The Sum is Greater than the Parts: Doubling Shared Prosperity in Indonesia Through Local and Global Integration i Table of Contents Page Preface v Abstract vi Executive Summary vii CHAPTER ONE 1 Indonesia’s Development Challenge: Doubling Shared Prosperity by Accelerating Sustainable, Inclusive Growth Cukup Baik Tidak Cukup – Good Enough is Not Enough 1 How fast has Indonesia grown? 3 How competitive is Indonesia’s growth? 12 How fairly has Indonesia grown? 16 Comparative Growth Performance 18 Study Context and Organization 24 CHAPTER TWO 27 Strategy for Accelerating Sustainable, Inclusive Growth: Local and Global Economic Integration The Binding Constraint in Accelerating Sustainable, Inclusive Growth 27 Local Economic Fragmentation 27 Global Economic Marginalization 31 Local and Global Economic Integration 33 CHAPTER THREE 39 Improving Hard and Soft Infrastructure: Reducing the Costs of Logistics and Transactions Indonesia’s High Cost Economy 39 The Context of Logistics and Transactions Costs 41 Indonesia’s Hard Infrastructure Deficit: Logistics Costs and Efficiency 44 Indonesia’s Soft Infrastructure Deficit: Transaction Costs and Productivity 53 Lessons and Policy Prescriptions 73 ii CHAPTER FOUR 76 Developing and Utilizing Human Resources: Promoting Productive Employment and Livelihoods Productive Work, Employment, Livelihoods, and Economic Growth 77 Boosting Productive Work in Indonesia 83 Raising Labor Productivity by Improving the Quality of Higher Education 93 Synergies in Broad-Based Initiatives 102 CHAPTER FIVE 104 Getting Things Done: The Politics of Doubling Shared Prosperity Political Benefits of Inclusive Growth 105 The Horizontal Politics of Getting Things Done: Executive-Legislative Relations 107 The Vertical Politics of Getting Things Done: Intergovernmental Relations 115 Promoting Local Investment: The Mining Sector 118 Politics, Investment, and Effective Decentralization 121 CHAPTER SIX 125 Moving Forward: Reactive, Proactive, and Transformative Policy Alternatives Three Development Paths 125 Reactive: Policy by Exception 126 Proactive: Sporadic Reform 128 Transformative: Fundamental Metamorphosis 130 The Road Not Taken 131 Annexes Annex 1: Indonesia – Selected Indicators 134 Annex 2: Labor, Capital and Total Factor Productivity in Indonesia 135 Annex 3: What are Public Private Partnerships? 138 Annex 4: Where Has All the Garlic Gone? 141 Annex 5: State Capacity, Governance, and Credibility 144 Annex 6: “HE Drives Growth” – Empirical Issues 147 References 149 iii Figures Figure 1.1: Indonesia’s YoY GDP Growth – With Focus on Krismon 5 Figure 1.2: Indonesia and Regional Peers – GDP Growth Rates (CAGR, %) 6 Figure 1.3: Indonesia and Country Peers – GDP Growth Rates (CAGR, %) 6 Figure 1.4: Manufacturing Value-Added per Employee (USD) 14 Figure 1.5: Saving and Investment Rates among Regional Peers 18 Figure 3.1: Domestic Credit Provided by Banking Sector (% of GDP) 55 Figure 3.2: Broad Money (% of GDP) 55 Figure 3.3: CPI Inflation Rates (%) 56 Figure 3.4: Nominal Prime Interest Rate (%) 59 Figure 3.5: Nominal Exchange Rate Against USD 67 Figure 3.6: Share of Manufacturing Output (% by Region) 72 Figure 3.7: Share of Manufacturing Output – Zoom in on the AFC (% by Region) 72 Figure 4.1: Population 15 Years of Age and Over by Main Industry (% Pop) 79 Figure 4.2: Population 15 Years of Age and Over by Main Employment Status (% Pop) 79 Figure 4.3: Arable Land and Agricultural Output 88 Figure 4.4: Employment in Agriculture (% of total) vs. Agriculture Output (% GDP) 89 Figure 4.5: HDI Index Trend Over Time 93 Figure 4.6: HDI Index Regional Benchmark, 2012 94 Text Boxes Box 1.1: Government of Indonesia’s Development Plans 2 Box 1.2: Indonesia’s Middle Class as a Driver of Economic Growth 8 Box 1.3: “Stability” and “Balance” in the Indonesian Economy 11 Box 1.4: Total Factor Productivity in Indonesia 15 Box 1.5: Measures and Trends of Inequality in Indonesia 17 Box 2.1: Why Is There So little Support for MP3EI? 36 Box 3.1: Improvements in Personal Transport as a Negative Sum Game 43 Box 3.2: Corruption and Growth 57 Box 3.3: Indonesia’s Banking System 60 Box 3.4: Dutch Disease 69 Box 3.5: Garlic, Salt, and Oranges – A Taste of Declining International Competitiveness 70 Box 4.1: Informal Work 78 Box 4.2: Labor Productivity and Long-Term Growth and Development 81 Box 4.3: Agricultural Workers and Output on Java and Outer Islands, 2007-2011 87 Box 4.4: The Educational Effect of Economic Growth 96 Box 5.1: Sources of Violence in Indonesia 106 Box 5.2: Legislative Leadership Constellation in Indonesia’s Emerging Democracy 108 Box 5.3: Consensus in Indonesian Politics 111 Box 5.4: The Capacities of the DPR Secretariat General 114 Box 5.5: The Political Economy of Reform in Southeast Asia 122 iv PREFACE In 2011, the Harvard Kennedy School Indonesia Program (HKSIP) published From Reformasi to Institutional Transformation: A Strategic Assessment of Indonesia’s Prospects for Growth, Equity and Democratic Governance. This was our first effort to understand Indonesia’s progress, opportunities, and challenges as it commenced its second decade as a democratic nation. In this study, we noted Indonesia’s remarkable emergence under Reformasi as the world’s first majority Muslim, multi- party democracy despite its geographic, ethnic, and religious diversity and the destabilizing turmoil that accompanied the end of Suharto’s New Order. We also noted Indonesia’s steady economic growth during the global financial crisis and subsequent economic recession experienced by most countries. However, despite this impressive progress, we highlighted a number of problems as well that were preventing Indonesia from achieving its full potential. These impediments all pointed to the need for fundamental institutional transformation: continuation of patrimonial politics, perpetuation of an economic oligarchy, high barriers to entry in a wide range of industries, a dysfunctional legal system, disempowered citizens, and insufficient investment in infrastructure, health, and education. Thus, in comparison with its regional neighbors and global competitors, Indonesia was falling behind in many crucial measures of economic and social well being. The Sum is Greater than the Parts: Doubling Shared Prosperity in Indonesia Through Local and Global Integration is a sequel to our first study. It further examines constraints to robust, sustainable, and equitable growth in Indonesia, and presents alternative develop strategies to achieve the government’s primary development objective of joining the ranks of upper middle-income countries by 2025. In addressing these issues, we ask: 1) Is Indonesia growing fast enough to double real per capita income over the next decade? 2) What is the quality of Indonesia’s growth? Is it sustainable? Is it equitable? The findings are discouraging. The growth rate is far below the level necessary to reach upper middle-income status by 2025, and this modest growth has been characterized by lack of job creation, declining competitiveness, and rising inequality. This is primarily because Indonesia has neither reaped the full benefits of being a large country nor positioned itself well in the global supply chain. But our recommendations leave us cautiously optimistic. Although adhering to the current growth strategy does not bode well for Indonesia’s future, the constraints to achieving high levels of sustainable, inclusive growth can be addressed, even in Indonesia’s current challenging political landscape. The key to both local and global integration is the same: greater investment in enabling hard infrastructure such as roads, ports, and power; improved soft infrastructure in the form of better government and governance; and development of human resources through more effective education and training. If Indonesia’s leaders take the proactive policy path outlined in this study, prospects for more rapid and higher quality growth over the next decade are good; they are even better if a more transformative approach is adopted. Like our first study, this report was written by an interdisciplinary team from the Ash Center for Democratic Governance and Innovation at the Harvard Kennedy School, and it benefitted enormously from the insights and guidance of numerous Indonesian colleagues. Its purpose is to contribute to a public discussion of critical decisions Indonesia’s leaders must make to move Indonesia onto a development trajectory that is more likely to meet the nation’s needs and aspirations. It complements our other efforts to enhance the quality of public policy formulation, implementation, and evaluation in Indonesia by bringing Indonesian students, faculty, and practitioners to Harvard, and engaging in collaborative research between Harvard and Indonesian scholars. We look forward to continuing our joint efforts to improve the current lives and future prospects of all Indonesians. Anthony J. Saich Daewoo Professor of International Affairs Director, Ash Center for Democratic Governance and Innovation Harvard Kennedy School Harvard University Cambridge, Massachusetts, United States v ABSTRACT The GOI’s primary development objective is to join the ranks of upper middle-income countries by 2025. If Indonesia could double shared prosperity over the next decade, that is, generate an annual real GDP per capita growth rate of 8.5 percent for the next ten years, it would be well on the path to achieving this objective. However, at the present maximum per capita annual growth rate of 4.5 percent, not only will Indonesia fall well