Investment in Indonesia: What is holding back recovery?

David Jay Green Country Director Asian Development Bank Jakarta dgreen@adb.org

Indonesia is having tremendous difficulties convincing investors, either foreign or Indonesian, to commit their funds for the long-term. A host of problems, ranging from political uncertainty and insecurity to a still weak banking sector discourage people from building new plants and buying new equipment. Some change is occurring -- a messy process of reform is producing some progress that, if sustained, could lure investors back to this huge, sprawling country.

Most adult Indonesians grew up in an economy very different from the one they face today. Most importantly, they were accustomed to an economy that grew substantially each year. There were difficult periods, but for decades average gross domestic product and average income rose, and the incidence of poverty fell. For most Indonesians, this world came to an end in 1997 with the East Asian Financial Crisis.

True, the Indonesian economy is still growing about 3 percent- 4 percent each year and that is better than in many countries. But it isn't like the old days. Importantly, it won't rescue many families from poverty. At 3-4 percent growth, with the population growing 1-2 percent each year, average incomes are rising only 1- 3 percent annually. This is better than nothing, but not always noticeable in a country where much of the population lives so close to the poverty line that illness or bad weather can push them under.

One reason growth is sluggish is that investment is running far below levels in the mid-1990s. From 1988 to 1997 investment grew 168 percent, helping GDP nearly double. In 2002, while GDP had recovered to within 2 percent of its 1997 peak, real investment was nearly one-third below the 1997 value. While one should not be overly nostalgic for the late 1990s -- growth then had many of the characteristics of an unsustainable speculative investment bubble. However, current purchases of new business equipment and the building of new plants by private or state- owned firms are too small to generate income, jobs, or higher growth.

Why are investors so cautious? Three broad sets of problems are hindering commitments by local and foreign investors: Concerns over peace and security, weak banking and financial sectors, and the cost of poor governance -- especially corruption.

First, there are the headline grabbing problems of peace and security. The financial crisis in Indonesia was not just a period of economic difficulties. The crisis was a trigger for wide- ranging political changes that moved to reverse decades of authoritarian rule. Understandably these changes are not smooth. The recent terrorist attacks in Bali have heightened the international impression that personal security is an issue in Indonesia and have surely discouraged foreign business interests in the country. But security is not just an issue for foreigners. Long-running conflicts in Aceh, the Moluccas, and other areas have kept Indonesians from making long-term investments in their own country.

The second set of problems rests in the weak banking and financial sectors. The financial crisis was partly a failure of the banking system to operate on commercial principles. Before 1997, investment in Indonesia was typically financed by bank loans -- often supplied by institutions that were little more than captives to larger industrial groups. The decision to loan was often made on the basis of non-economic considerations, sometimes simply on the assumption that politically well- connected investors or contractors would not lose money.

But now firms that blithely bought into projects touted for their political connectivity are looking for robust returns and examining project-related risk. This new environment requires a strong financial system. But in Indonesia the banking system is still quite weak. Rescue efforts effectively nationalized the major part of the banking sector. Fragile balance sheets continue to discourage aggressive loan expansion.

The third obstacle blocking investment is a new appreciation of the costs of poor governance, especially corruption and weaknesses in the legal and judicial system. International surveys rank Indonesia as facing one of the world's most severe corruption problems. Any reader of this newspaper has seen stories of judicial shakedowns in Indonesia and anyone currently operating in the country knows how difficult it is to avoid compromising oneself to get things done. Though often discussed purely in moral terms, corruption in Indonesia is systemic, reflecting problems with courts and the police and the need for civil service reform.

Before the crisis it was common to excuse corruption and associated problems as a cost of business, one that bought the access to power and privilege that ensured success. But there has been a reassessment. Across East Asia, especially in those economies hit by the crisis, investment has held up better where corruption is not seen as a massive problem. Corruption now appears to be one of the more serious barriers to business operations, particularly new businesses.

All these problems require solutions. Restoring business confidence is likely to be a long-term process. But business should not disregard the real progress being made in Indonesia. The government has had signal success in bringing down inflation, stabilizing the currency, meeting budget targets, and curbing the impact of the large public sector debt that is a legacy of the crisis. Without these efforts, the economy would still be in recession.

Improving security, strengthening the financial system, cleaning up the courts, revamping the police forces, and reducing the perception of corruption will take years. In each area efforts are under way that can contribute to longer-term progress. There has been a recent peace accord in Aceh and banks are being privatized. Anti-money laundering legislation was passed. If these efforts can continue, if some dent can be made in the perception that corruption is pervasive, then we will see people again willing to commit their funds to Indonesia's future.

The opinions expressed are those of the author and do not necessarily represent those of the ADB.