Indonesia must transform into know-how and technology-driven economy

It is indisputable that Indonesia has been grappling with deindustrialization over the past decade: The plummeting of manufacturing contribution to the gross domestic product (GDP) ratio from 27 percent in 2004 to 18 percent in 2022 and the slowing down of the investment-to-GDP ratio from 34 percent in 2013 to 27 percent in 2022. Compared with China, one of the world's fastest investment and manufacturing-driven economies, Indonesia's manufacturing- and investment-to-GDP ratios appear significantly lower, almost half that of China's. Contrary to the perception that China’s strength lies in its low-cost labor, the reality is that China heavily invests in productive assets, particularly advanced manufacturing equipment such as machines, vehicles and appliances. This investment strategy has catalyzed exponential growth in value-added goods and the accumulation of technological “know-how”. As a result, China has achieved remarkably low unit economics in advanced manufactured goods, including solar panels and electric vehicle (EV) batteries, primarily due to extensive “learning by doing”. This approach has led to an “industrial boom”, propelling China's productive economy forward. In stark contrast, approximately 75 percent of Indonesia's investments are channeled into non-productive assets like buildings and other static infrastructure. Consequently, Indonesia’s incremental capital-output ratio (ICOR) has remained steady at around 5-6.5 over the last decade. This trend reflects Indonesia's shift from a producer to a consumer in certain strategic industries despite having abundant natural resources. Indonesia's reliance on imports, which amount to about US$200 billion annually, with approximately 30 percent coming from China, clearly illustrates this issue. Many speculate that China’s investment and manufacturing-driven economy may slow down in the coming years. On the contrary, according to Pettis (2023), to achieve 4-5 percent annual GDP growth, China might need to aggressively expand into other countries' investment and manufacturing sectors, including, most strategically, Indonesia. China’s contribution to global investment is projected to increase to 38 percent over the next decade. As the largest manufacturing country globally, China is expected to augment its share in global manufacturing output to 40 percent in the next 10 years. This trend suggests that Indonesia and other targeted countries may be compelled to become more dependent on China for manufacturing, potentially reducing their investment-to-GDP ratios to below 20 percent. If Indonesia fails to reindustrialize, this scenario is likely to materialize. Indonesia therefore must reassess its growth strategy. One approach for Indonesia is to consider various degrees of industrial protectionism. As Haussman (2023) notes, industrial policies and “picking the winners” strategies are gaining traction globally, with more countries enacting legislation to boost local production. The United States, for instance, has implemented the $280 billion CHIPS and Science Act to expand its semiconductor industry and the $370 billion Inflation Reduction Act for energy-transition incentives, both aimed at reducing dependence on Chinese products in these markets. Haussman (2021) emphasizes that economic development in developing countries heavily relies on the accumulation of know-how. Like the game of Scrabble, each country starts with a set of existing capabilities or “letters” to form “words”, representing products that can be produced and exported. Countries can then collect more “letters” to form additional “words” through strategic partnerships, investments in education and diaspora and other policies. In the last decade, Indonesia has implemented a nickel export ban to incentivize local industrial smelters, an “upstream driven” policy to accumulate more smelter “letters”. President Joko “Jokowi” Widodo highlighted a 30-fold increase in the value of Indonesia's nickel-related exports since the ban's implementation. From the other side of the value chain, the government's “downstream driven” industrial policy, exemplified by EV tax incentives, has attracted major players like BYD to establish production facilities in Indonesia, thereby accumulating more automotive manufacturing “letters”. These initiatives, leveraging Indonesia’s rich natural resources and strategic positioning, are pivotal and should be intensified by accelerating ecosystem, education and skillset building, especially in science, technology, engineering and mathematics (STEM). In the coming decades, Indonesia is expected to undergo a demographic transformation, evolving from a young demography to a productive population. Indonesia is facing a race against time in this transition. A rapid build of an ecosystem conducive to attracting and nurturing know-how is essential. This involves establishing policies that retain local talent and attract foreign expertise and investment locally. Indonesia must cultivate an environment fostering innovation, research and development and entrepreneurial spirit. This can be achieved through incentives for high-tech industries, streamlined regulations that facilitate ease of doing business, robust intellectual property rights protection and, most importantly, by building leading, industry-specific, human capital institutions across Indonesia. Another lever is fostering partnerships with international companies and educational institutions, which can bring in a wealth of practical knowledge. Such collaborations can lead to technology transfer, skill development and the creation of high-value industries. This partnership strategy coincides with global economic transitions, including green energy initiatives, digitalization and advancements in artificial intelligence (AI). These developments present a unique opportunity for Indonesia to emerge as contributing, if not leading, in these developing sectors. Eventually, these industrial and downstream initiatives can achieve a multiplier effect beyond the targeted sectors. As a benchmark, Finland initially focused on developing value for its wood industry in paper or policies. It ended up with an advanced phone manufacturing industry, with Nokia at the center. While accumulating know-how in machines that cut wood, Finnish businessmen realized that the capabilities could be translated to automated machines that produce smartphones. This was also the case with the Middle Eastern countries entering into advanced, adjacent industries (i.e., airlines) from oil and gas. If industrial and downstream policies are implemented, Indonesia might develop other unexpected value-adding sectors. Indonesia must transform into an investment, know-how and technology-driven economy. In this vision, investment growth becomes the primary contributor to GDP growth. Such high growth not only creates high-quality job opportunities but also boosts and equalizes incomes in the long term. Large-scale investments targeted efficiently and effectively, and adopting new technologies and leading human capital will enhance economic productivity (ICOR). Ultimately, this cycle will create a strong development loop starting with the competitiveness of Indonesia's industry, maximizing value addition and boosting exports, leading to an industrialized and robust economy set to be enjoyed by future generations – strong enough to not be reliant on the Chinese economy.