Indonesia: Stop Chopping, Start Learning

The Indonesian economy, which for so long had been an also-ran in the Asian growth derby, is getting good press these days. There’s no mystery why. While much of the world is struggling in the aftermath of the global financial meltdown, Indonesia continues to post annual economic growth rates in excess of six per cent. What’s more, public debt is now less than 25 percent of GDP — down from 96 percent in 1999. And it is still falling relative to GDP: The budget deficit is only about two percent of GDP, among the lowest in the region.

It should have been no surprise when the McKinsey Global Institute, part of the eponymous management consulting company, concluded that Indonesia “is larger, more stable and more advanced than many companies and investors around the world realize.” Rapid economic growth will likely be sustained until 2030 at minimum, MGI concluded, when the economy will be the seventh largest in the world.

But lurking behind such optimistic scenarios is a troubling reality. Indonesia has (literally) burned through much of its generous endowment of natural resources in getting this far, and is on a path to consume much of the rest. To continue to grow rapidly for the decades needed to build a sustainable high-income economy, Indonesia will need to sharply increase investment in fixed assets, knowledge and skills and/or sharply cut natural resource depletion.

Resource economists use a simple rule of thumb — known as Hartwick Rule’s after the Canadian economist who first came up with it — to assess the sustainability of non-renewable resource use. The “economic rents” — that is, the market value minus the cost of production — generated in the exploitation of those resources should be offset by an equal (or larger) investment in physical and human capital.

The logic is straightforward. Natural resources in the ground are like money in the bank. If you simply withdraw money for consumption, it’s gone for good. But if you invest the cash, there’s a good chance it will yield returns that offset depletion of the nestegg. Investment can take the form of physical capital — factories, roads, telecom systems and the like — or human capital (education, research, etc.)

The Hartwick Rule has gained currency over the years as countries that have consumed the proceeds from natural resource exploitation have gone from boom to bust. The most notorious case is the Pacific island of Nauru, which was made of phosphate rock (used for fertilizer) that was strip-mined into wasteland in a generation. The World Bank now similarly estimates “genuine saving,” defined as gross domestic saving minus depreciation and depletion of natural resources, for a wide range of countries.

Unfortunately, the World Bank lacked data to include deforestation — Indonesia is home to huge tracts of valuable hard woods — in its estimate. So, to arrive at a ballpark figure for Indonesia’s genuine savings, I have used the conservative consensus estimate that Indonesia is currently losing about 600,000 hectares (1.5 million acres) per year in primary forests. Further, I have very conservatively assumed that the market value lost with each hectare is $30,000 (using the value of the dollar in 2000 to control for inflation).

As the graph below shows, Indonesia’s gross savings rate is about 30 percent of national income — a very respectable figure close to that of Thailand, Vietnam and the Philippines. The problem is that Indonesia is depleting natural resources at such a high rate that genuine savings amounts to just seven percent of national income. (By the way, Malaysia, another resource-rich country, is not doing much better, despite a reported gross saving rate of more than 35 percent.)

It’s worth noting that there is a somewhat reassuring trend in Indonesia’s genuine saving rate. Gross domestic saving has risen sharply in recent years. This gain, combined with a decrease in energy depletion as oil reserves are used up, has pushed Indonesia’s genuine saving into positive territory after many years of negative net saving. But the trend is vulnerable to reversal as Indonesia ramps up natural gas production and world commodity prices come down from their recent peaks.

Natural resource depletion also puts Indonesia’s currently healthy government finances at risk. Oil and gas sales generate more than one-fifth of total government revenue, reducing pressure on politicians to develop more sustainable sources of income. Indonesians were not forced to pay much in taxes during the authoritarian Suharto years, which, in a sense, was a wasted opportunity since well-entrenched military-backed governments have the luxury of promulgating unpopular policies. Today, Indonesia is a democracy, and the reluctance of successive administrations to pare down wasteful fuel subsidies from the budget or to raise taxes suggests how difficult it is for a country long accustomed to easing its fiscal problems by pumping oil to pull up its socks.

This much is clear, however: Indonesia cannot get rich by eating its seed corn. This doesn’t mean, however, that Indonesia must necessarily slow the exploitation of all natural resources. On one hand, the gains from protecting primary rainforests are particularly large given the massive social and political costs of forest destruction. On the other, mineral depletion still makes up a relatively small proportion of dissaving. What is clear is that the country must break the habit of financing consumption growth from natural resource rents, and that economic growth in the long run depends on sustained increases in investment in physical and human capital. The immediate goal then, should be containment of deforestation plus the phase-out of fuel subsidies — in particular, fuel subsidies to the affluent — and to create incentives for investment in productive capacity and skills.

Indonesia is hardly the only resource-rich emerging market country that is using its natural wealth in unsustainable ways. Saudi Arabia’s genuine savings rate was negative in 2008 (the latest year for which figures are available) and is probably in worse shape today. Failed states in Africa — think of Congo or Equitorial Guinea — save almost nothing and produce almost nothing other fast-depleting minerals. But Indonesia is an especially important case, a large country that in many ways appears ready for rapid development. It would be very sad, indeed, if a legacy of resource profligacy slowed it down.