Investing in Indonesia: The Tune of the Gamelan
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The post-crisis performance of Indonesia has been phenomenal. With its overall economy virtually untouched by the financial crisis and its equity markets rapidly rebounding, Indonesia has outperformed virtually all major emerging-market competition, including Brazil. What characteristics have brought about this growth and expansion, and to what extent are these trends likely to continue?
Indonesia is an archipelago lying along the equator, north of Australia and south of Malaysia and the Philippines. Accounts vary as to the exact number of Indonesian islands, but most estimates range between 17,000 and 19,000, of which perhaps half have been named and nearly 1,000 are permanently inhabited. Five islands—Sumatra, Borneo, Java, Sulawesi, and West Papua—are substantially larger than the others and hold the majority of the population.
More than 240 million people live in Indonesia, making it the fourth most populous country in the world (after China, India, and the United States, and just before Brazil). It is home to the largest single Muslim population, with slightly more than 85% of Indonesians identifying as Muslim—roughly one-sixth of all Muslims worldwide. Nearly 60% of Indonesians live on the densely populated island of Java, a situation that tends to skew economic and political power toward the ethnic Javanese. Indonesia’s two largest ethnic groups are the Javanese, at 40% of the population, and the Sundanese, at 15%; the remaining 45% come from over a dozen scattered minorities, including an ethnic Chinese population.
Table 1: Indonesia in Comparative Perspective
Sources: Five-year real GDP growth calculated with Economist Intelligence Unit numbers (accessed February 16, 2010); Corruption Index from Transparency International (accessed February 16, 2010); Economic Freedom Index from the Heritage Foundation (accessed February 16, 2010); all remaining figures from the CIA World Factbook.
At just over 1.0 trillion USD, the economy is the 16th largest in the world (2010 estimate, Central Intelligence Agency 2011) on a PPP (purchasing power parity) basis, ranking just behind Canada and ahead of Turkey. Although the economy is large, so is the population; therefore, the 2010 per capita GDP estimated by the World Bank (Central Intelligence Agency 2011) is only $4,300 PPP, similar to levels in Honduras and the Congo. Income inequality is less extreme than in the United States, although this likely reflects widely shared poverty more than anything else. Corruption is a serious problem: Indonesia rates a 2.8 (out of 10) on the “Corruption Perceptions Index” (Transparency International 2010), making it better than Mongolia, but not quite as clean as Kazakhstan.
Indonesia’s economy is reasonably diversified and incorporates a substantial domestic sector. The nation exports textiles and light manufactures including assembled electronics to Japan, Europe, and the United States, and commodities, metals, bauxite, and timber to China and India. Indonesia withdrew from OPEC in 2008 as increased domestic consumption and declining reserves turned the country into a net importer. The region’s volcanic soils are extremely fertile, but with only 11% of the land arable, Indonesia also must be a food importer, although extensive seafood supplies reduce that pressure to a moderate extent.
The islands that form modern Indonesia have been trading with one another and other regions for centuries. Geography and history have made Indonesians natural traders and entrepreneurs and receptive to the idea of an open economy. Indonesia’s political boundaries and fusion of diverse ethnicities are mainly due to Dutch colonial administration, which began in the 1600s and effectively ended with the Japanese invasion of World War II. Two days after Japan’s final surrender to the Allies, the Indonesian nationalist leader Sukarno declared independence from the Dutch; in short order he set himself up as Indonesia’s first president, and later, president for life. True independence came after four years of military resistance and diplomatic efforts, when the Dutch recognized Indonesia’s independence in 1949.
Sukarno’s vision for Indonesia was a mixture of nationalist, Marxist, and Muslim ideas. He sought economic self-sufficiency and pursued import-substitution industrialization policies that centered on creating state-controlled national industries—many forcibly nationalized from the private sector—protected by tariff barriers. Over time, these policies stifled innovation, eroded Indonesia’s terms of trade, and provoked inflation, which eventually reached 1000% annually. Meanwhile Sukarno’s governing style, which he described as “Guided Democracy,” grew increasingly Marxist and authoritarian. Finally, after two decades, the military forced Sukarno to cede powers to General Suharto, who became president in 1968. The move was supported by the United States, and many believe that it was also orchestrated by the US as part of its anti-Communist foreign policy.
Suharto shifted from an import-substitution to an export-promotion development model, opening the economy once again to foreign direct investment, and becoming one of the early adopters of this development style. Although he took a major step in liberalizing the economy and created stronger growth with reduced inflation, he did not greatly liberalize the political system. Rather, he repressed opposition, particularly any Communist sympathizers. He did not start to privatize existing state enterprises until fairly late in his tenure, and he used his position readily for personal and family enrichment, setting the tone for other officials in government. Nonetheless, the opening to foreign direct investment and relaxed economic controls made Indonesia part of the “Asian Miracle” of the 1980s and early 1990s. Under his “New Order” regime, Suharto remained president for three decades, until the disruption caused by the Asian financial crisis pushed the military and members of his own party—outraged by IMF revelations of government corruption and waste—to join the increasingly mobilized prodemocracy opposition.
After Suharto stepped down in 1998, the top office went through several twists and turns. Suharto’s deputy, Jusuf Habibie, briefly held office, introducing more political freedoms and overseeing elections for a new parliament. The parliament selected Abdurrahman Wahid as president in 1999, but he was discredited two years later in a corruption scandal and passed power to his vice president, Megawati Sukarnoputri (daughter of the original Sukarno). Susilo Yudhoyono was elected president by a direct popular vote in 2004 and re-elected to a second five-year term in 2009. During this constant turnover, it was difficult to maintain a coherent, long-term economic policy, but there has not been substantial ideological departure from previous models. The economy is fairly open, although it hasn’t dismantled many of its legacy state-owned enterprises. The appearance of continuity that came with Yudhoyono’s re-election has reassured many investors of both continuity and the possibility that democratic reforms may take lasting root.
Indonesia’s economy today is complex, befitting a country of 240 million densely packed people. Almost half of its GDP (46.8%) comes from the industrial sector; most of the other half comes from services (38.3%), and the remainder comes from agriculture (14.9%). A comparison of these figures with the labor force shown in Figure 1 reveals that only 20% of Indonesians are employed in industry, with the remaining population about equally divided between services and agriculture, at 40% each. This suggests that the labor productivity of industry is about three times that of services, which in turn is roughly three times as productive as agriculture. Although the labor figures here are approximately five years older than the GDP figures, both ratios change slowly enough that they can be compared.
Figure 1: Sectoral Composition of GDP and Labor Force in Indonesia
Source: CIA World Factbook, February 13, 2011.
Figure 2 charts the growth of Indonesia’s economy from 1980 to 2010. As the world economy recovered along with the US after 1982, Indonesia’s economy grew rapidly. During the 1980s and 1990s, it logged average real rates of 7.0–7.5%, until the eve of the Asian financial crisis in 1997–98.
Figure 2: Evolution of Indonesian Real GDP
Clearly visible in Figure 2, the impact of the Asian financial crisis on Indonesia’s economy was extreme. The economy contracted by over 13% in 1998, an intensely painful experience for any country. Once it recovered after 1999, it climbed to a lower but steadier growth rate that averaged about 5.2% for the decade of the 2000s. Most notably, Indonesia was only weakly affected by the 2001 recession and nearly untouched (in the real economy) by the 2007–09 recession. Indonesia’s economy (though not its financial markets) appears to be fairly decoupled from the global economy today, a fact many attribute to its large domestic consumption component.
Figure 3: Composition of Indonesian Real GDP
Figure 3 reveals Indonesian GDP by major component over time. The chart is relatively stable, aside from a disruption starting in 1997–99 that corresponds to the Asian financial crisis, the end of the Suharto regime, and the creation of Indonesian democracy. Under democracy, the investment component has dropped and the domestic consumption component has risen to compensate. This effect can explain both the slower post-crisis growth rate (lower fixed investment) and the increased decoupling from the world economy (larger domestic economy). In the external sectors, Indonesia’s exports have grown, but its imports have also increased almost in lockstep. There is a small trade surplus, but its growth contributes negligibly to overall GDP growth. Government expenditures have been fairly steady over time, but it is likely that they are starting to deliver more value per rupiah as transparency begins to improve.
Figure 4: Indonesian Real GDP Growth, Inflation, and Interest Rates
Major interest rates, together with average inflation and real GDP growth rates, appear in Figure 4. The crisis of 1998 stands out dramatically, going off the scale. Filtering out 1998, one sees a steady downward trend in interest rates across the chart, albeit with some volatility. Inflation has run fairly steadily at about 8.2% annually during “normal years,” although it reached 58% in 1998 and has been more volatile after the crisis than before. Although Indonesian inflation is likely to pick up again in 2011 in step with the rest the world, it will be rising off a low base and should remain manageable.
The major risks in Indonesia are macro, systemic, and political in nature. To some extent, the moderate decoupling of Indonesia’s economy from the global economy provides a buffer against these threats, but they are no less real. Two concerns are systemic: first, worries that global inflation will corrode returns or get out of control; second, a temporary pullback in emerging markets broadly, as hot money chases returns and developed markets begin to recover. Indonesia is somewhat vulnerable to both of these risks, but not excessively so. It is nearly self-sufficient in oil, and so somewhat insulated from energy price inflation in the near term. Food price inflation remains an issue because of dense populations and the small proportion of arable land. Access to seaborne food sources helps, but fish stocks still need to be managed sustainably.
Politically, Indonesia has made important strides in consolidating democracy, but with barely a decade’s track record it is still too early to declare full victory. Indonesia’s corruption levels remain among the worst in the region, and slow progress on this front, particularly in law enforcement and the judiciary, has made credit more expensive. Democratization, however, has allowed greater awareness and discussion of corruption, which is an essential step for combating it.
Separatism and separatist rebellions are an ongoing concern, and one of the earlier justifications for a centralized government and military authority. The colonial administration that brought the islands together is now defunct, competition among ethnic groups is widespread, and power remains fairly centralized in Jakarta. Given these factors, the push by some non-Javanese to secede will flare up at times, particularly if economic performance declines. Both Sukarno and Suharto regularly deployed the military to suppress rebellion, and a violent separatist movement in Aceh province only reconciled with the center when cooperation proved vital to recovering from the effects of the 2004 tsunami.
The large Muslim population has some Western countries worried that Indonesia could be a recruiting ground for terrorists. The 2002 Bali attack that killed 202 people is probably the most famous Indonesian terrorism incident. From 2000 to 2005, there were church bombings, mall bombings, and hotel bombings, many linked to the Islamist movement Jemaah Islamiyah, which seeks to establish a regional Islamic caliphate. The movement is real, but so far it seems more nationalist in orientation than truly in alliance with al-Qaida.
Finally, Indonesia’s economy is especially sensitive to global warming. A rise in sea levels will have a significant impact on the heavily populated low-lying areas of this island nation. As an equatorial country, Indonesia is less threatened by typhoons than its northern and southern neighbors, but changing storm patterns and intensities may make it more vulnerable, particularly Sumatra. And although it is not specifically climate related, the fact that Indonesia sits on a tectonic hot-spot means that volcanic eruptions, earthquakes, and even tsunamis can be expected with a certain regularity.
In the next article, we will look at Indonesia’s asset performance and characteristics from the standpoint of a portfolio of emerging markets.
Central Intelligence Agency. January 20, 2011. “Indonesia.” The World Factbook.
Transparency International. 2010. “Corruption Perceptions Index 2010.”
Heritage Foundation. 2010. Index of Economic Freedom. Accessed February 15, 2010.
–Bruce P. Chadwick, PhD, CFA, is principal at Chadwick Global Research and Consulting, an independent consulting firm specializing in macro strategy, including quantitative, emerging market, and SRI research.