Investment in Indonesia: What is holding back recovery?

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.