Indonesia: Selected Issues
Author:
International Monetary Fund
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Publication Date:
02 Jul 2004
eISBN:
9781451818314
Language:
English
Keywords:
ISCR; CR; Indonesia; export; bank; asset; IBRA; investment approval; climate study; E. government policy; composite index; FDI inflow; Foreign direct investment; Legal support in revenue administration; Infrastructure; Tax administration core functions; Asia and Pacific
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This Selected Issues paper takes stock of the progress made in meeting the objectives under Indonesia’s Extended Arrangements (1998–2003) program. The paper addresses progress in achieving the programs’ core macroeconomic objectives, with an emphasis on how Indonesia’s economic recovery compares with those of the other major Asian “crisis” countries. A major conclusion of the paper is that, while significant progress has been made against many of the key objectives of the arrangements, Indonesia’s overall economic performance has lagged behind others in the region.

Abstract

This Selected Issues paper takes stock of the progress made in meeting the objectives under Indonesia’s Extended Arrangements (1998–2003) program. The paper addresses progress in achieving the programs’ core macroeconomic objectives, with an emphasis on how Indonesia’s economic recovery compares with those of the other major Asian “crisis” countries. A major conclusion of the paper is that, while significant progress has been made against many of the key objectives of the arrangements, Indonesia’s overall economic performance has lagged behind others in the region.

V. Indonesia’s Investment Climate1

A. Introduction and Summary

1. This paper examines the factors underlying Indonesia’s relatively poor investment performance in recent years, and policies to enhance the investment climate. In business surveys, investors commonly cite a number of factors that impede investment, including the potential for a return of macroeconomic instability, institutional weaknesses that contribute to uncertainty and weak policy implementation, and inadequate infrastructure. In order to attract the levels of investment that Indonesia requires to meet its poverty reduction and employment objectives, it is widely recognized that the government will need to develop a supportive legal and institutional environment. Key aspects of such an environment include significantly reduced corruption, legal and policy certainty, improved revenue administration, and a competitive and flexible labor market.

B. Indonesia’s Investment Performance

2. Investment in recent years has remained weak. After a strong recovery in 2000-01, following a precipitous decline after the crisis, investment has remained relatively flat. The share of investment in GDP has averaged around 20 percent since 2001, down from a peak of over 30 percent before the crisis (Figure V.1).

Figure V.1.
Figure V.1.

Gross Fixed Capital Formation

Citation: IMF Staff Country Reports 2004, 189; 10.5089/9781451818314.002.A005

3. Foreign direct investment (FDI) similarly collapsed after the crisis and there have only recently been some signs of recovery. FDI inflows have fallen dramatically, averaging 1-2 percent of GDP in the post-crisis period, compared to above 5 percent prior to the crisis. Indonesia’s balance of payments have recorded persistent net outflows of FDI between 1998 and mid–2002, although net FDI turned positive in the second quarter of 2003. 2 While comparability of FDI data across countries is complicated by definitional differences, the balance of payments data indicate that Indonesia has been significantly less successful than its neighbors in attracting FDI (relative to GDP).

4. Investment approvals remain at or below their post-crisis average, although they show some improvement from the lows of 2002. Domestic and foreign investment approvals increased in 2003, albeit from a low base (domestic approvals almost doubled, while foreign approvals rose by 50 percent). Nevertheless, overall approvals in 2003 were still at or below their post-crisis averages.

C. Summary Indicators of the Investment Climate

5. Various summary indicators of competitiveness and the investment climate for 2003 place Indonesia in the lowest quartile of all countries ranked (Table V.1). These indicators consistently place Indonesia below its regional competitors as well. In the precrisis period, the International Country Risk Guide (ICRG) ranked Indonesia in the top half of all countries, but below the other Asian crisis countries (Figure V.2). With the onset of the crisis, the disparity between Indonesia’s ranking and that of the other Asian crisis countries and its neighbors further widened. In recent years, however, there has been some improvement in the ICRG rating for Indonesia. For example, Indonesia’s ranking in A.T. Kearney’s FDI confidence Index rose to 25 (out of 64) in 2003 its best ranking since the crisis, and various rating agencies have upgraded Indonesia a number of times since mid–2002.

Table V.1.

Investment Climate Indicators

article image
Sources: International Institute for Management Development; International Country Risk Group; and AT Kearney.
Figure V.2.
Figure V.2.

Indonesia’s ICRG Risk Ratings

Citation: IMF Staff Country Reports 2004, 189; 10.5089/9781451818314.002.A005

6. The regulatory environment for doing business in Indonesia is considered to be less conducive than in neighboring countries. The World Bank’s Doing Business Database provides indicators of the cost of doing business by focusing on regulations that enhance or constrain business investment, productivity and growth (Table V.2). According to the database, starting a business in Indonesia requires more procedures and time, but generally costs less, than in neighboring countries (and also compared to the broader averages in Asia). The laws relating to hiring and firing suggest that the Indonesian labor market is typically less flexible than in the rest of Asia. 3 Contract enforcement requires fewer procedures and takes less time than in some neighboring countries, although it costs more. Finally, closing a business takes on average 6 years (again, higher than in neighboring countries), and costs 18 percent of the estate (about the same as the regional average).

Table V.2.

Doing Business in Indonesia, 2003

article image
Source: World Bank Doing Business database (see www.rru.worldbank.org/DoingBusiness/SnapshotReports/Country.aspx?regionalid=90).

Lower values of the index indicate greater flexibility.

D. Key Areas of Concern

7. The crisis resulted in a prolonged period of macroeconomic instability, and a sweeping “regime change.” The resultant environment has been marked by a change in the “rules of the game,” with less predictability for businesses. In this context, the areas below—consistent with the findings of a number of recent assessments, and international comparative indicators—are highlighted as the key factors retarding investment in Indonesia (Box V.1).4

Macroeconomic Stability

8. The large swings in exchange rates, interest rates, inflation, and domestic demand severely impacted the Indonesian corporate and banking sectors. Despite a restoration of macroeconomic stability, the volatility of these indicators in recent years remains fresh in the minds of investors and financiers. It is thus not surprising that macroeconomic stability tops the list in the recent World Bank-AsDB survey of investor concerns, and still ranks high among concerns of international investors.

The Institutional Environment

9. Legal, institutional, and governance indicators for Indonesia compare unfavorably to neighboring countries (Table V.3). Measures of the quality of public institutions, government efficiency, and the regulatory environment place Indonesia near the bottom of all countries ranked, and consistently below neighboring countries. For example, Transparency International’s Corruption Perception Index ranks Indonesia 122 out of 133 countries, well below its peers. On measures of efficiency, integrity and effectiveness of the legal environment, Indonesia is again rated significantly below the rest of the sample. Political risk, according to the ICRG index, has increased significantly compared to the pre-crisis period, and Indonesia was ranked at 127 (of 140 countries) as of early 2003.

Table V.3.

Legal, Political, Institutional and Governance Climate

article image

Relates to perceptions of the degree of corruption as seen by business people, academics and risk analyst, and range between 10 (highly clean) and 0 (highly corrupt).

Index of legal and economic development constructed by Berkowitz et al.(2002) as a weighted average of Efficiency of the Judiciary, Rule of Law, Corruption, Risk of Expropriation & Risk of Contract Repudiation. Lower score=“better.”

The sum of dummies that identify one-share one-vote, proxy by mail, unblocked shares, cumulative vote/proportional rept., preemptive rights, oppressed minority and % of share to call an ESM. Higher score=“better.”

Assessment of the “efficiency and integrity of the legal environment as it affects business, particularly foreign firms” (La Porta et al., 1998), produced by Business International Corporation (a rating agency). Higher score=“better.”

10. Uncertainty stemming from the institutional environment translates into uncertain investment returns. The relatively poor legal and institutional environment, together with the dramatic change in the rules of the game (accompanying the political change in 1998) help explain why the crisis was so severe and protracted in Indonesia relative to the other crisis countries. With these changes came reduced coordination and proliferation in illegal “charges,” with a common perception that that these have increased in recent years. Survey results indicate that such corruption related costs are high in comparison to neighboring countries (World Bank) and are difficult to avoid, as a large share are accounted for by the payments to courts and the police.

Assessing Indonesia’s Investment Climate

Various recent studies have highlighted areas of concern regarding Indonesia’s investment climate:

A joint World Bank-Asian Development Bank private investment climate study is currently being prepared from surveys of investors in Indonesia. Preliminary results, based on responses of 400 firms mainly in Java, suggests that investors are most concerned about macroeconomic instability, policy uncertainty, and corruption, although other important concerns include tax rates and tax administration, cost of financing, the legal system, labor regulations and electricity. Decentralization has exacerbated the concerns of firms, particularly with regard to corruption and policy uncertainty, but to business licensing and labor regulations as well.

Regional Autonomy Watch (KKPOD) recently announced the results of its survey of over five thousand domestic and foreign firms located throughout Indonesia, and in various sectors of the economy. The survey identifies illegal fees as a major problem of doing business in Indonesia. It notes, moreover, that as the major recipients of these fees are the courts and police, businesses are unable to avoid paying them. The survey finds that 85 percent of responding firms reported having paid illegal fees, and that: (i) the average of illegal fees was around 2 percent of total production costs, and in the case of 3 percent of the respondents, was in the range 8–10 percent of the total production costs; (ii) illegal fees were on average around 60 percent of legal cost in government service agencies; and (iii) of the total fees paid, 13.1 percent were paid to court officials, 11.5 percent to security officers, 8.5 percent to community groups, and 6.1 percent to “thugs.”

A recent Japanese Bank for International Cooperation (JBIC) study notes that Indonesia has slipped to the sixth largest recipient of Japanese investment in 2003 (from fourth place in 2000), as Vietnam and India took the fourth and fifth places, respectively. The study cites the key factors discouraging investment as “the unstable political and social conditions, the local labor difficulties, as well as currency and price stability.”

A White Paper Monitoring Committee (consisting of groups representing domestic and foreign investors and independent economists) has been set up to monitor implementation of the elements of the White Paper of interest to the business community. The committee has highlighted three priority areas of (i) legal reforms; (ii) development of SMEs; and (iii) increasing labor force skills and empowering the poor.

Decentralization

11. While the decentralization process has generally been orderly, there have been some adverse consequences for the investment climate:

  • Survey results and discussions with entrepreneurs suggest that subnational regulations have created additional costs for business. Many subnational governments have increased the number of local taxes—as allowed under Law 34/00 which defines subnational taxes as an open list—leading to a proliferation of small ad hoc taxes and fees.5 The central government is given 30 days to review regional regulations and annul those that are in conflict with higher regulations/statutes. However, given the sheer volume of regulations submitted, only a fraction of these have been assessed within the required period, resulting in overlapping taxes and charges that are an additional burden on business.

  • Problems of corruption, policy uncertainty, business licensing, and labor regulations have been exacerbated, according to the preliminary findings of a World Bank-AsDB survey. Moreover, a recent study of the Regional Autonomy Watch reports that 20 percent of respondents indicate that regional regulations cause problems for them, with a vast majority (86 percent) indicating they were not involved in the formulation of regional regulations. Surveys also suggest that decentralization has created opportunities for new rent seeking at the subnational government level.

Tax Policy and Administration

12. While notable progress has been made in improving tax administration in recent years, this area still ranks high among the concerns of investors. Indonesia’s tax rates are generally at levels comparable to neighboring countries, but businesses often complain about uncertainty, particularly with respect to the amount of their tax liabilities, and that the appeals processes can be costly, complicated and ineffective, leaving them little protection.

Labor Issues

13. According to investors, in recent years the Indonesian labor market has become less flexible, more costly, and more uncertain. Minimum and industrial wages (the latter is an indicator of wages in the formal sector) have increased rapidly in recent years, significantly outpacing inflation and productivity growth (Figure V.3).6 The devolution of minimum wage setting to the regions in 2001 resulted in wide variations across regions and has led to a loss of policy coordination. In the aggregate, labor inputs in Indonesia are judged to be less productive relative to competitors; nonwage costs are higher as well.7

Figure V.3.
Figure V.3.

Wages and Prices

(1996=100)

Citation: IMF Staff Country Reports 2004, 189; 10.5089/9781451818314.002.A005

14. Based on various indicators, the formal labor market in Indonesia is less flexible than in much of Asia. The new labor legislation is a step forward as it provides a basic framework for labor relations, but care will need to be taken in devising the implementing regulations to ensure that the labor market does not become even less flexible. In particular, retrenchment and severance pay provisions under the new legislation must be defined carefully to ensure adequate flexibility while protecting workers’ basic rights. The same is true for employment provisions under the new bill.8

Infrastructure

15. The state of Indonesia’s infrastructure compares unfavorably to the region, and has deteriorated since the onset of the crisis. In 2003, Indonesia’s technology ranking (according to the Global Competitiveness Report) was at 78 of 102 countries, while its infrastructure ranking (according to IMD) was last among the 30 countries considered with populations greater than 20 million.9 The crisis contributed to the worsening of the problems in the infrastructure sectors, with infrastructure projects being postponed and scaled back, and some of the factors discussed above have also adversely affected infrastructure investment. For example, decentralization increased uncertainty regarding responsibilities for infrastructure provision, and weakened coordination mechanisms. The recent World Bank Report on Infrastructure (World Bank, 2003b) provides a more detailed assessment of the key problems and policy priorities in the infrastructure sector.

E. Government Policies to Attract Investment10

16. In the context of its White Paper, the government has adopted a number of policies to increase investment, exports and employment. These are summarized in Table V.4, and include the following key areas:

  • A proposed new investment law, which includes provisions to ensure the equal treatment of domestic and foreign investment; a one-stop shop for investment approval; removal of the requirement that foreign-owned companies divest part of their shareholdings to national shareholders; and allowance for foreign investors to repatriate most funds (subject to tax obligations having been settled).11

  • Improvements to the decentralization framework, through the revision of the decentralization laws.

  • Revenue administration reforms, including tax law amendments to strengthen policy and administration (focusing on extending the large taxpayer office model, providing better taxpayer services, improving governance, and medium-term modernization); and improving customs administration, with a particular emphasis on strengthening governance, facilitating trade, combating smuggling, and improving valuation control.

  • Completion of the new legal framework for labor issues.

  • Improvements to infrastructure, encompassing transportation, communications, energy, power, and water resources (with action plans in the form of projects, and the development of appropriate legal and regulatory frameworks).

  • Institutional/governance reforms, encompassing legal reforms, enhancements to security and law and order, and improved provision of public services (such as health, education, and sanitation).

Table V.4.

Key Initiatives in the White Paper to Improve the Investment Climate

article image
Source: Data provided by the Indonesian authorities.

17. A number of challenges will need to be addressed with the design and implementation of these policies. For example, to strengthen the decentralization framework, the related law amendments will need to be accompanied by reforms to enhance the governance framework, along with efforts to improve institutional capacity at the local government level and to ensure adequate coordination among the various levels of government. Indonesia’s infrastructure needs will require large investments over the medium term, with private sector participation which will, in turn, increase the importance of providing greater investment certainty through improved enforcement of property rights and contracts. Important legal reforms aimed at combating corruption and improving the functioning of the judiciary, commercial courts, and law enforcement will need to be complemented by the appointment of adequate professional staff and sufficient budget allocations.

F. Conclusion

18. With a number of major legislative changes in the pipeline, the priority going forward should be to improve policy certainty and coordination. Implementation of the reforms noted above will be key. For example, the revisions to the decentralization laws will need to be accompanied by appropriate structural reforms such as a strong governance and coordination framework. With regard to the labor laws, much of the detail remains to be fleshed out through a large number of implementing regulations.

19. Priorities over the medium terms include key legal and public administration reforms in support of a conducive policy environment. The legal reform priorities include enforcing property rights and contracts, together with creating an efficient judiciary, with the aim of bolstering legal certainty in the implementation of commercial law. In the area of public administration, the challenge is to improve governance and efficiency, particularly in the areas of tax and customs administration.

References

  • World Bank, 2003a, “Indonesia: Beyond Macro-Economic Stability,” World Bank Brief for the Consultative Group on Indonesia.

  • World Bank, 2003b, “Averting an Infrastructure Crisis: A Framework for Policy and Action,” (World Bank, 2003b).

  • World Bank, 2003c, “Maintaining Stability, Deepening Reforms,” World Bank Brief for the Consultative Group on Indonesia.

1

Prepared by Yougesh Khatri.

2

The FDI series has been revised to include divestment and IBRA asset sales to nonresidents. Moreover, from 2002 onwards, the official FDI series changed its methodology, reducing the ownership threshold from 50 percent to 10 percent. Net FDI is defined as FDI into Indonesia less FDI by Indonesia abroad.

3

These indices do not take into account the new implementing regulations of the Manpower Act (March 2003) and the Dispute Resolution Act (January 2004) which are in the process of being issued.

4

A broad array of other issues may also have affected investment in Indonesia: security concerns, separatist movements and regional conflicts; and high profile disputes involving multinational corporations and defaults on international borrowing.

5

The new taxes include fees for ID cards for expatriates, local taxes on heavy equipment, and charges for timber in addition to the fees already paid to the central government for the Reforestation Fund.

6

Taking the growth in income per worker averaged over the period.

7

Value-added per worker in Indonesia compares unfavorably to India and China in key sectors such as electronics, textiles and garments (World Bank, 2003a); and severance costs in Indonesia are a multiple of those in Vietnam or China.

8

For example, short fixed-term contracts are only permissible if the job is “temporary by nature or seasonal,” and outsourcing is restricted for activities that are not strictly auxiliary to the activities of the enterprise. Varying interpretations of these various provisions could act to limit firms’ flexibility in employment and production arrangements.

9

A bright spot appears to be telecommunications sector which, following liberalization in 1999, has seen significant growth in mobile phone users.

10

Currently, the Capital Investment Coordinating Board is the main body responsible for promoting foreign investment and approving investment proposals. Other mechanisms to promote investment and exports include the Bonded Zones and Integrated Economic Zones.

11

The proposed law is meant to be an umbrella for investment activities outside of upstream oil and gas, and financial services, which come under separate law. Note that nearly three years after passing the current oil and gas, some of the necessary implementing regulations have yet to be issued.

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Cover IMF Staff Country Reports
Indonesia: Selected Issues
Author:
International Monetary Fund
Volume/Issue:
Volume 2004: Issue 189
Publisher:
International Monetary Fund
ISBN:
9781451818314
ISSN:
1934-7685
Pages:
82
DOI:
https://doi.org/10.5089/9781451818314.002
Figure V.1.

Gross Fixed Capital Formation
Figure V.2.

Indonesia’s ICRG Risk Ratings
Figure V.3.

Wages and Prices

(1996=100)