Inflating project costs
Minister of Finance Mar'ie Muhammad's remarks early this week about the increasing tendency among Indonesian businessmen to mark up the costs of their investment projects reconfirmed the findings of the recent investigations into several large bad loans. It also endorsed the conclusion of a recent study by the World Bank that pointed out the gross inefficiency of investments in the country.
Noted economist Sumitro Djojohadikusumo also has often warned of the dangers of the unusually high incremental capital-output ratio (ICOR) in Indonesia. Sumitro estimated ICOR -- the ratio of capital invested to the volume of output generated -- at 4.9, compared to a range from 3 to 3.5 in other Southeast Asian countries. That indicates the high cost of Indonesia's economy.
But while the World Bank and Sumitro referred to the macro-conditions that cause the high-cost economy such as red tape, misallocation of resources and corruption, Mar'ie specifically talked about the practices among businessmen who inflate the costs of their investment projects. At first glance, one may simply reject such practices as entirely the business of the investors themselves because it is the businessmen who bear the risks of their investments.
However, as the finance minister explained at the national conference of the Indonesian Society of Accountants in Bandung early this week, the markup of project prices causes huge losses for the government and even the public.
An investment project whose capital costs are marked up obviously requires a higher amount of depreciation, thus resulting in smaller taxable income. The prices of its products also should be set higher than those of a similar project implemented with normal costs, thereby harming the interests of consumers. Since big projects usually are financed mostly by loans from private and state banks they also cause misallocation of resources at the expense of more productive and efficient investment ventures. Then, such projects face bigger risks of failure, resulting in bad loans.
Businessmen usually mark up the prices of their investment projects in their loan applications in order to finance their projects entirely with loan funds. For example, since a businessman usually is required to put up at least 30 percent of the cost of his project in equity capital, he marks up the price of his project at least by 30 percent in order to obtain loan funds equivalent to 100 percent of the project costs. Obviously, he will use 30 percent of the loan funds as his equity capital in the project.
However, such markup practices actually are not so sophisticated as to make them extremely difficult for bankers to detect. Therefore, such practices are possible only with collusion between the businessman and the credit officers of the lending bank. Moreover, since investment credits are normally disbursed in phases, according to the stage of project implementation, and big projects depend mostly on imported equipment, such practices could be detected during the pre-shipment inspection of imports by PT Surveyor Indonesia and its subcontractor, Societe Generale de Surveillance (SGS). In fact, SGS has often uncovered over-invoicing of oil mining equipment imported by mining contractors in Indonesia.
Mar'ie's warning of the adverse impact caused by the markup of investment project costs deserves the great attention of banks, consultants and other professionals involved in project proposals and implementation. Such practices, if allowed to go on unchecked, will adversely affect the very foundations of our economy. This is especially so because private investors have been allowed to operate in public infrastructure such as power generation, telecommunications, highways, airports and seaports, which were previously monopolized by state companies.