Author: Denise Bedell
TWO STEPS FORWARD, ONE STEP BACK
COUNTRY REPORT / INDONESIA

Indonesia has made great improvements recently but some persistent problems are still holding it back.

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Clear skies ahead? Jakarta has worked hard to improve access for foreign investors.

While much of the world has been picking its way through the post-subprime minefield, Indonesia has been enjoying a bumper year. Foreign investment grew sharply last year as the government passed the Investment Law of 2007, making it easier for foreign investors to enter the market. The country suffered little from the US and global credit crisis. Lending growth numbers—an indicator of economic strength—have been picking up and are very strong at the moment, fueled partly by the central bank’s easy monetary stance, which saw interest rates decline throughout 2007. “That has been an important factor in boosting lending growth,” says Robert Prior-Wandesforde, Southeast Asia economist at HSBC.

But Shariq Mukhtar, Citi’s country officer for Indonesia, says that from an economic standpoint the key consideration right now is inflation. “It has been relatively high compared to initial market expectation. For the next six to nine months we will be watching how inflation progresses.” In early June inflation figures hit the double digits as a result of government increases to subsidized fuel prices the month before.

Also critical is what will happen with interest rates. “Originally we expected they would come down from 8% to 7.5%, but because inflation is high, the central bank upped the rate to 8.25%,” says Mukhtar. The central bank hiked interest rates an additional 25 basis points in June in an attempt to quell rising inflation.

From an FDI perspective, clearly risk aversion has gone up, although not as much as might have been expected, given what has happened in developed markets and the impact that often has on emerging markets. Prior-Wandesforde believes there is little evidence of the global liquidity crunch having a significant detrimental impact on Indonesia. “Indonesia is among the least exposed countries to the US economy in terms of exports, and benefits more than many of its Asian partners from higher commodity prices as well,” he says.

“Foreign direct investment is higher than it was 12 months ago,” points out Mukhtar, “but that is true in most markets. With the announcements in April by the government about their concerns over the deficit and with the central bank focusing on inflation management, there are some concerns over that.”

Mukhtar is heartened by the confidence of foreign investors, who seem to be holding steady on Indonesia. Currently, he says, there is about $12 billion to $14 billion sitting in bonds from foreign investors, and foreign investment also accounts for a significant portion of the stock market. “What we have seen is that that money has stayed,” notes Mukhtar, “so those investors are holding on, which is a good thing. The risk premium in foreign swap rates has gone up, but we have not seen a huge outflow of money because of the strong fiscal policy of the government. Interest rates are also high, so that is favorable to foreign investment.”


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Attracting Foreign Investment
The government is trying to make the country more open to foreign investment, and the development of the Undang-Undang Penanaman Modal (Investment Law of 2007) was a big step toward that. As Indonesian socio-economic and political analysis firm iNusantara Networks explains in a report on the reforms: “The Legislative Assembly approved the Investment Law of 2007 with the sole intention of making the Indonesian economy more attractive to foreign investments. On a broad front, the Investment Coordinating Board (BKPM) wants to reduce the procedures to approve new investments by promoting better coordination between the various government institutions, providing tax incentives to make returns to investments attractive and by persuading major players to capitalize on the large domestic consumer market.” The tax incentives will apply to new investments and to ongoing investments that are partnered with local business and for ventures in rural and border areas.

The introduction of the Investment Law of 2007 was designed to make it easier for foreign investors to enter the market, Prior-Wandesforde says. “But at the same time the government extended the list of sectors that foreign participants couldn’t invest in. Two steps forward and one step back is often the way with Indonesia, as it seems to have a tough time balancing different parties and interests.”

One big issue that is not addressed by the Investment Law is the discrepancy between federal reforms and state application of those reforms. The law does not guarantee uniformity between government legislature and provincial and regency administrations. The iNusantara report explains: “These governors and regents usually have a mind and agenda of their own.”

The report continues: “Though the law passed with opposition only from two political parties in Legislative Assembly, it is likely that the increased ‘freebies’ to investors and the equal status granted to both foreign and domestic capital will become key issues among the Islam-oriented as well as Nationalist political parties in the 2009 general elections.”

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CITI'S Mukhtar: The key consideration right now is inflation.

Underinvestment Hinders Growth
One significant factor crimping Indonesia’s ability to take advantage of the current commodities boom is the historical lack of investment in the country’s physical infrastructure. Together with rigid labor market laws, this has previously discouraged foreign investment, leaving the country playing a game of catch-up in developing its commodities output. The potential for foreign investment—particularly in palm oil production but also in oil exploration—is huge, but the country has first to provide the necessary infrastructure.

Indonesia’s government is trying to remedy this, with big investment seen in roads and other critical infrastructure. “The pressure to boost investment in oil must be massive at the moment, given how prices are,” says Prior-Wandesforde. “It is reasonably easy to invest in Indonesia in certain sectors. But there is also a big list of areas that are protected from foreign investment. There are more protected areas than is seen in many other jurisdictions.”

Prior-Wandesforde believes the government wants to introduce more reforms. “They tried to [by loosening] the labor law, but it was rejected by parliament,” he says. “They have to manage what they would like to do with what they can do.”

Denise Bedell