In spite of the differences in economic structure between Java and the outer islands, Indonesia is likely to continue to use a single exchange rate and a single interest rate for the entire country. The manufacturing industry is mainly located in Java. The outer islands, particularly eastern Indonesia, are the main producers of primary commodities and typically involved in the agriculture, mining and fisheries industries.
An appreciation of the exchange rate due to a boom in primary commodities will erode the external competitiveness of the manufacturing industry in international markets.
At present, the money market instrument is limited to Bank Indonesia (BI) Certificate of Deposits because the State Treasury only issues a limited amount of short-term T-bills while the private sector’s money market instruments are not yet developed. As a result, the cost of open market operations of monetary policy in Indonesia is mainly borne by the central bank.
By regulation, the financial wealth of the public sector including state-owned enterprises, can only be deposited at state-owned banks. The financial wealth of provincial governments and companies are deposited at the Regional Development Bank in every province.
Because of the weak tax administration and legal system, public finance remains very weak after nearly 70 years of independence. Tax revenue is only about 13 percent of GDP. On the other hand, the Constitution expects a lot from the government as a provider of public goods such as defense and political stability.
Indonesia is an archipelagic country with over 17,000 islands. Because of the combination of poor transportation networks and bad government policies, Indonesia has no unified domestic market. Desegregated markets of goods and services along with financial and labor markets cause diseconomies of scale for many companies. President Joko “Jokowi” Widodo aims to unify these segmented markets by building sea line corridors, which require the development of shipping, harbors and other logistic industries.
On his visit to the Investment Coordinating Board (BKPM) on Oct. 28, Jokowi instructed the board to simplify the investment licensing system at the central government level and to adopt a single window by transferring all licensing powers of various ministries to BKPM. He expects the unification and simplification of the licensing system to be ready in three to six months.
He then promised to use the same simplification process at the provincial and lower levels of government.
However, there is no plan to remove the remaining non-tariff barriers in trade and auction off the licensing system and permits in mining as well as in government procurements.
Other measures to reduce production and transaction costs will take time to implement. These include the eradication of corruption, market failures and public sector failures as well as improvement in the legal system to protect private property rights and enforce contracts. This is also true for policies and programs that train the labor force to raise productivity.
The Jokowi administration inherited nationalistic sentiments from his predecessor in at least two areas, namely the banking industry and mining. Restrictions on foreign investments are shown in many documents such as the negative investment list of the BKPM as well in various ministerial and central bank regulations and decrees.
Introduced in April 2014, the latest negative investment list set out economic sectors widely open, partially open and totally closed for foreign investment.
In early 2013, BI and the House introduced restrictive foreign ownership policies in the banking industry to protect domestically owned banks including state-owned banks from foreign competition.
The draft of the new banking bill caps the limit of foreign ownership to between 40 and 49 percent. The new bank ownership rule canceled the plan of the Development Bank of Singapore in 2013 to take over a 99 percent equity share in Bank Danamon, including a 67 percent stake from Temasek’s Fullerton Financial Holdings.
Conversion of foreign bank branches into locally incorporated or limited liability companies affects their supervision, safety net and risk rating. A local incorporated bank is supervised by the Financial Services Authority (OJK) and covered by local safety nets.
Their deposits, for example, are insured by Indonesia’s Deposit Insurance Corporation (LPS). Branches of foreign banks are subject to supervision and covered by safety nets of their respective home countries. As branches they can borrow foreign exchange from their headquarters without being charged with a risk premium.
Foreign borrowing of Indonesian entities is more expensive because they are subject to Indonesian risk ratings. As a result, interest rates will increase after the change of legal status of branches of foreign banks to locally incorporated banks.
On top of the capping on foreign ownership in banking, BI also issued regulations in 2013 that affected the capital structure and direction of credit of foreign banks. The new capital equivalent maintained assets regulation requires foreign banks to invest a minimum amount of capital in their Indonesian branches.
The regulation also requires foreign banks to serve small and medium enterprises and open up offices outside Java. Only agriculture-based Rabobank of Holland and Norinchukin bank of Japan have experiences in financing agribusiness and cooperatives.
Amid declining commodity prices since 2011, the government introduced an export ban for unprocessed minerals. In 2013, the government informed the Netherlands to terminate its bilateral investment treaties starting from July 2015. This may be the beginning of the termination of another 62 bilateral investment treaties signed with other countries.
As it takes years to build expensive infrastructure and energy intensive smelter plants, the government restrictions on the export of unprocessed minerals further reduced both export and tax revenues of the government from royalties and mining related taxes. The nickel ore refiners in Japan, which obtained about 50 percent of their nickel ore from Indonesia, complained about the export ban and the high export tax.
The export ban was later replaced by a punitive export tax for category 1 minerals until the producers meet the minimum required level of processing and refining as specified in Government Regulation No. 1/2012 The export ban continuously applied to category 2 minerals as the producers already have some processing capacities. Category 1 minerals are primarily copper but also include iron ore, manganese, lead, zinc, ilmenite and titanium. Category 2 minerals are primarily nickel, bauxite, tin, gold, silver, chromium and 65 mineral products.
Building smelters for category 1 minerals are more expensive as they are subject to economies of scale, energy intensive and require large infrastructure such as harbor and land transportation both at the sources as well as at the receiving ends of mineral ores.
The investment treaty generally guarantees basic rights to investors of (i) fair and equitable treatment, (ii) adequate physical security and protection, (iii) most favored nation status, (iv) no expropriation or nationalization without market value compensation, (v) free repatriation of capital and profits and (vi) arbitration of dispute by International Center for Settlement Dispute (ICSID) in Washington, D.C.
The last item is very important. Again, the legal system is still relatively weak and therefore cannot properly protect property rights and enforce business contracts.
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 macroeconomics from Tufts University in the US.
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