Indonesia needs new development strategy

David E. Sumual, Jakarta

In the past one-month, many economic discussions have focused on two major external risks facing the Indonesian economy, namely the possibility of aggressive interest rate hikes by the Fed and the impact of higher oil prices on the government budget. Meanwhile, a possible hard landing for China's economy might not affect the country so much since the 4.7 percent share of Indonesia's exports to China (in April 2004) could be deemed insignificant.

These external threats coupled with excess liquidity and political uncertainty in relation to the upcoming presidential elections have put pressures on the rupiah and inflation, prompting Bank Indonesia (BI) to take measures to absorb banks' excess liquidity in the market.

Nevertheless, Indonesia might now breathe a sigh of relief as oil prices have cooled off to around US$36 per barrel in recent weeks.

The risk of U.S. inflation in May also appears to be in check. As such, the transition to higher U.S. interest rates may also happen at a measured pace with interest rates possibly only rising by a quarter-point at the Fed's next meeting on June 30th. Thus, business concerns over the possibility of higher interest rates would also recede accordingly.

What is not well understood is why the rupiah does not seem to be boosted by these encouraging developments given that it had mainly depreciated on concerns relating to external risks. It appears that the rupiah exchange rate in the short run is influenced by market sentiment on political issues rather than for economic reasons.

In other words, whatever happens, the political developments surrounding the July 5 presidential elections would be the best leading indicator of the rupiah, at least in the short run. As such, concerns on the rupiah are overdone, as its value will soon move back to its fundamental level as soon as the political uncertainty recedes.

As macro stability alone is not sufficient, what is more important is to give attention to some domestic structural problems that may affect Indonesia's economic outlook in the middle to long-term. As such, sustainable growth needs a policy that is unreservedly committed to both domestic and foreign direct investment (FDI).

The political leaders and the soon-to-be-elected president thus should become aware of how to increase Indonesia's investment competitiveness.

Developing an action program to improve Indonesia's competitiveness should be the first priority of the next government. Time is ticking given that Indonesia's competitors such as China, India, Vietnam and Thailand are now developing import-substitution industries, thus threatening the outlook for Indonesia's exports. It would be no surprise then if Indonesia's manufacturing exports fell in the years ahead as those countries will no longer need the goods they now import from Indonesia.

According to the World Investment Report published by the Economist magazine, world FDI will rebound by 31.2 percent to $754.8 billion in 2004 after three consecutive years of declines. Meanwhile, it is predicted that the global FDI inflows to developing countries will increase 22.8 percent from $186.9 billion in 2003 to $229.6 billion in 2004.

Citing data from the Investment Coordinating Board (BKPM), confidence in the investment climate continued to deteriorate in the first four months of this year as FDI approvals plummeted by 30.6 percent compared to the same period last year to only $2.30 billion.

Foreigners have regrettably lost their appetite to invest in Indonesia. Some of the problems include: Less-friendly government policies, corruption, and rigidity in the labor market. The rigidity in the labor market is caused, for example, by the regional minimum wages that are hiked each year, outpacing gains in productivity thus reducing the country's competitiveness. The country's corrupt and unpredictable judicial system also remains as a main obstacle to higher investment in Indonesia.

The latest example is an unfair ruling against the foreign investor, Rowe Evans Plc, which had to return a $2.3 million palm oil plantation because the executive who signed the contract in 2002 did not have the correct work permit. Despite the small sum of money involved, the case will surely have a negative impact on investor perceptions.

To tackle the investment problems, Indonesia should think a strategy well beyond just the security, political and macroeconomic stability. The main priority is to kick-start the development of domestic infrastructure to improve national productivity. Besides productivity, infrastructure investment would also be important to improve national efficiency and reduce the cost-push inflationary pressure by eliminating structural bottlenecks as a result of the dilapidating infrastructure.

There is already evidence of severe infrastructure deterioration in Indonesia. The decrepit road network that cannot cope with the rise in traffic volumes, and the electric power shortages are two main infrastructure problems in the country. And according to the National Development Planning Agency, the funds needed to upgrade the infrastructure network in 2005-2009 are huge (slightly more than $72 billion). As such, breakthrough ideas -- for example, by creating infrastructure funds in the stock market to attract new investment in infrastructure projects -- are needed.

The soon-to-be-elected president should also identify the country's indigenous strengths and adopt a dual-track development strategy. In other words, besides enhancing the investment climate by offering manageable levels of risk, the next government should also focus on the development of skill and resource driven SMEs (small and medium enterprises).

Such an initiative would strengthen Indonesia's microeconomic structure, one of the essential factors to boost growth sustainability. However, the real results of good strategy will only come from strong political leadership that insists on reforms and on meeting investor expectations in as many areas as possible.

The writer is an analyst of Danareksa Research Institute. This article is a personal view.