Indonesian Investment Climate and Foreign Direct Investment after the Asian Economic Crisis

Since the late 1980s up to the onset of the Asian economic crisis Indonesia experienced a surge in domestic and foreign direct investment. This surge was attributable to the successive deregulation measures which the Indonesian government had introduced after the end of the oil boom in 1982 to improve the investment climate for both domestic and foreign private investors. It was hoped that with a better investment climate, a more dynamic and efficient private sector would develop which would function as a new engine 17 of growth and major source of non-oil export revenues to offset the fall in oil export revenues.

Besides these deregulation measures, the government also introduced a series of trade reforms to reduce the strong anti-export bias of the protectionist trade regime. These trade reforms were intended to shift the import-substituting pattern of industrialisation during the oil boom era of the 1970s to an export-promoting one. The aim was to encourage the non-oil and gas sectors, particularly the manufacturing sector, to generate an expanding stream of non-oil exports to offset the decline in oil exports as well as an expanding stream of non-oil taxes to offset the decline in oil tax revenues.

As a result of the improvement in the investment climate and the reduction in the antiexport bias of the trade regime, export-oriented domestic and foreign direct investment (FDI) inflows since the late 1980s rose rapidly. Most of the export-oriented FDI came from the four East Asian newly-industrialising economies (NIEs)., particularly from South Korea and Taipei,China. Since the late 1980s many Korean and Taiwanese were relocating their labour-intensive operations to lower-wage countries in Southeast Asia, including Indonesia. The reason was that wages in their countries had risen rapidly and their currencies appreciated steeply, thus causing their labour-intensive industries to lose their comparative advantage (Thee, 1991: 55).

The surge of FDI into Indonesia since the late 1980s through 1996 occurred in two waves. The first wave occurred in 1988-90 when Indonesia’s textile sector (including the garment and footwear sub-sectors) received large amounts of export-oriented FDI from the East Asian NIEs. That investment led to the trebling of textile and garment exports in the four years to 1992/93 when they were Indonesia’s largest non-oil exports (World Bank, 1996: 12).

The second wave of FDI inflows started in early 1994. This wave was in part driven by a worldwide boom in FDI. By late 1994/early 1995 FDI inflows also rose rapidly as a result of the significant liberalisation of the foreign investment regime in June 1994. This liberalisation was intended to attract more export-oriented FDI to sustain the growth of Indonesia’s manufactured exports (World Bank, 1994: 12).

However, after the Asian economic crisis, domestic investment and FDI declined steeply, largely as a result of the deteriorating investment climate. As investment is crucial to raising economic growth, improving the investment climate is arguably Indonesia’s key economic priority (World Bank, 2005a: iv). Thus far economic growth is still largely driven by consumption growth. Even though investment, including both domestic and foreign, has slightly picked up in 2004 and 2005, in the long term the current situation is not sustainable.

This section will first discuss Indonesia’s recent growth and investment performance since the late Soeharto era in the mid-1990s. It will then discuss Indonesia’s poor investment climate, and the measures which the current government has to undertake to improve the investment climate.

3.1 Economic and investment growth

The severe economic contraction in 1998 was slightly reversed in 1999, when the economy grew again, though at a miniscule 0.8 per cent. From 2000 through 2003 economic growth was mainly driven by private and public consumption, while fixed investment, just like in the preceding years after the crisis, remained sluggish. As a result of sluggish investment growth, the investment to GDP ratio in 2003 dropped to 17.8 per cent in 2003, the lowest level since the early 1970s (World Bank, 2004: 2). During the late Soeharto era the investment to GDP ratio was around 30 per cent.

However, in 2004 for the first time after the Asian crisis GDP growth just exceeded 5 per cent. This time growth was not only driven by consumption, but also by investment, the growth of which for the first time after the crisis grew at double digits, namely 15.7 per cent. Export growth at 8.5 per cent was also higher than in 2002 and 2003. During the first and second quarters of 2005 fixed investment continued its double-digit growth (Table 1 [ PDF 67.8KB | 1 page ]).

Investment growth in 2004, however, was just like in the preceding years, mainly driven by investment in new property, accounting for 80 per cent of total fixed investment. But an expansion in the output of the capital goods industries and machinery imports also indicated that productive investment was gradually increasing (World Bank, 2005: 2). In fact, since the first quarter of 2004 through the first quarter of 2005 the double digit investment growth in machinery and equipment was far higher than investment in construction, which during this same period was only growing at single digits (McLeod, 2005: 135).

In general, however, both domestic investment and FDI remain sluggish. Domestic investment in the coming years is likely to stagnate in the coming years because after the 19 Asian financial crisis banks prefer to provide credit for consumption rather than for riskier investment. They also lack the long-term resources to finance growth in Indonesia. The reason is that more than 90 per cent of bank deposits are three month or less in maturity (World Bank, 2005c: 66, 88).

3.2 FDI in Indonesia after the Asian economic crisis

In view of the sluggish growth of domestic investment, new FDI inflows are needed for Indonesia’s economic recovery and future growth. However, in contrast to Thailand and particularly Korea, into which new FDI flowed again not long after the Asian crisis (World Bank, 2000: 6), Indonesia experienced continuous net FDI outflows since 1998 through 2003. The sluggish growth in FDI in Indonesia is a source of concern for the government. New FDI inflows not only strengthen the host country’s currency, but can also promote corporate restructuring, and allow infusions of new technologies and management methods (World Bank, 2000: 6) to revitalize the manufacturing sector.

A reflection of the lower competitiveness of Indonesia as a suitable location for FDI is that during 2002, more than 40 Korean firms and 10 Japanese firms left Indonesia to relocate to countries with a more favorable investment climate. The large majority of Korean firms left primarily because of frequent labor disputes and rapid increases in wages due to the annual mandatory rise in minimum wages. Many of these Korean firms relocated to Southeast Asian countries with lower wages, including Vietnam (Kinoshita, 2003: 4). Since then more foreign firms, including Sony, and a number of export-oriented domestic firms, have also left Indonesia.

Data on net FDI flows into or from Indonesia can be found in Bank Indonesia’s bilingual monthly Indonesian Financial Statistics (Statistik Ekonomi dan Keuangan Indonesia), specifically the section on the balance of payments (BOP). These data on net FDI flows monitored and recorded by Bank Indonesia (BI) are arguably the best source of information on realised FDI in Indonesia (Table 2 [ PDF 60.5KB | 1 page ]). For this reason both the IMF and UNCTAD in its annual World Investment Report use these BI data as the basis of their own data on realised FDI in Indonesia. However, while these BI data are quite reliable, they do not provide a complete picture of FDI in Indonesia, as they do not include the reinvestment of the profits earned by FDI firms. These net FDI outflows data also do not only include real capital flight by foreign investors, but also the debt service payments for long-term loans provided by their foreign principals in the home countries to their FDI projects in Indonesia.

There was great concern when over the period 1998 – 2003 Indonesia experienced net FDI outflows, although in 2002 a small net FDI inflow took place. To a large extent the net FDI outflows since 1998 through 2003 were caused by the fact that FDI inflows in the form of equity and long term loans to FDI projects as well as the proceeds from privatisation and banking restructuring were exceeded by the amount of repayments by FDI projects of long term loans to their principal overseas or to a foreign bank

However, in 2004 and the first half of 2005 net FDI inflows were again recorded. These net FDI inflows, though still smaller than during the investment boom years of the early 1990s, indicate that perceptions of foreign investors about Indonesia’s investment climate, though still unfavourable, have slightly improved after the election of President Susilo Bambang Yudhoyono in 2004. However, these net FDI inflows should not be a reason for complacency as Indonesia’s investment climate is still regarded as the worst in Southeast Asia.

3.3 FDI in Indonesia in regional perspective

The downturn in FDI in Indonesia after the Asian economic crisis is also evident if FDI flows to Indonesia after the Asian economic crisis are compared to the FDI flows to the other East Asian countries (Table 3 [ PDF 68.3KB | 1 page ]). Despite the weak investment climate of the past few years after the Asian economic crisis, most East Asian countries except Indonesia experienced positive FDI inflows. The contrast between Indonesia on the one hand and on the other Thailand and South Korea, the two other East Asian countries most severely affected by the Asian economic crisis, is evident. The latter two countries never experienced net FDI outflows at any one year after the crisis. Hence, Indonesia has shown the worst experience of any large country in the East Asian region during the post- Asian economic crisis period (Castle, 2004: 72).

It is clear that for the past decade the People’s Republic of China (PRC) has drawn by far the largest amount of FDI inflows, dwarfing the combined FDI inflows of all the other East Asian countries. Hence, these East Asian countries, particularly Indonesia, have to made a serious effort to improve their relative attractiveness as a suitable location for FDI. This need takes on added importance as the drive to attract FDI is significantly more competitive globally at present than at any time in the past decade (Castle, 2004: 74).

While PRC is indeed a formidable competitor in attracting large FDI inflows, the data on FDI inflows into PRC should be qualified. The FDI inflows into PRC are based on officially recorded FDI inflows which give an upward bias to PRC’s position. It is widely assumed that ‘round-tripping’, that is the export of domestically generated funds and its return to its country of origin as FDI, is more significant in PRC than elsewhere (Weiss, 2004: 6-7). Three reasons have been advanced to explain the phenomenon of ‘round-tripping’ in PRC, namely that the reinvestment of flight capital may have had its origins in the ‘black’ economy; that there is a preference to register enterprises as FDI to take advantage of tax incentives not available to local firms; and that there is a preference to incorporate companies abroad (particularly in Hong Kong, China) to take advantage of better legal protection, a better reputation and corporate governance, and superior financial services (Weiss, 2004: 7).

Despite serious concern that the FDI inflows into PRC will have an adverse effect on the FDI inflows into the other Asian countries, this is not necessarily the case for all Asian countries. A recent study by Barry Eichengreen and Hui Tong found that FDI into PRC provides a larger boost to FDI into high-income Asian countries that are producing components and capital equipment for production and assembly operations in PRC. Unfortunately, this is not the case with low-income Asian countries, including Indonesia, which do not make components and capital equipment for PRC’s production and assembly operations (Eichengreen & Tong, 2005: 10). This is confirmed by the findings of the latest survey on Japanese-affiliated manufacturers in Asia, conducted annually by the Japan External Trade Organization (JETRO), which found that the imported materials/parts cost ratio for these manufacturers was 71 per cent or more. This figure was higher than in Malaysia, the Philippines, and Thailand, where the materials/parts cost ratio ranged between 50-70 per cent. The reason for the higher materials/parts cost ratio in Indonesia is that its domestic supporting industries are relatively underdeveloped. Consequently, Japanese manufacturers engaged in assembling operations have to import a lot of their materials and parts and components (JETRO, 2005: 17). Hence, for low income Asian countries, such as Indonesia, PRC is indeed a formidable competitor in attracting FDI.

3.4 Indonesia’s current investment climate

In its review of the economic prospects for 2004, the National Development Planning Agency (Bappenas) listed the major domestic impediments to investment which have adversely affected Indonesia’s investment climate in the post-Soeharto period.2 These factors have in general also been mentioned by other observers of foreign investment in Indonesia. In a seminar in Jakarta in October 2004, Professor Toshihiko Kinoshita also pointed out largely similar impediments to investment, particularly FDI3. However, he also pointed out that foreign investors still tend to view Indonesia as a country with big potential. This potential would be enhanced by AFTA and the free trade agreements it will sign with a number of important non-ASEAN countries.

A better idea of Indonesia’s competitiveness in regard to its investment climate compared to that of the other Southeast Asian countries is presented in Table 4 [ PDF 78.1KB | 1 page ].

The above data were obtained from World Bank-sponsored Investment Climate Surveys in 53 developing countries, including Indonesia, for 2001-2003. These surveys were held to help the governments in these countries to design good investment policies, since a good investment climate requires government policies that provides an environment in which both domestic and foreign firms and entrepreneurs can invest productively, create jobs, and contribute to growth and poverty reduction (World Bank, 2005b: 277). Hence, the ultimate goal is to create an investment climate that benefits society as a whole, not just individual firms or entrepreneurs or a group of firms or entrepreneurs.

The data in Table 4 [ PDF 78.1KB | 1 page ] show that as regards policy uncertainty, corruption and the lack of confidence in the courts to uphold property rights, Indonesia’s investment climate is worse than in Malaysia and the Philippines, even though the Philippines is not known for its favourable investment climate. Firms in developing countries, whether domestic or foreign, rate economic and regulatory policy uncertainty, as their dominant concern among investment climate constraints. Hence, the high percentage of the responding firms which rated policy uncertainty in Indonesia as their dominant concern deserves serious attention from the government. This also applies to the problem of corruption, where the percentage of firms operating in Indonesia rating corruption as their major constraint is much higher than in the other countries. As good and dependable courts reduce the risks which firms face, particularly when the number of large and complex long-term transaction increase (World Bank, 2005b: 277), the high percentage of firms in Indonesia rating this problem as their major constraint also deserve serious attention by the government.

Even though in regard to some indicators, the difference between PRC’s investment climate and that of Indonesia is not large, PRC has been able to attract vastly more FDI than Indonesia. This suggest that besides a country’s investment climate, the country’s growth prospects and the lure of a vast, rapidly growing market and of a suitable export base because of relatively low wages, such as PRC has, are also important ‘pull’ factors in attracting FDI inflows, as Indonesia itself experienced from the late 1980s up to the Asian economic crisis.

A look at the views of Japanese manufacturers on the relative attractiveness of various potential host countries, including Indonesia, is of interest, as they are the largest foreign investors in Indonesia’s manufacturing sector (Table 5 [ PDF 70.3KB | 1 page ]).

The data in Table 5 [ PDF 70.3KB | 1 page ] confirm that PRC in the medium term is currently by far the most attractive host country for FDI by Japanese manufacturers, far outranking Indonesia. However, as this table reflects the views for the medium term rather than the short term, these unfavourable views on Indonesia may change in the near future if the Indonesian government is capable of improving the investment climate.

According to the World Bank, governments in developing countries in general face four primary challenges in improving the investment climate and achieving a proper balance between providing firms with incentives to invest and the interests of society. These challenges are:

1. Establishing credibility by maintaining economic and political stability and restraining arbitrary behaviour by the key agencies of the state;

2. Restraining corruption by public officials, firms and other interest groups.

3. Fostering public trust and legitimacy through participatory policy-making, transparency, and equity.

4. Ensuring that government policies realistically reflect current conditions and adapt to changing economic and business conditions (World Bank, 2005b: 277).

Improving the investment climate

To a larger extent than has been the case with the previous post-Soeharto administrations, the current administration has realized that raising the country’s growth rate to 7 percent by 2009 requires a substantial increase in new investment. The government realises that to achieve this, a substantial improvement in Indonesia’s investment climate is crucial. The government is also quite aware that an important weakness of the previous administrations was their inability to make significant progress in improving the country’s investment climate. This failure was not so much due to economic policy, but due to weaknesses in legal certainty and law enforcement, corrupt tax and customs officials, and labour laws and regulations (Sadli, 2004).

Hence, the current challenge facing the government is to create a strong political will and to do its ‘homework’ by tackling the problems deemed as constraints to investing in Indonesia (Kinoshita, 2005: 2). The determination of the government to achieve significant progress in improving the country’s investment climate is evident from the President’s recent instruction that the time taken to obtain investment approvals should be reduced to one month from the current 151 days. This has to be achieved by reducing the licensing procedures to start up and operate businesses to the same level of efficiency as those of the other ASEAN countries. In addition, the government is also focusing its efforts on reducing the high costs of handling exports and imports in the ports and customs areas. In its medium-term development plan for 2004-2009, the government has also set a goal of achieving at least half of the five-year targets for improving the investment climate within the first three years (Citigroup, 2005: 1-3).

Aburizal Bakri, the then Coordinating Minister for Economic Affairs, in 2004 stated that the government is preparing to change the role of the Capital Investment Coordinating Board (BKPM) from an investment approval agency to an investment promotion agency. Once this transformation of BKPM’s role has been accomplished, private investors, including foreign investors, will not need to obtain licenses any more from BKPM. Instead, they would only need to obtain the services of a notary, who would then contact the Department of Justice and the relevant technical departments to inform these agencies of the planned investments. Once this has been done, the investors can start investing in their planned project (Kompas, 2005: 13).

Indonesia’s investment climate, there is reason for hope as this government is the first post-Soeharto government which has staked its reputation on improving the investment climate. Judged by outcomes, the past year has seen relative success, as the rate of investment has risen significantly since 2004 and this lasted through the first two quarters of 2005 (Table 2 [ PDF 60.5KB | 1 page ] above). As a result the rate of investment has reached 22 per cent of GDP in the second quarter of 2005 after remaining flat at around 20 per cent of GDP for most of the time after the crisis. During the previous Megawati administration’s ‘Year of Investment for 2003-2004’ the investment rate fell to below 19 per cent. However, as PRC’s current investment rate is 45 per cent, while that of Vietnam is over 30 percent (Sen & Steer, 2005: 291), more determined and focused measures need to be taken to increase the investment rate further.

Unlike the previous three years, when new investment was heavily concentrated in real estate development, which had reached 83 per cent in 2003 from around 70 per cent in the early 1990s (Ishihara & Marks, 2005), since 2004 more investment has taken place in non-property activities, such as machinery and transport. These figures indicate an expansion in production capacity (Sen & Steer, 2005: 291). This is a positive development, because during the past few years investment was not forthcoming because of the poor investment climate. This is even though capacity utilization levels had reached high levels, estimated at an average of around 70 per cent by the Central Agency for Statistics (BPS), which should have triggered new investment (Ishihara & Marks, 2005). In fact, at the end of 2004 capacity utilization was higher than at any time since Indonesia was hit by the economic crisis in 1997/98. In some sectors there was, for the first time since the crisis, no possibility of expanding output without new investment (Sen & Steer, 2005: 292). That investment has finally increased, though rather slightly, thus indicates a renewed sense of confidence on the part of domestic and foreign investors in the future of the country.

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Comment(s)

There are [2] comment(s) for this entry. Post a comment.

1. Thee Kian Wee
   (posted 09 May 2006 / 01:39:20 PM)
   
   Dear Mr. Cabalza,
   
   You are absolutely right that the ethnic Chinese, both totoks and peranakans have played and are still playing an important rule in the Indonesian economy. I did not mention this in my paper, as my focus was on how the perception on the part of several Indonesian policy-makers of Chinese economic dominance have shaped various policies to curtail Chinese economic activities in order to promote indigenous Indonesian entrepreneurship. Most of these policies have not succeeded in substantially reducing the economic role of the Chinese, although over time a growing class of indigenous Indonesian entrepreneurs emerged during the New Order era without, however, substantially reducing the economic role of the Chinese.
   
   While during the late Soeharto era much resentment arose in response to the growth of Chinese-owned and -controlled conglomerates, it is often forgotten that the large majority of Chinese business consists of the large number of small- and medium-scale enterprises (SMEs) operating in manufacturing, trade, transportation, restaurants, and other services, such as the many shops all over Indonesia selling auto parts, electronic products, auto repair shops, and various other economic activities which keep the Indonesian economy running. The surge of manufactured exports after the deregulation measures and trade reforms after the end of the oil boom was to a large extent due to foreign-invested, export-oriented plants from Korea and Taiwan and to the Chinese run garment firms and other firms producing labor-intensive products.
   
   Thank you for your good comment.
   
   THEE Kian Wie
   Senior Economist
   Economic Research Centre
   Indonesian Institute of Sciences
   (P2E-LIPI), Jakarta
2. Chester Cabalza
   (posted 27 March 2006 / 08:14:46 AM)
   
   It would have been ok if you also highlighted the significant roles of the totoks and peranakans (of Chinese descent) in the economic progress of Indonesia. Despite, some persecutions experienced by this minority group, they have at least contributed a lot to the escalation of the largest economy in Southeast Asia.