Indonesia Compact II - Constraints Analysis

MCC’s evidence-based approach to its investments begins with a mutual understanding of a country’s main growth challenges. During the first phase of the compact or threshold program development process, MCC and the selected partner country, jointly conduct a constraints-to-growth analysis (CA). This analysis identifies the constraints to private investment and entrepreneurship that are most binding to economic growth in the country. The results of this analysis enable the country, together with MCC, to select activities most likely to contribute to sustainable, poverty-reducing growth.

The Constraints Analysis Report for the second Indonesia Compact highlights the following binding constraints to economic growth:

1. Barriers to Export-Oriented Competitiveness: Trade and FDI are each relatively heavily restricted in Indonesia, and evidence suggests the economy pays a substantial price in the forms of lower investment, firm productivity, and employee wages. Protection-induced stagnation helps explain the absence of per capita income increases from new exports since 2005. Also, economic growth rates have moderated as Indonesia has become more restrictive (relative to comparators). Finally, restrictions on trade and FDI have affected the composition of Indonesian firms and the type of production those firms engage in, such that Indonesian firms are less internationally competitive and more inward-focused.
2. Barriers to Domestic Productivity and Innovation: Indonesia’s SOE presence is extensive and its competition regime is weak. Consistent with this apparent dearth of competition, product, service, and process innovations are each rare at Indonesian firms, and research and development (R&D) spending is low. The outsized role that SOEs (which are in some cases monopolies and therefore spared from competitive pressures) play in the economy comes at a substantial cost in the form of foregone returns on equity, conservatively estimated to be half a percentage point of GDP (Australia Indonesia Partnership for Economic Governance, 2017). Moreover, firms in Indonesia appear to have relatively low rates of entry and exit, and therefore seem to face disproportionately low risks of having to shut down or face competition from new entrants (World Bank and International Finance Corporation, 2019). This helps explain service sector firms’ low propensities to innovate and Indonesian firms’ lack of export competitiveness.
3. Costly and Underdeveloped Financial Intermediation: Relative to comparator countries, Indonesia’s total financial sector assets, bank deposits, stock market capitalization, and credit to the private sector are all low, and its capital markets are shallow (World Bank and International Finance Corporation, 2019). The economic costs of this constraint take the forms of moderately high interest rates, onerous collateral requirements, and high reserve requirements which effectively constitute a tax on financial intermediation loans (World Bank, 2018). While the spread between lending and deposit interest rates is lower than in income comparators, it is higher than in regional comparators, which further suggests there are problems mobilizing savings. Finally, there is some evidence that firms’ value added is inversely related to their degree of reliance on loans, suggesting financial intermediation problems could be preventing certain kinds of firms from prospering.