Indonesia losing its footing?

SINCE Susilo Bambang Yudhoyono (SBY) came to power, I have been a fan. Mind you, Indonesia remains today a nation full of problems: political, economic and social. His reputation was built on sustaining a predictable regulatory environment.

Despite its problems, Fitch re-rated Indonesia in December 2011 with an investment-grade credit after 14 years in junk status, followed by a similar move in January 2012 from Moody's Investors Service. Indonesia, like many in Asia, expects sluggish global demand to slow its rapid growth, to 6.43% in the first quarter of 2012 after posting GDP growth of 6.5% in 2011, the quickest pace since the 1997-98 currency crisis.

During my last visit in March, I gathered investors are still flocking to Indonesia simply because there is a deep affiliation that “tomorrow will be better than today” and today is pretty good so far. Indonesia must realise that a good reputation is fragile. It is built over years but can be destroyed overnight.

Resource nationalism


Indonesia President Susilo Bambang Yudhoyono — AFP
Not long following Suharto's 1998 fall from power, Indonesia was transformed from a tightly-controlled autocracy to become one of the world's most vibrant democracies. With the run-up to the 1999 elections, the military has since stayed on the sidelines. Sweeping political and fiscal decentralisation devolved real power and resources to the nation's hundreds of districts and municipalities. The government created new, independent political institutions to provide for checks and balances, including a constitutional court, a judicial commission, and a corruption eradication commission. Constitutional reform formalised a presidential system under a direct one-man-one-vote regime, making Indonesia among the most democratic.

The nation's economic turnaround has been no less dramatic. Despite all the progress, there are decidedly many discordant notes.

As US scholar K. Brooks rightly pointed out: “Indonesia's ports are overstretched, its electrical grid is inadequate and its road system is one of the least developed in the region. These conditions make the Indonesian economy inefficient and will stifle its future growth.”

The president's new master plan (2011-14), which emphasises infrastructure development, is deemed inadequate. The government's dysfunctional regulatory framework and weak enforcement have discouraged private-sector participation. Besides, the inability to acquire land and endemic corruption have held back development. Indeed, corruption now runs deep at all levels of government since the devolution.

The SBY administration's promotion of Indonesia as an open, investor-friendly economy has slipped indeed, the gap between pronouncements and reality is rather wide. In fact, the back-slide has reversed some of its international commitments.

The government's most recent Investment Negative List, which lays down limitations on foreign investment, is the most restrictive so far. The late-2010 rule requires foreign companies that open new mines to sell stakes to Indonesian participants starting with 20% by the fifth year. In late 2011, this would be progressively raised to 51% by the 10th. It all started in 2009 when a new mining law changed the system based on contracts to one regulated by licences. This gives bureaucrats more discretionary power. The latest proposal imposes a coal and base metals export tax of 25% this year, rising to 50% in 2013.

As I understand it, this is ahead of a ban to be imposed on some unprocessed metals due in 2014. Its aim is to force the “beneficiation of minerals” in order to raise the value of exports as well as domestic employment. This policy is directed at extracting more from its resource base, particularly thermal coal (it being the world's largest exporter), and diverting it largely to domestic use.

These various moves have “upset” foreign direct investment (FDI). From their vantage point, these are reflective of: (i) evolving domestic political manoeuvres; (ii) government making policy on-the-run (ahead of presidential elections in 2014); and (iii) growing resource nationalism.

Given the government's often back-flips (eg. recent scaling back of gasoline subsidies), investors are expecting likely policy flip-flops. Indeed, indications are that some of the more extreme regulations are unlikely to be implemented. Jakarta had previously proposed minority ownership caps in banking, but has since apparently reversed its stance. Nevertheless, investors have reason to be nervous, when regulators are known to be working with politically well-connected businessmen.

Economic poster child

During the Asian currency crisis (1997/98), Indonesia looked like a state on the brink of collapse. The chaos left this nation, the 4th largest in the world covering a sprawling archipelago of more than 17,000 islands, 240 million people and the world's largest Muslim population, without hope. Today, Indonesia is hailed as the darling of the international financial community. In 1988, its economy contracted by more than 13%. Since then, it had expanded more than 5% a year, including 4.5% in 2009 when GDP in most of the rest of the world shrank.

Last year, its economy expanded the fastest in 15 years spurred by strong consumer spending and rapidly rising private investment outlays. Aggregate domestic consumption, which accounted for close-on two-thirds of GDP, rose by 4.7% in 2011, while private fixed capital formation expanded by 8.8%. FDIs ploughed in US$20bil in 2011, up from US$17bil in 2010. Singapore, Japan and the United States were among the top investors, centred mainly in mining and telecommunications as well as in much needed infrastructure works.

Exports too had done well: posted a 29% surge in 2011, exceeding the government's US$200bil target. The current balance of payments continued to show a modest surplus. Its international reserves remain sizable reaching close to US$120bil at the end of 2011, its highest ever, covering 2.3 times its short-term external debt. The basic domestic forward-looking indicators have continued to look strong: inflation fell to 4.1% in 2011 (6.3% in 2010) and held steady in quarter one 2012 (4%) although inflationary expectations are likely to stay elevated on uncertainty over the government's fuel-subsidy policy. The budget deficit had remained restrained (2% of GDP in 2011) and expected to fall to 1.5% in 2012. Reflecting the steady inflows of FDIs and strong exports, the exchange rate of the rupiah strengthened by about 3% in 2011. The industry sector has continued to expand up 5.2% in 2011 (4.7% in 2010), with strong performance from the non-oil and gas manufacturing moving up by 7% for the first time since 2005.

Demographic dividend

Sustaining growth in manufacturing has helped Indonesia create more jobs, especially higher value added jobs to raise living standards and provide productive employment for the growing 2 million new entrants into the labour force annually. Indonesia already faces significant under-employment and poverty. In 2011, unemployment was 6.6% while 12.5% still live below the poverty line, against unemployment of 9% & poverty of over 16% in 2004. But an estimated 65% of Indonesians are employed informally, mainly in agriculture. However, graduate unemployment has since dropped to 8% in 2011, from 11.9% in 2010. In recent years, the elasticity of employment growth to GDP has been around 0.5. That is, every one percentage point of GDP growth brings about a 0.5 percentage point rise in employment, i.e. creating about 500,000-600,000 jobs. But Indonesia has a young population, with a significant portion of its population still under the age of 30. This simply means that the proportion that is of working age will rise significantly over the next decade.

Economists like to link this with the prospect of a “demographic divided”, providing a comparative advantage over aging societies such as Japan and China. The younger generation will consume more and contribute to a more productive labour pool. To reap this benefit, Indonesia will need to create more and more higher quality and better paying jobs to transform this into a real dividend. Herein lies the challenge. Non-traditional sectors such as finance, real estate and manufacturing (including oil and gas) have increased their contribution to employment growth over the past three years. Potentially, they can provide important sources of higher productivity and higher wage jobs. For the government, realising growth with quality job creation will require improvements in skills, education and training, and a supportive regulatory environment. That is why attracting more and more FDIs must remain key to Indonesia's success in meeting this challenge. It is estimated that the nation requires more than US$400bil up to 2025 to build the needed infrastructure and manufacturing base to create the jobs required.

The outlook

Indonesia's growth has been remarkably stable and robust in recent years. GDP in quarter four 2011 expanded 6.5%, driven by strong household spending and private investment. Indications are that lower global demand for its exports had slowed its rapid pace in quarter one 2012 (1Q'12). However, the outlook for 2012 remains clouded by uncertainties in a Europe already experiencing recession. Industrial production in the euro-zone (accounting for 20% of its GDP) slumped in February 2012 by the steepest decline since end-2009. In the US, growth remains tentative, while the rise in China's GDP would slacken to 8.25 this year (9.2% in 2011 & 10.4% in 2010). Its GDP rose 8.1% in 1Q'12, the slowest in 11 quarters. According to the Asian Development Bank, emerging Asia's growth will “cool somewhat” to 6.9% in 2012, down from 7.2% in 2011 before edging higher again to 7.3% in 2013. The region is shifting to a “more sustainable long-run growth path,” based on strong domestic demand instead of exports which have been hit by wobbly western demand. For Indonesia, the median forecast of 11 leading economists was 6.48% in 2012, against a recently downgraded World Bank forecast of 6%.

In recent years, Indonesia has benefitted from political stability under SBY's administration, conservative fiscal management & deep reserves of natural resources. Its debt to GDP ratio had fallen from a high of 100.3% in 2000 to only 26% today, which compares favourably with its Asean neighbours. Inflation was at a high of 77% in 1998; it now hovers at just about 4% in '11. The rupiah, which lost over 4/5s of its value in '98, is at its strongest since 2004 and up 31% since '08. The recent upgrades by Moody's and Fitch “is a testament to Indonesia's economic fundamentals,” making demand for its bonds more attractive as yields are trending lower.

What, then, are we to do?

Looking forward, domestic capacity constraints and the recently “turned adverse” business climate remain key development challenges which can pull-down Indonesia's growth outlook & promote quality job creation. Furthermore, budget execution difficulties carries the risk of poor disbursements & ineffective spending. According to my old friend, Dr A. Siregar, a highly respected former Bank Indonesia Governor: “It is now up to Indonesia to transform foreign businessmen's increasing interest in investing in our country into reality. We have to improve the efficiency & effectiveness of our bureaucracy Essential infrastructure facilities should be improved significantly to create a sound & competitive environment”

Yet, as one market analyst recently observed: “The only thing certain about Indonesia's policies on resources is that there is no certainty whatsoever.” On this, Jakarta appears to have dug itself into a hole. Indonesia used to be an easier option for many FDIs, but this may no longer the case. As Siregar concluded: “We should be prepared for the worst and at the same time to seize likely opportunities”

Indonesia deserves credit for what it has done. Some gains are now under threat. Continued success requires a new wave of reform. But if the risk and cost of investing continue to rise and cloaked in legal uncertainty, Indonesia would only be hurting itself.

n Former banker, Dr Lin is a Harvard educated economist and a British Chartered Scientist who now spends time writing, teaching and promoting the public interest. Feedback is most welcome; email: [You must be registered and logged in to see this link.].