Breakneck economic growth in the past few years has made Indonesia a darling of foreign investors. The challenge is now to sustain it by ironing out some of the kinks.
Despite the fact that Indonesia had posted GDP growth of 6.3 percent in the first quarter of 2012, a number of economists are forecasting that the country’s growth would slow. The global slowdown was expected to take its toll, of course, but the Indonesian rupiah was on a downward curve, certain policy moves on the part of the government were expected to have a negative impact, and exports had begun shrinking. But in a manner fitting of the celebrated growth story it has become, Indonesia defied the naysayers to record GDP growth of 6.4 percent in the second quarter of the year. Buoyant domestic demand, especially in transport, hotels and government consumption, had kept growth on an even keel, in spite of the fact that Indonesia has had consecutive trade deficits between April and June this year.
Similarly, despite reports that Indonesia’s investment climate was growing more difficult, the country still managed to post foreign direct investment of 56.1 trillion rupiah ($5.9 billion) during the second quarter of the year, a quarterly record, and one that kept it on track the break the annual FDI record of $19.3 billion record set in 2011. Additionally, domestic Indonesian companies invested 20.8 trillion rupiah ($2.1 billion) in the second quarter, a 10 percent increase over last year. “Performing particularly well to date this year have been mining, and the chemical and pharmaceutical industries, which together attracted some $1 billion in FDI, while $600 million was invested in utilities, $500 million in food processing, and $500 million for metal, machinery and electronics,” says Ahmad Assegaf, managing partner of Assegaf Hamzah & Partners.
Assegaf says that while traditionally the mining and natural resources sectors have been the big attractions in Indonesia, in the plantation sector palm oil has also seen exponential growth over recent years. “However, this industry continues to face pressure on environmental issues from overseas, but I have no doubt that with the adoption of Roundtable on Sustainable Palm Oil (RSPO) best practices, palm oil will be able to continue expanding,” he says. However, the prospects for mining are looking bleak in the near-term as “the commodities cycle is clearly on a downward trajectory, and in the absence of significant stimulus in China, this is set to continue for the foreseeable future, and has the potential to significantly impact on Indonesia,” he adds.
Indra Safitri, senior of counsel with Melli Darsa & Co says that Indonesia’s growth story has much to do with the burgeoning middle class in Indonesia, which currently numbers about 43 million people, and the high potential of its buying power. “Moreover, there is a growth momentum in some big cities in Java, other than Jakarta, which will cause the real estate, telecommunication, transportation, trading, and creative industry sectors to grow rapidly,” he says.
Despite the healthy figures, Indonesia does have a number of impediments in its path. As noted above, investments in mining, one of the cornerstones of the Indonesian economy, have taken a hit following a series of much-talked-about policies in that sector. Popular but economically unviable fuel subsidies have been hurting the economy. The slowdown in Europe and China has hit exports, thus putting pressure on the rupiah. And other factors like legal and regulatory uncertainty and rampant corruption have the potential to derail the Indonesian growth train. Strong economic fundamentals helped it avoid the brunt of the Global Financial Crisis of 2008, but this time it might need to dig deeper.
The perils of uncertainty
One of the biggest problems facing Indonesia today is corruption, which is widely seen as holding back the economy. In August, Indonesian president Susilo Bambang Yudhoyono noted that corruption was on the rise, even in parliament, and that it was threatening economic growth in Southeast Asia's largest economy. There are few estimates of how much corruption costs Indonesia, but watchdog groups say it is prevalent in the civil service, police and judicial system, and that it adds to business costs in part by weakening confidence in the rule of law.
According to Assegaf, the “crucial factor” impacting investor attitudes towards Indonesia continues to be certain at the policy, regulatory, and judicial levels. “While there has been progress in recent years, there are problems we face in the mining sector, where, among other things, overlapping licences are a major issue,” he says. “This is often laid solely at the door of corruption. While it is true that corruption continues to play a significant role, it needs to be remembered that the problem of legal certainty also frequently involves lack of capacity at the local level. Even though a major chunk of governmental power was devolved to the regions back at the end of the 1990s, the regions to this day frequently lack the trained professionals required to fulfill the governmental responsibilities assigned to them.”
Safitri agrees that legal certainty is one of the biggest problems for investors in the mining sector. “In accordance with the characteristic of the mining sector which relates to licensing, land-ownership and environmental, thus the prevailing laws and regulations which regulates each of those matters are still conflicting and inharmonious, yet cause high cost and corruption,” he says.
In the judicial sphere, however, things have improved enormously in recent years. “In particular we view as a sensible step forward the Supreme Court’s plan to establish a chamber system so that the judges, who hear commercial cases, for example, will actually be experts in this area of the law,” says Assegaf. “Furthermore, the Supreme Court now publishes an enormous number of judicial decisions online, as well as a very informative annual report. Nevertheless, as our litigation department can attest, we still have a long way to go before we arrive at the stage where we can say we truly have a clean and reliable judiciary.”
Assegaf adds that transparency is also an issue, and information remains notoriously hard to come by in many sectors. “Even when information from one government department is obtained, it may conflict with information from another,” he says. “Take, for example, the maps used in the forestry sector – each institution appears to be producing its own, all the way from the local up to the central level.”
Finally, there is the issue of infrastructure, which, as ALB noted in its August issue, causes Indonesia to lag behind some of its regional peers in efficiency and productivity, mostly due to the poor state of its roads, airports, and other economic lifelines. The Land Acquisition Law was passed in December 2011, and the Yudhoyono government on Aug. 7 issued a regulation to speed up the procurement of land for public infrastructure projects. “However, it has received a less than warm welcome from the construction sector, which does not bode well for the rapid resolution of our chronic infrastructure deficit,” says Assegaf.
Up the value chain
One of the stated goals of the Indonesian government is to upgrade the country from being a low-cost manufacturing andore exporting economy to being a country that offers high-value goods and services. “There is no doubt in my mind that Indonesia is set to move up the value chain in the years ahead, following in the steps of such countries as Malaysia and Thailand, not to mention Korea and Taiwan,” says Assegaf. He points out that there has been something of a boom in the healthcare industry, which shows enormous potential for further expansion. “Also, retailing has been a boom sector in recent years, and will continue to be so,” he says. “In addition, the central government appears very serious about encouraging in-country processing of mineral ores, and quite a number of smelter projects are now in the pipeline as a result.”
Safitri says that the growth of the middle class in Indonesia has encouraged the development of investment opportunity in telecommunication and healthcare sectors, as well as the creative industry. “Basically, such development stimulates the arrival of the investors, who relate to the middle-class needs, from upstream to downstream,” he says.
He adds that as with many other policies, Indonesia still has a long way to go. “Despite the government’s 10,000 MW generating capacity development programme, many of our outer islands continue to suffer severe power deficits,” says Assegaf. “Ironically, it is on our outlying islands that most of the country’s mineral resources are located. By contrast, the vast majority of our population lives on resource-poor Java. So, we have a built-in imbalance here that obviously poses difficulties. For example, how are mining firms going to establish smelters when there isn’t enough power to run them?”
Another initiative of the government is to introduce an economic development acceleration programme (MP3EI) that focuses on the integrated development of six economic corridors around the country. “While this plan would seem to have great potential, industry and business remain skeptical to some extent given our history of inadequate policy coordination,” Assegaf says.
2014 and beyond
Indonesia’s next presidential election is slated for 2014, when Yudhoyono steps down following the completion of his second five-year term, and unsurprisingly there is much discussion about how his departure will impact the country, with excessive protectionism being one of the possible trends. “There is a general nervousness in the air that the current perceived move towards greater protectionism, particularly in the resources sector could gain further traction in the approach to the 2014 presidential election,” says Assegaf. “Recent moves that have produced some jitters include the introduction of a tax on resource exports and a cap on foreign ownership in the banking sector.”
On the positive side, Assegaf notes that there has been a broad continuity in this country’s industrial and development policy, despite frequent shifts at the micro level. “We expect this broad continuity to persist, no matter who wins the 2014 presidential election,” he says. “Despite the issues alluded to above, Indonesia remains a relatively welcoming destination for FDI. Given the current grossly inadequate level of capital formation, we believe that this will continue into the foreseeable future.”
Domestic economy flying
Indonesia’s central bank’s policy bias could shift towards tightening when global demand conditions improve. It has already moved to try to avoid bubbles in the property and auto sectors by tightening requirements for downpayments in June. Strong loan growth meant banking sector profits are up 19 per cent this year.
Transport and communications were the fastest growing sectors in the first half of the year, up 10.1 percent in the second quarter from a year ago. Luxury car sales are booming as growing wealth leads drivers to upgrade from Toyotas to BMWs, while young consumers are snapping up smartphones.
The trade, hotel and restaurant sector grew faster in the second quarter, with the world’s fourth-largest population increasingly flying on new airline routes to stay at branded budget hotels. In Jakarta, trendy new eateries regularly open, while convenience stores are spreading across the country.
Inflation picked up last month because of higher food prices ahead of the Muslim Ramadan period, although it looks set to stay within the central bank’s target range this year.
Government consumption also picked up in the second quarter, while foreign direct investment grew 30 percent to tap the country’s mineral resources and consumer demand.
“As per today’s data, Indonesia remains one of the fastest growing, and perhaps more importantly, one of the most stable economies in Asia,” says Taimur Baig at Deutsche Bank in Singapore.
But he adds: “We are concerned that rates are too low and could cause over-consumption and investment in the medium term, but for the time being we remain comfortable with the view that Indonesia is poised for 6 percent plus growth this year and next,” he said.
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