Drivers for Private Investment in Indonesia1
Against the backdrop of a commodity down-cycle and slower economic growth, private investment in Indonesia has slowed markedly in recent years, more so than peers. This paper discusses the recent trends and drivers for private investment in Indonesia, and the policies needed to support higher investment. The recent pickup in commodity prices is expected to lead to a gradual recovery in private investment, but structural headwinds need to be addressed to sustain investment and growth.
1. Total investment in the global and regional economies has slowed over the past several years, driven by private investment. Global investment has slowed into 2016, well below the levels prior to the Global Financial Crisis (GFC) (Figure 1). Asian economies have also seen a deceleration in investment, while investment in Latin America has contracted in recent years. The deceleration in investment has been driven by sluggish private investment, which accounts for around 90 percent of total investment (IMF, 2015b).
Figure 1.Investment Growth
Source:IMF, Wortá Economic Outlook.
2. The economic literature identifies the main factors behind sluggish private investment to be weak economic activity and the decline in commodity export prices. In the global economy, the main factor for sluggish private investment is weak economic activity, while in some economies, factors include lower commodity export prices, financial constraints, and policy uncertainty (IMF, 2015b; IMF, 2015a). Other studies find that policy uncertainty reduces investment (Baker and others, 2015), and exchange rate volatility can have a negative impact on investment (Darby and others, 1999). As for policy recommendations, the literature suggests that addressing the general weakness in economic activity is crucial to restore growth in private investment (IMF, 2015b) and more decisive progress in improving conditions for private investment would help a recovery in investment (IMF, 2015a).
3. Against this background, this paper proceeds as follows. Section B discusses overview of investment trends in Indonesia. Section C explains cyclical factors, and Section D focuses on structural factors. Section E goes over the implications of those structural constraints and a restrictive foreign direct investment (FDI) regime on external integration. Section F discusses an empirical study of firm-level panel regression to estimate drivers for private investment in Indonesia. Section G summarizes the main findings and policy implications.
B. Overview of Investment Trends in Indonesia
4. In Indonesia, investment has become more important in economic output over the past decade. Investment has steadily risen relative to GDP by around 10 percentage points since the early 2000s (Figure 2). Investment now accounts for more than a third of the output of the country’s economy, where private investment2 constitutes around 90 percent of total investment. During the commodity boom in 2011–12, investment contributed to as much as half of economic growth.
Sources: IMF, World Economic Outlook; and IMF staff estimates.
5. Nonetheless, Indonesia has seen a marked slowdown in private investment since 2014, compared with EM peers. The weakness in private investment intensified into 2016:H1 (Figure 3), and high frequency indicators—such as cement sales, capital goods imports, and investment credit—suggested little signs of a meaningful recovery into Q3:2016, although there are early signs in Q4:2016 that these indicators have stabilized somewhat. The slowdown is more distinct in Indonesia than that of EM peers which also have seen subdued investment (Figure 4).
Figure 3.Private Investment 1/
Sources: Bloomberg L.P.; and IMF staff eslimates.
1/ Net fixed assels of corporales.
Figure 4.Private Investment to Capital 1/
Sources: Orbis; and IMF staff estimates.
1/ computed as the purchase of gross fixed assets in a given year divided by total net value of property, plant, and equipment in the preceding year, Indinesia includes 433 listed firms, Malaysia 882 listed firms, the Philippines 218 listed firms; and China 5,688 listed firms.
6. The weakness in private investment is also in contrast with a pickup in public sector investment. Following the landmark 2015 reforms, the government has been ramping up infrastructure investment (Figure 5). As the government is pushing ahead with infrastructure development, the central government is increasingly channeling investment through local governments and encouraging state-owned enterprise (SOEs) to ramp up capital spending (Figure 6). Capital expenditure of SOEs doubled in 2016, and is expected to rise by around 35 percent in 2017. Most of the spending is centered on energy, mining and exploration, and transportation, aimed at meeting infrastructure development needs.
Figure 5.Growth in Public and Private Investment 1/
Sources: Ministry of Finance, Haver Analytics; and IMF slaff estimates.
1/ Nominal values; Public investment is the general gave, nments inuestment.
2/ H1:2016 is based on estimates.
Figure 6.Capital Spending of Government and SOEs
Sources: Indonesia, Ministry of Finance and Ministry of SOFs; and IMF staff estimates.
C. Cyclical Factors
7. Investment has heavily relied on the commodity sector since 2010. During the commodity boom until 2013, investment in the commodity sector surged, driving overall investment in Indonesia (Figure 7). Strong commodity prices led to an investment boom in the mining and quarrying, including oil, gas, and coal, and commodity related industries. Investment in the commodity sector accounted for half of annual realized investment during this period. This is in contrast with the 2000s when the manufacturing and service sectors were the main drivers for investment realization. The strong investment in the commodity sector has also been reflected in robust investment growth in Kalimantan and Sumatera, provinces based on commodities (Figure 8).
Figure 7.Investment Realization by Sector
Sources: EC Data Co. Ltd.; and IMF slaff estimates.
1/ Commodities also includes commodity based industries (food, wood, paper, rubber and, nonmetailc/meneral)
Figure 8.Direct Investment Realization
Sources: CEIC Data Co. Ltd.; and IMF staff estimates.
8. With the end of the commodity super-cycle and weakened economic growth, investment growth in the commodity sector stalled, while that in manufacturing contracted.
Investment growth in the commodity sector has stalled, limiting overall investment growth. During the commodity boom, particularly in the case of coal, new mining firms entered the market, while existing firms continued to expand production capacity. A sharp fall in commodity prices, in turn, resulted in a significant supply glut and slack capacity utilization. Some mining firms closed and reduced employees, while some mining firms faced difficulties in servicing debt obligations in 2015.
Investment in manufacturing has slowed markedly over the past few years, having been further impacted by the economic down-cycle. When commodity prices are high and economic growth is strong, robust household demand leads foreign corporates to invest more in manufacturing, including automotive. Since 2014, however, investment in manufacturing has sharply slowed, impacted by a confluence of weak economic activity, a slump in selling prices, and tighter borrowing conditions, such as the weak rupiah (Figure 9). In response to the soft economic activity and slack capacity utilization, a number of manufacturing firms operate on existing facilities and projects, rather than launching new projects.
Sourre: Haver Analytics.
9. Cash flows have fallen, particularly in manufacturing, which suggests limitations in investment capacity. In Indonesia, cash buffers are an important factor in investment decisions, since a number of corporates still rely on internal cash flows for funding, amid limited financial deepening. Cash flows, denoted by earnings before interest, taxes, and amortization (EBITA), have shown a sharp decline in non-commodity manufacturing (Figure 10). This implies limitations in financing capacity and the appetite for investment in manufacturing. The commodity sector has also exhibited a similar trend, albeit to a lesser extent, and has recently recovered somewhat. Despite the sharp fall in cash flows since 2011, Indonesia’s corporate profitability remains the highest among EM peers (Figure 11).
Figure 10.Indonesia: Corporate; EBITDA 1/
Sources: Orbis; and IMF staff estimates.
1/ Earnings before interest, taxes, and amortization.
Figure 11.Corporates Return on Assets
10. Macrofinancial linkages point to decelerated corporate borrowing and tightened financial conditions, which also weigh on investment. Corporate borrowing from banks and overseas has slowed, as corporates undertook consolidation and deleveraged their borrowing, particularly foreign currency denominated debt (Figure 12). While tepid credit demand from corporates has been the main driver of weak credit growth, corporates have also faced tightened financial conditions due to reduced cash flows and tightened lending standards in some banks (Figure 13). Banks have become more cautious, having been affected by weak economic activity and facing increased NPLs and tighter liquidity due to slowing deposit growth (Figure 14).
Figure 12.Growth: Investment-to-Capital and Credit and External Debt
Sources: Orbis; and IMF staff estimates.
Figure 13.Business Survey: Overall Industries
Source: Haver Analytics.
Figure 14.Loan and Deposit Growth
Sources: CEIC Data Co. Ltd; and IMF staff estimates.
D. Structural Factors
11. Structural impediments that cause higher fixed costs have also constrained investment, particularly in manufacturing. Over the past decade, investment in manufacturing has provided a limited contribution to overall investment. This is in contrast to the years prior to the Asian financial crisis, when manufacturing investment drove overall investment (Figure 7). A shift-share analysis (Elsby, 2013) suggests that investment in manufacturing and utilities has been lagging behind Indonesia’s overall investment trend (Figure 15). In contrast, investment in commodity and domestic consumption related industries, such as the wholesale and retail trades, exceeded the national investment trend. The continuing weakness in manufacturing investment has been affected by high-cost structural factors, such as weak infrastructure, uncertain investment climate, and low productivity from the labor force driven by rigid labor markets coupled with labor skill gaps (World Bank, 2016 and Tabor, 2015).
Figure 15.Drivers of Investment During 2006-2015
Sources: Orbis: and IMF slaff estamales.
12. In response, the government has started to improve the investment climate and has seen some early successes. The government has shifted the public debate towards policies to boost competitiveness and productivity. The business climate has started to improve, reflecting the government’s concerted efforts. The government has delivered 14 economic policy packages since August 2015 aimed at enhancing the investment climate mainly through deregulation, such as cutting bureaucracy and more one-stop shops, and rationalizing permit and license procedures. The FDI regime has been partially liberalized, the most significant move since 2007,3 and clarity has increased on the setting of the minimum wage. These actions have contributed to improvement in World Bank’s Doing Business ranking (by 18 positions to 91 position in 2016), and the authorities aim to improve it to within the top 40 in the near future (Figure 16).
Figure 16.Indonesia: Ease of Doing Business Indicators 2017
Source: World Bank
13. Nonetheless, structural bottlenecks that constrain investment in manufacturing remain, including:
Inadequate infrastructure, particularly logistics and energy. Underdeveloped infrastructure has been the most important barrier to investment in manufacturing and the third most important in services (Soejachmomen, 2015, Figure 17). Weak infrastructure has resulted in high costs and lost time in business decisions, weakening competitiveness and productivity. In particular, significant logistic costs and lack of reliable electricity adds real fixed costs to investment. For instance, weak road conditions and blackouts accounted for 4½ percent and almost 6 percent of total annual sales, respectively, and ownership of electricity generators for back-up power reached more than 60 percent in 2014, due to patchy power supplies (Institute for Economic and Social Research, 2014). In certain elements of logistics, indicators suggest that conditions have weakened this year (Figure 18).
Figure 17.Infrastructure Ranks
Sources: World Economic Forum, Global Competitiveness Report 2016-1017.
Figure 18.Ranking of Logistics Performance Indicators (LPI) 1/
Sources: World Bank: and IMF staff estímales.
1/ Out of 159 countries; LPI measures customs, infrastructure, international shipments, logistics, quality and competence, tracking and tracing, and timeliness.
The investment climate is still weak, with high regulatory compliance costs. Investment decisions tend to be costly and timing-consuming, due to inconsistent regulations among different layers of government, and burdensome regulations at the local level (e.g., nontariff trade barriers, local content requirements, and license regulations). Investors also express concerns about a lack of policy continuity and transparency, as well as regulatory uncertainty (Figure 19). The FDI regime, for instance, has a tendency for frequent and uncertain changes, and in some areas, the protection of domestic corporates was strengthened in the 2016 revision, which could undermine investor confidence and increase uncertainty.
Figure 19.Legal and Regulatory Risk 1/
Sources: Deloitte (2015) based on data from EIU and World Bank.
1/ Average of 2011-2015; higher index indicates higher risk.
The rigid labor market and labor skills gap have contributed to weak labor productivity, raising production costs. Indonesia’s labor markets remain one of the most rigid among EM peers, including high severance pay and complex work dismissal procedures (Figure 20). Rigid labor market practices have resulted in a proliferation of short-term contracts, in turn hampering labor skills buildup in the workplace (Allen, 2016). Investors note a lack of employees with appropriate job skills and vocational training, with gains in labor productivity have been lagging behind global trends and EM peers (Allen, 2016).
Figure 20.Labor Market Efficiency by Rank
Sources: World Economic Forum. Global Competitiveness Report 2016-17: and IMF staff estimai».
E. Weak External Linkages
14. The authorities have started to modernize the FDI regime, which will improve external linkages. Since August 2015, the authorities have started to enhance external linkages including through deregulations and the revision of the FDI regime. Prior to these reforms, Indonesia’s FDI regulations had become more restrictive, particularly in the primary sector (Figures 21 and 22). The restrictions were particularly rigid on foreign equity restrictions and hiring experienced foreign personnel (Varela, 2015).
Figure 21.FDI Regulatory Restrictiveness Index
Figure 22.Indonesia: FDI Regulatory Restrictiveness Index by Sector
15. Indonesia’s external linkages have lagged global trends. Exports of goods and services continue to trail world trends and regional peers and have decelerated since 2011 (Figure 23). Imports also show a similar trend, albeit to a lesser degree (Figure 24). Since commodity exports—including coal, crude, and palm oil—account for more than half of total exports in Indonesia, the decelerating growth in exports, in particular since 2011, can be also explained by weak growth in manufacturing exports, where structural constraints matter. In line with this trend, Indonesia’s share of the world market for manufactured goods fell to 0.6 percent in 2013 from 1.2 percent in 1995 (Tabor, 2015).
Figure 23.Exports of Goods and Services
Source: IMF, World Economic Outlook.
Figure 24.Imports of Goods and Services
Source: IMF, World Economic Outlook.
16. A closer look at exports shows that linkages with global value chains weakened across industries, particularly with low contribution from the services sector:
Foreign value-added share of gross exports declined. Since the Asian financial crisis, foreign value-added share of gross exports continued to decline (Figure 25). According to the latest available data, foreign value relative to gross exports in Indonesia is only around 12 percent, much lower than the levels of 30–40 percent in Malaysia, Thailand, and China (Figure 26). Given that cross-border production networks account for almost 50 percent of trade within ASEAN (Tabor, 2015), Indonesia demonstrates quite weak linkages even within ASEAN trade. The limited integration can be a drag on investment by reducing investment potential, as firms with higher imported inputs are exceptional performers in Indonesia and grow fast with larger capacity for investment (Rahardja and Varela, 2015).
Figure 25.Indonesia: Foreign Value Added of Gross Exports
Figure 26.Foreign Value-Added Share of Gross Exports
The service sectors’ contribution to exports is also low, mainly due to small contribution from foreign value (Figure 27). The small contribution from foreign value is broadly in line with the restrictive FDI regulations on the service sector. For instance, the rigid restrictions on hiring experienced foreign personnel in Indonesia is more detrimental to the service sector, as the service sector heavily relies on quick access to highly qualified personnel (Duggan and others, 2015). The service sector’s contribution to industry is weak across industries, from mining, food to chemicals (Figure 28). This suggests that there is room to strengthen the service sector, which will contribute to improve competitiveness and stimulate investment across industries.
Figure 27.Services Value Added Share of Gross Exports, 2011
Figure 28.Indonesia: Services Value Added Share by Industry, 2011
F. Drivers for Private Investment in Indonesia
17. This section is devoted to the empirical analysis of the drivers for private investment in Indonesia. The main hypothesis is that investment is driven by firm-level factors such as cash flows and access to finance, and also affected by macro-level factors including macroeconomic instability, international financial volatility, and policy uncertainty. Structural bottlenecks that cause high fixed costs and undermine corporate earnings could be a factor.
18. To estimate the drivers for private investment in Indonesia, firm-level panel fixed effects models are set up. This model uses the approach of Magud and Sosa (IMF, 2015b), which is based on liner panel regression allowing for both time and firm fixed effects, estimates determinants of private investment in EMs, including cash flows, changes in debt, and effective interest rate payments, among others. Data use the firm-level data of 370 listed Indonesian corporates for 2007–15, and macro variables, such as rupiah volatility, stock index volatility, and volatility index of the Chicago Board Options Exchanges (VIX) to incorporate factors beyond a firm-level, based on other existing literature. 4 The model is as follows:
I/K:I represents investment, measured as the firm’s purchase of gross fixed assets, and K is the stock of capital, measured as the total net value of property, plants, and equipment.
CF is cash flow, measured by EBITA.
ΔDebt is changes in debt.
Int stands for effective interest rate paid on total debt.
Q stands for the standard Tobin’s Q, estimated as the price-to-book value of the firm’s equity.
FX vol is rupiah volatility against the U.S. dollar (3 months). This is as a proxy for macroeconomic instability, based on Darby and others (1999).
VIX is the Volatility Index of the Chicago Board Options Exchanges (CBOE).
Stock vol is the volatility of Jakarta Stock Exchange Composite Index. This is a proxy for policy uncertainty, based on Baker and others (2015).
∈t is the time-specific fixed effect; θi the firm-fixed effect; and μi,t is an unobservable error term.
19. The estimation results confirm the hypothesis (Table 1). The empirical analysis concludes that private investment in Indonesia is affected by firm-level factors such as cash flows and access to finance. The analysis also concludes that macro-level factors, including macro instability, uncertainty arising from the international financial markets, and policy uncertainty in Indonesia, could have a negative effect on investment via lower cash flows. High-cost structural impediments that undermine corporate cash flows could have a negative effect on investment.
|Investment to Capital|
|Panel 1||Panel 2||Panel 3||Panel 4|
|Cash flow||0.65 ***||3.03 ***||1 02 ***||7.83 ***|
|Changes in debt||0.39 ***||0.39 ***||0.31 ***||0.35 ***|
|Lagged effective interest rate||−2.46||−2.44||−1.86||−2.20|
|Cash flow*rupiah volatility||−0.16 ***|
|Cash flow*VIX||−0.07 ***|
|Cash flow*stock price volatility||−0,37 ***|
Firm-level factors (Table 1, Panel 1)
Investment’s positive relationship with cash flows suggests that reduced cash flows during the economic downturn or commodity down-cycle could dampen investment. Cash buffers are an important factor in investment decisions, since Indonesian corporates still rely on internal cash flows for funding in Indonesia. The significance of cash flows in investment decisions leads to the discussion below that macro variables affecting cash flows could have an effect on investment in Indonesia.
Investment’s positive relationship with an increase in debt suggests that improving access to debt finance could contribute to investment (Table 1, Panel 1). Investment shows a positive relationship with a rise in debt, but no significant relationship with effective interest rate payment or Tobin Q. This suggests that alleviating access to debt finance is relatively more important than interest rate cost considerations or equity financing. In this context, improving access to debt finance, such as deepening corporate bond markets or strengthening bank’s asset quality or liquidity conditions, could support investment.
Macro-level factors: To estimate the effect of macro factors on corporate investment, interaction terms of macro variables with cash flows are tested, of which conclusion supports the hypothesis (Table 1, Panels 2–4).
Investment’s negative relationship with rupiah volatility suggests that maintaining macroeconomic stability is positive on investment (Table 1, Panel 2). Rupiah volatility is denoted for macro instability, based on Darby and others (1999) which find that exchange rate volatility can have an important negative impact on investment, albeit smaller than the cost of capital or expected earnings effects. The negative interaction term with rupiah volatility suggests that unstable macroeconomic conditions could weigh on investment, possibly through negative effect on higher cost of capital or lower expected earnings.
Investment’s negative relationship with VIX suggests that prolonged international financial volatility could weigh on investment (Table 1, Panel 3). Given corporates’ heavy reliance on external borrowing and exposure to foreign currency denominated debt (Ken and Shin, 2016), volatile international financial markets could lead to tighter external borrowing conditions or higher funding costs, and thus dampen investment decisions.
Investment’s negative relationship with stock price volatility possibly implies that strengthening policy certainty could support investment (Table 1, Panel 4). Equity price volatility is denoted for policy uncertainty, based on Baker and others (2015), which finds that policy uncertainty raises stock price volatility and reduces investment, especially in policy sensitive sectors such as infrastructure construction and healthcare. The negative interaction term with stock price volatility suggests that policy uncertainty could have a negative effect on investment, possibly via lower expected earnings.
The panel results could possibly imply that addressing costly structural impediments would help support investment growth. Reducing the major cost factors in production could help support investment by improving cash flows. These include accelerating infrastructure development, reducing regulatory compliance costs, and enhancing labor productivity.
20. Investment in Indonesia has also slowed more than in peer countries, with particular weakness in manufacturing. Sluggish commodity prices and soft economic activity have weakened corporate cash flows and limited internal financial space for investment. External financing such as bank loans or foreign bonds has also decelerated, partly because of weak investment sentiment and partly because some banks have tightened lending standards. At the same time, structural factors—such as limited infrastructure, the business climate, low labor productivity, and weakened linkages with global value chains—have hampered investment over the years, particularly in manufacturing.
21. To support the growth of investment, it is important to address the structural headwinds that raise the high cost of capital. With a pickup in commodity prices and economic growth, private investment is expected to gradually recover, but it is essential to address structural constraints and maintain stable macroeconomic conditions in order to sustain and expand the growth of investment.
22. In this regard, deepening structural reforms to support competitiveness and productivity growth could bolster private investment by lowering the cost of capital. Financial deepening to improve access to finance, such as domestic corporate bond markets, and continue to strengthen the financial system, would support investment. Accelerated infrastructure development would reduce logistics and energy-related costs and stimulate investment, especially in manufacturing. Stronger inter-agency coordination to streamline complex regulations and assure policy and regulatory consistency would alleviate costly factors. Opening new sectors of the economy to investment, particularly the primary and services sectors, and closing labor skill gaps through improved education, will strengthen the competitiveness and productivity of the economy and help sustain investment growth.
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Prepared by Jongsoon Shin (APD).
Private investment in this paper includes the investment of state-owned enterprises (SOEs).
The FDI regime was partially liberalized in May 2016, removing foreign ownership caps on 35 industries and allowing majority foreign ownership for selected sectors, but also limited access to some sectors to protect small and medium-sized enterprises (SMEs).