Survey of Recent Developments

SUMMARY

As Indonesia heads to the polls in 2014, its economy is slowing. The end of the commodities boom and the global return to more normal monetary policy has exposed some weaknesses. Exchange-rate depreciation has absorbed some of the adjustment; but structural rigidities are still likely to limit the expansion of non-commodity sectors, and the increased fuel-subsidy bill for imported oil is putting pressure on the current account and the budget. The immediate focus is on demand-side consolidation to manage inflation and the currentaccount deficit.

For an economy like Indonesia’s to be overheating, and for monetary and fiscal authorities to be engineering a soft landing, when growth is below 6%, points to major structural problems. If Indonesia is to prevent the current rate of growth from becoming the new normal, there will need to be a substantial supply-side response to lift productivity, as well as a restructuring of the economy and the introduction of policies that make the economy more flexible in adjusting to shocks. The current economic slowdown has yet to trigger sweeping reforms; policy coordination remains problematic as Indonesia enters a big political year.

Compared with its neighbours, Indonesia is largely on the outside of the regional production networks, and its manufacturing sector does not play into factory Asia. Now, faced with lower commodity prices globally—and growth in non-resource sectors is critical— the lack of a large manufacturing base appears to be a weakness. Indonesia is attracting more foreign direct investment than ever and is climbing the global rankings of preferred economies in which to invest, but this is occurring without improvements to its investment environment or competitiveness. Indonesia can participate more fully in global supply chains and increase its potential for growth by upgrading its infrastructure, improving its investment environment, and using regional initiatives strategically to make strong commitments that reinforce its priorities for domestic reform.

In its hosting of APEC in 2013, Indonesia championed infrastructure investment where the lack of structural reform and macroeconomic constraints are inhibiting much-needed expansion, both in Indonesia and in the region. The positive outcome, albeit only a small step forward for the Doha Round, at the WTO Ministerial Conference in Bali, in December, also builds momentum for better regional and global cooperation. The priority now is for Indonesia to commit to, and show leadership in, the Regional Comprehensive Economic Partnership (RCEP) and the implementation of the ASEAN Economic Community.

Seiring dengan beranjaknya Indonesia menuju pemilihan umum 2014, perekonomian justru menunjukkan tanda-tanda perlambatan. Berakhirnya masa keemasan komoditas dan kembalinya perekonomian global kepada pola kebijakan moneter yang normal telah menyingkap beberapa kelemahan. Depresiasi nilai tukar telah membantu menyerap sebagian kelemahan tersebut, namun kekakuan struktural masih akan membatasi ekspansi sektor-sektor non-komoditas. Selain itu, bertambahnya beban subsidi bahan bakar memberikan tekanan pada transaksi berjalan dan pada anggaran. Fokus jangka pendek adalah konsolidasi sisi permintaan untuk dapat mengelola inflasi dan deficit transaksi berjalan.

Bagi ekonomi seperti Indonesia, adanya gejala overheating, dan adanya upaya otoritas moneter dan fiskal untuk menahannya pada saat pertumbuhan di bawah 6%, menunjukkan adanya masalah struktural yang mendalam. Jika Indonesia tidak ingin terperangkap dalam pertumbuhan saat ini sebagai keseimbangan baru, berbagai respon dari sisi penawaran harus dilakukan untuk menaikkan produktivitas, disertai restrukturisasi ekonomi, serta kebijakan-kebijakan yang membuat perekonomian lebih fleksibel terhadap guncangan. Perlambatan ekonomi yang terjadi sekarang belum bisa memicu reformasi yang menyeluruh; kordinasi kebijakan tetap menjadi masalah utama saat Indonesia memasuki tahun politik 2014.

Dibandingkan dengan negara-negara tetangganya, Indonesia masih tertinggal dalam hal jaringan produksi regional, dan sektor industri pengolahannya belum terlibat dalam “pabrik Asia”. Saat ini, dengan turunnya harga komoditas global – dan pertumbuhan sektor-sektor selain sumber daya alam adalah sangat penting - kurangnya basis industri pengolahan menjadi salah satu satu kelemahan utama. Saat ini, Indonesia berhasil menarik investasi asing langsung (FDI) dalam jumlah yang terbesar dibandingkan periode-periode sebelumnya. Posisi Indonesia juga kini tengah berada di antara negara-negara favorit untuk investasi. Namun semua ini terjadi tanpa disertai perbaikan pada iklim investasi atau daya saing. Indonesia dapat berpartisipasi lebih dalam lagi dalam rantai penawaran global sekaligus menaikkan potensi pertumbuhannya dengan menambah kualitas dan jumlah infrastruktur, memperbaiki iklim investasi, serta memanfaatkan inisiatif-inisiatif regional untuk membuat komitmen yang dapat memperkuat prioritas reformasi dalam negeri.

Sebagai tuan rumah APEC pada tahun 2013, Indonesia mendorong perlunya investasi infrastruktur di saat kurangnya reformasi struktural dan adanya kendala-kendala makroekonomi menjadi penghambat ekpansi yang sangat dibutuhkan, baik di Indonesia maupun di negara-negara lain. Selain itu, sekalipun konferensi Tingkat Menteri di Bali yang diselenggarakan pada Desember lalu hanyalah sebagian kecil dari langkah bagi Perundingan Doha, keberadaannya juga berhasil membangun momentum bagi kerjasama regional dan global. Saat ini, prioritas Indonesia adalah untuk menunjukkan komitmen dan kepemimpinan di ajang Kerjasama Ekonomi Komprehensif Regional (Regional Comprehensive Economic Partnership/ RCEP) serta mengimplementasikan Masyarakat Ekonomi ASEAN/ MEA(ASEAN Economic Community/ AEC).

Keywords:

• economic stabilisation
• macroeconomics of development
• policy reform
• protectionism
• mineral processing

JEL classification:

• D72
• O11
• O24
• O53

View correction statement:

Corrigenda

POLITICAL DEVELOPMENTS

The year 2014 is an important one politically. Parliamentary elections will be held in April, and then in July Indonesians will directly elect their president for only the third time. If no presidential candidate receives more than 50% of the vote, there will be a run-off election in September. These are opportunities to entrench the country’s democratic system. Since the fall of Soeharto, during the 1997–98 Asian financial crisis, Indonesia’s democratisation has become an exemplar in Southeast Asia, and decentralisation of power to regional governments has helped to cement this process. Improvements in governance are still crystallising, but democratic Indonesia has enjoyed relative political stability and economic prosperity.

Yet corruption scandals and an ineffective coalition government have characterised President Yudhoyono’s second term (McRae 2013). The investigation of corruption scandals by Indonesia’s Corruption Eradication Commission (Komisi Pemberantasan Korupsi [KPK]) continues to uncover charges of corruption linked to political figures, mostly to those from parties supporting the current government (members of the coalition secretariat).¹ In addition to a bribery case involving the upstream oil and gas regulator (SKK Migas) (see Allford and Soejachmoen 2013), the investigation of Akil Mochtar, the ex-chairman of Indonesia’s Constitutional Court, has seen members of the powerful political clan of Ratu Atut (the governor of Banten and a senior member of a party supporting the coalition) arrested for alleged corruption and cronyism.

Among the many storylines that may play out in the parliamentary and presidential elections will be that of the Jakarta governor, Joko Widodo (known as Jokowi). Jokowi’s popularity stems from his success as the mayor of Solo, in Central Java, and his ability to connect with voters in Jakarta and with young voters. Half of Indonesia’s population is under 29 years of age, and up to 59 million of 190 million voters in the forthcoming elections will be young voters, from first-time voters (17-year-olds) to those aged 29. Jokowi holds a large lead in presidential polling² and is a political outsider relative to most other candidates, who come from the political establishment or the military.

On 14 March, Jokowi was nominated by his party, the Indonesian Democratic Party of Struggle (Partai Demokrasi Indonesia–Perjuangan [PDI–P]), in which party leader and former president Megawati Sukarnoputri alone has the authority to choose its presidential candidate. The financial market responded positively to Jokowi’s nomination–the Jakarta Composite Index (the benchmark indicator of stock prices) rose by 3.2% on the day of the announcement (Kompas, 15 Mar 2014). The question now is whether PDI–P will win the required 25% of the legislative vote or 20% of the parliamentary seats to nominate its own presidential candidate, without which it may have to form a weak coalition.³ Such an outcome could undermine the effectiveness of the new government, as it has done to that of the current government.

There is much speculation as to what a Jokowi presidency and a PDI–P-led government would mean for Indonesia. If Jokowi were elected, much would depend on whom he invited to take part in his economic policy team and selected for key economic policy positions in cabinet. Jokowi is less experienced in foreign policy and diplomacy than Yudhoyono was when he came to power, given that Yudhoyono became effective in diplomacy as a minister in the Wahid and Megawati presidencies.⁴

MACROECONOMIC DEVELOPMENTS

Economic Growth

Indonesia’s economy continues to face external pressures. The announcement in June 2013 by the US Federal Reserve that it would start to suspend the purchase of assets, or to taper quantitative easing, has tightened external financing conditions for emerging markets, including Indonesia. This pressure is unlikely to lift while the United States continues its economic recovery and the US Federal Reserve returns its monetary policy to more normal settings. These circumstances have also put pressure on the rupiah, as global portfolio investors adjust to tighter liquidity and rebalance their exposures from emerging countries, which are perceived to be at risk from rapid capital outflows (Allford and Soejachmoen 2013). Another source of pressure is the continued deficit in the current account. Subdued international commodity prices have reduced Indonesia’s export revenue, around 60% of which was derived from commodity exports. That trend seems to have reversed briefly, as miners rushed out mineral exports in the last quarter of 2013 before the export taxes and bans on unprocessed minerals were implemented in January 2014 (see ‘Mineral Export Policies’, below). There is a considerable negative balance in the oil and gas trade, which continues to increase and which is putting pressure on both the current account and the government budget, despite the adjustment to subsidised fuel prices in June 2013.

Policymakers in Bank Indonesia (BI) and the Ministry of Finance are trying to pilot a ‘soft landing’ for the economy by, for example, adjusting BI’s policy rate and allowing the exchange rate to absorb some of the pressures. Other measures include relaxing import quotas on beef and some other foodstuffs. But subdued commodity prices and the return to tighter global credit have exposed the economy to risks, as infrastructure bottlenecks and regulatory uncertainties overshadow growth prospects in non-commodity sectors. At a time of subdued growth in domestic demand, Indonesia could consider ways to use this momentum to grow its non-commodity exports. After all, it is home to 55% of labour in the big four ASEAN countries (Indonesia, Malaysia, Philippines, and Thailand) yet contributes just 17% of the non-commodity manufacturing exports of these countries.⁵

GDP in 2013 grew by 5.6% and 5.7% (year-on-year) in the third and fourth quarters, respectively, a decline from 6.2% and 6.1% in 2012. Slower growth in the last two quarters made total GDP in 2013 grow by 5.8%, a noticeable decrease from 6.3% in 2012. On the expenditure side, the main drag on growth in the last six months has been the continued weakening of investment. Gross fixed capital formation (GFCF) continued to weaken throughout 2013, as shown in table 1. Investment spending increased by only 3.8% in the fourth quarter of 2013, compared with 7.3% in the same period of 2012. In 2013, GFCF grew by 4.2%, less than half of the growth in 2012. The decline in investment growth was led by large decreases in the construction, machinery and equipment, and transport sectors. Rising interest rates and a depreciating rupiah are likely to be behind the continuing slowdown in investment in construction, which contributed 70% of total real investment in 2013.⁶

TABLE 1 Components of GDP Growth (2000 prices; % year-on-year)

Source: CEIC Asia Database.

Aggregate consumption spending has been relatively stable. Growth in real private consumption in the third and fourth quarters has stood up at 5.5% and 5.3%, respectively, and resulted in annual growth at 5.3%, the same as in 2012. The relative strength of private consumption is surprising, given that the food CPI increased by 14% and 12% (year-on-year) in the third and fourth quarters, respectively—higher than in 2012—which would have affected the real purchasing power of consumption of non-staple foods. Indeed, growth of non-food consumption remained relatively strong, at 6.2% and 5.9%, in the last two quarters, consistent with BI’s Retail Sales Survey, which indicated strong growth (BI 2013b). Growth in real government consumption spending has also picked up considerably, reaching 8.8% in the third quarter and 6.5% in the fourth. This surge in the third quarter is likely to have been driven by the government’s temporary cash-transfer program (Bantuan Langsung Sementara Masyarakat), used to offset higher fuel prices, which ran until September 2013. This was an unusually high disbursement from the government budget; its implementation involved a large outlay on electronic ID cards and related equipment, as well as paying PT Pos, the state-owned postal service, to administer the distribution of the transfers.

Indonesia’s strong export growth in the fourth quarter of 2013 was unexpected, given the declining trade surplus. Real exports of goods grew by 7.4% (year-on-year), an increase from 5.3% in the third quarter. Badan Pusat Statistik (BPS) recently revealed that nominal non-oil exports increased by 9.3% in December (year-on-year), a contrast to the 8.4% decline in December 2012 (year-on-year) (BPS, press release, 3 Feb 2014). The increase in exports in December created a $1.5 billion surplus in trade, the highest since November 2011. This increase was driven mainly by strong growth in exports of mineral ores, which suggests that mining companies were rushing to export unprocessed ores in anticipation of export restrictions on such minerals coming into effect in January 2014. Import volumes contracted in the fourth quarter, most likely because of the slowing economy and, again, the depreciating rupiah.

A relatively strong performance in the tradable sectors was the main contributor to GDP growth in 2013, with the trend in the second half the year following that in the first half of the year (Allford and Soejachmoen 2013). Meanwhile, the growth slowdown was noticeable in the non-tradable sectors, particularly in construction, and trade, hotels, and restaurants, which together contributed 24% of nominal GDP.

Monetary and Fiscal Policies

BI has demonstrated its determination to boost the credibility of its monetary policy. It surprised many observers by hiking its policy rate five times between May and December 2013, by a total of 175 basis points.⁷ It did so by raising the overnight deposit facility rate incrementally, from 3.75% to 5.75%, over the seven months. These small increases seem to have slowed growth in real money supply, which was growing at 8.5% in May but only 4.0% in November (figure 1). These measures have also dampened nominal credit growth–particularly outstanding working capital, which increased by 11% between May and December 2013, compared with 13% in the same months of 2012, while outstanding consumer credit slowed to 9% from 13% (BI 2013a, tables 1.8 and 1.10). Together, these decreases may have lowered expectations about rising inflation in the near future. BI’s measures, coupled with the exchange rate, which was allowed to depreciate, helped to cut the current-account deficit to 3.9% and 2.0% of GDP in the third and fourth quarters, respectively, down from 4.5% of GDP in the second quarter. On average, the rupiah depreciated by 21.5% in the fourth quarter against the US dollar (year-on-year), while the real effective exchange rate (REER) depreciated by 7.9%. The depreciation in the exchange rate encouraged exports and helped to reduce non–oil and gas imports. BI also sought to dampen growth in property loans, from 30 September, by introducing a regulation requiring larger down-payments from loan applicants for property purchases beyond their first property (Jakarta Post, 26 Sep 2013). This has already had an effect; the growth of loans outstanding for flats and apartments declined sharply to just 17% in December 2013 (compared with December 2012), down from 60% to 80% monthly growth during January–July 2013 (BI 2013a, table 1.5).

FIGURE 1 Bank Indonesia Rate, and Growth in Real Money Supply and Exchange Rates, 2013

TABLE 2 Balance of Payments ($ billion)

Source: CEIC Asia Database.

BPS announced that headline inflation, measured as percentage change in the aggregate consumer price index, declined slightly in January 2014 but remained high, at 8.2% (year-on-year). At the same time, food inflation was at 11.4% (year-on-year), and energy, housing, and rent inflation was at 6.6%. Also in January, heavy rain caused flooding in major rice-producing areas and along major transport routes in northern Java. Yet core inflation, which is directly influenced by monetary policy, fell to 4.5% (year-on-year) from 5% in December. The eruptions in February of Mount Sinabung, in North Sumatra, and Mount Kelud, in East Java, may make if difficult to distribute food, particularly horticultural products. There is a risk of further inflation in food prices, given the extent of the flooding (Kompas, 10 Feb 2014).

There is also risk in the excessive tightening of monetary policy. The impact of the interest-rate hike on dampening growth in real money supply is likely to understate its impact on liquidity in the banking sector. Indonesia’s money market is relatively underdeveloped, and its share of interbank claims as a proportion of the assets of its banks is low compared with those of other countries in Asia (Loretan and Wooldridge 2008). Trading in the interbank money market has remained relatively thin, consisting mostly of transactions with a maturity of less than one month. The market is also segmented (IMF 2013).⁸ As liquidity has tightened, banks have started to rely more on third-party deposits as their main source of loans, and competition for funds has increased (BI, press release, 18 Dec 2013).

Figure 2 shows that the average loan-to-deposit ratio exceeds 90%, which suggests that banks are finding it more difficult to extend loans using less expensive funds. Indonesia’s seven-day interbank money rate increased to 7.5% in December, and total interbank money-market transactions shrank by 22% and 38% in November and December, respectively. The Deposit Guarantee Agency (Lembaga Penjamin Simpanan) revealed that by November 2013 Indonesia’s eight largest banks had increased their deposit base by 24%, while the deposit base of the medium and smaller banks remained flat or was shrinking. Smaller banks had already raised time-deposit interest rates, and some were willing to offer 10%–11% annual interest rates for large customers (much higher than the 6.5%–7.0% annual rate offered by large banks), yet they struggled to attract more deposits. Should this continue, small banks may face an increasingly difficult situation, because cutting credit lines to existing customers may attract non-performing loans. Continuing to sustain loans at a higher cost of funds could reduce profitability and increase solvency risk.⁹

FIGURE 2 Loan-to-Deposit Ratio and Seven-Day Interbank Call-Money Rate, 2013 (%)

A feature of the recent monetary tightening has been the diminishing relevance of the rupiah’s exchange rate against the US dollar. BI has defended this rate in the past, and some analysts predicted that BI would intervene to keep the nominal exchange rate around a ‘psychological’ level of Rp 10,000–10,500 per dollar, to avoid capital outflows.¹⁰ Yet in July 2013 the newly appointed BI governor, Agus Martowardojo, stated publicly that BI would not try to maintain this level. Focusing on the rupiah’s value against the dollar ignores the importance of other regional currencies that also matter to the Indonesian economy. Instead, BI seems to have focused on containing inflation expectations and restoring its credibility. Its commitment to an inflation target gives BI a transparent and consistent objective.¹¹ It also suggests the bank’s willingness to impose exchange-rate and interest-rate measures to maintain macroeconomic stability.

Indonesia’s monetary and exchange-rate policies have absorbed some of the burden of adjusting to new external economic conditions, as has its coordinated fiscal policy, which has remained thoughtfully conservative. In the middle of 2013, the government undertook politically difficult reforms to reduce the budget deficit by raising subsidised fuel prices by 40%, which was set to save Rp 40 trillion (about $3.4 billion) (Allford and Soejachmoen 2013). In October 2013, the parliament approved the 2014 budget, with a projected deficit of 1.7% of GDP. But the persistently large fuel subsidies and the shortfall in tax revenue could push the deficit beyond the legally mandated maximum of 3%. Economic growth in 2014 is projected to be around 5.0% to 5.5%, lower than the 6.0% assumed in the budget. Together with other increasingly unrealistic budget assumptions, including the exchange rate, interest rate, and level of oil production, this inaccurate rate of projected growth will soon need to be revised.

BOX 1 Indonesia’s Social-Security Revolution

Indonesia introduced the National Social Security System (Sistem Jaminan Sosial Nasional [SJSN]) in January 2014, as mandated by Law 40/2004 on Social Security. The program consists of two components: public health insurance (Jaminan Kesehatan Masyarakat [Jamkesmas]), managed by the state’s social-security agency (Badan Penyelenggara Jaminan Sosial [BPJS]) and titled BPJS Health; and employment insurance, managed by a new arm of BPJS and titled BPJS Manpower.

All Indonesians must participate in Jamkesmas, and will be entitled to basic health care. Income earners and employers will contribute by paying insurance premiums, while the government will cover these costs for poor households. The government is targeting 176 million people, or 72% of the population, for immediate coverage. To be effective, the program will need to address low levels of access to health services, especially for the poor and for those in remote areas; the quality of these services; the participation of health providers; and high out-of-pocket expenses for participants (see, for example, Simmonds and Hort 2013).

The process of launching SJSN for employment is still underway, with BPJS Manpower set to start in June 2015. The government is transforming the current privatesector social-security provider, PT Jamsostek, into BPS Manpower, which will oversee a program covering both the formal and the informal sectors. It is uncertain whether BPJS Manpower will have the immediate institutional capacity to provide employment insurance, or the ability to set and enforce contribution levels for workers and employers.

On the revenue side, the shortfall in tax revenue in the 2013 budget is a concern. Total tax revenue grew at 9% in 2013, down from 12% in the previous year and still 10% below target for 2013. Most noticeable are the shortfalls in income tax and value-added tax, which are, respectively, Rp 36 trillion and Rp 40 trillion short of their 2013 targets. The government would do well to step up its efforts at tax reform by broadening the tax base and, for example, recruiting more tax inspectors. Another looming problem in 2014 is falling revenue from export tax on commodities and non-tax revenues from natural resources (royalties). They comprise up to 19% of total domestic revenues but this likely to decrease during 2014, given the decline in global commodity prices and the uncertainty about the restrictions on exports of unprocessed minerals.

On the spending side, preliminary data suggests that the government disbursed 95% of the 2013 budget, slightly below the 96% of 2012. Nevertheless, there have been spending improvements in several categories, such as capital and social spending, which so far have reached 89% and 96%, respectively, of their targets. An added challenge for the 2014 budget will be the need to cover subsidies of Rp 18 trillion for insurance-premium contributions to the new National Social Safety Program (Sistem Jaminan Sosial Nasional), which commenced this year (box 1).

Despite a relatively high international price for crude oil, a lack of new investment and explorations is depressing oil production far below the budget assumption of 870 thousand barrels per day. Lower revenue from the mining sector is likely to depress total revenue in the current budget. Extrapolating these developments to 2014 reveals that some of the main assumptions are likely to render the 2014 budget too conservative in its forecast of spending and too optimistic in its forecast of revenue.

With the tighter financing conditions and perceived higher risk of capital out-flows, owing to fears of a current-account deficit that Indonesia may find difficult to finance, and the possibility of subsequent depreciating pressure on the rupiah, investors will demand higher yields on government bonds. So far, government bond auctions have been highly oversubscribed, but at a higher coupon rate. Perhaps due in part to the prospect of an increase in interest rates in the United States (and possibly globally) and in part to Indonesia’s parliamentary elections in April, the government seems to have issued bonds earlier than usual in the year. By early February, the government had already raised 21% of the year ’s target bond issuance (Jakarta Post, 6 Feb 2014).

The government and parliament may use the current situation as an opportunity to revisit the 2014 budget. This being an election year raises some obstacles. For one, there is the practical problem of finding a window of time in which the government can submit a revised budget to parliament, as well as the possible reluctance on all sides of politics to champion the revision as the elections loom. Nevertheless, a deterioration of the current fiscal deficit, or other weakened economic conditions, will be an opportunity to propose as a priority a phased adjustment of the fuel subsidy to a lower amount per litre, and also to push for much-needed investment in infrastructure.

Balance of Payments

The current-account deficit moderated in the third quarter of 2013, as the economy slowed. The deficit decreased further in the fourth quarter, as the trade surplus increased and imports fell (because of the weaker rupiah and increased non-oil exports in the second half of 2013). Recent data from BPS show that greater natural-resource exports were the main reason for the increase in exports in December, which created a $1.5 billion surplus in the goods trade balance.¹² There was a surge in exports of raw materials preceding the ban on unprocessed minerals that started in January; ore shipments, for example, were 7.3% higher in December (year-on-year). The deficit in the current account was $4 billion (2% of GDP) in the fourth quarter, down from $10 billion (4.4% of GDP) in the second quarter. Most of the reduction was due to a decline in non–oil and gas imports, particularly those of capital goods and intermediate products, and stronger non–oil and gas exports. The net result was that the balance of non–oil and gas trade increased by 149% in the fourth quarter. But imports of oil and gas remained relatively large, in line with a 12% average increase in international crude prices. This suggests that the volume of oil imports did not decline by much, despite higher domestic retail prices and a slight economic slowdown. The deficit in services trade has adjusted to a decrease in trade more broadly, particularly slower import growth. A large part of the deficit in services trade is due to imports of transport services, which are closely related to trade in goods.

Meanwhile, the deficit in foreign income payments remains fairly steady in the fourth quarter, at $7.1 billion, or 3.5% of GDP. Allowing the rupiah to depreciate led to fears that investors and multinational companies would repatriate income. This has yet to happen, but it remains something to watch.

Foreign direct investment (FDI) into Indonesia was relatively strong in the third quarter of 2013, at $5.1 billion. Recent data on FDI realisation from Indonesia’s Investment Coordinating Board (Badan Koordinasi Penanaman Modal [BKPM]) suggests an increase of 17.5% in the fourth quarter (year-on-year). Net FDI in 2014 may be lower, owing to tighter external financing conditions and delays by investors waiting for the results of the elections.

CURRENT POLICY

Intervention, Protectionism, and Distortions

The Indonesian government has not managed to use the opportunities presented by the current economic slowdown to undo some of the protectionist trade policies introduced in recent years.¹³ It still tends to intervene in markets, for example, and implement policies that protect inefficient firms and industries.¹⁴ Constraints in capacity to develop or implement good economic policy, coupled with populist policies, have produced some economically damaging policies that contribute to the belief that Indonesia is becoming increasingly inward-looking.

As Indonesia enters a politically important year, implementing reforms becomes an even more complex bargaining process. All political interests—not just opposition parties—will weigh economic costs and benefits against outcomes in the upcoming elections. The government has made modest and incremental reforms, but it has muddled through in its approach to sectoral development. Of greatest concern is the slow progress of structural reform and the uncertainty about when numerous new laws will be enacted.

Reform has progressed in areas in which there is clear political consensus. The government, through BKPM, has led agencies in efforts to improve Indonesia’s ranking in the World Bank’s Doing Business indicators.¹⁵ Similarly, the government has been trying to cut the number of days taken to issue licences and permits and to connect electricity to new businesses.¹⁶ On domestic connectivity, the government is turning to external engagement, by building capacity and sharing experience (see ‘APEC Success and Next Steps’, below), to encourage more effective decision-making on priority infrastructure projects by the National Committee for the Acceleration of Infrastructure Provision (Komite Kebijakan Percepatan Penyediaan Infrastruktur), as well as to improve the regulatory environment.¹⁷

A series of new interventionist regulations give the impression of being solutions in search of market failures. In January 2014, President Yudhoyono enacted Law 3/2014 on Industry, which clarifies, in particular, the government’s responsibilities in acquiring sites for industrial development and identifying action plans to promote industrialisation. But the industry law also conveys a bureaucracyknows-best attitude to developing manufacturing. Nehru (2013, 160–61) discusses a few salient provisions in the law, some of which could lead to regulations that allow for unnecessary intervention in the market, create distortions that risk protecting inefficient firms driven by vested interests,¹⁸ create more red tape for businesses,¹⁹ and risk channelling public funds for ill-targeted government projects to support industrialisation.²⁰ For international investors, the detailed regulations of the industry law may increase uncertainty about the rules under which firms in Indonesia will operate (Castle 2013).

More recently, on 11 February, parliament passed a new trade law. In principle, this law will give the government far-reaching powers to use trade policy to protect domestic producers from imports and restrict exports. The government already held many of these powers under the old legislation that this law will replace. In addition, it remains to be seen whether the required government regulations and ministerial decrees to implement the law will employ each of the powers without breaking WTO commitments. Nevertheless, the passing of the law and, in particular, the public justifications given by parliamentarians and Deputy Trade Minister Bayu Krisnamurthi appear to underline policies of managed rather than free trade, and of protection of domestic producers (Jakarta Globe, 11 Feb 2014; Jakarta Post, 12, 13, 14 Feb 2014).

Also of concern is the abuse of quantitative import restrictions. For example, the high-profile corruption scandal over beef import quotas which surfaced in January 2013 led to the KPK’s conviction in December that year of former Prosperous Justice Party (Partai Keadilan Sejahtera) president Luthfi Hasan Ishaaq (Jakarta Globe, 28 Nov 2013; Jakarta Post, 10 Dec 2013). This case is just one example of the misuse of quantitative trade restrictions where the economic rent generated by the restrictions does not translate into government revenue but benefits private interests, particularly the holders of import licences. Another example unfolded more recently, when the government was put in a defensive position after the news media reported complaints from local rice traders that 16,000 tonnes of low-cost rice from Vietnam had entered the Indonesian market, allegedly brought in by private importers who abused legal import permits for high-quality rice (Kompas, 28 Jan 2014). The domestic price of rice in Indonesia is estimated to be 25% to 40% higher than that of rice of similar quality produced by other countries in the region (figure 3). Households have to pay this higher price, and the difference between the prices of domestic and imported rice, as well as the rent that the licensed private importers enjoy, is considerable. This problem may get worse for Indonesia, as Thai rice traders continue to rid themselves of Thailand’s record rice stocks and drive down international prices in the process (Jakarta Globe, 20 Feb 2014).

FIGURE 3 Domestic Price of Medium-Quality Rice in Indonesia and Thailand (Rp ’000/kg)

Mineral Export Policies

Prior to the 2009 national elections, Indonesia’s policymakers passed Law 4/2009 on Mineral and Coal Mining, which aims to increase the value of processed natural-resource exports (Baird and Wihardja 2010). This involves adding value to these sectors (at the cost of subtracting value from the economy as a whole) by using very capital-intensive methods of processing raw materials. Instead of creating the necessary infrastructure and environment to foster such activity, and this would in effect be a large subsidy to entice smelting, the government legislated for this to occur (Burke and Resosudarmo 2012) and intervened in a market where there is no obvious failure.

As a result, in seeking to develop a minerals processing industry, including trying to attract foreign capital for smelting plants, the government actually passed a law that taxes the exports of some unprocessed minerals, bans the exports of others (such as unprocessed nickel and bauxite), and stipulates minimum required levels of processing. The global shortage of nickel, in particular, was thought likely to attract foreign investors to build smelters in Indonesia. Some investment in nickel processing has started, such as PT Bintang Delapan’s nickel smelter in Central Sulawesi. Other projects are set to follow, but many are still undergoing feasibility studies or are in the design phase.

The regulations took effect on 12 January 2014. In the lead-up, the international and domestic prices of many of these minerals did not diverge greatly, indicating that expected and actual trade flows were not substantially affected (Financial Times, 8 Jan 2014). Many private mining companies did not invest in processing facilities during the five-year window, because they assumed that the regulations would not be implemented effectively. They were proved right; immediately before the law came into effect, the government was looking for loopholes in its own policy (Jakarta Post, 20 Dec 2013).

Considerable confusion has surrounded the implementation since mid-January. President Yudhoyono initially agreed to an exemption for the copper ore of the biggest mining firms in Indonesia, US-owned PT Freeport Indonesia and PT Newmont Nusa Tenggara (Jakarta Globe, 12 Jan 2014). But attempts of both companies to bring their lobbying power to bear steeled the government’s resolve. It subsequently clarified that the ban would, until 2016, take the form of an exporttax arrangement, which also covered these two companies (Jakarta Post, 30 Jan 2014). Exports of copper, iron, lead, tin, or zinc ores that are unprocessed or do not meet the minimum processing requirements (ranging from raw materials to concentrates of 15%–62% purity, depending on the mineral) will incur a tax of 20%–25% in 2014, increasing to 60% by the second half of 2016 (Jakarta Post, 1 Feb 2014). Nevertheless, in the course of February the Ministry of Energy and Mineral Resources offered mining firms an opportunity to evade these export taxes by demonstrating that they had advanced plans in place for smelter construction and by committing to a ‘surety bond’ (Jakarta Post, 7 Feb 2014). While some companies were willing to pay the export tax, and subsequently applied for export permits, Freeport and Newmont continued to stockpile produce. More recently, Freeport agreed with state-owned PT Aneka Tambang to study the construction of a new copper smelter while arguing the case for reduced export taxes, and both Freeport and Newmont are considering legal action against the Indonesian government for infringing their existing contracts of work (Jakarta Post, 4 Mar 2014). It seems that the wrangling over the mining export ban has yet to end.

Meanwhile, the distortions introduced by the government’s intervention in the mining sector, even if its regulations are not fully implemented, are potentially large and detrimental to non-energy mining. In the short term, the new regulations will decrease exports of unprocessed minerals without offsetting new exports of processed minerals, contributing to the deterioration of the current account and government revenues. They will lead to a discrepancy between the domestic and international prices of certain minerals, when stocks of produce for domestic processing accumulate as a result of insufficient processing capacity. This may lower the domestic prices of raw minerals and may create rents for smelting companies to exploit. The regulations have also increased uncertainty for investors, including in the non-mining sectors. Under the current tight international financing conditions, the flow-on effects of this policy for Indonesia’s balance of trade may add to the depreciating pressure on the exchange rate, and greater exchange risk may increase the costs of financing operations for investors in Indonesia.

The Fraser Institute’s annual Survey of Mining Companies had already ranked Indonesia as the least attractive country in which to do business in 2012–13 (Sailo 2013). Although these export regulations may have been politically popular domestically, in the eyes of foreign observers they have further damaged the credibility of Indonesia’s economic policymaking and that of the government in implementing its own policies.

Restructuring the Economy

Indonesia, like many other resource-rich economies, enjoyed high terms of trade for almost a decade, from the early 2000s. The domination of commodities in Indonesia’s exports meant that the fall in commodity prices has contributed greatly to the current-account deficit. Indonesia is not alone. Other emerging-market economies, some of which are rich in natural resources, such as Brazil, South Africa, Turkey, and India, are also adjusting to more normal global circumstances (that is, without a commodity boom and abnormally loose monetary policy in the United States).

The consequences of this monetary policy helped to keep the rupiah strong until mid-2013. Yet the fall in commodity prices since late 2011 has exposed some weaknesses in the domestic economy. The appreciation of the rupiah during the commodity boom boosted commodity exports and yielded a ballooning trade deficit in manufacturing and other non-commodity trade (Basri and Rahardja 2011). In contrast, the depreciation in the exchange rate since mid-2013 has not expanded exports or reduced the current-account deficit by any great amount, because of Indonesia’s export structure, in which commodities dominate. Aside from mineral exports, crude palm oil contributes 25% of exports, and rubber 14%. Manufacturing exports have not yet benefited from the more competitive currency, and they decreased during December 2013.

The fall in the exchange rate is likely to cause a supply-side response from, for example, labour-intensive operations that can absorb unskilled labour relatively quickly, such as textiles, clothing, and footwear. There may be a lag before those manufacturing exports pick up, but relying largely on currency depreciation will not change the nature of Indonesia’s manufacturing industry anytime soon. To date, there has been considerable under-investment in manufacturing, particularly in non-commodity exports (Lipsey and Sjöholm 2011). In contrast, much FDI has gone to the natural-resource sectors or been directed at production for domestic markets rather than for export. Indonesia’s manufacturing industry, and its volume of manufactured exports, is small compared with those of other countries in East Asia (Aswicahyono, Hill, and Narjoko 2011). Few manufacturing operations in Indonesia can adjust rapidly to changes in global markets and external circumstances as well as absorb the high internal logistics costs (Sandee, Nurridzki, and Dipo, forthcoming). If the economy retains its current structure, there will be little response in the short term from non-commodity exports to external demand and exchange-rate depreciation.

Structural change has the potential to create productive jobs and increase growth. Indonesia faces the challenge of creating enough jobs for the 2.3 million mostly young, new entrants to the workforce each year, without forgoing the benefits of the ‘demographic dividend’ (Kinugasa 2013).²¹ Manufacturing and services employment therefore needs to increase substantially—particularly in the high-productivity services sectors such as financing, insurance, construction, and business services, if possible (Aswicahyono, Hill, and Narjoko 2011). Figure 4 shows that the share of the workforce in the agricultural sector has fallen steadily, from 44% in 2005 to 35% in 2013. Labour from agriculture has largely been absorbed by community, social, and personal services, which occupied 11% in 2005 and 16% in 2013, and, to a lesser degree, by commercial services and manufacturing.²²

FIGURE 4 Share of Employment by Broad Sector, 2005, 2009, and 2013 (%)

Increasing the capacity of the economy will take time. But Indonesia cannot risk the current slowdown in growth, to 5.0%–5.7%, becoming the new normal, given the relatively young population and the stage of development of the economy. Yet there are few signs of successful structural reform from the current government (Wihardja 2013). Indonesia ranks very low (120th of 189 countries) in the World Bank’s ease-of-doing-business index, and its position has improved little over the past five years.²³

ECONOMIC INTEGRATION

The Investment Boom Paradox

In 2012 and 2013, FDI into Indonesia increased to record levels and investment peaked as a proportion of GDP (Allford and Soejachmoen 2013). In November 2013, Indonesia was ranked as the most promising country for overseas business over the medium-term (defined as the next three years or so) in the Japan Bank of International Cooperation (JBIC) survey of Japanese firms (JBIC 2013). It is the first time in the history of this survey, which started in 1989, that Indonesia has been ranked as the most attractive destination for Japanese investment, overtaking China, which has consistently been the highest. In a United Nations Conference on Trade and Development survey of multinational enterprises, Indonesia ranked as the fourth most prospective economy for hosting FDI in 2013–15. In 2012, the country became the 17th largest recipient of FDI, its first time in the top 20 (UNCTAD 2013).

Yet, in the JBIC survey, Indonesia still ranks behind India and China for overseas business in the longer term (defined as the next 10 years or so). China’s relative decline as the top destination in the medium term is due largely to rising labour costs, as Japanese firms restructure their investments in adjusting to the new economic circumstances in China (JBIC 2013).

The recent growth in FDI into Indonesia and the country’s improved prospects as an FDI recipient occurred even though there was little improvement in its investment environment or competitiveness. Indonesia ranked fourth among 58 countries in having the most restrictive regulatory regime for FDI in the OECD’s FDI Regulatory Restrictiveness Index of 2013.²⁴ Lipsey and Sjöholm (2011) explain that Indonesia started from a low base of FDI in East Asia, given its size and characteristics, and that poor infrastructure, a bad investment environment, inefficient government institutions, and low levels of education were to blame. Improvements in these areas have not been significant enough to explain their growing attractiveness to FDI. Indeed, FDI growth has occurred even under policies that have cast doubt on Indonesia’s openness to investment and trade, such as the ban on exports of unprocessed minerals (Cornish 2013). Rather, FDI growth appears to have been caused by market-seeking FDI aimed at Indonesia’s large domestic economy and FDI aimed at its resources sector, as well as by other FDI destinations becoming less attractive.

Investors had hoped that Indonesia’s new negative investment list (Daftar Negatif Investasi [DNI]), announced by BKPM chair Mahendra Siregar in December 2013 (Kompas, 25 Dec 2013), would be more open to, or at least not more restrictive of, foreign entry into more sectors. The revised DNI list has instead accommodated pressures for a less-open regime on logistics and on oil and gas exploration. The DNI has had implementation problems since it was introduced, in 2007; individual ministries have applied their own restrictions, thereby creating uncertainty in areas in which the DNI was supposed to be creating certainty (Magiera 2011). Opening up seaports and airports to foreign management would be a positive development in improving domestic and international connectivity, but its implementation remains uncertain. Foreign nationals are forbidden from participating in management, and state-owned operators PT Angkasa Pura (I and II) and PT Pelindo (I to IV) currently have exclusive rights to manage main airports and seaports, respectively (Jakarta Post, 7 Nov 13). Foreign ownership of ports is limited to a minority stake of 49%. Even if the government allows full foreign management of ports, restrictions will apply to foreign ownership of assets and facilities. This issue is not confined to domestic versus foreign entry into the sector; it also concerns increased competition and openness to domestic competition, and new entrants versus incumbents. Other important proposals for reforms to the DNI include increasing the cap of foreign investment in pharmaceuticals from 75% to 85% and in tourism from 49% to 70%.

Given that FDI has increased without any substantial policy changes or improvements to the investment environment, the question is whether Indonesia’s ability to attract FDI is sustainable. Major changes will be necessary to make large FDI inflows sustainable and to attract FDI into new sectors, which will boost employment and productivity. The following sections address these changes.

On the Fringes of Supply Chains

Indonesia’s manufacturing exports are much lower than those of Malaysia and Thailand, and, depending on the measure used, those of the Philippines and Vietnam (table 3). In addition, Indonesia has much lower exports of parts and components. Simply put, Indonesia is an outlier in the region, since it has at best achieved partial integration into international and regional supply chains (Lipsey and Sjöholm 2011; Soejachmoen 2012). Indonesia ranks behind its Asian neighbours in the World Investment Report’s global-value-chain participation rate (UNCTAD 2013, 134). Indonesia’s rate is 44%, lower than that of Singapore (82%), Malaysia (68%), the Philippines (56%), Thailand (52%), and Vietnam (48%).

TABLE 3 Non-commodity Exports as a Share of Total Exports and GDP, 2012 (%)

Source: Authors’ calculations from the United Nations Comtrade database and the World Bank’s World Development Indicators.

Note: Classification for parts and components trade from Athukorala (2003). The classification understates participation in parts and components trade, and hence production networks. For a full discussion, see Athukorala (2003).

The global fragmentation of production and the resulting supply chains have enabled deeper specialisation across countries and more efficient allocation of resources (Baldwin and Lopez-Gonzalez, 2013). Indonesia is part of the world’s most economically dynamic region, with many of its neighbours benefiting greatly from new market links and technologies (WTO and IDE-JETRO 2011). Production networks in Asia present many new opportunities for economies to specialise, to diversify, and to allocate resources more efficiently. The global growth in trade has been dominated by the growth of such supply chains (UNCTAD 2013; OECD 2013), and there are major growth opportunities in participating more fully in production networks.

Indonesia is, of course, connected to the lowest-cost suppliers in the region, via multinationals that import from their supply chains to their plants in Indonesia, produce goods, and then sell to the domestic market. But what is absent is a role for Indonesia-based producers as major suppliers to those networks. Table 3 shows that Indonesia is a less significant exporter of parts and components relative to the size of its economy. Indonesia has supplied the region with raw materials and final products, the latter usually from multinationals that were well established in Indonesia’s domestic market. There will be many opportunities in the future in the export of intermediate goods, as China and other large economies come to depend on procurements from lower-cost suppliers of parts and components, as well as tasks, in Asia and beyond.

Being part of production networks allows countries to specialise more and realise their comparative advantages, which is important in generating employment and importing technology, capital, and know-how. Coupled with regulatory reforms that allow more flexibility, it is also important in diversifying industries and improving competitiveness by opening up sectors to more competition. If Indonesia remains at the fringes of regional and global production networks, it forgoes opportunities to build deep specialisation in new industries and take advantage of countless opportunities to supply into the value chains. It could also find it difficult to increase productivity by relying on exports of natural resources, especially now that resource prices have fallen from their peak of a few years ago.

Supplying production networks requires competitiveness in production and supply. Much of the improved logistics, technology, and know-how can be achieved by attracting new investment—both foreign and domestic—into new or established industries. A more open and business-friendly investment environment may well be helped by a simplified DNI and by structural reforms, including improvements to Indonesia’s regulatory environment. Opening up and attracting new investment is likely to create resilience in economic activities within and between sectors, and to improve resilience in dealing with the required rapid adjustments to changes in economic circumstances. A more diversified economic structure, with a larger manufacturing base, would help to expand exports as the currency depreciated, which does not appear to be happening at the moment.

In addition to further opening up to investment, fuller participation in global supply chains would require improvements to infrastructure and a more competitive labour market (Soejachmoen 2012). The importance of labour quality is related not only to adding value in manufacturing production over time but also to maintaining the importance of services to production networks–service costs are one of the main determinants of a country’s success in production networks. Indonesia is not likely to have a competitive labour force if the recent trend of minimum wage hikes (44% in 2012 and 11% in 2013) continue to exceed growth in productivity and living costs (Aswicahyono and Manning 2011). In order to avoid a skills constraint as Indonesia moves from low-skilled manufacturing to more sophisticated exports, minimum-wage increases need to be tied to productivity and coupled with investment in education.

Indonesia ranked 59th globally in 2012 in the World Bank’s trade-related Logistics Performance Index, behind its Southeast Asian neighbours Singapore (which ranked 1st), Malaysia (29th), Thailand (38th), the Philippines (52nd), and Vietnam (53rd). The index ranks performance in infrastructure, customs, tracking and tracing shipments, timeliness, logistics competence, and international shipments.

As Chinese wages increase, they create more opportunities to grow the manufacturing sector in Indonesia and elsewhere. Labour costs in China, and not bilateral political tensions, were the primary stated reason why China became much less attractive as an investment destination for Japanese firms (JBIC 2013). If Indonesia can improve its domestic business environment and supply regional production networks, its attractiveness as an investment destination will last beyond the present investment boom.

Infrastructure

A major bottleneck in economic growth has been the insufficient development of infrastructure.²⁵ As an archipelago, Indonesia faces high domestic transport costs, and chronic under-investment in infrastructure has limited the integration of the domestic economy and the integration of the Indonesian economy into the regional and global economies. Key issues include the sizeable investment that infrastructure requires, the limits to the public budget, and the conditions that would attract private investment in infrastructure.

Infrastructure spending as a proportion of GDP has not returned to pre-Asian financial crisis levels, of around 9%. It averaged around 4% of GDP after the crisis, with a substantial increase during 2007–9, as figure 5 shows. Under-investment in infrastructure has led to much depreciation and degradation of existing infrastructure, as well as a backlog of nationally important projects. Perhaps most striking in figure 5 is the large fall in the private sector ’s contribution. This should be of concern, because the private sector is a major source of funding for infrastructure.

FIGURE 5 Infrastructure Spending as a Share of GDP, by Source, 1995–2011 (%)

A series of infrastructure summits in Indonesia and the development of regulations and incentives to encourage public–private partnerships (PPPs) have not succeeded in attracting sufficient investment from the private sector (Manning and Purnagunawan 2011). Many of the problems are in the project preparation phase, and include the lack of capacity in various ministries to prepare and assess projects; the lack of a financing environment that secures reasonable returns considering the risks of long-term infrastructure investment; and the lack of a stable and business-friendly regulatory environment that secures private-sector rights in building, owning, and operating facilities.²⁶ Also of concern are the processes used by private enterprises to tender for public projects, and the degree to which private-sector owners and operators of facilities are able to set prices themselves or be bound by the rulings of a non-independent regulator.

The project preparation phase for infrastructure investment in Indonesia needs to be improved and shortened, and decision-making must be more effective.²⁷ This preparation phase involves those ministries that are directly affected by the project, as well as the Ministry of Finance and the National Development Planning Agency (Bappenas). There is often ambiguity over which priority projects are financed by state-owned enterprises or the government budget and which are put out to tender for financing by the private sector or a PPP. Land-acquisition legislation is also a constraint. While the legislation itself contains sufficient detail for public agencies to resume land for public purposes, such as for infrastructure projects, it has often been used by vested interests to interfere with the approval of projects, which has created delays and uncertainty for investors.

The public service has made a considerable effort to reform or strengthen existing institutions by making procurement and tendering more transparent, providing more regulatory support, and increasing the government’s capacity for preparing projects. A notable innovation is viability gap funding (set out in Presidential Decree 56/2011 and Minister of Finance Regulation 223/2013), whereby the government can support and provide guarantees for infrastructure PPPs in order to increase their financial viability for private partners.

Two state-owned companies have been created to help establish PPPs. The 2005 Indonesia Infrastructure Guarantee Fund (PT Penjaminan Infrastruktur Indonesia [PII]),²⁸ prepares and provides funding guarantees for a variety of PPPs, and creates a single window in which to appraise proposals for infrastructure PPPs. In 2009, the Ministry of Finance established PT Sarana Multi Infrastruktur (SMI)²⁹ to help secure long-term financing of PPPs through mediation between project owners and private investors. Both state-owned firms have been instrumental in implementing new PPPs. Yet of the 21 PPPs that Indonesia has tendered since 2009, by October 2013 just 7 had reached the final stage of negotiations between the government contracting agency and the winning bidders (Bappenas 2013, xvi–xxi). Six of these projects are toll-road segments in Jakarta, which have been studied since 2005, were proposed in 2008, and then scheduled for construction by PT Jakarta Tollroad Development (JTD), which is owned by the Jakarta government (Investor Daily, 17 Oct 2011; Kompas, 21 Feb 2014). Putting the contract out to tender in 2011 yielded just two bids, despite the prospect of a PII guarantee. In 2012, JTD eventually won the right to negotiate, but it ran into difficulties in stitching together a consortium of banks to finance the six projects. In 2013, it found that Jokowi wanted to delay the projects until the construction of Jakarta’s Mass Rapid Transit system and monorail had started; Jokowi then put off signing the required environmental permit for the projects (Kompas, 30 Jul 2013; Bisnis Indonesia, 17 Jan 2014). If this experience can be generalised, PPP projects will require sustained commitment from investors, despite the services of PII and SMI.

APEC Success and Next Steps

Indonesia will face difficulties in pursuing economic restructuring policies that are divorced from the regional and global initiatives to which it has committed itself. Indonesia is involved in APEC and ASEAN, and engaged in the ASEAN Economic Community (AEC); the Regional Comprehensive Economic Partnership (RCEP) (which includes the ASEAN members plus Australia, China, India, Japan, South Korea, and New Zealand); and trade liberalisation at the multilateral level, as part of the WTO. These commitments are the vehicles for effecting much-needed structural changes to Indonesia’s economy, which would help the country participate more fully in regional supply chains and integrate itself into the regional and global economies.

The year 2013 was important for Indonesia’s foreign economic diplomacy. The country hosted the APEC leaders’ summit in October, and a series of APEC meetings of senior officials and ministers throughout the year. It also hosted the WTO ministerial meeting in Bali in December. All provided momentum for regional and global trade, investment, and growth. A message from the G20 on the primacy of the multilateral system, and a successful APEC summit that emphasised the region’s commitment to the multilateral system, guided the WTO ministerial meetings in Bali. As the host, but also as a strong proponent of multilateral trade liberalisation, Indonesia gave the Doha Round of negotiations some life, after many failed attempts by the WTO.

Indonesia used APEC 2013 strategically, by focusing on infrastructure investment, which is a domestic priority both for Indonesia (as discussed) and for many other countries in the region (Armstrong 2013). The consideration of infrastructure investment in APEC is important, because such investment is a shared priority with substantial cross-border spillovers—and also because sharing experience and building capacity can advance regulatory reform. Getting regulatory systems right is critical in attracting private capital in infrastructure investment; the Asian Development Bank has calculated that Asia will need $8 trillion in infrastructure investment by 2020 if it is to sustain economic growth (ADB 2009).

More connectedness across many dimensions, such as telecommunications, roads, ports, bridges, and institutions, within Indonesia and among the regional economies is growth-enhancing and has important positive externalities (Elek 2013b). Indonesia’s APEC year delivered a PPP pilot centre within the Indonesian Ministry of Finance, an APEC PPP Experts Advisory Panel, and experiencesharing and cooperation on different aspects of infrastructure investment. These outcomes alone will not attract more infrastructure investment to Indonesia and its neighbours, but they may help in exposing some of the main constraints and in determining best-practice solutions. The priority given to infrastructure in APEC means that Indonesia can make a connection between the regional and global cooperation forums, in which infrastructure investment is an important part of the G20’s sustainable growth agenda (Elek 2013a).

Beyond infrastructure, Indonesia needs to build on the successful strategy that it deployed at APEC and use the AEC, RCEP, and other external initiatives to reinforce its domestic priorities for structural change. There is urgency here for Indonesia, both domestically and regionally, because the next two years will see the end of the RCEP negotiations and the implementation of the AEC schedule. A successful RCEP and an Indonesia that is well prepared for the AEC will help its firms, and its economy, to participate in regional and global production networks. They will also help to restructure the economy and increase its growth potential.

Indonesia has a real opportunity to contribute to the success of RCEP. Indonesia’s new economic circumstances suggest that it needs to make ambitious commitments in RCEP to reinforce its domestic priorities, make itself more competitive, and provide positive spillovers for the region. Indonesia played the lead role in creating RCEP, and, as the coordinating country, has a strong interest in reaching a comprehensive and ambitious outcome.

The opportunity cost of an insignificant RCEP agreement could be high for the region and for its individual members. It could create the possibility that Indonesia’s major trading partners will sign up to the Trans-Pacific Partnership to the exclusion of Indonesia. RCEP includes the very large emerging economies of China and India, as well as Indonesia’s major regional partners, where future growth opportunities lie. Major international economic and geopolitical implications for the centrality of ASEAN Asian cooperation are at stake.

Just as Indonesia is important for a successful RCEP, the success of the AEC depends very much on Indonesia, and can help to transform its economy and lift it on to a higher growth trajectory. Yet with AEC implementation moving Indonesia towards a single market and production base by the end of 2015, the country appears to be ill-prepared, which could hamper the AEC’s development (Jakarta Globe, 19 Nov 2013). Indonesia already trails many of its neighbours in logistics and trade costs, and it could miss out on the many new opportunities that an AEC would present. For one, Indonesia has not made enough improvements to services liberalisation–exactly what it needs to join production networks more fully–since it has not implemented the seventh or eighth packages of the ASEAN Framework Agreement on Services (AFAS), and it will be the likely cause of a watered-down ninth package. For example, Indonesia’s AFAS commitment to foreign-equity limits, at 40% to 51%, is considerably lower than the most-favoured-nation limits of 65% to 95% defined in the most recent DNI (Dee 2013).

Many of Indonesia’s domestic economic challenges and regional opportunities are strongly complementary. By championing its own priorities in regional forums, Indonesia can avoid dragging down the regional economy and at the same time improve its own economic prospects.

The authors are very grateful to the many interviewees in Jakarta, who shared their insights and time, and to the members of the Indonesia Study Group at ANU, who provided extensive comments. Any errors are the authors’ own. Rahardja’s views are personal and do not necessarily reflect the views of the World Bank and its Board of Directors.

Notes

¹ The coalition secretariat (sekretariat gabungan) consists of the Democratic Party (Partai Demokrat), Golkar, the United Development Party (Partai Persatuan Pembangunan), the National Awakening Party (Partai Kebangkitan Bangsa), and the Prosperous Justice Party (Partai Keadilan Sejahtera).

² Jokowi enjoyed 43.5% support in January (Kompas, 8 Jan 2014), while the second-placed Prabowo, from Gerindra, attracted only 11.1%. Other polls have consistently shown Jokowi as the leading potential presidential candidate.

³ Article 9 in Law 42/2008 on Presidential Elections states that presidential and vice-presidential candidates can be nominated only by a political party or a coalition of political parties that secure 20% of seats in the parliament or obtain 25% of votes in the parliamentary election preceding the presidential election.

⁴ Interviewees for this ‘Survey’ noted that PDI–P is known as a nationalist party but that Megawati’s 2001–4 presidency was characterised by pragmatism in economic policy.

⁵ See the World Bank’s World Development Indicators (specifically, industry of employment for those aged 15 and over): http://data.worldbank.org/data-catalog/world-development-indicators. Export data are available at http://wits.worldbank.org/wits/. Non-commodity manufacturing is defined as Standard International Trade Classification 5–8.

⁶ See World Bank (2013) for a discussion of the decline in nominal credit growth and construction investment.

⁷ The unexpected monetary tightening under new BI governor Agus Martowardojo is a departure from the loose monetary policy under the previous governor, albeit in different economic circumstances. See, for example, http://www.bloomberg.com/news/2013-11-12/bank-indonesia-surprises-on-rates-in-credibility-boost-to-policy.html.

⁸ Uncollateralised funds have typically been more accessible to larger banks than to smaller banks, owing to the perception among larger banks that smaller banks carry more counterparty risk.

⁹ Liquidity is less of a problem for larger banks, because they can attract depositors easily and lend with relatively cheaper costs of funds. This can influence the outcome of monetary tightening (see, for example, Kashyap and Stein 1994).

¹⁰ See, for example, http://www.bloomberg.com/news/2013-04-04/bank-indonesiawon-t-let-rupiah-breech-10-000-bca-chief-says.html

¹¹ Until Indonesia’s current account turned negative in the last quarter of 2012 and the rupiah started to depreciate, BI tended to rely on what the IMF recently called ‘a combination of heavy intervention and moral suasion’ to stabilise the exchange rate (IMF 2013, 13). See Kenward (2013) for an appraisal of Indonesia’s experience with inflation targeting since 1999.

¹² The figure for natural-resource exports is listed under the trade classification Harmonized System 26.

¹³ Implicit quotas on horticultural and beef imports have been relaxed, but trade policy remains restrictive. Soesastro (1989) describes how declining terms of trade motivated significant economic deregulation throughout the 1980s.

¹⁴ Such policies are not new. The development of the automobile sector, for example, has been hampered by highly interventionist policies (Aswicahyono, Basri, and Hill 2000).

¹⁵ See http://www.doingbusiness.org/rankings.

¹⁶ Such as domicile permits, nuisance permits, and investment licences.

¹⁷ The government is currently revising Presidential Decree 42/2005 on the National Committee for the Acceleration of Infrastructure Provision, to streamline the committee’s decision-making process and provide it with a secretariat and funds to conduct pre-feasibility work.

¹⁸ Article 32 on potential restrictions on the export of raw materials, article 33 on promoting domestic value addition, and article 86 on prioritising domestic products in procurement of goods and services by government agencies or projects financed by the state budget.

¹⁹ Article 25 on workers’ competency, article 27.2 on the use of foreign experts, and criminal investigations for violating a product’s technical specifications.

²⁰ Article 16 on skills development and article 48 on financing institutions.

²¹ See also http://www4.bkpm.go.id/contents/general/8/demographics.

²² The note to figure 4 lists the BPS categories within these broad sectors.

²³ For more, see Thee (2013).

²⁴ See http://www.oecd.org/investment/fdiindex.htm.

²⁵ See Narjoko and Jotzo (2007), Manning and Purnagunawan (2011), and Mahi and Nazara (2012).

²⁶ See ‘Annex A—An APEC PPP Experts Advisory Panel and Pilot PPP Centre’, accessed 5 March 2014, http://www.apec.org/Meeting-Papers/Ministerial-Statements/Finance/2013_finance/annexa.aspx.

²⁷ See, for example, Younger (2013) and Bappenas (2013).

²⁸ See http://www.worldbank.org/projects/P118916/infrastructure-guarantee-fund?lang=en&tab=overview and http://www.iigf.co.id/Website/Home.aspx.

²⁹ For more on the role of PT SMI, see http://www.ptsmi.co.id/content/role-of-pt-smi/.