Australia and Indonesia: Neighbours Forever, But More Ambition Needed

By Arianto Patunru , is Fellow, Arndt-Corden Department of Economics, Australian national University. He is Policy Engagement Coordinator, ANU Indonesia Project,
and Hal Hill , H.W. Arndt Professor Emeritus of Southeast Asian Economies at the Australian National University

Following an Indonesian presidential visit to Australia this week, Arianto Patunru and Hal Hill explore the prospects for an economic reset in Australia-Indonesia relations.

Indonesia’s population is ten times as big as Australia’s, but its income per capita is one-tenth of Australia’s. A standard trade model would predict that the two neighbours would engage intensively in the flow of goods, money, and people. Yet, despite great potentials, the economic relationship between the two countries remains underdone. Following a visit to Australia this week by President Joko Widodo, the issue remains, will the changing geopolitics and the COVID crisis trigger a major reset in the bilateral relationship to the benefit of both countries?

The Indonesia Economy

Indonesia’s economic recovery after the pandemic has been impressive. Its GDP decline in 2020 was the smallest among comparable economies and its public debt position is comfortable, owing to prudent macroeconomic management. But like other countries, it faces a difficult global economic environment: high inflation, the Ukraine-Russia war, the China-US conflict, and a disrupted international trading system. At home, the country is still struggling to push for structural reform to accelerate its slowing economic growth over the preceding decade.

Indonesia is a significant industrial power with a broad-based manufacturing sector. Manufacturing output and employment have grown every year since the late 1960s, except for the crisis years of 1998 and 2020. Recently, however, manufacturing export growth has been modest due to lower global prices of many products in which Indonesia specialises, to the country’s surprisingly minor participation in the dynamic, East Asian-centred global production networks, and to its somewhat restrictive foreign investment regime.

To address this slower industrial growth President Joko Widodo has been promoting an activist (but in some quarters contentious) industrial policy by pursuing downstreaming (hilirisasi), particularly in certain mineral ores (most notably nickel), as a means of increasing domestic value added. By banning the export of raw commodities, the policy aims to incentivise the development of downstream sectors. The policy depresses domestic local prices and therefore increases the profitability of downstream users, including smelters and other processors, many of which are foreign-owned. In the few instances where Indonesia is a substantial global supplier with international market power (possibly nickel), the withdrawal of Indonesian supply may push up global prices and therefore benefit other exporting nations. The depressed domestic prices probably also discourage mining exploration. The direct employment effects of the export ban are minimal. Furthermore, the strategies of export bans and the accompanying local content requirements run counter to the goal of joining internationally oriented global value chains, which involve a ‘slicing up’ of production processes across borders, and therefore thinner value added in each process, but as part of a much larger scale of production.

Australia and Indonesia

In this context, increasing economic ties between Indonesia and Australia can help. The two countries should exploit the complementarities between their economies. Like Australia, Indonesia is embarking on the journey of energy transition to deal with the challenges posed by climate change. There has been discussion about collaborations in this area as the economies begin to decarbonise. These include joint ventures in EV battery manufacture, for which Indonesia has large nickel deposits but no lithium, which Australia possesses. It is important, however, not to limit this to a two-country endeavour alone, as EV batteries need much more than just nickel and lithium. Many of the other components of EV batteries need to be sourced from other countries. The EV battery industry should also be integrated with the internationally oriented automotive industry, in which Thailand is currently the Southeast Asian leader.

The joint ventures may also extend to the mineral processing sector. Most smelters in Indonesia are powered by electricity from coal. Collaboration for energy transition should thus include adoption of more environmentally friendly technologies such and wind, hydro, and solar power. Both countries also have to manage the complex political economy of this transition, including dealing with the politically powerful coal industry.

Great potential in services

The complementarity between Indonesia and Australia extends well beyond the mineral and energy sectors. In particular, the services sector continues to have great potential. Australia is – and has been for many years – one of the key destinations for young Indonesians to pursue tertiary education. Now this means not only Indonesians coming to Australia, but also Australian education coming to Indonesia. Monash University has established its Indonesian campus, and this will soon be followed by Deakin University and others, including TAFE-Delivered Vocational Education (TVET) providers. Pandemic-induced digitalisation of education has helped create many new opportunities in this sector. To build on these developments, it will be useful for both countries to relax their visa requirement for students, and to extend the various scholarship and other arrangements to study in the other country. Australian universities also need to rebuild their once impressive Indonesian academic and language programs.

Allowing Indonesian graduates of Australian universities to work here after graduation before returning home will strengthen the bridge for P2P relations between the two countries. To facilitate this further, mutual recognition of skills and qualifications should be expanded. The temporary work arrangements could also be expanded, to the benefit of the rural, tourism, aged care and other sectors

Health services provide another opportunity. Both Indonesian and Australian societies are aging, thus spending on health is increasing. For a long time, many Indonesians went to Singapore for a medical check-up. This then gradually shifted to Penang in Malaysia. With the recent trade and investment agreements between Indonesia and Australia, cooperation as pursued in the education sector should also be applied to the health sector, including through joint venture projects. In addition, Indonesia can develop its aged care and pension systems by looking at Australian experience.

With regard to tourism, Indonesia can further relax requirements for Australian investment in Indonesian tourist destinations (which should not be limited only to Bali). Conversely, Australia should make it much easier for Indonesian tourists to visit here.

Joint ventures in extensive agriculture also have potential. These includes Indonesian investment in the northern Australia cattle industry. Related to this, Indonesia should eliminate its restrictive breeder policy in the livestock sector, which hinders the full use of expanded quotas in the Indonesia-Australia Comprehensive Economic Partnership Agreement (IA-CEPA) and would hamper the development of a ‘powerhouse’ in the processed meat sector. Similarly, Indonesia should not implement an import substitution strategy in the food and beverage manufacturing industry as it will hamper the ability of an Indonesia-Australia food and beverage ‘powerhouse’ to develop and engage with global value chains.

Building on trade agreements

How should these potentials for increased economic ties be utilised? At present Indonesia and Australia are involved in three trade agreements: IA-CEPA, Australia-New Zealand and ASEAN Free Trade Agreement (AANZFTA) and the Regional Comprehensive Economic Partnership (RCEP). Even though the utilisation rates for the concessions offered under these agreements remain relatively low, and sensitive sectors are often excluded, Indonesia and Australia will benefit from utilising these agreements, while continuing their support for the multilateral trade agreement, as they were among the early adopters of the WTO in 1995. As the global trading system has become more fragmented, Indonesia has been involved in many trading negotiations, including through ASEAN, which will always be central to its international economic engagement. While it certainly makes sense for Indonesia to participate in all ASEAN initiatives, especially as ASEAN countries often “multilateralise” any concessions, and tend to have less restrictive “rules of origin” arrangements, it would not make sense for Indonesia to develop a trade policy based around negotiated reciprocity arrangements. Unilateral reform based on an assessment of Indonesia’s national interests can be regarded as the starting point in formulating effective commercial policy strategy.

Arianto Patunru is Fellow, Arndt-Corden Department of Economics, Australian national University. He is Policy Engagement Coordinator, ANU Indonesia Project. 

Hal Hill H.W. Arndt Professor Emeritus of Southeast Asian Economies at the Australian National University.