Indonesia’s growth performance is improving, following a slow recovery from the 1997-98 financial crisis. Growth is becoming increasingly reliant on the dynamism of domestic demand, rather than net exports. Investment is picking up, despite considerable business-climate obstacles to entrepreneurship. Unemployment remains high, and labour informality is pervasive, due predominantly to an increasingly onerous labour code. The macroeconomic policy setting is by and large appropriate. Fiscal policy has been conducted responsibly and in an increasingly decentralised manner. Public indebtedness has been reduced, creating room in the budget for raising spending on much needed infrastructure development, human capital accumulation and social protection. Monetary policy is now conducted within a fully-fledged inflation-targeting regime. It has delivered disinflation, albeit to a level of inflation that remains above that of Indonesia’s trading partners. Efforts to enhance credibility in the monetary policy framework would be helpful. This Economic Assessment argues that the main barriers to raising the economy’s growth potential are to be found on the supply side of the economy. Indonesia will need to improve the business environment and make better use of labour inputs to put the economy on a higher growth trajectory. The country’s income gap relative to the OECD is sizeable, and several years of sustained growth will be needed to eliminate it.

Indonesia’s business environment is discouraging entrepreneurship and holding back private-sector growth and development. Weaknesses in the regulatory framework, infrastructure bottlenecks and poor governance continue to weigh down on investment. Policies have been put in place to address these problems, but much remains to be done. An important recent initiative is the enactment of the Investment Law in 2007, which strengthened the foreign investment regime. This chapter argues that options for reform could focus on making regulations more probusiness, including by removing red tape and onerous provisions at the local level of government, improving governance and relaxing remaining restrictions on foreign investment. Further financial deepening would facilitate access by enterprises to more abundant, cheaper sources of finance.

Since the financial crisis of 1997-98 job creation has slowed, unemployment has been high, particularly among youths, and informality remains widespread. Important contributory factors are a tightening of employment protection legislation (EPL), especially with the enactment of the Manpower Law of 2003, and sharp increases in the real value of the minimum wage. Strict EPL is nevertheless failing to provide effective social protection for the needy, because it is not binding in the informal sector. It is also affecting Indonesia’s trade competitiveness, because the country has a comparative advantage in labour-intensive manufacturing, whose former dynamism has waned. This chapter argues that options for reform could focus on making labour legislation more flexible, particularly for regular contracts, while enhancing formal safety nets, especially through well targeted, conditional income-transfer programmes.