Foreign Direct Investment: Indonesia’s Golden Ticket?

Foreign Direct Investment: Indonesia’s Golden Ticket? Photo: Unsplash

President Joko Widodo has long touted foreign direct investment (FDI) as a means for Indonesia to avoid the middle-income trap (Humas, 2014). However, following the Covid-19 pandemic, FDI has taken on an even more important role as the President’s favoured means of kickstarting the economy (Widodo, 2020).

Foreign direct investment, as the name suggests, occurs when a corporation in one country establishes a business operation in another country (Otto, 2020). A recent example of FDI is when in November 2020 Hyundai, a Japanese company, announced that they would invest US $1.5B to set up a new factory in Indonesia (United Nations, 2020).

Indonesia was the 5th largest host economy for FDI in Asia in 2019, at just under US $25B, having achieved 14% growth in FDI in 2019 (United Nations, 2020). However, when measured as a percentage of GDP, Indonesia ranks 92nd in the world for FDI. This leaves it ranking is behind fellow ASEAN countries such as Singapore (5th), Cambodia (13th), Vietnam (27th), Timor Leste (57th), Laos (71st), Myanmar (72nd), and Brunei (77th); whilst being roughly on par with Malaysia (96th) and the Philippines (99th) (The World Bank, 2021). The only ASEAN country whom Indonesia is ranked considerably ahead of is Thailand (137th). Whilst this low FDI to GDP ratio can partially be explained by Indonesia’s large population and thus large non-FDI GDP, it also highlights the capacity for extensive FDI growth in Indonesia. This potential for growth was signified in the United Nation’s World Investment Report 2020, where it was stated that following the pandemic ‘longer term, a few countries with low labour cost advantages (e.g. Indonesia and Vietnam) could fare relatively better as multinational enterprise’s pick up operations’ (United Nations, 2020). By mentioning Indonesia by name in this statement, it is clear that the UN agrees with Jokowi’s stance on FDI.

FDI in Indonesia has historically been good for both the Indonesian economy and Indonesian workers. The economy has benefitted as foreign firms have consistently had higher labour productivity, higher total factor productivity and higher productivity growth rates than Indonesian firms (Lipsey & Sjoholm, 2011). Foreign firms have also been shown to be comparatively better exporters than Indonesian ones, due to their prior integration in the global marketplace, therefore meaning FDI concurrently helps Indonesia’s trade balance. Thus, the economic reasons for why the Jokowi administration wants more FDI to enable a “resilient economic recovery” are clear. For Indonesian workers, foreign firms pay higher wages than local counterparts, even after education and other extraneous variables are accounted for. It can be assumed that the aforementioned higher productivity of workers at foreign firms is the cause of the higher wages, following the fundamental economic equation Marginal Revenue Product of Labour = Wage (Taylor & Wirapana, 2012).

Critics of FDI may highlight negative spill over effects of FDI on domestic businesses. For example, foreign firms may outcompete local businesses due to better technology, better funding, and better human capital management. However, this has actually been of benefit to domestic firms as by being exposed to best practise, they often seek to emulate or compete through investments of their own. Therefore, it has been found that FDI contributes greater overall efficiency and productivity of these domestic firms, thus allowing them to increase their own profitability and employee wages (Lipsey & Sjoholm, 2004).

Given that the Indonesian government wants FDI, and Indonesia has many of the necessary conditions for growth in FDI, and FDI will be of benefit to the Indonesian people, it seems paradoxical that Indonesia has lower than expected levels of FDI. We will look at some of these reasons below, as well as analysing how the Indonesian Government intends to solve them.

CORRUPTION

Corruption is currently a factor that dissuades many potential investors from Indonesia. Globally, Indonesia is ranked 102nd on the corruption perception index, with a score of 37/100 (Transparency International, 2021). Whilst the ranking itself is problematic; the score is even more so, being closer to that of 157th placed Zimbabwe than that of FDI competitor Malaysia. Foreign corporations generally wish to maintain a clean public image on the international stage, as corruption scandals hurt their share price and marketability. Thus, if corruption can be avoided it will be. However, many of the factors that cause a market to be a target of FDI, such as low wages and large populations, are also factors that cause corruption (Lipsey & Sjoholm, 2011). This is why so many corporations put up with corruption in places such as Indonesia and Vietnam. It follows that if Indonesia can eliminate or reduce corruption, they can then gain a competitive advantage over competitors for FDI, such as Vietnam.

Unfortunately for Indonesia, during the post-decentralisation era, the corruption they experience is primarily non-standardised, arbitrary, and unpredictable in nature. Unpredictability is one of the last things corporations want when conducting FDI, as it impacts timelines and cannot be budgeted for. Therefore, if corruption is to exist it is preferential that it is predictable corruption. This is exemplified through Vietnam, where although ranked higher in terms of perceived corruption, they still receive comparatively greater amounts of FDI than Indonesia, in part due to the centralised and therefore predictable nature of this corruption.

Given that most of this non-standardised corruption occurs at a local government level and that there are great differences in the quality of public policy between local governments, the Omnibus Law has aimed to centralise and/or digitalise certain procedures, such as control over regional spatial planning. This process, referred to by the Central Government as de-bureaucratisation, should help reduce the scope for low level arbitrary corruption and thus encourage FDI.

Critics say that this aspect of the Law will allow for more corruption from the Central Government and merely change the beneficiary of such corruption because they will be the only ones involved in the investment process. However, even if that is the case it would still increase predictability, as there would only be one level of corruption, and thus make Indonesia a more attractive market for foreign investors. Therefore, it is anticipated that the measures in the Omnibus Law related to reducing corruption through de-bureaucratisation and digitalisation will help contribute towards attracting more FDI. This is because with the centralisation of contracting through d-bureaucratisation the avenues for corruption become far more predictable and stable for foreign investment. Furthermore, there are less stakeholders involved in the investment process, thus increasing the individual responsibility for any corruption that occurs and decreasing the chances of there being corrupt stakeholders.

CONTRACT ENFORCEMENT

The ability, or in Indonesia’s case inability, to enforce contracts plays a large role when doing business. If the contract enforcement process is time consuming and costs nearly as much as or more than the expected claim value, then contracts cease to be worth the paper they are written on. This is because both parties would both know of the other party’s reluctance to enforce it, and that the costs would outweigh the benefits. For corporations involved in FDI, the efficacy of a contract is particularly important as they are entering a new market where they have no established relationships. This is because once parties to a contract gain trust with one another they no longer see contract law as so important. However, this trust can only be built up over time and as such it does not exist when investing in new foreign markets.

Globally, Indonesia ranks 139th for contract enforcement, far below FDI competitor Vietnam (61st) (The World Bank, 2020). Despite having only improved their ranking 5 spots since 2013, Indonesia have had vast improvements in some of the key metrics that are factored into it. Firstly, they have reduced the average cost of bringing a contract based claim down from 139% of the claim value (amount awarded for the breach) in 2013 to 74% in 2019. Having a claim cost higher than a claim value means that parties are positively disincentivised from enforcing contracts. Given that the claim value now exceeds the claim cost greatly strengthens contract law in Indonesia as there is now an incentive to enforce a contract. Secondly, Indonesia has reduced the average time taken for a claim to be processed down to 390 days, an over 100-day reduction from in 2013. If these figures can continue to trend in the right direction, then it should bode well for contracting and foreign investment in Indonesia.

The Omnibus Law does not have a direct focus on contract enforcement processes. However, by simplifying the surrounding legislation the Central Government hopes to simultaneously streamline contract enforcement.

 

The Omnibus Law does not have a direct focus on contract enforcement processes. However, by simplifying the surrounding legislation the Central Government hopes to simultaneously streamline contract enforcement. There are concerns that due to the rushed nature of the Omnibus Law there may be an increase in ambiguities which would have the counterproductive effect of increasing litigation. This is because, by nature of the law being passed quickly, there are less drafts of clauses and there is less opportunity to analyse the ramifications of the language used to express each clause. There is also going to be a lack of established precedent for the Omnibus law which in turn will mean a lack of certainty as to how provisions will be interpreted by the courts.

BUSINESS LICENSING REFORM

‘Starting a Business’ is another area for improvement in Indonesia if it wishes to attract more foreign investment. This is the topic in the World Bank’s ‘Ease of Doing Business’ rankings that Indonesia places the lowest, all the way down at 140th (The World Bank, 2020). For some context, they are 93 places below Thailand, 72 places below Timor Leste, and 25 places below communist Vietnam. The Omnibus focus areas of ‘deregulation’ and ‘de-bureaucratisation’ are aimed at helping solve this (Indrawati, 2020).

To be more specific, the government is seeking to transition from a permit-based licensing system to a risk based one, of which there will be three tiers of risk(low, medium, high) (Oentoeng Suria & Partners, 2020). Low-risk business activity will now only require a Business Identification Number (NIB), while medium-risk activity will require an NIB and standard certification. In addition to the NIB, a business license will also be required from the relevant government institution for high-risk activity. The Omnibus Law has also removed a range of environmental licenses that were previously required. This new licensing process should increase the ease with which foreign corporations can set up business, particularly if it is of a low or medium risk nature. Omnibus Law changes to the Government administration process also now allow for decrees to be issued in an electronic format and no longer require a hardcopy to be issued, further expediating the licensing process in Indonesia.

However, it was noted in Moody Investor Service’s report on the Omnibus Law that the removal of the environmental license may discourage some foreign investors. This is due to the increased focus on corporate social responsibility and company image amongst corporations, with the Indonesian Government having already received a letter expressing ‘environmental concern’ from some global investors. The Asian Development Bank also noted ‘concerns on environmental sustainability’, but alike Moody’s had a favourable view of the anticipated impact of the Omnibus Law on FDI. Finally, there is the possibility of court action and protests if companies were to take advantage of the reduced environmental licensing requirements (Indonesian Centre for Environmental Law, 2020).

Overall, the anticipated positive impacts for FDI in Indonesia from the new business licensing processes outweigh the cons. There are now less forms, less stringent requirements, and shorter processing times for starting businesses in Indonesia and thus it will be easier for foreign corporations to invest.

TRADE ACROSS BORDERS

Another area for significant improvement that could cause FDI growth in Indonesia is ‘Trading Across Borders’. Currently, Indonesia currently ranks 116th for this, placing it 8th in ASEAN and only ahead of Cambodia (118th) and Brunei (149th) (The World Bank, 2020).

The time and cost to import to and export from Indonesia pose numerous difficulties for FDI in Indonesia. Firstly, the import processes make it both costly and time-consuming set up business in Indonesia. These fixed costs and opportunity costs related to the time and money required to import combine to increase the barriers to entry in Indonesia, thus turning away corporations that would otherwise invest in Indonesia for its low marginal costs. Secondly, the export processes make it difficult to use Indonesia as a base location for the international market, meaning most FDI in Indonesia is for the Indonesian market. This greatly limits the range of corporations that will invest in Indonesia and also serves to place a cap on the growth potential of FDI in Indonesia.

The Central Government has sought to address this by being a signatory to the Regional Comprehensive Economic Partnership (RCEP) in November 2020. RCEP is the largest free-trade-agreement in the world and therefore Indonesians participation should make the process of doing international business from Indonesia far easier (Australian Government, 2020). They also entered into a separate Comprehensive Economic Partnership Agreement (CEPA) with Australia in July 2020 (Australian Government, 2020).

The entry into these agreements should prove to be beneficial for FDI in Indonesia, as it will enhance the ability of corporations to conduct export-oriented manufacturing, a focus of the Government’s (Kartasasmita, 2021), from the archipelago. It will also make it easier for plants and factories to be set up by corporations based in signatory jurisdictions, as importing should become easier.

CONCLUSION

To quote President Joko Widodo, Indonesia is attempting to embark upon a “sustainable and resilient economic recovery”. Whilst questions remain of the sustainability aspect of that statement, by targeting areas of particular weakness when it comes to FDI Indonesia are positioning themselves for a strong post-pandemic economic recovery.

Indonesia should continue on its current trajectory of making it easier for foreign companies to invest as this will increase competition in labour markets, increase employment, and create growth in the country. While there may be some resistance from the Indonesian business community, this should be offset by other aspects of the bill that increase the ease of business as a whole. Moving forward, Jokowi should continue to liberalise Indonesia’s economy by reducing the bans on FDI in certain sectors. However, this may have negative political effects domestically and as it could be viewed domestically as him ‘selling out’ Indonesia to foreign investors.

It will be interesting to see how the Jokowi administration continues to balance liberalisation for economic growth and political realism throughout his second term.



Patrick Cassidy is an intern at the School of Government and Public Policy - Indonesia, which produces Strategic Review.

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