Indonesia is currently categorized as an upper-middle-income country. In 2019, the government announced its ambition of getting the country to high-income status by 2045. The goal is ambitious. It would require a sustained GDP growth rate of 5.5 percent per year from the recent 5.0 percent average, and increasing productivity growth by 1.6 times as expansion of the labor force slows. The country is faced with many challenges, including a slowdown in productivity growth from about 3 percent per year from 2002 to 2016 to about 2 percent per year. There are also indications that the growth of the middle class has slowed, possibly tipping the country into the so-called middle-income trap.
The McKinsey Global Institute (MGI) recently published a report—The enterprising archipelago: Propelling Indonesia’s productivity—that takes a deep dive into how Indonesia could achieve its 2045 ambition. In this Future of Asia interview, Phillia Wibowo talks to two of the authors, Kevin Russell and Khoon Tee Tan, to find what Indonesia needs to do to become a high-income country by 2045.
An edited transcript of the conversation follows.
Phillia Wibowo: Hello. I am Phillia Wibowo, a partner based in McKinsey’s Indonesia office, where I lead our People & Organization Practice for Southeast Asia.
Indonesia’s aspiration to become a high-income economy by 2045 is a bold ambition that will not be easy, but we think it could be possible. Achieving this goal will require productivity growth to accelerate 1.6 times, which will necessitate a fundamental shift in Indonesia’s business landscape from one dominated by microenterprises to a vibrant ecosystem of medium-size and large enterprises. This cannot be achieved through traditional economic growth and will demand a strategic transformation in how the country cultivates and deploys resources. It is not possible using just one capital, but five: financial, human, institutional, infrastructural, and entrepreneurial. For Indonesia to grow significantly, all development must take place in tandem across the archipelago.
Today, two of the coauthors of the MGI report are with me: Kevin Russell, who is a senior fellow at MGI, and Khoon Tee Tan, the managing partner and a senior partner in McKinsey’s Indonesia office.
Khoon Tee, in the report, you mention that Indonesia would need 60 percent productivity growth to become a high-income country. That is an aspirational number. What are the most promising levers for productivity?
Khoon Tee Tan: The most important driver of growth for a upper-middle-income country aiming to become a high-income country is productivity at company level, as it is companies that account for productivity growth in an economy. One of the biggest levers here is the number of mid-size and large companies. Through our research, we found that Indonesia has fewer large companies compared to higher-income economies. Indonesia needs to scale up more of its small and medium-size enterprises (SMEs) to become medium-size and large companies. These companies can increase productivity by investing to produce higher-margin products or adopt tech-enabled operational excellence and commercial excellence.
Phillia Wibowo: Kevin, which other economies did you look at that have similar aspirations to Indonesia?
Kevin Russell: We looked at countries that had similarly large populations, or at least large enough to be comparable, and that had taken the same journey that we think Indonesia is going to take. These are countries that started with a per person income of $4,000 that reached $14,000 per person when the countries became high income or nearly achieved that status. The success of these countries is why we believe that it could be possible for Indonesia to achieve its 2045 ambition.
The countries that have been fast-growing, middle-income countries over the past 40 years include Chile, China, Korea, Poland, and Turkey. If Indonesia grew at the rate of those countries, high income could be possible by perhaps 2040, faster than the 2045 goal. On the other hand, if Indonesia grew at growth rates similar to some of the countries that have been slower, such as Brazil or South Africa, it would take Indonesia till 2055 to become a high-income country. That’s why we looked at these comparative countries and at their investment levels, which is the main driver of fast growth.
Phillia Wibowo: Khoon Tee, how big should larger and medium-size companies be?
Khoon Tee: In our research, we categorized companies into large, medium-size, small, and micro. Large companies are those that employ over 250 people, medium-size companies employ 50 to 249 people, and small companies have ten to 49 employees. Companies that reach a certain level in terms of formal employment are able to improve productivity as a result of deploying more capital into the business. We found that for Indonesia to become a high-income country, it would need to triple the number of medium-size and large companies.
Phillia Wibowo: In Indonesia, companies can largely be divided into four sectors: manufacturing, resources, services, and agriculture. How do you think things should shift, Khoon Tee, to achieve that productivity level?
Khoon Tee: The most obvious sector for productivity growth is the services sector. In almost every high-income economy, the services sector is the biggest driver of GDP growth. In Indonesia, the services sector forms over half of the economy, but in high-income economies, that figure is over 70 percent. It’s also not just any kind of services that are needed, but higher value-added ones that require a more professional, skilled workforce, cutting across subsectors such as modern retail, tourism, logistics, and professional services such as ICT, legal, financial services, and so on.
The second big driver is the manufacturing sector. In Indonesia over the past years, the manufacturing sector has moved sideways or maybe even declined in terms of contribution to GDP, and the sector remains underutilized. But we found that in this increasingly interconnected world with global and regional supply chains, Indonesia could grow more advanced manufacturing subsectors to integrate into the global value chain. The country already has some good natural resources that are important aspects of the economy, such as nickel, aluminum, palm oil, and so on. There’s also a push toward downstreaming. We think that there is more that can be done to go all the way down to more advanced products.
Phillia Wibowo: If the services and manufacturing sectors need to increase to contribute to a large percentage of future GDP, how would that affect other sectors, and what would be the impact on employment?
Kevin Russell: When you talk about the sectors being part of the growth model, I think Indonesia is unique. This was something that we learned from our research, in part because we were looking at different growth models. Think about the kind of export-oriented manufacturing from some of the smaller East Asian economies; think about resources-driven economies such as Australia, Chile, and Norway. Each of those has a much smaller economy. What we realized when we looked at Indonesia is that it will have to have a multisector model.
First, it will have to do almost everything, because the population is so large that to become a high-income country, the country will need all engines firing. Second, it’s such a big country that each part of the country has its own strengths. There are natural endowments in Kalimantan, Sulawesi, or Sumatra, and then services in places such as Bali and Jakarta. Each of those can reinforce the other. If you have good infrastructure and logistics, you can enable trade between cities and other countries, whether that’s in resources, agriculture, or manufacturing.
The key to all of this is good jobs. What will likely happen is that employment in the agriculture sector, which stands at almost 30 percent of employment in Indonesia today, will likely go down to 12 or 15 percent as Indonesia becomes a high-income country. A lot of Indonesian agriculture is subsistence farming on small farms. As farming becomes more productive with increased mechanization and improved technology to plant and price crops, not as many people will be needed on farms and they can move to cities. At the same time, those who stay farming will see their incomes rise, as they will be able to use more of the capital that needs to come from investment.
Phillia Wibowo: What about the impact on employment in the services sector?
Kevin Russell: The services sector will be the biggest employer—that’s already true today. The challenge is that the vast majority of work is in informal retail trade. In fact, that has grown recently as urbanization has increased. There is a real opportunity here for businesses to invest and grow to raise productivity, because they’re the ones that are going to create the jobs and services. That could be in retail, construction, transportation, or food and accommodation services, which together account for over half of the services sector. These are areas where investments in buildings and infrastructure and logistics could really lift people’s incomes and create good jobs, while also creating more livable and sustainable cities.
Phillia Wibowo: Khoon Tee said that the number of medium-size or large companies needs to triple. It seems there will need to be a transformational shift toward the services sector and a productivity increase in manufacturing so that people move from a low-wage, low-productivity ecosystem into a high-wage, high-productivity ecosystem. What needs to be different for productivity to be unlocked? Kevin, what is the learning from other economies?
Kevin Russell: Indonesia has grown to the extent that it is currently an upper-middle income country. It now wants to achieve high-income status. That’s where the middle class grows and new possibilities become available to different sectors. The reason we focused on the corporate ecosystem is that this stage of development is where investments in larger companies really can have a big impact. They can serve a broader middle class and move from only investments in basic capital to more innovation. There are exciting possibilities on that supply side if the corporate ecosystem can get going. And, small businesses and large businesses grow productivity hand in hand; it’s not one or the other. Usually when larger firms grow, smaller firms get opportunities to be part of the supply chain or ecosystem. Getting the whole system off the ground is now an opportunity for Indonesia because it sits in the upper-middle-income category, growing into high income.
The enterprising archipelago: Propelling Indonesia’s productivity
Phillia Wibowo: Khoon Tee, what are the five capital enablers of productivity?
Khoon Tee: One of the most interesting insights that we gained from looking into the Indonesian economy benchmarked against high- or higher-income economies is the notion that to move from middle- to high-income status, it is necessary to build five forms of capital, not just one or two.
The most obvious is financial capital, because as the economy grows, it requires more financing, more financial assets, and accumulation of capital.
The second is human capital, which is fundamental to growth. The education levels in the Indonesian economy above high school and into tertiary education need to improve. The workforce also must be reskilled or upskilled to fit organizations’ requirements and the type of sectors needed in the future.
The third form of capital is institutional capital. What differentiates some economies from others is the level of bureaucratization, the simplicity of regulations and permitting, the ease of doing business, and consistency in following through on investment programs, et cetera.
The fourth is infrastructural capital. Indonesia has been growing in leaps and bounds in terms of improving transportation and logistics and urban and digital infrastructure. However, there is still room to continue growing infrastructural capital to make the economy more efficient in terms of logistics and infrastructural costs.
And last, there is entrepreneurial capital. How visionary, how ambitious are people? How much is entrepreneurship encouraged in Indonesia for businesses to start up and scale up?
Phillia Wibowo: Kevin, I’m curious to hear your thoughts on these types of capital when looking at other economies.
Kevin Russell: The reason we talk about these five forms of capital is because, for countries to invest significantly in their growth—which is the central tenet of our research—there has to be a willingness to invest. This depends on whether the environment is good for investment. Those five types of capital are what make investment attractive. Take financial capital, for example—companies will take risks and build new things, such as factories and technologies, when they have access to capital that’s cheap enough for them to do so. And where does that come from? It comes from the country’s savings. Across economies that have grown fast, the vast majority of investment comes from domestic savings.
Indonesia, in fact, has a very high savings rate at over 30 percent of GDP. The challenge is, does that capital go into the corporate ecosystem? Or does it stay in informal businesses as cash, or does it stay in companies that are less willing to make investments and take risks? You need instruments such as long-term pensions that can really enable that capital to go into investment. In Indonesia, there is not a lot of finance going through those types of instruments. So, it’s a matter of getting the flow going through the pipes when it comes to accessing the high savings that are already there.
I think entrepreneurial capital is critical. There’s no shortage of people able to start businesses in Indonesia. There are millions of informal businesses, many of them with self-employed owners. But the challenge is whether formal businesses can open, ones that are really going to lift productivity and increase investment in the country. That takes a certain environment and entrepreneurial spirit that, as the country grows, will likely catch on and increase. Currently this is happening less in Indonesia than, for example, in Brazil, a country that hasn’t grown as fast but has a higher share of formal businesses.
Phillia Wibowo: Are there any lessons from other countries that Indonesia could adopt to unlock human capital?
Kevin Russell: In our research, we saw there is a question of quantity and quality. For example, are there enough people graduating in Indonesia? Compared to reference economies, the share of secondary school graduates is low. Out of those aged 25 to 34, only 40 percent have completed upper-secondary school. Then there’s a quality question—is Indonesia investing in quality teachers in the right way? Are learning institutions teaching the subjects that are needed for the job pipeline? Those countries that were able to combine these different aspects have seen growth.
What we also found in our research is that even those people with good degrees do not necessarily match the jobs available in Indonesia. That mismatch of the share of the unemployed who have degrees is quite high relative to other countries. That suggests that human capital also has to do with mobility and having the right skills for the right jobs. This is an area where companies can play a role, either by supporting learning programs or training people on the job.
Phillia Wibowo: I think, in addition, problem-solving instincts need to be stronger, as well as softer skills such as the ability to deal with and develop people. Do you have any thoughts on human capital, Khoon Tee?
Khoon Tee: Both the public sector and the private sector play important roles. In the public sector, Kevin mentioned that about 40 percent of people have completed upper-secondary education in Indonesia—this figure is low and needs to improve, because more educated people will provide a bigger formal workforce talent pool, which is necessary for Indonesia to reach high-income economy levels.
From the private sector point of view, we have seen that collaboration between the private sector and universities and tertiary institutions works well to supplement the formal curriculum and to prepare people for the workforce of the future. People need to be ready for jobs, whether in IT, digital, or more advanced manufacturing jobs.
Last, it is important to reskill the existing workforce. In the report, we talk about some of the gaps that we face in this digital age, and Indonesia has made huge progress in this regard. The private sector, however, still needs to reskill the existing workforce.
Phillia Wibowo: I agree. Vocational education should make it easier for people to get employment, but that’s not always the case in Indonesia. The country is working on strengthening that link, but companies need to participate as well, working together with all stakeholders. Two other factors that remain core to all this are the importance of quality, early childhood nutrition and early childhood education—without them, productivity cannot grow as fast as necessary.
The question is, how does Indonesia execute all of this? We have been talking about the huge productivity growth that Indonesia needs to achieve and the five forms of capital that need to be developed in sync to have a multiplier effect. How does Indonesia deliver the outcome it wants?
Khoon Tee: Indonesia is blessed with leaders who are optimistic, driven, and forward-looking, which is a huge asset for the country. There are a few things to build on that base. One is the ability to coordinate regulations across multiple policy-making units to foster a more conducive investment climate. A lot of investors come to Indonesia as they are attracted by the optimism of the country, the growing middle class, and so on. However, many stall when it comes to complex permitting processes and how long it takes to set up a business, and finally go elsewhere to invest. Indonesia needs to fix that because there’s no shortage of people wanting to invest; the country must make it easier for them, from registering to building manufacturing plants or businesses.
Phillia Wibowo: That means a stronger coordination between the central and the regional regions of the country, and recognizing that Indonesia is an archipelago economy. Kevin, what is your view on how Indonesia could deliver the outcome it wants?
Kevin Russell: The premise for the report is that countries that take this high-income journey are ones that invest a lot and whose corporate ecosystem becomes the flywheel that accelerates investment and productivity growth. We’ve talked about the capital enablers, and how leaders need to consider regulation and institutions, but corporate leaders also need to address the situation—both the entrepreneurs who are scaling and creating formal businesses, and the larger corporate leaders who now have the opportunity to boost growth. They can take advantage of the growing middle class, build their capabilities as the five forms of capital strengthen, and find opportunities within growing services and manufacturing sectors where productivity lift is going to be profitable over time. Those are the business leaders who can grow the good jobs in the country.
Phillia Wibowo: If I could summarize, the aspiration to be a high-income economy by 2045 is bold, but it is possible that Indonesia could achieve it. To do so, productivity needs to increase by 60 percent, and the cornerstone of this is company productivity. If companies are to be productive, however, there needs to be a transformational shift in the size of companies, with the number of medium-size and large companies tripling.
The manufacturing sector is the key to being part of the global value chain, but the services sector is also very important for growth, as well as the levels of education to get people into higher-income jobs. Agriculture remains essential, but it needs to be more productive. Resources are at the back end, and the growth enabler is not one form of capital, but five: financial, human, institutional, infrastructural, and entrepreneurial.
There is a lot of disruption in Indonesia, and the transition to shift to a high-income country is not easy. We recognize that. But, as the saying goes, it is better to light a candle than to curse the darkness. Indonesia needs to keep propelling productivity to become the high-income enterprising archipelago it aims to be.
