Our Homework for 2019-2024

KOMPAS/DIDIE SW

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Without neglecting the importance of short-term management by Bank Indonesia, the recent development of the rupiah exchange rate provides an interesting setting to reexamine concepts of how exchange rates between two countries are determined.

For the short term, the foreign exchange demand-supply theory includes elements of expectations in exchange rate developments. Meanwhile, in the long run, popular theory is that the exchange rate is determined by the balance of purchasing power between two countries, so the theory is named the purchasing power parity theory.

In the 1990s, this theory started to be rivaled by a new concept that postulates that exchange rates are determined by differences in productivity between two countries, which are caused by supply side capabilities (see, for example, Tille, Stofells and Gorbachev [2001], Driver and Westway [2003], Peltonen and Sager [2009]). Therefore, the problem of the current account deficit seen in Indonesia is the problem of differences in productivity between Indonesia and its trading partner countries. The commodity bonanza of 2004-2012 was a strong medicine that covered Indonesia\'s weakness in terms of productivity.

When the commodity bonanza ended, this weakness was uncovered, reflecting in a current account deficit financed by capital inflows from abroad. Based on the Solow growth model, there are three sources of productivity growth: physical capital, manpower and technological change. The latest model variants have included the factors of physical capital quality, quality of human resources and innovation (R&D) as factors that can be engineered to improve the welfare of a country.

The vicious circle that occurs is that low productivity growth prevents per-capita income from increasing rapidly, which means the savings rate is also low. As a result, investment must be financed by capital flowing in from abroad. If these capital flows come more from short-term sources that enter and exit quickly, the consequences are exchange rate vulnerability to international economic turmoil, expectations for economic growth and other socio-economic factors.

As a first step to increase national productivity, the government in the 2015-2017 period focused on infrastructure development as a basis for future development. The lessons to be learned are different from those of the 1990s, due to technological advances, the multiplier effect on aggregate demand cannot be felt immediately. In the past, there was still a lot of work that could be done manually with hoes, shovels and crowbars. However, now heavy equipment and technology are more widely used for infrastructure projects. The solution to this problem is to create spillover from infrastructure projects to the surrounding community.

At Changi Airport, Singapore, we can see community members that are no longer young, even the elderly, involved in sanitation work. In the case of Indonesia, rest areas can be filled with food products, restaurants and local handicrafts. Maintenance of toll roads and other infrastructure can also be coordinated with the local governments, using local personnel.

As a first step, infrastructure development has improved the image of Indonesia\'s competitiveness. In 2017, Indonesia rose 15 ranks on the Ease of Doing Business Index, from the 106^th position to 91^st. It was among the 10 countries improving most rapidly (biggest climbers). The competitiveness index ranking improved from the 41^st to the 36^th position. Meanwhile, credit ratings were raised to investment grade. The logistical performance index (LPI) survey of 2018 shows that Indonesia jumped 17 levels  to the 46^th rank out of 160 countries.

State prosperity

World development shows that a country can no longer rely only on commodities and physical products. The technological content of products is getting bigger, in other words, the value of a product is mostly the knowledge, new ideas and innovation that went into the product’s creation. Science and innovation, therefore, have become a source of prosperity for developed countries. This situation can be used by developing countries to overcome their backwardness without having to go through the invention phase. However, to get such a shortcut, several conditions must be met, especially regarding the quality of the workforce and the innovation system.

In terms of quantitative achievement, Indonesia is actually not too far behind several countries other in Southeast Asia. The latest PISA survey shows that elementary school graduates in Indonesia have weaknesses in mathematics and reading, which indicates weaknesses in logical thinking and argumentation in written or oral language. The deepening of the materials emphasizes memorization, text repetitions, and textbook replication, while ignoring critical and creative thinking, communication and language skills. Such a quality of education may be good enough for the initial phase of an industry, which relies on unskilled workers, but it is not enough to upgrade to a technology-driven industry.

The change from quite centralized industrial production to interconnected production processes (chain values) across several countries is also difficult to realize, because it requires coordination skills related to communication and language. Until now, this talent shortage is still filled by expatriates, which adds pressure on the current account. The homework for the government is to improve national education at all competitive levels in line with the demands of the Industrial Revolution 4.0. In the long run, the government needs to make improvements to the education system at all levels, including vocational training, to produce adequate talent for the industrial sector that has been enhanced by science and technology. There are various ways to do this, for example, by sending teachers to join training courses again or by introducing national or international accreditation as a way to improve assurance of learning (AOL), in collaboration with overseas education institutions. Quickly catching up in research is another approach.

The high cost of locations and the scarcity of human resources able to coordinate (not only managers) at the shop-floor level make supporting industries like spare part manufacturers, intermediate goods, and auxiliary materials to be too expensive if located in Indonesia. Most of these companies are medium and small in scale and have lower capabilities than large-scale industries in shouldering additional costs. The companies\' operations depend on the seasonal downstream industry orders, so sufficient working capital is needed. The absence of these medium-scale industry segments has led to a high dependence on the import of raw and auxiliary materials, semi-finished goods and spare parts, which account for 75 percent of Indonesia\'s total imports. This structural weakness is an obstacle for Indonesia to grow fast, because the current account deficit will increase along with the increase in economic growth.

The task for the government is facilitating the development of these supporting industries by reducing logistics costs, as has been done now with infrastructure development. Fiscal incentives can be given to foreign direct investors that can attract other companies in their supporting industries, which are generally small and medium in scale, to Indonesia. The government can utilize its foreign trade attaché offices to provide market information and guide licensing administrators to industrial destination areas (the ultimate one-stop service).

Science and technology, sources of welfare

The industrial sector is in urgent need of upgrading amid the entrance of millennial generation cohorts to the labor market and consumer community. Millennials differ in their consumption habits from previous generations. Mediocre income does not prevent them from buying branded goods, traveling to make new experiences (leisure), and others. They can save for years just to experience a concert by Coldplay in Paris, for instance. This behavior can be transmitted to older generations. The phenomenon of abandoned shopping centers shows that those places have lost much of their appeal.

The government\'s task is to oversee this shift in order to be able to utilize it for economic growth. To make use of it, at least the purchasing power potential from the Indonesian supply side must be able to produce goods and services that become the ideals of the millennials as well as modernization of export-oriented industries. Failing to do it, this potential would be exploited by neighboring countries. To produce high-quality products, good raw materials are also needed. If not, the increase in demand will only cause a widening current account deficit. Curbing raw material imports without careful consideration will not be effective, because substitute goods of the same quality cannot be found within the country. Moreover, manufacturing exports also rely on high-quality imported goods.

The growing service sector with demands from the millennials, including tourism, can be used as a basis for the export of tourism services, while absorbing a surplus of labor from the traditional sector to the modern sector (manufacturing services) in the Lewis (1954) model, as practiced in China in the 1980s-1990s.

The innovation system in Indonesia consists of three players: the public sector, the private sector and higher education (universities). Private donations are very small for conducting R&D that has the potential to produce innovation (at 0.44 percent of the manufacturing production costs). Installing new machinery and equipment to upgrade production processes is one thing, but true innovation to come up with new products is quite another.

Universities, for their part, have in fact produced truly innovative products. The problem is, much of their innovation remains at the lab scale and is not implemented in mass production. The Triple Helix Model of the government-business world-academy world, it appears, does not work. The government\'s innovation system [led by the Indonesian Institute of Sciences (LIPI) and the Agency for Assessment and Application of Technology (BBPT)] and universities seems more like a silo or structure that is used to store bulk materials that have little connection with the business world. Excessive emphasis on the publication of scientific articles in indexed scientific journals, such as Scopus, does not help much to strengthen links between industry and academia. The emphasis on producing ready-made graduates has also shifted to education that is relevant in light of the needs of the community, with graduates that are ready to adapt to technological change.

The latest concept of endogenous growth also includes governance, environmental sustainability and health (including nutrition) as factors that influence national productivity (see, for example Olson, Sama, and Swamy [2000], Withagen and Velinga [2002] as well as Van Zon and Muysken [2002]).

In terms of environmental preservation, cities have to change into smart, efficient, environmentally friendly and comfortable places that will produce happy, healthy and productive people. The aging population will be supported by a sustainable social health network by combining aspects of basic heath and medical care in a pooling that allows cross insurance.

Rapid urbanization in Indonesia means that 69 percent of the population will be city dwellers in 2045, compared to just below 50 percent in 2010. Unlike in continental countries like the United States, the land area in the archipelago of Indonesia is not unlimited, so land use must be efficient and sustainable.

Residential and commercial areas are expanding fast from year to year – at the expense of agricultural land – with impacts on water management and food security. Floods and droughts are increasingly common as global climate change gives rise to more extreme weather pattern. Governance must be directed toward cooperation among local government authorities under the direction of the central government to address the problem of "illegal settlements" and reduce the externalities among  jurisdictional boundaries, as exemplified by efforts to restore rivers in the Citarum watershed. Central and regional transfers can be used to increase the bargaining power of the government.

To reduce human encroachment on water catchments, such as protected forests, farmers\' welfare must be improved. The minimum land that enables a farmer to live is more than 1 hectare. To prevent all the surplus labor from flocking to the cities, the rural off-farm economy must be developed with more post-harvest activities, such as sorting, warehousing, agro-tourism villages, and online marketing for farmers of the younger generation.

Ari Kuncoro, Dean and Professor, Economics and Business School, University of Indonesia