5 Percent Growth Trap
“The difficulty lies, not in the new ideas, but in escaping the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” The sentence was written by John Maynard Keynes in his seminal introductory book, The General Theory of Employment, Interest and Money.
The sentence seems to be true up to this day, especially when we are trapped in economic growth at the range of 5 percent. Of course we need to note, it is not easy to grow 5 percent in the midst of this turbulent world. However, we must also admit: that is not enough. We need to boost growth to avoid the risk of getting "old before rich". Unfortunately, these days we are trapped in a dilemma between stability and economic growth.
Statistics Indonesia (BPS) announced the economy grew 5.07 percent in the first quarter of 2019. Investment only grew 5 percent in the first quarter of 2019. This was lower than growth in the third quarter of 2018 (7 percent) and the fourth quarter of 2018 (6 percent). We’ve seen the same in government spending. Why? The government\'s efforts to stabilize the rupiah due to the high current account deficit and the increase in interest by the Fed has pressed down on government investment and expenditure.
This step certainly deserves appreciation. Indonesia has been able to handle this situation well, even better than Turkey, Argentina and India. Of course, it must be acknowledged, good luck is also with us: The Fed decided to "be patient" in raising interest rates. The combination of the two things has restored rupiah stability and eased pressure on the Indonesian financial market. We note that capital flows are returning to emerging markets (EM), including Indonesia. However, I want to remind people that we are still vulnerable. One day, if the Fed raises interest rates, the pressure on the rupiah will happen again. The current account deficit is blamed as the root of the problem. Then, we’ll shout in an anxious tone: the current account deficit must be lowered! This is certainly true but we must be careful.
Dilemma of growth and stability
Reducing the current account deficit by lowering imports can bring down economic growth. Why? Data shows that more than 90 percent of our imports are capital goods and raw materials. This actually consists of productive imports. Then, to keep the rupiah under control, should imports to build infrastructure be slowed or stopped? If not careful, we can get trapped in the dilemma between economic growth and macroeconomic stability and exchange rates. And, that is what’s happening now.
In other words, if we boost economic growth to 6 percent, the current account deficit will increase to 4-5 percent. If that happens, investors will move their investment portfolio. As a result, the rupiah weakens. Here we are trapped between the problem of the current account deficit and growth. Therefore, the important question that must be answered is how can Indonesia grow more than 6 percent but the rupiah and the financial market be maintained? There are three ways.
First, reduce ICOR by increasing productivity. However, this takes a long time. With high productivity, then with the same input, higher output will be generated (increasing marginal product). Mitali Das (2018) wrote an interesting treatise on productivity in Indonesia. She pointed out, improving the quality of human resources (HR), increasing exports and the flow of foreign direct investment would be able to drive Indonesia\'s economic growth to 7 percent. Therefore, export products must be diversified, both the type and countries of destination. We need innovation.
For innovation, entrepreneurs need to adopt foreign technology for local needs. The problem is that technology cannot be simply obtained from developed countries. On the other hand, innovation is a luxury item. Economist Dani Rodrik pointed out, if the entrepreneurs fail in this experiment, they would bear all the losses. Meanwhile if they are successful, other producers will emulate it and enter this activity. As a result, practically no one is interested in self-discovery. Innovation requires good human resources. That is why the focus on improving the quality of HR is the right step. The problem: how to do it? Is not 20 percent of our state budget has been allocated every year to finance education?
The result? Up to the present, our Program for International Student Assessment (PISA scores) in the fields of mathematics, science and reading skills is still among the lowest in the world. It means the problem is not money, but policy design. BPS data shows that there is an increase in young unemployed in the vocational school graduates. This happens because what is learned in the vocational schools does not match the needs of the companies. If that is the problem, give a double tax deduction for companies which conduct training to improve the quality of their human resources. Also do this for the manufacturing industry.
Second, increase domestic savings. With this, investment can be financed by local financing sources. How to do it? Perform financial deepening by encouraging more sources of funding from local investors so that the portion of external financing decreases. Provide incentives for SOEs, pension funds, insurance, and Haj funds to place their investments in government bonds and Sukuk. I once suggested that the government implement a reverse Tobin Tax. Data shows that repatriation of profits from foreign investment in Indonesia is around US$16 billion, more than half of our current account deficit in 2018. It means if the government provides tax incentives to investors not to repatriate their profits but reinvest their profits, the pressure in the current account deficit will decrease. More than that, create financial market instruments or products so that Indonesian people or Indonesian exporters have the option of placing portfolio investments in their foreign currency in Indonesia (onshore). Of course we need to note that to increase domestic savings we need time.
Deficits are normal
Third, a current account deficit is actually something normal in the early stages of developing a country, especially developing countries. At the beginning of their development, developing countries -- due to limited capital -- must import capital goods for production. Singapore, China, South Korea and Vietnam experienced a high current account deficit at the beginning of their development. The real problem is not the current account deficit itself but the financing. As long as the current account deficit is financed by direct investment in the export-oriented sector -- not a portfolio -- the current account deficit is not the problem. What is the difference?
Factories built through direct capital are not easy to move. On the other hand, portfolio investment can move in and out easily. As a result, there will be turmoil in the financial markets. Why are FDI in the export sector? Because exports generate foreign exchange so that when repatriation of profits is made, there is no pressure in the balance of payments due to currency mismatches. If economic growth is to be encouraged, without the need to worry about the stability of the rupiah, FDI must be encouraged. This is a short-term option and can be done immediately. Make structural reforms, specifically in the Labor Law (severance revision), negative investment list revision, and facilitate the licensing process.
Besides that, to ensure local governments also maintain the investment climate, create incentive instruments or penalties should be imposed. For example, increasing the special allocation funds (DAK). Give the DAK funds to regions that carry out improvements in the investment climate. Or conversely, the withdraw the DAK funds from regions that are unable to maintain the investment climate.
It is time for us to go beyond macroeconomic stability. There are limitations to monetary and fiscal policies in encouraging economic growth. What we need is structural reform. Without that we will be trapped in the 5 percent economic growth. Without that we will be trapped in the old idea, just like the one written by Keynes more than 80 years ago.
Muhamad Chatib Basri, Lecturer at the School of Economics and Business, University of Indonesia