Hurdles on Indonesia’s road to reform

As 2015 draws to a close, the Indonesian government is trying to convince the jury on two counts — first, that it has turned the corner towards more constructive economic policy, and second, that it has the political leadership and capacity to implement this new policy.

The scale of the challenge is large as Indonesia’s competitiveness has been sagging. Over the past few years a plethora of regulatory interventions have discouraged investment and widened the infrastructure gap. The government’s loss of policy credibility, owing to a lacklustre track record and difficult external environment, magnifies the challenge.

The jury is undecided on whether the Joko Widodo (Jokowi) government’s reform efforts are sufficient to tackle the challenge. One reason is that reform has so far focused on areas that prompt little political pushback. The prospect of fundamental reform entered the debate only in the last quarter of 2015.

The investment climate has been President Jokowi’s focus since early in his term. Reducing the cost of new business licensing through a more effective one-stop shop system is one example. Likewise, the president shone a light on reducing port dwelling times. These investment climate measures are important but do not challenge the interests standing in the way of a better investment environment.

Infrastructure has been a major priority. There are signs of better prospects for 2016. But, in this area as well, the government’s focus on building public infrastructure through the budget and state-owned enterprises has resulted in little political push back.

Yet it is the policy steps beyond investment climate and infrastructure that will define the success of the government’s new direction. Now, in the last quarter of 2015 — a year into the Jokowi administration — there are signs that the government will tackle the considerable political economy challenges that stand in the way of these reforms.

One such challenge is to foster openness. The choice is between a coherent trade and investment strategy, which supports participation in global value chains and foreign direct investment, versus a mercantilist squeeze on imports through a variety of non-tariff measures. Indonesia’s aspirations to join the Trans-Pacific Partnership and the prospect of re-energised free trade agreement discussions are encouraging.

But the challenge of changing the policy direction is enormous. For example, proposed streamlining import requirements for some consumer goods prompted a backlash from producers in related sectors that stalled the reform. The recently launched review of the negative investment list, which defines sectors not open to foreign investors, will be a key indicator of progress.

Challenging the labour market status quo is another critical and challenging reform. So far, focus has been on improving the minimum wage setting rule — the new rule is far from perfect but could be an improvement. A reversal of recently introduced foreign worker restrictions is also in line with greater openness. But an appetite to tackle the labour law on layoff rules and compensation, where Indonesia ranks poorly from a global perspective, has yet to develop.

The role of the public sector is a critical, yet missing, element of the policy discussion. Government and state-owned enterprises should play a leading role in reforms. This includes setting the regulatory environment, delivering public goods from infrastructure to education and actively driving economic developments through state-owned enterprises.

But, if the public sector is to take a leading role in delivering infrastructure, discussion needs to turn to how this infrastructure will be financed and produced. The government’s infrastructure aspirations are not matched by the financial and technical capacity of the public sector to deliver these aspirations. They will be hard to meet without a stronger private sector role. Yet, so far, it is not clear that this conclusion has been taken to heart.

So, how much time does the government have to tackle these fundamental issues? Perhaps not long. The degree of freedom for policy decisions is diminishing. A combination of growing expenditure needs as Indonesia transitions through to middle income status, including social security and infrastructure, are significantly increasing the spending baseline. This is set against modest revenue performance, where there have been ongoing one-off revenue reforms to a system in need of fundamental medium-term reform.

The risk is that fiscal pressures could trigger an unwinding of the government’s strategy. In the past, the standard release valve for fiscal deficit pressure was to increase fuel prices. But, to its credit, the government has dramatically reduced fuel subsidies. As a result, fiscal deficit reduction, in the short term, has to come from discretionary spending — a very small share of budget outlays. And, unfortunately, discretionary spending is dominated by infrastructure spending.

The government’s strategy of boosting infrastructure spending to increase demand and raise potential growth could easily come to a halt. Fundamental medium-term reform both on the spending and revenue sides of the budget is essential if Indonesia is to prosper in 2016 and beyond.

Dr David Nellor is Adjunct Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore.

This article is part of an EAF special feature series on 2015 in review and the year ahead.