INDONESIA RISING. Policy Priorities for 2010 and Beyond 53478 Fostering Competitiveness to Increase Investment, Trade And Good Jobs Key Messages 1. Indonesia has made good progress in improving the investment climate and implementing trade reforms. Formal sector employment is once again expanding, poverty has been falling, and an incipient middle class is emerging. 2. Less affected than its neighbors by the global economic crisis, Indonesia has a unique opportunity during the recovery and post-recovery to increase both global market share and domestic sales. 3. To make this happen, the key is to push ahead with reforms designed to improve competitiveness, increase flexibility in the labor market, and avoid protectionism that stifles efficiency and innovation. Key Action 1. Create the institutional structures needed to deliver consistent policy. Global evidence indicates that strong institutions drive regulatory reforms and improve coordination. 2. Accelerate administrative reforms designed to foster competitiveness. Reduce administrative burdens on businesses, improve the investment negative list (DNI or Daftar Negatif Investasi), lower non-tariff barriers, strengthen the national single window (NSW) and coordinate logistics policies. 3. Negotiate a `Grand Bargain' in labor reform ­ lower severance rates in exchange for reliable unemployment benefits ­ this would improve private sector flexibility while increasing protection for employees. 4. Take advantage of high global commodity prices to push investment in mining, oil and gas by completing key mining regulations and clarifying uncertainties relating to oil and gas. 5. Promote the export of new products through public-private research and development partnerships, align fiscal incentives to develop downstream industries, and support the Export Import Financing Agency (LPEI or Lembaga Pembiayaan Export Indonesia). exports like automobile parts. But there is room for Where Indonesia Stands Now improvement as overall manufacturing growth has been weak, the transition out of agriculture slow, and the mining The success of the Indonesian economy over the and energy sectors have performed poorly. past several years reflects a restoration of sound macroeconomic management, political stability, and up The weak performance of the manufacturing, mining until recent times a favorable global context. Growth and energy sectors reflects the challenges in Indonesia's surpassed 6 percent for two consecutive years and exports investment climate. Notwithstanding progress in several more than doubled between 2003 and 2008 thanks in areas, foreign and domestic investors face regulatory great part to the commodity price boom (see Fig 1). uncertainty, cumbersome bureaucratic procedures, Formal sector employment is expanding again, investment corruption, costly labor regulations and an overstretched has risen ­ particularly in the construction sector ­ and infrastructure. The government has responded with a there have been some pleasant surprises in manufacturing broad range of policies including new tax and investment 2 | INDONESIA RISING laws, trade facilitation initiatives, and economic policy manufacturing production and low labor absorption in the reform packages. While progress has been made in tax formal sector. administration and corruption eradication, additional restrictions have been imposed in key sectors such as The country's poor logistics system makes many mining, services and infrastructure. Indonesia remains one Indonesian products less competitive than foreign of the least favorable business environments for private imports. For example, it costs roughly US$400 to send sector investment in East Asia and Southeast Asia. a forty-foot container from Padang to Jakarta, but only US$175 to send it to Singapore, which is further away. Firms face complex procedures to start a new business The high cost of transporting high quality products like and costly and rigid labor regulations that affect their shrimp from eastern Indonesia to processing centers productivity and profitability. The present investment in Java makes them too expensive to export. The high climate and trade regulatory environment inhibit cost and uncertainty of domestic distribution channels investment and both domestic and international trade. also prevent Indonesia from being more integrated with Starting and operating a new business in Indonesia just-in-time production networks of higher value-added requires numerous approvals, registrations and licenses, products. Licensing and government-regulated pricing a process that can take up to eight months. Indonesia's reduce incentives to invest in better services, and restrict hiring and firing regulations are among the most rigid in competition between domestic sea and land freight East Asia and the world. International research indicates companies. Restrictions on foreign investment in the that developing countries with onerous labor regulations logistics sector only worsen the situation by restricting also experience lower rates of investment (particularly in access to new technology. manufacturing) and productivity. The Manpower Law (No. 13/2003) hurts firms' competitiveness by increasing Despite progress, Indonesia needs to do more to raise severance rates, estimated to be the equivalent of a "hiring port and customs efficiency to levels comparable to its tax" of approximately one-third of a worker's annual neighbors. The average import container dwell time in the wage. Despite the intended purpose of the law, the rigid main container terminal is more than seven days compared severance system fails to protect the majority of workers to less than three days in major regional ports. Imports of adequately from the risk of unemployment. Regulations empty containers clear in less than half the time needed are largely irrelevant for 92 percent of the active labor force for full containers, showing that most of the delay is caused employed informally or working without a contract in the by border control and inspection procedures rather than formal sector. High severance rates also restrict job creation by inadequate infrastructure. Burdensome and unclear and employment in the formal sector by discouraging administrative procedures contribute to import delays and entrepreneurs from creating new businesses and deterring invite corruption, undermining the competitiveness of potential investors. High minimum wages in the mid- industries that use imported components. 1990s and early 2000s, combined with increasingly rigid labor regulations, caused Indonesia's labor-intensive export Firms identify Indonesia's overstretched infrastructure industries to become uncompetitive, leading to stagnant as one of the greatest obstacles to private investment. Export Value Increased with Commodity Boom Share of Investment in GDP 1993-2008 (%) 90 Quarterly Growth of Indonesia's Export (% y to ty) 30 68 Oil and Gas Non Oil / Gas Total 25 45 Asian economic crisis 23 15 0 75 (23) 0 (45) 2001 2002 2003 2004 2005 2006 2007 2008 Source: BPS, WB Staff calculation Source: BPS Policy Priorities for 2010 and Beyond | 3 Although government considers infrastructure a top geological potential but tenth from the bottom (out of 64 priority, public infrastructure works have progressed slowly countries/regions) in mining policies. The biggest problems and very few large public-private projects have proceeded identified by investors in the oil and gas sector are (i) over the past five years. Of ten "model projects" offered uncertainty over cost recovery and the State Audit Agency at the second infrastructure summit in 2006, only two or BPKP audits; (ii) sanctity of contracts; (iii) interference have made substantial progress. Continued weakness in from other government agencies; (iv) tax issues such as the institutional and regulatory framework for public "ring fencing;" and (v) the security of assets, people and private partnerships (PPP) is hampering major advances. ownership rights. Slow progress towards resolving these The government has also been slow to allocate sufficient issues is causing Indonesia to miss out on a global wave of funds for project preparation, provide public support to new oil, gas and mining investments sparked by the surge make PPP projects viable, and facilitate land purchase. in global commodity prices up to mid-2008. Additional resources are needed for public infrastructure along with more efficient spending mechanisms. Indonesia is a very open economy in terms of tariffs, but non-tariff barriers remain significant and there has Policy Priorities in a Rising been a worrying trend towards their recent increase. Indonesia More than 40 percent of Indonesia's tariff lines currently require special import permits. Many of these permits Looking to the future, an Indonesia that takes dynamic exist for legitimate health and safety reasons, but they are and innovative steps, can position itself at the forefront implemented at the border in an unnecessary or excessively of regional economies. An aggressive push on investment bureaucratic fashion. Meanwhile, nearly one-third of and trade reform designed to achieve higher growth import containers are subject to physical inspection (red would increase employment opportunities in high-value lane) compared to less than 10 percent under international industries, while increasing domestic and international good practice. Often goods that are already subject to trade. Introducing a social protection system (pension, mandatory pre-shipment inspection at the port of loading health and unemployment benefits) while reducing are still subject to on-arrival inspection. termination costs would increase jobs in the formal sector (where workers get greater pay and are better protected) In recent years Indonesia's export growth has been while improving the competitive position of producers in highly dependent on a small number of traditional domestic and international markets. products with limited value added and is vulnerable to the volatility in these markets. Four commodities alone, Present reform efforts are moving in the correct direction palm oil, nickel, copper and coal, accounted for almost but will require a greater push to yield results. A number half of total non-oil export growth in 2007. The low of ongoing reform efforts are designed to streamline and technological content of overall exports is reflected in the simplify investment and trade related procedures and low share of medium and high tech manufactures in total practices, but will require a greater push to yield results. exports. There has been limited progress in diversifying The recent creation of a single window for trade that will exports since 1997 revealed by the fact that a decade later, replace manual paper processing with an online system relatively few new products play any substantial role. As that eliminates face-to-face contact between traders and a result, Indonesia lags behind its neighbors in terms of officials is a major initiative to reduce the time and expense the degree of processing of commodities, technological of exporting and importing. While progress has been content of exports and the export of new products. This made by establishing electronic links among government is in part because of the greater domestic tax applied to agencies that issue import permits, traders are still required processed products, an unfavorable business climate, lack to visit each agency individually. Electronic systems have of incentives, and the high costs of discovery for private been added on top of existing manual systems resulting enterprises. in double submissions and double checking. The creation of one-stop shops in local governments is an important Despite abundant mineral wealth, investment in mining step towards simplifying business start-ups. Although this has stagnated. The contribution of mining, oil and gas to can help reduce waiting time, one-stop shops will not cut GDP growth declined from 7 percent during 1986-1996 through the complex web of business regulations issued by to just 1 percent between 2000 and 2008 despite a boom central government agencies. A cohesive regulatory reform in commodity prices. Global mining companies rank program is necessary to streamline and simplify investment Indonesia among the top ten countries in the world in and trade procedures. 4 | INDONESIA RISING The key challenge is to create the institutional change the positive improvements in the 2007 revision needed to deliver the required reforms in regulatory while relaxing restrictions in key sectors, will boost and administrative procedures. Reform efforts have investment levels in infrastructure and critical services.1 suffered from a lack of coordination between ministries Push ahead on the National Single Window agenda and from a regulatory process that pays little attention (NSW). Eliminate the requirement to submit paper to the costs imposed on businesses. For instance, copies of trade documents and create a functioning regulators tend to design rules for their own narrow NSW as agreed with ASEAN, using a single scope of authority with little thought to those imposed administrative document, single submission, single by other regulators, resulting in overlapping requirements and synchronous processing, and single approval. To by different ministries. Impact assessments of draft allow the single window to reach its full potential, regulations to ensure that benefits outweigh costs are not strong leadership is needed to push the core agencies to normally performed. There is also a worrying tendency change their back-office procedures and to cooperate in to write restrictions directly into new laws rather than in simplifying trade systems. regulations, thereby tying the government's hands. Use the proposed regulatory review process to review and remove unnecessary non-tariff measures on goods The second challenge is the removal of administrative trade and obstacles to trade in services that constrain burdens, uncertainty and other domestic barriers to growth. Retain only necessary import permits and investment, jobs and trade to convert the large domestic streamline the import licensing regime to secure and market into a single market. This will permit firms strengthen past gains from tariff reforms. to reduce costs, increase investment, reap economies Negotiate a "Grand Bargain" with labor leaders of scale, and make the best use of labor and resources. that lowers severance rates in exchange for Allowing greater competition among domestic producers unemployment benefits to improve flexibility for and a better use of labor and resources will make the firms while increasing protection for employees. country more dynamic and help improve technological Adjust severance rates downward so that they fall in sophistication. line with regional standards to improve labor market flexibility and global competitiveness. At the same Early and decisive action by the new administration is time, introduce a complementary unemployment needed to improve investor perceptions and address key benefit system to improve the level of protection for constraints rather than attempting to tackle all problems at terminated employees. Introduce a "pay-as-you-go" once. High priority actions are: system to improve the predictability of firms' costs without impinging on their firing decisions, and 1. Implement the institutional change needed to deliver increase compliance. Unemployment benefits are one reforms. component of an effective social insurance system that Create a Regulatory Reform Commission. is needed to increase the level of protection for workers International experience shows that a coordinated top- and stimulate job creation by improving labor flexibility. down approach based on a strong legal foundation is Issue implementing regulations for the 2008 mining often the only way to overcome bureaucratic resistance law that provide the same security for investors as to reform. The National Team to Enhance Exports and is found in the Contract of Work system. Limit Investment (PEPI) could be considered as an early start costs associated with the new domestic processing to forming such a Regulatory Reform Commission. requirement and clarify transition provisions. Issue This Regulatory Reform Commission is to be clear rules on cost recovery and remove "ring fencing" composed of teams devoted to different topics, like on Production Sharing Contracts. Implement the the existing Tariff Team and a possible future logistics Extractive Industries Transparency Initiative (EITI) to council. improve public accountability in the use of Indonesia's Improve regulatory procedures by sending a draft mineral wealth. regulatory reform law to parliament incorporating the Finalize and implement the blueprint for logistics need for Regulatory Impact Assessments, a regulatory reform and establish a national logistics council. guillotine, and a 60-day public disclosure, discussion This council will need to be strongly empowered to and feedback period prior to enactment of new implement national logistics reform. Among the regulations. 1 Improving the investment climate will require restoring the degree 2. Push ahead with regulatory reforms. of openness embraced in 1994, when Government Regulation number Complete and update the Investment Negative List 20 was issued allowing 95% foreign ownership in key sectors such as telecommunications, ports, healthcare, construction services, insurance, (DNI). A further revision of the DNI, maintaining pharmaceuticals, and logistics. Policy Priorities for 2010 and Beyond | 5 changes envisaged are modifications to the regulations facilitation measures like the Indonesia National Single that restrict competition leading to high transport costs Window and the development of a blueprint for the and delays, and improvements in infrastructure. Some reform of the national logistic system. A series of cross- quick wins include extending the railway-to-the ports cutting Development Policy Loans also include policy network and providing 24/7 custom services in key and institutional reform measures to address some of the ports. constraints to private sector development in Indonesia. 3. Promote innovation and export diversification. Promote public-private R&D partnerships for new Future Directions product development and align fiscal incentives for the The World Bank Group's Investment Climate and private sector to move into downstream processes. Other Trade Teams can provide wide-ranging support to the practical actions are to support the efforts of the LPEI Government of Indonesia in the form of capacity building and related agencies to develop financing and guarantee and the facilitation of public private dialogues. Its advisory instruments to support exports of new products or exports work on trade and investment climate could include issues to new markets. like: Advising on best practice institutional set up and processes to implement regulatory reform in the areas of investment climate and trade facilitation. How The World Bank Can Help Training in risk management for government agencies participating in the Indonesia National Single Window. Current Support Monitoring implementation of policy reforms by The World Bank Group (World Bank and IFC) is working supporting Indonesian institutions to carry out closely with the Coordinating Ministry for Economic investment climate surveys. Affairs (CMEA), Ministry of Finance, Ministry of Trade, Supporting the development of the Ministry of Trade's Ministry of Home Affairs and State Ministry for Public roadmap for bureaucratic reform. Administration (MenPAN) among others, to improve Enhancing the capacity of key trade finance institutions the trade and investment climate in Indonesia. The World to support export diversification. Bank Group is supporting the National Team to Enhance Assisting the assessment of different reform options for Exports and Investment (Timnas PEPI) to improve the delivering unemployment benefits. policy formulation process, and assisting the CMEA with Helping to advance the social insurance agenda its regulatory reform initiatives including streamlining by exploring options to support the government business licensing at the national level. With financing institutions responsible for designing and from Multi-donor Trust Funds, it is also supporting trade implementing a social insurance system. The World Bank Office Jakarta for more information, please contact: Indonesia Stock Exchange Building Tower 2, 12th floor Mr. Enrique Aldaz-Carroll Jl. Jenderal Sudirman Kav. 52-53, Jakarta 12190, Indonesia Senior Economist ph. + 62 21 5299 3000 | fax. + 62 21 5299 3111 ealdazcarroll@worldbank.org http://www.worldbank.org/id Investing in Indonesia's Institutiond for Inclusive and Sustainable Development