M c K in s e y G lo b a l I n s t it u t e McKinsey Global Institute T h e a r c h ip e la g o e c o n o m y : U n le a s h in September 2012 g In d o n e s ia The archipelago ’s p o te n tia economy: Unleashing l Indonesia’s potential The McKinsey Global Institute The McKinsey Global Institute (MGI), the business and economics research arm of McKinsey & Company, was established in 1990 to develop a deeper understanding of the evolving global economy. Our goal is to provide leaders in the commercial, public, and social sectors with the facts and insights on which to base management and policy decisions. MGI research combines the disciplines of economics and management, employing the analytical tools of economics with the insights of business leaders. Our micro-to-macro methodology examines microeconomic industry trends to better understand the broad macroeconomic forces affecting business strategy and public policy. 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Copyright © McKinsey & Company 2012 McKinsey Global Institute September 2012 The archipelago economy: Unleashing Indonesia’s potential Raoul Oberman Richard Dobbs Arief Budiman Fraser Thompson Morten Rossé Indonesia today . . . 16th-largest economy in the world 45 million members of the consuming class 53% of the population in cities 74% producing of GDP 55 million skilled workers in the Indonesian economy $0.5 trillion market opportunity in consumer services, agriculture and fisheries, resources, and education . . . and in 2030 7th-largest economy in the world 135 million members of the consuming class 71% of the population in cities 86% producing of GDP 113 million skilled workers needed $1.8 trillion market opportunity in consumer services, agriculture and fisheries, resources, and education McKinsey Global Institute The archipelago economy: Unleashing Indonesia’s potential 1 Executive summary Indonesia’s economy has enormous promise. Already the 16th-largest economy in the world, this dynamic archipelago has the potential to be the seventh biggest by 2030. It is a much more stable and diversified economy than many outside observers assume. In recent years, Indonesia has made enormous strides in its macroeconomic management. Inflation has fallen from double into single figures, and government debt as a share of GDP is now lower than in the vast majority of advanced economies. The economy, part of a resurgent Asia, is transforming rapidly. Indonesia has a young population and is quickly urbanising, powering growth in incomes. Between now and 2030, Indonesia will be home to an estimated 90 million additional consumers with considerable spending power. This growth in Indonesia’s consuming class1 is stronger than in any economy of the world apart from China and India, a signal to international businesses and investors of considerable new opportunities. But Indonesia is at a critical juncture. The archipelago economy is confronted by three major challenges in the period to 2030. First, Indonesia faces a productivity imperative. The economy has performed relatively well on labour productivity, which has accounted for more than 60 percent of economic growth over the past two decades, the rest being delivered by growth in the labour force. But our analysis suggests that Indonesia needs to boost productivity growth by 60 percent from the rate achieved from 2000 to 2010 if the economy is to meet the government’s target of 7 percent annual GDP growth, above current trend growth of between 5 and 6 percent (Exhibit E1). Exhibit E1 Achieving Indonesia’s 7 percent annual GDP growth target will require labour productivity to grow 60 percent faster than in 2000–10 Annual real GDP growth rates % 7.0 2.4 4.6 Additional labour 60% productivity 2.9 growth required GDP growth target Expected growth Required growth Historical labour from increased from labour productivity labour inputs1 productivity, growth, 2000–102 2010–30 1 Driven by additional workers joining the workforce due to demographics and increased participation in workforce; productivity assumed to be the average in 2010–30 based on a business-as-usual growth rate of 5 to 6 percent. 2 Based on an average among national and international data sources. SOURCE:CEICData; Indonesia’s Central Bureau of Statistics; Conference Board Total Economy Database; International Monetary Fund (IMF); United Nations Population Division; McKinsey Global Institute analysis 1 We define the consuming class as those individuals with net income of more than $3,600 per annum in purchasing power parity (PPP), at 2005 exchange rates. 2 Second, an uneven distribution of growth across the archipelago and rising inequality are concerns. Indonesia might want to consider how to ensure that economic growth is as inclusive as possible. The third challenge is to ensure that Indonesia does not suffer from infrastructure and resource constraints as its expanding consuming class delivers a welcome injection of growth—and that this demand creates potentially lucrative new markets. In the years ahead, this once- in-a-generation economic transformation will need careful management. This report highlights action that Indonesia could take in three key sectors— consumer services, agriculture and fisheries, and resources—to boost productivity and remove constraints on growth. In addition, we highlight ways to tackle an impending shortage of skills across all sectors. If Indonesia embraces these four priority areas, it has the opportunity to build on recent successes and create a platform for a productive, inclusive, and resilient economy in the long term. IndonEsIa’s rECEnT IMprEssIvE EConoMIC pErforManCE Is noT wIdEly undErsTood The Indonesian economy, today the 16th largest in the world, has performed strongly over the past decade or more and is more diverse and stable than many observers from beyond its shores realise (Exhibit E2). Over the past decade or so, Indonesia has had the lowest volatility in economic growth among any advanced economy in the Organisation for Economic Co-operation and Development (OECD) or the BRICs (Brazil, Russia, India, and China) plus South Africa. Exhibit E2 Indonesia has performed impressively over the past decade Overview of OECD and BRIC1plus South Africa GDP growth GDP 2011, Real GDP growth, standard deviation, Share of debt to Inflation rate, current prices 2000–10 annualised, 2000–10 GDP, 2009 2011 Rank $ trillion % % % %, GDP deflator 1 United States 15.1 China 11.5 Indonesia 0.86 Russia 8.7 Japan -2.0 2 China 7.3 India 7.7 Australia 0.95 Estonia 9.0 Czech Republic -0.7 3 Japan 5.9 Indonesia 5.2 Portugal 1.48 Luxembourg 12.8 Ireland -0.4 4 Germany 3.6 Russia 4.9 Norway 1.56 China 16.5 Germany 0.7 5 France 2.8 Slovakia 4.9 France 1.59 Australia 24.1 Switzerland 0.7 6 Brazil 2.5 South Korea 4.2 New Zealand 1.70 Indonesia 2 25.0 Slovenia 0.8 7 United Kingdom 2.4 Turkey 4.0 Belgium 1.74 Czech Republic 32.0 Denmark 0.9 8 Italy 2.2 Poland 3.9 Switzerland 1.78 Norway 35.4 Sweden 0.9 9 Russia 1.9 Estonia 3.8 Canada 1.82 Slovakia 38.2 Portugal 1.0 10 Canada 1.7 Chile 3.7 India 1.85 Denmark 40.8 Italy 1.3 11 India 1.7 Brazil 3.6 South Korea 1.98 Sweden 44.2 Netherlands 1.4 12 Spain 1.5 South Africa 3.5 Poland 2.00 Spain 46.4 Spain 1.4 13 Australia 1.5 Czech Republic 3.4 China 2.02 Germany 47.6 France 1.6 14 Mexico 1.2 Israel 3.1 Netherlands 2.09 Poland 48.1 Greece 1.6 15 South Korea 1.1 Australia 3.1 United States 2.10 Turkey 51.4 Slovak Republic 1.6 16 Indonesia 0.8 Slovenia 2.8 South Africa 2.14 Canada 53.1 (36) S. Africa 7.8 17 Netherlands 0.8 Luxembourg 2.8 Austria 2.14 India 53.7 (38) Indonesia 8.4 18 Turkey 0.8 New Zealand 2.6 Italy 2.17 Netherlands 58.2 (39) Turkey 9.0 1 Organisation for Economic Co-operation and Development; Brazil, Russia, India, and China. 2 Based on 2011 debt level. SOURCE:Conference Board Total Economy Database; IMF; World Bank; McKinsey Global Institute analysis Government debt as a share of GDP has fallen by 70 percent over the past decade and is now lower than in 85 percent of OECD countries. Inflation has decreased from 20 percent to 8 percent and is now comparable with more mature economies such as South Africa and Turkey. According to the World Economic Forum’s competitiveness report on Indonesia, in 2012 the country ranked 25th on macroeconomic stability, a dramatic improvement from its 2007 McKinsey Global Institute The archipelago economy: Unleashing Indonesia’s potential 3 ranking of 89th place. Indonesia now ranks ahead of Brazil and India, as well as several ASEAN neighbours including Malaysia, Thailand, and the Philippines.2 Another misperception is that Indonesia’s economic growth centres almost exclusively on Jakarta; in fact, many other Indonesian cities are growing more rapidly, albeit from a lower base. The fastest-growing urban centres are large and mid-sized middleweight cities with more than two million inhabitants (excluding Jakarta), which have posted annual average growth of 6.4 percent since 2002, compared with Jakarta’s 5.8 percent. These cities include Medan, Bandung, and Surabaya as well as parts of Greater Jakarta such as Bogor, Tangerang, and Bekasi. Nor is Indonesia, as many assume, a typical Asian manufacturing exporter driven by its growing workforce or a commodity exporter driven by its rich endowments of natural resources. The reality is that, to a large extent, it is domestic consumption rather than exports, and services rather than manufacturing or resources, which are propelling growth. Indonesia’s exports as a share of GDP are roughly half those of Malaysia in 1989, when Malaysian average incomes were at similar levels to those of Indonesia today. The resource sector’s share of the economy has actually fallen since 2000 despite booming resource prices. Mining and oil and gas account for only 11 percent of Indonesia’s nominal GDP, similar to more advanced economies such as Australia (8.4 percent) and Russia (11 percent). Indeed, Indonesia is a net oil importer. In contrast, services account for roughly half of economic output. Over the past two decades, labour productivity improvements accounted for more than 60 percent of economic growth with the rest coming from more labour inputs due to an expanding working-age population. Perhaps surprisingly, the majority of Indonesia’s productivity gain has come not from a shift of workers from lower-productivity agriculture into more productive sectors, but from productivity improvements within sectors. The three sectors making the largest contributions to this productivity improvement are wholesale and retail trade; transport equipment and apparatus manufacturing; and transport and telecommunications. And contrary to the widespread belief that productivity improves at the expense of employment, both have risen in tandem in Indonesia in 35 of the past 51 years. ThE EConoMIC ouTlooK Is proMIsInG, supporTEd by favourablE loCal and InTErnaTIonal TrEnds Indonesia’s economic growth should benefit from a number of powerful positive trends including the resurgence of Asia, continuing urbanisation that is boosting the number of consumers with the power to spend on discretionary items, and a young population offering the economy a potential demographic dividend. On the current expected trajectory of growth, an additional 90 million Indonesians could join the global consuming class by 2030, powered by the continued rise of urban Indonesia (Exhibit E3). Only China and India are likely to surpass this increase in absolute terms, while Brazil, Egypt, Vietnam, and other fast-growing economies will each bring less than half of Indonesia’s number into the consuming class in the same period. By 2030, Indonesia could become the seventh-largest economy in the world after China, the United States, India, Japan, Brazil, and Russia— overtaking Germany and the United Kingdom. 2 Association of South East Asian Nations. 4 Exhibit E3 An estimated 90 million Indonesians could join the consuming class by 2030 Million people1 280 280 265 240 110 145 180 Below 195 consuming class 170 135 85 Consuming class2 45 2010 20203 2030 in 5–6% 2030 in 7% GDP scenario GDP scenario Additional people in 40 90 125 the consuming class 1 Rounded to the nearest five million. 2 Consuming class defined as individuals with an annual net income of above $3,600 at 2005 purchasing power parity (PPP). 3 Based on annual GDP growth of between 5 and 6 percent. SOURCE:McKinsey Consumer and Shopper Insight (CSI Indonesia 2011); 2010Population Census, Indonesia’s Central Bureau of Statistics; Canback Global Income Distribution Database (C-GIDD); McKinsey Global Growth Model; McKinsey Global Institute Cityscope 2.0; McKinsey Global Institute analysis ƒ The rise of Asia. The global consuming class will increase its membership by 1.8 billion members over the next 15 years, of whom more than 75 percent are likely to be in Asia. The economic transformation in India and China is happening at a scale and pace unprecedented in history. Average incomes are growing at ten times the pace and on more than 200 times the scale of their increase during England’s Industrial Revolution. This will fuel demand for a range of resources and commodities supplied by Indonesia. Exports to other Asian economies, particularly those of China and India, have already accelerated strongly in recent years at annual growth rates of 15 to 20 percent. In 2010, Indonesia exported $3.8 billion of palm oil to India and $2.1 billion to China. In the same year, China was Indonesia’s largest export market for coal, receiving $3.6 billion, and India was the destination for $2.0 billion of coal exports. ƒ Urbanisation. The proportion of Indonesians living in urban areas could reach 71 percent in 2030, up from 53 percent today, as an estimated 32 million people move from rural to urban areas. New cities will be created, helping to increase the overall share of Indonesian GDP generated by urban areas from an estimated 74 percent today to 86 percent in 2030. Other urban areas will continue to outpace Jakarta’s growth. Small middleweight cities, defined as having between 150,000 and two million inhabitants, will continue to contribute the majority of growth and increase their share of GDP to 37 percent (from 31 percent today) with annual growth of more than 6 percent. We expect that cities including Pekanbaru, Pontianak, Karawang, Makassar, and Balikpapan will lead growth among small middleweight cities, each having annual growth rates of more than 7 percent. Growing even faster in relative terms at rates of around 7 percent are 20 mid-sized and large middleweight cities with between two million and ten million inhabitants. Together, these cities will contribute roughly one-quarter of GDP in 2030. In contrast, Jakarta’s contribution to GDP is expected to remain relatively constant, at around 20 percent.