Deregulation makes RI attractive but interest rates to rise

JAKARTA (JP): Merrill Lynch & Co. of the United States says recent deregulatory measures make Indonesia the region's best site for foreign investment but warns that interest rates will likely edge higher next year.

The global securities research and economics company said in its latest monthly review, Asian Economic Commentary, that Indonesia's recent bold moves toward economic deregulation and a series of policy changes are likely to put it at the very forefront in terms of competition for the global investment dollar.

"Heeding earlier criticism from several quarters that Indonesia was rapidly losing out to countries like China, India and Vietnam in competition for foreign investment, the Indonesian government moved to thoroughly revamp its investment laws," the report said.

Last month, the Indonesian government introduced a new policy package, including import duty cuts for the agricultural, health and industrial sectors in anticipation of world trade developments. The package was meant to increase the competitiveness of Indonesian products in the international market.

Less than a month earlier the government had eased restrictions on foreign investments, allowing foreign investors to hold up to 100 percent in equity of projects in virtually all sectors of the economy.

According to the review, one of the most significant measures in the latest package is the abolition of minimum capital requirements for foreign investors. "These new rules should facilitate the development of small-scale and medium-sized industries that are likely to be critical to Indonesia's overall industrialization efforts.

The report also praised the Indonesian government's decision to substantially ease divestment rules.

"While foreign investors had been allowed previously to retain 100 percent ownership for at most 10 years, this has now been extended to 15 years," it said.

"More importantly, the divestment will be largely symbolic now and can be as small as one percent, as compared to the past requirement that, at least, 51 percent of equity be sold to local partners," Merril Lynch & Co. said.

Another important measure is the lowering of minimum local equity requirement for joint ventures from 20 percent to five percent.

Together with other significant deregulatory moves in ports, power generation, telecommunications, shipping, civil aviation, transportation, railways, water supply, education and mass media, Indonesia is expected become one of the most attractive destinations in Asia for foreign capital.

"In terms of its more immediate competitors, Indonesia's new investment rules would put it significantly ahead of China, India and Vietnam," the report added.

High costs

Merrill Lynch, however, cautioned that in spite of its significant moves, Indonesia still needs to further reduce the high cost structure of its economy.

"Although wages in Indonesia are lower than other Asian countries, like Malaysia and Thailand, the difference may be narrower if productivity is taken into account," the company said.

In addition, the hidden costs of doing business in Indonesia are still relatively high due to the complex, time-consuming procedures and a significant amount of red tape. The report also cited that protection of upstream industries, either via monopolies or import restrictions, implies inefficiency and higher costs for downstream industries.

The cost of capital is another key factor that makes for the current high-cost structure of the economy. "Although past financial reforms have brought down the cost of funds substantially, average lending rates for working capital at 17.3 percent at the end of March were significantly higher than comparable rates elsewhere in the region," it said.

"Although local interest rates stand sharply lower today compared with the highs of 1991 (the lending rate at end-April 1991 was 27.1 percent), spreads between deposit rates and lending rates are still large," it said.

The review conceded that more competition in the banking sector has helped narrow the spreads, although one constraint in the near term could be the problem of bad debts, especially among state-owned banks.

It cautioned that Indonesia will take several years to resolve the problem of non-performing loans, which are estimated to account for 16 percent of total outstanding credit.

The review praised the Indonesian government's efforts at curbing the banking sector's bad loans and bringing to justice those responsible for the loans.

Domestic demand

Merrill Lynch also predicts that net external demand will remain a major force of Indonesia's economic growth.

"Domestic demand is expected to be the major impetus to its gross domestic product (GDP) growth in 1994," the report said, adding that private consumer growth should rise further to a range of between seven percent and 7.5 percent in 1994, following growth of 6.2 percent last year.

It said that growth of real incomes will stem from rapid wage increases and a drop in inflation from the almost double-digit rate of 1993. Early this year, minimum wages were revised up sharply, in some cases by as much as 50 percent.

The review also noted that the need to upgrade infrastructure and expand productive capacity, coupled with the new foreign investment policies, should also see fixed investment growth.

Fixed capital formation is forecast to grow by nine percent to 9.5 percent in 1994, compared to the 4.9 percent growth last year. (fhp)