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Development Policy Review 2014 Indonesia: Avoiding The Trap THE WORLD BANK OFFICE JAKARTA Indonesia Stock Exchange Building, Tower II/12-13th Fl. Jl. Jend. Sudirman Kav. 52-53 Jakarta 12910 Tel: (6221) 5299-3000 Fax: (6221) 5299-3111 Printed in May 2014 Indonesia Development Policy Review 2014 is a product of staff of the World Bank. The findings, interpretation and conclusion expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the government they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denomination and other information shown on any map in this work do not imply any judgment on the part of the World Bank concerning the legal status of any territory or the endorsement of acceptance of such boundaries. Cover and chapters photos are: Copyright @ World Bank. Photos on Chapter 1 and 4 were taken by Jufferdy; on Chapter 2 by Education team; on Chapter 3 by Aldian; on Chapter 5,7 and 8 by Josh Estey; on Chapter 6 by Takiko ; and on Chapter 9 by Disater Risk Management team. All rights reserved. Development Policy Review 2014 Indonesia: Avoiding The Trap Poverty Reduction and Economic Management Department East Asia and Pacific Region Development Policy Review 2014 Indonesia: Avoiding The Trap Table of Contents Table of Contents Preface V Acknowledgments VI Executive Summary 1 The next decade brings opportunities and risks for Indonesia 2 What strategy for a strong and inclusive growth in Indonesia? 5 What policy priorities to support productivity-driven growth? 6 What policy priorities to ensure that prosperity is shared more widely? 13 The Challenge of Implementation: What Can Be Done? 17 Chapter I. Indonesia’s Economic Transformation Post-1997/98 25 1. The Turnaround in Macro Policymaking Post-1997/98 27 The legacy of the 1997/98 crisis 28 Addressing the fallout of the crisis 28 Good policies in bad times: policy response to the global financial crisis 29 2. The Transformational Impact of the Commodities Boom 29 The commodities boom: a significant and unforeseen positive shock 30 Impact on Indonesia’s terms-of-trade and corporate wealth 30 Contribution to Indonesia’s investment recovery 32 Contribution to Indonesia’s nominal GDP growth and household incomes 33 Supply-side response and the structural transformation 34 3. Over-reliance on Commodity Exports Has Fueled Vulnerability 39 Changes in the composition and destination of exports 39 Increased vulnerability to changes in commodities markets 40 4. The Commodities Boom Has Also Sharpened Environmental Concerns 41 Chapter II. The Economic Transformation’s Social Impacts 44 1. Poverty 45 Trend in income-poverty 45 The significant role of growth-driven job creation in poverty reduction 45 2. Vulnerability 47 Vulnerability to sliding back into poverty remains high 47 Vulnerable households face high food price risks 48 Vulnerable households are highly exposed to health shocks 49 There are gender differences in vulnerability 50 The job market is the key source of vulnerability 50 3. Inequality of income and opportunity 53 Income inequality has increased over the past decade 53 Inequality of opportunities has worsened 55 The role of the commodities boom in rising income inequality 56 Has fiscal policy helped to redress increasing inequality? 56 ii Development Policy Review 2014 Table of Contents Indonesia: Avoiding The Trap 4. Access to Basic Services 58 Education 58 Health 59 Water and sanitation 61 Electricity 62 Chapter III. The Road to Shared Prosperity 65 1. Key Opportunities and Risks 66 Key opportunities 66 Risk of a growth slowdown 68 Risk of growth not being inclusive enough 69 2. Growth Strategy 71 3. Priority Reform Areas 73 4. Addressing cross-cutting Implementation Challenges 75 Stronger Center of government 76 Streamlined Bureaucratic Procedures and Structures 77 Strategic Management of Human Resources 77 Delivering results with public spending 78 Refocus Local Governments to be Accountable for Improving Service Delivery 78 Chapter IV. Closing Indonesia’s Large Infrastructure Gap 81 1. Under-Investment in Infrastructure and the Cost to the Economy 83 Indonesia’s total investment ratio has recovered in recent years 83 However, infrastructure investment (as a proportion of GDP) is lagging behind… 84 …imposing higher costs in terms of economic growth… 86 …and under-investment cuts across most key infrastructure subsectors 86 2. Not Only About Money 91 Land acquisition complexities 91 Coordination issues 92 Public-private partnerships (PPP) 93 3. Policy Options 93 Mobilizing funding for infrastructure development 93 Coordination/engagement with ASEAN 95 Chapter V. Closing the Skills Gap in the Labor Force 97 1. Indonesia’s Scorecard to Date 98 The labor force is more educated 98 …but many graduates enter the labor market without the right skills 99 Skills shortages are related to quality and relevance of education 104 2. Policy Options 106 Focus on quality and skills, not only expansion 107 Improve relevance of feeders into the labor market: vocational education and tertiary education107 Upgrading skills of existing labor force 108 iii Development Policy Review 2014 Indonesia: Avoiding The Trap Table of Contents Chapter VI. Improving the Functioning of Markets 111 1. Improving the functioning of product markets 112 Key relevant product market/investment climate issues 112 Policy options 114 2. Reducing labor market rigidities and uncertainties 115 Key relevant labor market issues 115 Policy options 118 3. Deepening Financial Markets 119 Key relevant financial market issues 119 Policy options 120 4. Land Markets 121 Chapter VII. Improving Access to Quality Services for All 123 1. Poverty and Institutional Context 124 Trends in urban and rural poverty 124 Changes in the institutional context: decentralization 125 2. Access to High Quality Services in Urban Areas 126 3. Access to Improved Essential Services in Rural Areas 127 4. Policy Options for Improving Access to Services for All 130 More resources to front-line services and less on personnel and administration 130 Provide alternative financing options to local governments 131 Enhancing the quality of spending 132 Clarifying missions, refocusing the bureaucracy to be accountable for results 133 Strengthening Community-driven programs and demand-side accountability 133 Chapter VIII. Strengthening Social Protection 137 1. Building an Effective and Sustainable Social Security Framework 138 2. Strengthening Indonesia’s Emerging Safety Net for the Poor 142 Safety nets have an immediate impact on reducing extreme poverty 142 Further reforms are needed to strengthen safety nets 142 3. Maintain National Oversight to Ensure that Social Assistance Is Well-Coordinated and Integrated 144 Chapter IX. Managing Disaster Risks, Building Resilience 147 1. Urbanization and disaster risk profile and cost 148 2. Urbanization and Vulnerability to New Hazards 151 3. Policy Options 153 iv Development Policy Review 2014 Preface Indonesia: Avoiding The Trap Preface The World Bank undertakes, on a regular basis and in many emerging economies, an evidence- based review of development challenges and optional policy solutions to address these. One of such analytical pieces is called Development Policy Review. The World Bank has completed a Development Policy Review for Indonesia in 2009. That report identified the reforms of institutions and processes that govern the state as critical for unleashing the country’s development potential. That report provided an analytical underpinning for the Bank’s Country Partnership Strategy 2009-2014 and shaped the Bank’s support to the Government’s RPJMN 2010-2014. While the institutional reform agenda remains unfinished, the present report argues that Indonesia has the potential to rise and become more prosperous and equitable in the next two decades. Its central thesis is that with a few critical reforms in the six priority areas identified, Indonesia can climb the income ladder and join the rank of high-income economies within two decades, in an inclusive manner. At the same time, in the absence of critical reforms, Indonesia would float in the middle, as was the case of Brazil, Mexico, South Africa and other middle- income countries from the early 1980s to the mid-2000s. Which way Indonesia’s economy will go depends is, to a critical extent, on the hands of Indonesia’s authorities. The main difficulties lie in getting the reforms implemented in a complex institutional and decentralized framework. But Indonesia cannot afford to not try hard. The costs of complacency – and the rewards for action – are too high. The report was elaborated upon large consultations/ discussions with key stakeholders in Indonesia, including government officials, private sector leaders, non-governmental organizations, academics and labor unions. It is hoped that these stakeholders, as well as others readers will find it useful. Rodrigo A. Chaves Sudhir Shetty Country Director, Indonesia PREM Sector Director v Development Policy Review 2014 Indonesia: Avoiding The Trap Acknowledgments Acknowledgments This report was prepared by a team drawn from the different units of the World Bank’s Jakarta Office. The team was led by Ndiame Diop (Team leader) and comprised Fitria Fitrani, Yue Man Lee, Arvind Nair, Matthew Grant Wai-Poi, Alex Sienaert, Ashley Taylor and Maria Monica Wihardja (PREM), Carlos Pinerua and Connor P. Spreng (FPD), Iwan Gunawan, Taimur Samad and Renata Simatupang (SD), Samer Al-Samarrai, Pedro Cerdan-Infantes, Darren W. Dorkin and Mitchell Wiener (HD) and Dini Sari Djalal (EXT). Useful inputs and comments were received from: Vivi Alatas, Cut Dian Agustina, Mark Eugene Ahern, Hans Antlov, Brendan M. Coates, Fook Chuan Eng, Ahya Ihsan, Amri Ilmma, Blane D. Lewis, Mattia Makovec, Bernard Myers, Dhanie Nugroho, Gregorius D.V. Pattinasarany, Anh Nguyet Pham, Sjamsu Rahardja, Cristobal Ridao-Cano, Henry Sandee, Della Y.A. Temenggung,Violeta Vilovic and Robert Wrobel. The team thanks Arsianti and Peter Milne for their assistance on editing and formatting the report. The work was conducted under the guidance of Jim Brumby, Rodrigo Chaves and Sudhir Shetty.