Inflating project costs

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.