5 Three Basic Wisdoms to Attract Foreign Direct Investment: An Indonesian Experience

Claire Liuksila
Published Date:
December 1995
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Dahlam M. Sutalaksana

When Indonesia embarked on a more rational attempt to develop its economy at the end of the 1960s, it began by enhancing private sector involvement, including inviting foreign direct investment (FDI). It goes without saying that investment policy should be accompanied by a series of policy reforms and a good development strategy to ensure the success of development program implementation. High priority should be given to encouraging international participation in the development process. The core of a good development strategy is to combine the country’s commitment in three areas; namely, to provide suitable legal backup to investors, to keep the economy on a stable growth track, and to follow a development strategy to adjust domestic conditions to international investors.

Hosting International Investors

The first step is to modify the legal system to make it easier for foreign investors to do business. In Indonesia, this first step was the enactment in 1967 of Law No. 1 on Foreign Investments and its counterpart in the following year, Law No. 6 on Domestic Investments. This was followed by a number of other measures. The Capital Investment Co-ordinating Board, the Badan Koordinasi Penanaman Modal (BKPM), was established in 1973 to act as the hosting agent for international investors. BKPM was charged with the evaluation of foreign direct investment proposals and coordinating approvals of several government agencies (basically “an under one roof policy” for FDI licensing). The BKPM also coordinates the comprehensive evaluation of FDI implementation in an effort to improve the flow of FDI to Indonesia. Since its establishment, the BKPM has worked on a series of measures to simplify the approval process for FDI, including the reduction of administrative requirements for investment approval.

The changes in Indonesia’s investment laws made during 1970-90 were designed to give certainty to profit repatriation, expand sectoral coverage and foreign ownership, and clarify taxation. This improvement in the legal framework has encouraged private investment, especially in manufacturing and non-oil export production over the past two decades. The most recent improvement in the legal framework for private investment was Government Regulation No. 20 (1994), which opened more sectors to foreign investors and enlarged foreign ownership, including in sectors regarded as strategic sectors.

Economic Reforms to Support Stable Economic Growth

The series of major economic reforms taken in Indonesia since the early 1970s represented a decisive step in attracting FDI. The first major reform was the liberalization of the foreign exchange system in 1971, replacing the previous controlled regime. The objective of this reform was to restore the balance of payments to a sustainable position. It had severely deteriorated since early 1960 because of inappropriate policies. Given Indonesia’s heavy dependence on international trade, a liberal foreign exchange system was considered to be a precondition for building a strong international base for the economy.

Nevertheless, this policy was not without difficulties. The new international financial environment that arose from the collapse of the Bretton Woods system in the early 1970s, which resulted in a major increase in international capital movements, demanded a more active domestic monetary policy. One of the necessary conditions for a successful foreign exchange policy is to avoid excessive domestic inflation, while keeping interest rates at competitive levels. In principle, the rule is to stick to a balanced budget policy, to sterilize capital inflows, and to attune bank credit expansion to the required level of money demand. However, despite the success achieved in real sector development in Indonesia, the financial system remained vulnerable to other developments in the economy. The worldwide oil crisis required the government to reinforce its policies by a set of adjustments that included financial reforms in the 1980s.

Since Indonesia executed its First Five Year Plan, oil has been the major determinant of its economic growth. From 1973 until 1983, Indonesia’s economy was extremely dependent upon oil exports. Oil exports were the main source of foreign exchange revenues. Government revenues from oil averaged 52 percent of total government revenues annually and 64 percent of domestic revenues. Therefore, at the beginning of the 1980s, when world oil prices fell sharply, followed by a world recession, the real economy and the balance of payments showed unsatisfactory performances.

To cope with this problem, in January 1982, the government introduced a new policy to promote non-oil exports. This policy included reducing the interest rates applied to export credits and the requirements for export credits, and increasing export facilities. On March 30, 1983, the government devalued the rupiah by 27.8 percent and, at the same time, reconfirmed Indonesia’s free foreign exchange system and managed floating exchange rate policy. The devaluation was mainly aimed at increasing the competitiveness of traded goods. Along with these policies, some large development projects were rephased to place less stress on the balance of payments, and cuts in food and other subsidies were made.

The decline in oil export revenues was expected to place heavy constraints on the government’s role in economic development. Therefore, the private sector had to be encouraged to take a greater role in the economic development process. This greater role would be facilitated by mobilizing more funds for the private sector through the financial system and by reducing market controls. In response, the government altered the monetary and banking environment, and the central bank launched the first major fundamental policy reform, intended primarily to provide a new foundation for a sound market-oriented banking system. It marked the beginning of the true integration of the banking system. Although previously the state banks had enjoyed a concessionary position within the banking system, through the deregulation they are now treated the same as other banks. The new environment encouraged competition among banks in mobilizing funds, and in determining deposit and lending rates in such a way that margins would be sufficient to maintain the desired level of profit. As a consequence, banks became more concerned with raising efficiency, and improving the professional management of their operations. In this way, a climate conducive to sound market competition among banks has emerged, therefore creating an opportunity for the market system to work properly.

With a view to sustaining and achieving sufficiently high economic growth as well as expanding employment opportunities, the second package of fundamental deregulations for the financial, monetary, and banking fields was introduced in October 1988. The package contained a series of measures designed to promote mobilization of funds, non-oil exports, efficiency in the operations of banks, effectiveness in the implementation of monetary policy, and development of the capital market.

To accelerate the development of the capital market, policies were implemented to equalize the tax treatment of investment income, with a flat withholding tax of 15 percent on time deposits, saving deposits, and certificates of deposit, with the possibility of tax restitution for small savers (the withholding tax of 15 percent was eventually extended to capital gains earned in the capital market); and permission was given for banks to raise capital through the issuance of new shares in addition to increasing the equity participation of existing shareholders. Though the reforms were concentrated in the financial sector, it was expected, however, that an efficient and effective financial sector could in turn lead to an effective and efficient real sector. The reforms also provided for the clearer division of roles and rules of the game among monetary, fiscal, and sector policies.

The objective of the economic policy reform taken over the past decades was to preserve economic stability in the face of declining oil resources. The strong emphasis on macroeconomic stability and the willingness of policymakers to make hard decisions in times of boom and bust have kept Indonesia’s performance on track. In turn, this stance improved Indonesia’s credibility internationally and consequently increased its attractiveness as an outlet for FDI.

Securing Domestic Conditions to Attract International Investors

The policy of adjusting domestic conditions to attract international investors consists of a number of measures. The first issue is how to ensure the long-term stability of the country, economically as well as politically. Since 1971, Indonesia has routinely had general elections every five years. The representation of each and every social interest has been secured in the House of Representatives as well as in the People’s Assembly. A stable government has been in place for decades, based on the 1945 Constitution and the Pancasila (the five Basic Principles) philosophy. A system of centralized government with wide regional autonomy is well established, and peaceful and meaningful regional as well as international cooperation is the main foreign policy objective of Indonesia.

Indonesia’s population problem was addressed in at least two successful programs, namely through family planning, which reduced Indonesia’s population growth to 2 percent or less, and through achieving self-sufficiency in rice, the main staple food of the population. The latter was achieved through a policy that kept the agriculture sector growing (although at a lower rate), while the industrialization process was also under way.

The second issue that was addressed was making international investors familiar with Indonesia. Most of the investors came from a market-based economic system with strong ownership of capital and an active role of the private sector. In this respect, the surge in foreign investment implicitly (in several cases explicitly) confirmed the establishment of a market-based economy in Indonesia with a strong role for the private sector.

In countering the red tape issue, the government has taken clear steps toward deregulation and debureaucratization in the licensing and approval process to reduce the unnecessarily high costs to the economy of these regulations.

Last but not least is the legal issue. By joining international organizations, globally as well as regionally, Indonesia has clearly shown its concern for international laws and conventions in all sectors.

Almost three decades of Indonesian experience in hosting FDI have proven that the country’s national and policy commitment was undoubtedly essential in attracting FDI. Indonesia has been a good host to international investors in all respects, has maintained economic growth with stability, and has adjusted domestic conditions to suit foreign investors.

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