Investment climate under the Indonesian Jokowi administration

(Part 1 of 2)

President Joko “Jokowi” Widodo has issued conflicting signals on the direction of his economic policy. Judging from his modest background, there is great hope that he will improve business and investment climates in Indonesia, promote the export of manufactured goods and unify the large but segmented domestic market, therefore creating jobs for surplus labor in Java and circumventing the low middle-income trap.

On the other hand, the quality of Jokowi’s Cabinet is rather disappointing. None of the ministers is a good macro, monetary or trade economist and no one in his Cabinet understands the impact of the recent volatile global financial sector or is able to prepare Indonesia to enter the ASEAN Economic Community (AEC) in 2015 and the global supply chains. The national markets are segregated due to a combination of bad economic infrastructure and government regulations.

None of the Cabinet members understand how to implement President Jokowi’s dream to unify and strengthen the segmented goods and services markets and the financial and labor markets of Indonesia. It is also not clear how the present administration will finance the construction of the proposed expensive physical infrastructures.

On a positive note, President Jokowi came from a marhaen (humble upbringing) rather than the Javanese royal family, rent seekers or the elites. Before becoming the mayor of the city of Solo in Central Java he was a furniture maker for the export market. As an exporter he valued the internal and external macroeconomic stability, which allowed him to plan for the future.

He knows that the only way to penetrate international markets is by upgrading competitiveness through the improvement of efficiency and product design. After governing Solo, he became the governor of Jakarta for two years. From his management style and experiences as a public servant, he has a clear understanding of the problems of poverty and unemployment.

Jokowi is aware that in addition to promoting exports he should also introduce fiscal stimulus and invite foreign direct investment (FDI) to revive declining economic growth, eradicate poverty and create jobs. FDI is also needed to transfer of technology, train workers and open international markets. The same policies to raise labor productivity are needed to avoid the low middle-income trap and put Indonesia in the network of global supply chains.

It is only through these conditions that Indonesia can benefit from the various free trade agreements (FTA) that it has signed, enter AEC and export industrial spare parts and components to other countries in ASEAN and East Asia.

Jokowi is facing daunting challenges as he inherited a weak bureaucracy and a government with corruption in each one of its branches: executive, judicial and legislative. Provincial and sub-provincial governments are expanding fast but cannot efficiently provide basic public services. Introduced in the early 2000s, decentralization programs transfer over a third of the national budget to provincial and district governments in addition to a number of important and powerful sectors such as mining and forestry.

Like other high profile corruption cases, these sectors are ripe for graft and alternative sources of funding and power.

A number of high ranking officials are now in jail because of involvement with corruption. The cost of transaction in the Indonesian economy was high during the administration of president Susilo Bambang Yudhoyono because of the poor legal system that could not properly protect property rights or enforce business contracts.

As shown by the scandal of Bank Century, now renamed Bank Mutiara, poor implementation of prudential rules and regulations caused market failures while poor management of state-owned enterprises (SOEs) created public sector failures.

Jokowi is a great communicator and is known as a man of the common people.

The political problem has become more difficult as the Red and White coalition, headed by former general Prabowo Subianto, who is also the defeated candidate in the presidential election, exploited its two-thirds majority in the lame duck House of Representatives to pass a number of laws aimed at strengthening its position.

By grabbing the position of the Speaker of the House and other key committee posts, they are able to control not only the chairmanship of the legislative bodies (the House and People’s Consultative Assembly) but also the chairmanships of their key commissions. Recent cordial and friendly meetings between Jokowi and Prabowo were expected to reduce tensions between the opposing political camps.

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None of the Cabinet members understand how to implement President Jokowi’s dream.

Jokowi’s administration will probably respect tradition and continue the short-run stabilization policy and the medium- to long-term structural reforms that have been inherited from the IMF program during the economic crisis of 1997. The core of the stabilization policy is a managed floating exchange rate supported by (soft) inflation targeting and a conservative fiscal policy that employs strict fiscal and debt regulations from the European Union’s Maastricht Stability Rules.

These rules set a ceiling for both central and local government budget deficits to 3 percent of GDP and Regional Domestic Products. The debt rule sets the ratio of public debt to GDP at a sustainable level of 60 percent. The new budget and debt rules replaced the fiscal or “the balanced budget” and “debt” rules of the Soeharto regime that maximized Official Development Aid (ODA). From 1996 to 1998 all the budget deficits were financed by ODA from Western countries.

In 1998, the government started to issue long-term sovereign bonds to recapitalize the financially ailing banks and to finance budget deficits. To prevent the “original sin”, the bonds were mainly denominated in rupiah, the domestic currency, and sold in the domestic market. The securities are shielded from a currency crisis but not from interest rate risks.

In reality, it is still volatile as over 35 percent of the sovereign bonds, short-term Bank Indonesia Certificates (SBI) and securities sold in the Jakarta Stock Exchange are currently owned by short-term foreign capital. In 2004, Indonesia started to float sovereign bonds denominated in the US dollar that were sold in international markets. In 2009, the authorities issued the Samurai bonds in Japan that were partly guaranteed by the Japanese government.

The move to a managed floating exchange rate system does not reduce the need for an accumulation of foreign exchange rates. It is true that in the managed system, an exchange rate target is no longer used as a nominal anchor of monetary policy.

Nevertheless, market intervention is still needed to avoid extreme fluctuations of the exchange rate and thus prevent adverse impacts on the economy. The external reserve is needed to avoid volatile exchange rates that causes currency mismatch, particularly for those who borrow from overseas in foreign currencies.

The volatile exchange rate can also cause maturity mismatch when the short-term credit is being used to finance long-term projects. The external reserve is also needed to hedge against speculation and foreign exchange instability due to shortfalls in exports, reduction in labor remittances and capital flow reversals.

In addition, the foreign exchange reserves are used to maintain adequate fiscal space when facing economic crises. Asian countries, including Indonesia, are still reluctant to turn to the IMF for help because they were treated improperly when they sought help during the 1997 financial crisis.

The exchange rate policy is also a powerful instrument to promote exports of manufactured products and to reallocate resources from non-traded economic sectors with low productivity to more productive traded economic sectors.

Rising real effective exchange rate provides a financial incentive for export and for shifting resources toward traded sectors of the economy.

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The writer is a professor of  economics at the University of Indonesia. He is a former senior deputy governor of Bank Indonesia, the central bank. He obtained his PhD in mathematical macro economics from Tufts University in the US.