Reaching out: By decentralising growth, the authorities hope to achieve a more balanced economy

Investors have traditionally focused on the largest cities in Java, but as urbanisation and growth spread to more outlying regions in the last decade attention has broadened to provincial urban centres.

While challenges remain in coordinating policy amongst three powerful tiers of government, easing infrastructure constraints in larger cities like Jakarta and Surabaya will be key to supporting broad-based growth over the medium term. Given that every 1% increase in urbanisation has led to an average of 6% growth in per capita GDP in India and China, 8% in Vietnam and 10% in Thailand, in the 1970-2006 period, according to the World Bank, the aggregate impact will be substantial if Indonesia is able to harness this demographic dividend. However, infrastructure development within cities and along corridors linking key urban centres with their peripheries has become ever more important. With the World Bank forecasting that 67.5% of the population will be urban by 2025 – with the fastest increases coming from areas outside of Java – “the manner in which the country urbanises over the next 15 to 20 years is of crucial long-term significance to the country‘s socio-economic development,” according to the bank.

REGIONAL DYNAMICS: Indonesia’s urbanisation rate, which has grown from 30% in 1990 to 44% by 2010 and 49.8% in 2012 according to the Central Statistics Agency (BPS), has not generated even growth across all towns. While the sheer size of Jakarta and Surabaya, each home to over 10m people, has attracted greater focus from investors and policymakers, the economies of smaller cities have grown faster.

As in the Philippines, 13 mid-sized cities of between 1m and 5m inhabitants are growing the fastest, with a 2.4% annual rise in their population from 1993 to 2007, while its eight cities of between half and 1m grew 3.4% a year, according to the World Bank. Meanwhile smaller cities of between 100,000 and 500,000 saw their populations decline by an average of over 2% annually during the same period. A World Bank report on sub-national variations in urbanisation and economic growth, published in August 2012, has focused policymakers’ attention on the stronger economic growth record in secondary cities. “It is in the secondary and tertiary cities that the potential for rapid growth lies,” Luky Alfirman, head of the Ministry of Finance’s centre for macroeconomic policy, told OBG. Mid-sized cities have achieved growth in their gross regional domestic product (GRDP) at least as fast as the rise in their populations, demonstrating the boost to their productivity. While the GRDP per capita of midsized cities still trails that of Jakarta, their growth in the coming years will likely exceed Jakarta’s given the lower potential for marginal increases in productivity. Indeed, cities of between 500,000 and 1m people recorded the fastest rate of growth per capita, with average annual real productivity increases 3.4% between 1993 and 2007, as measured by GRDP per capita growth. Meanwhile, larger cities in Java like Bandung, Yogyakarta, Cirebond and Semarang, with populations between 1m and 5m, saw 0.7% net annual losses in GRDP per capita.

DECENTRALISED INVESTMENT: Foreign investment has spread to more outlying regions of the archipelago in recent years, with the share of foreign direct investment (FDI) in areas beyond Java rising from 18% of FDI in 2010 to 47% in the year to September 2012 according to the Indonesia Investment Coordinating Board. While most investment in remote areas has centred on the primary sector, including mining and plantations, it has contributed to strong growth in GRDP outside of Java. “FDI composition is spreading to more areas outside of Java and in more diverse sectors such as manufacturing,” Destry Damayanti, the chief economist at Bank Mandiri, told OBG. While much of the investment in outlying regions has focused on commodities, both in hard minerals and soft commodities like palm oil and rubber, the multiplier effects have generated associated investments in services and trade. While burgeoning cities like Sumatra’s Medan and Padang have grown the fastest, service firms are looking east for new opportunities. “There is more and more business in eastern Indonesia, and firms are establishing branches there to cater to provincial growth,” Nina Windyatantri, the head of the reinsurance department at state-owned credit insurer Asuransi Kredit Indonesia (ASKRINDO), told OBG.

Rising disposable incomes in provincial urban centres have placed pressure on public resources, however, under the system of decentralisation enshrined in the constitution – where some 40% of total public spending is devolved to sub-national governments including district heads ( bupatis) and governors – the central government has limited means of coercion. While local governments tend to spend an average of 25% of their budget on capital expenditure, the World Bank estimates that such investment is “significantly lower when it is offset against depreciation in the value of local public assets”. With growth constrained by infrastructure, as cities mushroom in size, administrators are under pressure to be accountable. “The rapid growth in secondary towns beyond Java is putting pressure on local governments to be sensitive to the infrastructure needs of their regions,” Fauzi Ichsan, the managing director and senior economist at Standard Chartered Bank, told OBG. While inner-city challenges are significant, the need to connect urban centres to their peripheries is key.

CHANNELING GROWTH: While inner-city infrastructure stands as a constraint on mid-sized cities’ growth, regional connectivity between urban centres has emerged as another important priority for the central government since 2011, under the Master Plan for Acceleration and Expansion of Indonesia’s Economic Development (MP3EI). While road and rail transport links will be key in integrating the Javanese corridor and cities such as Jakarta, Semarang, Bandung, Yogyakarta and Surabaya, marine transport links will be central for the other five corridors. Focusing on commodity-producing regions (aside from the Bali-Nusa Tenggara corridor, which focuses on tourism and food production) however, investment under MP3EI was ramping up in 2012 just as demand and pricing for commodities were on a downward cycle. “One of the key bottlenecks in the growth of secondary cities is infrastructure,” Anton Gunawan, the chief economist at Bank Danamon, told OBG. “While the MP3EI tends to focus on commodity-rich corridors, these are the very ones seeing a slowdown in 2012.”

AROUND AGAIN: Over the longer term, as the commodity cycle rebounds, the key links for eastern cities such as Papua’s Jayapura and Manokwari and Sulawesi’s Makassar and Manado will be key to integrating growth corridors centred on key secondary cities. The Sumatra corridor, focused on plantations-related activities, will link key cities including Bandah Aceh, Medan, Palembang, Riau and Padang, while Kalimantan will harness its existing mining potential to create higher-value-added mineral processing activities linking cities of Balikpapan, Banjarmasin and Pontianak.

However, progress has been uneven in terms of infrastructure development under the master plan, the World Bank report has flagged up important areas of investment required to support the growth of secondary centres and their capacity to absorb growing investment, both foreign and local.

The passing of the new land acquisition act in late 2011, meant to facilitate land purchases for large-scale infrastructure projects, is key to accelerating these projects. Important challenges still remain in coordinating policy and implementation across the three tiers of government, however, given persisting overlapping jurisdictions in permitting and concessions. These overlapping jurisdictions are nowhere more evident than in the spatial planning of urban centres, particularly in the fast-growing peripheries where urban centres are evolving from a single city centre to larger urban areas structured around numerous centres.

Over the longer term, the structural shift towards provincial growth will propel growth from the Jakarta area. To avoid the infrastructure constraints in the capital, authorities at the central, provincial and district levels will need to coordinate actions to unleash the long-term potential of smaller, more dynamic urban areas. With such a vast geography, more decentralised growth in Indonesia has implications for ASEAN integration with remote areas, such as eastern Indonesia connected to neighbouring areas like the southern Philippines, for instance. While decentralised expansion has become a reality, the ability of authorities to support and leverage this growth will be key.