Tuesday, May 24, 2011

Indonesia needs reform to remain an attractive investment destination

The feisty debate between the House of Representatives and the finance minister over purchasing a stake in miner Newmont Nusa Tenggara points to broader issues facing Indonesian investment laws.

Considering Indonesia's continued economic resilience during and following the global financial crisis that has plagued the economic growth of many countries, the economic outlook for the archipelago should be rosy.

Recent data from the government's statistics agency showed economic growth in the first quarter of this year of 6.5 percent, and there's no indication that it will slow.

Similarly investment has generally provided a good news story.  Despite some sectors plateauing in attracting new foreign direct investment, Bank Indonesia data show strong growth in the retail and manufacturing sectors in recent years.

Such an outcome is hardly surprising.  Coupled with limited export exposure to American and European markets in favor of Asean nations and China, Indonesia saw relative investment stability throughout the global financial crisis.

The contribution of foreign direct investment to economic growth is clear because it provides countries with the necessary finance to build infrastructure and grow industries that employ workers and pay taxes.  It also frees up domestic savings to finance other activities and increase overall economic welfare.

However, with other countries slowly pulling themselves out of recession the environment for accessing investment finance is going to become increasingly constrained and governments are going to need to continue reform to make them a safe and attractive destination.

And Indonesia's recent history provides good foundations that should be built on.  Since the mid-1980s successive governments have progressively liberalized government restrictions to make it a more attractive destination for foreign investment.

While some seem like easy options today, such as the 1987 reforms that allowed foreign investors to be on the stock exchange, more recent examples required significantly greater political and policy muscle.

The 2007 investment reforms that granted national treatment for foreign investors and established a transparent ''negative'' list for out-of-bounds investment sectors were considered a watershed in Indonesia's economic strategy.

Despite ranking highly on the OECD's latest investment restrictiveness index, investment liberalization efforts have improved Indonesia's international reputation, especially after the political instability and capital flight of the 1997 Asian currency crisis.

But the job is not done and by-products of Indonesia's spectacular decentralized democratization are now risks.

Concurrent with pro-investment regulation reform nationally, immature local governments are increasing investment burdens, often through opaque measures, that are posing perceptions of risk.

And these perceptions are being exacerbated by politics.

The recent challenges faced by mining giant Newmont surrounding its gold and copper mining on Sumbawa Island are a perfect example of how the perception of investors being squeezed between national and local regulation is occurring.

The national government has signaled its intent to purchase a 7 percent ownership share in the Newmont mining venture, despite protests of three local governments organized collaboratively who also wanted the investment opportunity.

In response to the national government's action, the local administrations who want the stake for themselves are threatening to revoke mining licenses placing the investment in doubt and with it Indonesia's reputation.

These perceptions couldn't come at a worse time and are being confirmed by international ratings agencies.

Earlier this month, Standard & Poor's released a report looking into 2009 investment reforms concluding subsequent regulations provide ''greater clarity'' toward a negative impact on the mining sector because of the consequences of decentralized decision making which could hit bottom lines.

Without improvements, these perceptions of investment risk could make it significantly harder for attracting private investment.  But it could also flow through to projects of government priority.

Outlined in the OECD's latest Indonesian investment review are the incredible infrastructure challenges widely recognized as a barrier to further economic growth the national government needs to raise considerable finance in the next five years.

With national plans outlining that the government is expecting 64 percent of all capital for infrastructure projects to come from the private sector it is going to need to look at innovative financing and ownership structures such as public-private partnerships.

Having legislative and regulatory requirements for shares of government ownership naturally lends itself to sovereign risk when the priorities of governments and foreign investors collide.  The situation is made worse when local and national authorities are also fighting.

And with ongoing cases like those faced by Newmont, the chances of investors going into business with the government appear risky, especially outside of Jakarta.

Instead of trying to manage these priorities the government should be looking toward further investment law reforms that consider the benefits of removing government ownership investment requirements all together.

Liberalizing investment ownership laws doesn't preclude the government securing their share of the dividend of exploiting Indonesia's scarce natural resources which can still be secured through well-designed licensing agreements.

Choosing to focus government interests through contracts rather than ownership is also replicable irrespective of investment type and avoids fostering risk perceptions from the government involving itself where it has little expertise.

The benefits of doing so are also likely to flow throughout the entire economy.

Considering the uncertainty of the international economy and the emerging constraint to attract financial capital, investors are looking for locations to grow their capital -- and that isn't where perceptions of sovereign risk remain.

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