Asia Competitiveness Institute Working Paper/Case Study Series
A Review of Indonesia’s Competitiveness and its Investment Climate
Sari Wahyuni Associate Professor Faculty of Economics, University of Indonesia
[email protected];
[email protected] DID: (62-21) 7270164 Fax: (62-21) 78849155
Ng Kwan Kee Research Fellow
[email protected] DID: 65-65167029 Fax: 65-67756471 469C Bukit Timah Road, Level 3 Singapore 259772
June/2008
The views expressed in the ACI Working Paper Series are those of the authors(s) and do not necessarily reflect those of the institute, Lee Kuan Yew School of Public Policy or National University of Singapore. Copyright belongs to the author(s). Papers may be downloaded for personal use only.
Abstract
There is a strong belief among scholars that country competitiveness has a significant influence on the flow of investment. This paper firstly reviews Indonesia’s competitiveness through a set of indicators, its industrialisation policies throughout different presidents and assesses its current investment climate. Despite steps taken by the Indonesian government such as renewing efforts to improve the business and investment climate and intensifying the anti-corruption drive, there is no significant improvement in inward foreign direct investment as investors are deterred by risks induced by macroeconomic instability and uncertainty in government policies and regulations. This paper highlights the importance of a coherent strategy that encompasses close connection between economics and politics, attractive investment policy as well as transparent regulation and existence of prominent leadership.
Keywords:
Indonesia, investment climate, foreign direct investment, policy
JEL Code:
F21, D78, O53 2
A REVIEW OF INDONESIA’S COMPETITIVENESS AND ITS INVESTMENT CLIMATE
Sari Wahyuni 1 and Ng Kwan Kee 2
1. Introduction The 1997 Asian Financial Crisis (AFC) had dealt a severe blow to the economic development programmes in several of the ASEAN economies. Among these countries, Indonesia is perhaps the most affected. Ten years since the AFC, Indonesia has yet to regain the same vitality and exuberance before the crisis. This paper can be divided into two parts. In the first part, we will highlight the past and current competitiveness performance and selected competitiveness determinants of Indonesia using indicators commonly cited by competitiveness scholars. In the second part, we attempt to do a review of the Indonesian economy and its industrialisation effort, highlighting competitiveness issues faced by Indonesia and linking them to the current investment climate. We also provide some key policy recommendations for enhancing the investment climate and the competitiveness of Indonesia.
2. Definition, framework, conceptual blocks and measures of competitiveness Due to increasing global competition and growing openness of national economies, more and more business people, policy makers and researchers have recognised the importance of international competitiveness for enhancing economic growth and the standard of living. However, defining it is not trivial. There are many books and articles published on competitiveness over the years, each taking a somewhat different approach to defining, measuring, and explaining it. The first obstacle faced by scholars studying competitiveness is that there is no agreement on how to define it. Some possible reasons for the difficulties pertaining to definition could be that these studies focused on different levels of analysis, have differing objectives due to different standpoints, the authors came from different disciplines, and they focused on different time horizons. 1
Sari Wahyuni is Editor in Chief of the South East Asian Journal of Management and Associate Professor at Faculty of Economics, University of Indonesia.
2
Ng Kwan Kee is Research Fellow at Asia Competitiveness Institute, Lee Kuan Yew School of Public Policy, National University of Singapore
3
The fragmented approaches towards studying competitiveness is mainly due to the interdisciplinary nature of the competitiveness concept which has attracted scholars from wide ranging disciplines such as economics, international business, organisational theory and strategy, and marketing. These scholars have different research interests and therefore emphasise different measures and explanations of competitiveness. The divergent approaches to competitiveness have produced different definitions of the concept. It is easier to define it for a firm (using performance indicators such as sales, market share or profitability) but more difficult to define it for an economy. However, in this paper, we focus on definitions that linked competitiveness to outcome of prosperity and sustainable growth. To illustrate, we have selected the OECD’s definition and Michael Porter’s definition that contained the elements of sustainable growth and prosperity. 2.1. Definitions linked to outcome of prosperity and sustainable growth
Competitiveness [should] be understood as the ability of companies, industries, regions, nations and supranational regions to generate, while being and remaining exposed to international competition, relatively high factor income and factor employment levels on a sustainable basis (OECD, 1994)
Michael Porter believes that competitiveness is the underpinning of prosperity, based on productive potential of a nation’s economy, which in turn is ultimately set by the productivity of its companies determined by: o sophistication of company operations and strategy and o quality of microeconomic business environment (Porter, Ketels, & Delgado, 2006)
A working definition of competitiveness thus has to encompass the long term view of sustainable growth, be it at the firm, industry, cluster, region or national level. It should be linked to fundamental objectives such as wealth creation, maximisation of welfare and prosperity. Non-fundamental objectives are in turn set to achieve these fundamental objectives. Developing competitiveness should also be taken to mean developing relative efficiency along with sustainable growth. Also, competitiveness should be understood as more of a process than an absolute state, and should only be assessed in a relative sense.
3. Conceptual blocks and measures of national competitiveness For this paper, we study the competitiveness of Indonesia by looking at competitiveness performance and competitiveness determinants. In competitiveness performance we analysed the role of the Indonesian economy through its shares in world population, world total trade, and world total inward foreign direct investment. We also look at outcome measures such as real GDP per capita in PPP terms and real GDP in PPP terms in level and growth. 4
For competitiveness determinants, we settled on using the following dimensions of determinants as reported by Global Competitiveness Index (9 pillars in 2006-2007; 12 pillars in 2007-2008) shown in Table 1. Table 1 - Dimensions of Determinants of Competitiveness by GCI Overall GCI for 2005/06, 2006/07 versions:
Overall GCI for 2007/08 version:
Basic Requirements subindex (pillars 1 to 4)
Basic Requirements subindex (pillars 1 to 4)
1st pillar: Institutions
1st pillar: Institutions
2nd pillar: Infrastructure
2nd pillar: Infrastructure
3rd pillar: Macroeconomy
3rd pillar: Macroeconomic stability
4th pillar: Health and primary education
4th pillar: Health and primary education
Efficiency Enhancers subindex (pillars 5 to 7)
Efficiency Enhancers subindex (pillars 5 to 10)
5th pillar: Higher education and training
5th pillar: Higher education and training
6th pillar: Market efficiency
6th pillar: Goods Market efficiency
7th pillar: Technological readiness
7th pillar: Labour Market efficiency
Innovation Factors subindex (pillars 8 to 9)
8th pillar: Financial market sophistication
8th pillar: Business sophistication
9th pillar: Technological readiness
9th pillar: Innovation
10th pillar: Market size Innovation and Sophistication subindex (pillars 11 to 12) 11th pillar: Business sophistication 12th pillar: Innovation
4. Introduction on Indonesia With a population of about 223 million in 2006, Indonesia is the world’s fourth most populous nation. It is also the world’ largest archipelago state, with over 13,000 islands spread over a distance of five thousand kilometers from west to east. It is also one of the five original member of ASEAN (Association of Southeast Asian Nations) established in 1967.
5
5. Role of Indonesia in ASEAN 5.1. Population Share in ASEAN and Market Size Figure 1 - Population Share in ASEAN
Indonesia is by far the most populous nation in ASEAN, with a population of 109.5 million in 1967, the year ASEAN was formed. Including all the current members of ASEAN today, Indonesia’s population made up of 42% of total ASEAN population (see Figure 1). Over the years, Indonesia has maintained that status. In 2006, at 223 million, Indonesia’s population share slightly reduced to 40% of the total population of ASEAN. Being the fourth most populous nation in the world implied that Indonesia was and still is a huge market size for consumer products in ASEAN.
6
5.2. GDP Share in ASEAN Figure 2 - GDP Share in ASEAN
Indonesia is still the largest economy in ASEAN. In 2006, Indonesia with a GDP of $796.3 billion, made up about one-third of the combined GDP of the whole of ASEAN6, namely, Indonesia, Malaysia, Singapore, Thailand, Philippines and Vietnam. Due to the growing share of all the other countries mentioned above, Indonesia’s GDP share has declined slightly from 36.2% in 1985 to 33.9% in 2006 (Figure 2).
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5.3. Trade Share in ASEAN Figure 3 - Trade Share in ASEAN
Indonesia has the fourth largest trade share in ASEAN total trade behind Singapore (35.1%), Malaysia (20.1%), and Thailand (17.8%) in 2006 (Figure 3). Its trade share stood at 12.6% and total trade at US$183.8 billion in the same year. Singapore, being the most open country in ASEAN and rely heavily on trade for economic growth, has the largest trade share in ASEAN. For Indonesia’s size of population and the size of its economy, it should have a larger trade share in ASEAN. However, Indonesia’s shares of world trade were stagnant around 0.7% and its global rankings in world trade were close to the rankings since 1980. With its trade growth slowing down, Indonesia’s trade to GDP ratio has also fallen from 66% in 2000 to 50% in 2006, although higher than that in 1980 and 1990.
8
5.4. Share of Inward FDI Stock in ASEAN Figure 4 - Share of Inward FDI Stock in ASEAN
Share of inward FDI stock in ASEAN shows the relative attractiveness of the ASEAN countries as an investment destination. Compared to 1980, although the inward FDI stock has increased from US$4.7 billion in 1980 to US$19.1 billion in 2006, Indonesia’s share of inward FDI stock in ASEAN has reduced significantly from 24.7% to 4.5% (Figure 4). Although we agreed that studying the cumulative stock over a longer period of time may present a more consistent picture, this nevertheless shows that Indonesia faced strong competition in the region in investment attraction at least in 2006.
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6. Competitiveness Performance of Indonesia
Table 2. Progress Made based on Real GDP Per Capita, PPP Terms from World Bank World Development Indicators Real GDP per capita PPP
1975
2006
Low income (US$905 or less)
China
Lower middle income (US$906US$3,595)
India, Indonesia, Malaysia, Philippines, Thailand, ASEAN4, ASEAN5, Egypt, Vietnam (1984), ASEAN6 (1984)
India, Indonesia, Vietnam
Upper middle income (US$3,596US$11,115)
Singapore, S Korea, Hong Kong, South Africa, Mexico, Brazil
China, Malaysia, Philippines, Thailand, ASEAN4, ASEAN5, ASEAN6, South Africa, Mexico, Brazil, Egypt
High income (US$11,116 or more)
Singapore, S Korea, Hong Kong
Notes: 1. 2. 3. 4. 5. 6.
ASEAN Formed in 1967 by five original member countries, namely, Indonesia, Malaysia, Philippines, Singapore, and Thailand Later joined by Brunei Darussalam (Jan 84), Vietnam (Jul 95), Laos & Myanmar (both Jul 97), and Cambodia (Apr 99) ASEAN4 refers to Indonesia, Malaysia, Philippines, and Thailand ASEAN5 refers to Indonesia, Malaysia, Philippines, Singapore, and Thailand ASEAN6 refers to Indonesia, Malaysia, Philippines, Singapore, Thailand and Vietnam ASEAN10 refers to Indonesia, Malaysia, Philippines, Singapore, Thailand, Vietnam, Brunei Darussalam, Laos, Myanmar and Cambodia 7. World Bank classifies all World Bank member economies, and all other economies with populations of more than 30,000. For operational and analytical purposes, economies are divided among income groups according to 2006 gross national income (GNI) per capita, calculated using the World Bank Atlas method. The groups are: low income, $905 or less; lower middle income, $906–3,595; upper middle income, $3,596–11,115; and high income, $11,116 or more. Other analytical groups based on geographic regions are also used. Income classifications are in effect until 1 July 2008. Taiwan data not available. Source: World Bank World Development Indicators Online
Based on income group classification by World Bank, we classified the selected countries based on their real GDP per capita, in PPP terms in both 1975 and 2006. The purpose is to track the progress made by these countries in terms of their prosperity over the years (often proxied by real GDP per capita). In Table 2, we found that among ASEAN countries, Indonesia and Vietnam still remain in the same category of lower middle income group over the period 1975-2006. Fellow ASEAN countries Malaysia, Philippines and Thailand have moved from lower middle to upper middle income group from 1975-2006, whereas Singapore moved from upper middle income to high income group. Figure 5 showed the real GDP per capita (in PPP terms) growth trends of these selected countries from 1975 to 2006, indexed at 1984=100. It is clear that Indonesia has higher growth than Malaysia, Vietnam, India and Philippines before the Asian Financial Crisis in 1997 but it managed only to pip Philippines after the crisis. 10
Figure 5 - GDP per Capita (in PPP terms) Growth Trends of Selected Countries
Table 3 - Summary Table on Real GDP Per Capita (PPP), Level and Growth GDP per capita, PPP (constant 2000 international $), CAGR ASEAN4 ASEAN5 ASEAN6b Indonesia Malaysia Philippines Singapore Thailand Vietnam China India
19801990
19901997
19971998
19982006
3.3 3.4 5.0 *
4.7 4.8 4.9
-10.8 -10.4 -9.2
3.2 3.3 3.6
GDP per capita, PPP (constant 2000 international $) ASEAN4 ASEAN5 ASEAN6b
4.4 3.3 -0.7 4.9 6.1 2.4 *
5.8 6.4 0.9 5.3 5.4 6.4
-14.3 -9.6 -2.6 -4.6 -11.4 4.3
3.0 3.3 2.7 4.1 4.0 5.9
Indonesia Malaysia Philippines Singapore Thailand Vietnam
1,440 4,035 3,982 9,245 2,546 -
2,224 5,561 3,703 14,986 4,596 1,153
3,292 8,597 3,931 21,472 6,651 1,774
2,821 7,771 3,829 20,480 5,892 1,850
2,905 8,573 4,032 23,594 6,321 2,040
3,570 10,091 4,731 28,305 8,065 2,925
7.7 3.6
10.2 3.5
6.8 4.2
8.5 5.3
China India
774 1,165
1,626 1,655
3,217 2,106
3,435 2,194
3,940 2,364
6,621 3,308
1980
1990
1997
1998
2000
2006
2,256 2,321 -
3,121 3,235 2,874
4,318 4,501 4,022
3,853 4,034 3,651
4,067 4,278 3,891
4,969 5,224 4,827
Notes: * Vietnam and ASEAN6b CAGRs computed for 1985-1990 due to availability of data 1. ASEAN4 refers to Indonesia, Malaysia, Philippines, and Thailand 2. ASEAN5 refers to Indonesia, Malaysia, Philippines, Singapore, and Thailand 3. ASEAN6b refers to Indonesia, Malaysia, Philippines, Singapore, Thailand and Vietnam 4. ASEAN10 refers to Indonesia, Malaysia, Philippines, Singapore, Thailand, Vietnam, Brunei Darussalam, Laos, Myanmar and Cambodia Source: World Bank World Development Indicators Online
From Table 3, it can be easily seen that Indonesia is the hardest hit during the Asian Financial Crisis in 1997-1998. Its real GDP declined by 14.3% during the period and its real GDP per capita (in PPP terms) was surpassed by China since 1998. Compared to ASEAN4 & 5 11
averages, Indonesia used to have stronger growth in periods before the crisis (such as 19801990, 1990-1997) but lacked behind the ASEAN averages after that. It has also been highlighted by an article in The Economist (2008) that real GDP per capita growth is a better gauge of economic performance than real GDP growth, due mainly to the part played by population growth or decline. A country with high real GDP growth rate may not be well off if it is being matched by rising population growth. Commonly used as a measure of prosperity or average living standards, real GDP growth should be used as a measure of competitiveness performance. 7. Selected Competitiveness Determinants of Indonesia Indonesia has a great number of obstacles to overcome in order to find its pride of place in the global production network. It has to face keen competition from many other developing and emerging economies in attracting foreign investments. Figure 6 – Overall Global Competitiveness Indices and Subindices for Indonesia, 2005 to 2007
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Figure 7 – Comparison of Overall GCI and Subindices for Indonesia and ASEAN Average, 2007 to 2008
From Figures 6 and 7, in terms of competitiveness determinants, Indonesia lagged behind ASEAN 6 (average of Indonesia, Malaysia, Philippines, Singapore, Thailand and Vietnam) and was relatively weak in terms of technological readiness, infrastructure, and institutions. Technological readiness measures the agility with which an economy adopts existing technologies (especially information and communication technologies) to enhance the productivity of its industries. In this sense, the presence of an ICT-friendly regulatory framework as well as the actual ICT penetration rates is of key importance for a country’s overall competitiveness (Sala-I-Martin et al, 2007). The existence of high-quality infrastructure is critical for ensuring the efficient functioning of the economy, as it is an important factor determining the location of economic activity and the types of activities or sectors that can develop in an economy. A well-developed transport and communications infrastructure network including effective modes of transport such as quality roads, railroads, ports, air transport, and an extensive telecommunication network are important, so is the uninterrupted supply of electricity. The institutional framework has strong bearing on competitiveness and growth as it plays a central role in the ways in which societies distribute the benefits and bear the costs of development strategies and policies, and it has bearing on investment decisions and on the organisation of production. This includes the legal framework, government’s attitudes towards markets and freedoms and the efficiency of its operations. Private sector transparency is also important. 13
It is clear that Indonesia’s competitiveness determinants such as lack of technological readiness, lack of innovation, and inefficient infrastructure do not feature well for a growing economy. It reflects an economy with lethargic bureaucracy and is still lacking in institutions to reduce and/or eliminate corruption. There is a dearth of skilled manpower, made worse with inefficient infrastructure. A vicious cycle of low productivity, low employment, low income led to low consumption and declining investment. 8. Overview of Indonesia Economy and Its Industrialization Effort It is apparent from the above summary on Indonesian competitiveness that although Indonesia has the largest population in ASEAN, its economic performance has been decreasing all over time. Why has this happened? How come the neighbors could strengthen their economy whereas Indonesian economic performance seems to be stagnant? In the following sections, we will briefly discuss the effectiveness of historical economic policies of the Indonesian government with regard to inculcating a conducive investment climate. We divide the analysis in 7 parts based on the different presidential administration in Indonesia which eventually led into different economic policies formulation and implementation. 8.1.
1945-1964, Sukarno regime ¾ aimed to reduce dominance of Dutch companies (controlled up to 25% of GDP) and companies owned by ethnic Chinese. Most Dutch companies were nationalized. ¾ Sukarno introduced ‘Indonesian-style socialism’ in a “Guided Economy.” Stateowned companies and trading houses were created which received preferential financing and monopoly rights for the import of essential commodities (Kian Wie, 2006). Private companies, especially those owned by ethnic Chinese, were excluded from the most lucrative businesses. The law governing foreign investment was repealed in 1958, leading to deteriorating conditions for foreign investors. In summary, Sukarno’s policies led to massive budget deficits and soaring inflation, which exceeded 600% annually. The economy stagnated and was close to collapse by the mid-1960s amid social disorder. Sukarno’s leadership was unable or unwilling to tackle the chronic twin-deficit problem – simultaneous balance of payments and budget deficits – at its root. Instead, they resorted to stop-gap measures through some combination of ad hoc monetary policy, exchange controls and multiple exchange rate system to win the economy another reprieve (Boediono, 2005).
8.2.
1965-1997, Suharto regime – The New Order ¾ Used stable macroeconomic policies to control inflation; introduced investment laws to make it easier to secure government approvals for investment; enhanced physical infrastructure and invested in rural development ¾ In the 1970s, moved to state-led industrialisation program of establishing large-scale, capital-intensive industries and also launched small enterprises development program 14
¾ 1982-97: characterized by an openness to trade and foreign investment; high domestic saving rates; prudent macroeconomic management; sustained public investment in health, education, family planning, and in physical infrastructure. A remarkably success development effort resulted in the economy growing by 7 – 8% annually, over the period 1985 – 96. Over this period, Indonesia witnessed a dramatic reduction in poverty. For more than 3 decades, through good policy and good fortune (oil boom), Suharto delivered economic and social progress unparalleled in history of Indonesia. However, the nature of the regime denied the country an adequate mechanism for checking cumulative growth of corruption, nepotism and other narrow interests that complicated and impaired the quality of economic policies in later years. The demise of the New Order highlighted the importance of the quality of institutions in the development process – inability of existing institutions to self-correct and respond coherently to unexpected stresses and strains that have become common in the globalize world (Boediono, 2005). 8.3. 1998-2004 (‘Reformasi’) 3 : 8.3.1. May 1998- Oct 1999: Habibie’s reform policy ¾ Introduced grass-roots World Bank programs that gave local communities a choice in setting their own infrastructure spending priorities and imposed new standards of openness and governance ¾ Introduced new Competition Law in 1999, commercial court and bankruptcy court set up to strengthen position of creditors; amended corruption law to stiffen penalties ¾ Identified decentralisation of public decision making a priority. Law 22 on Regional Autonomy, and Law 25 on Fiscal Balance between central and local govt were passed in 1999 ¾ Habibie indentified the decentralization of public decision making as a key priority (Rohdewohld, 1999). 11 policy areas (health, education and culture, agriculture, communications, industry and trade, capital investment, environment, land cooperatives, manpower affairs, management of natural resources, and urban development) were designated for decentralization, beginning on January 1, 2001 As a whole, Habibie succeeded in preventing imminent collapse of economy, stabilized it; several basic reforms initiated, paved the way for reforms later. Unfortunately, his achievements overshadowed by unfolding of a high profile corruption scandal (Bank Bali case) and an explosive political event (the separation of East Timor) (Boediono, 2005). The stabilization of the economy came too late to save Habibie, who was forced to resign in October 1999 by the People's Consultative Assembly (MPR). 3
The period after Suharto’s fall became known as “Reformasi”, the Indonesian word for reformation. As this is the first time (in the history of Indonesia) people can force a very powerful president step down from his chair and from that point onward the wind of democracy blow the mind of people.
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1998-2004 (‘Reformasi’) : 8.3.2. Oct 1999-Jul 2001: Wahid as President ¾ Slow pace of implementing reforms against powerful interest groups undermined macroeconomic stability – Rupiah devalued and inflation picked up ¾ Trade Union Act passed in 2000 gave unions significantly more power and stronger position in labour relations ¾ Concerns about the slow pace of reforms once again undermined macroeconomic stability. The Rupiah devalued, and inflation picked up. The Bank Indonesia was slow to respond, and pressure rose to rewrite the central bank law and remove top management. Wahid was eventually removed from office by parliament in July 2001 It appeared that the euphoria of high expectations and reform fervor soon turned to disappointment as delivery fell short of expectations (Boediono, 2005). Key reasons were: i. Wahid’s lack of managerial proficiency (& physical handicaps) to effectively manage a heterogeneous cabinet and economic team which were the product of political compromises, despite his formidable intellectual capacity and moral courage ii. Made worse by high turnovers of ministers iii. Escalated regional unrest and local conflicts iv. Relations between president and parliament turned sour and eventually grew into confrontation (he was forced out of office after only 21 months)
¾ ¾ ¾
¾
¾
¾
¾
1998-2004 (‘Reformasi’) : 8.3.3. Jul 2001-Sep 2004: Megawati oversaw Indonesia in transition Rated better than the previous administration in terms of cohesiveness and likemindedness of the cabinet, important for coherence and decisiveness in action Removed regulatory functions from Pertamina; liberalised telecoms and electricity sectors in 2002 In October 2002, a terrorist bomb in Bali killed more than 200 people. Another attack in August 2003 killed twelve people in the Marriott hotel, Jakarta. Indonesia became seen as not a safe place for business or tourism. Megawati declared 2003 to be the year of investment. A year later, however, domestic and foreign investment rates were still low and there was little sign of improvement (Miller, 2006). In 2003, government announced Indonesia’s graduation from IMF support, creation of investment and trade team to coordinate efforts on investment climate and anticorruption Implemented tariff reductions agreed under ASEAN FTA but used emergency exit clauses to retain protection for some sectors as she was concerned about fast pace of liberalization Introduced new labor law that significantly raised hiring costs and set severance pay higher than elsewhere in the region; individual provinces set their own minimum wage levels 16
In its 39 months in office, Megawati government succeeded in re-establishing economic stability but less successful in accelerating growth, largely due to it lacked of a solid and focus programme for achieving this goal. This can be seen from poor implementation of a coherent action program (mainly the investment and export parts) to assure the market that the government would continue to maintain economic stability and to improve the business climate after termination of IMF programme in December 2003. Some reasons of this poor performance: weak ownership of the programme by relevant ministries and agencies, a weak sense of urgency at the top, and the increasing focus of the government on election-related activities in 2004 (Boediono, 2005). 8.4. Sep 2004-now (SBY as the first Elected President): ¾ In 2004, announced “100-day Plan” of economic reforms with more active engagement in ASEAN and WTO ¾ The plan included measures to improve the business environment, improve labour laws, liberalize trade, tackle corruption, lower taxation, utilize public-private partnerships for infrastructure investment, and address poverty ¾ In May 2005 announced legislation and policy package to improve business environment, on infrastructure, investment climate and financial sector ¾ Business-friendly tax measures and investment law will take time to implement ¾ Regional governments unable to implement needed infrastructure investments given limited capacity; public private partnerships to be used but foreign companies deterred by unclear rules on govt’s role and projected rates of return ¾ Parliament passed long-awaited new investment law (Law 25/2007) in late March 2007 (Narjoko & Jotzo, 2007). Key features are: • A unified law: unifying the 2 formally separate laws governing foreign and domestic investment • A much longer time span for land titles: maximum title for land cultivation (from 35 to 95 years), building rights (30 to 80) and land use (from 25 to 75) • Fiscal incentives: tax exemptions & reductions offered for projects that generate significant employment, promote infrastructure and technological development and develop rural areas and pioneer industries • National treatment provisions: law provides legal grounds for equality of treatment for domestic and foreign investors • Greater details: law includes more explicit criteria (e.g., for determining the negative investment list and the fiscal incentives an investor can obtain) and clearer explanation (e.g., of which taxes may be imposed at regional level and which may not) • Commitment to less red tape: establishment of “one-stop shop” services for investment applications, and centralizes the process at the national level; this task is assigned to the Investment Coordinating Board (BKPM)
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¾ Successful implementation depends on tax and labor laws which complement the investment law. However, tax law being debated in parliament and government reluctant to revise labour law in light of 2009 election ¾ BKPM maintaining its traditional hold on overall direction of investment developments could lead to coordination problems with sub-national government and with related national-level ministries and institutions (law stipulates representation from other ministries & sub-national administrations in executing proposed one-shop investment licensing service but does not require various government agencies to transfer licensing authority to BKPM) ¾ The DPR's appointment of five new members of the Anti-Corruption Commission (KPK) followed a closed-door selection process, the outcome of which suggested that the commission faces capture and subversion by other public sector institutions seeking to block anti-corruption efforts. Finally, a case brought by the KPK against officials of the central bank, including the current governor, has provided strong evidence of the apparently widespread practice of government agencies bribing DPR members (Kong, Tao & Arief, 2008). SBY made changes to his cabinet in May 2007 but left his core economic team unchanged. This has inspired further confidence in his government’s economic policies but still fails to satisfy public expectations. In June 2007, based on Presidential Instruction 6/2007, he launched an economic policy package to accelerate policy improvements in four areas: o Investment climate o Financial sector o Infrastructure o Micro, small and medium enterprises (MSMEs) – included as a major item for the first time This new economic policy aims to help MSMEs by providing better access to financial resources; improving market access; and implementing other regulatory reforms. Notable difference between this and the previous packages is clearer specification of expected outcomes and more transparent ways of evaluating them by an independent external team – signaled the government’s recognition that effective monitoring of policy implementation is important for the package’s credibility. New investment law guarantees equal treatment of foreign and domestic firms in open sectors, but not equal opportunity to invest in all sectors (Takii & Ramstetter, 2007). The Indonesian government unveiled the long-awaited new negative investment list in July 2007 (Takii & Ramstetter, 2007). It includes:
25 closed sectors to protect “national interests” 300 industries conditionally open to investment, in which MSMEs are to be promoted, so investments is subject to foreign equity limitations, location requirements or special licences 18
The new investment law guarantees equal treatment of foreign and domestic firms in open sectors, but not equal opportunity to invest in all sectors. The new list is more transparent as it clearly specifies the restricted industries and has clearer mechanisms for revising the list, making it more difficult to increase number of protected industries than in the past. However, no indication that government will face consequences (other than loss of face) if fails to meet objectives. The underlying problem is related with the lack of strong incentives for bureaucracy to implement policy reforms that are often in conflict with its own interests (Takii & Ramstetter, 2007). Most complaints were focused on rationale for specific restrictions (e.g., 11 levels of foreign ownership limits – question need for such fine gradations of regulatory intervention; foreign ownership limits tightened in transport and logistics businesses from 95% to 49% where Indonesian facilities are deemed inefficient); concern about implementation and uncertainty about whether next review in 2010 will be more restrictive. In summary, government failed to reassure current and potential investors, many of whom had hoped that new list and new investment law would improve business environment significantly (Takii & Ramstetter, 2007). 9. Investment Climate in Indonesia
From the above analysis we can clearly see that the Indonesian government has taken steps in several areas to improve the investment climate. They managed to extend their progress in a number of directions –notably in kick-starting higher growth, renewing efforts to improve the business and investment climate, and intensifying the anti-corruption drive (Boediono, 2005). Now, we come to the key question: Do these economic reforms able to restore investor’s confidence? Can New Investment Law and INPRES NO. 6/2007 improves Investment Climate? Research conducted by World Bank in 2006 reported that about 53% of surveyed firm consider macroeconomic instability as a moderate to very severe obstacle. This is in line with a research conducted by the Investment Climate Study (2005) that shows even bigger number of macro economic instability (69%). Given the negative perceptions on the macroeconomic stability of the business community, to achieve a strong investment growth similar to the period prior to the Asian financial crisis remains a serious challenge. It seems negative perceptions prevail despite some gradual improvements in certain macroeconomic indicators. Figure 8 below shows the slightly difference in investors’ sentiments at the end of 2005 and in the middle of 2007. The red circles represent some deteriorating performance in several aspects.
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Comparing investors’ sentiments between end 2005 and mid 2007, infrastructure issues such as transportation, electricity, financial access and land procurement seemed to have deteriorated, same for institution and governance issues such as tax rate, labour regulation by central government, and crime. However, there seemed to be a huge improvement in macroeconomic instability, economic policy uncertainty and corruption at both the central and local governments. Customs and trade regulations at both the regional and national levels have also posed to be a less severe obstacle. Figure 8- Can New Investment Law and INPRES NO. 6/2007 improve the Investment Climate? Percent of respondents reporting obstacle to be moderate, severe, or very severe (ranked by mid-2006 survey)
Macroeconomic Instability Transportation Corruption Local Government Economic Policy Uncertainty Corruption Central Government Electricity Legal System&Conflict Resolution Tax rate Labor skill & Education Tax Administration Labor Regulation Local Government Cost of Finance Labor Regulation Central Government License & Permits Local Government Customs&Trade Regulation-Regional Customs&Trade Regulation-National Crime License & Permits Central Government Monopoly Practices Financial Access Telecommunication Land Procurement
66
53 42
49 48
59
43 43
52
47
36
42 41 39 38 39 39 38 39 38 37 37 37 37
34 35 36 35 36 33 36 32
end-2005
27 29 29 29 28 28 23
mid-2007
28
21 21 16
0
10
20
20
30
40
50
60
70
80
Source: The World Bank
We also compared these figures with that of the World Bank’s Productivity and Investment Climate Survey on Indonesia, 2003. Those components that were indicated by majority of investors as being severe or most severe obstacles in 2003 were highlighted for comparison to see whether these components have changed in mid 2007. The findings are:
Macroeconomic instability (inflation, exchange rate) (50.1% indicated as major or very severe obstacles in 2003), compared to 2007 (53%) - worsened Economic and regulatory policy uncertainty (48.3%), compared to 2007 (43%) improved Corruption of national government (2003: 37.3%, in 2007:43%) and local government (2003:39.2%, in 2007:48%) - worsened Tax rates (29.5%), compare to 2007 (39%) - worsened Cost to financing (28.5%), compare to 2007 (37%) - worsened 20
Compared over a longer period of time, it seems to indicate that the investment condition in 2007 is even worse compared to that in 2003 as only economic and regulatory policy uncertainty that shows improvement. The above mentioned components are still being considered as major obstacles to the operations and growth of their businesses. In addition, the World Bank Survey (2006) recorded that to start a new investment in Indonesia investor’s need 151 days couple with 12 types of procedures. Whereas in Thailand they only need 33 days with 8 procedures, in Malaysia 30 days with 9 procedures, in Philippines 48 days with 13 procedures, in China 48 days with 13 procedures, and in South Korea firms only need 22 days with 12 procedures. This is a daunting challenge, given that investor confidence in the Indonesian economy is particularly low. James Castle, the President of the American Chamber of Commerce in Indonesia was more cautious: “It’s not getting worse but it’s not getting better [either].”4 Indonesia is one of the five countries that suffered a drop in ranking in the 2007 Ease of Doing Business Ranking. These other countries are Vietnam, Philippines, Taiwan and Cambodia. Comparing the 2006 and 2005 data, the top three factors that caused the biggest drop in Indonesia’s rankings are ease of closing a business, ease of getting credit, and ease of trading across borders. Among the four countries of Indonesia, China, Vietnam and India, Indonesia has the lowest Ease of Doing Business ranking in 2007, overtaken by India which occupied the last spot among the four in 2006 (see Table 4 below). Table 4 – Comparison of 2006 & 2007 Ease of Doing Business Rankings Economy
2006 Ease of Doing Business Rank
2007 Ease of Doing Business Rank
China Vietnam India Indonesia
108 98 138 131
93 104 134 135
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Quoted in Agliony, Fortune reflects on its misfortune in the Java Sea, Financial Times, 28 December 2006.
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Figure 8– Comparison of 2006 & 2007 Ease of Doing Business Rankings
From Figure 8, Among the four countries in 2007’s ranking, Indonesia has competitive strengths in protecting investors, trading across borders, and to a certain extent getting credit. However, it has competitive disadvantage in starting a business, employing workers, registering property, and closing business. In addition, the recent closures and exodus of foreign firm operating in Indonesia and their moving to the People’s Republic of China (PRC) and Vietnam send a strong signal about the depth of Indonesian’s investment deterioration. And regulatory uncertainly and increased corruption (Asia Development Bank 2005).
10. Lesson we can learn The message here is clear: investment climate could not be improved only by imposing law for investment, launching Special Economic Zone policy, reduced central authority, etc. There are many other things need to be empowered. The urgent agenda for the government, business people and the overall Indonesian society can be divided in three broad spectra: 10.1.
A coherent overall strategy and close connection between economics and politics
In the present political setting it is probably more difficult to come up with such a coherent strategy, but it is not impossible. Much will depend on the clarity of the government’s vision, its technocratic capacity to translate this into operational policies, and its scale in maintaining the essential elements of the strategy and protecting its overall coherence, while accommodating elements trust on it by political realities. Paradoxically, from the viewpoint of economic management, the need for a coherence strategy as a policy anchor is more acute in a democratic setting, where the risk of policy swing is often perceived by economic actors 22
to be greater (Boediono, 2005). It is the task of the CEO of the country to come to the best workable balance between the need to secure maximum policy effectiveness and the imperative of accommodating political realities. Moreover, the strategy has to be implemented with a high degree of consistency over a long period. This created a predictable environment and provided sufficient comfort for domestic and foreign investors. In early stages of democratic experiment, sound economic basis must always be maintained and minimum amount of economic and social improvement must be achieved; also need strong sense of direction & shrewdness, and social and institutional leadership from cabinet Therefore, a solid economic team has to be in placed to provide a premium sound of economic policy. So far there is a lack of strong economic policy team for continuity in policy implementation and formulation despite change of power. e.g., Habibie’s policy to develop high tech industry not pursued after he stepped down, nobody knows when the SEZ law will be passed, etc. In this respect, the quality and solidarity of government economic team and nature of relationship with President are equally important as clarity, coherence and credibility of economic strategy is imperative for instilling confidence into investors.
10.2.
Attractiveness of investment policy packages to create a conducive investment climate
Over the years, Indonesia has formulated and implemented various investment policy packages aimed at attracting foreign direct investment into Indonesia. However, at various points in time, the effectiveness of such policy packages was called into question. These policy packages were either not effective in attracting foreign investment, or were not implemented in a consistent and timely manner. As mentioned, the Indonesian Parliament passed the long-awaited new investment law (Law 25/2007) in late March 2007 (Narjoko & Jotzo, 2007). It was observed that successful implementation depends on tax and labor laws which complement the investment law. However, the tax law was being debated in parliament and the government seems reluctant to revise the labour law in light of the impending 2009 election. To be successful and effective, as mentioned in the previous lesson to be learned, there is a need to have a coherent overall strategy. In a move to reduce the amount of red tape, we saw the establishment of “one-stop shop” services for investment applications. The process will be centralized at the national level and this task is assigned to the Investment Coordinating Board (BKPM). BKPM, in maintaining its traditional hold on overall direction of investment developments could lead to coordination problems with sub-national government and with related national-level ministries and institutions. This is because the law stipulates representation from other ministries and sub-national administrations in executing the proposed one-shop investment 23
licensing service but does not require various government agencies to transfer licensing authority to BKPM. The new investment law guarantees equal treatment of foreign and domestic firms in open sectors, but not equal opportunity to invest in all sectors. This can be seen from the longawaited new negative investment list unveiled by the Indonesian government in July 2007 (Takii & Ramstetter, 2007). Although the new list is more transparent as it clearly specifies the restricted industries and has clearer mechanisms for revising the list, there is no indication that government will face consequences (other than loss of face) if fails to meet objectives. The underlying problem is related to the lack of strong incentives for bureaucracy to implement policy reforms that are often in conflict with its own interests. One of the observations is that investors are concerned about implementation and uncertainty about whether next review in 2010 will be more restrictive. In summary, the Indonesian government seemed to have failed in reassuring current and potential investors, many of whom had hoped that new list and new investment law would improve business environment significantly. It is probably not new for scholars to comment that for Indonesia to improve its investment climate, they need a coherent and concerted overall strategy that covers the following broad aspects: ¾ ¾ ¾ ¾ ¾ ¾ ¾ ¾ ¾
Investment law and negative list Tax policies Special economic zone policies Labour policies Education policies Workforce training programmes to upgrade workforce skills Infrastructure building Institutional reforms Industrial policies: o plugging into global value chain and global production network o Indonesia need more investment in local manufacturing sector
As mentioned earlier, in order for the investment law to be effective, it has to be coordinated with the tax and labour policies. In tax policies, the Indonesian government would need to sort out the multitude and quantum of taxes to be paid by investors, both at the central government and regional government levels. In this regard, the long awaiting SEZ law which should include attractive tax incentives for companies investing in Special Economic Zones (SEZs) in Indonesia would be a useful tool to stimulate investors’ interests in SEZ. For example, the development of Batam, Bintan and Karimun (BBK) into an SEZ can be seen as a viable strategy for attracting foreign direct investments into Indonesia. If BBK can 24
be successfully developed into an SEZ, this can be used as a successful model for developing other SEZs in Indonesia, ultimately fulfilling the objective of revitalising the Indonesian economy. There are some unique locational advantages that BBK enjoys that make the choice of BBK as a leading ‘goose’ easier. Batam, part of the BBK, has a long history of being a manufacturing base and part of a growth triangle involving Singapore, Indonesia and Malaysia, and was co-developed by Singapore and Indonesia over the years. Attractive tax incentives aiming at lowering the cost and ease of doing business should be planned in the forthcoming SEZ law to fulfil the objectives. In labour policies, as the increase in minimum wages is tied to inflation, it is likely that minimum wages will continue to rise in the foreseeable future. This would be a key factor affecting investors investing in labour-intensive industries. The labour regulation regarding retrenchment compensation made it difficult for companies to make redundant their workers and together with the power of the union in Indonesia, labour issues become a key factor affecting Indonesia’s attractiveness as an investment location. Corroborative evidence can be seen from a survey from Japan External Trade Organisation (JETRO). According to the “Comparative Survey of the Labour Environment in ASEAN, China, India” by JETRO, October 2006, the top 5 problems of labour and employment in Indonesia (N=942) are: o Increase of employee wages (85.8%) o Restrictions on staff dismissal and reduction (46.5%) o Personnel costs of Japanese (expatriate) officers & staff (43.2%) o Difficulty in recruitment of local staff (middle management) (37.4%) o Labour issues (e.g., strikes, labour unions, etc.) (31.6%) As observed, despite wage increases, Indonesia is still a relatively low-wage economy, but it is finding it difficult to attract investment in more knowledge-intensive production due to the generally low skill level of its labour force. As such, a longer-term education policy for Indonesians and workers’ training and skills upgrading policy are needed to raise the human capital of Indonesia. Indonesia has fallen short of its pledge to allocate 20% of government’s budget to spending on education. In addition, workforce training programmes need to be devised at the national level to set up a system for continuously upgrade the skills of the workforce. For example, a national skills inventory study to identify skills needs at the sectoral level may be needed before drawing up diploma programmes for upgrading of identified skills sets for the various trades that are needed in various industrial sectors. As usual, infrastructure building is a precondition for success to attract investment. As highlighted earlier, infrastructure issues such as transportation, electricity, financial access and land procurement seemed to have become more of an obstacles for business growth recently in Indonesia. It is therefore imperative that infrastructure building policy not be neglected in building a conducive investment climate for investors. In the economic theory of production fragmentation and production network, infrastructure conditions will affect the 25
setup cost and service link cost of investors. If these two costs are too high, there is no reason for investors to consider investing in Indonesia. No prudent businessmen or investors would like to invest in a country that is corrupt and is weak in institution and governance. Whether Indonesia can fulfill its promises to improve the business operating environment to encourage both domestic and foreign investment will very much dependent on its institutional reform, particularly of the judiciary, and the need to improve legal certainty which will take longer. It is observed that Indonesia should start and sustain reforms in sectors that promise greatest systemic payoff: legal and law enforcement sectors and the bureaucracy. No doubt this is the most difficult to reform but is well worth the effort. At the industry or sectoral level, prudent industry policies are needed to enhance the competitiveness of Indonesia. In the past, international economists are concerned with computing Revealed Comparative Advantage (RCA) to obtain products (or sectors) to specialise in so as to have comparative advantages over other countries. Nowadays, scholars familiar with production fragmentation, agglomeration and production network theory are more concerned with specialising in production processes that a firm enjoys comparative advantage in a particular sector in a specified country. In this regard, the network set up cost, service link cost and production cost per se are three categories of costs that a firm would do well to minimise in their set up or relocation decision. As mentioned earlier, developing BBK SEZ to plug into the global value chain and global production network may be a good vehicle for revitalising the Indonesian economy, taking advantage of the unique location advantages BBK has. Facing with affordable China imported products such as motorcycles, it is observed that Indonesia is facing a serious de-industrialisation problem. Manufacturers have no incentive to manufacture and end up being distributors or retailers of imported manufactured products. Indonesia need more investment in local manufacturing sector and to achieve this, carefully thought out industry policies are needed, coupled with MSME policies in encouraging the development of local SMEs. 10.3.
Decentralization should be coupled with transparent regulation and prominent leadership
After the fall of Suharto, Indonesian political landscape changed towards a more democratic society with devolution of power away from central government. There was a demand from regional governments of resource-rich regions to have more authorities in self government (econ planning, taxation & licensing). Therefore, decentralisation law passed in 1999 & enacted in 2001 to delegate greater autonomy to around 400 districts.Despite greater flexibility and autonomy to the region, decentralization policy faces a number of concerns. The Law on Regional Autonomy (1999) is to general in assigning spending responsibilities, causing confusion to regions. The Law on Fiscal Balance (1999) also lacks clarity in the 26
assignment of functions that could exacerbate macroeconomic imbalance. The proposed revenue – sharing and fiscal arrangements might worsen the income disparity across regions. Decentralization led to a worsening of the business climate. Regional governments have been criticized for creating too many new taxes and charges under decentralization. On the other hand, they admit that they have experienced a “freedom” that did not exist during the centralized era, and gradually, the learning process of managing and administering the local governments is working. Due to political condition and limited time availability, the decentralization process in Indonesia jumped directly to the law drafting and a result, when there is confusion about the law itself, no valid reference is available (Ray, 2001; SMERU,2001). We have to be aware that decentralisation leads to greater fragmentation of government decision making power; resulting in breakdown in coordination by bureaucrats; leads to excess rent extraction (corruption). Race among districts to create new local regulations deemed necessary for their ‘well-being’ – use these regulations and resulting corruption and bribes as form of indirect taxation to compensate for income loss under the new budget arrangement (Kuncoro, 2006). To eliminate this decisive problem, transparency of policy, good governance and prominent leadership have to be established and maintained.
11. Conclusions Indeed, while some progress has been made on governance, as well as on legal and judicial reforms, more work needs to be done in these areas to revive investor confidence, and to enhance the level of competitiveness in Indonesia. Continued uncertainty arising from decentralization, slow progress on anticorruption measures, lack of credibility of legal and judicial institutions, and poor law and order in various provinces - all remain to be major obstacles to improving the investment climate. Given the need to enhance Indonesia’s international competitiveness, the government has to prepare a new investment law that will streamline all investment laws and regulations. The most severe constraint affecting investors in Indonesia is overall uncertainty. While all in investment involves risks in various forms, higher risks discourage firms from undertaking investments. In addition to concerns over security in Indonesia, risks are influenced by macroeconomic instability and the uncertainly in government policies and regulations affecting business. The ICS results show that the most severe constraints affecting firms in Indonesia all deal with high risks and uncertainties, rather than higher costs. Indonesia performed the worst in macroeconomic instability and economic and regulatory policy uncertainty. With the right policy framework and a strong commitment to reform, Indonesia should be able to capitalize on its fundamental economic strengths to restore investor confidence. Furthermore, the political situation (who will become the new President; power 27
of parliament; the decentralization experiment) will be the key determining factor in the path towards reform and good governance. References Blane D. Lewis, (2001). “Some Empirical Evidence on New Regional Taxes and Charges in Indonesia,”Jakarta. Boediono (2005), “Managing the Indonesian Economy: Some Lessons From the Past”, Bulletin of Indonesian Economic Studies, 41:3, 309-324 The Economist (2008), “Economics Focus – Grossly Distorted Picture”, March 15. Hofman, Bert, Rodrick-Jones, Ella, and Thee Kian Wie (2004), Indonesia; Rapid Growth, Weak Institutions, Paper Presented at the Global Conference on Poverty Reduction, Shanghai, 25-27 May. Japan External Trade Organisation (JETRO) (2006), “Comparative Survey of the Labour Environment in ASEAN, China, India”, October. Kong, Tao and Ramayandi, Arief (2008) “Survey of Recent Developments”, Bulletin of Indonesian Economic Studies, 44:1, 7-32 Kuncoro, Ari (2006), “Corruption, Decentralisation and Democracy in Indonesia” in East Asian Economic Perspectives, Vol. 17 No. 2, August 2006 Narjoko, Dionisius A. and Jotzo, Frank (2007) “Survey of Recent Developments”, Bulletin of Indonesian Economic Studies, 43:2, 143-170 Ray, David (2001), “Inventory of Trade – Distorting Local Regulation,” USAID-PEG Project, Ministry of Industry and Trade. Jakarta. Rohdewohld, R.(1999), A New Framework for Local Governance, GTZ Discussion Papper, available from www.gtzfdm.com Sala-I-Martin, X., Blanke, J., Hanouz, M.D., Geiger, T., Mia, I. and Paua, F. (2007), “The Global Competitiveness Index: Measuring the Productive Potential of Nations”. In Michael E. Porter, Xavier Sala-I-Martin, and Klaus Schwab, Global Competitiveness Report, 2007-2008. SMERU (2001). “Regional Autonomy and the Business climate: Three Kabupaten Case studies from North Sumatra. “ SMERU Field Report.Jakarta.
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Suzanne Miller, “Indonesia Disappoints,” fDi Magazine, Financial Times Business, Ltd., www.fdimagazine.com/news/printpage/php/aid/421/Indonesia_disappoints.html, accessed December 22, 2006. Takii, Sadayuki and Ramstetter, Eric D. (2007) “Survey of Recent Developments”, Bulletin of Indonesian Economic Studies, 43:3, 295-322 Kian Wie, Thee (2006), Policies for Private Sector Development in Indonesia, ADB Institute Discussion paper No.46, March.
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