Ekuilibrium: Jurnal Ilmiah Bidang Ilmu Ekonomi Vol. 19, No. 2 (2024): September, pp.

213-222
Economic Faculty, Universitas Muhammadiyah Ponorogo 213
p-ISSN 1858-165X / e-ISSN 2528-7672

Structural Transformation in the

Indonesian Economy: Why does
'Financial Development' Matter?
Muana Nangaa,1, William Widjajaa,2*
aManagement retail, Pradita University, Gading Serpong Boulevard No.1 Tower 1, Banten, 15810, Indonesia
[email protected], [email protected]*

* corresponding author

ARTICLE INFO ABSTRACT

This study offers a comprehensive examination of Indonesia's

Article history process of changing its economic structure from 2000 to 2020.
Received 2-1-2024 Structural transformation, characterized by changes in the
Revised 15-8-2024 distribution of jobs among different sectors, is crucial for
Accepted 27-8-2024 fostering economic growth. It emphasizes phenomena such as the
decrease in agricultural GDP shares, rural-urban migration and
shifts in economic sectors, which resemble the patterns observed
in emerging countries. Nevertheless, the rate of employment
Keywords transformation is comparatively slower than the fluctuations in
Digital technology GDP, suggesting a more gradual and protracted process of
Economic development structural change. The analysis focuses on obstacles to
Financial development transformation, such as insufficient personnel and digital
Human capital
Structural transformation infrastructure. The study examines the relationships between
structural transformation and economic indicators in the
provinces of Indonesia from 2011 to 2022, utilizing panel data
regression models. The findings indicate strong correlations
between economic development, human capital, financial
development, digital technology, and structural transformation.
The study highlights the significance of tackling these elements to
accelerate transformation. The policy implications of this
proposal suggest that Indonesia should prioritize economic and
digital growth, improve human capital, and strengthen the
financial sector. This will lead to a more rapid and comprehensive
structural transformation in the country.

This is an open access article under the CC–BY-SA license.

http://journal.umpo.ac.id/index.php/ekuilibrium
Ekuilibrium: Jurnal Ilmiah Bidang Ilmu Ekonomi Vol. 19, No. 2 (2024): September, pp. 213-222

1. Introduction
Structural transformation refers to shifts or changes in the distribution of output and
economic structure, is a process that always accompanies economic development and is also
considered the core of the economic development process itself (Atolia et al., 2020; Nafziger,
2012; Perkins D. H. et al., 2013). Structural transformation refers to shifting employment
from the agricultural domain to the industrial and service domains. One of the six hallmarks
of modern economic growth is a significant rate of structural transformation (Kuznets, 1955;
Zhou et al., 2021).
A shift in the economic structure is characterized by an increasing number of people
moving from rural agricultural production to urban-based employment in return for higher
wages (urban-based and higher-paying employment), usually in the manufacturing or
services sector (Perkins et al., 2013). In addition, the changes in the economic structure
encompass an elevation in the material prosperity of individuals with low incomes, a
reduction in the proportion of the agricultural sector, and an augmentation in the proportion
of the industrial and service sectors in the Gross National Product (GNP). Furthermore,
there is an enhancement in the education and expertise of the labor force, as well as
significant domestic-originated technological advancements (Nafziger, 2012).
Structural transformation is a fundamental aspect of the development process, serving
as both a catalyst and a result of economic progress. Four interconnected processes
determine structural transformation: (i) the declining contribution of agriculture to the GDP
and employment; (ii) The factors contributing to urbanization, including the movement of
people from rural to urban areas, the rapid growth of cities, the development of modern
industries and services, and the transition from high mortality and birth rates in
underdeveloped rural regions to lower rates in urban areas with better healthcare (Liu &
Wang, 2022; Timmer & Akkus, 2008).
Structural transformation is a regularity in the way the sectoral structure of an
economy changes as income increases. Structural transformation describes how the sectoral
contribution of various economic sectors (such as the primary, secondary, and tertiary
sector), both in total employment and GDP, changes when GDP per capita increases or
experiences an increase (Anderson & Ponnusamy, 2019; Chenery, 1981; Kuznets, 1955).
As for the structural transformation process that occurred in Indonesia, especially
during the last two decades (2000 - 2020), it can be stated that the structural changes or
transformations are mainly seen from changes in the structure of the domestic product
(GDP), which follow a pattern like that which occurs in many developing countries. Table 1
shows that the economic development of a country typically involves a transition in the
economic structure from the primary sector (agriculture, mining, etc.) to the secondary
sector (manufacturing, construction, etc.) and finally to the tertiary sector (services, finance,
etc.) (Ding et al., 2020; Rothbarth & Clark, 1941; Zuhroh & Harpiyansa, 2022).

Table 1. Structure of Indonesia's Gross Domestic Product (2000 – 2020)

The sectoral composition of GDP
Per capita GDP
Year
(Rp million) Primary sector (%) Secondary sector (%) Tertiary sector (%)
2000 6,145 31,16 32,26 36,58
2005 12,676 24,27 35,40 40,33
2010 27,028 26,45 35,82 37,73
2015 45,120 21,14 32,41 46,45
2020 57,290 20,13 31,80 48,07
Source: BPS, Indonesian Statistics (various editions), processed

However, different conditions occur in changes or transformations in the economic

structure of employment. Conversely, there is a transition in job distribution from the
primary to the tertiary sector. Labor transitions from the primary to the secondary sector, in
accordance with the typical pattern observed in shifts in economic structure based on GDP.
However, labor moves directly from the primary to the tertiary sector (see Table 2).

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Table 2. Structure of Indonesia's Employment (2000 – 2020)

Per capita GDP The sectoral composition of employment
Year (Rp million) Primary sector (%) Secondary sector (%) Tertiary sector (%)
2000 6,145 45,28 16,89 37,87
2005 12,676 44,89 17,13 37,98
2010 27,028 39,51 18,16 42,33
2015 45,120 34,03 20,69 45,28
2020 57,290 29,74 21,05 49,21
Source: BPS, Indonesian Statistics (various editions), processed

Structural changes or transformations in terms of employment are slower when

compared to structural changes in terms of GDP. In terms of GDP, the share of the primary
sector in total GDP in 2020 is only 20.13%. Meanwhile, in terms of employment, the primary
sector share is still 29.74%.
Regarding the problem of the slow structural transformation occurring in Indonesia,
several factors are strongly suspected to be the cause. One of them is the low quality of
human resources. The low quality of human resources impacts low labor productivity, which
determines the speed of the structural transformation process. Limited digital infrastructure
is another factor hindering Indonesia's rapid structural transformation (Sander & Yoong,
2020). Due to the inadequate quality of human resources, the process of structural
transformation takes place from the agricultural to the service sector, rather than from
agricultural to the industrial sector (Dartanto et al., 2017). In other words, the structural
transformation process experienced a leap.

2. Literature Review
Structural change, also known as structural transformation, is an inherent process that
occurs alongside a nation’s economic progress (Kuznets, 1955; Lewis, 1954) and is the core of
the economic development process (Baymul & Sen, 2020). Structural transformation is the
process of labor or population moving from one economic sector or activity to another within
a country or economy. This can encompass transitions from the agricultural to the industrial
sector, or from the informal to the formal sector.
Structural transformation, also often referred to as economic transformation, is crucial
for sustained job creation and resilience (Diwakar et al., 2019). In other words, structural
transformation is a transition of an economy that involves the process of reallocating
production factors, both labor and capital, that have low productivity and added value to the
sector or other economic activities that are skill-intensive have higher productivity and
added value (Baymul & Sen, 2020; Kanbur, 2017; Sen, 2016).
This structural transformation will encourage increased productivity, output, and
workers' income, impacting poverty reduction. Apart from that, because this structural
transformation increases productivity, output, and workers' income. The automatic
consequence of this is an increase in demand for goods and services, leading to the creation
of more jobs, both within the sector and across different sectors of the economy, so that
indirectly structural transformation can also reduce poverty (Alisjahbana et al., 2019).
Structural transformation refers to the process by which an economy shifts from
engaging in low-productivity, labor-intensive to high-productivity, skill-intensive activities.
The primary catalyst for structural transition is the fluctuations in productivity within the
contemporary sector, which is predominantly comprised of manufacturing and services.
Moreover, it is characterized by a shift in workforce distribution from tasks that involve
significant physical effort to tasks that demand a considerable level of specialized knowledge.
The labor movement is heavily influenced by the availability of job prospects in industries
that demand high-level expertise. However, labor can only transition to a different sector if it
possesses adequate training to be assimilated into that sector. Hence, the current workforce
will require appropriate training before transitioning into other industries.
Structural transformation is a shift in the economic structure, wherein there is a
transition from sectors that rely heavily on labor and have low productivity to sectors that

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require more capital and skills, resulting in higher productivity. A lasting transformation in
the underlying institutions of an economy elucidates the trajectory of economic growth and
progress. From a technological perspective, the structural restructuring of an economy is
influenced by four fundamental and interconnected processes: (i) the decline in the share of
agriculture in the Gross Domestic Product (GDP) and the workforce engaged in this sector;
(ii) the migration of individuals from rural to urban areas, enabled by the progress in both
rural; (iii) the emergence of modern industrial and service-oriented economies; and (iv) the
transition in demographics from high birth and death rates (typical in isolated and rural
areas) to lower rates, which is linked to improved health standards in developed and
urbanized nations (Chunan-Pole et al., 2014; Timmer & Akkus, 2008). Essentially, it refers
to redistributing economic activities among three primary sectors (agricultural,
manufacturing, and services) that occur alongside modern economic growth (Herrendorf et
al., 2013).
Structural transformation has a vital role in achieving higher productivity growth and
increasing per capita income. Furthermore, it plays a crucial role in expanding economic
structures, thereby strengthening a nation’s capacity to tolerate poverty and external
disturbances (UNIDO, 2012). Structural transformation is primarily facilitated by
institutions and policies that encourage the advancement, acceptance, and utilization of
technology to modify the composition of the economy and its production methods.
Specialization, production, and growth initiate the processes of agglomeration, subsequent
specialization, and technological advancement.
Several previous studies, including the research conducted by Buera and Kaboski
(2012), and (Runtunuwu et al., 2023), have developed models that highlight the importance
of increasing human resources or skill intensity in the service sector, as well as the role of
expanding technological scale, as complementary factors in explaining patterns of growth in
both industrial and service sectors during the development process. The impact of trade
openness and variations in productivity growth rates between sectors have significant
consequences for structural transformation. Researchers such as Lee and Wolpin, 2006;
Matsuyama et al. (2008) have developed a two-sector model to analyze the costs of
reallocating labor between sectors. They also assess the significance of changes in labor
demand, which can result from shifts in sectoral productivity and relative prices, as well as
labor supply factors like demographic changes, fertility rates, and educational attainment, in
driving structural transformation.
The study by Nickel et al. (2008) investigates how changes in relative prices,
technology, and endowment factors (capital, arable land) influence the changes in the
production structure of OECD countries. The findings reveal that the manufacturing sector's
contribution to GDP in the UK and the United States has declined faster than Germany and
Japan. This can be primarily attributed to patterns in total factor productivity (TFP) and
shifts in the relative prices of manufactured and non-manufactured goods. Furthermore,
they found that lower levels of education among men were associated with a higher share of
agricultural output.
Research conducted by Dabla-Norris et al. (2013) shows that human capital plays a
vital role in structural transformation. In addition, the study highlights the heterogeneous
impact of these human capital variables on sectoral shares across countries over time.

3. Research Method
Model Specifications
In this study, the analysis uses a panel data regression model, which is formulated as follows:
𝐿𝑜𝑔(𝑆𝑇𝑅) = 𝛽0 + 𝛽1 log(𝑌𝐶) + 𝛽2 log(𝐻𝐶) + 𝛽3 log(𝐹𝐷) + 𝛽4 log(𝐷𝑇) + 𝑒 ..........................(1)
Where:
STR : level of structural transformation as measured by the share of formal employment
to total employment (%)
YC : level of economic development proxied by the level of income (GRDP) per capita at
constant prices (Rp million)

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HC : level of development of human capital, which is measured by the average length of

time (MYS) (years)
FD : level of financial development as measured by the ratio of banking credit to GRDP
(%)
DT : development of digital technology is measured by the share of the number of
households that have computers in total households (%).
e : disturbance error.

Estimation Method
To estimate the regression coefficients from the regression model above, this will be
done using the fixed effects method (FEM) and the random effect method (REM). Testing
will be carried out using the Hausman test to determine which of these estimation methods
is more appropriate.

Data and Data Sources

The type of data used in this study is panel data, namely data that is a
combination of time-series data (2011 - 2022 period) and cross-section data (33
provinces). The data collected is secondary data, most of which was obtained from
publications by the Central Statistics Agency (BPS) and consisted of GRDP and GRDP
per capita data, data on mean years of schooling (MYS), and data on the percentage of
households with computers. Meanwhile, data on the amount of banking credit is taken from
Bank Indonesia publications. All data collected is for the period 2011 – 2022 and covers 33
provinces in Indonesia (excluding provinces that are new divisions).

4. Results and Discussion

The results of the models carried out using both the fixed effects method (FEM) and
the random effects method (REM) show that the four independent variables used in this
research are the level of economic development which is proxied by GRDP per capita, the
level of human capital development which proxied by the mean years of schooling (MYS)) for
junior high school (SMP), the level of financial development, which is proxied by the ratio of
banking credit to GRDP, and the digital technology development, which is proxied with the
percentage of households that own and control computers, it is proven that they all have a
positive and significant influence on the rate of structural transformation in Indonesia (see
Table 3).
Table 3. Structural Transformation Model Estimation Results (Dependent Variable:
Structural Transformation, Log (STR)
Fixed Effect Model (FEM) Random Effect Model (REM)
Variables
Coefficient t-Statistic Prob. Coefficient t-Statistic Prob.
C 1.692524 12.90935 0.0000 1.706939 13.19884 0.0000
Log(YC?)1) 0.261343 13.65209 0.0000 0.255323 13.54780 0.0000
Log(HC?)2) 0.046361 2.083939 0.0379 0.048531 2.197643 0.0286
Log(FD?)1) 0.202041 6.649788 0.0000 0.203042 6.860374 0.0000
Log(DT?)1) 0.117321 6.754191 0.0000 0.116756 6.801051 0.0000
Adjusted R2 0.559721 0.484221
F Statistic 14.94885 93.70785
N 396 396
Source: data processed (2023)
a. Has a significant effect on the rate of structural transformation at a significance level
(α)=1%.
b. Has a significant effect on the rate of structural transformation at a significance level
(α)=5%.
Among the four independent variables used, three of them, namely the level of
economic development (YC), the level of financial development (FD), and the development
of digital technology (DT) have a significant impact on structural transformation (STR) at

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the significance level (α) = 1%. In contrast, the human capital variable (HC) significantly
affects the significance level (α) = 5%.
The Hausman test findings indicate that the estimated chi-square value of 4.775 is less
than both the table chi-square value (with degrees of freedom = 4) and the significance level
(α) = 5% (equivalent to 9.49). according to the Hausman test results, the computed chi-
square value is smaller than the table chi-square value. Therefore, the random effects
method (REM) is the better suitable estimation method for estimating the regression
coefficient.
The parameter estimation results using the random effects method (REM) produced
an adjusted R2 value that was not too high, namely only 0.48422. The adjusted R 2 value of
0.48422 indicates that the four independent variables used in this study can only explain
48.42% of the variations or changes that occur in the structural transformation variable
simultaneously. Other variables outside the model were used to explain the remaining
51.58%.
Many factors other than those discussed in this research are strongly suspected to
influence the structural transformation process that has occurred so far. The availability of
arable land, age dependency ratio, access to electricity, terms of trade, population size,
urbanization, institutional quality, crop diversification, and the consumer price index are
factors or variables that influence the speed of the structural transformation process that
occurs (Dabla-Norris et al., 2013; López Jerez, 2022).

Discussion
The Influence of Economic Development on Structural Transformation
Structural transformation is a process that accompanies the economic development of
a country along with economic growth or an increase in income. The level of economic
development as proxied by income or GRDP per capita in this study was found to have a
positive and significant influence on the structural transformation of the regional economy
in Indonesia. The regression coefficient is 0.261343, which shows that if the level of per
capita income increases by 10%, the rate of structural transformation will increase by 2.61%.
Because the model used is a double log model, the regression coefficient is also an
elasticity coefficient. Because the value of the regression coefficient is smaller than one, the
structural transformation in Indonesia so far does not have an elastic relationship with
changes in the per capita income variable. This shows that economic development has not
always been accompanied by rapid structural transformation.
The findings in this research align with the findings of (George, 2020; Timmer, 1988;
Timmer & Akkus, 2008), who found that GDP per capita has a negative relationship with the
share of agricultural employment in total employment. In other words, increasing income or
GDP per capita encourages faster structural transformation, where the share of non-
agricultural sectors in GDP and employment increases. It is also in line with the opinions of
(Bilan et al., 2020; Chenery, 1981; Kuznets, 1955; Lewis, 1954), who stated that economic
development as measured by an increase in per capita income is a process that accompanies
the structural transformation that occurs in a country.

The Influence of Human Capital on Structural Transformation

Human capital is another variable used in this research model. Human resources are
believed to be a significant and determining factor for a country's economic development.
The importance of human resources was firmly stated by Harbison (1973) and Indrawati &
Kuncoro (2021), who stated that human resources constitute the ultimate basis for the
wealth of nations. The model estimation results show that human capital, proxied by the
average years of schooling, has also been proven to positively and significantly influence
structural transformation in Indonesia. The regression coefficient is 0.046361, which shows
that if human capital increases by 10%, then structural transformation will increase by
0.46%, and this demonstrates that the process of structural transformation in Indonesia is
not directly influenced by changes in human capital. The results of this study are reinforced
by the findings of Dabla-Norris et al. (2013), which demonstrate that human capital plays a

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crucial role in process of structural transformation. Furthermore, the study emphasises the
diverse influence of these human capital factors on the distribution of sectoral shares in
different nations over a period of time.
The existence of an inelastic relationship between structural transformation and
human capital shows that the structural transformation that has occurred so far has been
driven more by changes in factors other than human capital itself, such as the availability of
physical infrastructure, institutional factors, and government policies, which tends to place
more emphasis on developing physical capital than human capital.
The study conducted by Woldemichael and Shimeles (2019) in Africa revealed that
investing in human resources reduces the productivity gap, enhances labor productivity
growth, expedites structural transformation, and generates high-quality employment
opportunities. Human capital investments significantly influence labor productivity within
sectors and the speed at which labor transitions from low-productivity to high-productivity
jobs. Additional research, similarly discovered that enhancing the caliber of human
resources (education) resulted in the redistribution of the workforce from agricultural to
non-agricultural occupations (Porzio et al., 2022). This indicates that augmenting human
capital had a favorable impact on structural transformation.
Research by Su et al. (2021), which examines the role of the digital economy in
encouraging industrial structural up-grading, also found that the human capital factor, as
measured by the population's education level, has a positive and significant influence at a
significance level of 1 percent, in encouraging or promoting 'industrial structural upgrading.

The Influence of Financial Development on Structural Transformation

Various studies on financial development generally link financial development to
economic growth, income inequality, and poverty. There are still very few studies conducted
by experts that try to link financial development with structural transformation. Studies on
how financial development is related to structural transformation are still relatively limited.
The model estimation findings demonstrate that the financial development variable,
represented by the ratio of bank loan to GRDP, has a confirmed positive and considerable
impact on the rate of structural change in Indonesia, with a regression coefficient of
0.203042, which shows that if the financial or financial development variable experiences an
increase of 10%, then the structural transformation rate variable will increase by 2.03%. It
shows that the structural transformation is not sensitive or inelastic to changes in financial
development variables.
These findings indicate that the progress of financial development is crucial in
expediting the process of industrialization. The model is calibrated using South African data
from the period of 1960 to 2010, and it offers empirical evidence that supports these claims.
Empirical investigation across different countries demonstrates a robust association between
the level of financial development and the transition from the agricultural sector to the
manufacturing sector. This finding confirms the significant impact of financial development
in promoting industrialization and facilitating structural transformation. Ultimately, this
research offers significant understanding of the intricate elements that propel structural
transformation, emphasizing the crucial significance of adopting technology and fostering
financial prosperity (Avoumatodo, 2023).
Nwani et al. (2023), who researched structural transformation in the economies of
Sub-Saharan Africa (SSA) countries using panel data for the period (1995 – 2019), found
that financial development had a negative influence on output values. Extractive industries
and vice versa positively impact the output value of manufacturing and services industries.
This means that the financial sector's development has positively impacted the structural
transformation that is taking place in Sub-Saharan African countries.

The Influence of Digital Technology Developments on Structural

Transformation
Digitalization, broadly defined as the use of digital technology and data, is considered
necessary for the structural transformation of developing countries. Successful digitalization

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will enable countries to achieve structural transformation led or driven by a service sector
with high productivity growth (Melo & Solleder, 2022).
According to Ndulu et al. (2023) and Dwi Amalia & Citra Melati (2021), digital
technology can bring change to the economy in 3 ways; namely, digital technology can
change the economy through automation; digital technology can also change the nature of
how the market works, or functions, and digital technology can also change the organization
of the economy as a whole. In short, digital technology can lower the exchange costs in
markets, making exchanging goods, services, information, capital, or labor cheaper and more
effective. Digital technology's ability to change the economy also means that advances in
digital technology can be used as an essential instrument in accelerating a country's or
economy's structural transformation process.
The results of the model estimation indicate that the variable representing the
development of digital technology, measured by the percentage of households that possess
and have expertise in using computers, has a substantial and statistically significant effect on
the rate of structural transformation in Indonesia. The regression coefficient of 0.116756
suggests that a 10% increase in digital technology development leads to a 1.17% increase in
the rate of structural transfromation. This structural transformation is not sensitive or
inelastic to changes in digital technology development variables.
The findings in this research are strengthened by Freire's (2021) opinion that
technological changes, including digital technology, will encourage structural
transformation, which will result in economic diversification in a better direction.
Technological change is considered one of the specific factors driving structural change,
where structural change occurs in different ways between and within regions (Matthess &
Kunkel, 2020). Another research was conducted by Su et al. (2021), where technological
factors, in this case, technological innovation, were used as a mediating variable between the
digital economy and industrial structural grading', apparently has a positive and significant
'mediating effect' at the 1 percent significance level.

5. Conclusion
The results have shown that the variables of economic growth, human capital,
financial development, and progress in digital technology all have a positive and significant
impact on the level or speed of structural transformation in Indonesia. Per capita income
and the ratio of bank loans to GRDP are two significant variables that greatly influence
structural change in Indonesia. These variables serve as indicators of economic
development and financial development, respectively.
These findings imply that to accelerate the process or level of structural
transformation in Indonesia, efforts to increase economic and financial development,
especially in the regions, are significant to receive attention in the various development
policies implemented.
Finally, efforts to enhance economic development and financial development must be
accompanied by the augmentation of human capital and the advancement of digital
technology. These two elements have a direct influence on economic development,
including progress in the financial sector.
In line with the research findings, the policy implication is to encourage and accelerate
structural transformation in Indonesia. It is necessary to (a) continue to encourage regional
economic development, (b) develop human resources to increase population access to
various employment opportunities outside the agricultural sector and/or the informal sector,
(c) encourage the development of the financial sector to increase population access to
various sources of financing or capital, (d) continuing to encourage and improve digital
technology in various sectors and fields to support the acceleration of the structural
transformation process in the future.

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