Indonesia's digital sector: opportunities and challenges

This post is about what I know regarding the digital economy in Indonesia. Indonesia (and indeed the whole world) is currently caught up in the hype of Industry 4.0, the digital economy, the Internet of Things, and similar trends. Digitalization seems unavoidable. While globalization has been fading, data exchange has been growing exponentially. Some of this content also appears in a collaborative book by PPI Australia on Realizing Indonesia 4.0. That book covers much more, including the impact of digitalization on healthcare, education, and more.

Disclaimer: I’m not an expert on Indonesia’s digital economy. This post is just written in my spare time because the sector is fascinating, widely discussed, and seemingly inevitable. Happy to discuss!

The digital economy and Indonesia’s readiness

What exactly is the digital economy? I’m not entirely sure of the definition myself. Australia’s communications department defines it as social and economic activities enabled by information technology, including e-banking, social media, Netflix, and other businesses using computing, cloud, and other smart devices.

the global network of economic and social activities that are enabled by information and communications technologies, such as the internet, mobile and sensor networks

By this definition, what makes an economic activity “digital” is when it involves computing and the internet. The digital economy has naturally attracted attention from many stakeholders. In a report titled Digital Globalization, McKinsey noted that global data flows grew 45-fold between 2005 and 2014. This coincides with so-called ‘slowbalization’ – the declining growth in trade of goods, services, and global investment since the 2008 global financial crisis. In other words, even as worldwide trade in goods, services, and investment has slowed, data exchange has grown at breakneck speed.

Information technology is changing how people do business. Much faster and better communication enables multinational corporations (MNCs) to operate globally. Outsourcing production processes and lean manufacturing are made possible by increasingly rapid inter-personal coordination thanks to the internet. MNCs can source labor, raw materials, and capital from around the world and market their products globally as well. This applies not just to goods but also services like Netflix.

Improving computing power and internet speed have even made machine-to-machine communication possible. In the past, outsourcing meant designers sending fax drawings to factories. Email helped designers send drawings faster and in higher quality. CAD-CAM and 3D printing have made it even easier, as designers just need to send CAD files¹. Machine-to-machine communication is also enabled by technologies like RFID, and ever-faster computing and internet speeds have enabled cloud computing.

Sensor technology has further accelerated human-machine communication. Traditionally, we communicate with machines by manually inputting data. You’ve probably used Excel and manually entered numbers. This blog was written using manual keyboard input. Biometric sensors let you “command” your smartphone to grant access via fingerprint. Today, smartwatches benefit from various sensors that can transmit body information like heart rate to machines, potentially saving your life.

This combination of human-human, machine-machine, and human-machine data exchange is the enabler behind everyone’s favorite buzzword: Industry 4.0.

But talking about Industry 4.0 in Indonesia still seems premature. The World Economic Forum’s 2018 report placed Indonesia in the nascent category – still far from ready. Key problems cited include a skills gap in the workforce, inadequate and uneven infrastructure, poor cyber security, and regulations and institutions that need strengthening.

There aren’t many comprehensive studies on Industry 4.0 adoption in Indonesia, but this CSIS study on Industry 4.0 in the manufacturing sector is extremely interesting. CSIS conducted its own survey showing that most manufacturing firms don’t yet feel the need to increase their Industry 4.0 adoption. One reason is that labor remains relatively cheap and industries rely on low-skilled, labor-intensive production. Rather than upgrading technology, relocating to regions with lower minimum wages still makes more economic sense. They added that most firms acknowledge they don’t really understand the practical implementation of the government’s “Making Indonesia 4.0” at the ground level.

While Industry 4.0 adoption in manufacturing still seems distant, at least one sector has been growing rapidly. The World Economic Forum identified two assets that give Indonesia a foundation for the digital world: market size driven by a large population, and relatively strong foreign investment. We can see how both factors play a crucial role in developing Indonesia’s digital economy: e-commerce.

E-commerce growth in Indonesia

As the world’s 4th most populous country, Indonesia is a highly promising market. A large market is essential for building economies of scale, allowing businesses to have many customers. Increasingly affordable smartphone and data plan prices have made internet access easier for Indonesians. Indonesia has also been called a nation that is hungry for internet content and social media.

(Indonesians) spend a higher-than-average amount of time on the Internet, primarily engaging in heavy social media usage and e-commerce ….. Their social media usage is among the highest of any population in the world.

According to a study by SMERU, Indonesia has five startups that have achieved unicorn or decacorn status: Gojek, Tokopedia, OVO, Bukalapak, and Traveloka. Gojek claims to have contributed 55 trillion rupiah to the economy, while Grab claims 48.9 trillion. Tokopedia claims a contribution equivalent to 1.5% of GDP – roughly comparable to the contribution of the entire aviation industry in Indonesia! And that’s just Tokopedia²…

E-commerce transactions in Indonesia have grown rapidly. A CSIS Policy Brief shows e-commerce transaction values rising exponentially from 32.29 trillion rupiah in 2014 to around 265.07 trillion rupiah in 2019. These figures don’t even include off-platform transactions such as purchases through Facebook or Kaskus.

Click for visualization from CSIS Policy Brief on e-commerce transactions in Indonesia. If you're using dark mode, be careful -- the image has a white background

This strong demand is forecast to keep growing. As competition in the smartphone and telecom industries drives down the prices of phones and data plans, and as economic growth enables a growing middle class, the potential for online shopping is projected to accelerate further.

With such large demand potential, investment needs have also increased. The Indonesian government facilitated this opportunity by removing e-commerce from the negative investment list through Presidential Regulation 44/2016. Foreign investment flooded into the sector. Major players include Tencent, Alibaba, Temasek, and various venture capitalists from Western countries. Even Google and Microsoft got in on the action. Tirto quoted then-BKPM chief Thom Lembong in 2019, who said that around 15-20% of foreign investment entering Indonesia was going to e-commerce.

“We estimate that 15-20 percent [of total investment] goes to e-commerce. That’s about $2-2.5 billion per year,” said Thomas at a forum titled “Unicorn Investment: For Whom?”

This massive capital enabled platforms to subsidize their way to scale-up. It’s an open secret that Gojek and Grab in their early days competed fiercely by pouring out subsidies, sacrificing short-term profits to grow their user base. The same happened in e-commerce, where platforms offered enormous promotions, discounts, and flash sales. This certainly benefited consumers, at least in the short term.

Another advantage of e-commerce is the incredible range of services it offers, including online storefronts, payment systems, advertising, and even warehousing. This allows merchants to focus purely on their products without worrying about payment systems and marketing. This is great for SMEs with limited capital. If the product is outsourced or imported, a seller doesn’t even need to think about production – just marketing!

The rapid growth of the digital sector presents an opportunity for the government to increase tax revenue. Digital products can be taxed by the consumer’s country. So even if Netflix is already taxed in the US, Indonesia has the right to levy taxes on Netflix purchases by Indonesian consumers. The digital services tax regulation is embedded in Government Regulation in Lieu of Law No. 1/2020 on financial system policy during the COVID-19 pandemic. Despite the COVID-19 framing, this tax will likely persist even after the pandemic ends.

The technical details are in Minister of Finance Regulation 48/PMK.03/2020, and this tax is called VAT on Trade through Electronic Systems (PPN PMSE). Collection works similarly to restaurant tax – the Ministry of Finance partners with platforms like Netflix, Amazon, Google, Spotify, etc., so consumers pay the tax to the platform, which then remits it to the government.

Challenges ahead

As data needs are projected to keep rising, network investment must continue. Currently, investment in Indonesia is inefficient, partly because building network infrastructure (towers, cables) is expensive while returns are insufficient to justify the investment. In Australia, the government subsidizes internet infrastructure development and provides access to internet providers. The logic is similar to building toll roads: the government builds the road, and all vehicle owners can access it by paying a fee. At least the sunk cost and fixed cost can be reduced. Indonesia has the Palapa Ring, but I’m not yet clear on how it’s being utilized.

The challenge isn’t just about speeding up and expanding internet access, but also about even distribution. You’ve certainly heard how the quality of online schooling varies enormously due to vastly different network quality. Some students enjoy smooth video and ample bandwidth, while others can barely hear audio. We just got 4G, and 5G is already on the horizon. Combined with heavy reliance on private investment for network infrastructure, private companies respond to market incentives. They must choose between upgrading networks in major cities or extending coverage to smaller towns. Being private companies, they make decisions based on profit. This could widen the internet access gap even further.

Next is the challenge specific to e-commerce growth without corresponding growth in production capacity. We discussed how demand-side drivers (market size) can stimulate supply-side responses through foreign investment. But without complementary supply-side improvements such as business climate and investment conditions and workforce quality, we’ll fall behind on production. E-commerce is merely a market facilitator – production can come from anywhere. If domestic production can’t compete, the result is more imports.

The Jakarta Post in February 2019 quoted the Finance Minister saying that e-commerce product imports grew 9.11 percent in 2019, putting pressure on the trade balance – something the Indonesian government is deeply concerned about.

The Finance Ministry’s Customs and Excise Directorate General recorded that the contribution of import duties from e-commerce products to state revenue was recorded at Rp 1.19 trillion ($84.65 million) last year, about Rp 99.2 billion per month on average. However, the total import of e-commerce products reached US$17.17 billion in 2018 or 9.11 percent higher than the previous year’s figure. Meanwhile, the country’s trade deficit was recorded at US$8.57 in 2018.

E-commerce enables individual purchases, creating a phenomenon called ‘small package in large numbers’. You may recall that Indonesia previously had a duty-free threshold of $75 for imports. In the past, retailers bought in bulk. Thanks to e-commerce, purchases are now individual. As a result, many small packages valued under$75 entered Indonesia. Total imports didn’t decrease, but proportional customs revenue fell short. This prompted the government to revise the duty-free threshold down to $3.

Finally, there are challenges around data security and privacy. It’s no secret that data security and privacy are increasingly important worldwide. Indonesia experienced 88 million cyberattacks in Q1 2020. We’ve also heard multiple times about platforms being breached by hackers, including incidents involving the Indonesian government.

Better policy

Beyond challenges like infrastructure and human resources, the government needs to improve its ability to regulate this sector. Fintech regulation, the industrial relationship between online platforms and driver-partners, cloud computing, and Industry 4.0 all need clarity and consistent enforcement. Then there’s data privacy and security, which remains contentious not just in Indonesia but globally. We also have issues with rampant hoax dissemination and the controversial enforcement of the ITE Law.

The digital sector emerged suddenly and has grown extremely fast – faster than our ability to adapt. Fortunately, with the enormous hype around the digital economy, an increasing number of talented thinkers are helping the government formulate sound policy. Now it’s just about execution.

(((just)))