Food inflation is at historical highs, partly due to and Risks policy challenges related to the domestic food Global financial conditions remained tight as value chains, particularly in rice. The government expectations of US policy rate cuts diminished. (GoI) stepped up efforts to curb persistent food By the end of 2023, global markets anticipated that inflation by increasing the quota for rice imports for major advanced economy central banks would pivot A.5. Policy Priorities 2024 to 4.1 million tons (up from 3.1 million tons in from monetary tightening to easing. Subsequently, 2023) and extending the rice aid program to June.¹ however, expectations around the pace and depth Nonetheless, domestic food inflation remains high of policy rate cuts moderated. In the US, tight labor B.1. Introduction especially when compared to global and peer averages markets and fluctuating core inflation data have Figure A.3: Headline inflation eased, but food price Figure A.4: …partly due to challenges in the inflation remained strong… domestic food supply chain, particularly in rice (percentage points contribution to yoy growth) (percent, yoy) B.2. Performance of the Private Sector Non-administered services Indonesia, food inflation 34 Administered services 8 30 Average peers, food inflation Non-food 26 Food Global, food inflation 22 6 Headline inflation 18 14 10 4 6 Regualatory Uncertainty, 2 the Next Challenge -2 B.3. Tackling 2 -6 -10 0 -14 -18 Source: BPS, World Bank staff calculations. Source: FAO, World Bank Commodity Price Pink Sheet, World Bank Recommendations B.4. Takeaways Note: Administered services consist of housing, water, electricity, and staff calculations. and Policy fuels and transportation. Note: Peer countries are Thailand, India, the Philippines, Malaysia, and Vietnam. 1 In November 2023, the government announced the distribution of 10 kilograms of rice per month to the bottom 40 percent households. 2 This changed though in March where BULOG started to distribute subsidized medium-grade rice to both traditional and modern retailers as part of the Price Stabilization Program (SPHP). 3 In addition to rice, the NFA is also relaxing the retail reference prices for sugar, corn, eggs, and chicken meat until May 31. 7 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential prompted the Federal Reserve to push back against attributed to declining commodity exports, namely market expectations of aggressive rate cuts. Between mining, reflecting delays in mining permit approvals Contents Table of December 2023 and May 2024, global markets went and the decline of global commodity prices. While the from pricing in six US Fed Rate cuts (each by 25 bps) Rupiah saw a relatively sharper nominal depreciation, in 2024, to only one. Global financial conditions have the real effective exchange rate (REER)4 weakened Summary Executive therefore tightened, leading to an increase in the yield modestly compared to Asian peers (Figure A.8). The of the 10-year US Treasury bills (T-bills) by 40 basis simultaneous depreciation of several trading-partner points (bps) year-to-mid-June (now at 4.5 percent). currencies against the US Dollar partly explains why This prompted debt and equity portfolio outflows from the weaker Rupiah did not correspond to increased EMDEs, with notable outflows and currency pressures competitiveness of Indonesia’s exports. Tourism Developments A.1. Recent Economic in the East Asia region. receipts benefitted and posted the largest surplus since the pandemic (at 0.3 percent of GDP). Indeed, foreign In tandem, there were notable portfolio and other tourist arrivals in Q1-24 rose by 25.4 percent yoy, with investment outflows from Indonesia, as well as a monthly average of 1 million tourists—close to the A.2. The Policy rising domestic demand for foreign currency (FX). pre-pandemic average of 1.3 million. As a result, the Stance Portfolio investment, which is particularly susceptible services trade deficit moderated to 1.3 percent of GDP. to shifts in short-term investor sentiment, recorded a Meanwhile, the income account remained unchanged net outflow of 0.5 percent of GDP in Q1-24, a reversal at 2.2 percent of GDP (broadly, the same level since from the inflows of 1.4 percent of GDP in Q4-23. This 2018). As a result, the Q1-24 current account deficit A.3. Structural trend accelerated in April, with non-resident investors (CAD) widened by 0.3 ppts and recorded -0.6 percent Trends offloading US$1.5 billion in Indonesian sovereign of GDP (Figure A.9). bonds, US$1.0 billion in equities, and US$0.7 billion in SRBI (BI’s local currency securities) (Figure A.5). Worsening external conditions have pressured BI’s A.4. Outlook Outflows from Indonesia in March-April were larger foreign currency reserves and the Rupiah, but the and Risks than ASEAN EMDE peers (Figure A.6). Concurrently, impact softened after the central bank hiked its Indonesia’s yield spread against US T-bills has policy interest rate. With CAD and portfolio outflows narrowed and has been below that of other EMDEs deteriorating, BI’s FX reserves dropped rapidly by since mid-2022 (Figure A.7). The situation changed in US$4.2 billion in April. Using the assessment of A.5. Policy Priorities May after BI raised its policy rate. In parallel, Indonesian reserve adequacy for emerging markets (ARA EM) residents have increased investment in money market methodology,5 Indonesia’s ratio of reserves to ARA EM instruments abroad, reversing “other investment” metric recorded 1.1 by end-2023. While this is within B.1. Introduction account from a surplus to a deficit of 1.3 percent of the [1.0-1.5] band recommended by the IMF, the ratio GDP. Pressures were compounded by an apparent is among the lowest of ASEAN peers (Figure A.10). rise in FX demand domestically. Corporations had to Outflows have also pushed the Rupiah to multiyear shore up their FX buffers ahead of the dividend and lows, crossing the exchange rate of 16,200 per US$ in foreign debt payment season in Q2-24. Foreign Direct April. This prompted BI to react and raise the policy B.2. Performance of the Private Sector Investment (FDI), which picked up by 0.3 ppts reaching interest rate in April, spurring significant portfolio 1.8 percent of GDP in Q1-24, remains the largest source inflows in May (Figure A.5). As a result, FX reserves was of external finance, partly offsetting pressures from up by US$2.8 billion, and it now covers 6.3 months of short-term portfolio volatility. imports. The Rupiah temporarily improved thereafter, but overall, it depreciated by 6.0 percent year-to-mid- Worsening terms of trade led to a widening current June. The Rupiah’s depreciation is deeper than the Regualatory Uncertainty, the Next Challenge account deficit. The goods trade surplus narrowed depreciation of JP Morgan’s EM Currency Index at 4.5 B.3. Tackling to 2.9 percent of GDP in Q1-24, down 0.5 ppts from percent during the same period. Q4-23, on the back of declining exports. This is mostly Recommendations B.4. Takeaways and Policy 4 REER is measure of the Rupiah against a trade-weighted basket of currencies after adjusting for inflation. ⁵ ARA EM metric, developed by the IMF, gauges the adequacy of international reserves. The ratio of reserves to ARA EM metric depicts the coverage of a country’s FX reserves against four potential drains on the BoP: export income, broad money, short-term debt, and other liabilities. In general, ratios in the range of 1.0 – 1.5 of the metrics are considered broadly adequate for precautionary purposes (IMF, 2023). 8 Indonesia Economic Prospects June 2024 Figure A.5: April saw the largest capital outflows in the Figure A.6: Portfolio outflows were larger than past two years those observed in ASEAN EM peers, but situation Contents Table of (LHS: US$ billion; RHS: IDR/US$) revered in May after BI policy rate hike (portfolio outflows in percent GDP) 7 16,400 1.0 Summary Executive 5 16,000 0.8 Philippines Malaysia 0.6 3 15,600 Indonesia 0.4 1 15,200 0.2 Developments A.1. Recent Economic 0.0 -1 14,800 -0.2 Foreign flows to SRBI -3 14,400 -0.4 Foreign flows to equity Thailand Foreign flows to govt bonds -0.6 A.2. The Policy -5 IDR/USD - RHS 14,000 Feb-23 Feb-24 Jul-23 Jun-23 Aug-23 Oct-23 Jan-23 Jan-24 Nov-23 Dec-23 Mar-23 Mar-24 May-23 May-24 Apr-23 Sep-23 Apr-24 Stance Source: BI, IDX, MoF, World Bank staff calculations. Source: IIF, BI, IDX, World Bank staff calculations. A.3. Structural Figure A.7: Indonesia’s sovereign yield spread against Figure A.8: The Rupiah depreciated modestly in real Trends the US is narrower than for EM peers effective terms among regional peers (percentage points) (percent change, year-to-April) 8 2 A.4. Outlook and Risks 1 EMBI - US 6 0 10Y yield -0.2 spread -1 A.5. Policy Priorities 4 -2 -3 2 ID - US -4 B.1. Introduction 10Y Thailand Korea Philippines Vietnam Malaysia Indonesia Japan yield spread 0 Jan-20 Jan-21 Jan-22 Jan-23 Jan-24 Source: JP Morgan, CEIC, World Bank staff calculations. Source: JP Morgan Real Effective Exchange Rate, CPI based B.2. Performance of the Private Sector Note: EMBI is JP Morgan Emerging Market Bond Index yield. (2010=100), Haver Analytics, World Bank staff calculations. Note: Downward movement represents a depreciation. Figure A.9: The current account deficit widened due to Figure A.10: Indonesia’s ratio of reserves to IMF’s narrower surplus in goods trade ARA metric was the lowest among peers (percent of GDP) (ratio, at end of the year) Regualatory Uncertainty, Income 2.0 the Next Challenge Services trade 2022 2023 B.3. Tackling 6 Goods trade Current account balance 1.5 Suggested adequacy range 4 1.161.12 2 1.0 Recommendations 0 B.4. Takeaways and Policy -0.6 0.5 -2 -4 0.0 Mar-21 Sep-21 Mar-22 Sep-22 Mar-23 Sep-23 Mar-24 Indonesia Malaysia Philippines Thailand Source:BI, CEIC, World Bank staff calculations. Source: IMF Assessment of Reserve Adequacy, April 2024. 9 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Banking sector vulnerabilities remain low, liquidity objectives. Funding liquidity impacts the banking buffers adequate, and profitability strong thanks to sector’s ability to repay deposits and other short-term Contents Table of growing lending to the private sector. liabilities. Market liquidity refers to the ability of the banking sector to sell assets in a timely fashion without Bank asset quality is healthy, and banks have a significant loss. The liquidity coverage ratio (LCR) and Summary Executive adequate buffers to withstand potential adverse the net stable funding ratio (NSFR), designed to gauge shocks. System-wide non-performing loans (NPL) bank liquidity conditions in times of stress, stood at 219 ratio remains low at 2.3 percent as of March 2024 and 134 percent respectively, as of March 2024. Both (Figure A.11). The capital adequacy ratio (CAR) stood are above the 100 percent regulatory minimum. While at 26 percent, well above the regulatory minimum the loan-to-deposit ratio remains stable at 84 percent, Developments A.1. Recent Economic of 10.5 percent, and the level of provisioning was at the liquid asset-to-deposit and short funding ratio has 206 percent of NPLs, providing ample loss-absorption seen a consistent decline since mid-2021, in part due to capacity. Notably, the system-wide loan at risk (LAR) the growth of deposits during the commodity boom. ratio⁶ continued to trend down to only 11.1 percent as As of March 2024, it stood at 17.8 percent, below EAP A.2. The Policy of March, much lower than its levels of over 20 percent peers’ average and lower than 24-27 percent during Stance during COVID-19.⁷ Although a very limited set of the pandemic. Taken together, these developments forbearance measures have been extended until March indicate that funding and market liquidity remain ample 2024, with no further extensions, any vulnerabilities as BI conducts regular open market operations to drain that remain hidden are contained and unlikely to be excess liquidity and maintain an appropriate balance in A.3. Structural systemic for the overall banking system. However, the the market following the end of “twist operation” in Trends transfer of credit risks via credit insurance to the non- September 2023. The decline in the liquid asset ratio, bank financial institutions (NBFI) sector warrants close while largely reflecting banks’ continued willingness to monitoring. Efforts to reduce information asymmetry lend instead of hoarding excess liquidity, warrants close A.4. Outlook between banks and insurers and facilitate better monitoring of potential funding stress in the case of an and Risks pricing of risks would be beneficial. adverse shock. Ensuring adequate liquidity support for the growing NBFI sector also requires attention as it Banking sector profitability remains stable, as will impact market development for this segment of strong lending growth rates continue to support the financial sector. A.5. Policy Priorities the economy. As of March 2024, return-on-assets (ROA) and return-on-equity (ROE) stood at 2.6 and 14.6 Borrowing costs and domestic funding conditions percent, respectively, surpassing pre-pandemic levels. remain relatively stable due to largely contained B.1. Introduction The banking sector continues to expand lending to the risks, although funding costs are elevated relative private sector. After two and a half years of growth, to peers due to structural factors. Corporate bond lending to the private sector expanded by 12.4 percent issuance activities were subdued in every month of 2023 yoy in March (Figure A.12), albeit at a slower pace as compared to the same period in 2022, with issuance credit-to-GDP ratio has seen some decline. Moreover, totaling IDR830 million throughout 2023, and remains B.2. Performance of the Private Sector the growth of loans used for investment and working weak in Q1-24. Corporate borrowing costs remained capital has outpaced the growth of loans used for stable, as the 10-year AA corporate bond yield stood consumption. As of February, lending to micro, small at 8.9 percent in April 2024. Ten-year sovereign yield and medium enterprises (MSMEs) stood at IDR1,468 remained manageable at 7.1 percent in April following trillion (6.5 percent of GDP) and accounted for 20.3 a rise in non-resident holding of government debt percent of all bank lending. This is an increase from in 2023 for the first time since the pandemic. The Regualatory Uncertainty, the Next Challenge the lower baseline of 18 percent during COVID-19 and capital market still lacks depth, with limited secondary B.3. Tackling marks an improvement in financial inclusion for the trading, relative to global and regional peers and underserved segments of the economy. Indonesia’s own economic growth. The lack of local long-term investors constrains market development System-wide funding and market liquidity are and contribute to higher cost of borrowing relative to still ample with BI conducting regular liquidity some ASEAN peers and emerging market peers.⁸ management operations to balance different policy Recommendations B.4. Takeaways and Policy 6 LAR is a forward-looking indicator of bank asset quality defined as the sum of NPLs, restructured loans, and special mention loans. 7 The nine largest banks saw a LAR level exceeding 20 percent between 2021-2022 but all have since seen continued improvement. 8 Peer countries with lower cost of borrowing relative to Indonesia, after controlling for other factors, include Malaysia. Thailand, the Philippines, Vietnam, as well as global peers such as Colombia, Hungary, Peru and Mexico. See Buzas et al (2021). 10 Indonesia Economic Prospects June 2024 Figure A.11: Banks have adequate buffer to withstand Figure A.12: Lending to the private sector expanded Contents Table of potential adverse shocks in March (percent) (percent, yoy) Provision to NPL (RHS) 21% Total Loan Working Capital NPL (LHS) Investment Consumption Summary Executive CAR (LHS) 30% 240% 14% Tier-1 Capital (LHS) 20% 210% 7% Developments A.1. Recent Economic 10% 180% 0% 0% 150% -7% Jul-20 Jul-21 Jul-22 Jul-23 Nov-20 Nov-21 Nov-22 Nov-23 Mar-20 Mar-21 Mar-22 Mar-23 Mar-24 Jul-20 Jul-21 Jul-22 Jul-23 Nov-20 Nov-21 Nov-22 Nov-23 Mar-20 Mar-21 Mar-22 Mar-23 Mar-24 A.2. The Policy Stance Source: OJK, World Bank staff calculations. A.3. Structural 2. The Policy Stance Trends Fiscal policy has expanded amid a combination of contracted the most, particularly in the oil sector, as rising social spending, debt service obligations, and several oil fields depleted.10 subsiding commodity windfalls. A.4. Outlook and Risks Tax efficiency challenges have reduced the revenue After two years of fiscal consolidation, the fiscal gains from the VAT rate hike. Since the implementation stance loosened slightly. The fiscal accounts posted of the Tax Harmonization Law (THL) in April 2022, VAT a much smaller surplus in January to April of 2024 collection rose to 3.5 percent in 2022 and further to 3.7 A.5. Policy Priorities (4M-24) compared to the same period in 2023 (Figure percent in 2023. This increase can be partly attributed A.13). Government revenues declined by 7.7 percent to the VAT rate hike as well as the commodity price yoy as the effect of commodity windfalls subsided. At boom, which boosted domestic income and resulted the same time, spending grew by 10.9 percent due in higher VAT collection. Indeed, the commodity-led B.1. Introduction to rising primary expenditures (notably personnel income boost has offset the decline in demand that and material spending) as the GoI boosted social typically accompany a VAT hike due to rising prices. assistance to mitigate the effect of El-Nino on food Estimates suggest that the absolute effect of the rate prices. Meanwhile, net financing needs stood at 0.3 hike on VAT revenues was only 0.3 and 0.4 percent of B.2. Performance of percent of GDP in April, the smallest in ten years for GDP in 2022 and 2023, respectively. the Private Sector similar periods. Growth in total government spending accelerated. Revenues were impacted by subsiding commodity Total spending rose to 3.8 percent of GDP in 4M-24, windfalls. January to April revenues stood at 4.1 percent slightly higher from 3.7 percent in 4M-23. Personnel and of GDP, down from 4.8 percent of GDP a year earlier, material spending as well as interest payments were the Regualatory Uncertainty, explained mostly by the decline in natural resource largest contributors (Figure A.15). Personnel spending the Next Challenge B.3. Tackling revenues and tax revenues (Figure A.14). The drop in rose significantly following an 8 percent increase in tax revenues was mostly attributed to Income Tax and civil service salaries and the early disbursement of VAT, as domestic demand softened and commodity Eid allowance (Tunjangan Hari Raya/THR) in March. prices gradually declined. The government cited higher Material spending also picked up mostly due to the tax refunds as companies overpaid their taxes based disbursement of the school operational assistance on estimated revenues but then requested refunds (Bantuan Operasional Sekolah/BOS) and spending Recommendations due to worse-than-expected business performances.⁹ related to election preparation (APBN Kita, May 2024). B.4. Takeaways and Policy Among non-tax revenues, natural resource revenues Interest payments stood broadly unchanged at 0.7 9 Low commodity prices drag down state revenue, The Jakarta Post, March 25, 2024 (limited access) 10 APBN Kita, March 2024. 11 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential percent of GDP, despite the depreciation of the Rupiah. latter remained broadly flat, averaging 1.3 percent of Meanwhile, the GoI maintained the cash transfer and GDP since 2019. Compared to peers, public capital Contents Table of rice aid programs to mitigate the impact of rising food stock remains relatively low (Figure A.17). prices and announced an extension of the assistance to June 2024. As a result, social protection spending is Public debt remained flat, but global monetary Summary Executive expected to be 7.8 percent higher than the initial budget tightening and rising financing costs are changing allocation for 2024 (Figure A.16).11 In anticipation, MoF the composition of investors. With a budget balance extended the “automatic adjustment” mechanism in small surplus, central government debt to GDP that locks 5 percent of the allocated budget from stood at 38.6 percent in April, down from 38.8 percent each ministry/agency as contingency fund for shifting by end-2023. Most of the debt stock is domestic Developments A.1. Recent Economic expenditure priorities.12 (71.1 percent of total debt) and primarily medium to long-term (more than 90 percent). This reduces After a material drop at the start of the year, rollover and exchange rate risks. The largest share of pressures on energy subsidies are re-emerging government bonds is held by commercial banks (24 A.2. The Policy amid geopolitical tensions and recent currency percent), followed by BI with an increasing share since Stance depreciation. For January-to-April, subsidies dropped the pandemic (Figure A.18). BI’s purchases since 2023 by 16.4 percent. However, pressures are re-emerging have occurred though on the secondary market14 and as the Middle East conflict weighs on global energy are aimed at supporting yields rather than providing prices combined with the depreciation of the Rupiah. emergency financing as was the case during COVID-19. A.3. Structural In May, oil prices and the Rupiah were 1.7 and 8.3 Indeed, the bid-cover ratio has been declining, Trends percent higher than in the 2024 budget assumptions, reflecting weakening demand for GoI bonds despite respectively.13 It is estimated that a depreciation of higher yields (up 43 bps since April 2023 for long-term IDR500 against the US$ or every US$5 increase in the bonds). This follows global monetary tightening and A.4. Outlook oil price will raise the total subsidy spending by 0.1 investors’ appetite to purchase advanced economies’ and Risks percent of GDP, if demand remains unchanged. The debt. As a result, non-resident holding of Indonesia’s rising pressure from subsidy spending coupled with sovereign debt declined by 2.6 percent yoy in levels rising interest payments could crowd out priority and and by 1.2 ppts as a share. pro-growth spending, such as public investment. The A.5. Policy Priorities Figure A.13: Fiscal balance posted a small surplus… Figure A.14: …as revenues declined with subsiding (percent of GDP) commodity windfalls B.1. Introduction (contribution to revenue growth, percent, ppts) Grants 2.0 Revenues from public services 60 Other non-tax revenues Profits of SOEs 0.0 Natural resources revenues B.2. Performance of the Private Sector Tax revenues 40 Total revenues -2.0 2019 20 2020 -4.0 2021 2022 2023 0 Regualatory Uncertainty, -6.0 the Next Challenge 2024 B.3. Tackling -8.0 -20 Apr-19 Apr-20 Apr-21 Apr-22 Apr-23 Apr-24 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Recommendations B.4. Takeaways and Policy 11 Social protection spending is estimated to reach IDR 536 trillion in 2024 (2.4 percent of GDP), compared to an allocated budget of IDR 497 trillion (2.2 percent of GDP). 12 The ministry of finance has used this mechanism for emergency funds since 2022. 13 The 2024 Budget assumes an oil price of US$82 per barrel and a rupiah currency of IDR 15,000 to the US$. 14 During the COVID period, Bank Indonesia and the Ministry of Finance agreed on the ‘burden-sharing’ mechanism, where BI supported the MoF in financing the deficit. The support from BI was first introduced in April 2020 through a BI-MoF joint decree. The program was time bound and ended in 2022. 12 Indonesia Economic Prospects June 2024 Figure A.15: At the same time, expenditure growth Figure A.16: And the government increased its social Contents Table of picked up significantly protection spending (contribution to spending growth, percent, ppts) (IDR trillion) Other 20 Capital Interest payment Conditional cash transfer (PKH) Subsidy Social expenditure Summary Executive Voucher-based food aid (BPNT) Others Personnel 600 Subsidy 15 Material Total expenditure El Nino cash transfer + rice aid 10 400 Developments 5 A.1. Recent Economic 0 200 (5) (10) A.2. The Policy 0 Apr-19 Apr-20 Apr-21 Apr-22 Apr-23 Apr-24 2019 2020 2021 2022 2023 2024 Stance Figure A.17: Indonesia’s general government capital Figure A.18: Demand for Indonesian government stock is among the lowest among peers bonds lessened A.3. Structural (percent of GDP) (percent of total government bond) Trends 200 2000-2010 2015-2019 100 90 Foreign / Non-resident 150 80 A.4. Outlook and Risks 70 100 60 Commercial banks 50 50 40 Central bank A.5. Policy 30 Priorities 0 20 Other domestic investors 10 0 B.1. Introduction May-19 May-20 May-21 May-22 May-23 May-24 Source: Ministry of Finance, CEIC, World Bank Commodity Monitor, IMF Investment and Capital Stock Database, World Bank staff calculation. Bank Indonesia raised its policy rate to maintain This move complements efforts initiated by BI in Q4- currency stability and adequate external buffers, 23 to issue new securities—the SRBI, SVBI and SUVBI15 B.2. Performance of the Private Sector while it also provided macroprudential liquidity —designed to attract foreign currency from non- incentives to spur private credit growth. residents and domestic investors. Faced with mounting pressures on FX reserves and The rate hike helped reverse portfolio outflows. The the currency, BI increased its policy rate. External BI rate hike translated in higher interest on the SRBI, Regualatory Uncertainty, pressures prompted BI to unexpectedly raise the policy improving the appeal for these securities especially the Next Challenge rate by 25 bps in April, bringing it to 6.25 percent—the among non-resident investors (Figure A.5). Indeed, B.3. Tackling highest since 2016. BI rate hike, the first in six months, ownership significantly increased from 18.3 to 27.3 surprised market analysts who were factoring in cuts percent between April and May (see Box A.1). This has as early as Q2-24 to accommodate the normalizing also influenced the return of foreign capital flows into domestic demand. The monetary policy adjustment government bonds (US$1.1 billion) in tandem with the was motivated by a focus on addressing currency issuance of government JPY bonds (US$0.6 billion). Recommendations volatility and FX reserves accumulation through These recent developments allowed BI to intervene B.4. Takeaways and Policy widening the spread against the US Federal Fund Rate. more actively on the exchange market and soften Rupiah volatility. 15 SRBI is an IDR security first issued by BI in mid-September 2023. The SVBI and SUVBI are US$ denominated securities. The SVBI are conventional securities, while the SUVBI are sharia-compliant ones. Both were first traded in mid-November 2023 (see IEP December 2023). 13 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential To soften the impact of the policy rate hike on the expand the coverage of the 400 bps RRR discount economy, BI is using macroprudential liquidity to additional growth-driving sectors.16 These include Contents Table of incentives in support of private credit expansion. BI green economy, creative economy, wholesale trade, maintains a “tight interest rate, loose macroprudential” and export-oriented sectors. The incentive, which will policy mix, where the rate hike is complemented by become effective in June, is estimated to stimulate an Summary Executive easing the reserve requirement ratio (RRR) to boost additional 1.6 percent of private sector credit (IDR115 liquidity for private credit. As such, BI decided to trillion) by the end of 2024. BOX A.1 Developments A.1. Recent Economic A deeper look at SRBI: BI’s new instrument to maintain the stability of FX reserves In response to the US Fed rapid tightening cycle, which started in 2022, BI introduced a local currency security SRBI (Sekuritas Rupiah Bank Indonesia) aimed at attracting portfolio flows. In Q3-23, the 10-year UST yield reached a 16- year high, prompting Indonesia’s yield differentials to reach historical lows. This triggered substantial portfolio outflows A.2. The Policy (0.3 percent of GDP in Q3-23) fueling pressure on FX reserves and the currency. Indeed, the Rupiah had been sensitive to Stance changes in the net FX reserves position17 (Figure A.19), a proxy for BoP flows. Faced with these challenges, BI introduced new securities—the SRBI— in September 2023 primarily aimed to attract foreign investors. The introduction of SRBI replaced BI’s “twist operation”18 as a tool to improve the yield differential against US T-bills. A.3. Structural To increase its attractiveness, SRBI offers a higher interest than Indonesia’s local currency government securities Trends (SBN). SRBI is issued by BI in recognition of short-term debt using SBN held by BI as underlying assets. SRBI is an Open Market Operation (OMO) instrument that has served a dual mandate of absorbing excess liquidity, and attracting portfolio flows to maintain currency stability and external buffers. SRBI is thus eligible for ownership by non-residents. Compared to sovereign bonds, SRBI is a shorter-duration asset, with maturities of 6, 9, or 12 months. The interest rates of A.4. Outlook and Risks SRBI have been consistently higher than sovereign bonds (SBN). For example, during the SRBI auctions in early May 2024, the 1-year SRBI offered a return of 7.5 percent versus 6.7 percent on the 1-year SBN. The introduction of the SRBI has had unintended consequences. As a higher yielding instrument, the SRBI appeared to be crowding out government borrowing. Commercial banks reduced their holdings of government securities and turned A.5. Policy Priorities towards BI’s new securities. Between September 2023 and February 2024, commercial banks’ ownership of government bonds declined from 30.4 to 25.6 percent of total outstanding. In response, BI intervened on the secondary market to purchase government securities, increasing its holding from 16.2 to 20.7 percent. To prevent further crowding out, BI temporarily reduced the volume of SRBI issuances, cutting it by half from IDR 49.4 trillion to IDR 25.6 trillion between B.1. Introduction February and March 2024.19 Other risks include crowding out foreign equity investors who face higher credit risk but with relatively less attractive returns. Equity outflows from the Indonesia’s stock market exchange were indeed observed lately in April-June. In the wake of a more hawkish Fed, April saw broad-based portfolio outflows, including from SRBI. In Q1-24, B.2. Performance of non-resident investors held approximately 22 percent of total outstanding SRBI, while the remainder was largely owned the Private Sector by domestic commercial banks. However, as global monetary conditions have tightened, foreign investors have been selling their SRBI holdings. As a result, the share of foreign ownership in SRBI fell to 18 percent by the end of April 2024. Following the hike in BI policy rate in April 2024, interest on the 1-year SRBI simultaneously jumped by 500 bps (Figure A.20) to reach 7.5 percent in early May. This marks an even wider differential against the 1-year SBN at 6.8 percent. Going forward, BI decided to auction SRBI more frequently (from once to twice a week) to attract more portfolio inflows. Regualatory Uncertainty, With higher rates and more frequent auctions, SRBI posted IDR 81.6 trillion of foreign inflows and the share of foreign the Next Challenge ownership rose sharply to 27 percent of total outstanding SRBI in May. B.3. Tackling 16 The headline RRR is currently set at 9 percent for commercial banks. With this incentive, the RRR for banks that lend to certain activities could be as low as 5 percent. This incentive has been implemented since October 2023 for credit in eligible sectors, such as downstreaming, tourism, and MSMEs (see IEP December 2023). Recommendations B.4. Takeaways 17 Net FX reserves subtract predetermined short-term drains (from non-residents and residents, in up to one year) from the official reserves. and Policy 18 Under the “twist operation”, BI sold short-term and purchased long-term government securities (SBN) in the secondary market to increase the attractiveness of SBN yields (see IEP June 2023). 19 There is a cost associated to BI for issuing such instruments, referred to as sterilization costs. The cost is computed as the yield spread against a Treasury’s return on risk-free investments (such as, the yield on 1-year UST, currently around 230 basis points), multiplied by the total volume of issuances. A ballpark estimate for the sterilization costs of SRBI issuances points to 0.25 percent of total BI’s assets. 14 Indonesia Economic Prospects June 2024 Figure A.19: The stability of Rupiah has been Figure A.20: SRBI yields rose significantly following Contents Table of parallel with changes in net FX reserves the April hike in BI Rates (LHS: billion US$; RHS: US$ / IDR) (LHS: SRBI issuances in trillion IDR; RHS: percent) 40 6m SRBI 7.7 145 17,000 9m SRBI Summary Executive 135 IDR 35 12m SRBI 7.5 Weighted avg interest rate (RHS) 125 15,000 30 7.3 115 25 7.1 105 13,000 20 6.9 Developments A.1. Recent Economic 95 15 6.7 Net FX 85 Reserves 11,000 10 6.5 75 5 6.3 65 9,000 0 6.1 A.2. The Policy Jan-18 Jan-19 Jan-20 Jan-21 Jan-22 Jan-23 Jan-24 May-18 May-19 May-20 May-21 May-22 May-23 Sep-18 Sep-19 Sep-20 Sep-21 Sep-22 Sep-23 Feb-24 Oct-23 Oct-23 Jan-24 Dec-23 Nov-23 May-24 Sep-23 Apr-24 Stance Source: BI, IMF, World Bank staff calculations. Note: Net reserves subtract predetermined short-term drains from the official reserve position. A.3. Structural Trends 3. Structural Trends Within these near-term developments and policy growth has been dampened by inflationary pressures A.4. Outlook responses, there are four important structural trends and weak exports. Similarly, textiles and apparel, has and Risks that will need closer attention going forward. First, faced increasing challenges post-COVID, including a gradual increase in manufacturing concentration shrinking export markets in major advanced economies points to competitiveness challenges for the sector and tightening import restrictions. These challenges as a whole. have led to considerable layoffs and a steady decline in A.5. Policy Priorities the sector’s share in manufacturing value added, from Post-COVID-19, the growth of the manufacturing 6.2 percent in 2019 to 5.2 percent in 2023. Other higher sector has been bolstered by the marked expansion value-added priority industries such as transport B.1. Introduction of basic metals and metal products industries. Basic equipment and machinery, performed robustly, metals, and metal products and electronics have grown whereas rubber products and furniture contracted at an annual average growth rate of 14.5 percent and post-COVID. Overall, the share of manufacturing in 10.1 percent in 2022 and 2023, respectively, compared GDP remained below 20 percent in 2023. to only 5.9 percent and -0.6 percent in 2017-19. B.2. Performance of the Private Sector Supported by GoI’s downstreaming policies and Service sector growth has been resilient, consistently mining sector expansion, together these two sectors outpacing manufacturing both pre- and post- accounted for one-third of manufacturing growth COVID. With average annual growth rates above 6 post-COVID (Figure A.22). Notably, exports of iron and percent, services have accounted for more than half steel products reached a record high of US$27.8 billion of GDP growth (Figure A.21). Services have also proved Regualatory Uncertainty, in 2023, a more than fifteen-fold expansion from 2016. to be more resilient to multiple economic pressures the Next Challenge (COVID-19, geopolitical tensions, conflicts, commodity B.3. Tackling Several other priority manufacturing industries20 price shock), supported by the steady growth of have underperformed relative to their pre- higher value-added services such as information and pandemic averages. Food and beverages, by far the communication technology, as well as financial services largest contributor to manufacturing value added (35.1 (Figure A.23). Transportation and accommodation and percent of the total in 2023), slowed from an annual food services, benefitting from a strong post-COVID Recommendations average growth of 7.8 percent pre-COVID-19 to 4.7 rebound, accounted for about one third of post-COVID B.4. Takeaways and Policy percent after. While benefitting from robust domestic services growth. Wholesale and retail growth has been demand and the recovery of hospitality services, its stable, at around a quarter of services value added. 20 Ministry of Industry defines as priority industries food and beverages, textiles, electronics, automotive, and chemicals. 15 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential The shift towards commodity-based industries have equipment, motor vehicles, electrical equipment), led to an increasing concentration of manufacturing and high-skill global innovators (e.g., computers and Contents Table of value added. The concentration of industries21 within electronics, pharmaceuticals)—all of which Indonesia the manufacturing sector has steadily increased over has capacity in–tend to have strong pro-development the last decade (Figure A.24). In contrast, the services characteristics (i.e., value addition, productivity, Summary Executive sector concentration has remained broadly stable. tradability, jobs). These industries tend to have Whilst the growth of commodity-based processing is stronger global value chain linkages than commodity- reflective of Indonesia’s comparative advantage, the based processing, and therefore tend to be associated competitiveness of other manufacturing industries with higher productivity and better job creation. The will be important for long-term value addition. For competitiveness and growth of these manufacturing Developments A.1. Recent Economic example, low-skill labor intensive tradables (e.g., industries will be heavily influenced by the quality and textiles, apparel, furniture), medium-skill global competitiveness of service sector inputs. innovator manufacturing (e.g., machinery and A.2. The Policy Figure A.21: Services growth has been accounting for Figure A.22: Post-COVID19, the manufacturing sector Stance more than half of GDP growth has experienced notable shifts (percentage points contribution to yoy growth) (percentage points contribution to yoy growth) Food & Beverages Metal Products & Electronics Services Manufacturing Mining Agriculture A.3. Structural 6 Basic Metals Transport Equipment Trends Textiles & Wearing Apparel Manufacturing 5 5 0.5 0.5 0.5 0.5 0.3 4 4 1.6 1.4 1.3 1.5 0.8 1.6 3 0.7 3 0.2 0.8 0.3 A.4. Outlook and Risks 1.0 2 0.9 2 2.7 3.0 3.1 2.9 1 2.5 2.5 1.6 1 1.7 0 0.5 0 -0.7 -1 -1.7 A.5. Policy -1 Priorities -1.0 -2 -2 -3 2017 2018 2019 2020 2021 2022 2023 2017-2019 2020 2021-2023 B.1. Introduction Source:BPS, World Bank staff calculations. Figure A.23: The services sector growth has been Figure A.24: The manufacturing sector is becoming resilient, consistently outpacing manufacturing less diversified (percentage points contribution to yoy growth) (Herfindahl-Hirschman index of concentration) B.2. Performance of the Private Sector Wholesales & Retail Information & Communication Transportation & Storage Accommodation & Food 18 Manufacturing Services Financial & Insurance Activity Services 7 17 6 16 5 15 0.7 4 14 Regualatory Uncertainty, 3 1.5 the Next Challenge 2 1.1 13 B.3. Tackling 1.0 1 1.5 12 1.4 1.3 0 11 -1.1 -1 10 -2 -1.4 -3 9 -4 8 Recommendations 2017-2019 2020 2021-2023 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 B.4. Takeaways and Policy Source:BPS, World Bank staff calculations. 21 The Herfindahl-Hirschman Index (HHI) is a widely used measure of market concentration. HHI = sumI (si)2, where si represents the share of each industry in the total. 16 Indonesia Economic Prospects June 2024 Second, despite robust growth overall, there is scope to be weaker when excluding Java-Bali, pointing to the Contents to accelerate subnational income convergence to region’s significance in driving investment trends and Table of sustain inclusion gains. its weight in capital allocation within Indonesia (Figure A.28). Investment in physical assets remains uneven Regional income disparities have declined over the across regions, which in turn underscores the gaps in Summary Executive past three decades but have lately been stalling. infrastructure and technology. Other factors driving Between 1993-2002, there was convergence with catch- convergence—labor force participation, human up.22 Subnational income differences have declined as capital, structural reforms, investments, technological several provinces have been catching up with Java-Bali’s progress, and capacity for subregional governance— economic performance (Figure A.25). During 2003- have also varied across regions and requires further Developments A.1. Recent Economic 2012, there was convergence with faltering catch-up. analysis to determine their impact and binding Regional income disparities narrowed, while Java-Bali’s constraints to convergence and catch-up. economic dominance persisted. The last decade was a period of deceleration for both convergence and catch- Understanding subnational economic growth are A.2. The Policy up. Progress in reducing regional income inequalities vital for evaluating the effectiveness of policies Stance slowed and there has been little improvement in aimed at fostering balanced development and the catch-up of other regions with Java-Bali’s GDP reducing inequality across the archipelago. While per capita. Notably, when excluding Nusa Tenggara, income convergence was observable in Indonesia, convergence appears strongest, indicating that this progress has been uneven across regions. This is A.3. Structural region significantly influences the income gap (Figure particularly evident in disadvantaged areas of East Trends A.26). Further, there has been a divergence in income Indonesia, where the progress stalled the most. The per capita trends in Nusa Tenggara compared to the temporary nature of stronger income convergence rest of the country, contributing to the narrative of seems to coincide with periods of rising catch-up A.4. Outlook growth inequality in eastern Indonesia. propelled by commodity booms. This suggests that and Risks the economic convergence may be vulnerable to the The slowdown in convergence of investment offers volatility of commodity price cycles. insights into the distribution and dynamics of growth across regions (Figure A.27). Convergence appears A.5. Policy Priorities Figure A.25: Subnational income convergence and Figure A.26: Income convergence is strongest when catch-up have slowed down excluding Nusa Tenggara B.1. Introduction (mean log deviation of income per capita) (mean log deviation of income per capita) Exclude Sumatera Exclude Java-Bali Convergence among regions Exclude Kalimantan Exclude Sulawesi Catch-up with Java-Bali Exclude Nusa Tenggara Exclude Maluku 0.35 1.4 Exclude Papua 0.45 B.2. Performance of Average GDP/capita to Java-Bali the Private Sector 0.3 1.3 Average Income Gap Average Income Gap 0.35 0.25 1.2 0.25 0.2 1.1 0.15 Regualatory Uncertainty, 0.15 1 the Next Challenge B.3. Tackling 0.05 0.1 0.9 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020 2023 Recommendations B.4. Takeaways and Policy 22 Convergence evaluates whether income per capita gaps between regions are narrowing. Convergence occurs when the mean log deviation decreas- es over time, indicating that poorer regions are approaching the income levels of wealthier ones (known as sigma convergence in the economics liter- ature). Catch-up is measured by comparing the average income per capita of different regions relative to that of the most developed region, Java-Bali. 17 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Figure A.27: There has been also convergence in Figure A.28: But GFCF convergence is primarily driven Contents Table of subnational capital formation by Java-Bali (mean log deviation of income per capita) (mean log deviation of income per capita) 0.95 Exclude Sumatera Exclude Java-Bali Exclude Kalimantan Exclude Sulawesi Summary Executive 0.90 Exclude Nusa Tenggara Exclude Maluku Average Gap in Capital Formation Exclude Papua 0.85 1.20 Average Gap in Capital Formation 0.80 0.75 1.00 Developments 0.70 A.1. Recent Economic 0.65 0.80 0.60 0.60 0.55 0.50 0.40 A.2. The Policy 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 Stance 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 Source: BPS, SUSENAS, World Bank staff calculations. Note: Graphs show sigma-convergence; negative slope indicates a higher degree of convergence. GDP per capita and Gross Fixed Capital Formation (GFCF) are both in 2010 constant prices. Balanced panel of 26 parent provinces as in the pre-decentralization era. A.3. Structural Trends There is also scope to make growth more inclusive Since 2014, growth increasingly favored the poorest by tackling labor market trends, which have half of the population and began reversing the exacerbated inequality since the pandemic. trends of the previous decade. For the top 10 percent, the pace of growth fell by half (to 3 percent per year), A.4. Outlook and Risks In two decades, Indonesia has twice undergone while at the same time doubling to nearly 4 percent major shifts in the inclusiveness of economic for the poorest 10 percent of people. In 2015, growth growth. The pace of economic growth began for the bottom half outpaced the top for the first time accelerating in the early 2000s, following the Asian in a decade, and from 2014 to 2019, falling inequality A.5. Policy Priorities Financial Crisis. For individuals and families, this growth pushed the Gini Index down by nearly 4 points. This took the form of rising labor income fueling private remarkable turnaround was driven by a stronger labor consumption. Although the wellbeing of the poorest market. Returns to skills began increasing, and the steadily improved in the early 2000s, taken as a whole, B.1. Introduction share of skilled workers in the labor force rose from 33 Indonesia’s growth was regressively distributed. The percent in 2014 to 39 percent in 2019. As the sources commodity boom behind the high growth rate yielded of growth shifted into areas with higher demand for concentrated returns among those who were already labor, wages began climbing in agriculture, industry, well-off. Through 2014, the richest 10 percent of people and services alike (Figure A.31). Faster job creation in B.2. Performance of enjoyed consumption growth of 6 percent per year the Private Sector services and manufacturing led to a sectoral shift into after accounting for inflation, while the poorest 10 more remunerative work, and more than compensated percent of people, saw a modest 2 percent growth per for a modest drop in the agricultural labor force year over the same period (Figure A.29). Because those (Figure A.32). The agriculture sector nonetheless with top incomes started from a higher base, faster sustained output and wage growth, signaling rising growth at the top meant that the absolute increase in labor productivity. Regualatory Uncertainty, the Next Challenge consumption was even more skewed. Between 2003- B.3. Tackling 14, the richest 10 percent of the population obtained 43 Maintaining the inclusive trend is not a given as of the total increase in consumption, almost 22 times signs of slackening have recently emerged. Progress that of the poorest 10 percent. These trends rapidly in reducing inequality stagnated, and in the aftermath increased inequality. The Gini Index rose ten points— of COVID-19 the Gini Index began to slowly rise from 0.29 in 2003 to a peak of 0.39 in 2014, the highest again (Figure A.30). Moreover, after falling during the value yet measured in Indonesia (Figure A.30). pandemic, median wages have not yet fully recovered Recommendations B.4. Takeaways after accounting for inflation. and Policy 18 Indonesia Economic Prospects June 2024 Figure A.29: Annualized growth rate by percentile of Figure A.30: Gini index began to slowly rise post- Contents Table of consumption, adjusted for inflation pandemic (percent, yoy) (index) 2003-2023 2003-2014 2014-2023 0.39 0.39 Summary Executive 8.0% 0.37 7.0% 0.36 6.0% 0.35 5.4% Developments 5.0% A.1. Recent Economic 0.33 4.0% 3.0% 0.31 2.6% 2.0% 0.29 0.29 A.2. The Policy 1.0% Stance 15 22 29 36 43 50 57 64 71 78 85 92 99 1 8 Figure A.31: Annualized inflation-adjusted median wage Figure A.32: Growth in share of employment by median by sector wage for formal and informal sectors A.3. Structural Trends (percent) (percent) 20 Informal Formal 5.0% 2002 - 2013 2014 - 2019 High VA Manuf. serv. 4.0% 15 A.4. Outlook Other and Risks Agric. Low VA Other Median real wage 3.0% serv. 10 High VA serv. 2.0% 5 Low VA A.5. Policy Priorities 1.0% serv. Agric. Manuf. - 0.0% -6% -4% -2% 0% 2% 4% 6% 8% 10% Agriculture Industry Services Total Employment share growth 2014-2019 B.1. Introduction Source: Sakernas 2003-2024, World Bank staff calculations Note: Welfare is measured using reported household consumption expenditure and expressed in real terms by adjusting for district and yearly price differences. Fourth, inclusive growth will require mobility to necessarily inclusive, and in fact, often generates B.2. Performance of take on new jobs in higher productivity sectors, and widening inequality. This is because productivity the Private Sector in higher productivity places. growth is not constant across sectors or geography. Some sectors and some locations inevitably grow The path of structural transformation followed by faster than others. Thus, if workers are immobile, many countries that are now high income has remained will be unable to take part in the benefits of structural remarkably consistent for more than a century, transformation. Regualatory Uncertainty, including the consequences on the labor market. the Next Challenge B.3. Tackling Nearly all countries transitioning from low, to middle, Low levels of worker mobility suggests that if and then high-income levels have seen falling current trends continue, Indonesia faces a situation employment shares in rural agriculture and significant more akin to the less inclusive pattern than the domestic migration, as workers are drawn into growing more inclusive one. Spatially, Indonesia is one of the sectors with high labor demand. Policymakers should least mobile counties in the world, and the trends anticipate similar trends as Indonesia transitions to are worsening. The internal migration rate between Recommendations B.4. Takeaways a high-income country. As new higher productivity provinces was just 2.3 percent in 2023. This is lower and Policy activities emerge, they will compete to attract workers than pre-pandemic, lower than the global average of by offering higher wages. But this process is not 8 percent, and far from the frontier, which reaches 39 19 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential percent in some of the world’s most mobile countries Partially because of these trends, there has been like Australia. Moreover, even recent migration for no long-term convergence in welfare between Contents Table of Indonesians aged 18-30, which has been consistently Indonesia’s island groups over the past two the highest among all age groups, has been declining decades (Figure A.34). Median welfare—as measured in the past two years. Meanwhile, around 30 percent by consumption per capita—in Sumatera, Java-Bali, Summary Executive of migrants aged 56+ are back to their district of and Kalimantan has largely remained at or above birthplace. Indonesia’s limited mobility patterns the national median. Sulawesi, Maluku-Papua, and contributes to the striking lack of mobility from low- Nusa Tenggara have made remarkably little progress income districts to high income ones. In fact, the closing the gap. At 93 percent, Sulawesi’s typical level typical migrant in Indonesia is far more likely to be of welfare relative to the national median is nearly Developments A.1. Recent Economic moving out of a more dynamic labor market, than into unchanged over the past 20 years. Nusa Tenggara one (Figure A.33). Close to 70 percent of all migration has made very slow progress. At the current pace of originates in top two quintiles of district by median convergence, closing the gap to the national median income, compared to just 6 percent outmigration from would require another 140 years. Maluku and Papua A.2. The Policy the poorest quintile of districts. Furthermore, only have in fact lost ground, and if current trends continue Stance 24 percent of migrants move from poorer to richer will likely not converge to the national median. districts. Figure A.33: A 5-year migration flows by district Figure A.34: Regional convergence in median A.3. Structural income level consumption per capita Trends Two-track Indonesia 110% Q5 100% Q5 A.4. Outlook and Risks 90% Q4 80% Q4 70% Q3 A.5. Policy Priorities 60% Q3 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 Q2 Linear (Sumatera) Linear (Java-Bali) B.1. Introduction Q2 Linear (Nusa-tenggara) Linear (Kalimantan) Linear (Sulawesi) Linear (Maluku & Papua) Q1 Q1 Source: SUSENAS survey data and World Bank Staff Calculations. The labels Q1-Q5 refers to the poorest to the richest quintile of districts, ranked by median per consumption per capita. Values on the left B.2. Performance of of the graph indicate the typical welfare level of the district a migrant is leaving from, scaled by the share of total domestic migrants, while the Private Sector the value on the right indicates the welfare level of the destination district. 4. The Outlook and Risks Indonesia’s economy is projected to remain resilient bolstered by earlier reforms and new government throughout the outlook period, though slightly projects, including an acceleration in the construction Regualatory Uncertainty, the Next Challenge easing as terms of trade soften and domestic of the new capital city. Exports and imports are B.3. Tackling demand normalizes toward trend growth. GDP projected to grow at a more modest pace, given the growth is projected to average 5.1 percent over 2024- high base effects and uncertain global demand. 2026 (Table A.2). Private consumption will continue to drive growth but is expected to face headwinds Inflation is projected to remain within BI’s target as household purchasing power is affected by cost- band but faces upward pressure from global food push inflation pressures. Public consumption growth and energy prices. Headline inflation is expected to Recommendations B.4. Takeaways will reflect an increase in civil servant salaries in 2024, remain relatively stable, averaging 3 percent in 2024 and Policy further supported by new social spending programs and approximately 2.9 percent thereafter in 2025-2026 from the incoming administration. Investment is (Table A.2). This is well within BI’s inflation target band expected to gain momentum over the outlook period, of 2.5 +/- 1 percent. Inflation expectations are also 20 Indonesia Economic Prospects June 2024 anticipated to remain anchored within this range. With receipts strengthen from another 1 ppt hike in the the output gap estimated to close in 2025 and domestic VAT rate planned for 2025. With higher fiscal deficits Contents Table of demand normalizing, core inflation is expected to coupled with costlier financing due to sustained remain subdued over the outlook period. However, unfavorable global monetary conditions, public debt global energy and food prices are anticipated to exert is projected to remain broadly flat in the medium-term Summary Executive upward pressure on inflation. This follows multiple at an average of 38.7 percent of GDP up to 2029. armed conflicts and climate shocks that are disrupting global supply chains, as well as the new round of Social spending packages planned under the OPEC+ production cuts that are increasing oil prices. upcoming five-year economic program have the The authorities remain committed to maintaining potential to enhance human capital formation Developments A.1. Recent Economic inflation within their target range, including by utilizing within a sustainable fiscal framework. Social subsidies, price controls, and measures to ease programs were at the heart of the presidential domestic supply chain bottlenecks—all actions that election campaign and several announcements have been employed in recent years. point to a ramping up of social spending including A.2. The Policy through existing and new programs. These include Stance The external position is expected to remain the flagship school meal program (Box A.2), If they challenging due to weak global trade and financing are implemented fully and simultaneously, estimates pressures. The current account deficit is projected to show that the fiscal cost of these programs combined gradually widen and reach 1.6 percent of GDP by 2026, could reach 3 percent of GDP in the first year (2025) A.3. Structural as softer commodity prices and global uncertainty and around 2 percent of GDP thereafter. Gradual Trends hamper exports. FDI will continue to be the largest implementation coupled with tax reforms, which could source of external financing, with competitiveness bring yearly additional revenues of 1-1.5 percent of reforms, industrial downstreaming, and the construction GDP, would help the government adhere to its fiscal A.4. Outlook of the new capital yielding results and attracting new rules. Those rules have helped build a transparent and and Risks projects. BI’s monetary stance will remain focused on credible macroeconomic policy framework. This has guarding against rapid or excessive capital outflows. enabled Indonesia to successfully attract investment, However, monetary policy will have less leeway due to boost growth, and navigate external shocks. tighter inflation targets and persistently high interest A.5. Policy Priorities rates in advanced economies. Nevertheless, BI will The risks to Indonesia’s growth outlook remain tilted be more accommodating and is anticipated to lower to the downside amid heightened uncertainty. An policy rates in 2025, albeit at a much slower pace and intensification of armed conflicts and other geopolitical B.1. Introduction in alignment with normalization of US monetary policy. tensions could disrupt trade and commodity markets, Foreign currency reserves are projected to remain push up inflation, and affect global economic activity. adequate, covering 6 months of imports. Most notably disruptions to global oil supply from the conflict in the Middle East could have notable The fiscal stance is projected to loosen going effects on prices of energy, transport, as well as supply B.2. Performance of the Private Sector forward as the government ramps up social chains globally. Moreover, successive climate change spending and public investment, still within the 3 shocks are having detrimental effects on global food percent budget deficit rule. The extension of existing production notably for staple crops, undermining the social assistance programs,23 heightened subsidy disinflation process. Weaker-than-expected growth spending driven by currency depreciation, and higher in China, triggered for instance by a more prolonged interest payments are all expected to push the fiscal and deeper property sector downturn, or a sharper Regualatory Uncertainty, the Next Challenge deficit to 2.5 percent of GDP by the end of 2024. This slowdown of the US economy could have notable B.3. Tackling is above the 2.3 percent indicated in the budget law. In negative spillovers, particularly for EMDEs. All these the medium-term, the deficit is projected to stabilize at external shocks could have implications on Indonesia’s around 2.5 percent (Table A.2). This follows a gradual growth through a sharper decline in the terms of trade, increase in spending to accommodate the incoming resulting possibly in lower revenues and a tighter fiscal administration’s programs, including those related to position. Domestically, rising social spending with public investment and infrastructure. Subsidies are no additional revenues and expenditure efficiency Recommendations B.4. Takeaways projected to stabilize throughout the outlook period measures could deepen the fiscal deficit while slow and Policy in line with softening commodity prices. Meanwhile implementation of structural reforms could have revenues are forecasted to improve steadily as tax implication on productivity and growth. 23 Including the extension of cash transfer and rice aid program to the first half of 2024. 21 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential BOX A.2 Contents Table of International experience with School Meals School meals are a very popular intervention: in 2022, 418 million children were benefiting from school meals worldwide, surpassing pre-pandemic coverage levels (World Food Program - State of School Feeding Worldwide, 2022). School Summary Executive meals can have multiple objectives: improved health and nutrition, increased attendance and learning, as well as social protection. At the same time, the objective of school meals is evolving, with an increasing emphasis on the quality of food, the role meals can play in resilience building and shock response, as well as for strengthening linkages to local market development. With this evolution comes greater complexity in design and implementation. Importantly, Developments international evidence shows that school meals are most effective when they are complementary with other education, A.1. Recent Economic health, and nutrition interventions, as well as basic safety nets. Thus, their introduction or expansion should not come at the cost of lower spending or attention on other essential human capital interventions. Overall, it is essential to define and set clear objectives for such programs. This would ensure effective implementation and that supported interventions are the most cost-effective way to achieve the desired outcomes. A.2. The Policy Evidence. Evidence on returns to school meals is uneven across objectives, and the modality and quality of implementation Stance can make a big difference on final outcomes. In education, the evidence is relatively strong regarding impacts on school attendance in low- and lower-middle income countries where educational access is the issue, but the benefit of school meals on school participation is likely to be limited in countries where school enrolment is already high. Evidence on learning outcomes is less robust than for traditional pedagogic interventions (with higher variance, and stronger for more A.3. Structural vulnerable groups such as poor students and girls for example). With respect to nutrition, school meals are not designed Trends to impact stunting, as they are not targeted to the first 1,000 days of life. However, school meals may have an impact on dietary diversity and anemia among school-going children, though this will depend on the specific commodities offered. Generally, school meals can be effective where there are concerns for food security. To achieve better nutrition outcomes, more than 80 percent of national school meal programs combine food with the provision of school health and nutrition A.4. Outlook and Risks interventions (such as micronutrient supplementation, deworming, health/nutrition education curricula, school health policy interventions) to improve health outcomes and help ensure complementarity with stunting interventions aimed at the first 1000 days. School meals also indirectly benefit the economic wellbeing of the households of beneficiaries, an impact that is strongest in high-poverty settings where expenditures on food represent a larger share of household income. A.5. Policy Priorities Targeting. Decisions on targeting of school meals can have implications for program efficiency and effectiveness. Universal targeting, where food is supplied for all students at a given education level, is frequent in high-income settings, while in lower- and middle-income countries geographic targeting of high poverty areas or food insecurity areas is quite common. B.1. Introduction Income-targeting – where students receive free meals based on an assessment of their socioeconomic conditions – is not common outside of some higher income contexts, due to a combination of capacity constraints (existence of systems to support reliable targeting at school or individual level in cost-effective ways) as well as concerns about stigma limiting take-up or perceived unfairness at school level. B.2. Performance of the Private Sector Management models. In terms of implementation, practices range from highly centralized to fully decentralized models with significant tradeoffs in terms of the required implementation capacity, level of accountability and risk (e.g., for ensuring quality control of food refrigeration, storage, preparation and delivery to avoid health hazards). Programs in middle and high-income countries tend to rely more on local procurement that support local and small-holder production by generating a stable demand for their products. Programs with local procurement can also strengthen accountability and facilitate the adoption of culturally appropriate menus. However, such programs require a relatively Regualatory Uncertainty, high level of management capacity of local governments and schools. Usually, centralized models can better manage the Next Challenge food sourcing risks, and simplify oversight and quality control to avoid food poisoning etc. Possibly, supply chain models B.3. Tackling can be combined to form mixed models, such as by centralizing procurement of non-perishable staples and decentralize procurement of perishables. However, this may again increase complexity of implementation. Cost. Costs across school meal programs vary widely. The main factors influencing cost are the chosen intervention modality (a meal, snack or take-home ration), the quality of the meal (composition and size), the procurement type (local or centralized), the number of beneficiaries, and the geographical context, logistics and climate conditions. Recommendations B.4. Takeaways and Policy Sources: Bundy et al. (2024), Alderman, Bundy and Gelli (2024). 22 Indonesia Economic Prospects June 2024 5. Policy Priorities Contents Table of Fiscal gains from a VAT rate hike could be enhanced credits help tax authorities to track income and assets, if tax efficiency of collection improves. thereby improving tax collection (Gordon and Li, 2009, Lompo, 2024). Summary Executive Indonesia faces efficiency challenges that limit the potential of tax rate hikes to generate additional tax While raising tax rates addresses part of the reforms revenues. At only 0.53, the VAT C-efficiency ratio24 is from a policy design perspective, these would need 0.17 points below the average of regional peers (a ratio to be coupled with measures to broaden the tax Developments of 1 indicates a highly efficient tax collection system).25 base and enhance compliance. The impact of VAT A.1. Recent Economic This indicates that potential revenues that could have rate increase will be constrained by the narrow tax base been collected with the current rate are almost double and exacerbated by low compliance. Reforms initiated that of actual tax collections. If the C-collection ratio through the THL in 2021 could be complemented improved to a level that is equal to regional peers, by both short and medium-term measures. For the A.2. The Policy estimates show that the fiscal returns from the VAT short-term, the reforms could be complemented with Stance rate hike could increase by up to 32 percent, on top lower tax thresholds, the removal of tax exemptions, of current gains. Shortfalls stem from both the policy and improvements in audit mechanism to enhance design of the VAT and low tax compliance. Evidence compliance. In the medium term, options to raise tax A.3. Structural from other countries suggests that a statutory VAT collection could be implemented through improved Trends rate hike may yield minimal to no additional revenue access and availability of third-party data to track and gains if non-compliance challenges persist. The low verify incomes/revenues, as well as efforts to formalize tax efficiency is hence due to the narrow tax base and the economy. Higher tax take can in turn finance social low compliance, which results in limited additional tax assistance to compensate the poor impacted by the A.4. Outlook and Risks collection if the rate is increased. higher VAT rate. The low efficiency of tax collection can be attributed Figure A.35: Indonesia’s high VAT thresholds narrow to tax policy, tax compliance and the structure of the the tax base and lower the efficiency of collection A.5. Policy economy. First, Indonesia’s tax policy design features Priorities (US$ 000 for VAT threshold, LHS; ratio of threshold to low rates, high thresholds, and numerous exemptions, per capita GDP in 2022, RHS) resulting in a narrow tax base (Figure A.35).26 Second, VAT threshold (USD 000), LHS tax compliance is low due to challenges of enforcement, B.1. Introduction Threshold as multiple of GDP per capita, RHS prevalence of tax evasion, and low tax morale among 420 70 67 taxpayers.27 Third, the economy is characterized by 360 60 high informality, which excludes many businesses 300 50 from the tax system. Moreover, a shallow financial 240 40 sector limits firms’ access to formal financing, which B.2. Performance of the Private Sector 180 30 leads to firms having to rely on retained earnings to 120 20 finance business operations, incentivizing tax evasion. 60 10 The shallow financial sector also restricts the ability of the tax authority to monitor and enforce, limiting 0 0 Thailand Cambod Lao PDR evidence from the banking sector that could be used Indonesi Philippi nes Regualatory Uncertainty, ia a for auditing. Studies have shown that utilizing formal the Next Challenge financial institutions for deposits and working capital B.3. Tackling Source: IMF Tax Policy Assessment Framework (TPAF), World Bank staff calculations. 24 The C-efficiency ratio measures the actual tax collection to what could have been obtained if the standard VAT rate is applied to all domestic final consumption. It is used to analyze how effective the tax rate is in raising revenues. A ratio of 1 signifies a one-to-one increase in revenues, hence an efficient tax collection system. Recommendations Tax Policy Review in Indonesia: Corporate Income Tax, Alternative Final Tax, and Value-Added Tax, World Bank Working Paper, forthcoming. B.4. Takeaways 25 and Policy 26 In Indonesia, the threshold for a mandatory tax registration is currently US$320,000, six times higher than the average threshold in OECD countries (US$57,000 in 2022). This means that only firms with US$320,000 of gross turnover sales are required to register for VAT. Indonesia’s 2023 World Bank Enterprise Survey reveals that only 0.3 percent of small firms are currently paying VAT, as firm size distribution in Indonesia is heavily skewed toward micro and small firms. Therefore, the high VAT threshold substantially narrows the VAT tax base. Moreover, there are more sectors in Indonesia ex- empted from tax compared to peers, such as the mining and drilling products. 27 Tax morale is generally defined as the intrinsic motivation to pay taxes, which significantly influence the level of tax compliance as many tax systems depends on the self-reporting mechanism of incomes/revenues, OECD Library. 23 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Along with the need to improve revenue collection, Improved spending efficiency could be improving quality spending is paramount, implemented by leveraging the existing system, Contents Table of particularly for social protection, health, and such as the National Health Insurance (Jaminan boosting human capital. Kesehatan Nasional/JKN) for health spending. JKN can be leveraged by designing payment systems Summary Executive Amid rising fiscal pressures, redeploying spending that encourage primary care utilization, improve from less effective programs to boosting spending the quality of services, and reduce unnecessary on social protection is important for human capital hospital care. Performance based subnational formation and growth. Despite the recent increase in fiscal transfers and improved use of data will be social protection spending, there remain expenditure key to improving accountability and encouraging Developments A.1. Recent Economic gaps to provide social protection that serves all subnational government for better use of spending. Indonesians and across their lifecycle (Table A.1). The government could also invest more in equipment, Compared to recent expenditure trends, an additional supplies, and human resources for health to improve spending of around 0.5 percent of GDP is needed to the quality of care at all levels (Pustu, Posyandu, A.2. The Policy close this gap. Existing fiscal constraints imply that Puskesmas, hospitals, laboratories). Investment in Stance expanding coverage will have to be gradual and thus appropriate training to enhance the competence of requires prioritization and sequencing of different healthcare providers and abolish entry barriers for programs. Initially, financing can be met by reallocating new medical professionals to register and practice in existing expenditures, such as redeploying resources different localities is also important to improve the A.3. Structural spent on energy or other less effective subsidies to quality of health personnel. Trends direct social assistance. However, as pressure on energy subsidies keep mounting, the fiscal space also shrinks further. This then reenforces the urgency of revenue A.4. Outlook reforms to finance priority spending. and Risks Table A.1: Fiscal needs to reform the social protection program that serves all and across life cycle Cost (% of 2022 Budget Additional Spending Needs Program Reform Scenario A.5. Policy Priorities GDP) (% of GDP) (% of GDP) PKH and Sembako Expanded PKH, Sembako to 40% coverage with tapered benefit 0.77 0.37 0.40 levels. B.1. Introduction Elderly Assistance Expanded elderly assistance to 70% 0.17 0.15 0.02 coverage for elderly. Disability Assistance Expanded disability assistance to 70% coverage for people living 0.03 0 0.03 B.2. Performance of the Private Sector with disabilities. JKK and JKM Offer a government contribution of 0.54% of minimum wage* to all 0.12 0 0.12 adults. Pension Offer a pension contribution by the government of 3% of minimum 0.71 0 0.71 Regualatory Uncertainty, the Next Challenge wage* to all adults. B.3. Tackling Total additional spending needs (percent of GDP) 0.5 Source: World Bank (2020), World Bank staff calculation. Note: *The observed minimum wage for all workers from the 2018 labor force survey and is assumed to grow at the rate of wage growth in the economy. Recommendations B.4. Takeaways and Policy 24 Indonesia Economic Prospects June 2024 Table A.2: Selected Macroeconomic Indicators Contents Table of 2019 2020 2021 2022 2023 2024 2025 2026 Actual WB projection Real GDP growth and inflation, percent change Real GDP 5.0 -2.1 3.7 5.3 5.0 5.0 5.1 5.1 Summary Executive Consumer Price Inflation (CPI) (average, %) 2.8 2.0 1.6 4.1 3.7 3.0 2.9 2.9 Consumer Price Inflation (CPI) (end of 2.6 1.7 1.9 5.5 2.7 3.1 2.7 2.8 period, %) Private Consumption 5.2 -2.7 2.0 5.0 4.9 4.9 5.0 4.9 Developments A.1. Recent Economic Government Consumption 3.3 2.1 4.3 -4.5 2.9 5.4 4.0 4.8 Gross Fixed Investment 4.5 -5.0 3.8 3.9 4.4 4.5 5.4 6.0 Exports -0.5 -8.4 18.0 16.2 1.3 4.1 4.0 3.5 Imports -7.1 -17.6 24.9 15.0 -1.6 2.1 2.9 3.5 A.2. The Policy Fiscal accounts, central government, percent of GDP Stance Revenues 12.4 10.7 11.8 13.5 13.3 12.9 13.1 13.2 of which Tax Revenue 9.8 8.3 9.1 10.4 10.3 10.5 10.7 10.8 Expenditures 14.6 16.8 16.4 15.8 14.9 15.4 15.6 15.6 A.3. Structural Primary Balance -0.5 -4.1 -2.5 -0.4 0.4 -0.2 -0.1 0.0 Trends Fiscal Balance -2.2 -6.1 -4.6 -2.4 -1.7 -2.5 -2.5 -2.4 Central Government Debt(a) 30.2 39.3 40.7 39.5 39.0 39.0 39.1 38.9 Balance of Payments, percent of GDP unless indicated otherwise A.4. Outlook and Risks Current Account Balance -2.7 -0.4 0.3 1.0 -0.1 -0.9 -1.4 -1.6 Exports, Goods and Services 17.9 16.8 20.8 23.9 21.4 20.9 20.6 20.3 Imports, Goods and Services 18.2 15.1 18.3 20.7 19.3 18.8 18.6 18.6 Net Foreign Direct Investment 1.8 1.3 1.5 1.4 1.1 1.3 1.4 1.5 A.5. Policy Priorities Gross Reserves (months of imports of 7.6 10.2 8.0 6.0 6.5 6.8 6.6 6.4 goods and services) Memorandum items B.1. Introduction Nominal GDP (IDR trillion) 15,833 15,443 16,977 19,588 20,892 22,576 24,198 25,943 Real GDP Per Capita (IDR thousand) 40,459 39,203 40,237 41,952 43,661 45,476 47,409 49,429 B.2. Performance of the Private Sector Regualatory Uncertainty, the Next Challenge B.3. Tackling Recommendations B.4. Takeaways and Policy 25 B. Unleashing Indonesia’s Business Potential Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Contents Table of B. Unleashing Indonesia’s Business Potential Summary Executive Developments A.1. Recent Economic 1. Introduction Unlocking the private sector’s dynamism will be Notably, half of these firms were established in the past A.2. The Policy essential to Indonesia’s success in reaching high- 15 years, reflecting a dynamic entrepreneurial spirit. Stance income status by 2045. To graduate from the ranks Recent legislative changes, such as introducing the of middle-income countries in the next 20 years, the ‘Sole Proprietorship’ legal entity under the Job Creation World Bank forecasts that Indonesia must boost its Omnibus Law, have spurred a rise in newly registered growth rate to at least 6 percent annually, surpassing businesses. The private sector predominantly comprises A.3. Structural the 5 percent annual average observed over the past mature, small, and medium-sized enterprises (MSMEs), Trends five years (World Bank, 2023). Realizing this ambitious critical for local economies and employment. MSMEs growth target requires a marked improvement in operate mainly in the wholesale and retail sector the productivity of the private sector. According to (54 percent), followed by accommodation, food and A.4. Outlook projections by Ikhsan et al. (2022), achieving 6 percent beverage (20 percent), processing industry (14.5 and Risks economic growth will require a productivity growth percent), and other services (5.75 percent). rate of 3 percent—one percentage point higher than the average total factor productivity (TFP) growth in MSMEs dominate Indonesia’s business landscape recent years. and are pivotal to its economy. These enterprises A.5. Policy Priorities constitute 99% of all businesses and contribute 61% to To achieve that kind of productivity growth, the the nation’s Gross Domestic Product (GDP). The export private sector must find new dynamism and deepen contribution of MSMEs has also increased, from 14.4% B.1. Introduction its economic sophistication. The private sector in 2020 to 15.7% in 2021. Efforts to integrate these accounts for over 90 percent of all jobs. Eliminating businesses into the global market through Global obstacles to its development will be critical to enhancing Value Chains (GVC) and Global E-Commerce (GEC) are productivity, accelerating economic growth, ensuring underway, further enhancing their economic impact financial and environmental sustainability, and creating (Indonesian Chamber of Commerce, 2024). B.2. Performance of the Private Sector high-quality jobs. A more dynamic private sector can also help improve health and educational outcomes, Despite the vibrant MSME sector, Indonesian firms leading to further productivity, wages, and quality of generally have limited international exposure and life gains. minimal participation in global trade. This is a significant hurdle, especially given the favorable female Recognizing the importance of private sector participation rates in the private sector compared to Regualatory Uncertainty, the Next Challenge development, the government launched a bold peer countries. A comparative analysis using World B.3. Tackling and ambitious reform effort to unlock the private Bank Enterprise Survey data highlights Indonesia’s sector’s dynamism. The spirit of these reforms was on position relative to India, Mexico, the Philippines, target, but their implementation needs to catch up and and Türkiye. These comparisons underscore the need be addressed. We argue how. for Indonesia to bolster its global trade footprint. Enhancing international engagement and participation 1.1 Profile of the Private Sector is crucial for the nation’s journey toward high-income Recommendations B.4. Takeaways status and economic prosperity.28 and Policy The Indonesian economy is home to 66 million private businesses, of which 9 million are registered. 28 International Finance Corporation (IFC). Creating Markets in Indonesia: Country Private Sector Diagnostic. 2019. https://www.ifc.org/en/insights- reports/2010/cpsd-indonesia 27 Indonesia Economic Prospects June 2024 1.2 Overview of Economic Reforms These reforms and policies significantly reshaped perceptions of the business environment. Analysis Contents Table of As a result of consistent reform, Indonesia’s of the World Bank Enterprise Survey for 2015 and business environment has improved since 2015, 2023 reveals notable shifts in perceptions of what according to recently collected data from the constrained the Indonesian private sector (see Table Summary Executive World Bank Enterprise Survey (WBES).29 Indonesia B.1). In 2015, businesses cited informal competitors, embarked on a substantial regulatory reform program tax rates, political instability, licensing, and access to about a decade ago, during President Joko Widodo’s finance as their top concerns. By 2023, the landscape first term. In 2015, Indonesia’s first National Strategy for had changed, with access to finance, crime, theft and disorder, political instability, corruption, and Developments Regulatory Reform was released. Since then, sixteen A.1. Recent Economic economic reform packages, including regulatory competition from the informal sector emerging as the reform components, have been announced. Many predominant issues. critical global Good Regulatory Practice (GRP) elements have been strengthened.30 Finally, bold financial sector Objective measures of constraints on private sector A.2. The Policy reforms, to financial sector reforms to improve the development also evolved between 2015 and 2023. Stance functioning of the financial sector contributes to an Using the same survey data but objective data, we improving business environment. conducted an empirical analysis to identify variables that most significantly impacted firm-level productivity Indonesia’s first-generation reforms focused (see Table B.2). The findings indicate that access to A.3. Structural on building strong foundations for economic finance remained the most detrimental factor in 2015 Trends competitiveness (infrastructure, governance, and 2023. While the quality of electricity was a critical macroeconomic management, human capital). In issue in 2015, by 2023, it had been supplanted by the early 2000s, the country shifted towards enhancing corruption, which, though present in 2015, was only A.4. Outlook market efficiency, a trend that gained momentum with the fourth most significant constraint. Additionally, and Risks regulatory reforms in 2015. The momentum continued the skills of workers, a substantial impediment in 2015, with the Job Creation Omnibus Law in 2020, marking gave way to the regulatory compliance costs faced by a move towards fostering innovation, liberalizing firms in 2023. the foreign investment regime, and improving A.5. Policy Priorities market efficiency. While Indonesia has performed The government is committed to making doing well in implementing fundamental reforms, notable business for MSMEs easier. Government Regulation challenges remain in achieving efficiency reforms. No. 7 of 2021 underscores the central and regional B.1. Introduction governments’ support for MSMEs through several The Job Creation Omnibus Law represents key measures: (i) easing business licensing, (ii) Indonesia’s most ambitious reform to investment providing incentives and financing, (iii) promoting and trade in decades, significantly changing partnership schemes, and (iv) offering legal assistance business licensing procedures. It amended 76 and protection. It introduces several initiatives such B.2. Performance of the Private Sector national laws to simplify and harmonize business as single licensing, including business identification regulations and licensing, increase high-value number (NIB), national standards, and halal certificates, investment and jobs, and empower MSMEs. It also for low-risk activities of micro and small enterprises. It created the Indonesian Investment Authority (INA, the also dedicated promotional and development spaces Indonesian sovereign wealth fund), which mandated for micro and small enterprises, prioritizing MSME the crowding in of private capital to sustainable and products in government procurement, allocating Regualatory Uncertainty, the Next Challenge digital sectors in Indonesia. This comprehensive law business sectors for micro and small enterprises, and B.3. Tackling aims for a long-term, systemic transformation of incentivizing partnership schemes between medium Indonesia’s regulatory landscape to attract foreign and large enterprises with micro, small, and cooperative investment and stimulate economic growth. It helped businesses, among others. improve Indonesia’s business regulatory regime in a de jure sense. Recommendations B.4. Takeaways World Bank Enterprise Surveys (WBES) are nationally representative firm-level surveys with top managers and owners of businesses in over 150 and Policy 29 economies, reaching over 170 in upcoming years, that provide insight into many business environment topics such as access to finance, corruption, infrastructure, and performance, among others. Comprehensive data enable easy comparisons across economies and time. The information collected through our surveys is publicly available at the economy and firm level. The Enterprise Analysis team also conducts targeted surveys that provide an even deeper understanding of the business environment. Visit: www.enterprisesurveys.org 30 A good reference on Good Regulatory Practice (GRP) can be found here: https://asean.org/book/asean-handbook-on-good-regulatory-practice/ 31 See the June 2022 Indonesia Economic Prospects for a more complete discussion of financial sector issues and reforms in Indonesia. See link: https:// www.worldbank.org/en/country/indonesia/publication/indonesia-economic-prospect#2 28 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Table B.1: Opinion on top 5 constraints in 2015 and and Company Registration Certificate (TDP), has been Contents 2023 replaced by a Business Identification Number (NIB).34 Table of Rank 2015 2023 From August 2021 to October 2023, 9 million firms 1 Informal competitors Access to finance registered.35 Using the OSS system, 97 percent of the 2 Tax rates Crime, theft, and disorder enterprises are micro, small, and medium enterprises.36 Summary Executive 3 Political instability Political instability Business licensing reforms have positively impacted many micro, small, and medium-sized businesses. 4 Licensing and permits Corruption Obtaining the basic requirements for business 5 Access to finance Informal competitors licensing, such as suitability of space utilization activities Source: World Bank Enterprise Surveys Developments (KKPR), environmental approval, building approval, A.1. Recent Economic and functional certificates (SLF), is challenging enough Table B.2: Major constraint to productivity in 2015 and that the process becomes even more daunting when 2023 acquiring sectoral risk-based business licensing. Rank 2015 2023 A.2. The Policy 1 Access to finance Access to finance Despite these successes in businesses environment Stance 2 Quality of electricity Corruption reforms, regulatory constraints have emerged as 3 Skills32 Business regulation (Time a significant impediment to firm productivity. The spent complying with most notable is the inconsistent implementation of rules across the country. Moreover, lingering concerns about A.3. Structural regulations) regulatory unpredictability and associated corruption Trends 4 Corruption remain. Survey data reveal the economic impact of Source: World Bank Enterprise Surveys these challenges. Productivity remains stubbornly low, The government turned to digital technologies to with an industrial structure characterized by giant firms A.4. Outlook speed up compliance with regulatory requirements decoupled from the economic activity of numerous and Risks and remove discretion. It adopted a risk-based small enterprises—a persistent and pernicious feature approach to business licensing. It issued the licenses of Indonesia’s economic landscape. Understanding the through an online platform called the Online Single current situation is key for further progress. Submission (OSS) system, comprising sixteen sectoral A.5. Policy Priorities business licenses across eighteen ministries/agencies, which aims to facilitate investments and make it easier to do business in the country. Business activities are B.1. Introduction now grouped based on risk level, determining the required licensing. To start and carry out business activities, businesses must comply with (i) Basic Requirements for Business Licensing,33 (ii) Sectoral Risk-Based Business Licensing (assigned based on B.2. Performance of the Private Sector their Standard Business Classification/KBLI), and (iii) Business Licensing to Support Business Activities (PB UMKU, formerly known as commercial/operational licenses) to carry out a business activity. Regualatory Uncertainty, As a result of these efforts the business environment the Next Challenge improved. The business registration process, which B.3. Tackling previously required a Trading Business License (SIUP) Recommendations B.4. Takeaways 32 Analysis of skill in 2015 was possible due to the skill module 2015. However, an analysis could not be done again due to the lack of the skills module and Policy in WBES 2023, for which tax and environment modules had been included instead. 33 Includes Suitability of Space Utilization Activities (KKPR), Environmental Approval, Building Approval and Building Function Certificate (SLF). 34 Based on Article 7, paragraph (1) of the Job Creation Law, risk-based business licensing is carried out based on the determination of the risk level and the business scale rating of business activities. 35 Online Single Submission – Ministry of Investment (BKPM), May 2024. 36 Less than US$300,000 in start-up capital at registration or less than US$950,000 in revenues (when company information is updated). 29 Indonesia Economic Prospects June 2024 2. Performance of the Private Sector Contents Table of 2.1 How well does the average private firm per worker, and US$9,253 per worker, respectively. perform? Nevertheless, Indonesian firms could cope with the COVID-19 pandemic and recover faster than their peers Summary Executive Improvement in Indonesian firm performance in the Philippines. The average annual productivity of stopped in 2023, potentially due to the COVID-19 Indonesian firms declines by 4.2 percent. On the other crisis. From 2009 to 2015, Indonesia experienced stable hand, firms in the Philippines had a slower recovery labor output growth. However, the emergence of rate that with average productivity decline of 20.7 Developments A.1. Recent Economic COVID-19 and subsequent economic downturn from percent. 2020 to 2022 decreased sales for most firms (World Bank, 2023), leading to a decline in labor productivity Indonesian firms sold less and employed fewer during this timeframe. Labor productivity decreased workers than firms in other economies. Despite its from US$7,530 per worker in 2015 to US$5,336 per large domestic market, sales of manufacturing firms in A.2. The Policy Indonesia were around US$775,000. This is significantly Stance worker in 2023. lower than average sales in other large countries such Indonesian firms also perform poorly compared as Türkiye (US$4 million) and India (US$1.1 million). to those in similar countries.37 Indonesian firms Regarding employment, firms in different countries A.3. Structural have the lowest average labor productivity. Among employ more workers in Indonesia. On average, firms Trends the six comparable countries, Turkish firms boast the in Indonesia employed 20.1 workers, significantly less highest labor productivity at US$183,551 per worker. than Mexico in 2023 (29 workers) and Türkiye (21.9 Labor productivity for firms in Mexico, India, and workers). the Philippines is US$18,265 per worker, US$15,419 A.4. Outlook and Risks Figure B.1: Average Indonesian firm labor productivity Figure B.2: Labor productivity Indonesia vs. (2009-2023) comparators A.5. Policy Priorities 8,000 Labor productivty (LHS) Average annual growth of labor productivity (RHS) 7,000 20,000 5 6,000 B.1. Introduction 5,000 15,000 -2.5 US$/Worker US$/worker Percentage 4,000 10,000 -10 3,000 B.2. Performance of the Private Sector 2,000 5,000 -17.5 1,000 - -25 - Mexico India Philippines Indonesia 2009 2015 2023 (2023) (2022) (2023) (2023) Regualatory Uncertainty, Source: World Bank Enterprise Surveys. the Next Challenge Note: 1. Local currencies are expressed in 2009 US$. 2. Labor productivity is defined as value added per worker. 3. Turkiye experienced a B.3. Tackling dramatic devaluation of the Turkish Lira since 2013 and during the time of data collection (2019). This has resulted in some difficulties in estimating the real value of the domestic currency, and for this reason, we do not provide labor productivity for Turkiye in this figure. Recommendations B.4. Takeaways and Policy 37 We use the WBES to compare manufacturing firms’ contributions to employment and productivity in India (2022), Mexico (2023), the Philippines (2023), and Türkiye (2019) against Indonesia (2023). 30 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Figure B.3: Average number of workers per firm Figure B.4: Average sales per firm Contents Table of 35 2,500,000 30 2,000,000 25 Summary Executive Worker 20 1,500,000 US$ 15 1,000,000 10 500,000 5 Developments A.1. Recent Economic 0 - Mexico Philippines India Indonesia Mexico India Philippines Indonesia (2023) (2023) (2022) (2023) (2023) (2022) (2023) (2023) World Bank Enterprise Surveys. A.2. The Policy Note: All local currencies are expressed in 2009 US$. Stance 2.2 Sales inequality: the presence of large A notable aspect of Indonesia’s private sector is the firms in the economy small number of significantly large firms compared to the rest of the economy. Figure B.5. depicts a long A.3. Structural Trends Indonesia’s economy is characterized by a large right tail in the distribution of firms based on sales. mass of small-scale enterprises and a handful of The presence of long tail indicates the dominance major players, particularly in the manufacturing of a few large firms in the economy. This long tail is sector. Figure B.5 compares the distribution of firms’ only apparent in the size distribution for Indonesia. A.4. Outlook and Risks annual sales in the manufacturing and service sectors It does not appear in the distribution curve of other separately. Most of Indonesia’s distribution curve, comparator economies. whether in services or manufacturing, is situated to the left of the curves of other economies. This indicates Distributional analysis confirms the dominance of that the average Indonesian service or manufacturing A.5. Policy large firms in Indonesia’s economy. Compared to Priorities firm is smaller in scale. India, Mexico, Philippines, and Türkiye, Indonesia has B.1. Introduction Figure B.5: Kernel densities of sales of manufacturing and services firms: Indonesia vs. comparators Manufacturing Services Manufacturing India Indonesia India Indonesia Mexico Indonesia .4 .3 .4 .3 .2 .3 density density density .2 .2 B.2. Performance of .1 the Private Sector .1 .1 0 0 0 5 10 15 20 5 10 15 20 5 10 15 20 log of sales log of sales log of sales Services Manufacturing Services Mexico Indonesia Philippines Indonesia Philippines Indonesia .5 .4 .3 .4 Regualatory Uncertainty, density .3 .2 density density .3 the Next Challenge .2 .2 .1 .1 .1 B.3. Tackling 0 0 0 5 10 15 20 5 10 15 20 5 10 15 20 log of sales log of sales log of sales Manufacturing Services Turkiye Indonesia Turkiye Indonesia .4 .3 density .3 Recommendations .2 density .2 B.4. Takeaways .1 .1 and Policy 0 0 5 10 15 20 5 10 15 20 log of sales log of sales Source: World Bank Enterprise Surveys. Note: All local currencies are expressed in 2009 US$. 31 Indonesia Economic Prospects June 2024 heightened revenue inequality between firms. New Indonesia, providing substantial advantages that evidence shows that a smaller proportion of Indonesian smaller enterprises struggle to match. Chief among Contents Table of firms control a larger share of total revenue than other the potential benefits is large firms’ capacity for economies such as the Philippines. This suggests that higher productivity and innovation. Large firms can a smaller percentage of giant firms in Indonesia control lower production costs by leveraging economies of Summary Executive a more significant share of the total revenue compared scale and scope while investing significantly in quality to the Philippines or any other peer economy. Such improvements and adhering to international standards. distributional pattern for Indonesia has been persistent This propensity for innovation is tightly linked to their historically. Figure B.6 displays the Lorenz curve of productivity benefits, positioning them as key drivers manufacturing firms in Indonesia based on sales. The of economic advancement. Developments A.1. Recent Economic top 5 percent of large firms have dominated sales in the past 31 years. The presence of large firms can generate positive spillovers that benefit the broader economy. These This skewed and persistent distribution toward firms disseminate valuable knowledge and best A.2. The Policy larger Indonesian firms may have profound practices to smaller enterprises through agglomeration Stance implications. It could indicate a concentration of and robust supply chain linkages. Empirical evidence economic power and market influence among a select from South Korea illustrates how large companies’ group of firms, potentially hindering competition growth positively influences vendor SMEs’ growth and innovation within the manufacturing sector. The rates. Similar trends are observed in Europe and A.3. Structural question is whether this distribution affects other the United States, where small and medium-sized Trends performance indicators, like overall labor productivity. enterprises gain from being integrated into the supply chains of larger corporations, enhancing their growth At the same time, large firms could play a pivotal and competitiveness. A.4. Outlook role in the economic development of developing and Risks Figure B.6: Analysis of manufacturing firm sales Figure B.7: Analysis of manufacturing firm sales A.5. Policy distribution: Indonesia vs. comparators distribution: Indonesia across time Priorities 1 India Indonesia Mexico 1 cummulative share of real value added Philippines Turkiye 1988 2000 2010 2015 Cummulative share of sales .8 B.1. Introduction .8 .6 .6 .4 .4 B.2. Performance of the Private Sector .2 .2 0 0 0 20 40 60 80 100 0 20 40 60 80 100 % of firms (from lowest to highest sales) % of firms (from lowest to highest real value added) Regualatory Uncertainty, the Next Challenge B.3. Tackling Source: World Bank Enterprise Surveys. Source: Indonesia Central Statistics Agency (Badan Pusat Statistik, Note: All local currencies are expressed in 2009 US$. BPS)38 Recommendations B.4. Takeaways and Policy 38 Indonesia’s BPS (Badan Pusat Statistik) manufacturing data is a comprehensive dataset provided by the Indonesian Central Statistics Agency. This data encompasses various aspects of the manufacturing sector and medium and large firms, including production volumes, employment statistics, and economic output. The data is collected through regular surveys and censuses conducted by BPS. 32 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential 2.3 The Performance of Large Firms Figure B.8: Relationship between firm sales and Contents Table of employment – Indonesia vs. comparators Despite the presence of large firms, Indonesia’s 1500 average performance still needs to improve. This raises questions about these large firms’ relative Summary Executive performance and economic contribution. We want Number of worker 1000 to know their contributions to employment, average wages, and reallocation performance. 500 Developments Furthermore, large firms contribute to better A.1. Recent Economic labor market outcomes by offering higher wages and more secure employment.39 Workers in these 0 enterprises typically earn significantly more than 0 5000000 1.00e+07 1.50e+07 2.00e+07 smaller firms, with wage premiums averaging around Sales in US$  Comparator  Indonesia A.2. The Policy 22% higher per hour. This premium is even more Stance pronounced in lower-income countries, where large Source: World Bank Enterprise Surveys Note: All local currencies expressed in 2009 US$. firms provide formal jobs with valuable non-monetary benefits such as health insurance. These aspects 2.3.2 Efficient allocation of resources enhance worker welfare and contribute to a more A.3. Structural stable and productive labor force. Trends Understanding how well utilized scarce resources are allocated and used in the economy is crucial for Job creation and economic growth are also closely comprehending firm-level productivity dynamics tied to the activities of large firms. They significantly and overall economic health. Allocative efficiency A.4. Outlook contribute to net job creation and labor productivity and Risks measures whether there is an optimal distribution of growth, impacting national economies. For instance, resources among firms, where firms’ most productive in countries like Vietnam, Côte d’Ivoire, and Serbia, use of land, labor, and capital are allocated enough of the most prominent firms account for a considerable these resources to turn them into valuable products portion of total tax revenue and exports, underscoring A.5. Policy and services. This understanding of allocative efficiency Priorities their critical role in supporting public finances and enables an assessment of the effective deployment of international trade. resources across diverse businesses. Efficient allocation rewards the most productive firms, contributing to B.1. Introduction 2.3.1 Employment overall economic growth. In contrast, inefficiencies in allocation can lead to suboptimal outcomes, with less One important question is how large firms affect productive firms receiving an undue share of resources. employment. Figure B.8 illustrates the relationship between sales and employment, controlling for firm, To understand these efficiencies, we examine the B.2. Performance of the Private Sector sector, and country characteristics across firms in relationship between market shares at the industry Indonesia and comparator economies. As expected, the level and the average allocation of labor and capital figure shows a positive correlation between sales and that firms in the same industry employ. Specifically, jobs for firms in Indonesia and comparator economies. we investigate whether firms with above (below) Indonesian firms and their counterparts exhibit a average market share in sales employ more (less) Regualatory Uncertainty, similar positive association between sales and jobs, capital and labor than the average firm. This analysis the Next Challenge where higher sales are linked with higher employment helps determine if the market allocation is efficient. B.3. Tackling levels. This encouraging trend is consistent across both Where well-performing firms benefit the economy groups. However, despite this similarity, the strength of more, low-performing firms employ less than above- the correlation differs. Firms in comparator economies average resources. show a significantly stronger correlation between sales and employment than Indonesian firms, indicating Allocative inefficiency arises when firms with a lower employment response to sales growth for Recommendations market shares deviate from the average overuse or B.4. Takeaways Indonesian firms. and Policy 39 International Finance Corporation (IFC) Making It Big: Why Developing Countries Need More Large Firms 2020. https://thedocs.worldbank.org/en/ doc/717891604534837739-0090022020/original/110520MakingItBigWhyDevelopingCountriesNeedMoreLargeFirms.pdf 33 Indonesia Economic Prospects June 2024 underuse labor and capital resources. In Indonesia, a those with lower market shares employ less. These negative correlation is evident between a firm’s market comparator countries have no significant relationship Contents Table of share and its employment of labor and capital. This between market share and labor allocation. inefficiency is observed regardless of whether a firm’s market share is above or below average. Conversely, The results call into question the contribution to Summary Executive in comparator economies, only capital allocation productivity from large firms in the Indonesian exhibits a positive correlation with market share. Firms manufacturing economy. with higher market shares employ more capital, while Developments 3. Tackling Regulatory Uncertainty, the Next Challenge A.1. Recent Economic However, the structural inefficiencies of Indonesia’s resources and increasing costs, while navigating corporate landscape are only part of the story. regulations consumes time and reduces operational The other challenge lies in the realm of regulatory efficiency. Conversely, better access to finance enables A.2. The Policy uncertainty. As Indonesian businesses navigate firms to invest in growth and technology, enhancing Stance the complex legal and regulatory framework, they competitiveness. Thus, the subsequent section will are often affected by inconsistent policies and focus on these critical variables—corruption, bribery, unpredictable enforcement. This volatile environment and time spent with government regulation—to assess A.3. Structural affects entrepreneurial initiative and deters potential potential solutions for improving firm performance in Trends investments that could catalyze the much-needed Indonesia (see Figure B.9 and Figure B.10). economic dynamism and productivity enhancements. Thus, to comprehend the full spectrum of obstacles Time spent by managers dealing with government impeding Indonesia’s economic ascent, we must delve regulation has increased. Businesses flourish in A.4. Outlook and Risks into the intricacies of its regulatory climate. environments characterized by transparent, efficient, and predictable regulatory frameworks. Transparency Regulatory uncertainty may also reinforce Indonesia’s involves clear communication of rules, open processes private sector structure rigidities because large for regulatory changes, and easy access to relevant A.5. Policy Priorities firms can better navigate such an unpredictable information. Businesses thrive when they have a clear landscape. Typically, larger firms have more significant understanding of the rules and expectations. Efficiency financial and administrative resources to manage in regulation entails minimizing compliance burdens complex regulatory environments; an uncertain for businesses and governmental entities. Predictability B.1. Introduction regulatory environment favors them compared to within regulatory systems fosters a sense of certainty smaller firms. Large firms can afford specialized legal for enterprises, which is crucial for strategic planning and compliance teams to interpret and adhere to and operational decision-making. Clear delineation regulations, mitigating compliance costs. In contrast, of rules and their consistent application mitigates B.2. Performance of smaller firms often lack the resources and expertise to uncertainties, averting potential setbacks and the Private Sector navigate constantly evolving regulatory landscapes, delays that can dampen investment enthusiasm and leading to comparatively higher compliance costs. impede economic growth. By addressing these three Such uncertainty also exposes all firms to potential elements—a regulatory framework can be developed dubious practices to complete transaction. For smaller that supports business growth. firms, such practices present an onerous cost. Regualatory Uncertainty, Indonesia’s complex and inconsistent regulatory the Next Challenge B.3. Tackling Despite consistent improvement, including through landscape leads to significant enforcement issues. the recent Job Creation Omnibus Law, there are The discordance between central and local laws and indications that constraints within the business regulations creates varying compliance burdens for environment may continue to hinder productivity business across regions (see Figure B.10). For example, growth in Indonesia. Analysis shows that bribery and in West Java, executives dedicate approximately 4 regulatory burdens negatively impact firm productivity, percent of their time to navigating these regulatory Recommendations while improved access to finance has a positive effect. hoops. In stark contrast, the regulatory demands B.4. Takeaways and Policy Bribery fosters corruption and inefficiency, diverting impose a negligible burden on senior management 34 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Figure B.9: Senior management time spent dealing with Figure B.10: Bribery depth (percent of public Contents Table of requirements of government regulation transactions where a bribe was requested) Riau 0.0 Banten 0.0 Central Java 0.1 West Sumatra 0.1 Summary Executive East Kalimantan, North Kalimantan 0.1 East Kalimantan, North Kalimantan 0.3 East Nusa Tenggara 0.1 Riau 0.7 Special Capital Region of Jakarta 0.2 Aceh 1.2 Papua 0.2 West Nusa Tenggara 1.8 Developments West Kalimantan 0.2 West Java 1.8 A.1. Recent Economic West Sumatra 0.2 Bali 2.1 West Nusa Tenggara 0.3 Special Region of Yogyakarta 2.4 North Sumatra 0.3 Papua 4.8 Maluku Islands (Maluku and North Maluku) 0.4 West Kalimantan 6.0 South Kalimantan, Central Kalimantan 0.5 East Java 6.5 A.2. The Policy Banten 0.5 South Kalimantan, Central Kalimantan 7.0 Stance South Sumatra, Bengkulu, Jambi 0.6 East Nusa Tenggara 7.2 East Java 0.7 The Bangka Belitung Islands, the Riau Islands 10.5 Bali 0.8 South Sumatra, Bengkulu, Jambi 15.9 0.8 19.5 A.3. Structural The Bangka Belitung Islands, the Riau Islands Maluku Islands (Maluku and North Maluku) Trends Lampung 0.9 Special Capital Region of Jakarta 22.8 Special Region of Yogyakarta 0.9 Central Java 28.8 Aceh 1.2 Sulawesi 29.4 Sulawesi 1.4 North Sumatra 31.5 A.4. Outlook West Java 4.2 Lampung 34.4 and Risks 0 1 2 3 4 5 0 5 10 15 20 25 30 35 40 Source: World Bank Enterprise Survey data in Riau, Central Java, and East and North Kalimantan. corruption was likely a result of less cumbersome A.5. Policy Priorities Such disparities underscore the pressing need for regulations. However, firms frequently find themselves concerted efforts to streamline regulatory frameworks compelled to navigate unofficial channels alongside and enhance consistency in enforcement across official ones when securing business registration and B.1. Introduction Indonesia’s diverse jurisdictions. construction permits. Indeed, 29.5 percent of surveyed firms indicate the necessity of offering gifts to public Corruption remains a major constraint in the officials to expedite bureaucratic processes. Therefore, business environment. This was identified by 23.6 this underscores the need for sustained anti-corruption percent of surveyed firms. Navigating opaque and efforts, aided by streamlined regulations that reduce B.2. Performance of the Private Sector discretionary regulations often pushes businesses opportunities for bribery. toward illicit avenues, with bribery emerging as a coping mechanism of choice. The prevalence of Figure B.11: Bribery incidence (percent of firms that corruption in public transactions across Indonesia report at least one bribe payment request) fluctuates significantly. It correlates positively with Regualatory Uncertainty, senior management’s time complying with government the Next Challenge regulations (17 percent, discounting West Java as an B.3. Tackling 30.6 outlier 27.2 26.9 20.3 Corruption is declining, but the expectation of 15.8 ‘gifts’ to expedite the bureaucratic processes has 8.3 1.4 increased, and corruption remains among the top constraints to productivity. Bribery incidence peaked Recommendations B.4. Takeaways 2022 2009 2015 2023 2023 2023 2019 at 31 percent in 2015 and fell to 20 percent in 2023, and Policy INDIA INDONESIA MEXICO PHILIPPINES TURKIYE yet Indonesia’s rate is still higher than most countries, second only to India (Figure B.11). The drop in Indonesia’s Source: World Bank Enterprise Surveys (years indicate when the survey was implemented). 35 Indonesia Economic Prospects June 2024 Finally, corruption undermines firm performance. indicates the effect of various bribery-related factors Table B.3 reveals a clear negative correlation between on productivity, with negative values indicating a Contents Table of bribery and productivity firms that engage in or are detrimental impact. Firms deeply involved in bribery expected to engage in bribery more frequently than and those frequently having to pay bribes have average tend to exhibit lower productivity than those considerable reduction in productivity. But other factors Summary Executive that report fewer incidents of bribing government also, such as times spent dealing with regulations, the officials. This finding underscores the detrimental expectations to bribe, including to bribe tax officials, impact of corruption on economic efficiency and are all associated with reduced productivity. The business operations. consistent negative coefficients across all variables emphasize that both the anticipation and practice of Developments A.1. Recent Economic The negative relationship between bribery and firm bribery and associated regulatory burdens significantly productivity is evident across different forms and diminish firms’ productive capacities. stages of corruption. Each coefficient in Table B.3 Table B.3: Relationship between bribing and firm productivity A.2. The Policy Stance Expected to Expected Bribery depth Bribery Time spent w/ bribe to bribe tax incidence Regulation officials -0.009*** -0.006** -0.025*** -0.023*** -0.010*** A.3. Structural Trends Source: World Bank Enterprise Surveys Note: The table presents correlation coefficients between selected indicators of bribery and productivity of firm. *** statistically significant at the 0.001 level. 3.1 Regulatory Uncertainty actions: improving coordination across the regulatory A.4. Outlook and Risks system; ensuring the development of new regulations An unpredictable regulatory process further is evidence-based and transparent; and enhancing the weakens the business environment, inhibits transparency, efficiency, and currency of existing rules. competition, and deters potential investors. The A.5. Policy Priorities uncoordinated design and uneven implementation As a result of incomplete reforms, the specter of business-related laws and regulations exacerbate of regulatory uncertainty looms large, casting a deficiencies in the business climate by increasing shadow over firms’ investment endeavors and regulatory uncertainty. This is especially daunting for innovation prospects. Hallward-Driemeier, Khun- B.1. Introduction prospective investors, who are typically less willing to Jush, and Pritchett (2010) argue that this uncertainty, deal with such uncertainty than incumbent businesses stemming from ambiguous policy implementation, (World Bank 2020).40 jeopardizes firms’ capacity to realize returns on their investments and innovative pursuits. A pivotal B.2. Performance of distinction is drawn between policies enshrined in the Private Sector Indonesia’s regulatory reforms have yet to achieve the desired impact. The World Bank’s Regulatory Policy official documents and their practical execution, as and Delivery Review (RPDR) praised the government reflected in the actions of governmental authorities. for introducing or strengthening many critical aspects Even when policies remain ostensibly stable on paper, of global Good Regulatory Practice (GRP) by 2020, their implementation uncertainty persists, posing especially at the executive level. However, the Review intricate business challenges. Regualatory Uncertainty, the Next Challenge highlighted that these advances remain insufficiently B.3. Tackling established or only partially applied. Key areas Moreover, regulatory uncertainty exerts a tangible requiring improvement include regulatory overlap and drag on employment expansion. The authors’ analysis conflict due to poor coordination, overproduction of reveals stark disparities among firms within the same low-quality regulations, inadequate planning leading national jurisdiction in navigating diverse regulatory to frequent annulments, and a lack of clarity for requisites, be it the duration to procure operational innovative, technology-based activities. The Review licenses or to clear imported goods through customs. Recommendations B.4. Takeaways emphasized that piecemeal reforms cannot resolve These disparities align closely with the proportion and Policy Indonesia’s regulatory system’s deeper institutional of firms grappling with heightened uncertainty and structural issues. It recommended three broad regarding prevailing policies and regulations in their 40 World Bank. Indonesia Systematic Country Diagnostic Update. Washington, DC: World Bank, 2020. https://documents1.worldbank.org/curated/ en/717421594076964759/pdf/Indonesia-Systematic-Country-Diagnostic-Update.pdf 36 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential operational milieu. Furthermore, a discernible negative heightened significance against the backdrop of the risk-based business licensing framework, wherein Contents correlation emerges between heightened variability in Table of policy execution and firm-level employment growth, the business licensing procedures are contingent underscoring the inhibitive impact of regulatory upon risk classifications. The forthcoming revisions unpredictability. to Government Regulations No.5 Year 2021—about Summary Executive implementing risk-based licensing—promise to provide Regulatory officials with discretionary powers play greater clarity for business stakeholders navigating the a pivotal role in this narrative. Excessive discretion intricate terrain of establishing a business. can sometimes lead to challenges. In some cases, officials may expedite approvals in exchange for Facilitated by Job Creation Omnibus Law Developments A.1. Recent Economic incentives, bypassing legal mandates such as granting enactment, the government enhanced the online construction permits without adhering to prescribed platform for the business registration process quality standards. Conversely, regulatory processes (AHU Online) and the business licensing process may be slowed for certain businesses, leading to (OSS) leading to improvements in starting a A.2. The Policy consistency in the time required for regulatory business.43 The legislation streamlined and digitized Stance endorsements and increasing regulatory uncertainty. the registration process, consolidating various steps In the subsequent analysis, the report identifies where into a single online platform and adopting a risk- and how Indonesian businesses encounter regulatory based approach for OSS. The platform now provides uncertainty. The analysis is directed towards three comprehensive information and step-by-step A.3. Structural pivotal regulatory compliance domains: business procedures to guide businesses, reducing bureaucratic Trends registration, acquisition of construction permits, hurdles and expediting approvals. Additionally, the and tax inspections, each serving as barometers of law standardizes procedures and clarifies guidelines, regulatory uncertainty. enhancing transparency and efficiency to foster a A.4. Outlook more favorable business environment, encouraging and Risks 3.1.1 Business Registration41 investment and economic growth. Challenges remain, including ensuring full digital adoption and integration Establishing businesses in Indonesia presents major nationwide, addressing interoperability challenges, challenges. While companies must register only once, improving the digital literacy of users, and resolving A.5. Policy Priorities obtaining pertinent information on requirements, occasional technical issues with the online system. procedures, and associated fees is challenging, accessible through a web portal or the regulator’s 3.1.2 Construction permits B.1. Introduction office. Ostensibly, no informal requisites or procedures exist beyond the official ones. However, the reality belies Indonesia’s construction permit regime is complex this simplicity, as businesses often find themselves and lacks transparency, engendering a climate of compelled to dispense informal fees to expedite the uncertainty for businesses. The complex approval establishment and business licensing processes. These processes need more transparency, leaving applicants B.2. Performance of the Private Sector informal payments are perceived as essential lubricants in the dark regarding the fate of their submissions. to grease the wheels of bureaucratic machinery and Adverse decisions are rendered devoid of justification, navigate ambiguities inherent in the information and avenues for appeal are conspicuously absent. This provided to the registrar’s office. opacity fosters an environment ripe for hidden “fees” and breeds a culture of uncertainty. This challenge is exacerbated by the need for a Regualatory Uncertainty, the Next Challenge robust information system, which hinders businesses Recent reforms have ushered in changes to the B.3. Tackling from understanding the complex processes, costs, construction permit landscape. These reforms and timelines in starting operations. Entrepreneurs aim to replace Building Permits and Environmental are still grappling with bureaucratic complexities Permits with Building Approval and Environmental despite efforts made by various ministries to make Approval, respectively. However, this overhaul poses all requirements easily accessible including through a difficulty for larger firms embarking on investments the online platforms42 for business establishment necessitating these additional approvals. Although the Recommendations B.4. Takeaways and licensing procedures. This complexity assumes SIMBG (Building Management Information System) and Policy 41 The coverage of business registration in this section encompasses the company’s establishment and business licensing processes, which are part of business entry procedure. 42 Company establishment & Business Licensing’s procedure and requirement are available on the following platforms respectively: The platforms are AHU Online (https://panduan.ahu.go.id/doku.php) and OSS (https://oss.go.id/informasi). 37 43 AHU Online is one of the government/agency’s systems that has been integrated into the OSS system. Indonesia Economic Prospects June 2024 and AMDALNET (Environmental Approval System) 3.2.1 Efficiency and discretion: Cross-country analysis have been integrated into the OSS system since 2023, Contents Table of only some activities/requirements can be processed The WBES provides invaluable data on how online directly through the OSS. Medium-high risk regulations affect efficiency and uncertainty. and high-risk activities were only integrated from For instance, the average transaction time gauges Summary Executive AMDALNET into the OSS system in March 2024). regulatory efficiency, while the variance indicates uncertainty.45 A high variance suggests variability in wait Consequently, medium to high-risk projects grapple times, reflecting uncertainty, whereas a low variance with augmented compliance costs, requiring a signifies more predictable transactions.46 Therefore, cumbersome blend of online and offline procedures the variance is crucial for identifying and addressing Developments A.1. Recent Economic and entailing interactions with various public regulatory inefficiencies and uncertainties that may entities at both central and local levels. For example, compromise regulatory frameworks. The analysis the Building Approval (PBG) procedure, which uses the was conducted for Indonesia and four comparator digital SIMBG platform, aims to streamline approvals. countries and covers seven regulatory transactions, It A.2. The Policy However, it is currently slowed by lingering analog resulted in data for 35 country/regulatory pairs. Figure Stance practices and the need for fully digital documentation. B.12 illustrates the efficiency and uncertainty levels Additionally, the verification of technical documents by associated with these regulatory interfaces. professional teams can be complex. These complexities render these projects more susceptible to corruption The finding indicates that regulatory transactions A.3. Structural and discretionary practices among public officials, vary in efficiency and uncertainty levels. Graphed are Trends exacerbating the challenges inherent in Indonesia’s all of the regulatory transactions recorded by the WBES construction permit ecosystem. Addressing these undertaken by firms in four comparator countries, plus issues will help realize the benefits of faster and more Indonesia, in the latest round of surveys. They are A.4. Outlook efficient building approvals, enhancing the construction mapped by the average time it took to complete the and Risks process for businesses. transaction (efficiency) and the variance across firms of the time it took to complete these transactions 3.2 Efficiency and uncertainty in regulatory (uncertainty). compliance A.5. Policy Priorities Few regulatory interfaces qualify as efficient and To understand how regulatory complexity affects predictable (quadrant 1). At the same time, many are firms, we extend our analysis by looking into inefficient and highly uncertain (quadrant 3). Among B.1. Introduction the dynamics of efficiency and discretion across intermediate cases, some are efficient but highly a broader spectrum of regulatory compliance uncertain (quadrant 2), and a smaller number are regimes. Since there are more than 800 licensing inefficient but predictable. Most regulatory transactions regimes in the Indonesian regulatory system, we focus show high discretion (28 out of 35), indicating significant on universal government transactions no matter what variation. Interestingly, many efficient transactions also B.2. Performance of the Private Sector part of the world a firm operates.44 This way, we can have high discretion (23 out of 28), underscoring the compare how well Indonesia compares to the rest of complexity of regulatory processes. the world. Leveraging insights from multiple rounds of World Bank Enterprise Surveys conducted in Indonesia, There are notable differences between firms of we provide empirical evidence of the interplay between different sizes and their experience with regulatory regulatory efficacy and uncertainty, offering a new interfaces. Figure B.14 shows that, on average, Regualatory Uncertainty, the Next Challenge understanding of Indonesian businesses’ regulatory large firms took longer to complete the regulatory B.3. Tackling landscape. procedures than small and medium firms. However, the variance (CoV, in the chart) was lowest for the large firms, followed closely by medium firms, indicating that these two categories faced less uncertainty when complying with regulations than small firms. Recommendations B.4. Takeaways and Policy 44 Currently, there are 318 Sectoral Business Licensing and 550 Business Licensing to Support Business Activity (PB-UMKU) across more than 18 ministries/agencies. 45 We use the coefficient of variance as the measure of variance, which is the ratio of the standard deviation to the mean. Since larger firms have more complex transactions and consequently longer wait times, we normalize the variance of wait times by dividing by the average wait time for each transaction. This allows us to compare variances across different types of firms. 46 These are obtaining electricity and water connections, clearing exports and imports through customs, obtaining construction permits, and operating and import licenses. 38 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Figure B.12: Efficiency vs uncertainty in regulatory Figure B.13: Average efficiency and discretion Contents Table of compliance across regulatory compliance regimes: Indonesia and comparator countries 2.0 4.0 Summary Executive 1.8 Türkiye 3.5 2 Philippines 3 1.6 Coefficient of variation 3.0 Coefficient of variation 1.4 Indonesia India 2.5 1.2 China 2.0 1.0 Developments A.1. Recent Economic 0.8 Nigeria Egypt 1.5 0.6 1.0 Mexico 0.4 0.5 4 0.2 1 0.0 0.0 A.2. The Policy 0 20 40 60 80 100 0 10 20 30 Stance Average mumber of days Average number of days Source: World Bank Enterprise Survey data A.3. Structural by the variation of time taken, varied from a low of Trends Figure B.14: Indonesia: Regulatory efficiency and discretion across firm sizes in 2023 0.94 for import licenses to a high of 1.93 for obtaining a construction permit. Two of the five regulatory 16 2.5 Average CoV interfaces fell in the northeast quadrant, reflecting A.4. Outlook 14 the worst of both worlds, i.e., low efficiency and high and Risks 2.0 Weighted average time taken 12 discretion. All these areas relate to starting a business, Weighted average CoV 10 i.e., construction permits and operating licenses. 1.5 (in days) 8 The situation improved considerably by 2015, but A.5. Policy Priorities 6 1.0 momentum slowed more recently. There was much 4 less variation in performance across the regulatory 0.5 interfaces (Figure B.16; panel 2). All regulatory areas fell 2 B.1. Introduction in the two western quadrants, indicating a significant 0 0.0 improvement in efficiency. For example, the average Small Medium Large Firm size number of days to obtain a construction permit fell from 50 days in 2009 to 11 days, while that of obtaining Source: World Bank Enterprise Survey data an operating license from 20 days 8 five days. The B.2. Performance of the Private Sector variation ranged from 0.66 to 1.5. This trend is reversed Regulatory efficiency and uncertainty have in 2023 (Figure B.16; panel 3), but mainly in the degree improved. In 2009, there was wide variation in of discretion. All regulatory interfaces, except import efficiency across different regulatory interfaces. The clearance, had variation above the threshold of 1.0, time taken to complete a regulatory procedure ranged with a broader range than in 2015, i.e., from a low of from three days to obtain an export clearance to 50 0.8 for import clearance to a high of 2.5 for obtaining Regualatory Uncertainty, the Next Challenge days to obtain a construction permit (Figure B.16; an operating license. B.3. Tackling panel 1). Similarly, the degree of discretion, measured Recommendations B.4. Takeaways and Policy 39 Indonesia Economic Prospects June 2024 Figure B.15: Indonesia: Regulatory efficiency and discretion over time Contents Table of 2009 2015 2.5 2.5 Coefficient of variation Coefficient of variation 2.0 C 2.0 Summary Executive 1.5 X Cl 1.5 C OL M Cl OL 1.0 ML 1.0 ML 0.5 0.5 X Cl M Cl 0.0 0.0 Developments A.1. Recent 0 20 40 60 Economic 0 20 40 60 Average time taken in days Average time taken in days 2.5 OL 2023 C 2.0 Coefficient of variation A.2. The Policy Stance 1.5 ML 1.0 X Cl 0.5 M Cl 0.0 A.3. Structural 0 20 40 60 Trends Average time taken in days Source: World Bank Enterprise Survey Note: C refers to the construction permit, OL refers to operating license, M CL refers to import clearance, X CL refers to export clearance, and ML refers importing license A.4. Outlook and Risks 4. Takeaways and Policy Recommendations In the past ten years, Indonesia’s private sector corporations can enhance a nation’s export prowess, reforms have improved the business environment A.5. Policy positioning it as an industry leader on the international Priorities but have not translated into productivity gains. stage. The narrative has evolved from basic infrastructure and regulatory harmonization to a more difficult need However, there exist notable drawbacks. Such B.1. Introduction for market efficiency (quality of regulations, access sizeable entities translate into market dominance; to finance, trade, etc.), competition, and innovation. this can dampen competition, thereby diminishing Access to finance, corruption, and time spent dealing incentives for innovation and growth. This top- with government regulations affect firms’ productivity heavy market structure may also disadvantage smaller the most. enterprises since dethroning large firms will be a B.2. Performance of the Private Sector formidable challenge for up-and-coming firms that Indonesia’s private sector is characterized by many dare to enter a market dominated by large firms. smaller firms alongside few dominant players. Furthermore, market leaders may exploit their power, While this structure offers some potential advantages, impose higher prices, and potentially wield undue it also presents significant challenges for growth and influence over governmental policies to serve their Regualatory Uncertainty, development. interests. Moreover, limited consumer choice may the Next Challenge ensue when a handful of major players control the B.3. Tackling On the positive side, the scale of large firms grants market, curtailing variety in products and services. them the ability to capitalize on economies of scale, potentially yielding lower production costs The dominance of giant firms can operate in and consumer prices. Moreover, their substantial markets segmented from smaller firms. Such resources enable significant investments in research segmentation can impede growth, innovation, and Recommendations and development, propelling industry-wide innovation global competitiveness. Notably, the dominance of B.4. Takeaways and Policy and technological progress. Established brand large firms in Indonesia’s manufacturing sector could recognition and robust marketing capabilities extend impede opportunities for outsourcing or sourcing from their market reach, fostering stability and consumer local small-scale suppliers. Resource limitations make trust. Additionally, the global footprint of large the small-scale suppliers unattractive partners for 40 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential industry giants, disinclined to engage due to concerns 4.1 Policy Recommendations about quality consistency and scalability amid intense Contents Table of competition for contracts. Such dynamic impacts Addressing fragmentation between firms will knowledge transfer and technological innovation, create more and better jobs. Strengthening linkages hampering sector-wide competitiveness and growth among the various segments of the private sector— Summary Executive potential. formal and informal, small and large—will mitigate the dual economy issue, where segments operate Without links to larger firms, smaller firms may with little interaction. The government should adopt be more vulnerable to external shocks, such as a comprehensive approach beyond local content and economic downturns. With limited resources and Developments downstream initiatives to develop supplier quality, A.1. Recent Economic poor financial resilience, this vulnerability poses enhance technology transfers, and build resilience, significant risks, triggering cascading effects like job fostering a robust and interconnected private sector. losses and economic downturns. Additionally, unequal Supplier development programs will enable local revenue distribution within the sector exacerbates businesses to benefit from investments to improve A.2. The Policy disparities, as concentrated profits among a few large skills and the workforce sustainably. Enforcing contracts Stance firms limit government revenue, constraining crucial through streamlined court structures, transparent and social spending and infrastructure development vital standardized court proceedings and case management for citizen welfare and sustainable economic growth. rules, and advanced court automation systems will increase trust among formal firms. Additionally, A.3. Structural Lower labor productivity within the manufacturing alternative dispute resolution (ADR) mechanisms can Trends sector explains some of its lackluster performance. reduce the courts’ burden, provide more efficient and A cursory look at Indonesia’s manufacturing firms effective means of resolving disputes, and promote compared to cohorts in India, Mexico, the Philippines, greater access to justice for all stakeholders. These A.4. Outlook and Türkiye reveals a substantial concentration of data linkages can be partially strengthened by improving and Risks towards the lower end of the productivity spectrum the design and implementation of existing regulations within Indonesia’s distribution, depicted by a bell- on partnership between MSMEs and large firms shaped curve. This suggests that a significant workforce (Ministry of Investment Regulation No. 1 Year 2022) segment exhibits comparatively lower productivity and innovation (Ministry of Finance Regulation No. A.5. Policy Priorities levels than their counterparts in other economies. 153/PMK.010/2020). Lower labor productivity results in diminished Addressing regulatory uncertainty will enhance B.1. Introduction output per unit of labor input. Consequently, investment quality and facilitate business manufacturers may need help competing on price operations. The government could conduct digital- and quality in the global marketplace. This, in turn, inspection to assess the implementation gaps across can impede economic growth, as constrained output regions. Business compliance with environmental expansion within the manufacturing sector may stifle a and social standards remains a significant constraint. B.2. Performance of the Private Sector nation’s overall economic advancement. Hence, ensuring that risk-based licensing for medium and high-risk business activities can be completed The costs of complying with regulatory transactions online transparently and uniformly across the are trending downward and are low, but regulatory country is essential. This requires a comprehensive IT uncertainty is still a burden. Regulatory uncertainty modernization across various ministries, departments, and other hassles of dealing with regulatory bodies are and agencies. Reviewing, re-classifying and re- Regualatory Uncertainty, the Next Challenge often due to poor quality of regulatory governance, purposing the volume of licenses, many of which B.3. Tackling making policy and regulations vulnerable to capture, are redundant or require overly frequent renewal, privilege-seeking, and corruption. The government is a meaningful step. This reform would require recognizes this, and in 2015, it issued the National support from various sectoral ministries to ensure the Strategy for Regulatory Reform 2015-19, the first- effectiveness of digital-based licensing and compliance ever initiative of this nature. Sixteen economic policy with service level agreement. These cumulative packages followed from this. Some focused primarily improvements are expected to significantly facilitate Recommendations B.4. Takeaways on regulatory reforms, such as Economic Package 12 investment realization and business operationalization, and Policy and Economic Package 16, which aimed to accelerate aligning the country with international best practices. streamlining licensing and permitting processes. Other Eliminating uncertainty will benefit small and large economic packages also contained regulatory reform firms, stimulating enterprise dynamism and attracting components. much-needed investments. 41 Indonesia Economic Prospects June 2024 A n nex Contents Table of Summary Executive Annex Table 1: Allocative efficiency: Relationship between capital and labor allocations and size (sales) and market concentration (HHI Index) Developments Indonesia Comparators A.1. Recent Economic labor capital labor capital (1) (2) (3) (4) (5) (6) (7) (8) Missing reference category is 1st quartile in annual sales 2nd quartile in annual sales 0.5725** 0.6523** 0.0524 0.0507 0.4426*** 0.4601*** 0.3317*** 0.3408*** A.2. The Policy (dummy=1) Stance (0.288) (0.292) (0.459) (0.459) (0.114) (0.113) (0.110) (0.110) 3rd quartile in annual sales 0.6011** 0.6468*** -0.0627 -0.0623 1.1535*** 1.1598*** 0.4583*** 0.4429*** (dummy=1) (0.236) (0.235) (0.488) (0.489) (0.138) (0.138) (0.133) (0.133) A.3. Structural Trends 4th quartile in annual sales 0.8192*** 0.7691*** -0.5037 -0.5054 0.8866*** 0.9018*** 0.1640 0.1493 (dummy=1) (0.304) (0.279) (0.466) (0.466) (0.167) (0.166) (0.130) (0.130) Missing reference category is HHI Index=1 A.4. Outlook HHI Index=2 2.0111*** 0.2656 0.6302** and Risks (0.396) (0.286) (0.278) HHI Index=3 1.7596*** 0.4138 0.5843** (0.391) (0.275) (0.284) A.5. Policy Constant -1.8060*** -3.6260*** -1.1014*** -1.0997*** -1.6382*** -2.0144*** -0.8989*** -1.4994*** Priorities (0.153) (0.406) (0.365) (0.366) (0.071) (0.286) (0.060) (0.287) Observations 806 806 239 235 6,325 6,325 5,989 5,989 B.1. Introduction Standard errors in parentheses *** p<0.01, ** p<0.05, * p<0.1 This table provides the regression results on the relationship between the efficient allocation of labor and capital. B.2. Performance of It compares these allocations across different company sizes and market competitiveness levels. The unweighted the Private Sector estimates are based on the fixed effects of country, industry, and location. We are cautious about overinterpreting the results because of likely collinearity issues with one of the dependent variables (size based on sales) and the dependent variable (a derivative of industry-level market share). Also, when using the Herfindahl-Hirschman Index to measure market concentration, we dropped the industry dummy as market concentration is estimated at the industry level. Regualatory Uncertainty, the Next Challenge Columns (1) and (2) are the regression results for labor allocation for Indonesia. Columns (3) and (4), again for B.3. Tackling Indonesia, but the allocation results for capital allocation. Also, columns (5) and (6) are the regression results for labor allocation for comparator economies, while columns (7) and (8) are the regression results for capital allocation. Recommendations B.4. Takeaways and Policy 42 Indonesia Economic Unleashing Prospects Indonesia’s June Business 2024 Potential Re ference s Contents Table of Summary Executive PART A Developments A.1. Recent Economic Bundy et al. 2024. School Meals, Social Protection and Human Development Outcomes. World Bank Social Protection and Jobs Discussion Paper No. 2401 in Alderman, Bundy and Gelli. 2024. School Meals Are Evolving: Has the Evidence Kept Up? The World Bank Research Observer. Buzas, L. et. al. 2022. Analyzing the Determinants of EMDE Local-Currency Sovereign Yields: A Simple Comparative A.2. The Policy Approach. Washington, D.C.: World Bank Group. Stance Gordon, R., Li, Wei. 2009. Tax structures in developing countries: Many puzzles and a possible explanation. Journal of Public Economics, 2009, vol. 93, issue 7-8, 855-866. A.3. Structural Trends Lompo, A.A.B. 2024. How Does Financial Sector Development Improve Tax Revenue Mobilization for Developing Countries? Comparative Economic Studies Volume 66, pages 91–125. https://doi.org/10.1057/s41294-023-00207-9. Ministry of Finance. 2024. APBN KiTa. March. Republic of Indonesia. A.4. Outlook and Risks OECD. Tax Morale: What Drives People and Businesses to Pay Tax? OECD Library. World Bank. 2020. Indonesia Public Expenditure Review: Spending for Better Results. Washington, DC: World Bank. A.5. Policy Priorities World Bank. 2023a. Indonesia Economic Prospects, June 2023: The Invisible Toll of COVID-19 on Learning. Washington, DC: World Bank. World Bank. 2023b. Indonesia Economic Prospects, December 2023: Climate Action for Development. Washington, DC: B.1. Introduction World Bank. World Bank. 2024a. East Asia and the Pacific Economic Update: Firm Foundations of Growth. April. Washington, DC: World Bank. http://hdl.handle.net/10986/41211. B.2. Performance of the Private Sector World Bank. 2024b. Tax Policy Review in Indonesia: Corporate Income Tax, Alternative Final Tax, and Value-Added Tax. Forthcoming. World Bank. 2024c. Global Economic Prospects: Subdued Growth, Multiple Challenges. Washington, DC: World Bank. World Food Program. 2023. The State of School Feeding Worldwide 2022. Rome: World Food Program. Regualatory Uncertainty, the Next Challenge B.3. Tackling PART B Secretariat. 2022. ASEAN Handbook on Good Regulatory Practice. Jakarta: ASEAN Secretariat. Recommendations Ciani, A. et. al. 2020. Making It Big: Why Developing Countries Need More Large Firms. Washington, D.C.: World Bank B.4. Takeaways and Policy Group. Ikhsan, M. et al. 2022. The Productivity and Future Growth Potential of Indonesia. Economics and Finance in Indonesia: 43 Indonesia Economic Prospects June 2024 Vol. 67: No. 2, Article 6. DOI: 10.47291/efi.v67i2.996 Contents Table of International Finance Corporation. 2019. Creating Markets in Indonesia: Country Private Sector Diagnostic. https:// www.ifc.org/en/insights-reports/2010/cpsd-indonesia World Bank. World Bank Enterprise Surveys. https://www.enterprisesurveys.org/en/enterprisesurveys Summary Executive World Bank. 2020. Indonesia Systematic Country Diagnostic Update. Washington, DC: World Bank. World Bank. 2022. Indonesia Economic Prospects, June 2022: Financial Deepening for Stronger Growth and Sustainable Developments Recovery. Washington, DC: World Bank. A.1. Recent Economic World Bank. 2023. Indonesia Economic Prospects, December 2023: Climate Action for Development. Washington, DC: World Bank. A.2. The Policy Stance A.3. Structural Trends A.4. Outlook and Risks A.5. Policy Priorities B.1. Introduction B.2. Performance of the Private Sector Regualatory Uncertainty, the Next Challenge B.3. Tackling Recommendations B.4. Takeaways and Policy 44 Supported by funding from the Australian Government through the Australia-World Bank Indonesia Partnership (ABIP)