Bolstering Reform in Indonesia

WASHINGTON, DC: After a convincing victory in presidential elections, Indonesia’s President Joko Widodo, known as Jokowi, has his work cut out to deliver on campaign promises to put Indonesia on a higher growth path and find jobs for the millions joining the work force each year. He must act decisively to boost domestic competitiveness and reengage the global investment community to lift both investment and exports.

After a campaign marked by nationalistic rhetoric, often veering into outright xenophobia, foreign investors may wonder if Indonesia welcomes them. Yet facilitating and expanding foreign investment and reducing state involvement remain critical to the success of his next term.

The losing candidate, retired General Prabowo Subianto, lambasted foreigners for exploiting Indonesia’s natural resources. Less overtly hostile, Jokowi also ran a nationalist-heavy campaign, trumpeting successes from his first term in pushing out or reducing the role of foreign mining and energy companies including Chevron, Shell, Inpex, Total, Newmont, Rio Tinto and Freeport McMoran. He made no apologies for overseeing a larger role for state-owned enterprises in a broad range of industries that crowded out private foreign and domestic investors alike.

To his credit, Jokowi made progress in creating a stronger environment for investors. His most impressive achievement since taking power in 2014 was an overdue effort to narrow Indonesia’s yawning infrastructure deficit by adding a string of airports, ports and power stations and building thousands of miles of rural roads to connect many far-flung communities with market centers. After more than 30 years of planning, Jakarta opened its first subway in in March.

For much of his first term, Jokowi vigorously took on mountains of bureaucratic red tape that stand between investor ambitions and ready-to-go projects in Indonesia, issuing 16 packages of deregulation measures aimed at boosting investor interest. These include setting up a one-stop shop for licensing approvals, reducing customs and port dwelling times for goods, and slimming down the number of sectors restricted from foreign investment. He also lent support to Indonesia’s able, though under-resourced, anti-corruption commission. Expanded spending on rural infrastructure has been popular, slowing and even reversing wealth inequality. The results are apparent in global rankings. Since Jokowi was elected, Indonesia’s ranking in the World Bank’s Ease of Doing Business index jumped from a woeful 120 out of a 180 ranked countries to middle-of-the-pack 73. In global indices measuring logistics costs and corruption, Indonesia also made concrete gains.

A major challenge for Jokowi’s second term will be finding funds to continue investing in infrastructure and improving education and health outcomes. Indonesia’s education and health metrics fare poorly relative to its main regional competitors and require massive new investments to close the gap.

Planning officials estimated Indonesia required some $350 billion in infrastructure financing from 2015 to 2019 and will likely need as much for the coming five-year period, with more than half expected to be financed from private sources. Nationalist campaign rhetoric aside, foreign sources must supply a significant portion of that capital.

Years of bad policy and nationalist pressures have steadily reduced upstream hydrocarbon exploration and production, pushing Indonesia, once a charter member of the Organization of Petroleum Exporting Countries, closer to becoming a net oil importer. Recent industry analysis suggests Indonesia must invest more than $150 billion into exploration, gas distribution infrastructure and refinery capacity to slow production decline and meet growing demand. Without new investment, Indonesia could see its hydrocarbon production fall by another 20 percent before 2024.

A second priority is to increase domestic mobilization of resources and maintain a balanced borrowing portfolio between foreign and domestic sources. At below 12 percent, Indonesia’s tax ratio lags well behind that in neighboring countries such as the Philippines, Thailand and Vietnam, all in the range of 16 to 18 percent – product of the failure of successive Indonesian governments to formalize economic activity. Nearly two-thirds of the labor force works in the informal sector and pays no tax.

In 2014, Jokowi turned to a set of state-owned enterprises to jumpstart infrastructure development. While a defensible strategy at the time given the scale of Indonesia’s infrastructure deficit, the SOEs grew steadily more dominant in leading sectors, expanding into new areas and demanding preferential government treatment. Latest statistics show that assets under SOE control are equivalent to slightly more than 50 percent of GDP. SOEs have taken up more of the available lending capacity at domestic banks, gradually crowding out more efficient, privately owned firms. A batch of overseas investments by private Indonesian firms reflects their challenge in finding investment opportunities at home.

One way of redressing the problem is to stipulate a minimum share of private-sector involvement in major infrastructure and natural-resource projects. This rule could also be applied to projects financed under China’s Belt and Road Initiative, to reduce Indonesia’s political vulnerability to BRI-financed projects that turn out less than fully commercially viable. Indonesia submitted a project wish list worth more than $90 billion at the Belt and Road Initiative Summit in April, most situated within the three priority “economic corridors” in North Sumatra, North Kalimantan and North Sulawesi. While only a handful may receive BRI funding, new projects present opportunity for a broader set of partners, including private domestic and foreign businesses.

A third priority reform area is revitalizing the deregulation drive that marked the first three years of Jokowi’s first term. Despite notable improvements, Indonesia remains by regional standards a difficult place to invest. Protectionist regulations remain rampant. Foreign investors find it difficult to obtain visas for personnel. Labor rules make labor-intensive manufacturing non-competitive, with minimum wages increasing faster than worker productivity and severance arrangements so generous that investors are reluctant to hire.

Efforts to winnow down government limits on foreign investment in various sectors have made some headway. But Jokowi must resist political pressures to limit foreign capital and technology in key sectors of the economy like hydrocarbon and mining, insurance and the digital economy.

A fourth imperative for Jokowi’s economic agenda is to boost domestic competitiveness through accelerating trade flows and finalizing negotiations on new trade agreements. Worries over a rising current account deficit led to demonization of imports, taken to its logical extreme by Prabowo who called for an end to all imports, and a move toward import-substitution policies. Continued efforts to compress imports, many needed as raw materials, would risk precipitating a balance-of-payments crisis. Indonesia needs to export to finance persistent deficits. Import restrictions also raise prices of basic necessities, reducing real incomes of the poor who spend most of their earnings on food.

Jokowi, to be commended for concluding a sweeping free-trade pact with Australia, is moving ahead on a similar pact with the European Union – though disputes over palm oil could slow progress. And Indonesia could join four fellow ASEAN members in the CP-TPP, the name for the Trans Pacific Partnership after US withdrawal. The broad-based CP-TPP provides its 11 members preferential access to one another’s markets while requiring reforms and transparency in areas not covered by typical trade deals, including a level playing field for SOEs, government procurement policies, and labor and environmental regulations. Thailand and Philippines are also considering applying for membership.

Finally, Jokowi should invest some political capital to establish stronger institutions and processes for coordinating policy implementation. Existing policies in many instances point in the right direction yet fall short by ineffective implementation throughout a decentralized and often inexperienced bureaucracy, especially outside major cities. The national coordinating ministries, a legacy of Indonesia’s authoritarian past, lack resources and legal mandate. The president’s office urgently needs to devise a better approach to coordinate policy implementation and enforce performance expectations for cabinet ministers. Linking local government finance to performance indicators would reduce waste and abuse at the local level, where most public money is spent.