Business in Indonesia: New Challenges, Old Problems 9789812305398

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Business in Indonesia: New Challenges, Old Problems
 9789812305398

Table of contents :
CONTENTS
TABLES
FIGURES
CONTRIBUTORS
ACKNOWLEDGMENTS
GLOSSARY
1. BUSINESS IN INDONESIA: OLD PROBLEMS AND NEW CHALLENGES
PART I. Political and Economic Developments
2. POLITICAL UPDATE 2003: TERRORISM, NATIONALISM AND DISILLUSIONMENT WITH REFORM
3. ECONOMIC UPDATE 2003: AFTER FIVE YEARS OF REFORMASI EKONOMI, WHAT NEXT?
PART II. Overview of the Business Environment
4. A NEW POLITICAL ECONOMY? POLITICS, ETHNICITY AND BUSINESS IN INDONESIA
5. INVESTMENT PROSPECTS: A VIEW FROM THE PRIVATE SECTOR
PART III. Foreign Investment and Trade
6. RECENT TRENDS IN FOREIGN DIRECT INVESTMENT
7. EXPORTS BY SMALLAND MEDIUM-SIZED ENTERPRISES IN INDONESIA
PART IV. Key Issues in the Business Environment
8. THE EFFECTS OF DECENTRALISATION ON BUSINESS IN INDONESIA
9. POLITICAL ECONOMY OF PRIVATISATION OF STATE-OWNED ENTERPRISES IN INDONESIA
10 CORPORATE OWNERSHIPAND MANAGEMENT IN INDONESIA: DOES IT CHANGE?
11. TINKERING AROUND THE EDGES: INADEQUACY OF CORPORATE GOVERNANCE REFORM IN POST-CRISIS INDONESIA
12. UPHOLDING INDONESIAN BANKRUPTCY LEGISLATION
13. THE PRIVATE SECTOR RESPONSE TO PUBLIC SECTOR CORRUPTION
14. A CHALLENGE FOR BUSINESS? DEVELOPMENTS IN INDONESIAN TRADE UNIONISM AFTER SOEHARTO
15. LABOUR REGULATION AND THE BUSINESS ENVIRONMENT: TIME TO TAKE STOCK
REFERENCES
INDEX

Citation preview

1. Chronology of Developments in the Political Economy of Myanmar

BUSINESS IN INDONESIA

i

ii

U Tun Wai

The Research School of Pacific and Asian Studies (RSPAS) at The Australian National University (ANU) is home to the Indonesia Project, a major international centre of research and graduate training on the economy of Indonesia. Established in 1965 in the School’s Division of Economics, the Project is well known and respected in Indonesia and in other places where Indonesia attracts serious scholarly and official interest. Funded by ANU and the Australian Agency for International Development (AusAID), the Project monitors and analyses recent economic developments in Indonesia; informs Australian governments, business and the wider community about those developments and about future prospects; stimulates research on the Indonesian economy; and publishes the respected Bulletin of Indonesian Economic Studies. The School’s Department of Political and Social Change (PSC) focuses on domestic politics, social processes and state-society relationships in Asia and the Pacific, and has a long-established interest in Indonesia. Together with PSC and RSPAS, the Project holds the annual Indonesia Update conference, whose proceedings are published in the Indonesia Update Series (previously known as the Indonesia Assessment Series). Each Update offers an overview of recent economic and political developments, and devotes attention to a significant theme in Indonesia’s development. The Institute of Southeast Asian Studies (ISEAS) was established as an autonomous organization in 1968. It is a regional centre dedicated to the study of socio-political, security and economic trends and developments in Southeast Asia and its wider geostrategic and economic environment. The Institute’s research programmes are the Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS), and Regional Social and Cultural Studies (RSCS). ISEAS Publications, an established academic press, has issued more than 1,000 books and journals. It is the largest scholarly publisher of research about Southeast Asia from within the region. ISEAS Publications works with many other academic and trade publishers and distributors to disseminate important research and analyses from and about Southeast Asia to the rest of the world.

Indonesia Series in the Political Economy of Myanmar 1. ChronologyUpdate of Developments

iii

BUSINESS IN INDONESIA New Challenges, Old Problems edited by

M. Chatib Basri Pierre van der Eng

INSTITUTE OF SOUTHEAST ASIAN STUDIES Singapore

iv

U Tun Wai

First published in Singapore in 2004 by ISEAS Publications Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614 E-mail: [email protected] http://bookshop.iseas.edu.sg All rights reserved. No part of this publication may be reproduced, translated, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 2004 Institute of Southeast Asian Studies, Singapore The responsibility for facts and opinions in this publication rests exclusively with the authors and their interpretations do not necessarily reflect the views or the policy of the Institute or its supporters. ISEAS Library Cataloguing-in-Publication Data Business in Indonesia : new challenges, old problems / edited by M. Chatib Basri and Pierre van der Eng. 1. Business—Indonesia. 2. Privatization—Indonesia. 3. Corporate governance—Indonesia. 4. Political corruption—Indonesia. 5. Industrial relations—Indonesia. 6. Indonesia—Economic policy. 7. Indonesia—Politics and government—1998I. Basri, Muhammad Chatib. II. Eng, Pierre van der. HF3806.5 B97 2004 ISBN 981-230-247-6 (soft cover) ISBN 981-230-248-4 (hard cover) Copy-edited and typeset by Beth Thomson, Japan Online Indexed by Angela Grant Printed in Singapore by Seng Lee Press

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CONTENTS

Tables Figures Contributors Acknowledgments Glossary 1

Business in Indonesia: Old Problems and New Challenges Pierre van der Eng

PART I 2

3

Political Update 2003: Terrorism, Nationalism and Disillusionment with Reform Sidney Jones

Economic Update 2003: After Five Years of Reformasi Ekonomi, What Next? M. Chatib Basri

PART II 4 5

Political and Economic Developments

Overview of the Business Environment

A New Political Economy? Politics, Ethnicity and Business in Indonesia Sadanand Dhume Investment Prospects: A View from the Private Sector James Castle

v

vii ix xi xiii xv 1

23 39

61 72

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CONTENTS

PART III 6 7

Recent Trends in Foreign Direct Investment Kelly Bird

Exports by Small and Medium-Sized Enterprises in Indonesia Henry Sandee and Peter van Diermen

PART IV 8 9 10 11 12 13 14 15

Foreign Investment and Trade

Key Issues in the Business Environment

93 108

The Effects of Decentralisation on Business in Indonesia Bambang Brodjonegoro

125

Corporate Ownership and Management in Indonesia: Does It Change? Yuri Sato

158

Upholding Indonesian Bankruptcy Legislation Marie-Christine Schröeder-van Waes and Kevin Omar Sidharta

191

A Challenge for Business? Developments in Indonesian Trade Unionism after Soeharto Michele Ford

221

Political Economy of Privatisation of State-owned Enterprises in Indonesia Tony Prasetiantono

141

Tinkering Around the Edges: Inadequacy of Corporate Governance Reform in Post-Crisis Indonesia Daniel Fitzpatrick

178

The Private Sector Response to Public Sector Corruption Merly M. Khouw

204

Labour Regulation and the Business Environment: Time to Take Stock Chris Manning

234

References Index

251 261

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TABLES

1.1 3.1 3.2 5.1 5.2 5.3 5.4 5.5 6.1 6.2 7.1 7.2 7.3 7.4 8.1 8.2 8.3

Contribution of Investment to Economic Growth in Indonesia, 1975–2003 Quarterly Growth in GDP by Sector, 2002–03 Revealed Comparative Advantage of Manufacturing Products, 1985–2001 FDI in ASEAN and Selected Countries, 1991–2002 Level of Perceived Corruption in Asian Countries, 1995–2003 Level of Perceived Legal System Inadequacy in Asian Countries, 1996–2003 Index of Economic Freedom in ASEAN Countries, 1995–2003 Perceived Obstacles to FDI in Indonesia, 2002 Contribution of Foreign-owned Firms to Value Added and Employment in the Medium and Large-scale Manufacturing Sector, 1990–2000 Policy Issues of Most Concern to Exporters in Labourintensive Industries, July 2002 Firms in the Manufacturing Sector, 1996–2000 Employment in the Manufacturing Sector, 1996–2000 Change in Exports by Firm Dynamics, 1996–2000 The Jepara Furniture Industry, Selected Indicators, 1989–2002 Changes in the Distribution of Natural Resource Revenue since Decentralisation Contribution of Expenditure Components to Total Provincial GRDP, 1996 and 2001 Components of the Local Budget, 2002 vii

3 45 53 73 76 77 78 80 96 104 109 110 111 114 128 134 136

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9.1 9.2 9.3 9.4 9.5 10.1 10.2 10.3 10.4 10.5 10.6 10.7 10.8 13.1 13.2 13.3 13.4 13.5 13.6 13.7 13.8 16.1 16.2

TABLES

A Summary of the Characteristics of State-owned Enterprises, October 2003 Performance of State-owned Enterprises by Sector, 2001 Performance of Telkom, 1991–2002 Capacity and Ownership of Indonesian Cement Companies, 2003 Performance of Semen Gresik (Holding Company), 1996–2002 Classification of Corporate Ownership Ownership of Listed Companies in Indonesia Change of Ownership Structure of Top 100 Listed Companies in Indonesia, 1996 and 2000 Board Members of Indonesian Companies, 1996 and 2000 Correlation of Ownership Patterns and Economic Performance of Listed Non-financial Companies, 1996–2000 Correlation of Ownership–Management Patterns and Economic Performance of Listed Non-financial Companies, 1996–2000 Shares in Sales and Assets of Group-affiliated Companies in the Top 100 Listed Indonesian Companies, 1996 and 2000 Correlation of Group Affiliation and Group Type with Economic Performance in the Top 100 Listed Indonesian Companies, 1996 and 2000 Characteristics of the Business Enterprise Sample Top Three Obstacles to Business Growth in Seven Asian Countries Mean Score Comparison of 10 Factors Affecting Business Growth Respondents’ Reactions to Scenario of Bribing a Judge to Win a Case Respondents’ Reactions to Scenario of Accepting a Gift from a Supplier Respondents’ Reactions to Scenario of Marking up a Price to Win a Contract Frequency of Contacts, Contacts Involving Unofficial Payments and Average Amount, by Public Institution Money Spent on Unofficial Payments and Additional Tax Annual Growth in Manufacturing Employment by Scale of Establishment, 1975–2001 The Employment Situation in Indonesia, 2001–02

143 144 146 147 149 161 162 164 168 170 172 173 174 205 207 208 211 212 213 215 217 241 242

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FIGURES

1.1 3.1 3.2 3.3 3.4 3.5 3.6 3.7 5.1 6.1 6.2 6.3 6.4 6.5 13.1 13.2 13.3 16.1

Key Obstacles in Indonesia’s Business Environment, 2003 GDP in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 Private Consumption in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 Investment in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 Growth of GDP by Expenditure, March 2000 – September 2003 Growth of Motorcycle Sales and Inflation, September 2000 – December 2003 Growth of Domestic and Foreign Investment, 2000–03 CPI Inflation and Rp/$ Spot Rate, January 2002 – January 2004 FDI Approvals, Indonesia, 1990–2002 Trends in Aggregate Investment,1997–2003 Trends in FDI Approvals, 1985–2003 Distribution of FDI Approvals by Major Sector, 1990–2003 FDI Approvals by Type, 1996–2003 Trend in Formal and Informal Sector Employment, 1997–2002 Size of Unofficial Payments by Company Size Extent of Unofficial Payments by Amount of Time Spent by Senior Managers in Dealing with Government Officials Effect of Unofficial Payments on Import Processing Times Real Minimum Wages in Major Industrial Centres and All Indonesia, 1992–2002 ix

4 40 41 42 44 46 47 48 75 94 95 96 99 101 209 210 216 239

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16.2

FIGURES

Minimum Wages in Dollars Converted at the Nominal Average Annual Exchange Rate, Major Industrial Centres and All Indonesia, 1992–2002

240

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CONTRIBUTORS

M. Chatib Basri Director of Research, Institute for Economic and Social Research, University of Indonesia, Jakarta Kelly Bird Growth Through Investment and Trade Project adviser, National Development Planning Agency (Bappenas), Jakarta

Bambang Brodjonegoro Head, Department of Economics, University of Indonesia, Jakarta James Castle Chairman, CastleAsia, Jakarta

Sadanand Dhume Journalist and writer; former Indonesia correspondent of the Far Eastern Economic Review and the Asian Wall Street Journal, Jakarta

Daniel Fitzpatrick Senior Lecturer, Faculty of Law, Australian National University, Canberra

Michele Ford Lecturer, Asian Studies, School of Political and International Studies, Flinders University, Adelaide

Sidney Jones Director, South East Asia Project, International Crisis Group, Jakarta

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CONTRIBUTORS

Merly M. Khouw Executive Director, Quest Research Pty Ltd, Perth

Chris Manning Head, Indonesia Project, Research School of Pacific and Asian Studies, Australian National University, Canberra Tony Prasetiantono PhD candidate, Asia Pacific School of Economics and Government, Australian National University, Canberra

Henry Sandee Senior Research Fellow, Faculty of Economics, Free University, Amsterdam Yuri Sato Senior Research Fellow, Institute of Developing Economies (IDE-JETRO), Tokyo Marie-Christine Schröeder-van Waes PhD candidate, Faculty of Law, University of Utrecht

Kevin Omar Sidharta Associate of the law firm Ali Budiardjo, Nugroho, Reksodiputro, Jakarta

Pierre van der Eng Senior Lecturer, School of Business and Information Management, Australian National University, Canberra Peter van Diermen Senior Lecturer, School of Resources, Environment and Society, Australian National University, Canberra

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ACKNOWLEDGMENTS

This book is the result of the Indonesia Update conference held on 26–27 September 2003 at the Australian National University (ANU). The theme of the conference was ‘Business in the Reformasi Era: New Challenges, Old Problems’. Several organisations and a long list of people deserve our gratitude for making both the conference and the publication of this volume possible. Financial and logistical support was provided by several organisations, including the Australian Agency for International Development (AusAID) and the Research School of Pacific and Asian Studies (RSPAS) at the ANU. The well-attended conference had a long list of speakers, commentators and colleagues from Indonesia, Australia and other countries presiding over the sessions and attracted much public attention. We are grateful to all involved in the Indonesia Update, particularly the speakers and the inquisitive audience, but would like to thank a number of people specifically. Cathy Haberle and Trish van der Hoek at the Indonesia Project in the Division of Economics, RSPAS, as well as others at the school, provided valuable support. We also thank Neroli Vivian for her assistance with the media and Caterina Williams and her group of ANU Indonesian students for helping with the organisation of the conference. Ross McLeod, Hal Hill and particularly Chris Manning, Head of the Indonesia Project, provided valuable advice and encouragement in assembling the conference program. In editing the manuscript for the book, we were very fortunate to benefit from the professionalism of Beth Thomson and Sue Mathews. We are also grateful to the Institute of Southeast Asian Studies (ISEAS) in Singapore for again agreeing to publish this Indonesia Update volume and to Angela Grant for preparing the index. Lastly, we are thankful to the authors of the papers presented at the conference and collected in this book. They made the theme of the 2003 Indonesia xiii

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ACKNOWLEDGMENTS

Update conference and volume come alive, and exercised considerable patience in responding to our comments. M. Chatib Basri, Jakarta Pierre van der Eng, Canberra March 2004

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GLOSSARY

$ ACILS ADB AFTA ANU APBD Apindo Apkasi ASEAN Bapepam Bappenas BCA Benteng BIN BKPM BLBI BNI

US dollars American Center for International Labor Solidarity Asian Development Bank ASEAN Free Trade Area Australian National University Anggaran Pendapatan dan Belanja Daerah (local government budget) Asosiasi Pengusaha Indonesia (Employers Association of Indonesia) Asosiasi Pemerintah Kabupaten Seluruh Indonesia (Association of Indonesian Districts/District Heads) Association of Southeast Asian Nations Badan Pelaksana Pasar Modal (Capital Market Supervisory Agency) Badan Perencanaan Pembangunan Nasional (National Development Planning Agency) Bank Central Asia policy of granting pribumi importers privileged access to import licences in the early years of independence Badan Intelijen Nasional (National Intelligence Agency) Badan Koordinasi Penanaman Modal (Investment Coordinating Board) Bantuan Likuiditas Bank Indonesia (Bank Indonesia Liquidity Support for banks) Bank Negara Indonesia (State Bank of Indonesia, a stateowned commercial bank) xv

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BPK BPS BPSP BRI BUMN bupati bumiputera CAR CEO CGI CODB CPI CR CSPA D/E DAU DI DKI DPD DPR ECFIN EU FBSI FDI FEUI FNPBI FSPM

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GLOSSARY

Badan Pemeriksaan Keuangan (Supreme Audit Agency) Badan Pusat Statistik (Statistics Indonesia, the Central Statistics Agency, formerly Central Bureau of Statistics) Badan Penyelesaian Sengketa Pajak (Tax Disputes Settlement Agency) Bank Rakyat Indonesia (Indonesian People’s Bank, a state-owned bank specialising in microfinance and smallscale enterprises) Badan Usaha Milik Negara (state-owned enterprise) head of a kabupaten (district) indigenous Malays (literally, ‘sons of the soil’) capital adequacy ratio chief executive officer Consultative Group on Indonesia cost of doing business consumer price index current ratio of assets to liabilities conditional sale and purchase agreement (between Cemex and the Government of Indonesia) debt–equity ratio Dana Alokasi Umum (General Allocation Fund, General Purpose Fund, or fiscal equalisation transfer to regions) Daerah Istimewa (Special Region) Daerah Khusus Ibukota (Special Capital Region) Dewan Perwakilan Daerah (Council of Regional Representatives) Dewan Perwakilan Rakyat (People’s Representative Council, Indonesia’s parliament) Institute for Economics and Financial Research European Union Federasi Buruh Seluruh Indonesia (All-Indonesia Labour Federation) foreign direct investment Fakultas Ekonomi Universitas Indonesia (Faculty of Economics, University of Indonesia) Front Nasional Perjuangan Buruh Indonesia (National Front for Indonesian Workers’ Struggle) Federasi Serikat Pekerja Mandiri (Federation of Independent Workers’ Unions)

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GLOSSARY

FSPSI FSPSI-Reformasi FSU GAM GDP Golkar GRDP GSBI haj HMI IBRA ICFTU ICG ICMI ICSID ILO IMF Indonesia Bangkit Inpres IPO IPTN ISIC IUF JBIC JI

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Federasi Serikat Pekerja Selurah (Federation of AllIndonesia Workers’ Unions) Federasi Serikat Pekerja Selurah-Reformasi (Reformed Federation of All-Indonesia Workers’ Unions) Forum Solidaritas Unionis (Unionists’ Solidarity Forum) Gerakan Aceh Merdeka (Free Aceh Movement) gross domestic product Golongan Karya (the state political party under the New Order, and one of the major post-New Order parties) gross regional domestic product Gabungan Serikat Buruh Independen (Association of Independent Labour Unions) pilgrimage to Mecca Himpunan Mahasiswa Islam (Islamic Students’ Association) Indonesian Bank Restructuring Agency (also known as BPPN, National Banking Rehabilitation Agency) International Confederation of Free Trade Unions International Crisis Group Ikatan Cendekiawan Muslimin Indonesia (Indonesian Association of Muslim Intellectuals) International Centre for Settlement of Investment Disputes International Labour Organization International Monetary Fund Indonesia Arises (coalition of economists and other intellectuals who advocate ending Indonesia’s relationship with the IMF) Instruksi Presiden (Presidential Instruction, a program of special grants from the central government) initial public offering Industri Pesawat Terbang Nusantara (Indonesia’s stateowned aircraft manufacturing industry) International Standard Industrial Classification International Union of Food, Agricultural, Hotel, Restaurant, Catering, Tobacco and Allied Workers’ Associations Japan Bank for International Cooperation Jemaah Islamiyah

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jilbab JSE kabupaten Kadin Kapet Kepmen KHM KKN KL Kopassus Korpri kota KPC KPEN KPK KPKPN KPPOD KPPU KSBI KSBSI KSPSI KSO KSPI KTP

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GLOSSARY

headscarf Jakarta Stock Exchange district Kamar Dagang dan Industri (Chamber of Commerce and Industry) Kawasan Pengembangan Ekonomi Terpadu (Integrated Economic Development Zones) Keputusan Menteri (Ministerial Decree) Kebutuhan Hidup Minimum (Minimum Subsistence Needs [index]) korupsi, kolusi, nepotisme (corruption, collusion, nepotism) Kehidupan Layak (Appropriate Standard of Living [index]) Komando Pasukan Khusus (Special Forces Command) Korps Pegawai Republik Indonesia (Indonesian Civil Servants Corps) city, municipality Kaltim Prima Coal Komite Pemulihan Ekonomi Nasional (Committee for National Economic Recovery) Komisi Pemberantasan Korupsi (Corruption Eradication Commission) Komisi Pemeriksa Kekayaan Penyelenggara Negara (Public Officials’ Wealth Audit Commission) Komite Pemantauan Pelaksanaan Otonomi Daerah (Regional Autonomy Watch) Komisi Pengawas Persaingan Usaha (Business Competition Supervisory Commission) Konfederasi Serikat Buruh Indonesia (Indonesian Confederation of Trade Unions) Konfederasi Serikat Buruh Sejahtera Indonesia (Indonesian Confederation of Prosperous Trade Unions) Konfederasi Serikat Pekerja Seluruh Indonesia (Confederation of All-Indonesian Trade Unions) kerjasama operasi (joint operation scheme) Kongres Serikat Pekerja Indonesia (Indonesian Trade Union Congress) kartu tanda penduduk (resident identification card)

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GLOSSARY

LOI LPEM MFA MPR MRP Muhammadiyah NEP New Order NGO NU OECD OPM PAD PAN Pancasila PDI-P PEG peraturan daerah PERC pesantren PKB PKI PLN PP PPM PPP pribumi pungli reformasi ekonomi reformasi

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Letter of Intent Lembaga Penyelidikan Ekonomi dan Masyarakat (Economics and Management Research Institute, University of Indonesia) Multi-fibre Arrangement Majelis Permusyawaratan Rakyat (People’s Consultative Assembly) Majelis Rakyat Papua (Papuan People’s Council) Indonesia’s largest modernist Islamic organisation New Economic Policy (Malaysia) the Soeharto era, 1965–98 non-government organisation Nahdlatul Ulama (Indonesia’s largest traditionalist Islamic organisation) Organisation for Economic Co-operation and Development Organisasi Papua Merdeka (Free Papua Organisation) Pendapatan Asli Daerah (locally derived revenue) Partai Amanat Nasional (National Mandate Party) the five guiding principles of the Indonesian state Partai Demokrasi Indonesia-Perjuangan (Indonesian Democratic Party of Struggle) Partnership for Economic Growth (USAID program) local regulation, regional government by-law Political Economic Risk Consultancy Islamic boarding school Partai Kebangkitan Bangsa (People’s Awakening Party) Partai Komunis Indonesia (Indonesian Communist Party) Perusahaan Listrik Negara (State Electricity Company) Peraturan Pemerintah (Government Decree or Regulation) post-program monitoring Partai Persatuan Perbangunan (United Development Party, the Islamic political grouping) indigenous, not of immigrant stock pungutan liar (irregular payments) economic reform reform

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retribusi RCA ROA ROE Rp Sakernas SARS SBI SBJ SBSI SDO

shariah SI SITC SME SOE SPSI STT TNI UN UNCTAD US USAID VAT WIR WTO

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GLOSSARY

user charge, levy, local charge revealed comparative advantage return on assets return on equity rupiah Survei Angkatan Kerja Nasional (National Labour Force Survey) severe acute respiratory syndrome Sertifikat Bank Indonesia (Bank Indonesia Certificate) Serikat Buruh Jabotabek (Greater Jakarta Workers’ Union) Serikat Buruh Seluruh Indonesia (All Indonesia Labour Union) Subsidi Daerah Otonom (autonomous regional subsidies; central government grants to finance regional government expenditure before the 2001 decentralisation) Islamic law Sarekat Islam Standard International Trade Classification small and medium-sized enterprise state-owned enterprise Serikat Pekerja Seluruh Indonesia (All-Indonesia Workers Union) Singapore Telecom and Telemedia Tentara Nasional Indonesia (Indonesian National Army) United Nations United Nations Conference on Trade and Development United States US Agency for International Development value-added tax World Investment Report World Trade Organization

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BUSINESS IN INDONESIA: OLD PROBLEMS AND NEW CHALLENGES Pierre van der Eng

Six years ago, Indonesia’s business system was in turmoil. Companies were forced to absorb the consequences of a significant depreciation of the rupiah, accelerating inflation, and restricted access to credit due to growing reluctance of foreign lenders and the near-collapse of the domestic financial system. A change in the political regime and the conditions under which the International Monetary Fund (IMF) provided support to Indonesia during 1998–2003 brought an era of political change and reform – reformasi. New government policies were introduced to remedy the problems that had plagued Indonesia’s business system in the past. There have been significant improvements particularly at the macro level during the last six years. The all-encompassing banking crisis was addressed, a run on the banks was avoided and bad loans fell to 8 per cent of outstanding loans. Macroeconomic stability was regained, the rupiah was stabilised and appreciated, inflation moderated, interest rates fell, and export growth was recorded. Even the stock market perked up, reaching pre-crisis levels in January 2004. A new political reality offering a greater degree of openness and plurality emerged. Various policy reforms were introduced and generally sound macroeconomic policies were maintained. On the other hand, many observers have remained pessimistic, particularly in Indonesia where some ambivalent hankering for the Soeharto era has surfaced. The pessimists argue that reformasi so far has not achieved enough to bolster the bottom line: economic recovery. Indonesia experiences rates of economic growth well below those enjoyed under Soeharto, and below what is needed to generate the jobs and income opportunities that the growing population requires. Dismally low rates of foreign investment compared to other crisis countries, such as South Korea and Thailand, are often regarded as a concise indicator of the woes of Indonesia’s business environment. 1

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PIERRE VAN DER ENG

It is easy to share in the general impression of malaise and argue that the business environment in Indonesia is improving only slowly, if at all, compared, for instance, to the country’s neighbours. But such pessimistic observations detract from two facts. First, unlike in neighbouring countries, Indonesia’s post-crisis years were marked by drastic change of a multidimensional nature, not only economic change. The political, economic and institutional changes of post-Soeharto reformasi are monumental in historical terms. At the onset of reformasi, it was expected that the changes would soon crystallise and economic growth would resume. But any realistic assessment should have pointed to the contrary – reformasi could not have been anything else but gradual and a result of compromises. Second, domestic private firms actually accommodated the changes in the business environment, however difficult, quite quickly, to resume their activity with a vigour that belies the impression given by meagre inflows of foreign direct investment (FDI). This chapter seeks to take stock of some of the key changes in Indonesia’s business environment, several of which are elaborated in the chapters in this book. It starts with a brief macro perspective on business development during the reformasi era. It then describes some of the changes in Indonesia’s business environment during and since the crisis. A MACRO PERSPECTIVE ON BUSINESS IN THE REFORMASI ERA From a macroeconomic perspective, Indonesia has come through the upheaval of the reformasi era relatively well. The sharp economic contraction of 1997–98 subsided in 1999 and a recovery transpired during 2000–01. Many foreign manufacturing firms producing for export shunned new commitments, as Kelly Bird explains in Chapter 6. Still, foreign companies producing and marketing consumer goods for the local market, such as Unilever, Nestlé and Carrefour, expanded their commitments in Indonesia. Many domestic firms absorbed the changes in the business environment and, given the limitations, took advantage of new opportunities in Indonesia and overseas. The small and medium-sized enterprises (SMEs) in furniture-producing Jepara, discussed by Henry Sandee and Peter van Diermen in Chapter 7, are an example. Table 1.1 shows that the ratio of investment to GDP during 2000–01 was indeed lower than during the boom period of 1980–96, but still comparable to that during 1975–79. The table also shows that the contribution of real investment growth to real GDP growth was in all periods more than one-third. The ratio of investment to GDP was still significantly high during 2002–03, but the rate of real investment growth had decreased considerably, to the extent that consumption explains almost all of the growth during the past two years, as M. Chatib Basri elaborates in Chapter 3.

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BUSINESS IN INDONESIA: OLD PROBLEMS AND NEW CHALLENGES

3

Table 1.1 Contribution of Investment to Economic Growth in Indonesia, 1975–2003 (annual averages) a

1975–79 1980–96 2000–01 2002–03

Ratio of Investment to GDP (%)

Real GDP Growth

Real Investment Growth (%)

Contribution of Investment Growth to GDP Growth (%)

21 25 22 21

6.3 6.9 4.2 3.9

11.2 10.3 7.0 0.2

36 38 37 1

(%)

a Growth rates are calculated from the data in constant prices. Investment is the total of public and private capital formation. Source: BPS (various issues); EIU (2004: 4).

What caused the dramatic slowdown in investment growth during 2002–03? One explanation is continued low public investment in infrastructure due to public budget restraints following the 1997–98 crisis. However, given that about 70 per cent of investment was probably private investment, the trend has to be explained on the basis of investment decisions by private enterprise.1 And, given that during 1990–97 FDI was around 6 per cent of total investment, the trend has to be explained largely as a consequence of investment decisions by Indonesian private companies.2 Is the slowdown a temporary issue, caused by private firms postponing investment decisions until after the 2004 elections, or have the old problems and new challenges in business accumulated to the degree that firms will continue to baulk until these issues are addressed and the business environment improves? Any answer cannot be conclusive, as the future is difficult to foretell. Still, the tentative results of a recent survey of entrepreneurs throughout the country sponsored by the Asian Development Bank (ADB) yields a ranking of their concerns. Figure 1.1 shows the key gripes. These are also found on a much longer list of grievances that the Japanese Chamber of Commerce in Jakarta has articulated and started to discuss with the Indonesian government.3 James Castle notes these grievances in Chapter 5, and elaborates on several of them from a private sector perspective. It is not surprising that macroeconomic instability tops the list, despite the achievement of a degree of stability in recent years. The shock of exchange rate,

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PIERRE VAN DER ENG

Figure 1.1 Key Obstacles in Indonesia’s Business Environment, 2003 a Macroeconomic instability Political instability Corruption

Tax rates

Cost of financing Legal system

Labour regulation Electricity

Tax administration

Licensing by local government

Licensing by central government Transportation

0

0.5

1

1.5

2

2.5

a ‘Corruption’ refers to the average score for local and central government corruption. ‘Labour regulation’ refers to the average score for local and national labour regulation. The chart is based on the preliminary results of a survey involving 400 firms, mainly in Java. Responses were on a scale from 0 (none) to 4 (severe). Source: CGI (2003: 29).

price and interest rate volatility during and immediately after the 1997–98 crisis was damaging to most firms and is still fresh in the memory of those affected. Several (but not all) of the other issues will be explored below and in the various chapters of this book. PECULIARITIES OF THE PRE-CRISIS BUSINESS SYSTEM Indonesia’s business environment has never been an easy one for firms to operate in. In the colonial era, the underdeveloped physical and financial infrastructure was a deterrent, although business regulations were transparent (albeit in Dutch). The business climate deteriorated after independence due to the increasingly hostile attitude of the government towards private enterprise, be it foreign or domestic (Dick et al. 2002: 182–190). The business environment became more conducive to private enterprise with the start of the ‘New Order’ regime of President Soeharto in the late 1960s, when for instance the foreign investment regime was liberalised, physical infrastructure improved and access to finance became easier. This was taken a step

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further in the mid-1980s (Hill 2000a). Still, ambiguity in particular towards foreign enterprise and unfettered markets lingered, resulting in various idiosyncrasies. These included dense regulation of several economic sectors, an underdeveloped financial system dominated by state-owned banks, continuation and even expansion of state-owned enterprises (SOEs), insufficiently protected property rights, the involvement of the armed forces in business, suppression of independent labour unions and other labour rights, rampant corruption and, especially in the 1990s, rapid growth of family-owned business groups with concentrated ownership and little separation between owners and management. The latter were often controlled by ethnic Chinese families and/or associated with the family and associates of President Soeharto. These idiosyncrasies amounted to risk for firms seeking to conduct business in Indonesia. Risk of any kind is an eternal factor in business, but it is not necessarily a reason to abstain from it. Hence, firms explored and found various ways to minimise risk, including political patronage. With exceptions, firms with significant experience in Indonesia were able to deal with these idiosyncrasies successfully. However, the 1997–98 crisis and its aftermath changed the parameters of the business environment. POLITICAL CHANGE A major change affecting the business environment was the political instability and uncertainty accompanying the resignation of long-time President Soeharto in March 1998. The high general expectations of the change reformasi would bring may have caused private enterprise to adopt a wait-and-see attitude towards changes in government policy. Indonesia has since had three presidents, each of whom has installed his or her preferred combination of ministers. These cabinet reshuffles created uncertainty in terms of the political direction the government would map out. As Indonesia prepares for parliamentary, presidential and regional elections in 2004, this uncertainty continues. Despite the impression of sweeping change that the term reformasi may suggest, there were no drastic immediate and perpetual changes in the laws and regulations affecting business. Some significant changes in the legal and regulatory environment were introduced, as will be discussed below. But because the governments of Abdurrahman Wahid and Megawati Sukarnoputri lacked a majority in the democratically elected parliament, the introduction of the most sensitive reform legislation was either unsuccessful or a long-winded process, subject to public scrutiny and resulting in predictable compromise. Hence, the legal and regulatory environment has changed less than the banner of reformasi may have led many to believe was possible when the term was first coined in 1998. It should be comforting to notice, however, that none of the political par-

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ties due to take part in the 2004 elections has declared an intention to change the principles on which Indonesia’s economy operates. A revival of separatist movements in East Timor, former Irian Jaya (now three separate provinces) and Aceh, and regional ethnic or religious violence in Kalimantan, Sulawesi and Maluku, could be regarded as another source of political instability, particularly where the authority of Indonesia’s central government was challenged. Sidney Jones discusses political developments during 2003 in Chapter 2. Although these events affected some companies operating in these regions, particularly mining ventures, they hardly affected the overall business environment in the country as a whole, as the majority of companies are located well outside these troubled regions. Particularly where foreign ventures were involved, the business climate in the country’s hubs of economic activity was affected by the bombings by Islamist terrorists in Bali in October 2002 and of the Marriott Hotel in Jakarta in August 2003. Although the Indonesian government reacted to the threat of terrorism with tough measures, this has not eased the uncertainty among foreign workers and their families, and possibly also among non-indigenous (nonpribumi), non-Islamic Indonesian citizens. Another aspect of political change is the likelihood that several politicians, their parties and some business people may have explored new alliances for the purpose of mobilising financial support for election campaigns in return for a degree of influence in the political decision-making process. This is of course nothing new, given that some prominent business people flaunted their relations with leading figures associated with the Soeharto regime, including the president himself and his family (Eklöf 2002: 217–222). What is different, however, is that the 2004 election results are so difficult to predict that business people may find it hard to pick the winning horses. It is therefore uncertain at this stage how such alliances will pan out. Ethnic Chinese business people in particular appear to be keeping a low profile on this issue. The gross political violence directed at the ethnic Chinese in May 1998, and the current fluid political situation, may explain their caution. Sadanand Dhume, in Chapter 4, draws attention to the forces that may be simmering beneath the volcano that Indonesia can be. He suggests that popular discontent with the prominent position of ethnic non-pribumi in business may not have died away. Implicit in Dhume’s chapter is the possibility that leading politicians may be loath to capitalise on this issue, but that on the fringes, would-be politicians, possibly of a fundamentalist Muslim persuasion, may start to use it to rally popular support. If so, Indonesia may want to explore the option of a Malaysia-style situation of positive discrimination in favour of pribumi. This is of course nothing new in Indonesia. Over time the country has seen many government attempts to bolster the pribumi share in the economy (Sato 2003: 4–24). Posi-

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tive discrimination in favour of pribumi entrepreneurs and initiatives to advance SOEs and cooperatives have been tried. Even the rapid rise of business groups led by Soeharto’s family members on the basis of favouritism and outright nepotism has been justified with the argument that ‘at least they were pribumi’. Given the flaws in past approaches, a new policy approach may be required in an effort to nip a resurgence of economically damaging ethnic tension in the bud. Unfortunately, however, there are no ready answers to the question of what such an approach would entail.4 THE INDONESIAN BANK RESTRUCTURING AGENCY AND FINANCIAL SECTOR REFORM One of the first issues the Indonesian government had to address when the 1997–98 crisis started to bite and support from the IMF to overcome the crisis had been sought was the massive bad debts paralysing much of the financial sector. For this purpose, it established the Indonesian Bank Restructuring Agency (IBRA) in February 1998. IBRA did not begin its operations until one year later. In the meantime, the government provided cash injections to keep troubled banks afloat. IBRA has played a critical role in rebuilding the financial sector. It took control of banks that were teetering on the brink of bankruptcy and averted a run on the banks. It took some $60 billion worth of assets from the ailing banks or from the former bank owners. In all, it assumed control of outstanding, largely non-performing loans to more than 4,000 private firms, effectively becoming the country’s largest creditor. Using the threat of bankruptcy suits, IBRA secured asset pledges from debtors, which it sold to the private sector. Of the 240-odd pre-crisis banks, IBRA liquidated 68, nationalised 12 and forced 14 to merge into two larger entities. Altogether more than $75 billion of taxpayers’ money was spent on the restructuring and recapitalisation of Indonesia’s banks (Jakarta Post, 30 October 2003). Gradually, IBRA sold 95 per cent of the assets (non-performing loans, shares in the banks and fixed assets) to the private sector. The sales were intended to raise revenue to help finance the state budget, which had been severely burdened by the enormous cost of bailing out the troubled banks, and inject capital into the remaining companies so as to make them saleable. IBRA persuaded many of its debtor firms and their business groups to agree to debt workouts and restructuring in various forms.5 The Jakarta Initiative Task Force carried out the same task on a voluntary basis in cases where IBRA was not a major creditor. IBRA’s activity was not without concerns. It experienced a high turnover of senior officials, going through no less than seven chairmen during the five years of its existence. Its handling of assets was controversial in several instances,

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most notoriously the ‘Baligate’ scandal in 1999. Its sales activities were contentious, with complaints raised about the transparency of sale processes and asset valuations, possibly due to its preference to settle out of court. In addition, IBRA’s program experienced significant delays as assertive populist parliamentarians impeded the required parliamentary approvals. In 2003, fears surfaced that IBRA was selling assets to their original owners or to companies linked to the former owners at depreciated prices at the expense of creditors and taxpayers (Adrianto et al. 2003). In all, IBRA recouped just 28 per cent of the nominal value of the assets it took over (IBRA 2003b).6 On the other hand, IBRA did sell most of its assets and in broad terms generated the budgeted government income. It was terminated in February 2004 despite having unsold assets in the form of remaining minority shares in banks (Rp 4.5 trillion), bad loans (Rp 43 trillion, mainly from textile giant Texmaco whose case was continually delayed) and many small properties (Rp 24 trillion). They became the responsibility of the Ministry of State Enterprises, which plans to establish a state-owned asset management company to administer them (Jakarta Post, 22 December 2003, 4 March 2004). The restructuring and privatisation of Indonesia’s banks created an opportunity to revitalise the financial sector. The Ministry of Finance and the central bank, Bank Indonesia, did their bit by introducing new supervisory regulations for the financial sector, increasing the capital adequacy ratio (CAR) and forcing banks to write off some of their non-performing loans. Banks’ CAR did indeed increase from –16 per cent in late 1997 to around 23 per cent in late 2003, and the share of non-performing loans decreased to around 8 per cent of outstanding commercial bank loans. However, despite the sanitation of the banks, most still do not meet international capital standards. The 2002–03 Lippo Bank scandal – discussed by Daniel Fitzpatrick in Chapter 11 – did little to restore faith in the banking sector, while recent instances of fraud involving the state-owned banks BRI and BNI suggest that the banks still need to improve their internal control mechanisms. Banks have generally remained reluctant to lend to companies, preferring instead to keep their liquidity in government bonds and Bank Indonesia deposit certificates to the tune of about 50 per cent of their core capital in late 2003 (Jakarta Post, 30 October 2003). One reason is the heightened caution of banks in handling applications from firms for credit. Another is the likelihood that many banks have not yet been able to put adequate risk assessment and management procedures in place. Either way, firms experienced a credit crunch that continued until late 2003 despite falling interest rates after 1999. Bank lending did grow, but growth was sustained by lending for low-risk consumptive purposes. Private firms explored other ways of raising finance, particularly retained earnings and informal borrowing, despite their preference for bank borrowing (Agung et al. 2001: 54–55). The credit crunch also highlighted the

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state of underdevelopment of the financial sector, in which banks together still hold about 90 per cent of assets – the majority by state-owned banks – while lending by insurance, pension and finance firms remains small. Despite IBRA’s efforts to sanitise the banking sector, the implication for business of the current state of the banks and of monetary policy is that the cost of financing operations and expansion through bank loans remains relatively high. The domestic bond market is small and selling debentures in sceptical overseas securities markets is restricted to large companies with the best credit ratings. Hence, limited access to formal finance and the need for local companies to raise finance through retained earnings or the ‘curb market’ has placed limits on the investment plans of firms. DECENTRALISATION A major change has been Indonesia’s embrace of greater regional autonomy at district level, starting in 2001. There is no precedent in Indonesia’s history that could have provided guidance in the implementation of decentralisation, or in predicting the consequences. Given the profoundly centralist features of the former Soeharto regime, and the fact that the reforms were put in place in haste, it will take all involved in and affected by decentralisation time to adjust. In Chapter 8, Bambang Brodjonegoro provides an overview of the issues affecting Indonesia’s business environment, particularly the reasons why local governments draw up regulations that amount to interregional trade barriers. One issue is that the division of responsibility between the centre and the regions needs further clarification. Decentralisation has pitched some regions against the central government bureaucracy, which is tussling to retain some of its authority. Many regional governments have used the opportunity to introduce measures that amount to regional trade barriers and do not yet fully appreciate the opportunities they have to take initiatives to alter the local business environment in a positive way. But the experience is not all negative, as Brodjonegoro indicates. Some district governments did become aware of the opportunity to improve the economic lot of their regions and emerged as local exemplars of good governance. There have been efforts to inform and educate local authorities on this, and also to implement a system to rate and rank local governments on good governance. Planned revisions of the decentralisation laws aim to clarify the distribution of functions between levels of government, the distribution of financial transfers and the authority of regional governments to raise revenues locally, while banning extractive nuisance regulations. In addition an extensive survey, supported by the US Agency for International Development (USAID), of more than 1,000 regional firms in the second

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half of 2002 did not find a major degradation of the business environment as a consequence of decentralisation (Ray 2003a: 25). This may have been a reflection of the fact that 93 per cent of the firms surveyed were SMEs. Another survey confirmed that large firms more than SMEs perceived decentralisation as having increased problems associated with corruption, political uncertainty and labour regulation (CGI 2003: 29). CORRUPTION An old issue that continues to rate highly in any list of company concerns is that public officials at all levels require illegal payments for licences, permits and a host of other services that they are formally expected to provide free of charge or at a nominal fee. In Chapter 5, James Castle notes that Indonesia continues to obtain a high score in the international ranking of perceived levels of corruption. He notes that even Indonesia’s public servants themselves regard corruption as the most prominent obstacle to increasing foreign investment. Not everyone is convinced that corruption is a significant impediment to business, however. After all, corruption was rife while Indonesia was experiencing several decades of rapid growth before the 1997–98 crisis. Corruption could also be perceived as the grease that turns the wheels of commerce. Such arguments may have held in the past, but today the issue has become more urgent. In Chapter 13 Merly M. Khouw discusses the responses of business to the 2001 National Survey of Corruption, which reinforces the argument that corruption, despite its prevalence, should no longer be considered part of normal business practice. First, although they may take part in corrupt practices, the majority of firms do not condone such practices. Foreign investors may have accepted corruption as a cost of doing business in Indonesia, because the country offered very low wages for unskilled labour and a booming and protected domestic market that made production in Indonesia, rather than exporting, feasible. However, as Chris Manning discusses in Chapter 15, Indonesia has lost much of its lowwage advantage at a time when its economy is much more open to imports, particularly from ASEAN countries and – if the ASEAN–China free trade agreement materialises before 2010 – even from China. In other words, firms now have opportunities to evade the cost of corruption and produce for export in other countries – even making goods for export to Indonesia. Second, the US Foreign Corrupt Practices Act (1977) and Japan’s Unfair Competition Prevention Law (Additional Provisions, 1994) extend to the activities of American and Japanese companies, respectively, overseas. Corrupt behaviour in foreign lands may be difficult to prove, but Japanese authorities have stepped up their efforts to enforce the law, starting with Japanese firms

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holding contracts for Japanese development assistance projects in Indonesia. Japanese companies in Indonesia are expressing growing discomfort about corruption.7 And finally, firms in Indonesia say that the impost of corruption has increased, thus eroding their international competitiveness. Firms believe that in the past there was some guarantee that unofficial payments would ensure that an approval was received, that an agreed amount of tax would be paid or that a favourable court decision would be obtained. But decentralisation has increased the opportunity for demands for such payments by a wider range of local organisations, without the same perceived guarantees. Some international firms, such as Sony and Proctor and Gamble, have left the country. Even though they did not publicly mention the cost of corruption as a reason for their decision, it has been suggested informally that it was a factor. Some 100 other foreign firms have indicated to Indonesian’s foreign investment board BKPM that they intend to leave the country, many for lower-cost competitors such as China and Vietnam (Jakarta Post, 27 August 2003). Audits of government institutions and investigations of state officials and bureaucrats have aimed to stem endemic corruption and to alleviate low transparency and efficiency in the public service. The latter had been a consequence of the fact that under President Soeharto much discretionary power to implement regulations was in the hands of bureaucrats. Reformasi has resulted in a shift of the power balance to the law-makers in parliament, who support government efforts to heed the international call for a reduction in corruption. In December 2003, after a long delay, parliament accepted Law No. 30/ 2002, which formed the Corruption Eradication Commission (KPK). KPK replaced the Public Officials’ Wealth Audit Commission (KPKPN).8 While KPKPN had long been criticised as being toothless because it could only research and record the wealth of public officials, KPK was granted wide-ranging authority to investigate and prosecute those involved in major corruption cases (Jakarta Post, 18 December 2003). It has the power to take over corruption investigations from both the police and the Attorney-General’s Office. Various domestic groupings have increased the anti-corruption rhetoric ahead of the 2004 elections. For instance, in October 2003 the Indonesian Chamber of Commerce and Industry (Kadin) declared a national campaign against bribery for 2003–04, and a national movement against bribery for 2005–15 (Jakarta Post, 7 October 2003). A little later, the country’s two largest Muslim organisations, Nahdlatul Ulama (NU) and Muhammadiyah – together boasting 70 million members – signed a memorandum of understanding to initiate a nationwide anti-corruption movement and develop an Islamic interpretation of anti-corruption to assist in the development of good governance guidelines. Despite these initiatives, and despite an extensive World Bank (2003) report highlighting the vexed issue of corruption, there is no guarantee that efforts to

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curtail corrupt practices are likely to yield success soon. Given the existing collusive practices between business people and government officials, pre-election money politics are likely to prevail in Indonesia’s election year. PRIVATISATION Another issue that has taken on new dimensions under reformasi is the privatisation of SOEs. After the very poor performance of Indonesia’s large SOE sector was established in the late 1980s, privatisation was contemplated in the early 1990s and began in earnest in 1994 (Hill 2000a: 105–109). Some of the bigger and better managed SOEs were successful in going public, and this enhanced their performance. Several others went public in order to generate government revenue, increase transparency in management and encourage efficiency in sectors dominated by these firms. An example is the sale of regional divisions of Telkom to consortia of international telecommunications companies in 1995. However, the majority of SOEs continued to struggle with low profitability, overstaffing, unfocused operations and poor productivity On the whole, progress was slow until the consequences of the 1997–98 crisis forced the government to step up the pace of reform. As Tony Prasetiantono explains in Chapter 9, the privatisation of SOEs was a precondition for IMF support. Perhaps because it was an IMF precondition, privatisation became a more sensitive issue than it had been previously. The majority of privatisations actually went through smoothly, albeit with delays caused by the involved process of obtaining parliamentary approvals. But some prominent cases caused controversy. In particular, the sale of 26 per cent of Semen Gresik to Mexican firm Cemex and of 42 per cent of Indosat to Singaporean company Singapore Telecom and Telemedia (STT) stirred controversy for a mixture of reasons, ranging from lack of transparency in the transactions to the mere fact that significant portions of shares in such prominent firms were being sold to foreign companies. The privatisation of Telkom, although beneficial to the expansion of Telkom itself, proved disappointing to foreign investors. Australia’s Telstra and other consortium members sold their stake in the Central Java division of Telkom in September 2003 to local businessman Edwin Soeryadjaya for a price lower than they had paid in 1995. Prasetiantono explains some of the issues surrounding the cases of Semen Gresik and Telkom in Chapter 9. The case of Semen Gresik in particular appears to have been handled badly by the Ministry of State Enterprises. There may be some truth to the arguments put forward to criticise Cemex’s purchase of a share in the cement plant, as Prasetiantono indicates. But due to the controversy surrounding the spin-off of subsidiary firm Semen Padang, the annual report of Semen Gresik remains pro-

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visional. As a consequence, Cemex cannot adequately assess the value of its interest in Semen Gresik, and the firm risks being in breach of the rules of the New York Stock Exchange. In January 2004, Cemex brought the case of Semen Gresik to the International Centre for Settlement of Investment Disputes (ICSID) in Washington for arbitrage. If ICSID finds in favour of Cemex, the case will damage Indonesia’s reputation among international investors. It is likely to deter foreign interest in Indonesia’s continued privatisation effort, at least where it concerns minority shareholdings with the Indonesian government as the controlling partner. In the meantime, Semen Gresik is facing a fall-out in the form of lower credit ratings and an increased cost of borrowing. These developments have not generated any broad sense of concern and urgency in Indonesia. The main reason is the general ambivalence towards privatisation, despite government proclamations of its commitment. Populist politicians know that selling the state’s assets to foreign investors is unlikely to be a vote winner, while national and local politicians appreciate the positive aspects of keeping control over SOEs that can be milked as cash cows, particularly at election time. LEGAL, REGULATORY AND TAX REFORMS New laws, revisions of existing laws, and regulatory and tax reforms affecting corporations are changing Indonesia’s business environment. Examples are the trade practices, bankruptcy and capital market legislation, and the new corporate financial reporting and shareholder accountability requirements. Indonesia’s legal framework for intellectual property rights has improved over time, culminating in a patent law that amended and consolidated various related pieces of legislation in 2001, a trademark law in the same year and a new copyright law in 2002. In addition, changes in existing regulations have reduced trade barriers, opened sectors to foreign investment and generally relaxed the conditions under which foreign firms can operate in Indonesia. Restrictions on foreign company structures and local ownership requirements have been lifted, and the procedures to establish firms have been streamlined. The powers of supervisory bodies – such as those of the Capital Market Supervisory Agency Bapepam in supervising capital markets – have increased, while new independent regulatory authorities have been implemented.9 Many of these changes came about in a short time, signifying an urgency that was often prompted by the conditions attached to IMF support. In principle, the court system in many instances offers an opportunity for legal redress when firms take issue with the implementation of laws and regulations. Legal and regulatory reforms have been backed up with changes in the

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legal system, although these have been slow to be implemented. Examples are the appointment of ad hoc judges to commercial courts, the appointment of new judges to the Supreme Court and efforts to reduce judicial corruption. Measures such as these clearly aim to increase commercial certainty. Still, Indonesia’s legal and regulatory environment continues to be complex. Although abundant, laws and regulations are not always clear-cut and continue to leave room for interpretation, thus creating opportunities for persistent rentseeking behaviour. It is widely maintained that collusive practices between law enforcers and the parties involved in litigation as well as irregular payments continue to influence court decisions. Hence, the legal system is still widely regarded as the weakest link in all efforts to improve the business environment. Where possible, firms in Indonesia avoid the courts. The litmus test of the relevance of the many legal and regulatory reforms to business is whether they have indeed increased the security of contracts and property rights that firms expect a legal system to provide. Unfortunately, a negative impression prevails. For example, the infringement of intellectual property rights remains rife and largely goes unpunished (Arifin and Kurniawan 2003), notwithstanding the favourable ‘Davidoff’ ruling by Indonesia’s Supreme Court against a joint venture involving Gudang Garam in July 2003. Several high-profile cases involving foreign firms testify to the difficulties they experience in exercising their rights. The case of Mexican company Cemex, which ran up against accumulating problems when seeking to extend its stake in Semen Gresik, has already been mentioned. Another case concerns Kaltim Prima Coal (KPC), which was under a contractual obligation to divest a majority stake in the world’s largest coalmine, located in Northeast Kalimantan, to a local entity. But when a number of public authorities vied for the right to buy, mobilising court orders in the process, KPC’s owners, BP and Rio Tinto, sold their entire stake in the company in July 2003 for a price well below the valuation a year before. Several other firms in the regions have found themselves on the receiving end of disputes over land and the environment and acts of political violence. Local groups were able to conduct extended blockades of foreign-owned mines and oil production ventures in Riau and East Kalimantan because of a lack of effective law enforcement. Australian mining company Newcrest experienced popular protests in October 2003 against its NHM subsidiary in Maluku. Protesters squatted on the site until Newcrest informed the government that it would abandon its venture. The protesters were removed by paramilitary police in January 2004. In the latest twist, the Department of Forestry has banned mining operations in the area, even though NHM earlier secured permission from the Department of Geology and Mineral Resources to mine there. In another instance, in June 2002 the Commercial Court declared Canadianowned insurance company Manulife Indonesia bankrupt even though it had

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previously been declared solvent by the Ministry of Finance. Manulife’s appeal to the Supreme Court was successful, but the case highlights the legal uncertainty that firms may face. Manulife is one of many bankruptcy cases analysed by Marie-Christine Schröeder-van Waes and Kevin Omar Sidharta in Chapter 12. Their study involves close scrutiny of the implementation of Indonesia’s new bankruptcy legislation on the basis of intensive study of the more than 300 cases brought before the Commercial Court and the Supreme Court during 1998–2003. They conclude that it is not the law and the ability of the judges to understand and uphold the law that are defective. Rather, judges are subject to outside influences in the form of political pressure or possibly corruption, resulting in strange outcomes in some cases. Although not discussed in detail, an issue flowing from the study is that on average only some 60 cases are presented to the courts each year, rather than the possibly thousands of cases of companies that are terminated every year and that could require court involvement. It appears that a lack of trust in the fair application of the law has reduced demand for court guidance in winding up companies. Indonesia’s tax system suffers from two related problems. First, tax enforcement is poor and tax collection is low. Second, despite the introduction of new tax laws in 2000 and an accumulation of ministerial decrees and decisions by tax officials – or perhaps because of the latter – the tax system still contains contradictions and complexities that create insidious opportunities for tax administrators to demand unofficial payments. Complexities related to the decentralisation of taxation have led to suggestions that corrupt behaviour among tax officials has increased, but now without a guarantee that unofficial payments will resolve any disagreement. Hence, simplification of the tax system could increase tax revenue and reduce the incidence of tax-related corruption. The government’s White Paper of September 2003 called for such action. The Directorate General of Taxation has drafted amendments to laws on general taxation arrangements and procedures, income tax and value-added and luxury sales taxes to that effect, but as of March 2004 they had not reached parliament (Jakarta Post, 2 March 2004). Generalising these observations, one may argue that the principal problem relating to legal, regulatory and tax reform in Indonesia is not the absence or impracticality of rules and regulations. These may be imperfect to a degree, but the bigger problem appears to be their at times unpredictable implementation. If so, further legal and regulatory reforms are likely to be a drawn-out process, particularly where they are heavily politicised. Tony Prasetiantono’s discussion of the privatisation of Semen Gresik underlines that point. A further overhaul of rules and regulations may therefore not achieve the required transparency and accountability.

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In the medium term, one solution may be the establishment of further mediation facilities that are independent of Indonesia’s sprawling bureaucracy, and that resolve disputes in public so as to minimise outside influences. Schröedervan Waes and Sidharta argue in Chapter 12 that the Commercial Court is well able to do its job if no outside pressure is brought to bear. Another example is provided by the independent tax court, created in April 2002 as the successor of the Tax Disputes Settlement Agency (BPSP), which functioned under the Ministry of Finance. The tax court holds hearings on tax disputes in public to allay any concerns about irregularities; some 75 per cent of its decisions have been in favour of taxpayers (US Embassy 2003: A8). Business organisations, on the other hand, express dislike of public hearings because of the risk of exposing confidential business information. BUSINESS GROUPS AND CORPORATE GOVERNANCE The economic crisis focused attention on the consequences of lax regulatory regimes and corporate practices. Indonesia was perceived as having one of the poorest standards of corporate governance in the Asia Pacific. The business landscape was dominated by sprawling, family-controlled business groups, and business dealings were based largely on relationships rather than rules. Indonesian business was the most highly concentrated in East Asia (Claessens, Djankov and Lang 1999), with entrepreneurial ethnic Chinese families and/or members and friends of the Soeharto family dominating. Conglomerations of firms generally took the form of webs of cross-shareholdings, often with a pyramid structure.10 The situation confirmed the general rule that family control, whether as cause or as effect, is most common in countries with poor minority shareholder protection. The 1997–98 crisis and its aftermath encouraged deconcentration of company ownership in two ways. First, whether through the persuasion of IBRA or voluntarily, many groups returned to core competencies, selling interests in non-core, often loss-making, firms. Second, many groups sold equity in order to attract funds, pay debts and stem the fall in credit ratings – some more successfully than others. Other groups acquired ventures at relatively low prices. It is as yet unclear what the results of this reshuffling of the business groups will be; whether, for example, the Salim, Astra and Sinar Mas groups will still be as prominent as they were in the last published ranking for 1996 (Warta Ekonomi, 24 November 1997: 32).11 It is often taken for granted that Indonesia’s relationship-based, opaque business culture contributed to its woes in 1997–98, when foreign lenders and portfolio investors came to realise that they were not intimately familiar with the risks to their investments in the debentures and shares of many Indonesian

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companies. The World Bank-sponsored research by Stijn Claessens and his team substantiated the view that group-related companies in East Asia as a whole have tended to suffer from closely interlinked ownership and management, resulting in poor corporate governance practices that prevent transparency and accountability and therefore are disadvantageous to minority shareholders.12 In Chapter 10, Yuri Sato looks into the argument presented by Claessens et al. in the specific context of Indonesia. Based on an assessment of the top 100 non-financial public firms, she confirms that ownership was still highly concentrated in Indonesia in 2000 – albeit less so than in 1996 – and that ownership and management are still entwined. But her main finding is that concentrated ownership and non-separation of ownership and management do not by themselves predict poor company performance. Firms associated with established business groups such as Salim, Astra and Sinar Mas (all under ethnic Chinese control) showed better performance than firms associated with groups that had grown rapidly since the 1980s, such as Bimantara and Humpuss (both controlled by President Soeharto’s sons), and firms not affiliated with groups. To reinforce the impact of changes in regulation and debt restructuring, government and private initiatives have sought to increase company compliance with regulations by making firms more aware of the relevance of good corporate governance. Government initiatives have included the establishment of a national committee on corporate governance policy (which designed the 2000 code for good corporate governance), revisions of the Company Law and Capital Market Law, and a ruling from the Minister for State Enterprises in 2002 decreeing a national code of corporate governance for SOEs. A private initiative has been the Forum for Corporate Governance in Indonesia established by business and professional associations, which conducts self-assessment surveys among firms in Indonesia. Astra, Indosat and Timah have been mentioned as companies that are at the forefront of implementing good corporate governance principles. The aim of these initiatives is to promote a business environment that is based less on relationships and more on rules, enhancing the transparency of company activities in terms of decision-making and financial health and furthering the accountability of managers to shareholders, particularly minority shareholders. It is too soon to say whether firms in Indonesia in general have changed their ways. Daniel Fitzpatrick discusses the changes in regulations on corporate governance, particularly the decree from the Minister for State Enterprises, in Chapter 11. He argues that the implemented and proposed regulatory changes may improve the situation, but that the effects could be significantly diminished if the interaction between corrupt rule enforcers and family-controlled business groups is not addressed effectively.

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LABOUR ISSUES In an effort to keep up with inflation, minimum wages have been revised upwards several times since 1997. Starting in 2001, the administrative arrangement for the establishment of minimum wages was decentralised. Several local authorities ordered large increases in minimum wages to take effect in 2002, despite concerns expressed by the Employers Association of Indonesia (Apindo) about increases in wage costs at a time when firms were still trying to recover from the 1997–98 crisis. Several companies indicated that further increases in the minimum wage would make labour-intensive production prohibitively costly at a time when Indonesia was experiencing increased competition from firms in countries like China and Vietnam competing in the same labour-intensive, low-skill market segment. Rising wages would not matter if they were accompanied by commensurate increases in labour productivity, but this does not appear to be the case (CGI 2003: 35). Following decades of suppression of labour rights, relations between workers and management in firms have experienced profound change. In 1998 the government granted freedom of association, upon which unions and union activity proliferated, as Michele Ford explains in Chapter 14. She argues that the challenge to employers is not to suppress union demands, but to forge industrial relations that give a constructive role to unions and enhance mutual understanding. The government has sought to balance the protection of worker rights against the concerns of private companies about their competitiveness. It has issued new regulations, of which Ministerial Decree No. 150/2000 (Kepmen 150/2000) on severance and service payments is perhaps the most controversial. After prolonged debate, parliament passed Indonesia’s new Basic Manpower Law in February 2003, with qualified support from Apindo and the main unions. The new law covers a wide range of issues, of which rules on retrenchment and severance pay have attracted the most attention. Chris Manning explores some of the consequences of changes in labour standards, including minimum wage rises, in Chapter 15. He highlights the possibility that overregulation may stifle the mutually beneficial flexibility that employers and employees may want to consider in collective agreements. The Basic Manpower Law is not complete. Further legislation on other labour issues is expected to follow, such as a new law on the resolution of industrial disputes passed by parliament in December 2003. This law is expected to be crucial in resolving current uncertainty in industrial relations through arbitration and yet-to-be-established labour courts. But as long as further implementing regulations are not in place, and as long as uncertainty about the existing regulations remains, worker–management relations will remain fluid and a source of apprehension among employers.

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There are a number of wider issues that affect the labour market aspect of Indonesia’s business climate. For example, the shortage of qualified managerial and professional personnel due to the low quality of government educational institutions and the lack of job training opportunities is a continuing concern. Many foreign firms use in-house training facilities to correct the educational mismatch, but poaching of skilled workers puts limits on such efforts. CONCLUSION Indonesia’s economic recovery since the 1997–98 crisis has been modest, but appears persistent from a macroeconomic perspective. The devil is in the detail. At a micro level, several issues bug the business environment and prevent firms from making the kind of investments that will sustain robust macroeconomic development in the near future. This introduction has outlined only a few of the old and new issues in Indonesia’s business environment that concern firms and constrain their investment.13 In the short term the most crucial one is political uncertainty. The country will again go to the polls in 2004 to elect law-makers from a reduced number of political parties and later to vote for a new president. There is no certainty about the outcome of the elections, as the allegiances of voters and interparty coalitions are in flux. Still, the outcome of the elections is unlikely to result in any drastic changes, at least in the short term. Indonesia chose to graduate from the IMF support program at the end of 2003. It had instilled a sense of exigency in addressing the issues facing the private sector. The current political climate is likely to lead to further protraction of political processes and compromise. Although business surveys suggest that the new challenges and old problems in business have some urgency, it remains to be seen whether this will hasten the process of reformasi. NOTES 1

2 3

BPS does not publish a breakdown of public and private investment. However, a rough approximation by the International Finance Corporation suggests that on average 70 per cent was private investment during 1990–99 (Everhart and Sumlinski 2003). Based on realised foreign investment figures taken from the balance of payments data of Bank Indonesia, expressed as a percentage of total capital formation from the national accounts of BPS. For an update on the resolution of these grievances, see press releases on the website of the Coordinating Ministry of Economics and Finance, for example, ‘Pemerintah Indonesia dan Pengusaha Jepang Selesaikan Sebagian Besar Hambatan

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Investasi di Indonesia’, 26 February 2004, . Howard Dick (2001: 219) summed up the conclusions of a debate on this issue at a conference in 1999: ‘There is no “quick fix” to the problem of the Indonesian Chinese’. For a sceptical account of the sale process, see Hadiz and Robison (2003: 6–8). They suggest that the banks receiving state bail-outs used most of the funds for debt servicing of group companies, overseas investments or currency speculation, thus supporting their ailing business groups. This is lower than the results of similar agencies in South Korea and Thailand, which recouped 40 and 39 per cent respectively (Jakarta Post, 30 January 2004). Author’s survey of Japanese subsidiary firms in Indonesia, December 2003. Assegaf (2002) discusses the failed institutional attempts to combat corruption in Indonesia. Goodpaster (2003) discusses the independent regulatory commissions that Indonesia is putting in place, such as the Business Competition Supervisory Commission (KPPU). See Husnan (2001: 17–36) for a discussion of group cohesion and intragroup governance. Habir (1999) and Backman (2001) provide explanations for the rise of conglomerates of business groups in Indonesia. Hadiz and Robison (2003: 8) claim that the business groups survived IBRA’s effort at restructuring ‘substantially intact’, due to their ability to persuade IBRA to recapitalise the groups’ banks with public funds, rather than seize and sell the asset pledges of group companies indebted to these banks. In contrast, on the basis of scrutiny of IBRA’s sales of group banks and pledged assets until late 2001, Sato (2003: 37–46) concludes that the role of business groups in the Indonesian business system has decreased (see also Sato 2002: 77–87). At that stage IBRA still held some 85 per cent of the assets transferred to it, so it seems likely that further sales reinforced this trend. A definite answer may have to wait until the next listing of business groups by assets. Since 1999, Stijn Claessens and his team have generated a series of papers, some of which are now published, on the topic of corporate governance and group affiliation in East Asia. Some are available from the World Bank’s website, , others from Claessens’ website, . Handbooks on how to do business in Indonesia contain many others. See, for example, Brown (2002).

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PART I Political and Economic Developments

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POLITICAL UPDATE 2003: TERRORISM, NATIONALISM AND DISILLUSIONMENT WITH REFORM Sidney Jones

If the international community, especially Australia and the United States, saw terrorism as dominating developments in Indonesia during the year, most Indonesians did not. For the political elite, there were far more important issues: rising corruption; stalled democratic reform; how to maintain the country’s territorial integrity; the battle between the army and police for control of internal security; the impact of political Islam; the consequences of decentralisation; and manoeuvring for the 2004 elections. For those outside the elite, all politics was local. People were concerned about personal security, but less because of the Bali bombings than because of vigilantism in their neighbourhoods. In Lombok, the question of whether a ban on gambling would lead to increased tensions between ethnic Balinese and Sasaks was far more important than what happened to Amrozi. And yet there were issues that touched both the elite and non-elite across the country. One was the dismal performance of civilian leaders. As respect for President Megawati Sukarnoputri plummeted, nostalgia for Soeharto-style leadership grew and promised to be a factor in the 2004 elections. Nationalism, combined with suspicion of foreigners, was on the upsurge, and helped account for the strong public support for military operations in Aceh. The government managed to transform the name of the government from ‘RI’ – Republik Indonesia – to ‘NKRI’ – Unitary State of the Republic of Indonesia’ – and struck a responsive chord by promising to defend the nation from separatists, their foreign supporters and international institutions like the United Nations and the International Court of Justice.1 Anti-Western, and particularly anti-American, sentiment was high, fuelled by the war on Iraq. While the Indonesian reaction was muted and street demonstrations few, perceptions of the United States and its allies turned strongly 23

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negative across the board.2 This not only helped to reinforce the notion that the war on terror was a war on Islam, but also meant that, in relation to issues such as Aceh, military accountability for human rights abuses and security sector reform, international donors had even less leverage than they did under normal circumstances. Finally, Indonesians remained worried about communal tensions. The war in Ambon may have died down, but it flared again in Poso, Central Sulawesi, and mutual suspicions between Muslims and non-Muslims continued, as evidenced in particular by the reactions of both communities to a national education bill with a controversial provision on religious instruction.3 All of these issues – weak leadership, nationalism, anti-Westernism and communalism – affected the way in which the Indonesian government reacted to the problems it faced. TERRORISM That terrorism itself was not a major issue for Indonesians was indicated by the fact that, as of early September 2003, many Indonesians remained sceptical that Jemaah Islamiyah (JI) existed as an organisation. However, the generally professional performance of the police, working together with their counterparts in the Australian Federal Police, seemed to convince the public that the men arrested in connection with the Bali bombings were indeed the perpetrators, and the trials themselves, carried live by several television and radio stations, became must-see viewing for many Indonesians. But while belief that Indonesians had indeed carried out a major attack led many moderate Muslim leaders and politicians to condemn the use of violence, and others to bemoan the absence of Soeharto, who would not have allowed such violence to take place, it did not translate into an acceptance that an organisation called Jemaah Islamiyah had an extensive presence in the country.4 There was certainly no clamour to put more people behind bars. There were several reasons for this. The most obvious was that there were too many competing priorities. It was more than that, however: Muslim leaders and heads of Muslim organisations, though horrified by the bombings, were anxious to avoid ‘wounding’ Islam by using new terrorism legislation against Muslims, targeting religious boarding schools (pesantren) suspected of radical links or portraying the Islamic community (generically known as jemaah islamiyah) in a negative light.5 It was anathema to many Muslims to draw boundaries between ‘moderate’ and ‘radical’ Islam: there is only one Islam, and to acknowledge distinctions is to challenge the concept of a single community of the faithful. There were practical considerations as well. The activities of JI spilled over into many legiti-

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mate organisations in Indonesia, making it more difficult for some in those organisations to acknowledge JI’s criminal nature. Some JI members, for example, were affiliated with a charity called Kompak, which was set up in 1998 as a humanitarian agency to assist Muslims affected by poverty, social unrest and political violence, but which became involved in purchasing arms for the Ambon and Poso conflicts.6 Kompak was founded by the Islamic Propagation Council of Indonesia (Dewan Dakwah Islamiyah Indonesia), a perfectly respectable, if conservative, organisation dedicated to the implementation of Islamic law. The head of Kompak was Tamsil Linrung, the former treasurer of Amien Rais’s National Mandate Party (PAN). With ties thus leading directly into the political elite, condemnation of JI became more difficult. It was not only the vice-president, Hamzah Haz, who questioned JI’s existence, reflecting his constituency within the United Development Party (PPP), Indonesia’s third largest party. Even Syaafie Ma’arif, the moderate leader of Muhammadiyah, as late as mid-August after the Marriott bombings, said he had seen no hard evidence of an organisation called JI.7 The truth was that neither the police nor anyone else in the government had made the effort to sit down with key Muslim opinion-makers and set forth the evidence accumulated to date. For much of the year, the case against JI was being made to the Indonesian public by a largely non-Muslim police team, foreign governments or international organisations like the International Crisis Group. Only in mid-September 2003 did the police move to counter continuing scepticism by promising to make available some of the documents and publications seized from JI houses in Solo and Semarang. INTERNAL SECURITY The terrorism issue fuelled two related debates in Indonesia. One was over how much power should be given to the Indonesian government to address the problem. The other was over who should have control of internal security. The NGO community, including Indonesia’s best-known human rights activists, as well as many in the media and the educated urban elite, Muslim and non-Muslim alike, were concerned from the beginning about efforts to adopt new anti-terrorism legislation. If nostalgia for the New Order was growing in some quarters, this group was more worried that anti-terror measures might signal a return to Soeharto-era abuses. Already there was a concern about a rollback in fundamental freedoms of expression and association, particularly with the arrests of students in Java and peaceful pro-independence activists in Aceh under clauses of the Indonesian Criminal Code that had been used by the New Order to arrest dissidents.8

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Initial concerns about the decree-in-lieu-of-legislation proposed after Bali were that the looser rules of evidence would allow the National Intelligence Agency (BIN) or the army more of a role in counter-terrorism and that the new legislation would be used not just against organisations with a proven track record of criminal acts but also against activists in Aceh and Papua – a concern that proved prescient with respect to Aceh.9 In fact, however, the decree and Law No. 15/2003 that superseded it proved far less draconian than the Internal Security Act used in Singapore and Malaysia and contained many more safeguards against abuse. Fears in late 2002 that the legislation might lead to a witch-hunt against Muslim activists proved unfounded, in part because concern about the political backlash acted as a powerful brake on the police. After the Marriott bombing, however, both the army and Susilo Bambang Yudhoyono, Coordinating Minister for Political and Security Affairs, raised the issue of the need for an internal security act with provisions for preventive detention and an increased role for BIN. After a flurry of protests from both rights groups and Muslim organisations, the government shifted its efforts to strengthen the existing terrorism legislation, keeping the police in charge but with a provision that would allow the military a greater role in special circumstances. The amendments were still under debate at the time the annual parliamentary session ended in December 2003.10 The sensitivity to any hint of police misconduct was underscored by the outcry in September 2003 over the arrest of some 15 men suspected of aiding JI. Family members accused the police of ‘kidnapping’ because they were not immediately informed of their relatives’ whereabouts, and Muslim moderates joined in the call for an investigation into possible violations of criminal procedure. It was clear that any misstep by the police would immediately be exploited, not only by those looking for a chance to accuse the government of targeting Muslim ‘activists’ but also by those eager to see the police fail in their counter-terror role. THE ROLE OF THE MILITARY AND POLICE The debate over the terrorism legislation was part of a broader debate over internal security, taking place against the backdrop of intense military–police rivalry. That rivalry was taking place on several fronts simultaneously. The army, resentful of international attention to police success in the Bali investigation, made little secret of its contempt for police intelligence. It used the post-Bali climate to push for a strengthening of its own intelligence capacity down to the village level, in a way that would serve only to reinforce the existing territorial command structure – the gradual dismantling of which had generally been seen

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as an essential step towards moving the army out of daily political life. Not to be outdone, BIN under Hendropriyono also sought to take advantage of the war on terrorism, and the resources flowing into Indonesia to fight it, to enhance its standing as overall intelligence coordinator. BIN’s bid to outshine the army was underscored by the opening, with great fanfare, of an international intelligence academy on Batam Island in July. The People’s Representative Council (DPR) allocated an initial Rp 10 billion for 2003 to this institution.11 Debate over proposed legislation on the armed forces (TNI) became another means for the military to try and reassert its role in internal security as opposed to being ‘relegated’ to external defence. One article of a draft armed forces bill leaked to the press in February 2003 generated a huge public outcry because it would have allowed the military to intervene in a crisis without first getting presidential approval.12 Dubbed the ‘coup d’état clause’, Article 19 raised fears that the TNI was trying to use the bill to strengthen its powers, regain lost influence and undermine the principle of civilian control. The Ministry of Defence, in response to the protests, dropped the offending article and sent a new draft to the TNI. Instead of simply amending that version, the TNI put together a new drafting team and came up with a draft that reportedly reinserted the essence of Article 19 and reaffirmed the importance of the territorial command structure. The new draft had not been made public by the end of the year; a defence ministry spokesperson merely said that it had been turned over to the state secretariat in October, a preliminary step to its being submitted to parliament.13 At the same time that the TNI bill was under discussion, the military blocked a regulation proposed by the police in January 2003 that would have established guidelines for when and how the military would assist the police in emergencies or crises. The military reportedly said that, if it was to assist the police, it needed to have a separate budget for doing so. In August the police finally withdrew the draft, but the battle did nothing to improve police–military relations. Physical clashes between military and police continued to be frequent, often the consequence of a struggle to control local resources. ACEH One of the major policy battles during the year was fought over Aceh. The ultimate decision to use military force and abandon dialogue as a way of resolving the 27-year-old insurgency could be seen in part as evidence of growing military influence in the Megawati administration – and a victory of the military over the police on a key internal security issue. But, as always, the truth was more complicated. The Megawati government had given the peace process a reasonable chance and over the course of 2002

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had made substantial tactical concessions in the interests of reaching an agreement with the rebel Free Aceh Movement (GAM). The concessions, made in talks brokered by the Geneva-based Centre for Humanitarian Dialogue – better known in Aceh by its former name, the Henri Dunant Centre – included a willingness to allow international monitors. They did not include a willingness to allow local political parties or any mechanism that would have given GAM an incentive to participate in the Indonesian political system.14 The agreement that was eventually signed on 9 December 2002 was based on the principle that both sides accepted a 2001 law on special autonomy for Aceh as the starting point of negotiations. But the government had no intention of putting its own sovereignty on the line, GAM was not about to abandon its struggle for independence, and neither side had any real trust that the other was negotiating in good faith. There were vastly different interpretations of almost every major clause of agreement. And the behaviour of both sides during the initial two-month confidence-building period did more to undermine confidence in the process than to strengthen it. GAM in particular exploited the initial reduction in violence to organise pro-independence rallies, consolidate its forces and, apparently, increase its arms supplies. The TNI showed restraint at first, but by March it had begun to encourage or actively stage attacks on monitoring offices, first in Central Aceh, then in East Aceh. The attacks were allegedly carried out by local civilians angered at the failure of the monitors to effectively address GAM abuses, but links to the army were documented by the local press. As the peace process unravelled, Susilo Bambang Yudhoyono, Megawati’s Coordinating Minister for Political and Security Affairs, emerged as virtually the lone voice in cabinet for sustaining the dialogue rather than opting for military force. For someone with presidential aspirations, it was a politically risky stance, even if it played well internationally. Virtually all other politicians, and the Indonesian public outside Aceh, seemed convinced that it had been a mistake from the outset to allow an outside organisation a facilitating role, because it ‘internationalised’ a domestic problem, opened Indonesian territorial integrity to question and gave legitimacy to the rebels. In Tokyo, a last-ditch effort by the donor community to salvage the negotiations failed, and on 18 May Megawati declared a six-month military emergency in Aceh. The government’s options at the time were limited. If it had agreed to allow GAM to turn itself into a political party, it would have appeared to give in to the enemy. This would have put the government on the defensive – perhaps dangerously so given the level of military opposition – at a time when its popularity was already plummeting; moreover, there was no guarantee that such a concession would wring any similarly large concession from GAM. If the government completely eschewed the use of force, GAM would continue to grow, and elements within the military would almost surely have continued to

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covertly train and arm civilians. If the government declared a civil emergency, it would be forced to give additional powers to one of the country’s most notoriously corrupt governors, who himself had become an obstacle to peace. That said, the government still could have found ways to authorise some use of military force in a way less calculated to ensure the continued alienation of the Acehnese population.15 It could have employed fewer troops and focused instead on targeted operations based on good intelligence, especially after the immediate post-agreement euphoria led many GAM guerrillas to come down from the hills and mingle with the population and their military counterparts. It could have avoided the kind of mass loyalty oaths and forced flag-waving and indoctrination sessions virtually guaranteed to generate anger and humiliation.16 It could have won more sympathy within Aceh and abroad by ensuring some measure of civilian oversight of the operations and allowing an ongoing presence of international humanitarian workers and journalists, rather than drastically restricting access to the area. It could have engaged Acehnese in a dialogue at the same time as it was pursuing a military option against the rebels, particularly by offering to discuss the problems with the autonomy package that went into effect in 2001 and acknowledging the extent of Acehnese grievances, including the lack of justice for past abuses. It could have avoided installing retired military personnel as subdistrict heads in areas considered insecure, a practice that has served only to intensify suspicions about the economic interests of the military in Aceh and its desire for a long-term presence. Perhaps most importantly, it could have formulated and publicised an exit strategy indicating what it hoped to achieve by the military emergency and when and under what circumstances it would end. All of this it failed to do, and the emergency was extended for another six months in November 2003. By virtually ceding control of Aceh and Aceh policy to the military, the Megawati government weakened the principle of civilian supremacy, strengthened the hand of the TNI in policy-making more generally, opened the door to a greater role for the TNI in Papua and destroyed any notion that Acehnese actually have anything to say about their own governance. At least for the moment, autonomy in Aceh is dead. PAPUA The debate over Aceh was very much a national debate that engaged ordinary Indonesians and fuelled nationalist sentiment. Papua, by contrast, was a sideshow, but one in which Jakarta-based political struggles played themselves out. The disastrous Inpres (Presidential Instruction) in January 2003 to divide the province into three appears to have been a move primarily to weaken the

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independence movement, but in the process to assist the Indonesian Democratic Party of Struggle (PDI-P) in its local struggles against Golkar, and perhaps make it easier for the Jakarta elite to obtain economic spoils.17 The ostensible reason for the move was to bring local government closer to the people and improve the delivery of services, but few believed it. The concern of cabinet hardliners was that the law on special autonomy for Papua, adopted by the Indonesian parliament in October 2001, gave away too much, and laid the institutional groundwork for strengthening Papuan nationalism. In Aceh, GAM guerrillas posed the main security risk, but in Papua the government saw the threat coming less from the poorly equipped fighters of the Free Papua Organisation (OPM) than from the political pro-independence movement. In November 2001, that concern had led directly to the murder by Kopassus soldiers of independence leader Theys Eluay, and when they were convicted earlier this year, the army chief of staff called them ‘heroes’ for targeting a ‘rebel leader’.18 The government was also concerned that Papuan nationalism would be fuelled by a growing international campaign to ‘rectify history’ and review the 1969 UN-supervised Act of Free Choice that had led to Papua’s integration into Indonesia.19 Accordingly, in the January instruction, the government resuscitated a law – passed in 1999 but never implemented – dividing Papua into three provinces: West Irian Jaya, Central Irian Jaya and Irian Jaya. Like the military emergency in Aceh, the move seemed deliberately crafted to alienate important Papuan constituencies, including the moderate wing of the pro-independence movement that had been willing to give autonomy a chance. However much the Megawati administration tried to deny it, the instruction was legally incompatible with the special autonomy law, which specified that any division of the province had to be approved by a body called the Papuan People’s Council (MRP). But the MRP was precisely the kind of Papua-wide institution that autonomy-phobes thought would fuel separatism, and the Ministry of Home Affairs obstructed its creation.20 The instruction also brought back the hated name of Irian Jaya that President Abdurrahman Wahid had gone to great lengths to change as a way of acknowledging both Papuan culture and Papuan grievances against Jakarta. The strength of the outcry against the Presidential Instruction seemed to take the government by surprise, but condemnation was not universal. Papuans who believed they would benefit in terms of jobs, contracts or political influence from siding with Jakarta, or who felt that they had not received their due from special autonomy, voiced support for the measure. They included Bram Atururi, the man appointed governor of West Irian Jaya, who quickly moved to set up office and hold an inauguration parade for himself in Manokwari in February 2003. They also included a number of other district heads (bupati) and district council heads who believed that, if they supported a three-way division,

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it would be easier to further subdivide the provinces later and fulfil their own dreams of lucrative governorships. In Jakarta as well, the elite was divided. At the same time as the Ministry of Home Affairs was moving forward with implementation, Yudhoyono, ever the moderate, was telling Papuan leaders that the division would be put on hold until after the 2004 elections. In July, Home Affairs installed six people in senior positions in the provincial government of West Irian Jaya. There were grumbles, but no violence. Then, on 23 August, local politicians in Timika announced that the province of Central Irian Jaya was open for business. This time the anti-division forces openly challenged the move, and fighting broke out between the two sides. When it was over, five people were dead, and Yudhoyono had announced that implementation of the January instruction would be frozen and the entire process reviewed – tantamount to an admission, as one local magazine put it, that the whole thing had been a mistake.21 However, apparently the freezing applied only to Central Irian Jaya, and not to West Irian Jaya, which in early September was allocated three seats in parliament by the national election commission preparing the 2004 ballot. The allocation highlighted another sordid aspect of the division: the fact that before the January Presidential Instruction all the key Papuan provincial posts were held by Golkar, whose officials also stood to reap a significant share of the windfall revenues from special autonomy. By creating a new province in the west, the Megawati government virtually assured three new seats for PDI-P. On 14 November, the Ministry of Home Affairs formally installed Brigadier General (retired) Bram Atururi as governor of West Irian Jaya. REGIONAL AUTONOMY AND DECENTRALISATION Turmoil in Aceh and Papua highlighted the anomalies of decentralisation in Indonesia, arguably the most significant transformation of the political system since independence. Two laws passed in 1999 devolved political and economic powers from the central government to the then 360 or so districts, bypassing Indonesia’s 26 provinces, largely because of fears that giving power to resource-rich provinces such as Aceh, Papua, Riau and East Kalimantan would fuel centrifugal tendencies and weaken Indonesian unity. The central government retained control over defence and security, justice, international relations, monetary and fiscal policy and religion, but the laws were vague and sometimes contradictory about the exact nature of the division of powers between district and province. As 2003 came to an end, there was increasing concern in the centre over the lack of adequate regulatory capacity to monitor what different districts were

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doing and increasing concern in the districts over the central government’s announced desire to revise the decentralisation laws and take back some of the newly devolved powers.22 Ironically, the provinces stand to be the likely beneficiaries of any amendments to the decentralisation laws, although any such amendments are likely to await the formation of the Council of Regional Representatives (DPD) after the 2004 elections. One by-product of decentralisation, which went into effect in January 2001, was administrative fragmentation, under a regulation that set out a mechanism through which new provinces and districts could be created.23 By mid-2003, the number of districts had risen to 416 and the number of provinces to more than 30 (the dispute over the Papuan division made the final tally uncertain). The process threw up all sorts of interesting dynamics. In some areas, traditional elites used the opportunity to try and recreate old kingdoms or sultanates, long submerged under the deadening uniformity of Soeharto’s New Order. Thus, in late November 2003, the old sultanate of Toja became the new district of Toja Una-Una, carved out of Poso district in Central Sulawesi; the campaign for the district’s creation had been led by the grandson of the last raja. Likewise, the fragmentation of Luwu district in South Sulawesi into four new districts raised hopes that a new province could emerge with the boundaries of the old Bugis kingdom of Luwu.24 The new province of West Sulawesi, also carved out of South Sulawesi, was expected to be approved before the end of 2003, a development that would almost certainly lead to pressure on Tana Toraja, sandwiched between Luwu and West Sulawesi, to also split from South Sulawesi and become a province in its own right. Flores and Sumba both had aspirations to break away from East Nusa Tenggara, although the campaign for Flores was more advanced. Proponents of new provinces here argued that the provincial capital, Kupang, was too far away to provide essential services, but cultural pride and more parochial economic interests were often more important in the dynamics of administrative division than any altruistic desire for improved public services. Fragmentation unquestionably created new opportunities for graft and corruption, but it also created new opportunities for political participation by groups long excluded from a role in local government. Ethnic Mandars in the would-be West Sulawesi, for example, argued that they had never secured high posts in the South Sulawesi provincial administration, which tended to favour Bugis and Makassarese. The prospect of having one’s own district, let alone one’s own province, often generated an excitement and interest in the political process outside Jakarta that served to counter the general despair in the capital over the setbacks to reform. The process also threw up new and interesting political leaders, unknown outside their own regions, who offered some hope for better national leadership in the future.

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In some areas, administrative fragmentation raised fears that new communal or ethnic conflicts might arise, caused by resource competition, struggle for local political office or efforts to redress past wrongs. West Kutai, one of several new districts carved out of Kutai in East Kalimantan, for example, emerged with an almost even balance of Christians and Muslims, but with Christians getting most of the top district jobs. In August 2002, before they disbanded, Laskar Jihad activists were trying to claim discrimination, while at the same time suggesting that Christian Dayaks were promoting a Free Borneo movement.25 Efforts to fan communal tensions proved unsuccessful, but not all areas may be so immune. Another area to watch is Ceram, once a single district in central Maluku, which is now being divided into a largely Muslim West Ceram and a largely Christian East. Divisions along communal lines did not have to lead to increased tensions, however. Largely Muslim Gorontalo, which broke away from North Sulawesi in 1999, has proven to be a dynamic new province, setting standards for delivery of primary education among other things, and the separation seems to have benefited all concerned. COMMUNAL RELATIONS Communal relations more generally remained somewhat uneasy, particularly after parliament pushed through a national education law that required all students to have access to a religious teacher of their own religion. Non-Muslims saw the bill as a back-door effort to open the way to a more Islamic orientation in state and private schools, and there were widespread protests against the bill in largely Christian North Sulawesi and Papua. There were also some striking improvements to be noted, particularly in the Moluccas. Many displaced families returned to North Maluku during the year, and the civil emergency was formally lifted in Ambon and elsewhere in central Maluku in September 2003, after a new governor was installed without incident. The departure of the Central Java-based militia Laskar Jihad, better behaviour of security forces and general war-weariness may have been as important in this regard as the millions of dollars poured into reconciliation efforts, but the fact remains that both Maluku and North Maluku were generally quiet during 2003. The same could not be said of Poso, Central Sulawesi, the site of violent conflict in 2000 and 2001 that was fuelled by local politics, migrant–indigenous tensions, army–police rivalry, and the presence of outside fighters belonging to local, regional and international jihadist organisations. A peace accord brokered in December 2001 by Yusuf Kalla, Megawati’s Coordinating Minister for People’s Welfare, led to an uneasy truce between Muslim and Christian leaders, but

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there were outbreaks of violence throughout 2002 and 2003, with a particularly violent one in October 2003. A series of arrests of suspected JI members in Palu, the provincial capital, in April 2003 reinforced suspicions that JI had some institutional presence in the region; arrests following the October outbreak seemed to point to local perpetrators being trained by JI rather than operating under their command. There was little evidence to support rumours in Papua of a large Laskar Jihad presence. The radical group led by Ja’far Umar Thalib that had sent thousands of fighters to Ambon and Poso had dissolved itself in early October 2002, just before the Bali bombings. Diplomats in Jakarta suggested the main reason was the drying up of Saudi funding, but sources close to the organisation said internal dissension was more important. The sudden decision to disband took many members by surprise, and left thousands stranded in eastern Indonesia, without even money to return to Java, a situation that only increased resentment towards the leadership. There was nothing to suggest that Laskar Jihad members fared any better in Papua after the dissolution than they had in Ambon and Poso. They had had a small presence in the Sorong and Manokwari region of western Papua in 2001, though there were no hard data as to numbers, and estimates varied wildly from a few dozen to more than 100. But Papuans might well have been confusing Laskar Jihad with Jemaah Tabligh, an apolitical South Asia-based proselytising organisation with hundreds of thousands of members in Indonesia, including some in Papua. Many wear the white robes and turbans associated with Laskar Jihad, and that may account for the confusion. PREPARATIONS FOR THE 2004 ELECTIONS As the 2004 elections drew nearer, there was no sign that any dynamic, visionary leader was on the horizon to cope with terrorism, separatism, communal tensions, intra-elite battles over internal security, poorly managed decentralisation or any of the other monumental problems facing the country. New laws passed in July 2003 setting out the framework for the 2004 elections militated against any dark horse candidate emerging from the ranks. The country’s first direct presidential elections ever will be held in early July 2004. Only parties or coalitions that have been able to secure 3 per cent of the seats in parliament or 5 per cent of the vote in the legislative elections scheduled for April 2004 will be able to field a presidential candidate. If no candidate receives more than 50 per cent of the vote, with at least 20 per cent in at least half the provinces, a run-off election will take place between the two highest votegetters.26

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The laws gave an obvious edge to Golkar and PDI-P, but deep rifts in the ranks of both parties promised to make the race more interesting than might otherwise have been the case. Even after playing the nationalist card in Aceh, Megawati continued to lose ground with a disillusioned electorate, although most observers, inside Indonesia and out, still believed the election was hers to lose. She and her political advisers appeared to be trying to stem the erosion of support by ensuring the election of loyalist governors in key provinces – several with military backgrounds – in a way that would guarantee an adequate campaign war chest and perhaps local goon squads to turn out the vote. The strong-arm and money-laden tactics used in the mid-year gubernatorial elections in Central Java, East Java, Bali and elsewhere would have made Soeharto blush. Megawati’s position is secure as the unchallenged candidate of PDI-P, but the question is who she will choose as a running mate. The general consensus is that it has to be someone with the strong Muslim credentials that she herself lacks. As of September, the possibilities included Golkar’s Yusuf Kalla, who would also balance Megawati’s support in Java and Bali with his strong Sulawesi base; a re-run with Hamzah Haz; and, less likely, the leader of Nahdlatul Ulama (NU), Hasyim Muzadi, or Susilo Bambang Yudhoyono. Within Golkar, the choice at year’s end seemed to be between Akbar Tanjung, the party chairman whose corruption conviction was nearing a final appeal, and retired General Wiranto, who has campaigned on the basis of a return to the safety, prosperity and decisive leadership of the good old days. The Muslim scholar Nurcholish Madjid, known for his honesty and integrity, showed brief interest in a Golkar run. This generated excitement in Jakarta, but after he was dubbed ‘the detergent’ it quickly became clear that he was only being used to clean up the party’s image, and he withdrew from the race. Yusuf Kalla has made no secret of his interest in the presidency, but probably lacks the support to come out on top. At year’s end, speculation continued about a possible bid for the top slot by Yudhoyono, especially after a survey by the International Fund for Electoral Services showed him outpolling Megawati in her Bali stronghold. There is no question that Yudhoyono wants the presidency; the question is what party he will use for the purpose.27 If Megawati and her running mate are forced into a run-off, the likelihood of an ‘anyone-but-Mega’ coalition being formed is high. In such a scenario, the alliance-building capacity and political skills of Amien Rais could come into play, turning him once again into a behind-the-scenes power broker. The gold and goon factors should not be lightly dismissed, however. Megawati, like any incumbent, has the power to marshal major resources, and the likelihood of a strategically timed distribution of cash is high. The manoeu-

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vring in Papua and Aceh could pay off for PDI-P in economic as much as political terms. In a parliamentary hearing in January 2003, one forestry official cited a pattern of increased illegal logging as election campaigns heat up, apparently because of the need of politicians for cash.28 The larger parties are also training and equipping paramilitary units, usually known as satgas parpol or pam swakarsa after the civilian guards set up by Wiranto to ‘protect’ the November 1998 session of the People’s Consultative Assembly (MPR). There are hundreds of local pam swakarsa across the country, all ready to be mobilised by candidates for district, provincial or national office. If they serve to provide additional protection for candidates, well and good; if they seek to stir up local antagonisms, they could mean serious trouble. CONCLUSIONS Indonesian political leaders have shown no capacity to deal effectively with the problems their country faces. The vested interests that Harold Crouch noted in last year’s update chapter continue to block reform (Crouch 2003: 33). The discovery of a deeply embedded terrorist network inside Indonesia did not galvanise the government into action; it merely added one new problem to the mix. Yet the picture was not entirely bleak. However sordid the bargaining process, the parliament managed to pass laws that were often better than the laws they succeeded. Direct presidential elections will go forward; a constitutional court will be set up. If the field of presidential candidates is cause for despair, the decentralisation process is producing at the local level some dynamic leaders with far more energy and creativity than their Jakarta-based counterparts. The success of the police in their pursuit of JI suspects has given some hope that in the long run, and with enough training, the police really can become the civilian guardians of law and order, although they are only one small part of a disastrously dysfunctional legal system that needs a complete overhaul. But the positives remain outweighed by the negatives: the lack of any political will to curb corruption; the shortsightedness of policies in Aceh and Papua; the intra-elite battles over internal security; and the lack of anyone at the national level with a sense of strategic vision. Regardless of who is elected next year, Indonesia is probably doomed to more of the same.

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NOTES 1

2 3 4 5 6 7 8 9

10 11 12 13 14 15 16 17

The United Nations had overseen East Timor’s separation from Indonesia. In December 2002, the International Court of Justice in The Hague supported Malaysia over Indonesia in their dispute over ownership of Ligatan and Sipadan, two small islands off the coast of Borneo. The decision was not unexpected, but led to fears that islands in other border areas could be in danger and to the determination never again to leave a decision over territory to the International Court of Justice. See ‘Views of a Changing World’, Global Attitudes Survey by the Pew Charitable Trusts, June 2003, . ‘Indonesia’s Education Bill Opens Pandora’s Box’, Straits Times, 10 June 2003; Frans Hendra Winarta, ‘RUU Sisdiknas dan Hak Azasi Manusia’, Sinar Harapan, 20 May 2003. ‘Challenge to the US: Prove JI Exists’, Sydney Morning Herald, 9 September 2003. See, for example, H. Usep Romli, ‘Dan Pesantrenpun Berlinang Air Mata’, Pikiran Rakyat, 19 December 2002. See Kompak’s website, , for a mission statement. After the Marriott bombing, Ma’arif appeared on the television station TVRI with the author and Erwin Mappaseng, head of the criminal investigation section of the Indonesian national police, to discuss the possible role of JI. ‘Indonesia: Old Laws – New Prisoners of Conscience’, Amnesty International, ASA 21/027/2003, 10 July 2003, and ‘A Return to the New Order? Political Prisoners in Megawati’s Indonesia’, Human Rights Watch, 15(4C), July 2003. On 19 May 2003, immediately after the collapse of peace negotiations on Aceh, five men negotiating on behalf of GAM were arrested and charged with involvement in terrorism and rebellion. They were sentenced to prison terms in October as follows: Teungku Mohamed Usman Lampoh Awe, 13 years; Amni bin Ahmad Marzuki, 12 years; Sofyan Ibrahim Tiba, 15 years; Nashiruddin Ahmad, 13 years; and Teungku Kamaruzzaman, 13 years. ‘Opposition Ups against Move to Amend Antiterror Law’, Jakarta Post, 15 September 2003. ‘Presiden Resmikan Pencanangan Sekolah Intelijen’, Kompas, 10 July 2003. ‘Bill Drafters Reject TNI Return to Power’, Jakarta Post, 5 March 2003; Y. Herman Ibrahim, ‘TNI Akan Kudeta dengan Pasal 19 RUU TNI?’, Pikiran Rakyat, 22 April 2003. ‘Draft RUU TNI Sudah di Sekretariat Negara’, Tempointeraktif, 31 October 2003. See ‘Aceh: A Fragile Peace’, ICG Asia Report No. 47, 27 February 2003, for an analysis of the agreement. ‘Aceh: Why the Military Option Still Won’t Work’, ICG Indonesia Briefing, 9 May 2003. ‘Aceh: How Not to Win Hearts and Minds’, ICG Indonesia Briefing, 23 July 2003. ‘Dividing Papua: How Not to Do It’, ICG Indonesia Briefing, 9 April 2003.

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18 ‘Murderers Praised by Indonesia’s Top Soldier’, Radio Australia News, 24 April 2003. 19 ‘Dividing Papua: How Not to Do It’, ICG Indonesia Briefing, 9 April 2003. 20 On 5 November 2003, the Ministry of Home Affairs sent a draft regulation to establish the MRP to President Megawati for her signature, but the draft was a shadow of the Papuan concept of the institution. The November draft turned the MRP into a toothless cultural body with very little real power. 21 ‘Pemekaran yg Menulut Perang’, Tempo, 7 September 2003. 22 See the website of the Indonesian Association of District Governments (Apkasi) for critical comments on the proposed revisions, . 23 The process is known as pemekaran in Bahasa Indonesia. 24 ‘Indonesia: Managing Decentralisation and Conflict in South Sulawesi’, ICG Asia Report No. 60, 18 July 2003. 25 ‘Ancaman Kristen dari Kutai Barat’, Laskar Jihad (tabloid newspaper), 23 August 2002. 26 ‘Indonesia Backgrounder: A Guide to the 2004 Elections’, ICG Asia Report No. 71, 18 December 2003. 27 ‘Kapan Majunya, Jenderal?’, Tempo, 14 September 2003: 24–30. 28 I Made Subadia, Director General of Forest Protection and Nature Conservation, made the statement, noted in a Jakarta Post article of 30 January 2003, quoted in Down to Earth Bulletin No. 56, February 2003.

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ECONOMIC UPDATE 2003: AFTER FIVE YEARS OF REFORMASI EKONOMI, WHAT NEXT? M. Chatib Basri

The year 2003 marked the fifth anniversary of reformasi, the movement for political and economic reform that began with the fall of Soeharto in 1998. It also marked kemandirian (independence) from five years of implementing the International Monetary Fund’s (IMF’s) economic policies, with the Indonesian government declaring its decision in July 2003 to exit from the IMF program that was due to expire in December that year. Drawing up the balance sheet on Indonesian economic performance is a discouraging job. For five years Indonesia has been mired in economic crisis, its fortunes rising or falling in concert with the rupiah. Although the rupiah strengthened to Rp 8,600/$ in July 2003, the debt/GDP ratio declined from 90 per cent in 2001 to 72 per cent in 2002 and consumption growth remains robust, the economy has not yet fully recovered. Many problems remain in the investment and manufacturing sectors, their causes lying in poor governance, institutional failure and lack of government credibility. Indonesia has been ‘muddling through’ with the economy since 1998. Economic growth of 3–4 per cent annually is far from adequate to create employment opportunities in the formal sector and stimulate growth. Because of the severity of the economic crisis and the shortcomings in institutional reform, a recovery is unlikely in the short term. Other factors such as continuing political uncertainty are also hampering an economic recovery. Despite these obstacles to economic performance, and the threat to global conditions posed by the threat of terrorism, the US invasion of Iraq and severe acute respiratory syndrome (SARS), most of Indonesia’s macroeconomic indicators were positive through to August 2003. MacIntyre and Resosudarmo (2003) argue that macroeconomic improvement and a more viable system of national government partly explain the ability of the Indonesian government to cope with internal and external shocks such as SARS, the war in Iraq and the Marriott Hotel bombing in Jakarta. 39

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Figure 3.1 GDP in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 (1997 = 100) 140 120 100 80 60 40 20 0

1997

1998 Indonesia

1999 Korea

2000 Malaysia

2001

2002 Thailand

Source: CEIC Data Company.

This chapter will address the progress that has been made since the launch of reformasi ekonomi (economic reform) in 1998. What are the main problems that have been encountered? What will the Indonesian economy look like, postIMF? How will industry fare? These are the main questions that will be addressed in this chapter. The next section sets the scene for a discussion of the main issues by providing an overview of macroeconomic development. The third section focuses on post-IMF Indonesia, and the fourth critically examines Indonesia’s industrial policy and the future prospects of industry. OVERVIEW OF RECENT ECONOMIC DEVELOPMENTS Indonesia in Comparative Perspective

The economic crisis affected the whole of Asia, not just Indonesia. To acquire a better picture of the effects of the economic crisis, a comparative perspective is needed. Most economic indicators point to a recovery in other crisis-affected countries, although at different speeds (Ikhsan 2003). The comparison of real GDP in Indonesia, South Korea, Malaysia and Thailand illustrated in Figure 3.1 shows that Indonesia is the only country in which real GDP in 2002 remained

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Figure 3.2 Private Consumption in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 (1997 = 100) 120 100 80 60 40 20 0

1997

1998 Indonesia

1999 Korea

2000 Malaysia

2001

2002 Thailand

Source: CEIC Data Company.

below the pre-crisis level in 1997, although it was predicted to reach the precrisis level in 2003. Per capita income in Indonesia in 2003 was still well below the pre-crisis level, and is expected to take several more years to recover. The overall pattern of economic recovery has been similar in Indonesia, South Korea, Malaysia and Thailand. Figure 3.2 shows that in all of these countries, real consumption has recovered, and has even surpassed pre-crisis levels. Investment, however, continues to lag behind pre-crisis levels (Figure 3.3). Indonesia is the only one of the four countries whose 2002 exports of goods and services have not recovered to pre-crisis levels. These findings help us to recognise two major problem areas in the Indonesian economy: investment and exports. They are closely associated with the lethargic performance of the manufacturing sector, as will be discussed in detail below. Macroeconomic Review of 2003

The beginning of 2003 was marked by widespread protests in major Indonesian cities over government price hikes. Price increases in electricity (6 per cent), fuel (3–23 per cent) and telephone charges (15 per cent) took effect on 1 January 2003 (Waslin 2003). President Megawati Sukarnoputri publicly defended

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Figure 3.3 Investment in Indonesia, South Korea, Malaysia and Thailand, 1997–2002 (1997 = 100) 120 100 80 60 40 20 0

1997

1998 Indonesia

1999 Korea

2000 Malaysia

2001

2002 Thailand

Source: CEIC Data Company.

the price increases, but the government was eventually forced to revise its decision on diesel oil and postpone the increase in telephone rates. Many Indonesians were concerned that the price hikes would fuel inflation. Some economists at the University of Indonesia argued, however, that the impact on inflation would be relatively limited because of the small share of energy in the consumption bundle (LPEM-FEUI 2003a). The monthly inflation rate in January was in fact only 0.8 per cent. Protesters and some opposition politicians also argued that the price increases would increase the burden on the poor. This argument is not entirely true either, as fuel subsidies, other than those on kerosene, mainly benefit the non-poor (LPEM-FEUI 2003a). Thus, the argument for the rejection of subsidies was based on emotional and political rather than rational economic motives. The government’s decision to reverse its decision on prices signals a growing inclination to give way to populist sentiment that can only harm sound economic policy-making. The Indonesian economy also faced external problems in 2003, including SARS and the war in Iraq. Fortunately, the impact of both was relatively limited. As MacIntyre and Resosudarmo (2003) have pointed out, there are two reasons why growing anti-US sentiment over the war in Iraq did not translate into political turmoil, which in turn would have affected the economy. First,

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most Indonesian politicians and religious leaders are pragmatic, and recognise the importance of maintaining a stable relationship with the United States. And second, the duration of the war was relatively short. The impact of SARS was also limited, again for two reasons. First, the fear that SARS would spread to Indonesia proved to be unfounded. And second, the effects on tourism were largely irrelevant, as the sector had not yet recovered from the downturn experienced after the Bali bombing of October 2002. Another potentially destabilising influence on the economy was the war between the Indonesian government and the Aceh separatist movement in Sumatra. So far, however, the war in Aceh has not had a significant impact on the Indonesian economy. Despite these internal and external threats, macroeconomic progress continued: inflation was low; interest rates fell; the rupiah appreciated; and stock prices surged. Year-on-year real GDP growth for the second quarter of 2003 grew by 3.8 per cent over the same period in the previous year, yielding a GDP growth rate of 3.6 per cent for the first half of the year. With positive signs of macroeconomic stabilisation, a sense of optimism was felt in some economic sectors, particularly consumer goods and portfolio investment. These signs must, however, be treated with great caution. There is still a long way to go to repair the damage caused by the economic crisis of 1997–98, when the economy contracted by more than 13 per cent. As in previous years, the main drivers of economic growth were private and government consumption, which grew by 4.7 per cent and 9.2 per cent (yearon-year) respectively in the second quarter of 2003 (Figure 3.4). Investment and export growth also made a positive contribution to overall growth in GDP. All sectors of the economy contributed positively in the second quarter. However, year-on-year growth in the manufacturing sector remained slow (at 2.8 per cent), reflecting the problems in some industries, particularly oil and gas manufacturing, which contracted by 9 per cent (Table 3.1). Key Indicators: Consumption and Investment

Economic growth continues to depend heavily on private consumption and government expenditure. I will focus on the former, because the share of private consumption in total GDP is around 80 per cent whereas the share of government expenditure is relatively small. The strong growth in private consumption was driven by non-food products. Several leading indicators, including cement and motor vehicle sales, reflected the ability of durable goods to boost the economy. Sales of motorcycles, for example, have been remarkably resilient over the last few years. After reaching 1.8 million units in 1997, motorcycle sales dropped sharply to around 500,000 units in 1998 as a result of the economic crisis. As the Indonesian economy

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Figure 3.4 Growth of GDP by Expenditure, March 2000 – September 2003 (% change) 40 30 20 10 0 -10 -20

Jun 2000 Private consumption

Jun 2001

Government consumption

Source: BPS.

Jun 2002

Jun 2003

Gross fixed capital formation

Exports of goods and services

improved, sales rebounded to reach 1.6 million units in 2001 and 2.3 million units in 2002, higher than the pre-crisis level. Although the rate of growth shows signs of slowing, 1.2 million motorcycles were sold during the first half of 2003. Growth rates of other non-food items have also generally accelerated since mid-2001, owing to increases in consumer credit and wages and a decline in the prices of some goods. A recovery in consumer confidence and the inflationhedging activities of consumers may also have prompted the surge in durable goods consumption. The comparison of motorcycle sales and inflation shown in Figure 3.5 suggests that anticipation of inflation is inducing many consumers to speed up their purchases of durable goods. Not only this, but consumers are often spending more than they had planned to. The initial boom will be followed by an inevitable slowdown, simply because most of the new goods will not need to be replaced for quite some time. Thus the issue arises as to whether this pattern of non-food and durable goods consumption is sustainable. It is worth noting that overall growth in non-food consumption has been slowing since late 2001, from 15.8 per cent (year-on-year) in the fourth quarter

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Table 3.1 Quarterly Growth in GDP by Sector, 2002–03 (year-on-year, %)

Total GDP Total GDP without oil & gas Agriculture, livestock, forestry and fisheries Mining & quarrying Manufacturing industries Petroleum & gas Excluding petroleum & gas Electricity, gas & water supply Construction Trade, hotels & restaurants Transport & communications Financial, ownership & business services Services

2002

2003

Q1

Q2

Q3

Q4

Q1

Q2

2.7 2.8

3.9 4.0

4.3 4.6

3.8 4.2

3.5 4.5

3.8 4.7

–3.1 –1.5 5.6 0.0 6.3 8.0 1.9 2.7 8.9

3.9 2.2 3.9 1.9 4.1 3.1 3.2 3.3 8.8

3.8 2.7 4.1 3.9 4.2 4.5 5.4 4.7 7.5

2.4 5.7 2.4 2.6 2.4 9.1 5.9 3.7 6.2

4.3 –0.8 2.3 –9.0 3.6 5.7 5.3 4.3 6.8

1.6 4.4 2.8 –9.0 4.1 7.5 5.2 4.6 7.3

4.4 2.7

5.2 1.8

5.8 1.6

6.8 1.8

6.2 2.0

5.8 2.2

Source: BPS.

of 2001 to 5 per cent in the second quarter of 2003. This is still higher than growth in food consumption, which increased from –0.1 per cent in the second quarter of 2002 to 4.3 per cent (year-on-year) in the same period in 2003. As noted earlier, overall private and government consumption grew by 4.7 per cent and 9.2 per cent respectively (year-on-year) in the second quarter of 2003. The outlook for investment, meanwhile, remains bleak. Investment growth started to pick up in the second quarter of 2003 but was insufficient to make up for the severe damage of the last five years. The bombing of the Marriott Hotel in Jakarta in August 2003 did not immediately harm the economy, but it did damage investment confidence and may prevent new investors from coming to Indonesia in the near future. Closer observation of the figures reveals that whereas growth in foreign investment has been negative, domestic investment growth has remained positive (Figure 3.6). One possible explanation for this lies in the appreciation of the rupiah, which has caused imported capital goods to become more expensive. It has been argued that the strengthening of the rupiah suggests an inflow

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Figure 3.5 Growth of Motorcycle Sales and Inflation, September 2000 – December 2003 Sales (% change) 140

Inflation (%) 16

120

14

100

12

80

10

60

8

40

6

20

4

0

2

Sep-00 Nov-00 Jan-01 Mar-01 May-01 Jul-01 Sep-01 Nov-01 Jan-02 Mar-02 May-02 Jul-02 Sep-02 Nov-02 Jan-03 Mar-03 May-03 Jul-03 Sep-03 Nov-03

-20

Motorcycle sales (% change)

0

Inflation (%)

Source: CEIC Data Company.

of capital to Indonesia. This may be true, but most of this would have been in the form of portfolio investment, which does not have a significant impact on investment in the goods-producing sectors of the economy. The government should also be wary of the possibility of reverse capital flow, when short-term capital exits a country in response to an economic or political shock. Nevertheless it would be fair to say that, thus far, the Indonesian government has succeeded in maintaining political stability, and that the country’s money and capital markets are becoming less sensitive to political developments. The Monetary Sphere

The rupiah has strengthened tremendously against the dollar since April 2003. In the first half of the year, the rupiah moved above 8,890, then dropped to 8,740 before fluctuating at around 8,700. In the first seven months of 2003 the average exchange rate was around Rp 8,646/$, much stronger than the 2002

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Figure 3.6 Growth of Domestic and Foreign Investment, 2000–03 (year-on-year, %) 160 120 80 40 0 -40

Q1

Q2

Q3

2000

Q4

Q1

Q2

Q3

2001

Domestic investment

Q4

Q1

Q2

Q3

2002

Q4

Q1

Q2

2003

Foreign investment

Source: BPS.

average of around Rp 9,300. Factors that explain the rupiah’s strength include the increase in net capital inflows created by a relatively high discrepancy between domestic and international interest rates, the high returns of mutual funds, and global sentiment due to the depreciation of the dollar against most currencies, particularly key currencies such as the euro. From double-digit figures in 2001–02, inflation decelerated in 2003. Cumulative inflation from January to July 2003 was 1.3 per cent, while year-on-year inflation stood at around 5.8 per cent in July. Some have attributed the good inflation figures to the central bank’s monetary policy; others think that it is caused by the country’s low rate of economic growth. My own view is that the exchange rate is a major determinant of inflation, particularly since the crisis in 1997 (Basri, Damajanti and Sutisna 2001). Both the strengthening of the rupiah against the dollar and the broadly stable exchange rates since early 2002 have been accompanied by a downward trend in year-on-year inflation (Figure 3.7). The monthly food price index fell in early 2003 after successive increases in November and December 2002, when it surged by 5 per cent and 2.4 per cent respectively. This suggests a correction in food prices, and a return to more normal levels. However, several food items in the CPI, such as cereal and cassava

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Figure 3.7 CPI Inflation and Rp/$ Spot Rate, January 2002 – January 2004 (Jan 2000 = 100, % change)

Inflation (%) 16

Spot rate (Rp/$) 140

14

130

12

120

10 8

110

6

100

4 JanAprJulOctJanAprJulOctJanJan XX Apr XX Jul XX Oct XX Jan XX Apr XX Jul XX Oct XX Jan XX 02 02 02 02 03 03 03 03 04 Spot rate (Rp/$)

Inflation (%)

Source: CEIC Data Company; LPEM.

products, spices, fruit and ‘other’ food items, are strongly correlated with the Rp/$ exchange rate, particularly in 2003 (LPEM-FEUI 2003b). Thus the appreciation of the rupiah may have helped to reduce food price inflation through its effect on imported food items whose prices fall when the rupiah appreciates. Among these, cereal and cassava products probably receive the highest weight in the calculation of the food price index and are therefore most likely to have influenced it during 2003. As food price inflation is a strong determinant of the overall rate of inflation, there would be a close relationship between exchange rates and overall inflation (LPEM-FEUI 2003b). The strengthening of the rupiah and Indonesia’s stable macroeconomic conditions have given Bank Indonesia room to relax monetary policy. The central bank’s target for growth in base money is 13–14 per cent. This is not entirely consistent with the inflation trend. As discussed earlier, inflation is projected to be around 5–6 per cent in 2003, with economic growth of around 3.5–4 per cent predicted. Together, the projections for economic growth and inflation suggest that base money growth should be less than 13 per cent.

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In line with the decline in inflation, the three-month Bank Indonesia Certificate (SBI) rate continued to fall during the first half of 2003, from 12.9 per cent in January to 9.1 per cent in July. The SBI one-month rate followed the same downward pattern, falling to 9.1 per cent by the end of July. The downward trend in the SBI rate was expected to slow as the US economy recovered and portfolio investment returned to the country. Yet evidence of a US economic recovery was inconclusive, pushing the dollar down further against other currencies, including the rupiah. Demand for the SBI increased, providing ample room for the monetary authority to lower rates. The decline in SBI rates flowed on to a decrease in the interbank and deposit rates. Despite this, lending rates remained high. As a result, the impact of the decline in interest rates on the real sector has not yet emerged to any significant extent. The banking sector remains reluctant to provide lending in the real sector, where risk remains high due to uncertainties related to labour issues, the cost of doing business and smuggling. Monetary policies to stimulate the real sector will only be effective if the banking sector maintains its intermediary function, but at present it is difficult for banks to perform this role adequately. The loan to deposit ratio remained under 40 per cent in 2001, reflecting the inability of the banks to deliver credit owing to the high risk of business failure and their own low capital adequacy ratios (CARs). The ability of banks to maintain their intermediary function is heavily dependent on the economic and legal reform process. Without economic recovery, legal reform and political certainty, banks will find it difficult to improve sufficiently to maintain their already low CARs. In addition, there are political and social constraints to the immediate restructuring and strengthening of the financial sector. There is no clear consensus on the degree of ownership and control that should be allowed in the sector between the state and the private sector, between domestic and foreign companies, and between large and medium-sized corporations. The banking sector cannot be expected to significantly increase loans to the real sector until at least 2004, meaning that domestic investment will continue to be constrained by funding issues related to problems in the sector. Despite the slow progress in banking sector recovery, however, the sector as a whole has demonstrated improvements as indicated by an increase in third party funds as well as in loans provided by the banks. POST-IMF INDONESIA From 2002 through to mid-2003, economic debate in Indonesia centred on the role of the IMF. To the chagrin of many, debate on the IMF program focused merely on whether it was needed, not on what action should be taken to achieve future fiscal sustainability.

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Economists generally fell into two opposing groups. The first held that, like it or not, external pressure – including from the IMF – was needed to remind the government of its target of economic recovery and dissuade it from succumbing to partisan political and economic interests. They pointed out that the economy was still vulnerable as reflected by several financial indicators, including fluctuating exchange rates, and that public confidence in the economy had not yet returned. Although the rate of return on long-term deposits was better than that for short-term portfolios, a one-month rather than a 24-month deposit was still the preferred option for most Indonesians. The opposing view was that the IMF had diagnosed Indonesia’s economic problems incorrectly, and that the IMF program would therefore not lead to an economic recovery. Those advocating this view urged the government not to extend the IMF program and to pay back all the loan obligations to the IMF that had been used to support the balance of payments. This view was articulated in particular by a group of 35 leading economists calling themselves Indonesia Bangkit (Indonesia Arises) who campaigned strongly for an end to the relationship with the IMF (MacIntyre and Resosudarmo 2003).1 Following political pressure from parliament, in July 2003 the Indonesian government decided not to extend the IMF program beyond the end of 2003 and selected post-program monitoring (PPM) by the IMF as its exit strategy. There was lingering concern over how the exit strategy would be conducted and the extent to which the fiscal consolidation program would be ready to cope with the consequences of this decision. As predicted, however, the business community responded calmly to the decision to opt for PPM. The exchange rate and the stock market remained stable, and the Indonesian Chamber of Commerce and Industry (Kadin) welcomed the move. As a consequence of its decision to exit from the IMF program, the Indonesian government had to set out its own economic program in a Letter of Intent (commonly known as the ‘White Paper’), but will continue to engage in a postprogram dialogue with the IMF.2 Under this scenario, the Indonesian government will pay off its loan obligations on the current schedule, which extends until 2012, rather than paying them off immediately as suggested by Indonesia Bangkit. By opting for PPM rather than an extension of the IMF program, Indonesia will lose the option to reschedule debt through the Paris Club.3 Under the IMF program, Indonesia had been able to obtain low-cost IMF loans and reschedule its debts (amounting to $3 billion in 2003), lessening the pressure on the government budget. The 2004 budget, which was framed against the background of exit from the IMF program, reflects the consequences of the PPM option. It emphasises the need for continued strong efforts to optimise non-oil tax revenue while at the same time restraining expenditure. The government aims to lower the deficit from 2 per cent of GDP in 2003 to 1.2 per cent in 2004. Tax revenue is targeted

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to rise to 13.5 per cent of GDP in 2004, compared with 13.1 per cent in 2003. Current expenditure is programmed to decline from 13.1 per cent to 12.7 per cent of GDP, while development expenditure will remain stable at 3.4 per cent of GDP. The budget assumes that interest payments on both domestic and foreign debt will fall because of lower interest rates and higher exchange rates; a change in either of these assumptions could affect the level of expenditure. As Indonesia will not be able to reschedule debt through the Paris Club, there will be a fiscal shortage of around $3 billion. In the 2004 budget, net foreign financing appears to be a negative Rp 14.9 trillion (negative meaning that the government pays back debt instead of receiving financing), due to the significant increase in debt amortisation and interest payments from Rp 17 trillion in 2003 to Rp 45 trillion in 2004. The government will fill the gap by issuing domestic and foreign bonds, through privatisations, and through asset sales conducted by the Indonesian Bank Restructuring Agency (IBRA). Indonesia Bangkit and some members of parliament have suggested that the government ‘optimise’ potential tax revenue so that government expenditure can be increased. This could only be accomplished through improvements to the tax system and extending the tax base. However, it would not be wise to place an additional tax burden on firms at a time when the business sector is struggling. Another proposal was to increase budget efficiency by eliminating corruption, collusion and nepotism (KKN), although unfortunately Indonesia Bangkit did not say precisely how this was to be achieved. Given the current progress of institutional and legal reform, it is dangerously heroic to expect KKN to be eliminated any time soon. While highly desirable in principle, the elimination of corruption is more viable as a long-term goal than a short-term goal. By setting out its own economic program in the White Paper, the Indonesian government will finally be able to take charge of economic policy-making after five years of IMF guidance. The other side of the coin is that it will also have to take responsibility for any failure to implement the program in a disciplined manner. If the government is not able to overcome the financing gap created by the withdrawal of the IMF, its credibility will remain in question. The White Paper is widely perceived as an instrument to impose discipline on the government in imposing economic reform. While the main prerequisite for economic recovery is the implementation of government policies in a disciplined manner, this needs to be seen against the background of incidents that reflect a lack of government discipline such as the ‘Sukhoi-gate’ case.4 The White Paper is expected to address this credibility gap between government policy and government practice. However, the question of who will monitor government policy and ensure that it is not hijacked by competing political and economic interests remains unanswered.

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LOOKING AHEAD: INDUSTRIAL POLICY AT THE CROSSROADS Exports Remain Sluggish

Although macroeconomic indicators have improved, little has been achieved in the areas of trade and investment, particularly in the manufacturing sector. In the medium term, these are the main areas of concern in the Indonesian economy. When this article was written, the White Paper was still in draft form. It is likely that the government’s economic recovery program will address the issues of maintaining fiscal sustainability, strengthening the financial system and improving the trade and investment climate. The first two will be easier to tackle than the third, however, for two reasons. First, the problems in trade and investment are very complex and include various institutional aspects. Second, the resolution of trade and investment issues will require the cooperation of several government offices with competing interests that will be difficult to bridge. My best guess is that the trade and investment policies in the White Paper will try to accommodate all the interests of various government offices, resulting in loose and vague economic policies. Export growth has been sluggish since 2001. In 2001 and 2002, the slowdown in exports could be attributed to weak global economic demand following the September 11 attacks. In the first half of 2003, textile, leather and footwear products grew by 7.5 per cent, and wood products by 6.9 per cent. This improvement may have been due to a shift in demand from some East Asian countries to Indonesia because of SARS, particularly in the case of garments.5 This argument is supported by the export figures for January–July 2003, which show that textile exports grew by more than 5 per cent. Nevertheless, serious problems persist and seem to be systemic. The slowdown in exports can be attributed to supply-side problems, including the high cost of doing business (the high-cost economy), the government’s weak industrial relations policy, increases in the minimum wage and poor infrastructure. Basri and Syahrial (2004) show that whereas export growth was driven mainly by increases in market share (the competitiveness factor) from 1985 to 2001, it was dominated by demand-related factors between 1995 and 2001. Most sectors experienced a decline in their export market share during the latter period, except for a few products such as palm oil, printing and writing paper, and electronics. In fact, a similar pattern is evident in most other Asian countries, excluding China, Vietnam and the Philippines. Table 3.2 shows trends in the specialisation of major Indonesian manufacturing products based on revealed comparative advantage (RCA).6 From 1985 to 1995, all of the products listed experienced an increase in RCA (arrow running left to right). However, the RCA of some of these products, including plywood, footwear and some textile and garment products, showed a declining

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Table 3.2 Revealed Comparative Advantage of Manufacturing Products, 1985–2001 a SITC-4 6342 6349 6597 6343 6353 8421 7511 6516 8432 8510 6354 8443 6423 6531 8442 8433 7628 6521 5621 6581

Product (Revision 2)

1985

1995

2001

Plywood Wood, simply shaped Plaits and plaited products Improved and reconstituted wood Builders’ carpentry and joinery Men’s overcoats and other coats Typewriters, cheque-writing machines Yarn Women’s suits & costumes Footwear Manufactures of wood for domestic use Women’s undergarments Registers, exercise books, notebooks Synthetic fabrics Men’s undergarments Women’s dresses, of textile fabrics Other radio-broadcast receivers Cotton fabrics Mineral or chemical fertilisers Sacks and bags, of textile materials

SITC: Standard International Trade Classification. a An arrow running left to right shows an increase in revealed comparative advantage or specialisation; an arrow running right to left shows a decline in revealed comparative advantage or specialisation. Source: Basri and Syahrial (2004).

trend between 1995 and 2001 (arrow running right to left). These figures reinforce the suggestion that export growth was driven mainly by supply-side factors (competitiveness) from 1985 to 1995, but has been dominated by demandside factors since then.

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To make matters worse, the declining competitiveness of Indonesian exports is combined with creeping protectionism. While there is no conclusive relationship between trade openness and growth in many countries, neither is there any evidence that trade protection is systematically associated with high economic growth (Rodrik 2002). Protectionism is not the answer to the difficulties in making progress on market access issues at the multilateral level through the World Trade Organization (WTO), and does not provide a sustainable basis for growth. In the case of Indonesia, protectionism is likely to undermine the current open trade regime that has served the country so well in the past (Aswicahyono 1998; Basri 2001; Hill 1996). The signs of increasing protectionism imply that the Indonesian government is using trade policy to compensate for supply-side inefficiencies rather than addressing the problem of lagging productivity. The trend towards protection has continued since 2001, with an increase in tariffs on wheat flour and the introduction of further trade regulations (tata niaga) in the textile, steel, sugar and clove industries. It is worth noting that non-tariff barriers – the most common instrument of protection – fall directly under the authority of the Ministry of Trade and Industry (Ray 2003b). This is understandable since the Ministry of Finance, which is responsible for tariffs, is less inclined to protectionism. Nevertheless, despite continuing signs of increased protectionism, the level of protection in Indonesia remains low in comparison with that in other Asian countries, including China and Thailand (Basri and Hill 2004). The textile and garment industry faces an uncertain future. While the integration of the Multi-fibre Arrangement (MFA) into the WTO and the elimination of quotas will provide opportunities for the industry, its ability to capture those opportunities will depend heavily on its competitiveness. Entering the post-MFA era in 2005, competition will intensify and the development of expertise and knowhow will become the key factors for success. Unfortunately, some of Indonesia’s manufacturing products, including textiles, are struggling with internal or supply-side problems, including erosion of competitiveness in upstream industry and low labour productivity compared with other emerging Asian countries. In addition, industry is generally suffering from a lack of new investment. From a level of 14.4 per cent per annum in 1988–92, for example, investment growth decreased to 2.3 per cent per annum in 1995–2001. Without new investment, machinery and equipment soon becomes obsolete, resulting in higher production costs. On the external front, the emergence of strong competitors in China, Vietnam and low-cost ASEAN countries is placing pressure on Indonesian textile and garment manufacturers. Exports of textiles and textile products from Indonesia to the United States decreased by 40 per cent between 1998 and 1999, and by 12.2 per cent between 1999 and 2001 (Tanudjaja 2002). Indonesia’s share of the US market is now smaller than that of China, South Korea or Taiwan. A similar trend is evident in

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exports to the European Union: although Indonesia ranked first in 1994 with a 22.6 per cent share of the EU textile market, by 2001 it ranked third after China and Thailand, with a share of only 10.5 per cent. Diao and Somwaru (2001) argue that, post-MFA, the textile and apparel market will be dominated by developing countries, particularly China; faced with intense competition from other developing countries, Indonesia’s prospects are not promising. The Indonesian Minister for Trade and Industry paid a visit to the US Secretary of Trade to discuss the possibility of having the current quota system extended, arguing that Indonesia would lose market share if the quota system were not extended. Despite his efforts, it is unlikely that an extension of the quota system will be granted. The Investment Climate, Corruption and Institutional Reform

Export performance is closely associated with foreign direct investment (FDI), particularly in the export-oriented sector. As discussed earlier, investment, particularly FDI, remains a problem for Indonesia. The ability of the government to attract foreign investment to Indonesia is highly dependent on political stability and the ease of doing business in the country, but at present these preconditions are perceived to be lacking. A study by LPEM-FEUI (2002) indicates that political instability, labour problems and local taxes increase the cost of doing business in Indonesia. It found that bribery is no longer an efficient means to cut transaction costs in connection with the bureaucracy, and that there is a tendency for the government to set the level of bribes and additional fees and charges in line with the ability of business people to pay. Furthermore, with the distribution of power to the regions under the decentralisation policy, corruption has become decentralised. As Bardhan (1997) points out, decentralised corruption may result in a higher bribe per unit of transaction than that in centralised or ‘one-stop’ corruption. Although the amount of each bribe may be less than in the highly centralised Soeharto period, this has failed to translate into reduced transaction costs because of the increase in the number of officials who have to be bribed. The outcome is increased business uncertainty, less predictability and a far from conducive investment climate. It is hard to imagine that foreign investors will opt to invest in Indonesia while business uncertainty prevails (LPEM-FEUI 2002). Neither is there any incentive to invest in manufacturing when smuggling is rampant. The imposition of luxury taxes, for example, has created a large disparity between domestic and international prices, increasing the incentive to smuggle luxury goods to Indonesia. The other issue widely discussed in relation to the investment climate is the impact of the forthcoming 2004 general election. Despite a generally pes-

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simistic view of its effects on investment, however, there are few signs that it will seriously disturb the economy. The key problem related to the general election is the issue of privatisation. The prospects for further privatisations, particularly in 2004, remain bleak. There are several reasons for this. First, political parties and members of parliament have politicised the issue, using nationalist sentiment as an argument for rejecting privatisations. The controversy surrounding the cases of Indosat and Semen Padang illustrates this trend. Second, as McLeod (2002) points out, politicians often regard state-owned enterprises as ‘cash cows’ that can be used as sources of funding for political parties. Government performance to date and the obstacles faced in implementing good governance suggest that the cost of doing business is unlikely to decline significantly in the near future. This implies that foreign investment will not return unless significant reforms are made in the area of law and order. Indonesia may have to prepare itself to live without significant foreign investment inflows for the next two or three years. CONCLUDING REMARKS Economic recovery seemed to be heading in the right direction in the first half of 2003. The government successfully managed some potential external threats and maintained political stability. Several macroeconomic indicators, including the exchange rate and inflation, showed signs of improvement. Although consumption began to slow in mid-2002, it remained strong and should continue to be a source of growth in 2004. However, consumption-driven growth alone will not produce sustainable growth. The economy is expected to grow by 4–5 per cent in 2004, not enough to significantly reduce unemployment, poverty and social tensions. Investment and exports remain sluggish, reflecting the serious problems that persist in the manufacturing sector. The government has decided not to extend the IMF program in Indonesia. The general reaction to this decision was positive, with no signs of economic destabilisation. The decision to choose PPM as an exit mechanism was also welcomed by the business community. In anticipation of the exit from the IMF program, the government is currently preparing a White Paper setting out its economic policies. In general terms, the White Paper will focus on three issues: fiscal sustainability, the banking and financial sector, and trade and investment issues. So far the government has been able to fill the financing gap, although policy credibility remains a central issue. The main prerequisite for economic recovery, particularly in the areas of trade and investment, is the implementation of sound government policies and government discipline. Exports and investment remain sluggish. Supply-side problems – including labour unrest,

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minimum wage increases, high economic costs, poor infrastructure and lack of FDI – are holding back growth in exports, particularly in the manufacturing sector. The trend towards creeping protectionism may also harm export growth. The investment climate remains bleak due to various labour and institutional problems. Without an improvement in government performance and governance, it seems unlikely that the investment climate will improve soon. These findings suggest that it is important for the government to maintain political stability and tackle labour as well as local tax issues. The cost of doing business is unlikely to drop in 2004. The implication is that foreign investment will not return unless significant reforms are made in the political arena as well as in the sphere of law and order. All of these factors will influence Indonesia’s economic growth during 2004. NOTES 1

2 3 4

5 6

Indonesia Bangkit is led by Rizal Ramli, who served as Coordinating Minister for Economic Affairs and Minister for Finance under President Abdurrahman Wahid, and is supported by the Minister for the National Development Planning Agency, Kwik Kian Gie. The group strongly criticised Megawati’s economic team, stating that once the IMF had got its hands off Indonesia the economy would expand strongly, and that growth might even return to its pre-crisis levels of 7 per cent by 2005. Indicating the strong support of the president, the White Paper will come under a Presidential Instruction (Inpres). The Paris Club is an informal group of official creditors whose role is to find coordinated and sustainable solutions to the payment difficulties experienced by debtor nations. Paris Club creditors commonly agree to reschedule the debts due to them. Much of the political and economic debate in mid-2003 centred on a deal between Indonesia and Russia in which the Indonesian government exchanged textile and agricultural products for Russian military aircraft (known as Sukhoi). The trade was financed by, but not previously listed in, the government budget. Based on an interview with Benny Soetrisno, Chairman of the Indonesian Textile Association. RCA is calculated as (Xij/Xj)/(Xiw/Xw), where Xij is exports of commodity i from country j; Xj is total exports of country j; Xiw is exports of commodity i in the world market; and Xw is total world exports.

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PART II Overview of the Business Environment

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A NEW POLITICAL ECONOMY? POLITICS, ETHNICITY AND BUSINESS IN INDONESIA Sadanand Dhume

Nearly six years after the fall of Soeharto, a casual visitor to Indonesia may well find it unrecognisable. Long ruled by a general, the country is now run by a housewife. Long one of the most centralised countries in Asia, it is now one of the most decentralised, with newly empowered governors and district heads (bupati) in an unseemly rush to set up everything from airlines to Disneylandstyle theme parks. Where once the press was a poodle, it is now a pitbull. How many of us can imagine a newspaper headline from the 1970s, 1980s or 1990s announcing that President Soeharto’s mouth ‘smells of diesel fuel’, as Rakyat Merdeka said of President Megawati Sukarnoputri in 2002? Among the most profound differences between the old Indonesia and the new is a resurgence of ethnic and religious identity. At times this has found peaceful expression, as in the return of the dragon dance to public view on Chinese New Year. Often, it has taken a darker form, as attested to by countless stories from Ambon, Poso and Sampit, and, you could argue, Aceh and Papua as well. Indeed, the combination of economic stagnation and ethnic strife has been such that even today a line on the Jakarta Post’s home page asks whether Indonesia can survive until 2050. Yet, for all the dizzying change, one important aspect of Indonesia’s political economy remains largely the same. The relationship between ethnicity and business – forged under Dutch rule and hardened under Soeharto – has not been shaken. The military may have lost much of its clout, the regions may have found new resources, and the press and civil society may have new teeth. But when viewed through the narrow prism of ethnicity, Indonesia’s private economy remains much the same – dominated by the minority ethnic Chinese community, with indigenous or pribumi ownership of major corporations more the exception than the rule. 61

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This dominance is one of those facts of Indonesian life we tend to take for granted, as unchanging as traffic jams on Jalan Sudirman or the smell of clove cigarettes in elevators. Yet, just a few years ago, in the chaos that followed Soeharto’s downfall, most seasoned Indonesia watchers would not have imagined that things would turn out this way. In 1999 Adam Schwarz wrote: … the political transformation underway in Indonesia will almost surely result in a less favourable climate for ethnic-Chinese businesses. It was a measure of the strength of Soeharto’s authoritarian control that the ethnic Chinese community, representing less than 4 per cent of the population, amassed as much economic clout as it had during the New Order. The Chinese possessed entrepreneurial talent, access to overseas financial networks and a strong commitment to education. But another essential ingredient of their success in New Order Indonesia was a tightly controlled political system that nullified the demographic weight of the pribumi, or indigenous majority. With the fall of Soeharto, that ingredient is now missing Consequently the erosion of the ethnic Chinese economic clout is likely. How that will be accomplished, and at what cost to Indonesia’s near-term economic prospects, is much more difficult to predict (Schwartz 1999: 415).

This chapter examines the delicate issue of ethnicity and conflict in business against the backdrop of an ongoing Islamic resurgence in Indonesia. If measured by outward signs – women wearing the jilbab, regular prayers by officegoers, the haj pilgrimage to Mecca by elites – Indonesia is undoubtedly a more pious place than it was a generation ago. At the same time, the gulf between Islam’s grassroots appeal and the prosperous Chinese remains vast. The chapter asks why democratic politics in Indonesia has not translated into redistributive economic policies that – though possibly damaging from an economic perspective – would likely find grassroots support. Why has Indonesia not taken measures similar to those adopted by neighbouring Malaysia? In Malaysia, broad Muslim self-assertion in terms of religion was accompanied by profound changes in politics and policies. The New Economic Policy (NEP) explicitly set out to defuse ethnic tensions, partly by creating a class of bumiputera (‘sons of the soil’) business tycoons. To put it differently, why has the logic of democratic politics not caught up with the making of economic policy in Indonesia? CLOSE NEIGHBOURS, DISTANT POLICIES Though Malaysia and Indonesia are both Muslim-majority countries linked by history, culture and language, their policies towards affirmative action in the private sector have been a study in contrasts. In general, Malaysia is a country explicitly divided on religious and racial lines, a sort of apartheid democracy, where each major race – Malays, Chinese and Indians – has its own schools,

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languages and political parties. Indonesia, by contrast, has aspired to be more a melting pot than a salad bowl, seeking ways to erase, or at the very least downplay, ethnic, religious and linguistic differences. In terms of policy, Malaysia’s preoccupation with race is reflected in the NEP, which is traced to race riots between Malays and ethnic Chinese in 1969. Edmund Terence Gomez (2002: 84) neatly sums up its key aims: an attempt to create national unity by reducing the wealth gap between bumiputera and ethnic Chinese Malaysians. In practice, this involved an extensive government program whose elements included mobilising savings for ethnic Malays, putting in place quotas for bumiputera ownership of corporations and skewing university admissions policies for their benefit. The results of Malaysia’s efforts have been mixed. The NEP has created a class of high-profile ethnic Malay business tycoons as well as a large Malay middle class. By 1990, Malays owned 20.3 per cent of share capital in the country, up from only 1.6 per cent two decades earlier (Crouch 2001: 148). In recent times the NEP has come under attack from former Prime Minister Mahathir Mohamad himself, its most prominent architect, for having created a class of Malays who take higher education and cushy jobs for granted. But whatever the pros and cons of the Malaysian experience, there is no denying the existence of an explicit relationship between an identifiable political problem (ethnic disparities in wealth) and government policy (the NEP). In more than half a century of Indonesian independence, there has been no shortage of discriminatory policies against the ethnic Chinese community – ranging from their needing to obtain special identification documents to, until recently, restrictions on Chinese language and education. Yet, in terms of economic policy, Indonesia has lacked a clear sense of direction, especially when compared with Malaysia. In 1951, the Indonesian government tried to create a ‘native’ bourgeoisie by attempting to break the monopoly on imported goods held by large trading companies. It imposed a quota on import licences and excluded Indonesian Chinese from the program until 1955.1 In 1959, Indonesia forbade alien-owned retail stores from operating in rural areas, affecting the Chinese, both Indonesian citizens and non-citizens (Schwarz 1999: 105). But all in all these efforts were few and far between. During Soeharto’s New Order regime, the promotion of indigenous enterprise remained a vaguely held government goal, certainly not a priority. In one list of the regime’s economic objectives, ‘the promotion of indigenous enterprise’ was but a second-tier objective, below priorities that included, among others, growth, low inflation, less dependence on foreign aid and poverty alleviation (Hill 2000a: 96). Yet the absence of an activist government policy to balance ethnic disparities in the Indonesian economy ought not to be confused with public apathy. There is a widely held belief in Indonesian society that the Chinese business

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community has been both the engine of economic liberalisation and its main beneficiary. Why has Indonesia followed such a different path from Malaysia when the tensions in Indonesian society have arguably been greater, and the amount of violence generated by those tensions inarguably so? At one level, the difference may be explained by the philosophical foundations of the Indonesian state, at whose heart lies a striving for oneness that has traditionally discouraged the overt discussion of racial issues. Even today, the debate in Jakarta is couched in language about small and medium-sized enterprises and cooperatives, monopolies and conglomerates – all code words for what would be baldly defined in racial terms in Kuala Lumpur. Then there is the traditional argument about the interdependence of the Soeharto-led army elite and a class of ethnic Chinese business tycoons. Soeharto showered these tycoons – Liem Sioe Liong, Bob Hasan, Prajogo Pangestu and so on – with special favours and they in turn took care of both the president’s family and his government’s development objectives.2 Many argue that the end of the Soeharto regime has not ended the traditional relationship between politics and business in Indonesia, that the relationships between political and business elites nurtured during more than three decades of the New Order – some, like the Salim group’s connections with Soeharto even pre-dating that – have become too deeply rooted for things to change.3 Variations of this argument, which could be called the ‘Chinese bagman’ theory, are common in Indonesian intellectual circles as well. Bluntly put, the popular syllogism goes like this. Politicians need money. The Chinese have money. Therefore the politicians need the Chinese – for political fundraising, for personal luxury and, often, for policy implementation as well. There are other, less cynical, explanations for having maintained the status quo. Key economic policy-makers in Indonesia recognise that ethnic Chinese capital parked offshore holds the key to any sustainable economic recovery, and beating the drum of ethnic preferences for pribumi is not exactly the best way to inspire confidence in the business community.4 Moreover, in recent years Indonesia has had relatively little policy wiggle room under the tutelage of the International Monetary Fund (IMF). Ethnicity and culture hardly figure in the economic policy advice the Indonesian government receives from international institutions such as the IMF. All in all, Indonesia’s experience illustrates a curious disconnect between politics and policy. The mechanism that connects the engine of public opinion to the steering wheel of government policy is broken, or at best functions only sporadically. In a holdover from the New Order, economic policy has largely remained the preserve of economists. Take just two examples from 2003 – the hike in fuel, telecom and electricity prices, and the decision to sack thousands of workers at aircraft manufacturer IPTN in Bandung. If Indonesia were a normal

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democracy, where politicians – for the most part clueless about economics – made policy, it is likely that neither of these decisions would have been made. For a poor country on the brink of a presidential election, Indonesia spends an awful lot of time worrying about the fiscal deficit. One of the fundamental freedoms offered by democracy is the freedom to make bad policy as long as it is good politics. What will happen when Indonesian politicians begin to exercise that freedom?5 LOOKING BACK: THE ENGINE OF CHANGE THAT SPUTTERED Indonesia’s business landscape has changed a lot over the past five years. The banking sector has gone from being dominated by ethnic Chinese-owned conglomerates to involving a dominant role for the state as well as foreign capital. This fact is somewhat complicated by Singapore’s role as a foreign investor. In terms of Indonesia’s ethnic politics, Singaporean firms are seen to represent Chinese capital and consequently face far more public protest over their Indonesian acquisitions than do Malaysian firms.6 The forestry sector has also seen big changes, with plywood king and Soeharto’s former golfing buddy Bob Hasan downgraded to playing badminton on the prison island he shares with, among others, Hutomo Mandala Putra, better known as Tommy Soeharto. Several leading ethnic Chinese tycoons of the Soeharto era – including Sudono and Anthony Salim, Prajogo Pangestu and Sjamsul Nursalim – have seen their fortunes diminish to varying degrees. Meanwhile, in oil and gas, mainland Chinese firms now compete with Western giants such as Exxon Mobil and Caltex. Yet, though the Indonesian economy may no longer be as top-heavy with conglomerates, the economic crisis has also battered the leading pribumi businesses.7 Away from their father’s nurturing shadow, Bambang Trihatmodjo’s Bimantara group and Tommy Soeharto’s Humpuss have lost their sheen. In hindsight, the diminished role of the conglomerates seems almost trivial when compared to what had been predicted in the early days of the post-Soeharto era. Schwarz (1999) has detailed the Habibie government’s enthusiasm for altering the ethnic balance in Indonesian business, which included a greater role in the economy for cooperatives (enshrined in Indonesia’s constitution, but largely ignored), the use of the Indonesian Bank Restructuring Agency (IBRA) and strident calls by pribumi businessmen such as Aburizal Bakrie for Malaysia-style affirmative action in business (Schwarz 1999: 416–18; Eklöf 2002: 243). In addition, Indonesia’s newly constituted Competition Commission was widely seen as another battering ram against the fortress of Chinese business interests, especially since the word ‘monopoly’ in Indonesia carries a connotation more ethnic than economic (Hill 2000a: 289).

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In fact, few of the hopes or worries (depending on your political persuasion) expressed amidst the early years of post-Soeharto turmoil have come to pass. Adi Sasono, former Minister for Cooperatives and the prime mover behind the idea of putting cooperatives at the heart of the Indonesian economy, is no longer in power. The accepted wisdom on IBRA is that it has been happy to sell assets back to former owners – often operating through flimsy front companies – at a deep discount. And moderates on the Competition Commission have prevailed over their more radical colleagues to ensure that it has not emerged as a significant tool of harassment. Chinese business people themselves, though usually extremely guarded on matters of race and religion, tend to list lack of policy certainty, demands by inexperienced local governments empowered by decentralisation, rampant corruption in the customs and taxation departments, and the criminalisation of business (often by fellow ethnic Chinese) as their main concerns.8 These immediate concerns contributed to both a dramatic slowdown in investment rates compared to the New Order and a redirection of investments away from longterm, capital-intensive projects, such as Prajogo Pangestu’s involvement in Chandra Asri Petrochemical, towards more speculative areas such as property where the lag between investments and returns is shorter. Even if Indonesian Chinese business people are thinking about the long-term implications of the rise of Islam, it is certainly not something that they are talking about, at least not in public. But, especially after the trauma of the 1998 riots, the community remains sensitive to the risks of political turmoil, and in general those who can keep their options open – in terms of savings and investments overseas or overseas education and citizenship for their children – do so. Though it may be tempting, it is far too early for economic pragmatists to declare victory over those whose vision of Indonesia is driven more by ideas of racial equity than of secular growth. Indonesian society is moving towards a more explicitly Islamic identity, one whose political consequences will keep issues of equity firmly at the heart of the country’s economic debate. THE RISE OF ISLAM IN INDONESIAN SOCIETY Over the past quarter-century or so, Indonesia has experienced an unprecedented Islamisation. Robert Hefner has captured the key elements of this process – unprecedented construction of new mosques, attendance at Friday prayers and alms collection – and its causes, which included uniform religious education for primary school students and a turn to religion in a fast-changing society (Hefner 2000: 17). Measuring this phenomenon is an inexact science, but there is no shortage of anecdotal evidence, such as the profusion of jilbab on college campuses and the growth of active proselytising movements such as

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the Islamic Propagation Council of Indonesia (Dewan Dakwah Islamiyah Indonesia). In the realm of politics, the entry of Islam into the public sphere is usually considered to be marked by two events – President Soeharto’s haj pilgrimage to Mecca in 1991, described, tongue-in-cheek, as the first ever haj by a reigning Javanese monarch, and the birth of the Indonesian Association of Muslim Intellectuals (ICMI), whose members are in general more sensitive to issues of equity than are more mainstream economists. The fact that most Indonesian Chinese are Buddhist or Christian adds a religious dimension to the racial divide. The political influence of Islam in Indonesia is again very hard to measure. According to a poll in the news weekly Tempo in late 2002, 71 per cent of Indonesians support the implementation of shariah, or Islamic law (Dhume 2003). Whether this implies a vague desire to live in consonance with God’s law or an explicit endorsement of hand-chopping for thieves and stoning for adulterers remains unclear. In practice, most Indonesian Muslims are moderate, and the country’s two largest Muslim organisations, Nahdlatul Ulama (NU) and Muhammadiyah, which between them claim about 70 million members, have historically adopted moderate positions, including a rejection of the so-called Jakarta Charter, which demands that Indonesian Muslims be constitutionally obliged to follow shariah. Translating a broad resurgence in the orthodox practice of Islam into electoral behaviour is fraught with complications. In a comparison of the elections of 1955 and 1999, widely perceived to be the last two genuinely free polls in Indonesian history, Leo Suryadinata points out that whereas in 1955 Islamic parties won 43.5 per cent of the vote, by 1999 this had shrunk to a mere 17.8 per cent (Suryadinata 2002: 106.). Using a broader definition of ‘Islamic party’ to include both Abdurrahman Wahid’s People’s Awakening Party (PKB) and Amien Rais’s National Mandate Party (PAN) – which draw their core support from NU and Muhammadiyah respectively, though they are non-sectarian in terms of their politics – only bumps up the Islamic component of the vote to 37.5 per cent.9 Though these figures suggest a decline in the political appeal of Islam, there is enough complexity in Indonesian politics to muddy that neat conclusion. To start with, the 1999 election was no ordinary poll, and Megawati’s success must factor in her powerful martyr’s halo as the wronged daughter of the nation’s founding president. This is most likely a one-off effect. Moreover, measuring the vote received by religious parties is not the only barometer of the power of Islamic sentiment in politics. The mainstream itself has moved, as evidenced in last year’s support by Golkar, a nominally secular party, for a move backed by Islamic groupings to ensure that Christian schools would have to provide Islamic religious instruction to Muslim students. This distinction between overtly

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Islamic parties and the strengthening of Islam in nominally secular parties is made using the terms politik Islam and politik Muslim (Suryadinata 2002: 36). An obvious example of Muslim politics that would not show up in data on election results is Akbar Tanjung’s remarkable staying power as the head of Golkar, derived at least in part from his network of support among alumni of the modernist Islamic Students’ Association (HMI). The presence in virtually every political opinion poll of candidates who draw their standing from either Islamic scholarship or piety – such as Nurcholish Madjid, Abdullah Gymnastiar (A.A. Gym) and Hidayat Nurwahid – is another such example. UNFINISHED BUSINESS In its traditional form Islam recognises no division between church and state. Rather, as the Princeton University scholar Bernard Lewis has written, it is din wa dawla, both religion and state (Lewis 1993: 4). In general, the economic ideas embedded in Islam as a political ideology privilege equity rather than growth, with a particular emphasis on the fair distribution of wealth (Armstrong 2001: 5.). Inequity has been a weapon in the hands of Islamist ideologues in the Middle East, particularly in the oil-rich monarchies. In Indonesia, ambiguity towards free markets has also been rooted in the leftist ideas that dominated the country in the Sukarno years. Before the massacres of the mid-1960s Indonesia was home to the largest communist party in the non-communist world. Yet, even after the pendulum of power swung decisively away from the left – with the communists annihilated and Sukarno’s failed economic policies discredited – Indonesia did not fully embrace what is sometimes called ‘free fight competition’. This ambiguity towards the market, coupled with concerns about ethnic inequality, also runs though the history of political Islam in Indonesia. One of the country’s earliest Islamist organisations – and Indonesia’s first modern mass organisation for political rights – Sarekat Islam (SI), was established in 1912 to defend the interests of Muslim merchants against Chinese rivals (see, for example, Hefner 2000: 38). In 1921, SI’s leader, H.O.S. Tjokroaminoto, said: We await a new messenger of God, the successor of Moses, Jesus, and Mohammed, who will drive all evil desires from the hearts of men. This is the messenger called Ratu Adil. All of us, whatever our religion, await him. But this Ratu Adil will not appear in human form; rather, he will appear in the form of socialism. It is to this that the SI looks forward (H.O.S. Tjokroaminoto, as quoted in Jones 1971: 58).

After more than three decades of military rule, with the political left literally obliterated, much of the rhetoric of social justice – an emphasis on equity

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over growth – has been claimed by Islam. As Eklöf has observed, there is no love lost with the Chinese: Just as on earlier occasions in Indonesian history, Islam provided a focus for the resentment, especially, it seems, for parts of the urban pribumi middle class. Since the 1970s, the Islamic identity of Indonesia’s Muslim middle class had strengthened and in some quarters the Islamic message also involved strident anti-Chinese and anti-Christian rhetoric. Although probably only a small minority of Indonesia’s pribumi middle class overtly subscribed to extremist and racist sentiments, it seems that resentment against the Sino-Indonesian domination of the economy increased as more and more pribumi professionals and small-scale businessmen joined the modern economy and came into direct contact with the ethnic Chinese domination of the corporate world from the 1980s and after (Eklöf 2002: 223).

How, then, will democracy shape interethnic relations? For Indonesia’s Chinese, the past five years have been both the best of times and the worst of times. Many of the harshest restrictions placed on the community by the New Order – which essentially boiled down to banishing any public display of Chineseness – have been abrogated. The dragon dance is seen in public, Taiwanese soap operas rule the airwaves and at least one news channel broadcasts a bulletin in Mandarin. Yet the same period has seen riots, attempts to reduce Chinese control of the economy and uncertainty about the future. To be sure, the idea of Indonesia remains powerful, and one that insulates minorities from the second-class status they face in Malaysia. Moreover, the very weakness of Indonesia’s ethnic Chinese in numbers – 3–4 per cent in Indonesia versus upwards of 30 per cent in Malaysia at the time the NEP was introduced – may blunt calls for redistribution simply by making a complete takeover of the nation’s economy less threatening. Yet, with the economy clocking unimpressive 3–4 per cent growth rates, unemployment continuing to soar and corruption widely perceived to be more widespread than ever, it is hard to believe that politicians over the next decade will resist the temptation to appeal to populist ideas of redistribution. It is worth quoting Amy Chua, Law Professor at Yale University, who has examined what happens to so-called market-dominant minorities in free market democracies. She argues that the introduction of free markets and democracy to countries with market-dominant minorities results in three possible outcomes. When free-market democracy is pursued in the presence of a market-dominant minority, the result, almost invariably, is backlash. Typically, it takes one of three forms. The first is a backlash against markets that targets the market-dominant minority’s wealth. The second is an attack against democracy by forces favorable to the market-dominant minority. And the third is violence, sometimes genocidal, directed against the market-dominant minority itself (Chua 2002: 69).

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Viewed through this framework, post-Soeharto Indonesia has experienced some combination of the first (the Habibie-era backlash against Chinese wealth) and the third (the anti-Chinese riots of 1998). To conclude, an inclusive national idea, economic pragmatism, a political need for funding and a strong international voice in economic policy have stopped Indonesia from pursuing ethnicity-based wealth redistribution policies despite the example of its close neighbour Malaysia. Yet, though the past few years have seen attempts to alter the ethnic topography of Indonesia’s business landscape subside, this is but a temporary lull. At present, Indonesian politics is in a state of flux and Chinese business concerns – stability and predictability of policy – are no different from those of others in the business community. However, it would be a mistake to view the current calm as permanent. Like one of Indonesia’s famous volcanoes, the issue is dormant but not dead. Today’s salient issues – corruption, excessive red tape caused by decentralisation and loss of international competitiveness to China and Vietnam – will not vanish. In the longer term, however, the rise of political Islam in Indonesian society and its consequences for the country’s economy will likely remain among the most fundamental questions facing the country’s young democracy. With its traditional animus towards the ethnic Chinese, the rise of Islam, in both society and politics, will offer a powerful ideological challenge to the status quo. It is impossible to predict whether pragmatism will prevail in Indonesia, but it is very unlikely that ethnic imbalances will cease to be a hotly contested issue. How Indonesia deals with this issue – and the means will be at least as important as the ends – will be one of the most important questions the country faces going forward. NOTES 1 2 3 4 5

6

For more on this so-called Benteng policy, see, for example, Onghokam (2003: 284). See, for example, Schwarz (1999: 107–8). See, for example, Eklöf (2002: 243). Author’s interview with Dorodjatun Kuntjoro-Jakti, Coordinating Minister for the Economy, 31 December 2001. Of course, I make this observation with a tinge of envy. In my country, India, we wish the policy-makers would worry a little more about the deficit and less about elections. And we all know the wilderness into which politicians can steer an economy. For example, contrast the protests surrounding Singtel’s purchase of a stake in mobile phone company Telkomsel with the calm surrounding the takeover of the Salim group’s palm oil plantations in Riau by Kumpulan Guthrie Berhad of Malaysia in 2001.

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Sato (this volume) shows that in 2000, 58 per cent of the top 100 public firms in Indonesia were controlled by a single family/individual. That is down from 78 per cent in 1996, but still rather high. Author’s confidential interviews, December 2003 and January 2004. Abdurrahman Wahid is a former head of NU; Amien Rais is a former head of Muhammadiyah.

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Approaching its second democratic election in the post-Soeharto reformasi era, Indonesia is experiencing a degree of political stability and economic growth that few would have predicted when Soeharto’s 30-year New Order government collapsed in the rubble of the May 1998 riots. Indonesia’s strong currency and vibrant stock and bond markets may well surprise those who do not follow Indonesia regularly or who have not visited the country recently. Those who follow Indonesia mainly through international media headline events like the Bali terrorist bombings in October 2002, the Marriott bombing in August 2003 or the ongoing civil war in the resource-rich province of Aceh will be surprised by the high degree of social stability in Indonesia’s major cities and populous rural areas (MacIntyre and Resosudarmo 2003: 148–9). While Indonesia has not returned to the high-growth mode of the New Order, there is no doubt that the economy has been stabilised. Sound macroeconomic policies and prudent financial leadership have put the country back on a path of modest growth. Businesses can expect 3–5 per cent GDP growth and relatively low inflation for the next several years. These are respectable recovery numbers, but well below the 6–8 per cent GDP growth necessary to achieve a rapid increase in per capita incomes and a decrease in poverty. It is important to keep the last five years in perspective because, in a frank assessment of Indonesia’s failure to attract investment, it is easy to become pessimistic and forget how much the country has recovered since the collapse of the economy and the New Order government in 1998. THE GLOBAL ENVIRONMENT

The World Investment Report 2003 (UNCTAD 2003) shows a sharp decline in cross-border investment globally since the peak of $1.4 trillion in 2000. In 2001 72

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Table 5.1 FDI in ASEAN and Selected Countries, 1991–2002 (annual averages, $ million)

Singapore Thailand Malaysia Vietnam Philippines Brunei Myanmar Cambodia Laos Indonesia

Total Total (excluding Indonesia) China Hong Kong Taiwan South Korea Australia

1991–96

1998–2002

6,856 1,964 5,436 1,217 1,226 210 256 120 53 2,985

10,907 4,283 3,413 1,593 1,357 689 399 165 44 –1,296

25,476 6,057 1,311 1,234

44,763 25,024 2,655 5,395

20,323 17,338

6,238

21,554 22,850

7,942

Source: UNCTAD (2003: 251, Table B1).

it dropped by over 40 per cent to around $823 billion and then dropped another 20 per cent to $651 billion in 2002, the lowest level since 1998. During this period of sharp decline, the Asia Pacific region declined least, but this was primarily because of the strong performance of China ‘which with a record inflow of $53 billion became the world’s biggest host country’ (UNCTAD 2003: 8). Indonesia has shown negative foreign investment every year since 1998, which indicates that foreign investors have, on a net basis, withdrawn investments from the country. This is the worst performance of any large country during the period. Table 5.1 shows foreign direct investment (FDI) in selected countries from 1991 to 2002. Despite the weak investment climate of the past several years, most Asian countries have actually averaged more foreign investment per annum in the five years since the crisis (1998–2002) than in the six years preceding it (1991–96).

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Given the decline in global investment flows since their peak in 2000, many countries have increased their efforts to improve their relative attractiveness. The drive to attract FDI is significantly more competitive globally today than at any time in the past decade. World Investment Report 2003 notes: Government policies are becoming more open, involving more incentives and focused promotion strategies … as well as participation in more investment and trade agreements … Converging patterns of FDI links and investment and trade agreements are generating mega blocks. To help attract FDI, countries increasingly conclude [International Investment Agreements] … at the bilateral, regional and multilateral levels … which, by their nature, entail a loss of policy space [author’s emphasis] (UNCTAD 2003: 11–23).

The report presents data showing that the number of countries that introduced changes in their investment regimes increased from 35 in 1991 to 70 in 2002; over the same period, the number of changes tripled, from 82 to 248, with 95 per cent being favourable to FDI. In addition to the global slowdown, there has been a major shift in investor attitude since the Asian crisis because of the significant new industrial capacity that was financed in the 1990s, leading up to the 1997–98 crash. In those heady days, many companies were moving into virtually every market with greenfield sites, assuming 10–20 per cent annual market growth for the indefinite future. This was always unrealistic, and reality came crashing down with a thud when the crisis rolled across some of the most vibrant economies in Asia. Nevertheless, much new capacity was successfully installed across the region, so many sectors still have excess capacity and are in no need of further investment for the time being. Consequently, in today’s world relatively few investors are interested in greenfield projects. Rather, most investors who have a keen interest in Indonesia are interested in restructuring opportunities or privatisation of state-owned enterprises (SOEs) – for example, Guthrie Plantations, Bank Central Asia (BCA) and Indosat. Others are interested in helping existing businesses to expand – for example, Singtel, with its 35 per cent share of Telkomsel. It is important to recognise this shift in attitude, because many investment policies, including Indonesia’s as managed by the Investment Coordinating Board (BKPM), have historically been geared towards export manufacturing, greenfield investments and constraint and control, rather than promotion. Even if Indonesia were among the more attractive FDI destinations, the going would be tough.1 In this context the reasons for Indonesia’s failure to attract investment become strikingly clear. The current government, insecure both at home and in its international relations, feels in no position to push reforms that entail a ‘loss of policy space’. Indeed, it is not too much to suggest that any policy option that

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Figure 5.1 FDI Approvals, Indonesia, 1990–2002 Value ($ billion) 40

Projects (no.) 1,800 1,500

30

1,200

20

900 600

10 0

300 1990

Source: BKPM.

1992

1994

1996

Value ($ billion)

1998

2000

2002

0

Projects (no.)

entails such a loss is a priori unacceptable to the political elite in its current mood of insecurity. Approvals of FDI projects by BKPM are at a low level. Exploration activities in mining, petroleum and natural gas, historically Indonesia’s primary magnets for foreign investment, are also extremely low. Perhaps surprisingly, the number of foreign investment projects approved has increased sharply, even though the total value is significantly lower than before. Figure 5.1 shows that the number of project approvals increased by 68 per cent between 1997 and 2000 but that the average size of a project decreased from $29.4 million in 1991–97 to $7.2 million in 1998–2002. It seems that small and medium-sized enterprises (SMEs) are not finding the investment climate as forbidding as large investors. COMPETITIVE DISADVANTAGE Corruption, uncertainty and lack of transparency are frequently cited as major obstacles to investment. Indonesia consistently scores very poorly on comparative country rankings in these sensitive areas. In terms of corruption, Political

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Table 5.2 Level of Perceived Corruption in Asian Countries, 1995–2003 a 1995 1996 1997 1998 1999 2000 2001 2002 2003 Average Singapore Hong Kong Japan Malaysia Taiwan South Korea Philippines Vietnam Thailand China India Indonesia

1.2 2.8 2.0 4.6 4.2 4.0 6.6 n.a. 5.9 7.3 7.0 7.3

1.1 2.8 1.9 5.0 5.5 5.2 7.0 7.8 6.6 8.0 6.9 7.7

1.1 3.0 4.6 5.8 6.0 7.7 6.5 8.0 7.5 8.1 8.2 8.7

1.4 2.7 5.0 5.4 5.2 7.1 7.2 8.3 8.3 7.0 7.4 9.0

1.6 4.1 4.3 7.5 6.9 8.2 6.7 8.5 7.6 9.0 9.2 9.9

0.7 2.5 3.9 5.5 6.9 8.3 8.7 9.2 8.2 9.1 9.5 9.9

0.8 3.8 2.5 6.0 6.0 7.0 9.0 9.8 8.6 7.9 9.3 9.7

0.9 3.3 3.3 5.7 5.8 5.8 8.0 8.3 8.9 7.0 9.2 9.9

0.4 3.6 4.5 6.0 6.3 5.5 7.7 8.8 8.8 8.3 9.3 9.3

1.0 3.2 3.6 5.7 5.9 6.5 7.5 8.6 7.8 8.0 8.4 9.0

n.a.: not available. a Rankings are on a scale of 1–10, where 1.0 is the least corruption and 10.0 is the most corruption. Source: PERC survey of expatriates working in the country rated (respondents were not asked to rate other countries), accessed at .

Economic Risk Consultancy (PERC) surveys consistently rank Indonesia among the worst of all countries rated. Its average score since 1996 is 9.0 (Table 5.2), with 1.0 being the best and 10.0 being the worst. The next worst countries are India at 8.4 and Vietnam at 8.6. By contrast, Singapore averages 1.0, Hong Kong 3.2 and Japan 3.6. Indonesia’s legal system also rates poorly (Table 5.3), with an index average of 8.7, marginally below China at 8.3 and Vietnam at 8.2. Not only is Indonesia consistently at the bottom of these rankings, but the deterioration of Indonesia’s corruption scores since the collapse of the Soeharto regime is telling. In 1995 Indonesia’s score was 7.3; by 2002 it had declined to 9.9, improving only slightly in 2003, to 9.3 (Table 5.2). The Heritage Foundation’s index of economic freedom also gives a gloomy picture, although Indonesia fares somewhat better here on a comparative basis, because it is generally open to foreign investment and because its free foreign exchange regime builds confidence in investors. In 2003 Indonesia ranked in the middle (16th out of 32 Asia Pacific countries and 12th out of 22 Asian countries). Compared with the ASEAN countries (excluding Brunei) that are Indo-

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Table 5.3 Level of Perceived Legal System Inadequacy in Asian Countries, 1996–2003 a 1996 1997 1998 1999 2000 2001 2002 2003 Average Singapore Hong Kong Japan Malaysia Taiwan South Korea Philippines India Thailand Vietnam China Indonesia

2.8 2.4 4.1 5.0 5.5 5.9 7.1 5.0 6.0 8.1 8.4 7.2

2.7 1.8 4.6 5.0 6.1 6.9 5.6 5.5 6.1 7.3 7.8 8.1

2.3 2.9 4.9 5.9 5.9 6.5 7.6 7.0 7.8 8.5 8.3 8.7

3.2 4.2 5.1 6.3 7.2 7.7 5.9 7.9 8.4 9.3 8.3 9.8

2.6 3.6 5.0 7.0 5.8 6.8 6.5 8.0 7.0 9.6 9.3 8.1

3.3 3.4 4.3 4.2 5.9 5.3 7.2 6.8 7.3 8.9 8.4 9.2

1.7 2.9 3.7 6.3 6.3 4.8 7.8 7.3 8.0 7.1 7.8 9.8

1.4 2.3 2.0 5.3 6.0 5.0 6.8 8.0 6.5 6.8 8.3 9.0

2.5 2.9 4.2 5.6 6.1 6.1 6.8 6.9 7.1 8.2 8.3 8.7

a Rankings are on a scale of 1–10, where 1.0 is the least corruption and 10.0 is the most corruption. Source: PERC survey of expatriates working in the country rated (respondents were not asked to rate other countries), accessed at .

nesia’s most immediate and direct competitors for the foreign investment dollar, however, Indonesia has consistently been near the bottom of the charts; since 1999, it has ranked sixth, ahead of only Vietnam, Burma and Laos, hardly a ringing endorsement (Table 5.4). Even in 1995–97, when it attracted its highest levels of foreign investment, Indonesia scored poorly in the investment ratings. China continues to attract vast sums of foreign investment, but Indonesia scores better than China in the index of economic freedom and only slightly worse in the PERC surveys of corruption and legal system inadequacies. Problems like corruption, legal system inadequacies and low economic freedom exist in many countries, particularly in the developing world. Still, some countries do better than others in attracting investment, even though their ratings on matters like corruption and legal uncertainty are not very different from those of Indonesia. The competitive difference must lie, at least in part, in the host government’s attitude toward foreign investors and the quality and spirit of their response to investor problems. Terms like ‘attitude’, ‘quality’ and ‘spirit’

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Table 5.4 Index of Economic Freedom in ASEAN Countries, 1995–2003 a Country Singapore Cambodia Thailand Philippines Malaysia Indonesia Vietnam Burma Laos

1995 1996 1997 1998 1999 2000 2001 2002 2003 Average 1.5 n.a. 2.4 3.2 2.4 3.4 4.5 n.a. n.a.

1.5 n.a. 2.4 3.0 2.7 2.9 4.5 4.3 4.4

1.5 3.5 2.3 2.9 2.8 2.9 4.5 4.3 4.5

1.4 3.1 2.4 2.7 2.6 2.9 4.4 4.2 4.5

1.4 3.0 2.4 2.9 2.6 3.2 4.1 4.1 4.5

1.5 3.0 2.7 2.9 2.7 3.5 4.3 4.1 4.6

1.6 2.9 2.2 3.1 3.0 3.6 4.1 4.2 4.7

1.6 2.6 2.4 3.0 3.1 3.4 3.9 4.1 4.6

1.5 2.5 2.6 2.9 3.0 3.3 3.7 4.2 4.4

1.5 2.9 2.4 2.9 2.8 3.2 4.2 4.2 4.5

n.a.: not available. a The lower the number, the greater the level of economic freedom as defined by the Heritage Foundation. Source: Heritage Foundation, accessed at .

are normative and not easily subject to quantification. However, my work with investors over the years suggests that such attributes are important and constitute a significant distinction between Indonesia and China today, for example, or between New Order and reformasi Indonesia. Indeed, the concerns of foreign and domestic investors now operating in Indonesia are much more detailed and specific than generic terms such as ‘corruption’, ‘legal system inadequacies’ and ‘economic freedom’ express. Among the foreign chambers of commerce in Indonesia, the Jakarta Japan Club has been one of the most efficient and effective lobbying groups in its efforts to improve the business environment. The Jakarta Japan Club represents the majority of Japanese investors in Indonesia. Its concerns were publicised in a July 2003 press release from the Coordinating Ministry of Economic Affairs, which claimed that ‘of 78 issues and hurdles currently faced by Japanese businessmen in Indonesia, 36 have already been entirely solved’.2 Appendix 5.1 lists some of the 78 issues evaluated by the ministry. The Japan Bank for International Cooperation (JBIC) identifies the main concerns as follows:3 • •

high tariff rates; time-consuming and burdensome customs procedures;

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• • • • • • • • • • • • • •

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unstable exchange rates; restrictions on rupiah transactions; delays in refunds of overcharged corporate tax and value-added tax (VAT); high luxury taxes; arbitrary and non-transparent taxation procedures; labour law deviation from international standards; frequent increases in the minimum wage; a national monopoly in the energy industry; lack of enforcement of intellectual property rights; widespread piracy; an underdeveloped system of law and regulation; inefficient administrative procedures; corruption; and lack of physical security.

The vast majority of the 78 items discussed by the ministry are concerned with either administrative duplication or inconsistent implementation. Even where the government has issued new regulations or directives and considers the matter to be solved, a number of Jakarta Japan Club members privately say that officials in the field often fail to follow the directives. This reflects a mindset on the part of senior officials that problems can be solved by pieces of paper without effective follow-up or bureaucratic discipline. More importantly, however, the emphasis on practical problems implies that the Indonesian government can intervene at a more detailed level and overcome broader systematic inadequacies to make the investment climate more attractive, even when major reform efforts take longer. This is crucial, because everyone understands that the creation of legal certainty and a strong judicial system takes a long time. If investors have to wait for such actions, they will despair of improving the investment climate in the immediate future. The experiences of both China today and Indonesia in the late New Order period show that interventions can be made even if they fall short of wholesale reform of the legal system, important as the latter surely is. There is a broad consensus on the major problems facing the investment community in Indonesia. In September 2002, I addressed a meeting of government officials representing 27 of Indonesia’s 30 provinces and conducted a simple survey to gain an understanding of their views on obstacles to investment. The problems they identified were not very different from those of the business community and showed a fairly sound understanding of the major issues and obstacles. Table 5.5 summarises the results of the survey. Sixty per cent of those surveyed said that foreign investment is necessary to economic recovery, 11 per cent said that it was somewhat important, and 22 per cent said that it was not at all important or not very important. Respondents identified bureaucratic

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Table 5.5 Perceived Obstacles to FDI in Indonesia, 2002 (no.) No Minor No Major Critical Total Major + Problem Problem Impact Problem Problem Answers Critical

Bureaucratic corruption Stability of policies Port infrastructure Transport infrastructure Attitude to foreigners in DPR/MPR Availability of good middle management & technical people Political stability Ability to accept global business practices Import taxes Labour reliability Labour laws/regulations Labour cost Labour productivity Currency stability Accessibility of government officials Local market growth Bureaucratic red tape Security of assets & staff Government attitude Communication infrastructure Corporate income taxes Tax holidays Tax treaties Comfortable local lifestyle Economic stability Local market size/ access Public’s attitude to foreigners Total (% of total answers)

1 4 4 5

1 2 7 8

2 1 2 2

8 14 13 10

11 4 1 2

23 25 27 27

19 18 14 12

4

9

1

6

5

25

11

7 5

7 5

2 4

7 9

4 2

27 25

11 11

2 7 8 1 7 6 6

8 5 6 5 8 8 8

2 2 2 12 2 2 3

9 9 5 7 8 8 6

2 1 4 2 1 1 2

23 24 25 27 26 25 25

11 10 9 9 9 9 8

3 11 1 9 4

10 3 4 9 7

2 2 15 3 11

6 2 5 3 3

2 5 2 2 2

23 23 27 26 27

8 7 7 5 5

8 8 8 9

13 8 9 8

1 4 3 6

4 4 4 1

1 1 1 3

27 25 25 27

5 5 5 4

10 4

9 10

4 10

2 1

2 2

27 27

4 3

13

7

4

2

1

27

3

11

9

1

2

1

24

3

166 (24)

193 (28)

105 (15)

158 (23)

67 (10)

689 (100)

Source: Author’s unpublished survey of regional officials from 27 provinces, September 2002.

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corruption as the most important problem (indicated by being both major and critical), with policy stability a close second, followed by port infrastructure and transportation infrastructure. All of these have more to do with behaviour and operational issues than with legislation or policy statements. The officials surveyed felt that bureaucratic behaviour had a greater effect on the investment climate than legislative perfection, a view consistent with that of business.4 Respondents identified the attitude of the Indonesian parliament (MPR/ DPR) as a major problem. However, they saw the attitude of the general public towards foreign investors as virtually no problem at all.5 This is consistent with sentiment in the international business community in Jakarta today. Senior officials say that foreign investment is welcome, but further down the bureaucratic chain, where most foreign investors have their most frequent interactions with Indonesia’s highly intrusive regulatory environment, there is a distinct sense that foreign investors are resented. Even at the highest level, it is sometimes extremely difficult to reconcile the statements of senior officials with their actions. The most glaring contradiction can be found in the fact that in February 2003 the president declared 2003 as the ‘Year of Investment’, yet on 4 August 2003 she told parliament: For a long time, foreigners have violated our land, sea and air territories. Our abundant national resources that have the potential to offer welfare and job opportunities to our people, have been exploited and absorbed by various groups, generally with strong financial support and sophisticated technology.6

Anti-foreign sentiment in the bureaucracy is reflected in other ways. Hostility towards – or at least dissatisfaction with – the presence of expatriates in the economy is reflected in recent statements that expatriates should pass an Indonesian language fluency test before being allowed to work in Indonesia. A broader bureaucratic discontent with the involvement of foreigners in Indonesia is reflected in the recent drive to require most foreigners to obtain tourist visas before entering the country, despite the bitter objections of the domestic travel and hotel industry and the absence of grassroots pressure for this measure. Indeed, it seems there is no consensus within the senior leadership on whether or not Indonesia wants foreign investment and, if it does, under what conditions. In July 2003, the government actively sought the opinions of all the major foreign and domestic business groups in Indonesia as input for a White Paper that was to be announced in parallel with the president’s 2004 budget speech to parliament on 16 August. After much internal debate within cabinet, the White Paper finally appeared on 17 September 2003, one month late. Its 31page summary touches on many issues that business identifies as obstacles to investment, especially the need to continue to improve tax administration and

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increase transparency. But the overall thrust of the paper is towards control and intrusion rather than facilitation or streamlining. The section on labour is particularly discouraging in this regard. The government seems intent on reducing labour market flexibility. It is also signalling its clear intent to further restrict the employment of expatriates.7 It is difficult to avoid the impression that Indonesia – battered and insecure because of the failure of its economy to recover strongly since the 1997–98 crisis, facing an increasing number of terrorist incidents and dealing with strained relations with major business partners such as Australia and the United States over issues related to terrorism and the government’s harsh security policies in Aceh and Papua – may be retreating inward. Many in the business world were stunned when respected economist Faisal Basri said that Indonesia should withdraw from the ASEAN Free Trade Area (AFTA) because it could not compete.8 If relatively liberal and sound economic thinkers are encouraging this kind of behaviour, what is the sentiment among the more emotional nationalists or the less economically savvy elite? THE BUREAUCRATIC RESPONSE Not surprisingly, the government is responding to the failure to attract investment in the same way as it is responding to so many of its other problems – by writing new rules and regulations rather than seeking effective, transparent and balanced implementation of the rules and regulations that already exist. Nevertheless, the business community understands that a draft investment law is working its way through the bureaucracy. This causes concern because the government has never consulted important stakeholders such as the Chamber of Commerce and Industry (Kadin), the Indonesia Business Club, districts and provinces, interested NGOs and other civil society organisations.9 The government actively sought input from domestic and foreign business communities on the delayed White Paper mentioned above. With the draft investment law, on the other hand, the government is continuing its Soehartolike penchant for what I have come to call ‘stealth’ legislation and regulation. This is a dangerous practice. Ministerial Decree No. 150/2000 (Kepmen 150/ 2000) from the Department of Manpower caused the labour unrest that shook the Abdurrahman government in May 2001 and became a contributing factor to its demise later in the year. It was a draconian piece of labour regulation promulgated by the Department of Manpower after private consultation with only one or two union leaders. It was not discussed in any public forum. No members of the domestic business community, let alone foreign investors, were invited to comment on it prior to its promulgation. The result was a radical

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reform of the labour environment, including many unrealistic provisions that gave workers expectations that could not be met. The creation of unrealistic expectations led to increased labour militancy and the closure of a number of labour-intensive firms. Parliament passed compromise legislation in late 2002, but the damage had been done. The process left all parties feeling aggrieved. MacIntyre and Resosudarmo (2003: 149) noted: ‘The revised framework is still viewed as one of the most anti business in the region’. Business still feels that the package is uncompetitive and is a disincentive to investors. Business also feels that it can no longer count on the Department of Manpower to be a reasonable and fair arbiter in labour disputes. Unions and workers, for their part, are angry because they feel they have lost privileges and benefits that had been granted under Kepmen 150/2000. The Department of Manpower feels that its credibility and prestige have been damaged by the fact that it was virtually sidelined in the final stages of negotiation over the labour law. That occurred because both business and labour went directly to parliament because both had lost confidence in the department. All of these impressions are unfortunately correct. It is a perfect example of a lose–lose situation. While the consequences will not be so serious, the government is headed for a similar lose–lose situation with its new investment law. The proposal has gone through many drafts in BKPM over the past several years and is now working its way through the administration to parliament. The government says it intends to pass the law before the end of 2004. The contents of this law have never been discussed in any public forum. It is another example of stealth legislation. Passage of the law may not have the same negative impact on the business climate as the Department of Manpower’s pernicious Kepmen 150/2000, but it is a lost opportunity to improve the investment environment. One person involved in a review of the draft investment law now under consideration told me that it seems to focus on who gets to ‘control’ the investor rather than how to provide the best possible service and ease of establishment. If so, this would be a major step backward. The person indicated that in many areas the tone was so negative that it could cause a neutral reader to wonder whether the government really desired investment. Apparently, many officials view foreign investors as a necessary evil or a golden goose to be plucked. And the draft legislation seems to imply that all investors are potential criminals rather than a significant positive force for economic development. While there are a number of weaknesses in the current investment law, its terms and conditions are not particularly onerous and Indonesia is comparatively open to foreign investment. Regulations can always be improved, but the major problems investors face are not with the current rules but with their implementation throughout the bureaucracy, which is badly in need of streamlining, rationalisation and discipline.

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NEED FOR NEW ATTITUDES Investors believe that the problems of the current environment are more ones of attitude than detailed specifics. This perception is illustrated by the title of the Indonesia Business Club’s submission to the Ministry of Finance as input into the post-IMF White Paper mentioned above – ‘Indonesia’s Investment Policy Framework: New Paradigms and New Mindsets Urgently Needed’.10 The submission states: More than just superficial changes are required to reverse the damage which has been done to Indonesia’s image and economy. New thinking is required, including the adoption of new paradigms and mindsets towards direct investment, irregardless of whether it is foreign or domestic in origin.

To the extent that improvements in attitude are needed, business would recommend a switch from a ‘control’ mentality of approvals to a registration and reporting system. Investors, foreign and domestic, should simply be required to register their investment and their proposed activities. Once registered and given a business number (which ideally would be the same number used for local business permits, import licences, tax registrations and so on), the business entity should be allowed to operate in any area not prohibited to foreign investment under the law. It should not require further government approvals. There can be any number of legitimate reporting requirements, particularly with regard to capital inflows, but the control mentality of the old system that still lives on in many bureaucratic hearts is an uncompetitive obstacle to investment. Properly registered foreign investments should be allowed a generous number of expatriate work permits for management positions. The investor, not the government, should decide whether to use expatriates in management and technical positions. To facilitate the entry of small and medium-sized entrepreneurs, owners should be given permanent residence status if they so desire. The submission from the international business community strongly urges that any new laws or regulations that are promulgated bear in mind some important principles. They concern the need to: • • • • • • • •

establish a national corporate registry; leave the terms of articles of association and joint venture contracts to investors; allow legal entities to have a broad scope of activities; review investments only for large projects (say over $100 million); empower investors rather than control them; simplify licensing requirements; streamline and reduce reporting requirements; eliminate additional tax burdens for community development;

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• • •

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allow businesses to outsource; make fiscal incentives clear and transparent; and grant permanent residency for individual foreign investors.

The principles would apply to foreign and domestic investors alike. Indeed, the legal distinction between foreign and domestic investors should be eliminated. CONCLUSION Those who are actively concerned with investment in Indonesia feel the time has come for the country to declare explicitly whether it really wants private investment as an engine of economic growth. The signals are ambiguous right now. If Indonesia does want investment, it must focus on creating an enabling environment for both foreign and domestic investors. Indonesia is competing with more than 150 countries for new investment. Its own domestic investors are being attracted to other countries. Most countries are trying hard to improve conditions for foreign investors, but Indonesia is becoming an increasingly bureaucratic and high-cost environment. Policymakers seem intent on perpetuating a complex command and control regulatory environment rather than creating an enabling or facilitating environment. Many of the changes suggested by international business may seem radical from the perspective of certain vested interests or past practices in Indonesia, but they are merely best-practice changes consistent with the global trend identified by UNCTAD – the trend towards welcoming foreign investment, a practice that has been adopted successfully all over the world.

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APPENDIX 5.1 BUSINESS HURDLES IDENTIFIED BY THE JAKARTA JAPAN CLUB, 25 JULY 2003 (a) Customs and duty Items that have been solved • Authority of signature a • Faster customs clearance a • Better customs service on Fridays (so-called ‘desperate Fridays’) a • Abolition of UTM [‘under table money’] and moral improvement a • Clarification of all documents • Improved information system a • Stipulation for penalty regulation a • Consensus of all officers’ understanding • Improvement measures for slight mistakes • Simplification of documents • Assessment (evaluation) • Clarification of harmonised system code • Removal of fence inside the bonded warehouse • Simplification of the import process for second-hand machines a • Electronic data interchange system to simplify export procedures Items that are still under discussion • Working outside regular office hours • Abolition of double application • Standardisation of treatment of bonded cargoes in the bonded warehouse • Expansion of possibilities in the bonded warehouse • Expansion of users’ status in the bonded warehouse • Simplification of treatment of molding • Establishment of ‘one-stop centre’ • Reducing the priority of the master list • Simplified processing for returnable containers • Introduction of delayed payment system for duty, import tax, etc. • Faster receipt of cargoes that are less than a container load • Reduction of terminal handling charge • Improvements in the integrated electronic data interchange system and its operation

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(b) Taxation Items that have been solved • Clarification of deductible cost on company car and hand-phone a • Unreasonable treatment on computer management for VAT refund a • Large penalties for small faults on VAT invoices • Unfair treatment for VAT mistakes by sellers a • Wrong procedure on calculation of corporate tax a • VAT problem around the border a • Revision of depreciation • Reduction of withholding tax percentage on Maklon services b • Enactment issues concerning new tax laws/regulations • Enforcement issues concerning new tax laws/regulations • VAT on export of service • VAT on import of service • Establishment of a support team for taxpayers in the headquarters of the Directorate General of Taxation Items that are still under discussion • None (all items have been solved) (c) Labour Items that have been solved • Definition of legal strike and the distinction between a legal strike and an illegal strike • Educational campaign for all members of union labour, regarding the proper legal procedures to conduct a strike • Better arbitration and settlement on labour issues a • Employers’ salary liability during strikes • Absolution from liability for retirement allowances for employees dismissed for serious fault, misconduct or failing to obey the law a • Simplification of dismissal procedures for employees dismissed for serious fault, misconduct or failing to obey the law • Labour conditions for subcontractors Items that are still under discussion, among others • Rigorous observance of legal procedures • Quick settlement of illegal strikes • Clear definition of ‘prohibition of violent behaviour during a strike and immediate intervention by policy authorities against violence’ • Establishment of a method of rational appraisal for the minimum wage • Responsibility for employment of subcontractors

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(d) Investment promotion and support for industry development Items that have been solved • None Items that are still under discussion, among others • Early improvement of the investment environment and active public relations • Establishment of tax incentives for investment • Increasing industrial competitiveness by strengthening supporting industries • Simplifying and speeding up procedures to obtain investment licences • Promotion of information about investment • Expectations of the new investment law • Upgrading research institutions to increase the additional value for promoting a supporting industry • Increasing competitiveness in other areas (e) Electric power c Items that have been solved • Independent power producer issues Items that are still under discussion, among others • Reforming the financial structure of PLN, the state electricity company • Increasing the capacity of existing power plants through rehabilitation and expansion programs • Expeditious development of new generation capacity • Reinforcement of key transmission lines and substations • Improvement of the reliability of power systems VAT: value-added tax. a Classified as urgent. b Maklon services are contract manufacturing services. c The document notes that the Coordinating Minister ‘hopes that the sub-committee for Electric Power could be extended to include other infrastructures such as communication, seaports and airports, etc’. Source: Coordinating Minister for Economic and Financial Affairs, Press Release, 25 July 2003.

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NOTES This article relies on information developed by the International Business Chamber of Indonesia and AmCham Indonesia. The author is a board member and past chair of both organisations, which do outstanding work gathering information and communicating foreign investor concerns to the government of Indonesia and our home governments. The article also draws on frequent discussions with senior members of Kadin. Nevertheless, the conclusions drawn and the recommendations made are the author’s and should not be assumed to be those of either the International Business Chamber of Indonesia or AmCham Indonesia unless specifically stated. 1

In spite of the continued policy fascination with export manufacturing investment, most investment in Indonesia during 1967–97 was either to produce products for the domestic market or to develop natural resources for the global market. Few companies came to Indonesia to manufacture for the export market, and those that did in the early years quickly left because of short-sighted government policies. Who remembers the National Semiconductor and Fairchild chip factories that were established in Indonesia in the early 1970s, well before Malaysia became the chipproducing king of Southeast Asia, and that left because the government would not allow 100 per cent foreign ownership? 2 ‘Indonesian Government and Japanese Businessmen Eliminate Business Hurdles’, Coordinating Ministry of Economic Affairs, 25 July 2003. 3 Unpublished JBIC presentation materials, August 2003. 4 The biggest difference between these civil servants and the private sector was the failure of the officials to recognise the importance of labour problems to investors. 5 The survey did not ask about the attitude of bureaucrats. 6 President Megawati’s speech on the opening of the MPR session on 4 August 2003. 7 Section XIII.1.c.xxiv, ‘Regulation for Those Using Foreign Employees on Competency Standards Position’ [sic.]. 8 ‘Noted Economist Calls on Indonesia to Quit AFTA’, Asia Pulse, 11 September 2003. Indonesia has remained a linchpin of AFTA by being among the most faithful in implementing its requirements. It would not be appropriate to be too alarmist yet, but Indonesia’s AFTA compliance will certainly bear close scrutiny. 9 In fact, Indonesia’s investment regulations are relatively competitive with those of its neighbours and much of the developing world. The only thing that really needs significant improvement is the excessive intrusion of government, for example, multiple registrations and the need for redundant requirements by various departments. Unfortunately, every time a regulatory or legislative ‘improvement’ is promulgated, it is added to the burden rather than being used to replace other regulations. One recent example is the regulation by the Ministry of Finance requiring importers to register. All importers were already required to register at the Department of Trade and Industry. 10 Letter from the International Business Chamber of Indonesia to the Coordinating Ministry of Economic Affairs, July 2003.

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RECENT TRENDS IN FOREIGN DIRECT INVESTMENT Kelly Bird

The recovery in investment – both domestic and foreign – during the post-crisis period has been sluggish, partly explaining the relatively low economic growth rates in Indonesia since 2001. The consequences of this low-growth period have been slow employment creation in the formal/modern sector and rapid expansion in the informal/traditional sector. Higher rates of investment are required to shift Indonesia to a higher growth path. This chapter reviews recent trends in investment and discusses the factors that explain the sluggish recovery in foreign direct investment (FDI) in particular. The next section reviews recent trends and the changing pattern of FDI. The third section touches briefly on the consequences of the slow recovery in investment, and the fourth discusses the obstacles to a recovery. This is followed by a brief discussion of the government’s investment and employment strategy as outlined in its White Paper. TRENDS IN INVESTMENT DURING THE POST-CRISIS PERIOD

As mentioned above, the recovery in both domestic and foreign investment has been sluggish during the post-crisis period. As demonstrated in Figure 6.1, real aggregate investment in the economy collapsed in 1998 and bottomed out in the second quarter of 1999 at half the pre-crisis peak investment levels. There was a sharp rebound in 2000, with investment climbing to 70 per cent of pre-crisis levels, but the recovery stagnated in 2001 and 2002. Investment picked up slightly at the end of 2002 and continued its modest recovery in the first semester of 2003. Consistent with aggregate investment in the economy, new FDI remains at historically low levels. Some foreign firms have closed their subsidiaries in Indonesia during the last few years, especially in footwear and other labour-intensive sectors. 93

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Figure 6.1 Trends in Aggregate Investment,1997–2003 (in 1993 prices, 1997Q1 = 100) 120 100 80 60 40 20 0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

1997

1998

1999

2000

2001

2002

2003

Source: National Income Accounts.

In addition to low levels of investment, the pattern of FDI during the postcrisis period has changed in three ways compared to pre-crisis patterns: • • •

the average size of new FDI is considerably smaller; FDI has shifted away from manufacturing and other tradable goods sectors towards trade-related services; and foreign investment has shifted away from greenfield investment towards the acquisition of domestic firms.1

Figure 6.2 shows that FDI approvals in US dollars declined almost continuously during the post-crisis period, from a peak of $34 billion in 1997 to $14 billion in 1998 and $10 billion in 2002.2 However, the actual number of approved FDI projects continued to hold up during the post-crisis period, indicating that the average dollar value of approved FDI projects has declined considerably. Another notable change in FDI during the post-crisis period is the shift away from investment in the tradable goods sectors, especially manufacturing, towards non-tradable sectors such as wholesale and retail trade. Figure 6.3 shows the change in FDI approvals by major economic sector since 1990. In the early 1990s manufacturing accounted for over 70 per cent of all FDI approvals by both number of projects and value. This percentage declined to under 60 per cent in the mid-1990s as FDI expanded to modern services and other sectors.

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Figure 6.2 Trends in FDI Approvals, 1985–2003 No. of projects

$ billion

1,600

40

1,200

30

800

20

400

10

0

1985

1987

Source: BKPM.

1989

1991

1993

No. of projects

1995

1997

1999

2001

2003

0

$ billion

The post-crisis period is strikingly different from the pre-crisis boom years. FDI approvals in manufacturing continued to decline and were overtaken by traderelated services as the preferred sector for intended FDI. Investment in the distribution sector increased, primarily as a result of the government’s removal of restrictions on foreign investment in this sector in early 1998 (see box). While new FDI in the tradable sector, especially manufacturing, has been limited, several foreign firms with operations in Indonesia have expanded either by building new capacity or through friendly acquisitions. Unilever, for example, has expanded its operations by buying brands that are popular in consumer markets. Foreign firms in the manufacturing sector have also seen their market shares expand during the post-crisis period. According to the annual survey of medium and large-scale manufacturing establishments, the share of foreignowned firms in total value added in manufacturing increased from around 22 per cent in 1990 to 33 per cent in 1997 and 38 per cent in 2000, as Table 6.1 shows. Foreign firms were also an important source of employment generation during the crisis, accounting for 21 per cent of total medium and large-scale manufacturing employment in 2000, up from 10 per cent in 1990 and 18.8 per cent in 1997. This relative expansion partly reflects the greater resilience of foreign firms during the crisis. They were less affected by the financial crisis than

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Figure 6.3 Distribution of FDI Approvals by Major Sector, 1990–2003 (% of total no. of approved projects) 80 60 40 20 0

1990

Agriculture

Manufacturing

1997

Trade

2000

Professional services

2003

Other services/utilities

Source: BKPM.

Table 6.1 Contribution of Foreign-owned Firms to Value Added and Employment in the Medium and Large-scale Manufacturing Sector, 1990–2000 (%) a

Share of FDI in total value added Share of FDI in total employment Annual average employment growth All firms Foreign-owned firms Domestic firms

1990

1997

2000

21.8 10.1

32.9 18.8

38.1 21.4

1990–97 8.1 27.4 5.9

1997–98 –1.1 0.6 –1.5

1998–2000 2.9 9.1 1.5

a Medium and large-scale plants refer to establishments with 20 or more employees. Source: BPS, Statistik Industri: Hasil Pengolahan Data Perusahaan Industri Besar dan Sedang, Jakarta.

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DEREGULATION AND INVESTMENT IN THE DISTRIBUTION SECTOR

In 1998, the government removed restrictions on foreign investment in the wholesale and retail sectors. The change included granting permission to foreign producers operating in Indonesia to distribute their own products in the domestic market (previously they had had to distribute their products through a local partner). As a result, foreign investment in the distribution sector has increased over the five years to the end of 2003. One major investor is French retailer Carrefour. It established its first outlet in Jakarta in October 1998 and has since opened an additional 10 outlets in the capital and two in Bandung. Carrefour directly employs around 4,000 workers and indirectly 3,000 workers. Its rapid expansion in the capital has raised calls from local competitors and some government officials for the reintroduction of controls on foreign investment on the grounds that the retailer (and modern retailers in general) is driving out small traders. However, there is little evidence to indicate that Carrefour and other modern retailers are driving out small traders. Recent market research by ACNielsen shows that modern markets account for only about one-quarter of total retail sales of non-durable goods in the 14 main urban centres, although this proportion is rising. In contrast, modern markets account for well over 50 per cent of retail sales in the Philippines and Thailand. Moreover, modern retail outlets compete in different market segments, selling products of higher price and quality than do small traders. In addition, Carrefour and other large retailers reportedly source as much as 90 per cent of their products from local suppliers. Rather, Carrefour has taken market share from the local modern retailers, Matahari and Hero. Its success is attributed to its lower product prices, achieved by buying directly from producers and in bulk. Besides Carrefour, several local modern retailers have also expanded in recent years. Ramayana, one of Indonesia’s largest retail department chain operators, has opened more than 10 outlets per year outside Java. Mini-markets – which are in closer competition with smaller traders – have expanded rapidly in main urban centres. Expansion of the modern retail sector in recent years is also the result of regional autonomy. Local governments have assumed authority over the granting of investment approvals in the modern retail sector, whereas in the past the director of domestic trade at the Ministry of Industry and Trade had authority to approve investments in the regions. This issue has created tension between the centre and the regions, and the ministry is reportedly preparing a presidential decree to regain control over investment in the modern retail sector. While modern supermarkets represent only a fraction of retail trade sector employment, their linkages with the economy (in particular with small and medium-sized enterprises (SMEs) and the rural sector) are potentially significant. For example, Matahari Putra Prima, a leading supermarket chain, has long run a successful vendor development program, with more than 3,000 local producers supplying the bulk of products sold.

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domestic firms because they were less reliant on the domestic banking sector for working capital or trade finance, had lower leverage rates and deeper pockets, and were more export-oriented. It should be emphasised that in terms of employment and income creation it does not matter where an investment originates or which sector it enters, as long as investment decisions are based on a proper assessment of profitability and risk. Another feature of the pattern of investment during the post-crisis or recovery period has been the significant number of plant closures – both foreign and domestic – especially in the labour-intensive garment and footwear sectors since 2001. The reasons for the closures vary across sectors. According to garment and footwear industry sources, more than 130 plants in Jakarta, Bandung and Surabaya have shut down since 2001 and this is expected to accelerate in 2004.3 Consequently, tens of thousands of workers, the majority of them young women, have lost their jobs. Greater competition from China and Vietnam and rapidly rising domestic wage costs in an uncertain industrial relations environment are believed to have contributed to plant closures in these sectors. In the electronics sector, Sony relocated its audio production to Malaysia early in 2003, resulting in a loss of more than 1,000 jobs in Bekasi. The closure was part of the company’s global production restructuring efforts in the face of strong competition from South Korean electronics producers such as Samsung and LG, and changes in global demand conditions. Sony plants in several other countries were also closed as part of this consolidation effort. However, the decision to relocate audio production to Malaysia was also indicative of Indonesia’s uncertain investment climate. Industry officials consider the Malaysian plant more efficient at delivering products on a timely basis. Malaysia offers well-developed supporting industries, more efficient and lower-cost infrastructure (port operations, for example, are more efficient) and a more stable industrial relations environment than Indonesia. Indonesia’s high luxury tax was another factor that probably influenced Sony’s departure. High luxury taxes on electronic goods (up to 70 per cent on large TV sets) had encouraged widespread smuggling of electronics into Indonesia, substantially reducing Sony’s domestic sales of TVs. The government subsequently responded to this tax issue by eliminating or reducing luxury tax rates on a wide range of electronic products in February 2003, and this has provided a stimulus to major electronics producers in Indonesia. Although the withdrawal of Sony was widely reported, it remains to be seen whether the firm has set a trend for the industry. For instance, the Samsung plant in Jakarta is the third largest Samsung plant worldwide and has seen both exports and domestic sales increase significantly in recent years. Perhaps the most significant feature of the pattern of FDI in recent years is the substantial increase in the proportion of FDI flows that involve acquisitions and buyouts related to corporate debt restructuring. Approvals of new green-

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Figure 6.4 FDI Approvals by Type, 1996–2003 (% of total value of approved projects) 80 60 40 20 0

1996 New FDI

1999 Expansion

2003 Change in status

Source: BKPM.

field investments were typically about 60 per cent of total FDI approvals during the pre-crisis period (with the remainder related to plant expansions and acquisitions/mergers), but had fallen to around 30 per cent of total approvals by 2003 (Figure 6.4). In contrast, Figure 6.4 shows that the change in status from domestic to foreign ownership accounted for 55 per cent of total FDI approvals in 2003, up from an average of 20 per cent before the crisis.4 Acquisitions have occurred as part of the asset sales of the Indonesian Bank Restructuring Agency (IBRA) as well as through debt-restructuring deals unrelated to IBRA. By mid-2003, IBRA had raised a total of Rp 165 trillion (about $18 billion) from the disposal of assets and bad loans since 1999. While the proportion of IBRA assets sold to foreign firms is not reported, several highprofile sales to foreign investors have included Astra International, former Salim group palm oil plantations, and three nationalised banks – Bank Central Asia (to a mixture of foreign and Indonesian investors), Bank Danamon and Bank Niaga. Sales of assets to foreign investors have also occurred outside IBRA’s asset disposal program. The sale of equity to foreign investors has been a feature of several large private debt-restructuring deals with creditors, although most of these resulted in the transfer of only minority share ownership to foreign

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investors. One example where a controlling share has been transferred to foreign investors is the cement industry, once considered a strategic industry under the control of the government. Ownership in the cement industry has changed dramatically as a result of corporate debt restructuring. In 2001, the Salim group sold a controlling share in Indocement Tunggal Prakarsa to European cement producer Heidelberger Zement, as part of Indocement’s restructuring of more than $1 billion of debt. This sale was part of the Salim group’s efforts to refocus its business on core activities in consumer products. In 2002, another European cement producer, Holcim of Switzerland, acquired Semen Cibinong, formerly owned by the Tirtamas Group, as part of this company’s debt restructuring. This means that three of Indonesia’s seven cement producers now have majority foreign ownership. A fourth, Semen Gresik, has minority foreign ownership. Foreign ownership has also increased in a small number of partially privatised state-owned enterprises. Some of these divestments have been controversial, such as the sale of minority equity in Semen Gresik to Cemex in 1998 (see Prasetiantono, this volume). Others have been less controversial, such as the sale of 49 per cent of shares in Telkom to both domestic and foreign investors. There have been several cases of assets being disposed of through the courts, although these have been relatively infrequent and in the main controversial, such as the case of Manulife. While there has been significant acquisition activity by foreigners in the past two years, this should not be overstated, as the amount of assets that have passed to foreign investors account for only a very small proportion of total distressed corporate assets in Indonesia. Nevertheless, acquisition and buyout activity is an important part of facilitating corporate debt restructuring, industrial restructuring and a revival of investment and jobs in the economy. Foreign investment has injected much needed capital into distressed enterprises, improving their long-term viability. In some cases the change in ownership is likely to improve corporate governance, competition and efficiency in the industry. The change in ownership in the cement industry, for example, may inject new competitive pressures and break down the cartel practices that characterised the industry until it was deregulated in 1998. CONSEQUENCES OF LOW INVESTMENT RATES Household consumption growth has been the primary contributor to economic growth since 2001. However, higher growth rates can only be achieved through increased investment and exports. One consequence of the sluggish economic recovery has been slow employment creation and a rapidly expanding informal or traditional sector. While aggregate employment expanded by about 1.8 million between 2000 and 2002, in a dualistic, labour-surplus economy such as

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Figure 6.5 Trend in Formal and Informal Sector Employment, 1997–2002 (1997 = 100) 120 100 80 60 40 20 0

1997

1998

1999

Formal sector

2000

2001

2002

Informal sector

Source: National Labour Force Survey.

Indonesia these aggregate numbers mask weaknesses in the labour market. The reason is that, in the absence of unemployment insurance, workers who cannot find a paid job in the formal/modern sector must seek refuge in the informal/ traditional sector rather than risk being unemployed. Thus, labour market adjustment occurs in the informal sector. Poor policies hurting the modern sector will also show up in an expansion of informal employment and reduced earnings in that sector. Data from the National Labour Force Survey shown in Figure 6.5 indicate that formal/modern sector employment (defined as wage employment) stagnated in 2001 and actually declined in 2002, while the informal sector expanded. Slow economic growth, rapid increases in wage costs since 2000 and the high transaction costs noted in Table 6.2 (see below) have contributed to this weak employment situation. The long-term implication of this growth in the informal sector is that more and more families will be vulnerable to poverty. FACTORS AFFECTING INVESTMENT RECOVERY In this section I discuss the factors that have been a drag on the recovery in investment. These factors can be categorised into three groups. The first set of

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factors relates to macroeconomic policy, the second to risk factors of doing business in Indonesia and the third to industry competitiveness. Macroeconomic Policy

A stable macroeconomic environment is fundamentally important for investment to take place. An unsustainable fiscal policy, an unstable exchange rate, high real interest rates and expectations of high inflation create an uncertain and risky investment environment, as well as discouraging longer-term investment. While some measure of macroeconomic stability was achieved in late 1998 and early 1999, much of the post-crisis period from mid-2000 to late 2001 was characterised by an uncertain and unstable macroeconomy, as well as political instability. During this period the exchange rate continuously depreciated relative to the dollar, reaching Rp 12,000 at one point in June 2001. Inflation accelerated throughout 2001, peaking at 15 per cent in February 2002, and Bank Indonesia’s interest rates reached as high as 18 per cent in late 2001. Underlying these deteriorating macroeconomic indicators were serious concerns over the ability of government to manage fiscal sustainability. The government debt to GDP ratio rose above 100 per cent in 2000; interest payments and subsidies in the state budget amounted to almost 7 per cent of GDP. Political instability and soured relations with international donors, particularly the International Monetary Fund (IMF), exacerbated these concerns about fiscal sustainability and in particular whether the government could service debt. Under these circumstances very few businesses, including domestic firms, would make new long-term investment commitments. It was only after the new government of President Megawati Sukarnoputri was installed in mid-2001 that there were signs that medium-term macroeconomic stability might be achievable. The fiscal situation began to improve in 2002 after the government introduced a series of unpopular fiscal measures, including a reduction in subsidies. The inflation rate fell, the exchange rate began to appreciate, and interest rates began to inch down.5 This macroeconomic stability has not translated into any significant recovery of investment and economic growth in 2003. However, one would expect a lag in aggregate investment growth, as it takes time for the community to believe that the government has in fact achieved stability. Indeed, it was only in the second quarter of 2003 that portfolio capital inflows began to pick up significantly and international credit-rating agencies began to upgrade Indonesia’s sovereign rating, indicating that investors were starting to form positive views on the macroeconomy in 2003 and future growth prospects. Even so, it will take some time for investors to make long-term commitments. Moreover, with a general election due in 2004, major investments are likely to be delayed until after the new government is formed. Thus, we might not expect to see a significant recovery of investment until at least 2005.

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Economic Governance

Macro stability is a necessary condition for investment to take place, but is not sufficient on its own. Economic governance is also important. The second set of factors that continue to deter investment relates to the perception of the political and legal risk of doing business in Indonesia. Investors look for a stable and predictable policy environment and do not like surprises. Factors that affect investors’ perceptions about the risk of business include political stability, government effectiveness (including policy coordination), transparency and quality of regulations, control of corruption, rule of law and legal certainty. A high risk of doing business means that investors need a relatively high profit rate to make investing attractive, and this also helps explain why real lending rates can remain stubbornly high. Various surveys indicate that the risk of doing business in Indonesia is high relative to neighbouring countries such as Thailand and Malaysia. Some analysts and commentators take the view that political stability and government coordination have improved in the last two years (MacIntyre and Resosudarmo 2003: 133). However, many of the government-created sources of business risk and uncertainty noted above have not improved sufficiently to change perceptions about doing business in Indonesia. Indeed, creeping, nontransparent forms of protectionism from the Ministry of Industry and Trade and poor labour policy are two examples of poor-quality regulations that are hurting investors (see below). Competitiveness

The final set of factors that affect investment relates to competitiveness. On paper the government’s investment policy has improved in recent years. There are fewer restrictions on foreign investment today than there were before the crisis. Equity and divestment restrictions have been eliminated for most sectors, except some service sectors and the oil and mining sector. Foreign firms can own land. Several aspects of export policy are also considered relatively efficient by developing country standards. For example, bonded factories operate smoothly and the number of exporters that have converted to bonded factories has doubled since 1997.6 The export-processing zone of Batam operates relatively efficiently, has attracted several new investments and has recorded economic growth of over 7 per cent for the last two years. Nevertheless, there are several policies that negatively affect competitiveness and slow the reallocation of resources to potential growth sectors. Labourintensive industries in particular have been struggling since 2001. Table 6.2 provides a summary of the results of several surveys and reports that have highlighted rapid increases in wage costs driven by minimum wage policy, an uncertain industrial relations environment, infrastructure bottlenecks, costly

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Table 6.2 Policy Issues of Most Concern to Exporters in Labour-intensive Industries, July 2002 Labour policy

Minimum wage policy Severance pay regulation Multiple unions

Taxation

Port operations

Property rights Energy costs

Export policy

Luxury tax Tax administration

Recent increase in port handling fees Port inefficiencies Land ownership

Minimum wage increases are too high and too frequent to be supported by productivity growth. Recent increases have created worker expectations of large future increases. This uncertainty is encouraging firms to plan the introduction of low-level automation. The cost of the severance pay regulation is high. It is seen as encouraging disharmony because the regulation also covers workers who are dismissed for misconduct. Multiple unions are not seen as a major problem as long as there are clear rules on selecting the agent to represent workers in collective bargaining.

High luxury taxes have encouraged smuggling of certain goods. a Officials have wide discretion and corruption is endemic.

Tanjung Priok’s port handling fees are now among the highest in the region. Port productivity is among the lowest in the region.

There is uncertainty over land ownership. Regulations pertaining to the use of agricultural land (e.g. maximum 30-year leases) inhibit long-term development of a modern, agriculture-based export sector.

Fuel prices

In general exporters are not seriously concerned about electricity tariffs, which are still lower than those of regional competitors. But they are concerned about possible supply shortages in the next few years. Fuel prices are not seen as a major problem on their own.

Bonded factories Bonded warehouses

Bonded warehouses are not permitted to source locally made materials. This discourages backward linkages.

Electricity tariffs and supply Bintek facility

It takes more than 12 months for exporters to receive customs duty and value-added tax rebates. There is uncertainty over the status of Bintek. Exporters are satisfied with this facility.

a In January 2003 the government reduced and eliminated luxury taxes on electronics and other products vulnerable to smuggling. Source: Bappenas (2003).

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port operations, corruption in customs and tax administration and the proliferation of local government trade restrictions as important constraints to growth in labour-intensive sectors. There has been some backtracking on reforms and a return to creeping, nontransparent forms of protectionism. While tariff rates remain low, non-tariff barriers issued by the Ministry of Industry and Trade have proliferated. According to a recent trade policy review by the World Trade Organization (WTO), more than 800 import lines are subject to some kind of non-tariff barrier, although their ‘restrictiveness’ on imports has not been quantified (WTO 2003). Changes in labour policy and the industrial relations environment have been two of the most controversial areas affecting competitiveness in the postSoeharto period. A recent review of labour policy published by the National Development Planning Agency (Bappenas 2003) raised concerns that several provisions of the new law, related to minimum wages, dismissals, temporary work contracts and outsourcing, threatened to create rigidities in the labour market that would slow employment growth in the modern sector (see Manning, this volume). THE WHITE PAPER In September 2003, the government set out its IMF exit strategy in a document commonly referred to as the White Paper (see Basri, this volume). The strategy has three components: macro policy, financial sector reforms, and investment, exports and employment. The strategy addresses several of the concerns mentioned in this article. While the White Paper has been criticised for being vague in several areas and overloaded with commitments – and implementation of some items has already slipped – it is notable in that it has encouraged more systematic policy coordination across the bureaucracy as well as greater policy debate. The strategy in the White Paper resists the temptation to provide a special FDI policy. It implicitly recognises that the problems facing foreign investors are the same as those facing domestic investors, and that an improvement in any area will benefit all. In this regard the economic strategy focuses on improving the investment framework for all investors – both foreign and domestic. One commitment was the submission of a draft investment law to parliament in December 2003, to replace the existing domestic and foreign investment laws. The new law is an important promotional tool. More importantly, it promises equal treatment between investors, whether local or foreign and irrespective of the country of origin of the foreign investment. In taking this step, the government is signalling to investors that it intends to provide a level playing field for investors. Nevertheless, there have been calls from the chair of the

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Investment Coordinating Board (BKPM) for the government to provide investors with tax incentives, in particular tax holidays, as one way of offsetting the high cost of doing business in Indonesia. However, there is no empirical evidence in Indonesia or elsewhere to indicate that tax holidays are effective in attracting new investment. Indeed, there are significant costs associated with such a policy, including losses in potential tax revenue and distortions in investment decisions. CONCLUDING REMARKS This chapter has reviewed recent trends in FDI and the factors that help explain the low level of aggregate investment, and of foreign investment in particular. The level of both foreign and domestic investment remains low, and this has been a drag on economic growth and job creation. In addition, the pattern of FDI during the post-crisis period has changed in three ways compared to the pre-crisis pattern. First, the average size of new FDI is considerably smaller than before the crisis. Second, FDI has shifted away from manufacturing and other tradable goods sectors towards trade-related services. And third, foreign investment has shifted away from greenfield investment and towards the acquisition of domestic firms. The chapter has argued that poor governance and high compliance costs associated with the regulatory environment, as well as the relatively high transaction costs associated with customs, port operations and dealing with the bureaucracy, have all hurt investment. The government’s IMF exit strategy set out in the White Paper attempts to address some of these obstacles. Effective implementation will be important in this regard. NOTES 1

2

Comprehensive data on FDI flows to and from Indonesia are not available. Thus, the discussion in this chapter is based on a variety of sources, including FDI approval figures from the Investment Coordinating Board (BKPM), the annual survey of medium and large-scale manufacturing establishments, financial houses’ investment reports, IBRA reports, media reports and the author’s discussions with investors. Investment approvals are best interpreted as an indicator of investor interest and intentions, and not as a proxy for realised investment. Studies carried out before the crisis find that approvals are weak predictors of realised investment and that only a small proportion (perhaps anywhere between 10 and 25 per cent) of approvals are implemented within three years of approval being given. All foreign investment proposals are required to obtain approval from BKPM before they can proceed. Thus, FDI approval figures are complete. However, domestic investment approval data are

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3 4 5

6

107

less reliable, because domestic investors require BKPM’s approval only if they are requesting tax incentives. In recent years many of these incentives have been cut back, and so fewer domestic investors are lodging applications with BKPM. Also, since decentralisation, the authority to approve domestic investment proposals has been transferred to local governments. This is believed to have led to a breakdown in the reporting of data to the central government agency BKPM. Thus, in most of this chapter FDI approval figures are used as a rough indicator of investor intentions. Based on interviews with officials from the Employers Association of Indonesia (Apindo). Some proportion of this 55 per cent is due to domestic firms relocating their head offices overseas. By the end of 2003, annual inflation had declined to 5.1 per cent, Bank Indonesia Certificate (SBI) interest rates had fallen to close to 8 per cent, and the exchange rate was remarkably stable at around Rp 8,400. The government debt to GDP ratio had fallen to 70 per cent. Bonded factories provide exporters with exemptions from duty and value-added tax on imported materials used to produce goods for the export market. Imported goods are shipped to the factory under lock, where they are inspected by customs officials. This system has significant advantages in terms of improved trade facilitation and cost savings compared with other arrangements such as the duty drawback facility whereby the exporter pays duty up-front and requests a rebate. Rebates can take up to 12 months and not all are actually received. As of mid-2001, there were over 510 bonded factories in Indonesia, compared with 232 at the end of 1997 (data from Customs Department, Ministry of Finance).

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Henry Sandee and Peter van Diermen Small and medium-sized enterprises (SMEs) continue to receive significant attention from both Indonesian policy-makers and researchers. One explanation can be found in the important role SMEs play in poverty alleviation. The sector accounts for a considerable amount of employment for workers. It has been able to adjust to the financial crisis and maintain employment levels while other sectors of the economy have contracted. However, SMEs are not only associated with poverty alleviation and job creation, they can also create productive jobs, adopt innovations and export successfully. This chapter concentrates on SME exports from Indonesia since the 1997–98 crisis. Ter Wengel and Sandee (2004) show that SME exports have increased significantly during that time. From 1996 to 2000, SME exports increased by 83 per cent while the exports of the largest enterprises decreased by 10 per cent. Ter Wengel and Rodriguez (2004) have analysed the factors that explain SME export performance in Indonesia. Both existing and new SMEs have generally participated in the growth of exports that is concentrated in so-called clusters or agglomerations of firms in the same subsector. Ter Wengel and Rodriguez note the importance of foreign buyers and investors in promoting SME exports. Small firms that have a relatively large share of exports in total sales tend to have better developed links with foreign counterparts than do other firms. This chapter attempts to show the importance of strategic alliances between foreign buyers and Indonesian small firms in promoting exports. Buyers are involved in a much wider range of supporting activities than is generally assumed. We show that strategic alliances are an essential part of upgrading technological and marketing capabilities of small firms and provide examples based mainly on our own fieldwork in Indonesia. The chapter is arranged as follows. First, we present an overview of SME exports in Indonesia since the crisis. Next we look at explanations for this rapid 108

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Table 7.1 Firms in the Manufacturing Sector, 1996–2000 Firm Size a

20–49 50–99 100–199 200–499 500–999 1,000< Total

1996

12,519 3,798 2,607 2,261 1,007 805

22,997

Closures, 1996–2000 (no.)

(%)

4,468 772 400 304 102 54

35.6 20.3 15.3 13.4 10.1 6.7

6,100

26.5

Remaining Firms

8,051 3,026 2,207 1,957 905 751

16,897

New Firms

2000

(no.)

(%)

3,232 878 559 400 133 75

40.1 29.0 25.3 20.4 14.7 9.9

5,277

31.2

11,283 3,904 2,766 2,357 1,038 826

22,174

a Number of workers.

Source: Ter Wengel and Sandee (2004).

growth. Then we review some of our own experiences in examining collaboration and competition among foreign buyers and Indonesian exporters. The furniture industry in Jepara, a region of central Java, will be one of the cases discussed. Other case studies are based on recent interviews with SME exporters in Jakarta and the surrounding area. Finally, we discuss policy issues. One of the challenging questions concerns how foreign buyers can be involved in policy formulation for SME exports. SME EXPORTS FROM INDONESIA SINCE THE CRISIS Shortly after the 1997–98 crisis, people gained the impression that SMEs were weathering the crisis better than larger companies. Longitudinal data sets from the Central Statistics Agency (BPS) allow further analysis of trends in the SME sector. Table 7.1 presents data from the annual manufacturing surveys for the period 1996–2000. The data refer only to firms with more than 20 workers and therefore do not allow an exhaustive analysis of the small-scale sector. Table 7.1 suggests that the total number of manufacturing enterprises in Indonesia decreased slightly during the period. It shows that firms employing 20–49 workers were most affected by the crisis. Interestingly, the SME sector recorded

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Table 7.2 Employment in the Manufacturing Sector, 1996–2000 Firm Size a

Job Losses Job due to Expansion Firm at RemainClosures ing Firms

20–49 –121,375 50–99 –51,988 100–199 –54,988 200–499 –93,716 500–999 –68,675 >1,000 –118,745 Total

–509,487

27,945 20,663 39,100 23,956 40,091 –74,705 77,050

Jobs at New Firms

Total Loss/ Gain

391,227 59,493 75,677 121,367 91,061 144,956

297,797 28,168 59,789 51,607 62,477 –48,494

883,781

151,849

1996 Change Employ- (%) ment 3,363,463 260,363 365,710 711,553 706,252 1,807,626

7,214,967

8.9 10.8 16.4 7.2 8.8 –2.6 2.1

a Number of workers.

Source: Ter Wengel and Rodriguez (2004).

the most closures as well as the most vigorous response to the new opportunities presented in this five-year period. Ter Wengel and Sandee (2004) conclude that there has been an enormous reshuffle in the SME sector. Table 7.2 shows changes in employment levels in the manufacturing sector between 1996 and 2000. The reshuffle has not resulted in significant losses in total employment. Table 7.2 shows that total manufacturing employment increased between 1996 and 2000, despite substantial job losses in all firm size categories. The table makes a distinction between new jobs arising from the expansion of existing firms and new jobs created by new start-up firms. It shows that new firms created a large number of new jobs. Further analysis shows that jobs in the manufacturing sector have become more productive. The gains in value added proved to be highest for the smallest firms and lower for the remaining size groups (Ter Wengel and Rodriguez 2004). Table 7.3 shows how export values changed between 1996 and 2000, by different firm size categories. Table 7.2 suggested that the smallest firms shed some labour during the crisis and that employment has subsequently been subject to much reshuffling with many closures and new starts. However, Table 7.3 shows that SMEs’ exports increased impressively during 1996–2000. Exports by the largest enterprises decreased by almost 10 per cent but exports by the

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Table 7.3 Change in Exports by Firm Dynamics, 1996–2000 (Rp billion at constant 2000 rate) Firm Size a

20–49 50–99 100–199 200–499 500–999 >1,000 Total

Firm Exits

Expansions

New Entries

Total

(1)

(2)

(3)

(4)=(1) +(2)+(3)

–354 –448 –830 –1,832 –2,793 –5,288

608 571 2,866 3,204 7,170 –5,486

579 1,287 3,311 4,279 5,608 4,540

833 1,410 5,347 5,651 9,985 –6,234

–11,545

8,933

19,604

16,993

Total Exports in 1996 (5)

Export Growth (%) (4)/(5)

1,001 2,531 7,346 23,958 23,440 64,336

83.2 55.7 72.8 23.6 42.6 –9.7

122,612

13.9

a Number of workers.

Source: Ter Wengel and Sandee (2004).

smallest firms increased by 83 per cent. Export growth was also substantial for firms with 50–99 and 100–199 workers. The boost came from both expansion by existing exporters and new entries in the export market. However, the share of the SME sector in total manufacturing exports continues to be limited. EXPLAINING SME EXPORT PERFORMANCE Berry and Levy (1999) discuss SME exports from Indonesia prior to the crisis. They conducted fieldwork in Java among garment, wooden furniture and rattan SME exporters and came to three main conclusions. First, most SME exporters are fairly well educated in comparison with SME entrepreneurs in general. There is limited evidence that micro-entrepreneurs with only basic education transform into SME exporters as time proceeds. Second, SME exporters are frequently not very active in domestic markets. Most have either given up producing for the domestic market or started to export their products directly. Third, SME exporters are highly dynamic and their performance has been just as good as that of larger firms.

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These conclusions suggest that SME exporters constitute a specific group with characteristics that are rather different from SMEs in general. Sandee and Ibrahim (2002) identify two main characteristics of SME export promotion in Indonesia. First, SME exports are concentrated in a limited number of subsectors only. More than 50 per cent of SME exports come from wood products, textiles and garments, and footwear. These are all labour-intensive subsectors where low wages are an important instrument for enhancing competitiveness on foreign markets. Second, Indonesian exports are concentrated in clusters. A significant share of SME export production is primarily located in agglomerations of small firms. Indonesian SME exporters can roughly be classified into two categories: those that export through trade networks and those that export directly (Berry and Levy 1999: 6–7; Sandee and Ibrahim 2002: 4–5). Most SMEs export their products through trade networks. Intermediaries link the small firms to international markets and they provide a range of bundled services that include prefinancing of production, market access, technology and skills upgrading, and advice on designs, patent rights and so on. Such private channels are highly important in fostering SME exports. The SMEs have limited involvement in activities outside direct production and buyers take many of the decisions on the trajectory of development. A minority of SME exporters have direct access to foreign markets, especially as a consequence of their participation in trade fairs and exhibitions. Many of these exporters are manufacturing handicrafts. The main constraint to increased exports is access to credit, in particular pre-shipment financing. The 1997–98 crisis has been beneficial for further growth of SME exports from Indonesia. The depreciation of the rupiah offered incentives to labourintensive industries that have a low import component. Being less reliant on formal markets and formal credit, they could respond more flexibly to sudden shocks than could their larger counterparts. In addition, the crisis has resulted in further liberalisation of the economy that has improved the business climate for foreign investors and buyers. In particular, the minimum size limit for foreign investment has been lowered, facilitating interaction between intermediate buyers and small firms. Hill (2002: 169–170) reviews case studies on SME dynamics in recent years. The success stories suggest a model of SME development in which ‘injections of technical, design and marketing expertise’ are essential for integrating small firms into international markets. Frequently, foreign buyers and investors are key players in the transfer of expertise. Hill suggests that dynamic SMEs are located in areas with some basic industrial competence and reasonably good infrastructure. All evidence indicates that SME exporters are a specific group located in clusters and operating in selected subsectors only. In addition, as mentioned

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above, most export through trade networks. Later we will suggest that this identification of the SME export sector offers opportunities for targeted policy, as it is possible to target support well. Ter Wengel and Rodriguez (2004) examine and quantify variables that explain exports at the individual establishment level using data from annual manufacturing surveys for 1996–2000. Their study allows us to put the findings of case studies into perspective. They concentrate on analysing exports by firm size, and define two size classes – small and large firms – on the basis of the number of employees. They find that small firms that export make more use of formal credit than do non-exporters. In addition, SME exporters have access to more sophisticated technology than do other firms. A main finding is that the newer cohorts of small firms export much more than the older ones. This suggests that the crisis has contributed to the emergence of new SME exporters that are benefiting from the changes in the business environment that have occurred since the crisis. Alliances with foreign firms have been essential for strengthening the export capabilities of small exporters, and there has been more scope for such initiatives since the crisis. The presence of foreign buyers and investors increases the share of exports from Indonesian firms. SME exports from Indonesia remain limited but have grown impressively. Clusters are of prime importance for SME exports that are concentrated in a limited number of subsectors. SME exports reach international markets mainly through trade networks in which buyers and investors play leading roles. The prominence of new cohorts among SME exporters suggests that small firms may face barriers in switching from domestic to export production. Factors such as quality standards, delivery schedules, language proficiency and education may inhibit successful participation in export markets. New cohorts may be better equipped to fulfil the standards on international markets. In the next section of this chapter we will review several case studies that explain how the alliances between Indonesian SME exporters and foreign buyers and investors are shaped and how they change as business relationships mature. FOREIGN BUYERS, SME EXPORTERS AND THE DEVELOPMENT OF THE JEPARA FURNITURE INDUSTRY Jepara’s Transformation

Jepara is the main cluster of furniture production in Indonesia. In 2002, close to 60,000 workers were active in the region’s furniture industry, spread over some 150 medium-scale firms and more than 3,500 small firms. There are also some large firms. Jepara has become the focal point for skills upgrading, design, tech-

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Table 7.4 The Jepara Furniture Industry, Selected Indicators, 1989–2002

No. of enterprises No. employed Value of exports ($ thousand)

1989

1996

1998

2001

2002

675 8,400

2,347 35,624

2,493 43,916

3,593 57,488

3,720 58,210

3,852

97,431

169,251

74,737

58,807

Source: Jepara provincial office of the Ministry of Industry and Trade.

nology transfer and best work practices in and outside Java. Groups of Jepara business people serve furniture markets in Brunei and East Timor. The significant growth of the Jepara cluster is explained to an important extent by two substantial depreciations of the rupiah, in 1986 and 1997–98. In 1986, the rupiah fell from Rp 425/$ to Rp 800/$; during the crisis its value declined from about Rp 2,200/$ to a steady Rp 12,000/$. On both occasions, the competitive position of Jepara furniture in international markets improved considerably. This encouraged a range of experienced and not so experienced buyers to do business in Indonesian furniture (Sandee, Andadari and Sulandjari 2000). Restrictions on sawn timber exports in 1986 and the ban on exports of raw wood logs in 1988 also boosted the export furniture industry. The emergence of an export industry has made quality control and standardisation of output important issues. This has supported the emergence of larger firms to supervise the production of smaller enterprises and take responsibility for finishing and quality control prior to export. Success in export markets requires especially that teakwood is properly dried before processing. Drying wood in kilns is essential, although many producers do not yet have timely access (Ewasechko 2003: 9–10). During the 1990s the furniture industry went through a substantial transformation. Table 7.4 summarises some key indicators. The number of enterprises and total employment increased significantly. Working in the furniture industry became an important career option for both low-skilled and highly skilled high school and university graduates in the region. Workers in the industry are better off than in the past (Loebis and Schmitz 2003: 5). The general improvement in earnings is reflected in the statistics on registered motorcycles, which increased by 54 per cent between 1998 and 2001. Table 7.4 also shows that in recent years the value of exports has decreased in importance. To some extent, this is due to the strengthening of the rupiah during the last few years. However,

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there is now sufficient evidence that the industry is going through difficult times and that it has lost its competitive advantage vis-à-vis furniture exporters elsewhere in Indonesia and in countries like China and Vietnam. The transformation of the industry fits well into the SME export analysis presented above. Many traditional small firms were not able to make the switch to the export industry. Most were household enterprises and did not have the capacity to produce good products of consistent quality in accordance with agreed time schedules. Consequently, the emergence of export opportunities in Jepara was only possible through a reshuffling of the industry. New cohorts of small firms have entered the industry, managed by relatively well-educated business people. These firms have grown into key players in subcontracting networks in which traditional crafts people have become disguised wage labourers. Recent studies have queried the sustainability of the Jepara industry (Loebis and Schmitz 2003; Andadari 2003). There is considerable use of illegally harvested wood in the industry. The illegal trade in wood is thriving. The cutting of underaged trees accelerates deforestation and threatens the long-term viability of the furniture industry. In recent years, the price of logs in the region has increased significantly. Insiders consider this to be a consequence of wood scarcity. The substantial growth of the industry in the last decade clearly has undermined the long-term patterns of planting and cutting teak. Furthermore, Jepara’s international business reputation has become less favourable in recent years. The presence of foreign business people has increased substantially (from 28 in 1989 to more than 400 in 2002), but tensions between foreign and Indonesian business communities have discouraged investment expansion. Jepara’s Exports in a Regional Perspective

An International Labour Organization (ILO) survey of global buyers puts the prospects and constraints for furniture exports from Indonesia in a regional context (Ewasechko 2003). Interviews with global buyers during international trade fairs in the Philippines indicate that Indonesian furniture is popular on international markets. Demand for teak products from Indonesia remains high due to the depreciation of the rupiah. Indonesian furniture is available at reasonable prices. The appreciation of the rupiah during the last few years has undermined the competitive position of Jepara furniture. Loebis and Schmitz (2003) argue that the recent decline in export earnings from the cluster shows that Jepara’s growth trajectory was based on low product prices rather than high-quality designs and ongoing upgrading of production processes. Jepara may have focused too much on the so-called ‘low road to competitiveness’. The ILO survey also indicates that buyers consider Indonesian furniture exporters to perform worse than their neighbouring counterparts with respect to the delivery of products of consistent quality and the nurturing of long-term

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relationships with buyers. Follow-up orders often lack the level of quality delivered earlier. Buyers are not concerned about the unsustainable exploitation of teak forests in Java. In their opinion ‘the market will adjust itself’ and prices will increase. This will lead to the exit of buyers and producers that are not able to compensate for price increases with quality improvements. Buyers believe that this will be ‘a healthy development’ for the industry. We met several buyers who were not overly concerned about the threat of deforestation in the region. This is because many make use of recycled wood only, buying old teak houses and using the wood for furniture production. Furniture made of recycled wood is popular in Europe at the moment. One buyer mentioned that his customers like recycled furniture from Jepara because ‘every piece of furniture has its own story’. The recent decline in exports from Jepara has had an impact on the nature of alliances between buyers and domestic firms. Previously, demand was so high that Indonesian firms were hardly concerned about the marketing of their products. Furthermore, if certain customers were not satisfied with the quality of output, it was no problem to link up with other buyers. These business relationships have recently begun to change. Declining buyer interest means that Indonesian producers and exporters need to operate more aggressively. During a recent visit to a Dutch retailer, we were introduced to a couple from Jepara who were looking for customers in Europe. The couple spoke English well, had prepared a glossy catalogue and already had business contacts in Europe and the United States. The Dutch buyers explained that such visits by business people from Jepara are occurring more frequently these days. Classifying Buyers and SME Producers in Jepara

In this section, we aim to classify the buyer–producer alliances in Jepara. In particular, we are interested in the extent to which the various distinct relationships offer challenges to producers and their subcontractors to upgrade their small businesses. The buyers in Jepara can be classified into four main groups: global buyers, specialised teak furniture buyers, non-specialised buyers and incidental buyers.

Global Buyers These buyers operate large furniture stores in Europe and the United States, where they sell a range of products made in different countries and of different types of wood. Jepara furniture is usually the only teak product in their showrooms. However, the recent appreciation of the rupiah has meant that teak furniture has become more expensive. Consequently, customers are becoming more interested in furniture made from other types of wood. China is becoming an increasingly important supplier of furniture other than teak.

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Demand is not always predictable, which sometimes results in several orders being placed close together. Most Jepara exports are destined for large stores, are expensive and are of high quality. Global buyers use suppliers in Jepara with whom they have long-term business relationships. Moreover, these buyers locate their own personnel in Jepara to supervise production. Often, they invest in dry kilns and other equipment needed to upgrade and standardise production. The producers involved in the trade networks developed by global buyers primarily manufacture high-quality furniture. They have access to good equipment and facilities. The production process is buyer-driven; producers and their subcontractors have virtually no influence over either production or marketing processes. Thus, buyers are heavily involved in financing production, transport, design development and quality control. Their business partners in Jepara are predominantly medium-sized firms that concentrate on finishing products that have been made by networks of specialised subcontractors.

Specialised Teak Furniture Buyers Many other buyers in Jepara and neighbouring furniture clusters specialise in teak products. Some have been active in the region for decades, speak Bahasa Indonesia and have established strong business relationships with their Indonesian counterparts. Others have established alliances in the Jepara cluster since the rupiah depreciation of 1986. They are aware of the current problems, but it is not easy for them to switch production to other clusters as they have invested much time and money in developing business alliances in Jepara. Specialised buyers operate on a smaller scale than global buyers. In many cases they do not have a catalogue from which retailers can order. They sell what they have in stock. It is simply too costly for them to accept orders for products that have yet to be made and shipped from Jepara. However, over the years these buyers have developed a good sense of the types of products that are popular in Western countries. Some specialised buyers operate on a larger scale; they often have their own factories in Jepara, where finishing and quality control takes place. Smaller specialised buyers do not normally have such facilities, but may form alliances with powerful producers. In contrast to global buyers, specialised buyers appear to have fewer opportunities to upgrade their business and appear to face greater challenges in doing so. There are three main reasons for this. First, there is more scope for producers linked to specialised buyers to develop and sell indigenous designs. Buyers shop around for good designs and are open to creative ideas by local entrepreneurs. Second, specialised buyers welcome visits to Western countries by Indonesian producers or their representatives. These buyers are interested in new and creative designs and are willing to meet producers. This is not the case with global buyers, who dictate designs to their Jepara produc-

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ers. Third, many specialised buyers take an interest in sustainable forest management. Both the specialised buyers and their customers pay attention to buying furniture from teak that has been legally harvested. Furthermore, this segment of the furniture market makes intensive use of recycled wood due to significant customer interest in such wood. Non-specialised Buyers This group consists of buyers that are specialists in trading Indonesian SME products rather than trading specifically in furniture. Their interest is chiefly in traditional Jepara furniture that is aimed at a specific group of customers. They are interested in ready-made products and normally do not discuss design, quality or production techniques with the producers. Often, products were made many years ago and are bought in Indonesia from small firms, households or shops or at exhibitions. Buyers do not give producers much feedback on quality, design or customer preferences. These buyers concentrate primarily on purchasing existing stock.

Incidental Buyers Finally, there is a group of incidental buyers who are irregular visitors to Jepara or other furniture clusters on Java. They purchase a container load of furniture and then set up a business at home for the purpose of selling their goods. Some succeed and become steady visitors to Jepara; many others fail. Most incidental buyers are tourists who identify a business opportunity. They do not have existing or ongoing business relations with suppliers in the region. Rather, they buy whatever is available; this may include products that have been rejected by other buyers. In general, they buy products of low quality that can be shipped immediately. Are Relationships with Buyers a Challenge for Upgrading?

In comparing the four groups of buyers, our main concern is to identify the opportunities for small producers to use specific trade networks to upgrade their businesses. From the discussion on the different types of buyers, it is clear that there is a dynamic middle segment that offers scope for continual upgrading. Specialised teak furniture buyers form interesting and promising alliances with small producers that give room for domestic upgrading of technological and marketing capabilities. Moreover, these trade channels appear to promote the sustainable use of teak. Other buyer–producer relationships seem to provide buyers with more limited opportunities for upgrading their businesses. In global buyer chains, producers operate under strict surveillance by large buyers, who determine both production and marketing. There is little scope for learning. Likewise, non-

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specialised and incidental buyers offer little scope for small producers in Jepara to upgrade their business, as alliances remain weak. We conclude that matching specialised buyers and dynamic small producers seems to offer the best prospect for the furniture industry in Jepara. POLICY IMPLICATIONS Having identified the strategic role of global buyers in enabling local producers to access export markets, we consider policy implications. Can appropriate policies be formulated and implemented to extend the benefits of the Jepara furniture export industry to other clusters of SMEs? How can the role of specialised buyers in upgrading local furniture producers be strengthened? What role should the government and global buyers play? These and related issues should be considered in the light of international experience and in the context of Indonesia’s current situation. We first examine some international experience in SME policy formulation, before considering the Indonesian context in which such policies must be implemented. This will lead to a brief discussion of specific policy options and what in our opinion is the most appropriate policy to apply in the current circumstances. For many countries, particularly Indonesia, the policy issue is as much how to implement policy as how to identify the policy to be implemented. There are two reasons for this. First, the prevailing view among makers of industrial policy is that specific government interventions to promote SMEs in the developing world have rarely been successful (Snodgrass and Biggs 1996). Industrial policy-makers generally accept that governments are not very efficient at implementing direct interventions. For example, the Committee of Donor Agencies for Small Enterprise Development (2001), in its guidelines to members, discourages direct interventions by multilateral donors and governments alike. It argues that the role of government should be to facilitate market solutions to problems faced by SMEs. Evidence about the performance of SME intervention programs in developing countries comes from an extensive study of SME policies by Snodgrass and Biggs (1996: 37). Their general conclusion was ‘that relatively little of this money was spent effectively’. They suggest that broader economic development policies are more effective than specific SME policies. As a general rule, SME policies should improve efficiency, address issues of market failure and not create additional market distortions. The second reason for highlighting the way in which policies are implemented has to do with Indonesia’s capacity in SME policy-making. As Hill (2002: 161) notes, Indonesia has had a long history of developing SME policy. However, policies have rarely been motivated by the desire for improved eco-

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nomic efficiency. Rather, they have often served political agendas to support particular groups in society. The process of decentralisation has exacerbated the problem of policy implementation. The devolution of power from the centre to the districts has had two effects on policy-makers. First, central government agencies are increasingly unwilling to take responsibility. Second, at the district level there is often a lack of institutional capacity for the development and implementation of policies. Moreover, the sheer number and variety of districts makes it difficult to implement national SME policies effectively and uniformly. The devolution of power and finance to the districts offers policy opportunities. Since decentralisation, local governments are in a position to have a much greater and direct impact on industrial development in their region. A number of districts are actively trying to promote and encourage local economic activity. They often lack the institutional capacity, but under decentralisation kabupaten heads (bupati) have more opportunities than before to make changes to the regulatory environment. Nevertheless, policy initiatives need to be considered in light of local government institutional capacity. Where local government has limited institutional capacity, policy initiatives must first build the capacity to deliver services. Taking best-practice models from neighbouring Singapore or Taiwan makes little sense if the capacity to implement the policy or program is largely missing. On the other hand, reducing local regulatory bottlenecks takes less effort and requires only appropriate identification of the bottlenecks and the removal or modification of the appropriate regulations. Moreover, the lack of capacity within local government and the desire by some districts to address the problem provide opportunities for multilateral agencies to work with local governments. In particular, local governments can encourage buyers to form links with local producers. First, they can identify and address ‘roadblocks’ at the local level that prevent international and specialist buyers from linking with local producers, or make it more difficult to do so. Local chambers of commerce, specialist trade organisations and producer organisations can help to identify such roadblocks. Second, international certification of production standards and quality by an independent and internationally recognised authority allows buyers to have greater confidence in their business dealings with producers. Schemes to encourage and provide incentives for producers to reach such standards have proven successful in the past. In response to these opportunities, multilateral agencies and donors who are interested in facilitating the development of appropriate SME policies are now focusing their efforts more at the district level. At a recent meeting in Jakarta in August 2003, leading donors, including the International Finance Corporation, the ILO, the US Agency for International Development (USAID), the Japan International Cooperation Agency and the Asian Development Bank (ADB),

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discussed their SME projects and programs. The consensus was that working with counterparts at the national level was unlikely to be effective and that future SME policy work should focus on working with bupati to create appropriate institutions and a regulatory environment conducive for business. In the context of these broad policy issues, the question remains: can the Jepara success story be generalised and reproduced for other clusters of SMEs in Indonesia? From the case study, it is clear that buyers play an important role in introducing new technology, design, market information and quality control. They are also able to readily identify and link up with clusters of furniture makers. Moreover, furniture makers are competitive, especially after the devaluation of the rupiah. We indicated above that other SME exporters generally exhibit characteristics similar to those of our case study. Sandee and Ibrahim (2002) found that exporters were mostly concentrated in wood products, textiles, garments and footwear, and that these were normally found in clusters. Thus, we postulate that there are other export-oriented clusters in Indonesia that exhibit similar characteristics to those of Jepara. This is supported by the evidence of Cole (1998) from the Bali garment sector. Foreign buyers have played an important role in introducing new technology, design, market information and quality control to Bali’s small-scale garment manufacturers. They have also been able to link up with clusters, and garment manufacturing has become more competitive since devaluation. Other examples of the important role of buyers are the Bandung footwear cluster and Jakarta’s garment clusters. This shows that Jepara is not unique and that there are other clusters in which foreign buyers play a pivotal role. A closer examination of these export clusters illustrates that direct policy interventions have not played a crucial role in enabling SMEs to export or in encouraging linkages between entrepreneurs and foreign buyers. More significant influences are the historical development of clusters, natural resource endowments and overall macroeconomic settings.

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PART IV Key Issues in the Business Environment

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THE EFFECTS OF DECENTRALISATION ON BUSINESS IN INDONESIA Bambang Brodjonegoro

Indonesia has experienced positive economic growth since 1999 and there are signs of an economic recovery. Still, it is too early to conclude that economic growth is back on track, as most of the recovery so far has been generated by an expansion of private consumption of around 4–5 per cent annually. Investment, on the other hand, has experienced negative growth of between zero and –1 per cent. This pattern may be acceptable for a short period of time, but in the medium to long term it could lead to economic stagnation, high unemployment and social unrest. Given Indonesia’s stable macroeconomic conditions and huge market, a key question is why it has not succeeded in attracting more investment, especially foreign investment. In their dialogues with the government, existing and potential investors have mentioned various obstacles to investment, including security problems, lack of law enforcement and a high level of uncertainty. They also mention the ongoing process that will determine the shape of the country in the future: decentralisation. The question that then needs to be asked is whether decentralisation is a major factor contributing to Indonesia’s negative investment growth. Although it is easy to point the finger at decentralisation as an obstacle to incoming investment, the security, political and legal problems experienced in Indonesia in 2000–03 may have contributed more to the reluctance of investors to invest there. This chapter examines the effects on the business community, especially at the local level, of the implementation of decentralisation on 1 January 2001. Although it is difficult to exclude other factors affecting the investment climate, I will at least give information on how the current decentralisation process may have affected the local investment climate and what local governments could learn in seeking to make their regions more attractive to potential investors. The following section will discuss political, administrative and fiscal decentralisation. The next will present the results of surveys conducted during 125

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2001–02 among samples of local governments. The fourth section will discuss the ‘classical’ but forgotten conflict between the local budget (APBD) and the local economy (as represented by gross regional domestic product, or GRDP). Most local governments tend to focus more on the local budget and on defending their performance before the local legislature, the most powerful body at the local level. Because of this overemphasis on the budget, the target of GRDP growth and job generation receives little attention. Consequently, local governments consider investment promotion to be a low priority. OVERVIEW OF DECENTRALISATION Decentralisation is usually viewed as a multidimensional policy in which many factors affect each other. However, it may also lend itself to being described in a sequential way, with political decentralisation as the first stage of the process, followed by administrative and then fiscal decentralisation. In Indonesia, Law No. 22/1999 provides the basis for political and administrative decentralisation, and Law No. 25/1999 the basis for fiscal decentralisation. Implicitly, funding should follow the decentralisation of government functions; that is, Law No. 25/1999 should provide the financial resources for the implementation of Law No. 22/1999. However, the Indonesian government put some legal instruments in place to provide rules and regulations for local executives and legislatures even before the enactment of Law No. 22/1999. Hence, in Indonesia’s case, it appears that decentralisation has largely been a sequential process, with some unavoidable overlap in the sequencing of the stages. A notable characteristic of Indonesian decentralisation is the devolution of power and authority from the central government to the second tier of local government, the districts (kabupaten) and municipalities (kota). This is a drastic change given Indonesia’s previously very centralised, strong government. In principle the idea fits the main purpose of any decentralisation process: to bring government closer to the people. However, the lack of suitable skilled officials at the local level and the immaturity of the democratisation process itself have the potential to disrupt the early stage of decentralisation. One component that has been missing from the political decentralisation process has been direct elections for both the legislature and the executive. Under the present system of indirect elections, there is no incentive for legislators and local officials to be accountable to local voters, increasing the potential for collusion between executive and legislature. The legislature, meanwhile, has become the most powerful institution in local government; it is basically responsible for all decisions, including the ratification of local regulations (peraturan daerah). Fortunately, the new political laws to be applied in 2004 have

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accommodated these concerns, and the next general election will mark the beginning of direct elections for all local officials. On the administrative side of decentralisation, the power shift from central to local government has significantly reduced the role (and size) of the former. With only five areas of authority retained at the central level (defence and security, foreign policy, monetary and fiscal policy, judicial affairs and religious affairs), the central government has had to drastically reduce its so-called deconcentration function and, subsequently, the number of its local branches. The deconcentrated units of central ministries – except those with specific, ‘traditional’ national responsibilities – have been transferred to the provincial or local level as appropriate. This has led, for instance, to the transfer of about two million civil servants, most of them elementary school teachers, to the district level of government. The greater autonomy of local governments has broken down the hierarchical relationship between the districts and the provinces. Local government heads now report to locally elected assemblies rather than to the provincial governor. Provincial governments continue to report to the central government. Thus under the new decentralisation scheme, the provincial level of government has a reduced role as the representative of central government and the coordinator of interdistrict affairs. Another striking (and risky) feature of Law No. 22/1999 is that it permits the formation and amalgamation of new provinces, districts and municipalities. Since 2001, five new provinces and 80 new districts and municipalities have come into being. Law No. 25/1999 on Fiscal Balance between the Central Government and the Regions focuses on fiscal decentralisation or, more explicitly, the intergovernmental fiscal system. Four categories of regional government revenue are now defined: own-source, Balancing Fund, regional loans and ‘other’. The most significant changes are those associated with the establishment of the Balancing Fund. They concern the introduction of the sharing of revenue derived from the exploitation of natural resources with regional governments – not surprising given the political pressure to do so – and the reorganisation of the transfer system. The old autonomous regional subsidies (SDO) and Presidential Instruction (Inpres) grants have been subsumed by general purpose grants administered through a General Allocation Fund (DAU), the total of which is set at 25 per cent of central government domestic revenue. From a political perspective, perhaps the most significant changes concern the sharing of revenue derived from natural resources (Table 8.1). In the distribution system there are obvious concessions to the place of origin: 15 per cent of oil revenue, 30 per cent of natural gas revenue and 40 per cent of reforestation fees are distributed to the regions compared with zero previously; and the regional share of licence fees from forestry enterprises has increased from 45

Source: Ford and Brodjonegoro (2004).

20% centre; 80% distributed equally among districts

20% centre; 16% provinces; 32% district of origin; 32% other districts in province of origin 20% centre; 80% distributed equally among districts

Continued, with new sharing arrangement favouring districts in province of origin Newly introduced Newly introduced

20% centre; 16% provinces; 32% district of origin; 32% other districts in province of origin 20% centre; 16% provinces; 64% districts

Continued, with new sharing arrangement favouring districts in province of origin Continued, with new sharing arrangement

128



85% centre; 3% province of origin 6% district of origin; 6% other districts in province of origin 70% centre; 6% province of origin 12% district of origin; 12% other districts in province of origin 60% centre; 40% regional governments of origin 20% centre; 16% provinces; 64% districts

New Sharing Arrangement

Assignment of share of revenue after tax deduction to regional governments Assignment of share of revenue after tax deduction to regional governments Regional government component integrated into specific grants Continued, with new sharing arrangement

Major Change

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55% centre; 30% provinces; 15% districts 30% centre; 70% regional governments 65% centre; 19% provinces; 16% districts 30% centre; 56% provinces; 14% districts –

100% centre

100% centre

100% centre

Old Sharing Arrangement

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Fishery enterprise fee (pungutan pengusahaan perikanan) Fee on fishery income (pungutan hasil perikanan)

Oil revenue (penerimaan negara dari pertambangan minyak bumi) Gas revenue (penerimaan negara dari pertambangan gas) Reforestation fee (dana reboisasi) Forestry enterprise licence fee (iuran hak pengusahaan hutan) Forestry production royalties (provinsi sumber daya hutan, formerly iuran hasil hutan) Mining land rent (iuran tetap sektor pertambangan) Mining royalties (iuran eksplotasi)

Revenue Source

Table 8.1 Changes in the Distribution of Natural Resource Revenue since Decentralisation

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per cent to 80 per cent. There has been a 10 per cent rise in the share of forestry production and mining royalties directed to regional governments, and a 45 per cent rise in mining land rents. New fishery enterprise fees are now shared 20:80 between the centre and the place of origin. Equally striking is the favourable distribution to the districts. Six per cent of oil revenue is given to the district of origin and 6 per cent is distributed among the other districts in the province of origin; 12 per cent of natural gas revenue goes to the district of origin and another 12 per cent to other districts in the province of origin; and 64 per cent of forestry enterprise licence fees go to the districts. This pattern prevails for all natural resource-based revenue, except the reforestation fee. Circumstances have changed since the first attempt to establish a decentralised system of government in Indonesia in 1950–51; understanding of and appreciation for intergovernmental instruments have increased substantially. Nevertheless, the situation today retains a flavour of the complex history of intergovernmental relations in Indonesia. The current reforms were born out of crisis and were hastily conceived; the legislation was written without clearly established objectives and with little consultation with, or involvement of, the public. The new fiscal law continues the reluctance to give local governments any meaningful ability to raise local revenue. This omission jeopardises a key benefit of decentralisation: to enforce the accountability of local governments to their constituencies. As long as local communities do not have to pay directly for the local public services they receive, they have little incentive to focus on the performance of their elected officials. The difficulties encountered in persuading the central government tax agency to transfer the property tax to the jurisdiction of local governments have only worsened this situation. The analytical underpinnings of key elements of the new intergovernmental fiscal system are also in question. For instance, the pool for the DAU was set at 25 per cent of general revenue, even though it was unclear whether this amount would be adequate or excessive. THE LOCAL BUSINESS CLIMATE The devolution of power to local governments implies that they will have greater opportunity to influence the local business climate. One area in which they can exercise this influence is the business licensing process, which has become the responsibility of local governments even though the central government still retains some significant powers. A positive approach to licensing could help to dispel some of the uncertainty surrounding the sudden, ‘big bang’ approach to decentralisation, leading to an improvement in the business climate.

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The number of firms that are established in a region, and how long they last, should provide an indication of the health of the local business climate. Of course, the economic potential of the region will also influence the outcome. However, business surveys conducted in 2001 and 2002 – since the start of decentralisation – indicate that potential investors place more emphasis on local regulations than on economic potential when making their investment decisions. Cost of Doing Business Survey

A preliminary impression of the local business climate is given by a survey on the cost of doing business (CODB) at the local level conducted by LPEM-FEUI in 2001 (LPEM-FEUI 2002). The survey covered 60 kabupaten/kota in 20 provinces. The emphasis was on the impact of decentralisation and regional autonomy on the CODB at the local level and on how local governments have prepared themselves to attract investment. In-depth interviews were conducted with local business people and government officials to collect the information. A major purpose of the survey was to complement the information on bribery at the local level that is implicitly recorded (but underestimated) in the annual industrial survey conducted by the Central Statistics Agency (BPS). As the implementation of decentralisation and regional autonomy proceeds, it will be interesting to see whether local bribery has become more destructive and, consequently, has reduced local economic competitiveness. The survey revealed that uncertainty in doing business locally has been increasing since 1999, that is, since well before the implementation of decentralisation. Political instability and security concerns were the main sources of this uncertainty. These have indirectly generated costs for companies, which have had to spend more on protection to compensate for the perceived inadequacy of the police. Local business people cited lack of law enforcement and labour problems as other concerns. Law enforcement was a problem even before the economic crisis; the current democratisation process, which significantly reduces the authority of government, has had little effect either for better or for worse. However, democratisation has tended to worsen the relationship between labour and management/owners. Many respondents felt that labour issues had become a significant obstacle to maintaining a good business climate and predicted that the situation would become critical if a solution were not found. The combination of problems cited above would certainly discourage investors from undertaking new investments or expanding their existing businesses in Indonesia. Beginning in 2001, regional autonomy and decentralisation became an additional problem for business, with business people not knowing what to expect with regard to local regulations and policies. On the positive side, most respon-

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dents expressed relief that the first year of decentralisation had passed without any serious effect on their business. Firms considered local fees and charges to pose a serious threat to business, with other items, such as licensing, environmental impact assessments and taxation, not regarded as a major concern. Most local business people expected that they would have to pay higher local taxes and fees eventually. Another potential addition to their production costs was the ‘extra’ cost of dealing with the local bureaucracy. Although the amounts involved may not prove to be significant, uncertainty was again perceived to be a problem, since even quite prominent local business people did not know exactly how much the ‘extra’ cost would amount to. Spatially, there was not much difference between Java and the rest of Indonesia (non-Java) in the impact of decentralisation on local business. The difference became more obvious when districts in the survey were classified by stage of development: developed, moderate and less developed. Local governments in developed regions (often in Java) tended to generate ‘policy surprises’ and issue regulations that disrupted the licensing process. Those in moderate regions (as in Sumatra) and in less developed regions (as in Eastern Indonesia) were thought to be uncooperative and had a tendency to issue additional fees, charges and taxes. Furthermore, their bureaucracies were considered to be obstructive to business. In terms of the sectoral impact of decentralisation, the agricultural sector is most at threat from additional fees and charges because of the prevalence of agricultural activities at the district level. Similarly, large and medium-sized companies are likely to be asked to pay more in additional fees and charges than smaller firms. The survey facilitated the calculation of a composite CODB index consisting of factors such as additional costs, the impact of regional autonomy, local government responses, security and infrastructure. The index provides an early indication of which of the 60 local governments in the sample are most supportive of business. The top 10 were clearly dominated by districts in Java, especially Central Java, with the district of Klaten at the top. Three districts outside Java were also in the top 10: Banjarmasin (in South Kalimantan), Gorontalo (in the new province of Gorontalo) and Badung (in Bali). Surprisingly, the bottom 10 were dominated by districts in West Java and Banten. Despite survey weaknesses, it was still surprising to see Batam, Manado, Tanggerang and Bandung among the bottom 10. As well as ranking the 60 local governments, the survey attempted to calculate the additional cost firms would incur as a result of the implementation of decentralisation. It found an additional cost of 6–12 per cent for firms in the agricultural sector, 9–12 per cent for firms in services and less than 9 per cent for manufacturing firms. The additional cost was generally lower in Java than outside Java; it could reach as high as 11 per cent of total production costs for

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firms outside Java, and about 9.7 per cent in Java. Costs related to the licensing process played a significant role in forming the overall additional cost, along with extra fees and charges. Interestingly, many firms did not regard the additional cost as an obstacle to doing business, since those who paid it received benefits in return in terms of local government services and attention. However, the fact that the additional cost was more of a burden for medium-sized (and small) companies than for larger ones raises doubts as to whether the government is serious about wanting to assist in the development of small and medium-sized enterprises (SMEs) as the backbone of the Indonesian economy. Regional Investment Attractiveness Survey

A regional investment attractiveness survey carried out by Regional Autonomy Watch (KPPOD) in 2002 focused on the rating (and ranking) of local governments in Indonesia based on the local investment climate (KPPOD 2003). KPPOD considered 134 local governments, of which 20 were selected as the survey sample. For the final rating (and ranking), KPPOD interviewers used a technique known as the analytical hierarchy process to obtain the perceptions of both national and local business people on a range of issues. This yielded a wealth of information beyond that used to rank the 20 local governments in the sample. The availability of such information can be expected to affect the future decisions of firms to invest in certain areas. Among five factors that might be expected to affect the local business climate, institutions emerged as the most important, followed by socio-political conditions, local economic potential, labour productivity and physical infrastructure. Since the survey was intended exclusively to assess the effects of decentralisation on the local business climate, this finding was not surprising; institutional factors include the performance of local governments in formulating local regulations, the consistency of regulations and local law enforcement. This result is somewhat consistent with the finding of the CODB survey that uncertainty surrounding laws and regulations at the local level – or what can be referred to as ‘policy surprises’ – was a major concern of business. The second factor, socio-political conditions, covers items such as local culture, security and political stability. A similar survey conducted in 2001 found that this was the most significant factor affecting the business climate, generally reflecting the series of security-related problems Indonesia had experienced in that year. The prominence of institutional and socio-political concerns suggests that regions with local governments that are relatively ‘mature’ and/or able to maintain social and political stability have a better chance of attracting investment than others. As with the CODB survey, the regions most favoured by business were located in Java, particularly the municipalities. Semarang city came top, fol-

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lowed by Balikpapan city (East Kalimantan) and Sawah Lunto city (West Sumatra). The highest-ranking district was Dairi (North Sumatra), followed by Bekasi (West Java) and Kendal (Central Java). The biggest discrepancy with the CODB survey result was the placing of Tanggerang and Batam cities among the top 10, whereas the CODB survey had placed them among the bottom 10. The 10 lowest-ranking local governments were dominated by less developed regions, especially in the Nusa Tenggara area. Bima (West Nusa Tenggara) was in last place, quite clearly because it had imposed an ‘export tax’ on agricultural products shipped outside the district. This internal trade barrier clearly counts as one of the institutional criteria that matter most to potential and existing investors. Most of the bottom 10 regions had similar problems in the form of internal trade barriers or excessive extra charges and fees. Since most of these problems have been generated by new local regulations, it is clear that the ability of local executives and legislatures to draft and approve local regulations has become a critical point in shaping the local business climate. In addition to rating the local business climate, the KPPOD survey asked a series of questions applying to certain sectors. It found that the manufacturing sector was the main victim of ‘extra’ fees and charges, some of them illegal. The plantation and mining sectors had specific problems related to local people and companies; firms in these two sectors were relatively vulnerable to local social conflicts. Furthermore, the central government was criticised as having failed to issue clear guidance and consistent policies in the mining sector, contributing to a decline in investment in the mining industry. The fisheries sector also suffered from a lack of government attention, while new levies imposed by local governments had certainly hurt local fishermen. A series of questions on new local regulations revealed that they had affected the inter-regional movement not only of goods, but also of people. In one Sumatran city, for example, a local government regulation imposed fees on local companies that hired workers from other areas. The intention was to use the revenue thus raised to train local workers. However, indirectly it has created a barrier to entry for all job-seekers from outside the city. Disruption of this type runs counter to one of the basic tenets of decentralisation, that local government decisions should not hinder the movement of people and goods. INVESTMENT VERSUS LOCAL BUDGET Given the survey results outlined above, it is not surprising that many regions have failed to attract and generate investment. Investment was not the most important expenditure component of GRDP in most provinces in 1996, and has tended to decline since the onset of the 1997–98 economic crisis. As Table 8.2 shows, investment has played an important role in generating economic activ-

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Table 8.2 Contribution of Expenditure Components to Total Provincial GRDP, 1996 and 2001 (%) Province

Private Government Consumption Expenditure

Investment

Net Exports

1996 2001 1996 2001 1996 2001 1996 2001

Nanggroe Aceh Darussalam North Sumatra West Sumatra Riau Jambi South Sumatra Bangka Belitung Bengkulu Lampung DKI Jakarta West Java Banten Central Java DI Yogyakarta East Java Bali West Kalimantan Central Kalimantan South Kalimantan East Kalimantan North Sulawesi Gorontalo Central Sulawesi South Sulawesi Southeast Sulawesi West Nusa Tenggara East Nusa Tenggara Maluku North Maluku Papua Indonesia

36.8 49.8 54.5 21.7 53.6 53.7 – 50.9 54.9 42.2 55.5 – 53.3 43.2 56.7 54.6 48.0 53.5 36.3 12.3 54.0 – 52.3 53.3 51.6 55.2 60.7 41.4 – 44.8 61.7

56.6 61.9 63.8 29.6 62.1 58.6 56.8 67.4 57.3 49.6 76.4 57.9 66.4 47.8 65.4 54.1 49.3 53.8 45.6 24.3 59.9 70.9 60.7 55.8 52.8 40.6 64.6 52.5 52.5 50.3 72.7

7.1 7.5 12.9 3.8 10.5 7.3 – 24.4 11.3 5.4 6.6 – 10.6 18.1 7.0 11.2 13.0 12.3 10.8 2.0 20.8 – 16.2 21.1 24.0 19.6 21.7 13.1 – 8.2 7.7

9.5 11.6 12.8 4.1 17.6 7.5 6.0 20.9 10.8 4.0 7.1 3.5 16.8 19.4 7.0 11.6 13.5 17.3 15.9 2.9 23.3 36.5 14.6 21.4 22.7 14.9 28.1 26.2 26.2 12.3 7.6

14.7 30.5 27.1 34.4 33.2 36.1 – 28.2 35.4 47.0 31.4 – 29.7 33.6 36.9 28.7 32.3 39.3 18.3 47.7 26.0 – 34.7 27.8 27.3 33.3 28.6 27.8 – 38.1 33.7

14.0 41.4 19.9 26.1 12.3 0.4 19.7 5.6 3.7 24.4 40.1 42.0 20.9 2.7 –0.6 35.1 2.7 –1.1 33.1 – 4.2 13.0 –3.8 –1.2 34.7 –1.8 –2.8 38.1 5.5 8.4 15.9 6.5 0.6 22.9 – 15.6 –0.6 6.4 17.5 34.8 5.1 –2.0 23.5 –0.6 4.1 17.5 5.5 16.9 32.8 6.7 4.5 32.9 –5.0 –4.1 20.8 34.6 17.7 20.2 37.9 52.6 25.1 –0.7 –8.3 36.8 – –44.2 21.1 –3.1 3.6 24.2 –2.1 –1.4 28.3 –2.9 –3.8 28.0 –8.0 16.6 55.9 –11.0 –48.6 6.1 17.7 15.2 6.1 – 15.2 41.0 9.0 –3.6 16.0 –3.1 3.8

DKI: Daerah Khusus Ibukota (Special Capital Region); DI: Daerah Istimewa (Special Region). Source: BPS (1997, 2002a).

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ity only in the provinces that are rich in natural resources, such as East Kalimantan, Riau and Papua, and in developed provinces such as Jakarta. Before the crisis, investment was the most important component in Jakarta’s expenditure on GRDP, at 47 per cent in 1996 compared with 42 per cent for private consumption. This changed after the crisis. In 2001, private consumption contributed almost 50 per cent of Jakarta’s expenditure on GRDP, while investment contributed 38 per cent. A similar story applies to East Kalimantan and Riau, where a decline in investment was offset by an increase in net exports (exports minus imports) in GRDP. In 2001 there was no single province in Indonesia relying on investment as the main component of expenditure on GRDP, whereas in 1996 two provinces (Jakarta and East Kalimantan) had depended heavily on investment. Of course, given that the policy of regional autonomy and decentralisation was introduced only in 2001, it cannot be blamed for this changing pattern; the general economic and political crisis was undoubtedly the main cause of the decrease in investment. Thus, with or without decentralisation, the figures for 2001 may not have been very different. The investment component of GRDP consists of private and government investment. An evaluation of the local business climate requires information on private investment, but BPS does not publish such data. The level of private investment could be estimated, by subtracting government investment from total investment. The only reliable data on local government investment are contained in the annual local government budget, the APBD. Central government investment is likely to be higher than local government investment because the central government continues to fund a significant number of local projects despite decentralisation. However, information on central government investment at the local level is not readily available, and it would be quite a challenge to collect such data since the projects are spread over various sectors/ ministries and often last several years. Without accurate data on private investment, it is very difficult to assess the local business climate before and after decentralisation. As briefly mentioned, a major concern for the local business community is the possibility of an increase in costs as a result of higher or additional fees and charges imposed by local governments. Local governments seek additional revenue from firms in their regions for two main reasons. First, they hope to increase the generally low proportion of locally derived revenue (PAD) in the local budget. And second, they lack incentives to promote regional macroeconomic growth and reduce local unemployment. The low proportion of own-source revenue is a result of the weak taxing power of local governments, as the tax base is still largely controlled by the central government. Transfers from the central government, especially by means of the DAU, clearly dominate the revenue of local governments, together with revenue sharing in the case of a few regions. Table 8.3 indicates that in 2002, PAD

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Table 8.3 Components of the Local Budget, 2002 (%) Share (%)

< 10 10–20 20–30 30–40 40–50 50–60 60–70 70–80 >80 Total

Budget OwnShared Shared Surplus source Tax Nonfrom Revenue Revenue tax Previous Revenue Year

83.7 11.5 4.0 0.9 0.0 0.0 0.0 0.0 0.0

100.0

87.1 10.9 1.4 0.3 0.0 0.3 0.0 0.0 0.0

100.0

89.4 9.7 0.9 0.0 0.0 0.0 0.0 0.0 0.0

100.0

86.0 4.9 2.6 3.4 2.0 1.1 0.0 0.0 0.0

100.0

General Allocation Fund

3.7 0.9 2.6 4.0 2.3 3.7 12.3 24.9 45.6

100.0

Routine DevelopExpenment diture Expenditure

4.9 0.0 0.9 2.3 6.3 9.5 22.1 31.5 22.6

100.0

10.9 16.6 31.5 22.1 9. 6.3 2.3 0.9 0.0

100.0

Source: Local government budget (APBD) for 2002, accessed at .

generated less than 10 per cent of the local budget for 87 per cent of local governments, and less than 20 per cent for 98 per cent of them. PAD comprised more than 50 per cent of the total budget for only 0.3 per cent of local governments, or literally only one local government, the district of Badung in Bali. Although every local government receives sufficient grants from the DAU to cover most of its fiscal gap (fiscal need minus fiscal capacity), the issue is not so much the total amount of the budget itself but the fact that dependence on central government transfers creates a degree of uncertainty in the cashflow management of local governments. The distribution of the DAU is relatively regular and certain, with one-twelfth of the total amount being transferred to local governments each month. But the experience with other transfers, especially shared non-tax revenue, has generated some distrust among local governments about the intentions of the central government. These transfers almost always arrive late, sometimes by as much as six months. This late disbursement affects local cashflow management. As a result, some local governments have a relatively high budget surplus that they carry over to the next fiscal year. Table 8.3 indicates that about 5 per cent of local governments have a budget surplus of 20–40 per cent of the total budget.

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Many local governments try hard to maximise their PAD, but their weak local taxing power makes this practically impossible. Local governments can impose only a limited number of local taxes, garnering relatively small amounts of revenue. In addition, most local governments do not really feel that they need to intensify their efforts to collect existing taxes, because they can rely on the DAU to finance their major needs. Hence, imposing new charges, levies and fees has become the preferred tool for local governments to generate additional revenue and ensure stable cashflow management. Unfortunately, local businesses are the easiest target for such additional charges. Footloose companies can avoid them by moving to another region, but this is not an option for firms in industries such as mining, forestry and plantations. It is not surprising, then, to find plantation companies in Sumatra complaining about the extra fees and levies. The second reason for the reliance on business as a source of revenue – the lack of incentives for local governments to promote growth – stems from a combination of the political and economic structure of local government and the relationship between the central and local governments. In the current relationship between local executive and legislature, the latter has become the more powerful party. Local executives are obliged to follow the guidance of the legislature, with evaluations of their performance based mainly on the size of the APBD and how it is allocated. It is very rare to hear a local legislature go further to scrutinise the effect of the APBD on local economic development and growth, and consequently on employment generation and the mitigation of local unemployment. In other words, it is the APBD that matters for both local legislatures and executives; GRDP is assumed to automatically follow national economic conditions. The lack of accountability of local elected officials under the present electoral system is another reason why local economic growth and unemployment are not perceived to be as important as increasing the size of the APBD. The central government has not helped the situation by retaining its decision-making power over some business licences. The existence of conflicts between decentralisation laws and laws affecting specific economic sectors suggests that some parts of the central government are reluctant to give up their authority. While it is true that the centre needs to have some control over the issue of business licences and investment approvals, excessive centralised control without the participation of local governments may not be conducive to a good local business climate. The failure of the New Order’s Integrated Economic Development Zones (Kapet) initiative, which offered significant fiscal incentives for firms to invest mainly in Eastern Indonesia, showed that a centralised and homogeneous investment policy would not work for the whole of Indonesia, with its great diversity of regions. To some extent, it has to be acknowledged that local governments are the best judges of how to attract investment.

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On the other hand, local governments should not equate the potential advantages of their region with a conducive local business climate. They need to treat local firms initially as partners in promoting local economic growth and generating new jobs, and eventually as potential sources of revenue, but in a non-distorting way. This has not been the case during the first two years of decentralisation. There have been many cases where local governments have tried to take control of state-owned enterprises (BUMN), or at least obtain a share of their revenue. The BUMN in the plantation sector have suffered the most from this unnecessary intervention. But the most disturbing case for the international business community was the reluctance of the West Sumatra provincial government to agree to the sale of a local cement plant, Semen Padang, to a foreign firm. Some local governments have even tried to gain control of private companies. For example, the divestment of a 51 per cent stake in Kaltim Prima Coal (KPC), as set out in a contract between KPC and the government of Indonesia, was upset by a dispute between two regional governments over which should be the preferred bidder for the company. The contract did not rank potential buyers, stating only that they must be Indonesian. When the central government withdrew from the bidding process due to a lack of funding, both the East Kalimantan provincial government and the East Kutai district government claimed that it should be the preferred bidder, despite the unwillingness of either to conduct due diligence as agreed in the initial contract between KPC and the government of Indonesia. The current tax system does not provide sufficient room for the creation of some types of fiscal incentives at the local level. The cause lies in the inability of local governments to impose direct taxes at the local level (except for vehicle taxes at the provincial level). Of course, local governments could use indirect local taxes as incentive instruments, but with their already low levels of own-source revenue (as shown in Table 8.3), it would be risky for them to sacrifice an existing revenue stream for something so full of uncertainty. Nevertheless, local governments could utilise their authority in business licensing more effectively as part of an incentive package for business. For instance, they could give incentives to local investors who spend a significant amount on training local workers, in the form of longer or even free licences, or longer or free land-use rights. The regulation that disrupts the interregional movement of people, mentioned earlier, would have a completely different effect if it were redrafted to allow every company that invested in local worker training to receive incentives in the form of a more attractive business licence or a reduced land rent. High-quality local regulations are the basic infrastructure facilitating a supportive business climate. From a legal point of view, local regulations are important in providing the practical details of laws, government regulations and

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presidential decrees. However, excessive regulation is not necessary, especially if the present laws and government regulations are already sufficiently clear. Another problem with the current drafting process is that local executives and legislatures use regulations to legalise a ‘high-cost economy’. This abuse can even extend to ignoring a central government veto or rejection of a local regulation. For instance, one district in West Java continues to collect an oil production tax despite a central government veto. Ray (2003a) has elaborated some of the problems related to local regulation formation in Indonesia, including poor problem identification, lack of consideration of alternatives to regulation, lack of effective review of local regulations and poor public participation. In the substance of the local regulations themselves, he has identified problems such as poor use of user charges (retribusi), trade distortions (such as internal trade tariffs and certificates of origin), failure to ensure competitive neutrality, and multiple taxation. To overcome these problems, he suggests a regulatory reform program that would include increasing the supervisory role of provinces, introducing economic incentives and sanctions, returning the ‘burden of proof’ to the regions and asking for regulatory impact statements. CONCLUDING REMARKS It is premature to single out the current decentralisation process as a major factor in the decline of investment in Indonesia; the economic and political crisis has contributed more to the lack of a good local business climate. Decentralisation has, however, increased uncertainty in doing business at the local level. The main concern of businesses is that additional fees and charges levied in distorting ways will raise their production costs. The two surveys on the local business climate discussed in this chapter clearly demonstrate this concern. The surveys found that the institutional factor, especially how local governments treat local firms, is a critical factor in the local business climate. Implicitly, this conclusion suggests that current business conditions in Indonesia are abnormal, with institutional and social factors still more important in investment decisions than economic potential. With no direct taxes at the local level and without the direct election of local officials, the current decentralisation scheme leaves little scope for local governments to create incentive packages for business. The transfer of property tax to the local jurisdiction will help in this respect. The system of direct elections for local officials to begin in 2004 will also support local governments in creating effective incentive packages. But local executives and legislatures still need to gain a greater appreciation of the importance of the local budget and the local economy, and their consequences for local welfare. If local governments

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find it difficult to create incentives, then they should at least avoid creating disincentives. The disincentives created during the first two years of decentralisation have mainly been in the form of poorly defined user charges and fees, and disruption to the interregional movement of people and goods. The most fundamental way to improve the local business climate is to improve the skills of local governments to draft local regulations, including clarifying the substance of the regulations themselves. Stronger monitoring and strict enforcement will be necessary to ensure that local regulations do not create a high-cost economy and internal trade barriers. The regulation makers should be able to demonstrate the impact of local regulations on society. In addition, local governments must respect legal decisions made in the past about the ownership of mining, forestry and plantation companies. If they want changes, then they will have to wait until the current contracts expire. Local governments also need to realise that many investors are footloose, and could move to another region if there is a decline in the competitiveness of the regions where they are currently located.

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POLITICAL ECONOMY OF PRIVATISATION OF STATE-OWNED ENTERPRISES IN INDONESIA Tony Prasetiantono

Together with fiscal austerity and market liberalisation, the privatisation of state-owned enterprises (SOEs) was one of three pillars of International Monetary Fund (IMF) advice given to governments of less developed countries throughout the 1980s and 1990s (Stiglitz 2002: 53). Privatisation involves the transfer of responsibilities from the public to the private sector. Proponents argue that it lowers costs, improves the quality of goods and services, increases consumer choice and results in the more efficient allocation of resources. However, Zinnes, Eilat and Sachs (2001: 146) found that economic performance gains come only from ‘deep’ privatisation.1 Hence, the success of a privatisation program will depend on the level of complementary reforms. Hill (2000a: 103–109) noted that until the early 1990s the aggregate performance of SOEs in Indonesia was poor, prompting calls for reform and reorganisation through the privatisation of SOEs. Semen Gresik, a cement company, was the first Indonesian SOE to be privatised. It was listed on the Jakarta Stock Exchange (JSE) in July 1991 after a successful initial public offering (IPO). This divestiture was followed by other privatisations, including that of Indosat (1995), Telkom (1995), Bank BNI (1996) and Timah (1996). All were relatively successful. The two profitable telecommunications SOEs, Indosat and Telkom, have even been listed on the New York Stock Exchange. Although most of the early cases of privatisation went smoothly, today the privatisation process is mired in controversy. The trouble began at the time the government sold a 14 per cent stake in Semen Gresik to strategic investor Cemex in September 1998, at the peak of the 1997–98 economic crisis. Several issues came to a head, making this Indonesia’s most complicated divestiture case so far. The size of the divestiture (which lowered the government holding in the company to 51 per cent), the low price obtained for the shares and the 141

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implications of the sale for some of the companies in the Gresik holding company, especially Semen Padang, led to strong opposition from the public, parliaments (both central and local) and local government. Although opinion is now divided, the partial divestiture of Telkom in 1995 can be considered a successful case in Indonesia’s privatisation program. The divestiture was accompanied by agreements with several leading international telecommunications companies to invest in five of seven regions in Indonesia. However, controversy surrounded the sale in 2002 of 42 per cent of Indosat to Singapore Telecom and Telemedia (STT), a subsidiary of the Temasek holding company, owned by the government of Singapore. The main issue in this case appeared to be widely shared nationalist sentiment that telecommunications was a strategic sector that should be controlled by the government. This chapter investigates the privatisations of Semen Gresik and Telkom. It seeks to answer the following questions. Has there been any improvement in the performance of these SOEs since their partial privatisation? What are the bottlenecks in the privatisation program? And who are the actors involved in the privatisation program, and what roles do they play? A BRIEF OVERVIEW OF INDONESIA’S STATE-OWNED ENTERPRISES Until 2001, most SOEs (103 out of 162, or 63 per cent) recorded very low rates of growth or even incurred losses. According to a classification developed by the Ministry of State Enterprises (2002: 12–13), only 13 SOEs recorded ‘high sustainable growth’ of revenue of over 18 per cent; 19 recorded ‘sustainable growth’ of 7–18 per cent and 10 recorded ‘low growth’ of less than 7 per cent. Table 9.1 shows that the net income (profit) of Indonesia’s 162 SOEs was only Rp 26 trillion in October 2003; their average return on assets (ROA) was a low 2.7 per cent. Despite the classical argument that SOEs play a role as ‘agents of development’ and have a ‘public service obligation’, proponents of privatisation often use this low level of net income to promote the privatisation program. Of the 162 SOEs, 124 (77 per cent) were involved in competitive industries, 12 (7 per cent) enjoyed a monopoly and 26 (16 per cent) were engaged in sectors with a mixed competitive, monopolistic and public service-oriented market structure. Examples of competitive markets are banking, construction, plantations and trade, while the airport service authority is a good example of a monopolistic market. Clearly, ROAs varied considerably across sectors, and were negative in several cases, including airlines, paper and steel production (Table 9.2).

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Table 9.1 A Summary of the Characteristics of State-owned Enterprises, October 2003 a Indicator

Amount

Total number Total assets (Rp billion) Total return on assets Total debt (Rp billion) Total equity (Rp billion) Net income (profit) (Rp billion) Contribution of dividends to government budget (Rp billion)

162 968,000 2.7 675,000 283,000 26,000 10,000

a Unlike Table 9.2, this table includes the giant state oil company Pertamina, which officially became an SOE in mid-2003 rather than a state company receiving special treatment (perusahaan negara). Source: Ministry of State Enterprises, as quoted in Koran Tempo (27 October 2003).

A CASE STUDY OF TELKOM Telkom and its predecessors have long been responsible for telephone services. In October 1995, Telkom entered into joint operation schemes (KSOs) with five privately owned joint venture companies to develop and manage five regional divisions (the ‘KSO divisions’). In all, Telkom has seven regional divisions: Division I (Sumatra), Division II (Jakarta and surrounding areas), Division III (West Java), Division IV (Central Java), Division V (East Java), Division VI (Kalimantan) and Division VII (Eastern Indonesia). Each of the five investors consisted of a consortium of Indonesian companies and at least one international telecommunications operator. The international companies involved were France Cable et Radio SA in Division I; U.S. West International BV (a subsidiary of AT&T) in Division III; Telstra Global Ltd in Division IV; NTT Corp. in Division VI; and Singapore Telecommunication International Pte Ltd in Division VII. Telkom continues to operate Divisions II and V, historically the most profitable divisions. In November 1995, the government sold about 20 per cent of Telkom through a global IPO. In December 1996 it sold an additional 388 million shares and in May 1999 it sold another 898 million shares. The government of Indonesia now owns 54.3 per cent of Telkom and private shareholders 45.7 per cent.

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Table 9.2 Performance of State-owned Enterprises by Sector, 2001 Sector 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

Number

Banking 5 Insurance 9 Finance 6 Construction 9 Construction consulting 5 Construction support 2 Propert appraisal 4 Other services 2 Hospitals 13 Ports 4 Shipping 4 Airports 2 Transportation 3 Logistics 3 Trade 5 Dredging 1 Pharmacies 3 Tourism 3 Industrial estates 7 Airlines 2 Dockyards 4 Plantations 15 Agriculture 2 Fisheries 4 Fertiliser 2 Forestry 6 Paper 2 Printing & publishing 4 Mining 3 Energy 4 Technology-based industries 5 Steel 3 Telecommunications 5 Defence 2 Cement 3 Textile & garments 2 Other 3

Total

161

Total Revenue (Rp billion)

Total Assets (Rp billion)

Return on Assets (%)

207,390

772,501

3.6

64,169 11,414 1,274 4,735 133 957 662 145 0 3,271 2,070 2,288 1,997 1,335 2,870 175 3,276 328 334 14,186 1,560 10,407 770 121 9,637 2,204 768 659 2,475 33,491 1,981 5,405 16,074 576 4,696 643 393

Source: Ministry of State Enterprises (2002: 10).

475,361 30,605 10,013 6,158 99 3,691 832 245 0 7,902 6,416 6,078 3,204 1,941 1,380 531 2,254 471 802 10,215 4,270 14,121 312 105 13,815 2,751 1,733 876 4,818 83,823 4,558 7,270 54,235 549 9,889 533 647

1.4 3.2 1.0 2.3 9.2 5.4 –12.7 11.4 – 14.2 1.8 14.0 1.2 2.4 3.3 –10.6 23.9 13.1 17.5 –0.1 3.1 3.6 –1.6 –8.0 8.7 3.8 –1.1 7.9 11.3 5.7 –1.0 –3.3 16.7 6.2 6.6 4.7 9.6

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The Telkom IPO was successful in capturing the enthusiasm of potential investors. In part this was because of the attractive conditions attached to the sale: the government granted monopoly rights to Telkom for the 10 years following the IPO. In addition, Telkom management reduced the company’s workforce from 42,170 employees in 1994 to 37,584 employees in 1995. Third, Telkom persuaded five prominent international firms in the telecommunications industry to invest in the company through KSOs. And finally, prominent financial advisers such as Goldman Sachs, Lehman Brothers, Merrill Lynch, SBC Warburg, Morgan Stanley and Salomon Brothers acted as international underwriters for the IPO.2 The first two factors were nothing new, but the third was an innovation. The government promoted the development of KSO agreements for at least two reasons. First, it anticipated that Telkom would use the capital invested by foreign partners to speed up the development of fixed lines. And second, it expected these prominent international firms to transfer their knowhow (expertise, knowledge, technology, and management) to their local consortia partners and to Telkom.3 Unfortunately, the expectations of both Telkom and the foreign investors proved to be overstretched. In the first year of the KSOs, Telkom was not able to meet the agreed target of adding two million fixed lines, while the transfer of knowledge and technology did not happen automatically. The two regional divisions without foreign investors (Jakarta and West Java) performed better than the KSO divisions. With the onset of the crisis of 1997–98, it became even more difficult for Telkom to meet the agreed targets for new fixed lines (Nasution 2002: 166–170).4 As a consequence, Telkom became embroiled in various disagreements with its foreign partners about meeting the quantitative targets, and about the low returns and strategic management of Telkom. There are two possible solutions to overcome such disputes between Telkom and its foreign partners. First, the high targets for new fixed lines could be lowered. And second, Telkom could buy out some of the KSO firms in the five regional divisions. In August 2003, Telkom and U.S. West did in fact agree to such a sale. Despite the disagreements between Telkom and its foreign partners, the performance of Telkom improved after privatisation. As Table 9.3 shows, net income grew by 66 per cent between 1995 and 1996, the number of lines in service (fixed lines) jumped by 27 per cent and the domestic call volume increased by 25 per cent. This success can be attributed to the fact that the privatisation was accompanied by a restructuring program and executed at a time when the Indonesian economy was performing well. The next step is for Telkom to meet the challenge of a new competitor, Indosat, in the domestic call market. In return for giving up its monopoly on domestic calls, from 2004 Telkom will be allowed to provide international calls,

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Table 9.3 Performance of Telkom, 1991–2002 Year

Net Income (Rp billion)

Total Employees (no.)

Lines in Service (× 1,000)

1991 1992 1993 1994 1995 a 1996 1997 1998 1999 2000 2001 2002

n.a. n.a. 500 794 906 1,503 1,152 1,168 2,172 3,010 4,250 8,345

39,520 39,298 39,048 42,170 37,584 37,644 37,974 38,117 37,983 37,705 37,422 34,678

1,276 1,548 1,863 2,462 3,290 4,186 4,982 5,571 6,080 6,662 7,218 7,750

Lines in Domestic Service Call Volume per 100 (billion Inhabitants pulses) 0.7 0.8 1.0 1.3 1.7 2.1 2.5 2.7 2.9 3.1 3.3 3.5

10.4 13.2 17.9 23.4 28.3 35.3 42.1 45.9 47.3 52.9 58.4 61.1

n.a.: not available. a Year of privatisation (14 November 1995). Source: Telkom Annual Report, 1995–2002.

on which Indosat has had a monopoly. The duopoly in both markets is expected to enhance competition. In an unprecedented move, the government has agreed to compensate both firms for the loss of their monopolies: it will pay Rp 478 billion to Telkom and Rp 178 billion to Indosat. A CASE STUDY OF SEMEN GRESIK

Indonesia’s cement industry has been dominated by SOEs since the nationalisation of Dutch private companies in 1957–58. As Table 9.4 shows, Indonesia currently has nine cement companies (Semen Gresik, Semen Padang, Semen Tonasa, Semen Cibinong, Indocement, Semen Andalas, Semen Bosowa, Semen Baturaha and Semen Kupang) with a total capacity of 48 million tonnes per year. Three are located in Sumatra, four in Java, and one each in Sulawesi and West Nusa Tenggara. Of these nine companies, five are fully or partially stateowned: Semen Padang, Semen Tonasa, Semen Gresik, Semen Baturaja and Semen Kupang.

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Table 9.4 Capacity and Ownership of Indonesian Cement Companies, 2003 Company

Capacity

Composition of Ownership

(thousand tons/year)

(%)

Semen Gresik Group (holding company) PT Semen Padang PT Semen Gresik PT Semen Tonasa

17,550

36.7

Government of Indonesia (51.01%); Cemex (Mexico) (25.53%); public (23.46%)

PT Semen Cibinong Narogong Cilacap

9,750 5,650 4,100

20.3

Holcim (Switzerland) (76%); public and creditors (24%)

15,650 10,600 2,600 2,450

32.7

Heidelberger (Germany) (61.7%); Government of Indonesia (16.9%); Mekar Perkasa (13.4%); public (8%)

PT Semen Andalas

1,400

2.9

Cementia Holding (Switzerland) (88%); International Finance Corporation (World Bank) (12%)

PT Semen Bosowa Maros

1,800

3.8

Bosowa Group (100%)

PT Semen Baturaja

1,250

2.5

Government of Indonesia (100%)

PT Semen Kupang

570

1.2

Government of Indonesia (100%)

47,970

100.0

Government of Indonesia (100%)

PT Indocement Citeurep Palimanan Tarjun

Total

5,870 8,200 3,480

Source: Indonesian Cement Association, Jakarta, 2004.

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Semen Gresik was the first SOE to be privatised. It was listed on the JSE in July 1991, with the company issuing 40 million shares. The aims of the divestiture were to raise capital for the construction of a new plant in Tuban with a capacity of 2.3 million tons and to give the public an opportunity to own shares in a well-run SOE. After the divestiture, the government retained 73.1 per cent of the company. In 1995, the government merged Semen Gresik, Semen Padang and Semen Tonasa under a new holding company (also called Semen Gresik) to enable them to compete more effectively with private firms, especially Indocement.5 It then issued another 444,864,000 new shares in the holding company. After this further divestiture, the government share of Semen Gresik dropped to 65 per cent. In September 1998, because of the need to cover its budget deficit, the Indonesian government sold 14 per cent of Semen Gresik to strategic investor Cemex of Mexico. The conditional sale and purchase agreement (CSPA) between Cemex and the government included a ‘put option’ that gave the government the option of selling its remaining 51 per cent stake in the company to Cemex by October 2001 (Cemex/GOI 1998). However, this put option was not exercised owing to the strong opposition of several groups, particularly local people in Padang and, to a lesser extent, Makassar, with support from members of the local and national parliaments. Thus currently, the government continues to hold 51 per cent of Semen Gresik, while Cemex owns 25.5 per cent6 and private investors hold 23.5 per cent. Opponents object to any further divestiture of Semen Gresik to Cemex for two reasons. First, Cemex paid only $1.38 per share for its stake in Semen Gresik, a level believed to be below fair value.7 Establishing the fair value of a company is always a tricky business, but Cemex confirmed in its annual report for 1998 that it had ‘purchased Indonesian assets at a favourable price for the company’ (p. 5).8 Second, although Cemex had acquired only 14 per cent of Semen Gresik, the CSPA gave it the right to appoint two members to the board of directors and two to the board of commissioners, including a vice-president – a powerful position – on each board. The CSPA also specified that all-important decisions required the joint approval of the president and vice-president of both boards.9 This part of the agreement is inconsistent with Indonesia’s Company Law of 1995. Article 3 says: ‘Company shareholders are not responsible for any loss of the company in a greater proportion than their shareholding’. Hence, as a minority shareholder, Cemex is responsible for no more than 26 per cent of any losses, although the company’s nominees hold powerful positions on each of the boards. Moreover, in 2000 the local people of Padang, supported by their local parliament and government, the management of Semen Padang and NGO activists,

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Table 9.5 Performance of Semen Gresik (Holding Company), 1996–2002 Year

1996 1997 1998 a 1999 2000 2001 2002 b

Sales Volume Net (thousand Sales tons) (Rp billion) 8,812 10,267 10,138 12,625 13,738 15,126 14,485

1,362 1,640 2,314 3,091 3,596 4,659 5,177

Net Return Income on Assets (Rp million) (%) 219,267 232,552 221,611 240,586 342,763 317,467 268,767

5.2 4.4 3.1 3.3 4.6 3.6 3.9

Return on Equity (%) 8.9 8.9 8.6 8.8 11.5 10.0 8.2

a Year of further privatisation (17 September 1998). b Figures for 2002 are provisional because they include data from the unaudited financial statements of Semen Padang. Source: Semen Gresik Tbk annual report (various issues).

began to demand the spin-off of Semen Padang from holding company Semen Gresik. They claimed that the acquisition of Semen Padang by Semen Gresik in 1995 was illegal because no government decree (PP) had been issued.10 After long and difficult negotiations, the government finally accepted the demand for a spin-off, calling an extraordinary general meeting of shareholders to establish a new management team at Semen Padang in May 2003. The new management team executed the spin-off during the rest of 2003. Cemex is opposed to the spin-off and is currently pursuing court action. Table 9.5 shows that in terms of sales volume, net sales and net income, Semen Gresik’s performance improved significantly following Cemex’s purchase of shares in 1998. An important reason is of course the gradual economic recovery that began in 1999. THE ACTORS INVOLVED IN PRIVATISATION This section generalises the roles played by the various groups involved in the privatisation program. In all, it is possible to identify at least nine major groups, each with their own interests and interacting in complex ways.

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Multilateral Agencies

Two powerful multilateral agencies, the IMF and the World Bank, were instrumental in speeding up the privatisation effort in Indonesia as part of the program of therapy to recover from the 1997–98 crisis. In order to qualify for financial support, the Indonesian government was required to submit regular Letters of Intent (LOIs) to the IMF. If it was satisfied with the accomplishments outlined in the LOIs, the IMF would then disburse its loans to Indonesia. Privatisation of SOEs was one of the policies that needed to be included in the LOIs. The IMF as well as the World Bank can therefore be regarded as ‘external pressure groups’ in the privatisation program. IMF Chief Representative in Jakarta David C.L. Nellor said recently that the IMF was not satisfied with the pace of privatisation in Indonesia.11 Somewhat inconsistently, he also claimed that the revenue target for privatisations of Rp 8 trillion in 2003 was too high, considering current constraints such as opposition from the public, an unattractive investment climate and a weak capital market worldwide. He argued that a more realistic target would be about Rp 5 trillion.12 Despite criticism of their post-crisis policies, both the IMF and the World Bank in Indonesia still believe that privatisation is the answer to reducing the budget deficit and increasing the efficiency of SOEs. Both expect the government to continue this program following Indonesia’s withdrawal from the IMF program at the end of 2003.13 The Government of Indonesia

Pressure from the IMF through the necessity to submit LOIs enhanced the government’s political will to privatise the SOEs.14 This commitment revealed itself, for instance, in former President Soeharto’s establishment of the Ministry of State Enterprises in March 1998 and the ongoing commitment to this cabinet post by Presidents Habibie, Abdurrahman Wahid and Megawati. The ministry coordinates the divestiture of both SOEs and the assets managed by the Indonesian Bank Restructuring Agency (IBRA).15 The government acknowledged that privatisation was necessary (but not always sufficient) to combat the inefficiency of SOEs and promote transparency, and also to prevent politicians and political parties using them as ‘cash cows’.16 In the case of Semen Padang, however, it ran into strong opposition from parliaments at both the national and local level and was forced to back down. Other SOEs have been offered for sale since without arousing the same controversy. Still, it remains to be seen whether the backdown in the case of Semen Padang was inspired by political opportunism in the face of the 2004 elections or by sincere reluctance to privatise the company and see it fall into foreign hands. Further efforts will be required to convince critics that the privatisation program is on track and that the economy benefits from it. The government can be

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expected to campaign harder against those who oppose privatisation by promoting a discourse on, and increasing understanding of, this issue. For instance, many critics do not appreciate that privatisation is occurring worldwide, even in centrally planned economies such as China and in countries with autocratic governments such as Saudi Arabia. Legislature

The political opponents of privatisation tend to base their arguments on nationalism and anti-foreign sentiment rather than economic factors such as efficiency.17 The government needs to convince a majority in the legislature to accept the need for privatisation, as each privatisation program must be approved by parliament. The legislature in turn should acknowledge that revenue from privatisation is a key source of income to minimise the budget deficit. No party has an overall majority in parliament. The ruling party, the Indonesian Democratic Party of Struggle (PDI-P), has 153 seats, Golkar 120, the United Development Party (PPP) 58, the People’s Awakening Party (PKB) 51 and the National Mandate Party (PAN) 34. Support from the ruling party alone is therefore not sufficient to speed up the privatisation program. To complicate matters further, even PDI-P members of parliament are not unified in support of the privatisation program, and opinion across the parliament is mixed. Proponents of privatisation are not always from the ruling party; opponents are not always from the other parties. Despite opposition, Law No. 19/2003 on state enterprises was approved by parliament and signed into law by President Megawati on 19 June 2003. Chapter 8 of the law regulates the restructuring of SOEs and the privatisation program. According to Article 76, an SOE can be privatised if (a) the industry is competitive and there are no barriers to entry and exit; and (b) the technology used in the industry is subject to rapid change, as is the case in the telecommunications industry. Article 77 specifies the cases in which an SOE cannot be privatised. These include a ban on privatisations in selected industries in which only SOEs are allowed to operate – such as defence and natural resources – and in situations where SOEs hold public service obligations. Foreign Investors

Foreign investors have snapped up large parcels of shares in partially privatised SOEs. Very few have encountered difficulties of the type faced by Cemex in its attempt to acquire a majority holding in Semen Gresik. Despite widespread lobbying of government officials and parliamentarians in Jakarta and West Sumatra, backed by a nationwide media campaign to persuade the Indonesian people that the sale would bolster the state budget and increase foreign investors’ con-

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fidence in Indonesia’s investment climate, Cemex has so far failed to persuade the government to give up its remaining 51 per cent stake in Semen Gresik. For Cemex, the urgency of the put option is clear. It needs it to become a majority shareholder, as it did with Rizal Cement in the Philippines, in order to maximise its role in the management of the Semen Gresik holding company. Understandably, then, it is opposed to the spin-off of Semen Padang from Semen Gresik. Cemex as a minority shareholder lodged an appeal with the International Centre for Settlement of Investment Disputes (ICSID) in Washington accusing the Indonesian government of violating the CSPA. However, even if the arbitrator decides in favour of Cemex, it may have no choice but to fall in line with the decision of the majority shareholder. Managers of SOEs

Some managers of SOEs agree with the privatisation program.18 Many of them believe that SOEs should be transparent and accountable, and that the best way to achieve this is through a public listing on the stock exchange. They tend to be cooperative and supportive of the government’s privatisation program, although they are naturally concerned that they may lose their jobs if their companies are privatised. Privatisation is not always accompanied by a large-scale turnover of management, however. For example, the new majority shareholder of Bank Niaga – a Malaysian consortium – did not replace the existing management team led by Peter B. Stok, saying it had performed well. Formally, managers of SOEs and members of the board of commissioners do not have the power to oppose the government’s privatisation decisions. Their best chance of retaining their positions in a newly privatised firm is simply to work hard and perform well. Local Government and Local Parliament

Any large SOE situated in an outlying area will have a significant impact on the economy of the surrounding region, where there are generally few other major providers of primary and secondary employment. This helps to explain the controversy surrounding the sale of Semen Padang as part of the Semen Gresik holding company. The government of West Sumatra opposed the inclusion of Semen Padang in the privatisation of Semen Gresik, arguing that it was a historical, cultural and economic icon in the region. Moreover, as a well-run company, there was no justification for disposing of it on economic grounds.19 Notably, the municipal government of Padang City did not oppose the privatisation of Semen Padang and, indeed, supported the put option. It argued that it could accept the presence of a foreign investor, as long as the company continued to contribute to the development of the city by paying taxes, hiring local

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employees and remaining involved in the development of the local community.20 However, the municipal government proved to be less influential than the provincial government and local demand for a spin-off predominated.21 Sadli (2001: 1) provides another point of view, pointing to the vested interests of local people (particularly the management and staff of the company and local bureaucrats) as a possible explanation for their opposition to the sale of the plant to Cemex. He suggests that some of them may have been concerned about the possibility of disclosure of their involvement in corruption, collusion and nepotism (KKN) after the takeover of Semen Padang by a foreign investor. The local parliament of South Sulawesi – where Semen Tonasa, another cement plant in the holding company, is located – also opposed any further divestiture of Semen Gresik.22 In February 2001, the governor asked President Abdurrahman to spin Semen Tonasa off from the Semen Gresik holding company, and the president apparently agreed to this request.23 However, local opposition was not as strong in South Sulawesi as in West Sumatra, for two reasons.24 First, Semen Tonasa has a relatively small capacity compared to Semen Padang. And second, unlike Semen Padang, Semen Tonasa is not the only major company in Makassar and the surrounding region. Industry Associations

The Chamber of Commerce and Industry (Kadin) supports privatisation for at least two reasons. First, it believes in competition and the market mechanism. It views privatisation as a vehicle to promote competition as it invites more players into an industry and encourages transparency and accountability. Second, some of its members are potential investors in the companies that are the subject of the privatisation program.25 The industry body representing the cement industry, the Indonesian Cement Association, is not opposed to the privatisation program as long as it does not disturb the market. Its main concern is to ensure the availability of its members’ products in the market. As long as there is no shortage of supply, the association has no preference regarding the nationality of investors.26 Trade Unions

Trade unions tend to oppose privatisations because they often involve lay-offs. As a trigger for strike action, however, privatisation is a relatively new concern of trade unions; throughout the 1990s, most strikes were about wages, annual bonuses, collective labour agreements, the formation of unions, social insurance and other working conditions, including dismissals (Manning 1998: 215). A major trade union-organised strike occurred in February 2003 in opposition to the divestiture of 42 per cent of Indosat to STT. Another strike in the

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same month involved Telkom. The company’s trade union wanted management and the government to cancel the plan to divest Telkomsel, Telkom’s most profitable subsidiary. The strike was unique in that it was organised not by Telkomsel’s trade union but by Telkom’s union, which had no direct relationship with Telkomsel. Public Opinion Leaders

After the fall of Soeharto, both President Habibie and President Abdurrahman consistently promoted freedom of speech and freedom of the press. This helped to create the present climate in which public opinion leaders can exert considerable influence on public policy. The postponement of the implementation of the put option over Semen Gresik provides a good example of how the media can influence public opinion and play a role in the privatisation program. Heavy media coverage of the issue placed strong pressure on the government to agree to the spin-off of Semen Padang. Of course such pressure can work both ways: the government and foreign investors may also attempt to mobilise public opinion to expedite privatisation. The transaction fee paid for the divestment of Indosat in 1995 was another issue that attracted the attention of domestic observers.27 The government earned Rp 5.2 trillion from the sale while the financial adviser earned a higher than usual ‘success fee’ of Rp 400 billion.28 The mass media and domestic observers have also expressed strong views about Indonesia’s relationship with the IMF. The Indonesia Bangkit group of economists, for instance, accused the IMF of dictating the terms of LOIs to the Indonesian government. They urged the government to end the IMF program, arguing that adherence to IMF plans had not brought about any significant economic improvement in Indonesia since the end of 1997 and that the government needed to design its own program of economic recovery.29 Summary

All the actors in the above nine groups interact on the basis of their beliefs and in pursuit of their own interests. It is not easy to reconcile their disparate views, indicating the complexity of the contentious cases in Indonesia’s privatisation program. Nevertheless, the privatisation program proceeded smoothly in the second half of 2003. Shares in the last three SOEs scheduled for privatisation in 2003 (Bank Mandiri, Bank BRI and Perusahaan Gas Negara) were divested through an IPO without complaint. This suggests that the privatisation process can be conducted without controversy as long as it is transparent. The wellestablished procedure of conducting an IPO is generally considered to be the most appropriate way to achieve such transparency.

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CONCLUSIONS Some aspects of Indonesia’s privatisation program are controversial. It is often hard to convince the Indonesian people that privatisation is more an economic issue than a political issue. Our discussion allows a few conclusions. All the privatisations in Indonesia so far have been partial divestments; as yet no SOE has been fully privatised. Privatisation through an IPO or rights issue in the capital market tends to be more acceptable to the public than a strategic sale. The divestment of Semen Gresik (1991), Indosat and Telkom (1995), Timah and Bank BNI (1996), and Bank Mandiri, Bank BRI and Perusahaan Gas Negara (2003) were all relatively successful in the sense that there was little opposition to the privatisation of these firms. Telkom’s privatisation through an IPO in 1995 attracted significant interest from potential investors. The privatisation was supported by three factors: the timing was correct because the economy was booming; the government offered some sweeteners; and telecommunications was one of the most attractive sectors. The privatisation of Semen Gresik through an IPO in 1991 was not controversial; neither was the acquisition of Semen Padang and Semen Tonasa by Semen Gresik in 1995. However, when the government sold shares to Cemex in 1998, controversy flared. The issue became convoluted, with the complications including nationalist sentiment, questions about the fairness of the price and terms and conditions of the sale as presented in the CSPA, and the fact that the 1995 acquisition lacked a sufficiently firm legal basis. In future, the government should promote its privatisation program through IPOs rather than strategic sales, to reduce unnecessarily controversy. Strategic sales are only appropriate when transparency in the privatisation process can be assured. NOTES 1 2

3 4

‘Deep’ privatisation refers to full rather than partial privatisation, accompanied by industrial policies such as deregulation. Some top domestic financial advisers were also involved, including Danareksa, Bahana and Jardine Fleming (see the 1995 prospectus and an interview with the former president of Telkom, Setyanto P. Santosa, in Eksekutif, No. 201, March 1996: 46–58). Author’s interviews with Setyanto P. Santosa, former President of Telkom, Jakarta, 17 July 2003; and Thomas Wijanarto, former Chair of the Business Development Telkom/privatisation task force, Bandung, 25 June 2003. Telkom’s current president, Kristiono, admitted this in an interview with the author in Jakarta on 17 June 2003.

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8

9 10

11 12 13 14

15

16 17 18

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Author’s interview with Martiono Hadianto, Director General of State Enterprises in the Ministry of Finance in 1995, Jakarta, 13 June 2003. Cemex acquired an additional 11.53 per cent stake in 1998–99 by buying shares on the JSE. This was more than the $1.21 per share offered by Switzerland’s Holderbank but nevertheless low in view of the undervaluation of the rupiah at the time, causing Asiaweek to call Semen Gresik ‘a low-cost manufacturer that turned a $80 million profit in 1997’ (Tesoro 1999: 26). The deal is equivalent to $47.50 per ton capacity. This is certainly far below the price paid for other new cement plants in the region of, for example, $152.86 in Vietnam (Nikon and Mitsubishi), $143.75 in the Philippines (Halla Eng), $120.83 in China (Lafarge), $170.29 in the Philippines (Alsons) and $187.50 in Bangladesh (Lafarge Surma) (Asia Cement, February, March and May 1998). Cemex itself acquired another plant, Rizal Cement in the Philippines, for $114.28 per ton capacity (Republika, 30 June 2003). Of course the undervaluation of the rupiah is one of the main reasons for the low price of Semen Gresik in US dollar terms. See point 10 on minority rights in Cemex/GOI (1998: 24–25). According to Martiono Hadianto, Director General of State Enterprises at the time, the government did prepare a legal document. However, before it could be implemented Martiono was dismissed by former President Soeharto because of a dispute between him and one of Telkom’s domestic underwriters, Makindo, a brokerage firm with close business links to the Soeharto family (author’s interview with Martiono Hadianto, Jakarta, 14 August 2003). Author’s interview with David C.L. Nellor, IMF Chief Representative in Jakarta, Jakarta, 19 June 2003. In fact, proceeds from privatisation reached Rp 7.3 trillion by the end of 2003. Author’s interview with Bert Hofman, Chief Economist at the World Bank in Jakarta, Jakarta, 24 July 2003. Privatisation of SOEs was explicitly mentioned as one of the programs that had to be implemented before the IMF would provide $400 million to strengthen Indonesia’s foreign exchange reserves. See, for instance, a letter by Ginandjar Kartasasmita, State Coordinating Minister for Economy, Finance and Industry, to Michel Camdessus, Managing Director of the IMF, dated 19 October 1998. There have been three Ministers for State Enterprises so far: Tanri Abeng (under President Soeharto and President Habibie), Laksamana Sukardi (under President Abdurrahman and President Megawati) and Rozy Munir (also under President Abdurrahman, replacing Laksamana Sukardi). Author’s interview with Laksamana Sukardi, Minister for State Enterprises, Jakarta, 21 May 2003. For instance, Amien Rais, Chair of the People’s Consultative Assembly (MPR), involved himself in the case of Indosat when he wrote a prologue to a book arguing against the divestment (BPAP 2003). Author’s interviews with Kristiono, President of Telkom (17 June 2003); Satriyo, President of Semen Gresik (2 June 2003); E.C.W. Neloe, President of Bank Mandiri (9 May 2003); Saifuddien Hasan, President of Bank BNI (30 July 2003); Rudjito, President of Bank BRI (18 June 2003); Widya Purnama, President of Indosat (21

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20 21

22 23 24 25 26 27 28

29

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May 2003); and Zaenal Soedjais, President of Pusri (holding company) (27 May 2003). See, for instance, the book by Zed, Chaniago and Jasmi (2001) describing the importance of Semen Padang to the local people. The governor of West Sumatra, Zainal Bakar, and the president of Semen Padang, Ikhdan Nizar, have also stressed the highly developed sense of belonging held by both local people and the company (author’s interviews, Padang, 2–3 July 2003). Author’s interview with Makmur Lubuk, Member of the Padang Municipal Parliament, Padang, 3 July 2003. Local newspapers exposed the struggle of the management for a spin-off during June–July 2003. See, for instance, the articles on the decision of the Minister for State Enterprises to establish a taskforce on the spin-off in Haluan (24 June 2003), Mimbar Minang (24 June 2003), Padang Ekspres (24 June 2003), Singgalang (24 June 2003) and the national daily Media Indonesia (25 June 2003). Kompas, 14 November 2001. Tempo, 16 September 2001: 22. Author’s interview with Satriyo, President of Semen Gresik, Gresik, 2 June 2003; and with Bacelius Ruru, Secretary of the Minister for State Enterprises, Jakarta, 8 May 2003. Author’s interview with Aburizal Bakrie, Chair of Kadin, Jakarta, 15 August 2003. Author’s interview with Supardjo, Chair of the Indonesian Cement Association, Jakarta, 13 August 2003. An NGO called Barisan Penyelamat Aset Bangsa (Front to Save the Nation’s Assets) has published a book discussing this controversy (BPAB 2003). In an interview with the author (Jakarta, 15 August 2003), Aburizal Bakrie, Chair of Kadin, disclosed that the normal fee for a financial adviser would usually be no more than 4 per cent of the transaction, in this case, Rp 224 billion. In an interview with Forum Keadilan, senior economist and observer Hartojo Wignjowijoto also commented that the transaction fee was certainly too high (23 February 2003: 80–84). In an interview, I Putu Gede Ary Suta, former Chair of IBRA and Bapepam, said that the IMF drew up the LOIs and the government of Indonesia simply signed them (Forum Keadilan, 9 March 2003: 80–84).

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CORPORATE OWNERSHIP AND MANAGEMENT IN INDONESIA: DOES IT CHANGE? Yuri Sato

It has been argued that the Asian economic crisis of 1997–98 can be attributed to the vulnerability of the corporate sector in Asian countries, especially the poor system of corporate governance that shielded corporations from market discipline (World Bank 1998). A series of papers generated by a research project supported by the World Bank has revealed that East Asian corporations were characterised by high leverage, concentrated ownership, a high level of ultimate control by a few families and expropriation of minority shareholders, and argued that these characteristics contributed to weak corporate governance and poor corporate performance (Claessens, Djankov and Lang 1999, 2000; Claessens, Djankov, Fan and Lang 1999a, 1999b). Empirical and theoretical study of corporate ownership and governance has evolved rapidly in recent years, coincidentally in the post-Asian crisis period after 1997.1 For example, La Porta, Lopez-de-Silanes and Shleifer (1999) provided evidence that concentrated ownership is common in modern corporations in developed countries around the world. Widely dispersed ownership, which some have taken as a modern standard in company organisation, is prevalent only in the United States and the United Kingdom. This suggests that concentrated corporate ownership does not necessarily imply weak corporate governance. This chapter re-examines the thesis that concentrated ownership and family control over management characterises Indonesian corporations. It also discusses whether corporate ownership and management patterns have changed since the crisis and whether they have affected corporate performance. I begin by explaining the data and classifications used in the study. Next, I examine ownership and management patterns and analyse how they affected corporate performance before and after the crisis. Finally, I summarise the findings of the study. 158

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DATA AND CLASSIFICATION OF OWNERSHIP This study uses data for public companies listed on the Jakarta Stock Exchange (JSE) and data compiled and published by the Institute for Economics and Financial Research (ECFIN). The JSE company data are the only published data that contain both financial statements and lists of shareholders and board members. This permits analysis of ownership and management structures and how they relate to the financial performance of the companies concerned. The database I used comprises two time-series data sets: a database of all publicly listed companies, and a database containing the top 100 publicly listed firms. This database can be used to indicate trends, though it is not entirely representative of Indonesian corporations because most state-owned enterprises (SOEs) and major foreign joint venture companies are not listed on Indonesia’s stock markets. In addition, many Indonesian business groups have opened only some of their companies to the public, so the database is inadequate for an analysis based on business groups. Nevertheless, the data can help us to grasp the trends for domestic private large capital in general. The database covered about 50 per cent of the largest 600 domestic private companies in terms of sales in 1998. The aggregate value of the annual sales of all listed companies remained constant at around 25 per cent of GDP throughout 1996–2000, although market capitalisation decreased by around 20 per cent after the crisis. This suggests that the data for listed firms are appropriate for tracing changes in the domestic private corporate sector. The database shows that the publicly listed companies demonstrate a marked concentration in scale. In 2000, the aggregate sales of the top 10 companies accounted for 39 per cent of sales, and those of the top 100 companies accounted for 89 per cent of sales of all 305 listed companies. I have therefore used the data on the top 100 listed companies to analyse the characteristics of the largest group of domestic private firms. Classification of Ownership

I classify Indonesian corporate ownership into five groups: family/individual, Indonesian corporation, foreign, state and widely held. This classification is broadly similar to those of Claessens, Djankov and Lang (1999) and Suehiro (2001), but differs in some important respects discussed below. Claessens, Djankov and Lang (1999) classified corporations into two broad groups: widely held corporations and corporations with ultimate controlling owners. Widely held corporations were those in which none of the owners had a significant control right. Corporations with ultimate owners were those in which certain shareholders – those controlling 10, 20, 30 or 40 per cent of vot-

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ing rights, depending on the cut-off point – could be traced in the chain of ownership. Claessens, Djankov and Lang (1999: 8) further divided ultimate owners into families, widely held corporations, widely held financial institutions and the state. I have not retained the financial institution classification, because in Indonesia there are very few companies in which a widely held financial institution is the largest shareholder. Instead, I have incorporated the foreign ownership category used by Suehiro (2001) in his work on Thailand. In Indonesia, this is as important as the ‘state’ category when comparing performance with domestic private corporations. Moreover, I do not use the ultimate owner approach of Claessens, Djankov and Lang (1999), because it is difficult to trace the complete chain of shareholdings of all listed companies in Indonesia to find who has the highest level of voting rights.2 Rather, my classification is based on a shareholding ratio (shares owned by a shareholder as a percentage of total shares in the company) of more than 20 or 40 per cent, depending on the cut-off level. Table 10.1 summarises my classification and compares it to that of Claessens, Djankov and Lang (1999). My ‘family /individual’ classification is broader than their ‘family’ category in that it includes corporations controlled by a single family, a single individual, more than one family or more than one individual. Moreover, I calculated the total shareholding ratio of the same families or individuals, aggregating their shares under both their personal names and those of the corporations controlled by them. My ‘Indonesian corporation’ classification refers to a single Indonesian corporation that is not controlled by a founding family or individuals but whose shares are dispersed among several investors. An example is PT Astra International. Subsidiary companies of PT Astra International are placed in the ‘Indonesian corporation’ category, while PT Astra International itself is placed in the ‘widely held’ category. Table 10.1 also shows which of my five categories can be regarded as indicating ‘concentrated ownership’. Companies in the family/individual, Indonesian corporation, foreign and state classifications have controlling shareholders. My ‘widely held’ category indicates dispersed ownership. However, the term is not used in the same way in Indonesia as in Anglo-American countries. In the Anglo-American context, it is used in the sense of dispersed ownership, where atomistic shareholders acquire shares through market portfolio investment. In Indonesia, it may mean that several families or individuals may together hold a majority of the shares. For example, at the 20 per cent cut-off level, no shareholder may hold more than 20 per cent of shares but three or four different families and/or individuals may each hold 15 per cent of total shares. Because of this, I further classify the ‘family/individual’ and ‘widely dispersed’ groups as ‘family/individual ownership’ and the ‘Indonesian corporation’, ‘foreign’ and ‘state’ classifications as ‘non-family/individual ownership’.

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Table 10.1 Classification of Corporate Ownership World Bank Study a Ultimate owner Family Widely held corporation Widely held financial institution State Widely held

Author’s Study Shareholding more than 20% or 40% b Family/ individual Indonesian corporation Foreign

Concentration of Ownership

Type of Ownership

Concentrated

Family/ individual Non-family/ individual Non-family/ individual

Concentrated Concentrated

State

Concentrated

Widely held

Dispersed

Non-family/ individual Family/ individual

a Claessens, Djankov and Lang (1999). b Depending on the cut-off level.

OWNERSHIP Table 10.2 shows ownership patterns of Indonesian listed companies for 1996. In my study, 78 of the top 100 companies were in the family/individual ownership category at the 20 per cent cut-off level, and 70 at the 40 per cent cut-off level. Claessens, Djankov and Lang (1999) found a lower level of family/ individual ownership, especially at the 40 per cent cut-off level. There are two possible reasons for this difference. One is that I adopted a wider definition of family/individual ownership (see above). The other, more important, reason is the way in which I calculated aggregate shares held by the same family/ individual in order to reflect the actualities of ownership. As explained above, I did not automatically classify a corporation in which no shareholder holds more than 40 per cent as a ‘widely held’ corporation. Rather, at the 40 per cent cut-off level, for example, I classified it as a ‘family/individual’ corporation if two shareholder companies owned by the same family/individual each had a 20 per cent shareholding. My results clearly show that in 1996 large Indonesian

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Table 10.2 Ownership of Listed Companies in Indonesia Ownership Pattern

Cut-off level 20% Concentrated ownership Family/individual Indonesian corporation Foreign State Subtotal Widely held Mixed Private c plus state Private c plus foreign Total Cut-off level 40% Concentrated ownership Family/individual Indonesian corporation Foreign State Subtotal Widely held Mixed Private c plus state Private c plus foreign Total n.a.: not applicable a Data for 178 companies. b Data for top 100 companies. c Private = family/individual.

World Bank Study a 1996 (%)

Author’s Study b All

Financial

All

Financial

71.5 15.2 n.a. 8.2 94.9 5.1

78 3 8 5 94 2

20 0 0 1 21 0

58 5 13 14 90 4

3 0 0 8 11 0

n.a. n.a. 100.0

1 3 100

0 0 21

3 3 100

0 0 11

35.4 7.3 n.a. 5.6 48.3 51.7

70 2 9 5 86 13

14 0 0 1 15 6

49 5 13 16 83 17

2 0 0 8 10 1

n.a. n.a. 100.0

0 1 100

0 0 21

0 0 100

0 0 11

1996

2000

Source: World Bank data from Claessens, Djankov and Lang (1999: 30); author’s data from ECFIN (various years) and CISI Raya Utama (1999).

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listed companies had a highly concentrated ownership, with most being under family/individual ownership. After the crisis, family/individual ownership fell and state and foreign ownership rose (Table 10.2). Of the 100 companies analysed, family/individual ownership decreased between 1996 and 2000, from 78 to 58 at the 20 per cent cut-off level and from 70 to 49 at the 40 per cent cut-off level. In contrast, state and foreign ownership combined rose from 13 to 27 at the 20 per cent cut-off level and from 14 to 29 at the 40 per cent cut-off level. The rise in state ownership in the financial sector (from one to eight at both the 20 per cent and 40 per cent cut-off levels) is particularly conspicuous; it is a result of government capital injection and the nationalisation of leading banks.3 However, the shift from domestic private to state and foreign ownership took place among firms with concentrated ownership. Even at the 40 per cent cut-off level, concentrated ownership remains dominant. There was no tendency for ownership to become more dispersed after the crisis. In 1996, of the 100 largest publicly listed companies, more than 85 had concentrated ownership at the 40 per cent cut-off level (Table 10.2); of these, more than 70 were family/individual owned. In 2000, more than 80 companies still had concentrated ownership, and around 50 were still owned by a family/individual. The number of companies with dispersed ownership increased from two to four at the 20 per cent cut-off level and from 13 to 17 at the 40 per cent cut-off level, but these firms remained a minority. This result contrasts with that of Claessens, Djankov and Lang (1999), who found that dispersed ownership accounted for 52 per cent of companies at the 40 per cent cut-off level. However, my result is consistent with the fact that the average shareholding ratio of the single largest shareholder in the top 100 companies increased from 51 per cent in 1996 to 55 per cent in 2000. Table 10.3 focuses on family/individual versus non-family/individual ownership, examining the shareholding composition of each ownership group in 1996 and 2000. It reveals that family/individual shareholding ratios among family/individual-owned companies decreased from 50 per cent in 1996 to 46 per cent in 2000. In particular, the share of group-affiliated companies showed a relatively large decrease, from 56 per cent to 49 per cent. Foreign investment companies and the public, meanwhile, greatly increased their shareholdings in these companies, particularly the group-affiliated ones. By contrast, the ratio of controlling shareholders in non-family/individual ownership companies (the Indonesian corporation, foreign and state categories) rose. MANAGEMENT

Indonesian corporations use a two-tier system of management inherited from the Dutch Commercial Code.4 The two tiers are the dewan komisaris (board of

100

37.7

52.8 b 0.0 0.0

3 10 5 2.0

0.0 53.1 0.0

0.0 12.3 0.0 8.0

0.4 0.0 0.0 0.3

7.9 23.3 0.6 10.3

Foreign

14.7

0.0 0.0 66.6

0.0 0.0 0.0 0.0

State

Foreign

3.7

18.1 3.4 0.0

3.5 4.3 22.4 4.6

0.1

0.0 0.3 0.0

0.2 0.0 0.2 0.2

0.8

0.0 11.1 0.0

0.0 0.1 8.1 0.5

0.9

0.0 2.5 0.0

1.1 1.3 0.3 1.1

Corpo- Invest- Corpo- Investration ment ration ment Co. Co.

Private

Secondary Shareholder

1.2

0.0 0.2 0.0

2.0 0.1 0.0 1.6

0.6

0.0 0.0 0.0

1.1 0.1 0.2 0.8

30.3

29.1 17.3 33.4

28.1 29.8 57.9 30.0

100

100 100 100

100 100 100 100

Cooper- Public Total ative/ State Managers

164

Total

Non-family/ individual Indonesian corporation Foreign State

55.5 40.7 10.4 50.4

Family/ Coindivi- founder dual

Private

Controlling Shareholder

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54 26 2 82

No. of Companies

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1996 Family/ individual Group Non-group Widely held Subtotal

Ownership Pattern

Table 10.3 Change of Ownership Structure of Top 100 Listed Companies in Indonesia, 1996 and 2000 a

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25.9

5.7

5.7

0.0 54.2 0.0 31.7

0.0 0.0 86.7 c

0.0 0.0 0.0 0.0

1.0

2.3 2.8 0.5

0.8 1.8 0.0 1.0

0.1

0.0 0.5 0.0

0.0 0.0 0.0 0.0

1.9

0.0 12.4 1.4

0.1 0.4 0.0 0.1

2.9

3.0 2.5 0.0

5.3 3.7 0.0 5.0

0.2

0.0 0.0 0.0

0.5 0.0 0.0 0.4

0.1

0.0 0.0 0.0

0.3 0.0 0.1 0.2

25.0

19.7 24.0 9.2

38.0 29.6 89.6 36.6

100

100 100 100

100 100 100 100

Source: Compiled from ECFIN (various years).

a Percentages are calculated by aggregating each company’s equity capital value multiplied by shareholding composition ratios, and divided by the total value of equity capital. Ownership classification here differs from Table 10.2, as ‘mixed’ ownership is converted to family/ individual, state or foreign according to the largest shareholder, and ‘widely held’ is converted to foreign when the largest shareholder is a foreign company. b Owned by dispersed Indonesian corporations, not by family/individual. c Of this, 37.5 per cent is temporary state ownership (capital injection or nationalisation) or state (IBRA) control of assets.

100

2.3 3.1 0.0

72.8 b 0.5 2.3

5 17 16

0.3 0.6 0.0 0.3

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Total

6.1 28.8 4.2 10.4

48.7 35.1 6.1 45.9

37 24 1 62

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Non-family/ individual Indonesian corporation Foreign State

2000 Family/ individual Group Non-group Widely held Subtotal

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commissioners) and the direksi (directors). The board of commissioners has authority to supervise all the tasks of directors. The general meeting of shareholders appoints all members of the two managerial groups. Table 10.4 shows the composition of boards of commissioners and directors. Again, I present data for companies in family/individual ownership and non-family/individual ownership. The focus is on the percentage of members who are both shareholders and board members, the so-called owner–managers. I examined all commissioners and directors for 1996 and 2000 (1,916 people), judged whether they were shareholders or not, judged whether they were controlling family/individuals or not, and classified them by each ownership pattern. For companies under family/individual ownership in 1996, shareholder– managers accounted for 56 per cent of boards of commissioners and 34 per cent of boards of directors. This is considered to be a high level – as high as in Thailand (Suehiro 2001) and much higher than in South Korea (NANAM 1999).5 However, in Indonesia the high level of shareholder–commissioners is not unique to companies under family/individual ownership but is a more general phenomenon. Indeed, levels are higher in companies in the ‘widely held’, nonfamily/individual ‘Indonesian corporation’ and ‘foreign’ categories than in the ‘family/individual’ category. This indicates that boards of commissioners generally function as representatives of controlling shareholders. Between 1996 and 2000, the proportion of shareholder–commissioners decreased from 55 per cent to 38 per cent. The decrease was particularly marked for family/individual shareholder–commissioners (from 41 per cent to 25 per cent). Among group-affiliated companies, there was also a decrease in shareholder–directors from 35 per cent in 1996 to 29 per cent in 2000. These changes suggest that, at least in their publicly disclosed affiliated companies, owners of large business groups tended to withdraw from managerial posts after the crisis. However, this trend does not necessarily apply to companies under family/individual ownership in general. In fact, between 1996 and 2000, in the non-group-affiliated companies there was a sharp increase in shareholder–directors from 37 per cent to 41 per cent, and an increase from 23 per cent to 35 per cent for family/individual shareholders. In other words, the shareholders of non-group-affiliated companies have strengthened their grip on daily management. There has also been a quasi-separation of ownership and management among companies owned by Indonesian corporations. From 1996 to 2000, the proportion of shareholder–commissioners rose from 58 per cent to 66 per cent, while that of shareholder–directors decreased from 24 per cent to 0 per cent (Table 10.4). This occurred because shareholding corporations such as PT Astra International increased their membership on boards of commissioners but with-

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drew members acting as directors, leaving daily management to professionals at each affiliated company level. This situation can be characterised as a type of headquarter governance through a board of commissioners, where the board of commissioners represents the interests of shareholders and the directors are completely separated from shareholders. CORPORATE PERFORMANCE I now examine how the ownership–management patterns of large Indonesian corporations discussed above relate to corporate performance. I test the assumption that companies with concentrated ownership or family ownership without separation from management perform less well than those that are widely held, are owned by non-family shareholders or have management separated from ownership. This assumption is based on the view that concentrated family ownership has costs, because ‘it may lead controlling owners to expropriate other investors and stakeholders, pursue personal non-profit-maximising objectives, impede the development of professional managers’ (World Bank 1998: 60) and consequently lead to poor economic performance.6 I use four indicators to measure corporate performance: the current ratio (CR, the ratio of current assets to current liabilities) as a measurement of a firm’s short-term solvency, the debt– equity (D/E) ratio as a measurement of leverage, and the return on assets (ROA) and return on equity (ROE) as a measurement of profitability. I calculate the indicators for 1996–2000 for each ownership category. Table 10.5 shows the results. Throughout 1996–2000, companies in the state ownership category7 performed best in terms of all four indicators, with high CRs, low D/E ratios and high ROAs and ROEs. Companies in the foreign ownership category showed the second best performance. Both types of company performed better in terms of profitability before the crisis and in terms of all indicators after the crisis. The difference between these two and the family/ individual categories is statistically significant, except for D/E ratios for the foreign category. There are three other categories of domestic private corporations: family/individual, Indonesian corporation and widely held. Of these, family/ individual companies and widely held companies had the poorest ROAs. However, companies in the family/individual category performed relatively better than Indonesian corporations as indicated by liquidity (CR) and post-crisis debt management (D/E ratio) and performed better than widely held companies as indicated by ROEs after the crisis. The difference between the three categories is not statistically significant (Table 10.6). It is thus hard to argue that family/ individual ownership resulted in a poor performance by domestic private companies.

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Table 10.4 Board Members of Indonesian Companies, 1996 and 2000 (%) a No. Shareholder Non-shareholder Total of Compa- Family/ CoSub- Private b Govt Subnies Indivi- founder total Officials c total dual Partner Board of Commissioners 1996 Family/ individual 54 41.0 Group Non-group 26 46.1 Widely held 2 29.8 Subtotal 82 43.6 Non-family/ individual Indonesian corporation 3 44.3 Foreign 10 78.3 2000 Family/ individual Group Non-group Widely held Subtotal Non-family/ individual Indonesian corporation d Foreign

14.0 7.2 57.7 12.4

55.0 53.3 87.5 56.0

41.4 43.5 0.0 40.2

3.7 3.2 12.5 3.7

45.0 46.7 12.5 44.0

100 100 100 100

14.1 0.0

58.4 78.3

40.1 18.0

1.4 3.7

41.6 21.7

100 100

37 24 1 62

25.0 36.7 50.0 30.0

12.6 10.9 0.0 11.7

37.6 47.6 50.0 41.7

57.2 48.2 50.0 53.6

5.1 4.2 0.0 4.7

62.4 52.4 50.0 58.3

100 100 100 100

5 17

60.6 43.3

5.7 18.6

66.3 61.9

33.7 38.1

0.0 0.0

33.7 38.1

100 100

a Percentages are calculated by the number of posts weighted by 3 for president, 2 for vice-president and 1 for other board members, and divided by the total weighted value of the posts. b Non-shareholder ‘private’ includes both outsiders and insiders in the company concerned.

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Table 10.4 (continued) No. Shareholder Non-shareholder Total of Compa- Family/ CoSub- Private b Govt Subnies Indivi- founder total Officials c total dual Partner Board of Directors 1996 Family/ individual Group 54 Non-group 26 Widely held 2 Subtotal 82 Non-family/ individual Indonesian 3 corporation Foreign 10 2000 Family/ individual Group Non-group Widely held Subtotal Non-family/ individual Indonesian corporation d Foreign

0.4 65.5 0.0 63.5 0.0 100.0 0.3 65.7

100 100 100 100

0.0 0.0

76.1 44.8

100 100

70.1 59.1 100.0 66.3

1.5 71.5 0.0 59.1 0.0 100.0 0.9 67.2

100 100 100 100

100.0 54.3

0.0 100.0 0.0 54.3

100 100

26.7 22.8 0.0 24.8

7.8 13.8 0.0 9.5

34.5 36.5 0.0 34.3

65.1 63.5 100.0 65.5

23.9 41.6

0.0 13.6

23.9 55.2

76.1 44.8

37 24 1 62

23.9 35.1 0.0 27.8

4.6 5.8 0.0 5.0

28.5 40.9 0.0 32.8

5 17

0.0 38.1

0.0 7.6

0.0 45.7

c Non-shareholder ‘government officials’ include former ministers, bureaucrats, managers of stated-owned enterprises and military officers. d In the Indonesian corporation category, the Indonesian corporation is the controlling shareholder. Shareholder–commissioners and shareholder–directors in this category mean those who are board members of the Indonesian corporation and concurrently hold managerial posts in the affiliated companies. Source: ECFIN (various years); CISI Raya Utama (1990, 1999); various sources of background information.

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Table 10.5 Correlation of Ownership Patterns and Economic Performance of Listed Non-financial Companies, 1996–2000 a No.

1996

1997

1998

1999

2000

t-value

Current ratio of assets to liabilities Family/individual 175 Indonesian corporation 6 Widely held 9 State 6 Foreign 30 Total 226

1.56 0.96 1.72 1.05 1.24 1.50

1.05 0.95 1.18 1.37 1.22 1.10

0.77 0.65 1.25 1.86 1.10 0.83

0.77 0.63 1.31 2.20 1.59 0.89

0.79 1.11 2.30 2.61 2.06 1.06

0.711 –2.177* –2.606** –1.944*

1.36 1.31 0.71 0.86 1.49 1.30

2.33 2.07 1.87 0.42 1.57 2.19

2.22 3.27 2.69 0.39 0.92 1.92

1.43 2.30 1.86 0.79 0.94 1.35

0.75 2.54 1.01 0.44 0.80 0.82

–1.575 –0.024 3.331** 1.412

4.18 4.17 6.02 6.82 6.84 4.47

–2.51 –9.16 0.10 –1.12 –1.73 –11.62 5.08 10.04 4.28 0.97 –0.97 –5.23

1.84 6.87 1.71 9.83 9.68 3.41

–7.32 1.73 0.68 15.23 7.69 –2.36

–1.685 –0.412 –3.882*** –2.858**

10.74 13.36 12.21 13.83 13.00 10.75

–1.76 –1.37 –0.32 –13.11 –8.56 2.23 16.66 25.84 8.76 17.69 0.98 1.45

9.31 22.87 5.42 20.32 25.73 11.35

16.84 4.38 –2.56 20.70 15.86 16.08

0.185 0.990 –3.062** –2.060*

Debt–equity ratio Family/individual 175 Indonesian corporation 6 Widely held 9 State 6 Foreign 30 Total 226

Return on assets (%) Family/individual 175 Indonesian corporation 6 Widely held 9 State 6 Foreign 30 Total 226

Return on equity (%) Family/individual 175 Indonesian corporation 6 Widely held 9 State 6 Foreign 30 Total 226

*** indicates significance at the 1 per cent level; ** indicates significance at the 5 per cent level; * indicates significance at the 10 per cent level. a Ownership patterns are based on the 20 per cent cut-off level. For the sake of simplicity, companies with mixed ownership are sorted into other categories according to the ownership of the largest shareholder. The table includes delisted companies for which serial data for at least three of the five years from 1996 to 2000 are available. Twenty-four companies newly listed after 1998 are excluded from the calculations. Figures are medians of the sample. T-values indicate differences between the performance of each category and that of the family/individual category. Source: ECFIN (various years).

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Effects of Separating Ownership and Management

Table 10.6 compares the performance of companies where management is separated from ownership with that where it is not. A company with ownership– management separation is defined as a firm that has no controlling family/individual shareholders on the board of commissioners or among the directors. Of the 226 listed companies in 1998, 21 companies met this strict definition. Companies where ownership is not separated from management had better CRs and ROEs than other companies, but their D/E ratios and ROAs fluctuated. The difference in performance between the two is not statistically significant. This indicates that companies where management was separated from ownership did not necessarily perform better than those where it was not. In other words, neither concentrated family/individual ownership nor the lack of ownership–management separation can explain why domestic private companies perform less well than SOEs and foreign-owned companies. Business Group Affiliation

Business group affiliation may also explain corporate performance. Here, I seek to establish whether a company’s affiliation to a business group, and the type of business group it is affiliated with, affected its performance before and after the 1997–98 crisis, and, if so, how. In 1996, a significantly high proportion of publicly listed companies were group-affiliated.8 Of the top 100 listed companies, 58 were group-affiliated companies, accounting for 70 per cent of aggregate sales and 73 per cent of aggregate assets; 29 were non-group-affiliated domestic private companies, accounting for only 15 per cent of aggregate sales and 9 per cent of aggregate assets (Table 10.7). The difference in performance between the group-affiliated companies and the other companies was obvious in 1996. In particular, the group-affiliated companies showed higher D/E ratios and lower ROAs than the other companies (Table 10.8). By 2000, after the crisis, the number of group-affiliated companies in the top 100 listed companies had decreased to 44, their share in sales had fallen to 56 per cent, and their share in assets had decreased to only 36 per cent. There was little change in the indicators for the companies not affiliated with business groups. The difference in performance becomes clearer when I classify the group-affiliated companies into three subcategories: those affiliated with ‘established business groups’, those affiliated with ‘rapid-growth business groups’ and those affiliated with other business groups. Table 10.7 provides definitions of these groups. The companies affiliated with established groups survived the crisis with relative ease; those affiliated with rapid-growth groups suffered most heavily from the crisis, as indicated by a sharp drop in sales and

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Table 10.6 Correlation of Ownership–Management Patterns and Economic Performance of Listed Non-financial Companies, 1996–2000 a

Current ratio of assets to liabilities Management and ownership not separated Management and ownership separated All non-financial companies Debt–equity ratio Management and ownership not separated Management and ownership separated All non-financial companies

Return on assets (%) Management and ownership not separated Management and ownership separated All non-financial companies

Return on equity (%) Management and ownership not separated Management and ownership separated All non-financial companies

No.

1996 1997 1998 1999 2000 t-value

154

1.56

1.09

0.79

0.78

0.81

21 226

1.57 1.50

0.95 1.10

0.50 0.83

0.57 0.89

0.60 1.06

154

1.39

2.32

2.23

1.43

0.69

21 226

0.88 1.30

154

4.25 –1.57 –8.24

21 226

154

21 226

2.38 2.19

1.93 1.92

3.01 –4.70 –17.97 4.47 –0.97 –5.23 10.80

1.37 1.35

1.29 0.82

1.71 –7.54

5.68 –7.10 3.41 –2.36

0.22 –1.29 10.11 18.44

5.23 –11.17 –5.66 2.34 12.78 10.75 0.98 1.45 11.35 16.08

0.673

0.104

0.400

1.251

a Ownership patterns are based on the 20 per cent cut-off level. For the sake of simplification, companies with mixed ownership are sorted into other categories according to the ownership of the largest shareholder. The table includes delisted companies for which serial data for at least three of the five years from 1996 to 2000 are available. Twenty-four companies newly listed after 1998 are excluded from the calculations. Figures are medians of the sample. T-values indicate differences between the performance of each category and that of the family/individual category; t-values are not significant at the 1, 5 or 10 per cent levels. Source: ECFIN (various years).

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Table 10.7 Shares in Sales and Assets of Group-affiliated Companies in the Top 100 Listed Indonesian Companies, 1996 and 2000 No. of Companies Group-affiliated a Established b Rapid-growth c Other group

Non-group-affiliated State Foreign d Total

Sales (% of all companies)

Assets (% of all companies)

1996

2000

1996

2000

1996

2000

58 20 12 26

44 18 9 17

70.0 39.9 12.3 17.9

55.5 36.1 6.4 13.0

73.4 35.5 21.8 16.1

36.3 21.9 6.7 7.8

100

100

100.0

100.0

100.0

100.0

29 5 8

27 16 13

14.9 11.1 3.9

15.0 22.5 7.0

8.9 16.3 1.4

7.8 52.9 3.0

a Of the top 50 business groups in an annual sales ranking in 1996, 40 groups listed their affiliated companies on the Jakarta Stock Exchange. b Nine business groups that concurrently satisfy the following three conditions: (1) started core business (or discontinuous spurt) in the 1970s or earlier; (2) ranked among the 20 largest groups in the 1980s; and (3) ranked among the 10 largest groups in 1996. c Eight business groups that satisfy either of the following conditions: (1) started core business (or discontinuous spurt) in the 1980s and ranked among the 30 largest groups in 1996 or (2) ranked below 20th in the 1980s but among the 10 largest groups in 1996. d Excludes four ‘apparent’ foreign companies that are owned by Indonesians. These are treated as domestic private companies. Source: ECFIN (various years).

assets. Table 10.8 shows the sharp contrast between the performance of the two types of group. In 1996, the companies affiliated with rapid-growth groups had the lowest ROEs, while companies affiliated with established groups showed the highest D/E ratios and significantly high ROEs. By 2000, companies affiliated with rapid-growth groups had negative D/E ratios and showed the largest negative ROAs. Negative D/E ratios are due to negative equity, meaning that the liabilities of a company exceed its assets. The results imply that these companies became insolvent following the crisis and a serious loss of business.

1.3

0.8

1.5

1.3 4.7 0.8 4.5

3.5

3.4 8.5 6.4

3.2 2.9 3.0 3.4

–2.4

0.3

–1.8 1.4 7.1

–1.6 0.5 –17.7 –2.5

2000

10.8

13.5

14.4 17.0 16.5

13.0 16.0 11.0 12.6

1996

16.1

7.9

0.4 11.5 15.1

7.1 6.6 23.4 4.6

1.6

4.7

2.5 2.7 1.9

6.3 10.5 5.3 3.6

1996

–1.3

–0.8

1.9 7.7 1.6

-6.3 –13.2 –4.7 0.3

2000

5.0

4.8

4.3 10.3 6.9

4.0 4.0 3.2 4.4

1996

–7.4

–3.5

–3.3 6.4 10.1

–11.5 –2.9 –20.9 –16.2

2000

ROA (mean)

11.2

14.2

11.6 16.2 15.4

14.3 17.7 10.9 12.9

1996

44.3

–11.9

–30.9 –2.1 14.5

–14.5 –20.1 –43.4 3.8

2000 a

ROE (mean)

174

D/E: debt–equity ratio; ROA: return on assets; ROE: return on equity. a Excludes 23 companies with negative equity, because their ROEs would be extraordinarily high. In the rapid-growth group subcategory, six out of nine companies are excluded, so the figures are not reliable. b Of the top 50 business groups in an annual sales ranking in 1996, 40 groups listed their affiliated companies on the Jakarta Stock Exchange. c Nine business groups that concurrently satisfy the following three conditions: (1) started core business (or discontinuous spurt) in the 1970s or earlier; (2) ranked among the 20 largest groups in the 1980s; and (3) ranked among the 10 largest groups in 1996. d Eight business groups that satisfy either of the following conditions: (1) started core business (or discontinuous spurt) in the 1980s and ranked among the 30 largest groups in 1996 or (2) ranked below 20th in the 1980s but among the 10 largest groups in 1996. e Excludes four ‘apparent’ foreign companies that are owned by Indonesians. These are treated as domestic private companies. Source: ECFIN (various years).

1.8

Grand total (226 companies)

Top 100 total

1.7 0.7 1.7

2.0 2.8 –3.2 1.2

1996

D/E (mean)

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Non-group-affiliated State Foreign e

2.0 2.8 1.7 1.9

2000

2000 a

ROA (median) ROE (median)

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Group-affiliated b Established c Rapid-growth d Other group

1996

D/E (median)

Table 10.8 Correlation of Group Affiliation and Group Type with Economic Performance in the Top 100 Listed Indonesian Companies, 1996 and 2000

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The discussion indicates that corporate ownership patterns (concentrated or dispersed and family/individual or non-family/individual) and separation of management from ownership did not obviously affect corporate performance before and after the crisis. Rather, the difference in performance seems to depend on whether the company is affiliated with a business group and whether the group is an established or rapid-growth one. Still, most of the companies concerned have similarly concentrated family/individual ownership without separation from management. CONCLUSION What conclusions can we draw about changes in corporate ownership and management in Indonesia between 1996 and 2000 and their effect on corporate performance? Let me summarise the above discussion as follows: Ownership and Management • • • • •

There has been a fall in private ownership and a rise in state and foreign ownership. There has been a reduction in the number of family/individual-owned financial corporations and rapid-growth business groups. There has been a decrease in the presence of shareholder–managers. However, concentrated ownership remains dominant. Family/individual ownership is still a major pattern in groups with concentrated ownership.

Correlation with Performance • • •

State and foreign-owned listed companies performed better than domestic private companies throughout the period. Domestic private companies with concentrated family/individual ownership did not perform significantly less well than those with dispersed ownership and with non-family/individual ownership. Companies where management was not separated from ownership did not perform significantly worse than those where management and ownership were separated.

Thus it is difficult to find a convincing explanation for the poor performance of domestic private companies by looking at concentrated ownership, family/individual ownership or coincidence of ownership and management. Business group affiliation was a more obvious cause of the difference in performance among companies that have concentrated family/individual own-

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ership without any separation of ownership and management. Group-affiliated companies showed notably higher indebtedness than non-group affiliated companies before the crisis and suffered heavily from the crisis. Those affiliated with established groups had the highest indebtedness but relatively high ROEs before the crisis and were more likely to survive the crisis; those affiliated with rapid-growth groups had the lowest profitability and suffered most from the crisis. In other words, concentrated ownership, family/individual ownership and coincidence of ownership and management may not matter in themselves; it seems that business group governance and borrowing behaviour may be more important. NOTES 1 2

3

4

5

6

See, for instance, Shleifer and Vishny (1997); La Porta, Lopez-de-Silanes and Shleifer (1999); Morck (2000); Tirole (2001); and Aoki (2001). For a brief review, see Sato (2004). Another reason I do not use the ultimate owner approach is that it is not necessarily self-evident how to judge an owner as ‘ultimate’. Without additional information, it would often be difficult to tell a core controlling owner from a parasite shareholder. Claessens, Djankov and Lang (1999) found the Soeharto family to be the family controlling the largest share (17 per cent) of total market capitalisation in Indonesia and treated it as the ultimate owner of Salim group, Kedaung Group and Mulia Group. In reality, however, the Soeharto family is only a parasite shareholder of these groups. The state category here includes not only banks subjected to government capital injection and nationalisation, but also companies under the control of the Indonesian Bank Restructuring Agency (IBRA) for asset sales in order to repay their debts. For details, see Sato (2003: 35–42). Based on the Dutch Commercial Code of the time, the Commercial Code (Kitab Undang-Undang Hukum Dagang or Wetboek van Koophandel) for the Netherlands East Indies was enacted in 1847 and remains valid. However, provisions in the code regarding stock companies were replaced by a new Company Law enacted in 1995. In South Korea, the percentage of managerial posts occupied by each owner family of the five largest chaebol (business groups) was only 4 per cent (70 out of 1,648 posts) in their listed companies as of 1997 (NANAM 1999). In Thailand, 52 per cent of family-owned listed companies (including quasi-family-owned companies) – that is, 73 out of 140 companies – had a CEO or president from the major shareholder family in 2000 (Suehiro 2001:48). While the World Bank (1998) stresses the cost side, it also points out that ownership concentration has benefits for efficiency of operations and investment, and (p. 60) that empirical evidence shows an inverted U-shaped relationship between the degree of ownership concentration and profitability.

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177

This category refers not to SOEs in general but only to the very limited number of publicly listed SOEs. The term ‘business groups’ here refers to the 50 largest business groups by 1996 ranking of annual sales based on Warta Ekonomi, 9(27), 24 November 1997. Of these 50 groups, 40 had publicly listed affiliated companies in either 1996 or 2000.

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TINKERING AROUND THE EDGES: INADEQUACY OF CORPORATE GOVERNANCE REFORM IN POST-CRISIS INDONESIA Daniel Fitzpatrick

Few would dispute that better corporate governance is important to Indonesia’s recovery from the economic crisis of 1997–98. With a significant number of major banks and corporations still under the control of the Indonesian Bank Restructuring Agency (IBRA), the process of divestment will succeed only if prospective investors are confident that their investments will be managed in their own best interests. Equally, with equity markets weak and bank financing likely to remain dominant, improving management and lending practices in the banking sector will be essential to both reducing the cost of capital and preventing future liquidity and capital account crises. What regulatory reforms, then, have been introduced since 1997 to improve corporate governance in Indonesia? The most significant are a National Code of Corporate Governance (‘the Corporate Governance Code’), Decree No. 117/ 2002 of the Minister for State Enterprises concerning good corporate governance in state-owned enterprises (SOEs) (‘the Ministerial Decree’), and Jakarta Stock Exchange (JSE) Regulation No. I-A (‘the JSE Regulation’).1 Other activities of note include the circulation of draft new company and capital market laws, the institution of ‘annual report awards’ for listed companies, and the creation of a number of NGOs and NGO-related programs to ‘socialise’ better corporate governance practices in Indonesia (ADB 2003). This chapter briefly considers how well these regulatory measures are likely to improve corporate governance in Indonesia. It will argue that they have some merit in themselves but ultimately will have little effect on the central problem, which is the interaction between institutional corruption and family-owned corporate conglomerates. First, I introduce this argument by canvassing the main characteristics of Indonesian corporate governance. Then I consider corporate governance-related reforms since 1997, including the Corporate Governance Code and the mandatory requirement for independent commissioners and audit 178

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committees in listed enterprises and SOEs. In particular, I argue that these reforms have not adequately addressed the question of conflicts of interest and related party dealings. I conclude with an overview of reforms that would better address this fundamental issue. THE NATURE OF THE PROBLEM: INDONESIAN CORPORATE GOVERNANCE BEFORE AND AFTER 1997 Corporate Governance before 1997

Before the 1997 crisis, corporate governance in Indonesia had three main characteristics. First, large corporations exhibited highly concentrated ownership patterns, often within the context of family control and a diversified conglomerate structure (Claessens, Djankov and Lang 1999; Husnan 2000: 19–23). This not only facilitated expropriation of corporate wealth at the expense of minority shareholders (Claessens, Djankov, Fan and Lang 1999a) but also negated many of the ‘shareholder-friendly’ aspects of the 1995 Company Law and 1995 Capital Markets Law. For example, the orthodox notion that boards of commissioners and directors monitor management on behalf of all shareholders proved irrelevant in the context of overwhelming management control by dominant shareholders (Fitzpatrick 2000). Similarly, the disciplining role traditionally played by threat of hostile takeover in the event of underperformance had little meaning in an environment where management and controlling shareholders were essentially indistinguishable (Capulong et al. 2000: Sections 2.4, 3.5; Bennett 1999: 19–26). Second, most conglomerates established their own banks after financial sector deregulation in the 1990s, and then borrowed heavily from them with little regard for prudential lending requirements or rules governing related party lending (Fitzpatrick 1998: 184–189; Husnan 2000: 22, 37). Thus the system of bank-centred corporate governance found in Germany and Japan, where the ‘insider’ role provides the opportunity to monitor corporate debtor management, did not evolve in Indonesia. Instead, banks and other financial institutions were subordinated to related party borrowers, which left their portfolios weak and highly vulnerable to external economic shocks. Third, most large corporations participated in patrimonial relationships with an often corrupt political and bureaucratic elite (Husnan 2000: 38). This phenomenon of ‘crony capitalism’ particularly affected issues of enforcement, whether through regulatory authorities such as the Capital Market Supervisory Agency (Bapepam) or the JSE, or through private litigation by disgruntled shareholders or creditors. Indeed, a striking feature of Indonesian corporate governance has been the low level of successful court enforcement proceedings

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relative to a high level of corporate abuses (Tabalujan 2000: Ch. 4). Without the threat of enforcement, corporate actors have few disincentives for misbehaviour; without judicial rulings to give content to corporate rules and standards, corporate governance standards have not developed into detailed prescriptions for behaviour. Corporate Governance after 1997

The above characteristics of Indonesian corporate governance before 1997 are well known, yet deserve brief repetition because they provide the context for evaluating subsequent regulatory reforms. Less well known is the nature of developments in corporate governance since 1997. In this regard it is necessary to highlight the central role of IBRA. IBRA continues to own much of the banking sector and also holds substantial equity in many large corporations as a result of transfers made in satisfaction of Bank Indonesia emergency bank liquidity credits (World Bank 2000a). IBRA’s processes of divestment will thus be crucial to future ownership, finance and governance patterns in Indonesia. IBRA was established in 1997 with a brief to manage the restructuring of Indonesia’s moribund banking sector. In September 1998 it established three categories of banks under its control. Category A banks, with capital adequacy ratios (CARs) of more than 4 per cent, were allowed to restructure and recapitalise under the control of their owners. Category B banks, with CARs of more than –25 per cent but less than 4 per cent, were subject to joint recapitalisation, with the ‘owners’ providing a minimum of 20 per cent and the state injecting up to 80 per cent of the necessary funds. A notable proviso was that owners and managers had to pass a ‘fit and proper’ test before recapitalisation could take place. Category C banks, those with a CAR of less than –25 per cent, were closed (World Bank 2000a). After an audit in March 1999, 74 banks were placed in category A, 30 in category B and 17 in category C. Subsequently, 21 banks in category B were closed because their owners or managers failed the ‘fit and proper’ test (EFIC 2000). IBRA has reached its short-term objective of re-establishing a functioning (although still vulnerable) banking sector in Indonesia, but the long process of divesting itself of its corporate and banking assets has barely begun (IBRA 2003a). Critical issues in this process will include the level of transparency and the nature of valuations in the sale process, the nature of management processes in recapitalised and/or sold banks, and the possibility that conglomerate owners will reclaim ownership of assets ‘through the back door’, thereby perhaps reestablishing the corporate governance practices that existed before 1997. In this regard, there are some reasons for concern that IBRA’s divestment processes will allow familiar patterns of crony capitalism to re-emerge in corporate Indonesia. I will illustrate this possibility through a brief description of the contro-

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versies surrounding the emergency bank liquidity credits (BLBI) program, the divestment of IBRA’s stake in PT Indomobil and recent financial reporting by Bank Lippo. Post-1997 Corporate Governance Case Studies Emergency Bank Liquidity Credits

During the economic crisis of the late 1990s, Bank Indonesia provided Rp 144.5 trillion to 48 commercial banks in the form of emergency bank liquidity credits. These credits were necessary to prevent the total collapse of the banking sector. In May 1999, Indonesia’s Supreme Audit Agency (BPK) reported that their recipients had misused approximately 95 per cent of this money (Rp 138 trillion, or approximately $15.5 billion). Under public pressure a series of prosecutions followed; yet these have been widely derided for their failure to target leading conglomerate owners, to recover anything but a very small proportion of the funds involved or to ensure that convicted individuals actually serve the prison sentences handed down. Of the relatively few (and relatively unimportant) conglomerate owners who have been convicted, most have simply disappeared without much apparent effort by the Attorney-General’s Office or the police to arrest or extradite them.2 In relation to the missing Rp 138 trillion, it is reported that only 17 cases have been prosecuted, involving only about Rp 30 trillion; as of April 2003 the courts had ordered the return of a mere Rp 2.82 trillion from the 14 cases taken to completion.3 In somewhat dubious circumstances, then, Indonesia’s major conglomerate owners have largely escaped legal sanction for the events of 1997 and the subsequent use of BLBI funds; they stand ready to resume their activities once IBRA has completed its processes of divestment. The Indomobil Sale In December 2001, IBRA sold its 72 per cent stake in PT Indomobil Sukses International, Indonesia’s second largest car manufacturer, to a consortium led by PT Trimegah Securities. IBRA obtained its stake from the Salim group in part satisfaction of Bank Indonesia emergency bank liquidity credits. In May 2002, Indonesia’s Business Competition Supervisory Commission (KPPU) concluded that six parties, including members of the successful consortium and Deloitte Touche FAS (the government adviser on the sale), had conspired to subvert the bidding process in breach of Article 22 of the 1999 Anti-monopoly Law. A central aspect of the bid that aroused suspicion was the fact that the sale price was reportedly Rp 625 per share, whereas at the time of its transfer to IBRA in 1999 the company had been valued at Rp 2,500 per share. It was also alleged that the successful consortium was linked to the Salim group, which had been banned from repurchasing the asset.4

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After losses before various district courts in Jakarta, KPPU appealed to the Indonesian Supreme Court, which in January 2003 ruled that KPPU’s findings should be cancelled on the basis of legal errors. In particular, the court reportedly determined that, because KPPU used the phrase ‘for the sake of justice, based on the belief in one Supreme God’ – a phrase used in court judgments – it had taken on a judicial role that had not been ceded to it by the 1999 Antimonopoly Law.5 The main point of this example is to illustrate controversial aspects of IBRA’s divestment process, but an important technical point may be made in response to the Supreme Court ruling. The 1999 Anti-monopoly Law clearly establishes KPPU’s authority to conduct investigations and impose administrative penalties in relation to anti-competitive conduct (including collusion affecting a public bidding process). There is no question that in substantive terms KPPU had the authority to conduct an investigation, make determinations of fact and apply administrative penalties. Bodies such as Bapepam and the JSE regularly exercise similar functions. Of course, KPPU was under a legal obligation not to make errors of law, including relating to procedural fairness, in its investigating and reporting process; but if it did so the courts have the discretion to correct the error and send the matter back for reconsideration. Given the importance of the alleged breach of the Anti-monopoly Law and the fact that the alleged legal error did not greatly prejudice the parties, it is surprising that the Supreme Court did not at least send the case back to KPPU with a direction to reconsider the matter in the absence of phrases that suggested the assumption of judicial authority.

Financial Reporting by Bank Lippo On 28 November 2002, Bank Lippo issued a financial report that was represented as ‘audited’. Published in the mass media, it reported the bank’s net profit at 30 September 2001 as Rp 98.77 billion and its CAR as 24.77 per cent. One month later, Bank Lippo issued a further report to the JSE, also purporting to state the bank’s financial condition as at 30 September 2001, which recorded a loss of Rp 1.273 trillion and a CAR of 4.23 per cent (Bapepam 2003). Subsequently, Bank Lippo’s management explained the massive difference as representing a revaluation of foreclosed assets. At the time, IBRA held a 59.3 per cent stake in the bank; however Mochtar Riady, founder of the Lippo group, remained president commissioner of Bank Lippo. On 17 March 2003, Bapepam issued the results of its investigation into the matter. It concluded that the first report had not been audited, contrary to representations made by Lippo, but accepted its explanation that this was an oversight and that the revaluation of foreclosed assets accounted for the difference in amounts. Accordingly, it imposed a fine of Rp 2.5 billion on the board of directors of Bank Lippo and ordered it to explain its ‘negligence’ to Lippo’s

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general meeting of shareholders (Bapepam 2003). Subsequently, the JSE issued a ‘Serious Warning’ to Bank Lippo management for its ‘negligence’ in representing the first report as audited (JSE 2003). The Ministry of Finance has also issued written warnings and/or temporarily suspended the practising licences of three appraisers and an auditor connected with the revaluation of Lippo’s foreclosed assets.6 Leaving aside the weakness of these sanctions and Bank Lippo’s explanation of the events, a key issue is the possibility that the case is related to IBRA’s forthcoming divestment of its stake in the bank. The Jakarta Post has quoted some analysts’ opinions that Bank Lippo was seeking to deflate its share price in order to facilitate repurchase of shares by the Lippo group prior to and as part of IBRA’s divestment process.7 Similar allegations were made by Lin Che Wei, a well-known banking analyst who one of Bank Lippo’s commissioners subsequently reported to the Attorney-General’s Office for alleged defamation (Transparency International 2003). These examples are given not because they provide conclusive evidence of corruption, but because they illustrate the risk that pre-1997 corporate governance practices will re-establish themselves in post-IBRA Indonesia.8 Indeed, the situation is analogous to the period shortly before economic liberalisation in the 1990s, when the Indonesian state controlled the ‘commanding heights’ of the economy. The process of relinquishing that control through deregulation and economic liberalisation under President Soeharto was fraught with corruption and cronyism. Given the extent of institutional corruption in Indonesia, and the fact that major conglomerate owners have largely escaped sanction for the events of 1997 and 1998, who would be confident that similar patterns will not re-emerge in contemporary Indonesia? REGULATORY MEASURES SINCE 1997

With this brief sketch of potential corporate governance patterns in mind, it is now appropriate to consider corporate governance-related reforms in Indonesia since 1997. As mentioned, these reforms may principally be found in the Corporate Governance Code, the Ministerial Decree and the JSE Regulation. It is not possible to canvass the full scope of these documents here, but I will pay attention to three major issues: the appointment of independent commissioners, the establishment of audit committees, and the absence of effective reforms relating to conflicts of interest and related party dealings. Independent Commissioners

The 1995 Company Law vests management powers in the board of directors and gives the board of commissioners a brief to supervise and advise directors.

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This structure is characteristic of civil law systems. The Corporate Governance Code seeks to strengthen the commissioners’ supervisory role by elaborating on their appointment, remuneration and rights to information (Article II(1–6)). A draft new company law further elaborates on their obligations by stating that the board of commissioners must review the business plan and annual budget prior to submission to the general meeting of shareholders (Article 58(1)); provide an annual report on its role to the general meeting of shareholders (Article 58(3)); and sign the annual report and/or provide a written explanation for not doing so which must be attached to the report (Article 58(4)).9 Most significantly, the Corporate Governance Code states that ‘at least 20 per cent of the board of commissioners shall be independent of the directors and controlling shareholders and hold no interests that might impair their ability to perform their duties on behalf of the company’ (Article II(2)).10 The Ministerial Decree similarly requires that no less than 20 per cent of the board of commissioners in SOEs must be independent but, unlike the Corporate Governance Code, provides a detailed definition of independence for these purposes (Article 10(2)). The JSE Regulation has now extended this requirement to listed corporations, and lifted the minimum number of independent commissioners to 30 per cent of the board (Chapter G.7). In June 2003 the JSE reported that, of the 331 listed corporations, 324 had appointed independent commissioners, and of that number 305 had complied with the requirement that they constitute no less than 30 per cent of the board’s membership (Notice No. 577/BEJ-PSJ/KI/06-2003). In technical terms, these provisions are inadequate because they lack complementary provisions relating to voting, appointment and quorum requirements. For example, why should the minimum number of independent commissioners be set so low? The commissioners’ brief is simply to supervise and advise directors. In ordinary circumstances they have no management authority. Why, then, should they not constitute at least a majority of the board of commissioners? Indeed, if the brief is to monitor management on behalf of all shareholders, and the controlling shareholder retains a dominant influence over the board of directors, why should any commissioner be related to the controlling shareholder? Equally, it is strongly arguable that the new independent commissioner requirements must be complemented by mandatory cumulative voting provisions (OECD 2003: 27). Cumulative voting simply means that shareholders holding more than a certain percentage of shares (say 10 per cent) are entitled to nominate or appoint one commissioner. Currently there is no such entitlement in Indonesia and so, unless a corporation’s articles of association state otherwise, all commissioners are nominated and appointed by an ordinary majority vote of the shareholders. This means that most ‘independent’ commissioners will be nominated and appointed by the controlling shareholder, which

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opens the possibility that they will be individuals who are not truly independent of the controlling interest. Finally, there are no additional provisions that require a majority of independent commissioners to be present for a resolution to be valid, or that require certain management decisions, such as entering into related party transactions, to be approved by a majority of independent commissioners. These also should be established to ensure that independent commissioners will have sufficient voting power to act as an effective check on controlling shareholder actions (OECD 2003: 27–28). More fundamentally, the phenomenon of crony capitalism itself appears to pose a basic obstacle to effective outside directors or commissioners in Indonesia. It is well recognised that in Australia and the United States independent directors are often ineffective because they have inadequate access to information or they subconsciously align themselves with management’s interests and objectives. How much more likely is this to be so in an environment where corporate insiders are closely connected to a dominant political elite, access to information depends on consent by controlling shareholders and information rights rely on an unreliable judiciary (OECD 2003: 27)? The improvement of corporate governance in Indonesia will require much more than the mandatory appointment of independent commissioners, even if there are enhanced provisions on appointment, quorum and voting issues. Audit Committees

To what extent would audit committees assist? The Corporate Governance Code states that the board of commissioners ‘may establish an audit committee comprised of outside auditors and top members of the internal audit staff’. This committee is to report solely to the board of commissioners, and its members can be removed only by unanimous vote of the commissioners. Its duties include promoting corporate discipline and a controlled environment to prevent fraud and abuse, improving the quality of financial disclosure and reporting, and reviewing the scope, performance and independence of the external auditors (Article IV(2)). The Ministerial Decree makes audit committees compulsory for SOEs where the enterprise has insurance and financial assets, has been publicly listed, is included in the privatisation program or has assets of not less than Rp 1 trillion. The committee is to assist commissioners in the performance of their duties, and in particular is to establish effective internal monitoring systems and a system to ‘effectively realise’ the authority of external and internal auditors (Article IV(2)). The commissioners may also establish remuneration, nomination, risk assessment and some other committees.

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The JSE Regulation (Chapter G.7) made audit committees mandatory for listed corporations. In June 2003 the JSE stated that, of 331 listed corporations, 282 had established audit committees, of which 262 complied with the requirements that the audit committee include one independent commissioner, have at least one outside member and have a minimum of three members. Audit committees have a role to play in improving corporate governance in any system; and yet, as with independent commissioners, they are only as effective as the information they receive or obtain. The existence of an audit committee does not of itself increase the incentive for controlling shareholders to disclose or grant access to contentious information, including in relation to related party transactions and debt commitments within a corporate group. Let me give one spectacular example of this information problem: in 1995 Bank Indonesia required all private banks to establish audit committees; yet none uncovered the widespread violation of related party lending limits prior to 1997 (Husnan 2000: 28). Equally, it is well established that auditing firms can lose professional independence when they become dependent on consulting and accounting income from major clients. In Indonesia this problem is compounded by the fact that most auditing firms have long-term relationships with their clients; and external auditors are nominated and appointed by controlling shareholders (Husnan 2000: 29). It is compounded further by the apparent failure of the Indonesian Accounting Association to manage disciplinary issues within the profession.11 Conflicts of Interest and Related Party Transactions

At the heart of Indonesia’s poor corporate governance record lies the problem of self-dealing and conflicts of interest. Related party lending by private banks and financial institutions, transfer pricing and dubious asset sales within corporate groups, undisclosed cross-shareholdings and cross-debt guarantees, and the alleged use of nominee arrangements to reclaim control of banking and corporate assets – all of these fundamental issues could be addressed at least in part by effective laws on conflicts of interest and related party dealings. What, then, is the current law on this issue, and to what extent may it be improved by further regulatory reform? The 1995 Company Law includes general requirements that directors and commissioners act in good faith and with a full sense of responsibility (see Articles 85 and 98). There are also articles that impose personal liability on directors and commissioners in two types of circumstances: where the annual accounts are incorrect or misleading, unless the director or commissioner in question can prove that he or she was not at fault (Article 60), and for any fault, error or negligence in the discharge of their responsibilities (Articles 85 and 98). More specifically, directors and commissioners must disclose to the company any

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interests they or their family hold in the company or in other companies (Articles 87 and 99). A director is prohibited from representing a company if there is a court proceeding between him or her and the company, or the director has an interest that conflicts with the interests of the company (Article 84(1)). These provisions aside, the Company Law does not establish any requirement for disclosure of conflicts of interest by directors, commissioners, controlling shareholders and/or their affiliates involving contracts entered into by the company. Similarly, there is no requirement for shareholder approval of conflict of interest transactions in non-listed corporations. The only directly relevant requirement is that the annual financial reporting of all companies include the consolidated balance sheets of affiliated companies, together with their balance (Article 56). Notoriously, of course, this provision failed to induce disclosure of the extent of related party lending practices by private banks and financial institutions prior to 1997.12 To find more stringent requirements concerning conflicts of interest and related party transactions one must turn to the 1995 Capital Markets Law and subsequent Bapepam regulations. In relation to listed corporations, Bapepam Rule No. X.E.1 states that independent shareholders must approve any transaction involving a conflict of interest between the economic interests of the company and the personal economic interests of a director, commissioner or substantial shareholder.13 In practice, this rule appears to have been followed only in the most visible of self-dealing cases, such as the series of internal acquisitions in the Salim and Lippo groups in the 1990s. Even in those cases, disinterested shareholder approval was forthcoming in part because of the presence of the state as a shareholder and the fear of reprisals against those casting a dissenting vote (Fitzpatrick 1999). Some drafts of the Corporate Governance Code prohibited shareholders, commissioners or directors from engaging in self-dealing with the intent of personal gain, and required the company to establish an effective internal control mechanism to monitor these types of practices. However, the official version issued in May 2000 includes no substantive provisions on conflicts of interest and related party transactions other than a recommendation for the disclosure of related party transactions and ‘cross-shareholdings and cross-debt guarantees’ to the general meeting of shareholders (Article I(4)). In contrast, the Ministerial Decree does prohibit directors and commissioners of SOEs from receiving loans from the company and entering into transactions that constitute a conflict of interest (Articles 13 and 20). Four reforms would strengthen these decidedly inadequate provisions. First, the obligation to disclose and seek independent shareholder approval of related party transactions should be extended to all corporations, on the basis that Indonesia’s corporate governance problems are not limited to listed corporations, but derive from interaction between private and public companies within

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a conglomerate structure. This would at least create greater transparency in relation to transactions within a corporate group. Second, the test for approval of related party dealings by the general meeting of shareholders and/or the courts should be elevated to one of ‘clear advantage’ to the company in question (Clark 1986: 1,809). Alternatively, the majority necessary for approval could be raised to 75 per cent (OECD 2003: 27). In either case, the rationale would be that enhanced provisions are required given the history of widespread self-dealing and expropriation of minority shareholder wealth in Indonesia. Third, a detailed list of transactions requiring shareholder approval should be established. Such a list could state specifically, for example, that crossguarantees and asset sales within a corporate group, loans from an affiliated bank, the sale or purchase of assets outside the ordinary course of business to corporate insiders or relatives, and/or any form of payment or transfer to the controlling shareholder or its beneficial owners (other than agreed executive compensation) are related party transactions that require shareholder approval. This is particularly necessary because, in the absence of judicial clarification of what constitutes a conflict of interest and related party transaction, it is all too easy for corporate actors and advisers to determine that in their opinion generalised rules do not apply to the circumstances of their particular case. Additionally, without the deterrence provided by fear of judicial enforcement, there is a need for legal rules governing related party transactions to have inbuilt sanctions – for example, that such transactions are void and without legal effect, or that directors or commissioners involved will be disqualified from management where disclosure has not been made or shareholder approval has not been sought. Fourth, special rules need to be established in relation to the banking sector. We have seen that the greatest corporate governance risk in Indonesia is the possibility that well-connected conglomerates will regain influence over their former banks and thereby re-establish related party lending practices. Given this possibility and the economic significance of the issue, it is arguable that a simple prohibition should be applied to related party lending by any bank or financial institution. After all, existing requirements for audit committees in banks and shareholder approval of related party transactions in listed corporations conspicuously failed to uncover or prevent the accumulation of related party debt by 1997. Why not therefore prohibit any related party lending? Again, such a rule could be supported by a built-in sanction such as loss of the banking or financial institution licence and a detailed definition of ‘related parties’ so as to cover the potential range of indirect and nominee arrangements.

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CONCLUSION If an outsider were only to read the Corporate Governance Code and consider the corporate training and conference programs of Indonesian institutions (governmental and non-governmental), they would be forgiven for thinking that unprofessional management alone accounted for Indonesia’s poor record in the field of corporate governance. Hence, measures such as improving the professionalism of management, defining internal corporate responsibilities and requiring proactive disclosure of non-financial issues would be seen as appropriate responses to the problem. Moreover, these responses would best be voluntary because over time they would be ‘socialised’ and adopted by all corporations as a result of market discipline and capital requirements. Equally, if an observer were only to consider the mandatory requirements for independent commissioners and audit committees in listed enterprises and SOEs, they would be forgiven for thinking that the central corporate governance issue in Indonesia involved protecting dispersed shareholders from opportunistic or incompetent employed managers. Hence, adopting and adapting Anglo-American corporate governance institutions (such as independent directors and audit committees) would be seen as an appropriate response, particularly as they avoid the collective action problems of dispersed ownership by establishing internal intermediaries to monitor management on the shareholders’ behalf. The truth is quite different. The central problem in Indonesia is not unprofessional management or dispersed ownership; it is the interaction between institutional corruption and family-owned conglomerates. Hence corporate governance reforms should focus on the one area that lacks specific measures: related party transactions and conflicts of interest. In particular, those involved should pay much greater attention to expanding the list of ‘self-dealing’ transactions which either are prohibited or require shareholder approval; tightening the test for shareholder or court approval of such transactions; and developing built-in sanctions against transactions that proceed despite a general prohibition or a failure to gain the necessary shareholder approval. NOTES 1 2 3

Related reforms have been made to the system of company registrations and prudential supervision of the banking sector but I do not consider them here. See Muninggar Sri Saraswati, ‘Ficorinvest Directors Convicted with BLBI Graft’, Jakarta Post, 14 August 2003. See Berni K. Moestafa, ‘BLBI Trials a Cost of Poor Judiciary’, Jakarta Post, 7 April 2003. In fairness, however, it should be noted that three former Bank Indonesia

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directors have been sentenced to significant jail terms (ranging between 2.5 and three years) for their role in the BLBI investment cases; see ‘Third Former BI Director Convicted’, Jakarta Post, 5 April 2003. See ‘KPPU Loses Legal Battle in Indomobil Case’, Jakarta Post, 17 January 2003. See ; see also ‘KPPU Loses Legal Battle in Indomobil Case’, Jakarta Post, 17 January 2003. See ‘Sanctions Imposed on Lippo’s Appraisers’ Auditor’, Jakarta Post, 29 March 2003. See ‘Lippo Posts Loss Ahead of Divestment’, Jakarta Post, 4 June 2003; and Dadan Wijaksana, ‘Bapepam Analyses Lippo Management’, Jakarta Post, 18 March 2003. See Sato (this volume) for some useful empirical findings concerning changes in corporate ownership and structure since the crisis. In particular, she relevantly determines that (1) there has been some increase in foreign ownership and some reduction in family ownership of public corporations, but ownership structures remain highly concentrated in general; and (2) there has been a significant reduction in the proportion of commissioners who are shareholders, but some increase in shareholders who are directors. While increases in foreign ownership and reductions in shareholder–commissioners may indeed be positive steps in favour of improved corporate governance, these findings are not inconsistent with the central argument of this article, namely that corrupt links between the state and family-owned conglomerates, in combination with the weakness of legal reforms relating to independent commissioners, audit committees and (especially) related party dealings, mean that there is a substantial risk that pre-1997 patterns of corporate governance will re-establish themselves to a significant extent in post-IBRA Indonesia. The draft company law in question is that provided by the Asian Development Bank report, available at . The Corporate Governance Code also requires at least 20 per cent independent directors (Article III(2)). I do not consider this requirement here as it has not been taken up in the Ministerial Decree or the JSE Regulation. For a discussion of the possible role and efficacy of independent directors in Indonesia, see Fitzpatrick (2000). For example, in response to allegations that 10 accounting firms participated in fraudulent auditing of some banks in 1997, the Indonesian Accounting Association barred only three firms from auditing banking clients and simply reprimanded the other firms allegedly involved. See ‘Strong Sanctions against Bad Accountants a Must’, Jakarta Post, 13 July 2002. Additionally, under Article 26 of the Anti-monopoly and Unfair Competition Law, companies managed by the same director may not enter into transactions with one another if the companies are in the same market, have a close relationship in the type of business, or jointly dominate a market for goods or services so as to create either monopolistic or unfair competition conditions. A director or commissioner must also disclose to Bapepam their ownership of shares in the company and any changes to that ownership no later than 10 working days from the date of that change (Article 87(1) of the Capital Markets Law and Bapepam Rule No. X.M.1). Article 95 of the Capital Markets Law also contains a basic provision against insider trading, which has been developed in subsequent regulations.

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Marie-Christine Schröeder-van Waes and Kevin Omar Sidharta When the Asian economic crisis hit Indonesia in 1997, the Indonesian government initiated commercial sector reform. The need for institutional reform in this sector was widely recognised in Indonesia before the crisis. All Indonesian legal professions, both public and private, had in fact agreed on a course of reform, reflected in the 1997 ‘Legal Diagnostic’.1 The Legal Diagnostic recognised the difficulties posed by wholesale reform and identified commercial law as one of the key areas in which to proceed. In 1998, the International Monetary Fund (IMF) began to plan an incentive scheme for private debt restructuring and credible enforcement through a new bankruptcy court, the Commercial Court. They used some of the Legal Diagnostic recommendations in this task. By the end of March 1998, the IMF and the Indonesian government had agreed on how to proceed with bankruptcy law reform and had outlined a set of principles to be followed. Throughout March and April, a team appointed by the Indonesian government drafted the amendments to the bankruptcy law.2 In June 1998, the government established a steering committee to oversee preparations for the operation of the Commercial Court.3 The committee consisted of representatives from the Supreme Court, the State Secretariat, the Department of Justice and the National Development Planning Agency (Bappenas); it paid close attention to the selection of competent and reliable judges, the establishment of the Commercial Court, the proper education of the judges appointed to the Commercial Court, and the appointment and education of private independent receivers and administrators.4 On 20 August 1998, the amendments to the Indonesian Bankruptcy Law became effective and the Commercial Court was opened. The bankruptcy law amendments significantly revised the Indonesian Bankruptcy Ordinance of 1906, as we will discuss further below. The objective of the bankruptcy law reform was to provide a system that would guarantee speedy, efficient and transparent restructuring and bankruptcy 191

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proceedings. The amendments focused on maximising asset recovery, equitability and predictability, and on providing opportunities for reorganisations. These bankruptcy law amendments were enacted more than five years ago. In magazines, newspapers and legal studies, there has been much discussion on whether the objectives have been reached and, if so, to what extent. The articles make three main points. First, the system is vulnerable to corruption. Second, Commercial Court and Supreme Court judges do not fully understand the principles of the Bankruptcy Law and the way it interacts with the Civil Code, the Commercial Code, the Company Law and other commercial laws. Third, the Bankruptcy Law is badly made law – with complaints ranging from a lack of clarity to the law’s unsuitability for Indonesia’s legal culture. There may be some truth in these three criticisms, but we reach a different conclusion. From our involvement in the bankruptcy law reform process and subsequent discussions with Indonesian lawyers, judges and foreign experts, we conclude that there is a gap between the general perception and reality. From the very beginning we were, in the background, involved in the process leading to bankruptcy law reform. After the law was amended, we monitored all Commercial Court hearings and analysed all Commercial Court and Supreme Court decisions on bankruptcy law issues from August 1998 to August 2003.5 Unlike other assessments, our results are based on a systematic analysis of all written Commercial Court decisions and subsequent Supreme Court rulings in cassation and civil review. We placed each decision in one of five categories,6 making it possible to give an overview of general court performance, performance on certain key legal issues, performance over the years, performance of individual judges, and performance of the Commercial Court versus the Supreme Court. We limited our research to the first stage of bankruptcy proceedings: Commercial Court and Supreme Court decisions on petitions for bankruptcy and suspension of payments. In the future, we will also analyse decisions taken after a debtor has been granted a suspension of payments or is declared bankrupt – dealing with subjects like granting a permanent suspension of payments, replacing the receiver, ratification of composition, claw-back provisions and the verification of claims. Here we confine ourselves to challenging general perceptions, comparing the situation before and after the amendment of the Bankruptcy Law and suggesting how Indonesian bankruptcy law reform should proceed. CHALLENGING GENERAL PERCEPTIONS, AND NEW QUESTIONS As foreshadowed above, we challenge some general criticisms of the Commercial Court and yet we raise troubling new questions. Here, we outline just two of our findings as a pointer to where the principal challenges lie.

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Contrary to general perception, we found that most rulings on complicated legal issues were well motivated and that the court had gone astray in relatively few cases.7 This is an important point. The finding is encouraging, but raises new questions of a different kind. For example, our research shows that court error and inconsistency are not limited to clearly demarcated legal issues. One might expect court error or inconsistency to occur mainly in relation to highly technical, complicated or controversial issues. Instead, it occurs in relation to nearly all legal issues that come before the court. Moreover, error or inconsistency does not seem to be related to the expertise of particular judges: in one case a panel may decide a complicated legal issue using acute and sound reasoning; in another case involving the same legal issue, the same panel may reach a highly inconsistent and plainly erroneous decision. We do not attempt here to identify the causes and dynamics of such court and judicial inconsistency, but it is clear that the soundness and consistency of Commercial Court decisions are determined not only by legal complications or the ability of individual judges but also by other factors. Our findings also challenge the general perception, in Indonesia and abroad, that the problems in the Commercial Court are directly tied to the judges. This widely held view is not unfounded, but the situation is not as simple as the previous paragraph indicates. Our findings reveal an issue that is widely ignored: the extraordinarily weak performance of the private sector, notably the bankruptcy lawyers, whose performance has improved very little over the past five years. Many bankruptcy petitions or debtor defences presented in court are utter nonsense, lacking any legal basis or intellectual or legal discipline, and seldom referring to case law. This occurs not just occasionally but as a matter of routine. This weak performance may be the result of the deliberate use of wrong arguments (in the hope that judges will accept them anyhow) or a lack of understanding of bankruptcy law, but it is a problem that needs attention. We will give just three of numerous examples of poor performance by bankruptcy lawyers. First, lawyers for the debtor often discuss the amount of a debt, even though it follows from both the Bankruptcy Law and consistent Commercial Court and Supreme Court case law that the amount of a debt is not relevant as long as the existence of the debt can be established. Second, lawyers frequently use arguments that the Commercial Court has consistently rejected from the very beginning – for example, the argument that a debtor cannot pay because of the economic crisis (the so-called force majeure defence). Third, lawyers repeatedly file petitions for cassation too late or fail to file relevant evidence. For example, they may fail to file evidence to prove that the debtor has more than one creditor (the so-called ‘plurality of creditors’); this causes rejection of the bankruptcy petition because plurality of creditors is one of the two bankruptcy requirements. The track record of the bankruptcy lawyers is clearly inferior to that of the judges.

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A compounding factor in the weak individual performance of bankruptcy lawyers is their murky organisational structure. We tried to see whether there is a pattern between specific judges, specific lawyers and decisions issued. It appeared to be impossible to compile a reliable overview of bankruptcy lawyers. In particular, we could not identify whom they worked for. Typically, lawyers work for different law firms – or pretend to do so: some are impossible to trace. Law firms often merge and separate, firms may change their names, and lawyers may start a new firm on their own. This makes it impossible to get an idea of different interests and relationships. Moreover, it is impossible to perform a conflict of interest test, as judges are supposed to do. In the end, and in many cases, people cannot even determine who the client of a lawyer is. The lawyers for the creditor, the debtor and even the receiver may all be controlled by the same principal. We recognise that there are major issues of professionalism in the courts, but our findings suggest that professional standards in the private legal professions are significantly weaker than those of judges and seem designed to purposely obscure and obstruct proper administration of justice. TO WHAT EXTENT HAS BANKRUPTCY LAW REFORM BEEN SUCCESSFUL? Change in Court Proceedings

In this section, we focus on four recent beneficial changes to the Indonesian legal system. The first concerns the time taken to reach a decision. In the past it could take years for courts to issue a decision on a bankruptcy petition – if a decision was reached at all. Civil and criminal court proceedings were also lengthy. Since August 1998, debtors and creditors have been assured of a written Commercial Court decision within one month of filing a petition.8 So far, 99 per cent of the Commercial Court’s decisions have come out within the required 30 calendar days. The second change concerns making decisions accessible to the public. In Indonesian courts in general, decisions are normally only made available to the parties involved because judges have misinterpreted an ancient rule. This rule is that each decision must be made available to the public by reading it in open court. In the early days there were no typewriters, let alone computers or the internet, so the only way to make a decision available to the public was to read it in open court. Nowadays, judges still apply this rule: they read out the ruling in open court and assume that they have fulfilled the requirement that decisions must be available to the public. The parties involved must pay for a decision in writing; the public normally cannot get a decision in writing. This makes legal

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discussion very difficult, because nobody knows the reasoning behind a decision. With the establishment of the Commercial Court this has changed, as it issues all its rulings in writing and makes these written decisions available to the public. The Supreme Court also publishes decisions on bankruptcy issues in writing. Moreover, in the Commercial Court parties may request the appointment of an ad hoc judge, and judges may issue a dissenting opinion. Court decisions and the performance of individual judges are discussed in legal magazines and newspapers and on television and the internet. Commercial Court hearings are open to the public. In other words, the transparency of bankruptcy proceedings has increased considerably, unlike other areas of the Indonesian judicial system. The third change concerns the receivership. If a bankruptcy is declared or a provisional suspension is granted, an independent licensed receiver or administrator with a legal or accountancy background is now appointed, instead of the government agency (the so-called Balai Harta Peninggalan or ‘Orphan’s Chamber’) used in the past.9 The fourth change concerns notification of the results of proceedings. Bankruptcies are now declared and suspensions granted, though not yet to the degree experts hoped for. People face a certain threat from bankruptcy proceedings, as indicated by the fact that more than one-third of all initiated bankruptcy proceedings are withdrawn by the petitioner because an out-of-court settlement has been reached. A final important gain is that the judges’ performance has improved. Contrary to general opinion, court performance could be effective if the independence of judges were better protected, as we will discuss below. Judges’ Performance

Indonesian judges face many challenges. One is that public opinion of their work is based on incomplete information, because the media report only the most notorious cases. Cases such as the Manulife affair, the PT Panca ‘fictitious creditors’ and other examples of structural corruption seriously hinder the development of bankruptcy law reform in Indonesia, because they are not a proper representation of the judges’ understanding of the law or of the willingness of judges to make the system work. As described above and in note 6, we placed each Commercial Court and Supreme Court decision between August 1998 and August 2003 in category A, B, C, D or E. We found that an average of 73 per cent of all Commercial Court rulings and 64 per cent of all Supreme Court rulings ranged from A (‘in accordance with the law’) to C (‘justifiable’), leaving 27 per cent of the Commercial Court rulings and 36 per cent of the Supreme Court rulings against the law (D and E).10

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These numbers would be considered low in countries with well-functioning legal systems, but in Indonesia the problems of implementing a bankruptcy declaration or suspension are probably even more substantial than in other countries, and the low level of the overall functioning of the restructuring and bankruptcy procedures is disquieting. Nevertheless, our preliminary findings show a better court performance and more potential for improvement than generally believed. As mentioned above, commentators believe that most rulings are not in accordance with the law, partly because judges do not understand the law. Our results suggest the contrary: most rulings are in accordance with the law, and judges do understand the law. That leaves inconsistency in judicial performance as the main problem to be solved. Judges’ Understanding of the Bankruptcy Law

We do not deny that the education of judges requires attention, but, as stated above, we found that judges are capable of issuing well-motivated and correct decisions on all key legal subjects. People often suggest that the interpretations of syndicated loan agreements, acceleration and maturity clauses, the position of secured creditors and the meaning of ‘debt’ indicate that judges do not understand complicated issues.11 We found that well-founded judgments were issued on such matters. Our impression is that as long as judges are ‘left alone’ – in the sense that they are not under internal, governmental or party pressure to issue a certain ruling – their rulings are in accordance with the law. It is of course not possible to prove if, when and to what extent pressure or corruption is involved. Most probably, these occur in high-profile cases and/or cases involving foreign creditors, but they may also occur in low-profile cases between Indonesian parties. We do not know how a certain decision was reached; we only conclude, from the written court judgments, that a correct decision has been issued on all key legal subjects. We also found that the standard court opinion on a certain legal issue was usually consistent from the beginning or from a certain point in time. This could imply that judges have no difficulty understanding the law but pretend to misinterpret the law or contract if they are under pressure to accept or reject a petition. When we finalise our research we will be able to give an exact overview of all the decisions of judges on key legal subjects, how these have changed over time and the extent to which the opinions of each specific judge are consistent. If the final results confirm our preliminary findings discussed above, there is no reason to question the ability of judges to implement the Bankruptcy Law correctly. Judges’ Acceptance of the Current Bankruptcy Law

Another common complaint is that Indonesian judges do not accept the current Bankruptcy Law and deliberately obstruct the system. We have not found evi-

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dence that some judges make more decisions against the law than others or that judges seem to obstruct the law. It is well known that some judges are more vulnerable to corruption than others, but that is an issue of personal strength, which is a moral and character issue and may partly relate to financial independence. It does not say anything about the ‘inner belief’ of individual judges that the proper functioning of the current Bankruptcy Law would be in Indonesia’s interests. Moreover, for quite a few subjects we found consistent and correct applications of the Bankruptcy Law, suggesting that judges want to make the system work. Below, we give some interesting examples. The first concerns the timing of petitions. The Bankruptcy Law has two different kinds of procedures. Debtors can be petitioned (or voluntarily apply) for bankruptcy or may request a temporary suspension of debt repayment in order to reorganise their financial situation and/or try to reach a debt settlement with their creditors. The Bankruptcy Law stipulates that if a bankruptcy petition and suspension of payments petition are heard at the same time, the petition for suspension of payments must be heard first.12 After the first hearing, the Commercial Court must immediately, without investigation beyond the formal requirements, grant a provisional suspension of payments.13 However, some debtors developed a tactic to gain time. They defended their financial position in reply to a bankruptcy petition by bringing up all kinds of excuses and witnesses while submitting a great deal of evidence, deliberately delaying the bankruptcy proceedings. Then, at the end of the 30-day period within which the Commercial Court must issue a decision on the bankruptcy petition, they filed a petition for suspension of payments – sometimes only half an hour before the court was due to issue its ruling. In that way, debtors were sure to prevent a bankruptcy declaration, as the Commercial Court must grant a provisional suspension of payments immediately if both petitions are heard at ‘the same time’. Dutch bankruptcy law is almost identical to that of Indonesia, and Dutch bankruptcy judges accept such an interpretation of the law. In Indonesia, however, the Commercial Court judges realised that debtors were deliberately obstructing the law and stopped the practice by interpreting the words ‘heard at the same time’ in a very limited way. In July 2000, the Commercial Court issued a clear ruling on the time until which a petition for suspension of payments could be filed, forcing debtors to choose between the two proceedings and limiting misuse of the law. The Commercial Court ruled that a petition for a provisional suspension of payments must be filed before the second session regarding the bankruptcy petition, so that the suspension of payments petition is examined first and the examination of the bankruptcy petition can be postponed. This interpretation has been confirmed by the Supreme Court and has since been applied almost consistently.14 The second indication that judges are willing to apply the Bankruptcy Law correctly is, as mentioned above, that some legal problems, such as the interpretation of an acceleration clause in a syndicated loan agreement, have been

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solved quickly. For some subjects, such as the legal status of a debtor in liquidation, we found a clear ‘turnaround point’ after which the law was applied correctly and almost consistently. A third example is the interpretation of ‘debt’, which has been almost consistent since the beginning of 1999.15 Moreover, contrary to general impressions, judges apply reasoning consistently for many subjects. For example, the Commercial Court’s opinion on what is required to establish plurality of creditors has been almost literally the same over the years. Finally, judges often make reference to previous Commercial Court and Supreme Court case law to substantiate certain judgments. WHAT COULD AND SHOULD CHANGE? Failure or Work in Progress?

We have argued that many of the initial goals of bankruptcy law reform have not yet been achieved. What could and should change? Could the Bankruptcy Law in its current format function properly in the future? Could the present problems be solved by further Bankruptcy Law amendments or should a completely different law – for example, an American style ‘Chapter 11’ – replace the Bankruptcy Law?16 We like to call Indonesia’s bankruptcy law reform a ‘work in progress’ rather than a failure. The current system contains no failures or problems that cannot be solved. There is no need to overhaul the current Bankruptcy Law. However, in the present circumstances it does not look as though problems will be solved in the short term. The bankruptcy system still receives foreign and Indonesian support, but international aid and attention seem to focus on new issues like ‘good governance’ and ‘fighting corruption’; as a result, commercial courts are asked to concentrate on intellectual property rights and other commercial disputes rather than bankruptcy. A consequence is the continuing decline in the number of petitions filed. This further diminishes the confidence of creditors and debtors. Some judges and commentators argue that the decline in bankruptcy cases implies that ‘the problem has been solved’ and that Indonesia’s economic recovery has resulted in a decrease in the number of insolvent companies. However, in 2002 more than 1,600 Indonesian companies ceased operation outside bankruptcy,17 while only 39 bankruptcy petitions were filed. Such figures suggest that there is still significant scope for bankruptcy-related legal services in Indonesia. There has also been a problem in granting access to data. AusAID and KPMG Melbourne provided the Commercial Court with assistance to develop a website, but the project never took off.18 The aim was to grant public access to all of the Commercial Court’s data through the website, . This objective has not been fully realised, and it has become more

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difficult to receive hard copies of rulings from the Commercial Court. Moreover, the notice board in the Commercial Court no longer contains updated time schedules. This is all detrimental to the transparency of bankruptcy proceedings. If such an approach continues, it is unlikely that bankruptcy proceedings will work effectively in the short term. Addressing Obstacles to the Bankruptcy Law

Most obstacles to implementing Indonesia’s Bankruptcy Law are related to the unpredictability of the courts. Solutions could include combating internal and external pressure and corruption and improving the standards of bankruptcy lawyers. However, the most important issue is to identify the reasons for the unpredictability. This should be given a high priority if Indonesia wants to continue restructuring and bankruptcy law reform and enhance its court performance in general. If solving the unpredictability, and hence the unreliability, of the court performance is a long-term project, as argued by some Indonesian and foreign experts, any law reform will be dead by the time the problems are identified and addressed properly. Replacing the Bankruptcy Law by another regulation is unlikely to be an effective solution. Judges under pressure will misinterpret every regulation to reach the desired outcome. Amendment of certain parts of the current law could be considered in order to make the system less vulnerable to internal and external influence. An example would be altering the powerful position of the supervisory judge who oversees the receiver. The few purely legal obstacles are not particularly complicated and could be solved by amending the Bankruptcy Law and implementing regulations – for example, implementing a more effective system aimed at safeguarding the quality and behaviour of lawyers. It is beyond the scope of this article to discuss all legal subjects that should or could be amended. We simply note that starting all over again with a new system would cost a lot of time and effort without clear gains. Moreover, a new system could cause substantial new problems, particularly because a common law insolvency system – the best alternative according to some specialists – may not fit very well with Indonesia’s civil law jurisdiction. That brings us to the second issue: gaining a proper understanding of the functioning and scope of the current Bankruptcy Law in the context of a civil law jurisdiction. This chapter would contain too many legal details if we started to elaborate all misunderstandings surrounding the Bankruptcy Law and its interaction with the Civil Code and Company Law. Rather, we address below three of the most striking misconceptions. Many legal commentators believe that the Indonesian Bankruptcy Law in general is a badly made, outdated colonial law. But the same law is still in force in the Netherlands, and its current format in both countries is the result of

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numerous revisions throughout the 20th century to meet the demands of modern society and to codify case law adjustments and interpretations. So far, the Dutch bankruptcy law has been able to serve Dutch society and economy even for substantial bankruptcy cases such as those concerning OGEM,19 the Bank of Credit and Commerce International, DAF,20 Fokker, Tulip and Air Holland. The fact that the law functions properly in the Netherlands is not in itself a reason to believe that the current law should be appropriate for Indonesia as well, because each country has a very different economic and political environment. However, if the Indonesian law is to be replaced, it should be for reasons other than the fact that it is considered to be ‘an outdated colonial regulation’. A second often-heard complaint about the current law in a civil law jurisdiction like Indonesia’s is that, unlike common law jurisdictions, there is no doctrine of precedents. Neither the Netherlands nor Indonesia has a formal principle of binding precedents, but in practice the principle has been applied for centuries in both countries. The Commercial Court and Supreme Court rulings on bankruptcy issues confirm the principle of binding precedents. There are some exceptions, but judges do refer to earlier Commercial Court and Supreme Court case law and repeatedly apply the same interpretation of legal terms used in earlier rulings. A third misconception is that Indonesia’s Bankruptcy Law is mainly directed towards the liquidation of debtors. Both the bankruptcy chapter and the suspension of payments chapter of the current Bankruptcy Law contain extensive procedures to sustain debtor restructuring. It is often said that a company that is declared bankrupt will be liquidated. In fact, the contrary is true. After the bankruptcy declaration, the bankrupt company will not be declared to be in a ‘state of insolvency’ until all restructuring measures have failed. Only then is the receiver allowed to start liquidating the bankrupt company. Further, the suspension of payments chapter of the Bankruptcy Law is completely directed towards restructuring the debtor in suspension. It may well be that at present the current restructuring provisions of the Bankruptcy Law are not implemented successfully. However, as argued above, most of these problems can probably be reduced to corruption associations between the judges, the supervisory judge, the receiver, the lawyers, the debtor and the police. As suggested above, the government could consider amending parts of the Bankruptcy Law to reduce its vulnerability to internal and external pressure and to enhance its restructuring ability.21 CONCLUSION

On one hand, Indonesian bankruptcy law reform has been a success. The new law introduced published decisions, a fixed time frame, ad hoc judges, dissent-

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ing opinions and independent receivership. Moreover, it seems to bring parties to the negotiation table: one-third of all bankruptcy petitions filed ends in an out-of-court settlement. On the other hand, after five years the bankruptcy law reform initiated in 1998 seems to be petering out. The number of bankruptcy and suspension of payments petitions filed has declined considerably; the commercial courts – which were initially established to handle restructuring and bankruptcy cases under the Bankruptcy Law – have been asked to concentrate on other commercial issues; and Indonesian and foreign focus has shifted towards other problems in the country. The apparent malfunctioning of bankruptcy law reform is generally attributed to three factors: the system’s vulnerability to corruption; Commercial Court and Supreme Court judges’ lack of understanding of the Bankruptcy Law and Indonesian law in general; and the contents of the current Bankruptcy Law. We believe that the reality is not so simple. The Commercial Court and Supreme Court performance is indeed not reliable, because the outcomes of rulings are highly unpredictable. But what dynamics cause the unpredictability? Judges show the capability and willingness to implement the Bankruptcy Law. The structure of the law needs some amendment, but the law could function effectively within Indonesia’s legal framework. Clearly, the soundness and consistency of court decisions are not determined only by legal complexity or the ability of individual judges. Rather, it seems that most error and inconsistency is caused by other unidentified dynamics – of which corruption is a part, but not the only part. Our findings flag at least one other problem: the performance of bankruptcy lawyers. The professional standards of the private legal professions not only are significantly weaker than these of the judiciary but also seem to be deliberately designed to obscure and obstruct the proper administration of justice. NOTES The authors thank Wisnu, Hendrianto, Herry N. Kurnjawan, Pierre van der Eng and Sebastiaan Pompe for their input and useful comments on earlier drafts of this chapter. 1

2 3

‘Diagnostic Assessment of Legal Development in Indonesia (IDF Grant No. 28557)’, research study undertaken by Ali Budiardjo, Nugroho, Reksodiputro (in cooperation with Mochtar, Karuwin and Komar) together with CYBERconsult for the World Bank and Bappenas, 1996–97. A summary of this paper is available online at . See Churchill (2000). Specific dates are mentioned on p. 172; for the whole overview see pp. 171–183. By Decree of the State Minister for National Development Planning/Head of the

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National Development Planning Agency (Keputusan Menteri Negara PPN/Kepala Bappenas), No. KEP-216/KEP/6/1998 of 16 June 1998. 4 KEP-216/KEP/6/1998 of 16 June 1998, footnote 3, p. 174. 5 In 1998 (August – December) there were 31 cases; in 1999, 100 cases; in 2000, 84 cases; in 2001, 61 cases; in 2002, 39 cases; and in 2003, 38 cases. 6 ‘A’ stands for ‘considerations and outcome in accordance with the law and/or in line with earlier Commercial Court and/or Supreme Court case law’. ‘B’ stands for ‘considerations partly correct (that is, mostly in accordance with the law and in line with earlier case law) and/or partly open for discussion, outcome sustainable’. ‘C’ stands for ‘considerations and outcome partly not correct (either not in accordance with the law or not in line with earlier case law) to our opinion, but arguable and defensible’. ‘D’ stands for ‘considerations and outcome mostly not in accordance with the law or not in line with earlier case law, but an understandable misinterpretation/ misunderstanding of the law that can probably be attributed to an indistinctness/ illegibility in, or unaccustomedness with, the law or underlying agreement’; in other words, the outcome may be sustainable (that is, the petition had to be rejected/ accepted, but the considerations are (mostly) not in accordance with the law). ‘E’ stands for ‘considerations all or mostly not in accordance with the law and not in line with Commercial Court and/or Supreme Court case law, non-defensible misunderstanding, unwillingness to understand the law, complete nonsense, probable misconduct’. 7 In other words, the court’s considerations were well founded, with the rulings containing clear legal motivations, compared with, say, a decision rejecting a bankruptcy petition without explaining why it was rejected. 8 Bankruptcy Law, Article 6, section 4. 9 The Orphan’s Chamber may still be appointed (Bankruptcy Law, Article 13, section 2) but so far this has seldom occurred, because parties almost always request the appointment of a private receiver. In that case the Commercial Court or Supreme Court appoints a private receiver, contrary to what some experts believe. See Brietzke (2001). 10 These percentages represent an average of all Commercial Court and Supreme Court rulings in cassation and civil review. Exact numbers per court (Commercial Court and Supreme Court) and development over the five years from 1998 to 2003 will be available when we finish our study, which we expect to be published in the course of 2004. We stress that these numbers show the performance of the Commercial Court and the Supreme Court only with respect to decisions on bankruptcy and suspension of payments petitions. Moreover, they qualify decisions as a whole and do not show the court’s performance on key issues, which are discussed later in this chapter. 11 For example, Sullivan, Ng and Tardifk (2003: 7) say: ‘In this regard the Commercial Court has not proved to be that much different from the rest of the Indonesian court system, plagued as it is with … inability and/or unwillingness to understand complex business and financial structures’. And Lindsey and Taylor (2000: 10) say: ‘The Commercial Court bench clearly has significant difficulties with understanding complex financial transactions, such as derivatives and syndicated loans’. 12 Bankruptcy Law, Article 217, section 6.

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13 Bankruptcy Law, Article 214, section 2. 14 Commercial Court No. 41/Pailit/2000/PN.Niaga/Jkt.Pst.: IBRA versus PT Landasan Terus Sentosa. 15 Based on preliminary findings; these results could change when we finalise our study. 16 Chapter 11 of the United States Bankruptcy Act regarding corporate restructuring and rehabilitation. There are three main differences between this act and the Indonesian rules for restructuring (the Indonesian Bankruptcy Law chapter on suspension of payments). The first concerns the requirements needed to enter the restructuring proceedings (under the US system, good faith; under the Indonesian system, failure to pay a due and payable debt and two or more creditors). The second concerns who controls the company during restructuring. Under the US system, these are the debtor’s directors unless the court orders their replacement by a trustee; under the Indonesian system, it is a court-appointed registered administrator. The third is the time to develop a restructuring plan (under the US system, 120 days; under the Indonesian system, 270 days). 17 According to the Central Statistics Agency (BPS); see Sebastiaan Pompe, ‘Indonesian Courts Create Unemployment’, Jakarta Post, 26 January 2004. 18 See Churchill (2000: 171–183). 19 Overzeese Gas- en Electriciteitsmaatschappij. 20 Van Doorne’s Auto Fabriek. 21 In the Netherlands (Bill 27 244), the five most important measures recommended to enhance the restructuring of Dutch bankruptcy law are to tighten the entrance controls for a suspension of payments and broaden the scope; to extend the stay in suspension of payments from one to two months, with one possible extension for another month (the current Indonesian Bankruptcy Law has a stay on secured and preferred creditors’ rights for the full period of the proceedings, which is a maximum period of 270 days); to increase the role of the administrator and supervisory judge; to change the position of the debtor’s energy providers; and to establish a central public register for information concerning suspensions of payment. See Declercq (2002: 50–57).

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As the supply side of the corruption supply-and-demand equation, the private sector is regarded as a major contributor to public sector corruption. Transparency International’s 2002 Bribe Payers Index found that public officials in the public works and construction industry and in the arms and defence, oil and gas and real estate and property sectors were the most inclined to be involved in bribery (Lyne and Bruns 2002). A survey of South African businesses found that the private sector initiated the unfair business practices first, and 44 per cent of respondents agreed that private sector practices contributed to public sector corruption (Carrazedo and Barnes n.d.). The authors found that corruption appears to be driven less by public sector demands than by business practices more generally, but the literature recognises that corruption hinders the development of the private sector. Small and medium-sized firms (defined as having 50–500 employees) are seen as being particularly vulnerable to corruption, because they often depend on single contracts and because they tend to lack the internal procedures that large and foreign-owned firms use to resist corruption (Arvis and Berenbeim 2002). The Asian financial crisis has shown that there is no ‘Asian exception’ to the problem of corruption (Arvis and Berenbeim 2002). There is increasing evidence to refute the notion of the ‘grease hypothesis’ that corruption mitigates bureaucratic inefficiency and is a consequence of economic underdevelopment. The distinction between private and public sector corruption loses significance, as it is the interaction between the two that produces the corruption in the first place. The bribe giver is no less culpable than the bribe receiver (Partnership against Corruption 2003). This chapter examines the relationship between private and public sector corruption. It is based on data from the National Survey of Corruption in Indonesia 2001 conducted by the Partnership for Governance Reform in Indonesia.1 204

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Table 13.1 Characteristics of the Business Enterprise Sample Location Size

Company characteristics

Respondent characteristics

94 per cent of companies were located in urban areas and 6 per cent in semi-urban and rural areas. 52 per cent of companies were classified as small (5–50 employees), 37 per cent as medium-sized (51–200 employees) and 13 per cent as large (more than 200 employees).

49 per cent of businesses were private companies; 17 per cent were publicly listed; 32 per cent were proprietorships or partnerships; and 2 per cent were other legal organisations such as state-owned enterprises, foundations, cooperatives and cottage industries. 18 per cent of companies had foreign ownership; about one-third of these had up to 20 per cent foreign ownership, about one-third had 20 per cent to 50 per cent foreign ownership, and about one-third had more than 50 per cent foreign ownership. 50 per cent of companies started operations after 1990, 40 per cent were established between 1965 and 1990 and 10 per cent were established prior to 1965. 34 per cent of respondents were directors, owners or partners, 60 per cent were managers and 6 per cent were other company staff. 84 per cent of respondents were male and 16 per cent were female. 54 per cent of respondents were university graduates; 11 per cent also held postgraduate degrees; and 13 per cent held associate diplomas. The remaining 22 per cent were educated to high school level.

The survey resulted in responses by 400 business enterprises from seven industry sectors and eight cities2 out of a total sample of 2,300 respondents.3 Table 13.1 provides sample characteristics of the respondents. Results from four other surveys are used for comparison. These are the 1997 World Economic Forum survey of more than 3,000 firms in 59 countries; the 1999–2000 World Bank survey of 3,600 firms in 69 countries (Arvis and Berenbeim 2002); a 2002 sur-

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vey of 11 companies in West Java (Azfar 2003); and a 2001 study by LPEM– FEUI on the relationship between the frequency of bribe payments and the amount of time spent in dealing with government bureaucracy (Basri 2003). Analysis of data from the 2001 Indonesian national survey was limited by the absence of survey questions about the nature of private sector corruption – for example, questions about the type of payment and payment method. In addition, the usable sample size was reduced because of ambiguities in the data. This occurred because many respondents did not answer questions about some variables, and the survey report gave these a zero ranking, the same as the ranking for deliberate non-zero responses. In other words, there was no way to distinguish between zero as a missing response and zero as a deliberate nonresponse to a particular question. Accordingly, the limited sample size was not large enough for multivariate analyses: results were largely confined to descriptive statistics and should be interpreted in the light of sample bias. THE PARADOX OF CORRUPTION Hess and Dunfee (2000) described the problem of corruption as a paradox in that it is ‘universally disapproved yet universally prevalent’. The results of the Indonesian national survey certainly supported the prevalence of corruption, but were less definite about the extent of disapproval. Some 87 per cent of companies considered corruption in the public sector to be ‘common’; 41 per cent of respondents reported having to frequently or always pay bribes in the course of business. The 2001 Indonesian national survey also found that companies were more likely to have experienced corruption than were other respondents: 45 per cent of business enterprise respondents reported having observed corruption involving a public official in the previous two years compared to 41 per cent of public officials and 35 per cent of households. While 32 per cent of business enterprise respondents admitted knowing the procedure for reporting corruption, only 22 per cent had actually reported corruption they had observed (Partnership against Corruption 2003). The 1999–2000 World Bank survey found corruption to be one of the three most important obstacles to conducting business in developing countries (Arvis and Berenbeim 2002). In Indonesia, corruption was not among the top three obstacles, unlike the situation in the Philippines, Thailand and India. Rather, its scores were more similar to those of Malaysia and China. Table 13.2 compares the top three obstacles to business growth in seven Asian countries based on mean scores from the World Bank survey. Respondents to the World Bank survey ranked corruption the sixth most problematic obstacle to conducting business in Indonesia, after macroeconomic

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Table 13.2 Top Three Obstacles to Business Growth in Seven Asian Countries Country

Most Problematic

Second Most Problematic

Third Most Problematic

China

Availability of financing

Inflation

Policy instability

Inflation

Policy instability

Corruption

Availability of financing

Inflation

Policy instability

India

Indonesia

Exchange rate

Philippines

Exchange rate

Malaysia

Singapore Thailand

Availability of financing

Organised crime

Inflation

Inflation

Policy instability Corruption

Exchange rate

Inflation

Exchange rate

Corruption

Source: PGRI (2001); World Bank (2000b).

factors and alongside street crime. The fact that corruption was not among the top three probably reflects prevailing economic concerns at the time the survey was conducted (two years after the financial crisis) but also points to a lower level of awareness of corruption as a problem for business in Indonesia compared with other countries. Responses to similar questions in the 2001 Indonesian national survey ranked corruption as the second-last most important obstacle, ahead of ineffective courts and police. In the 2002 West Java survey (Azfar 2003), most companies considered corruption to be ‘a very serious problem’ but they also considered the cost of inputs and labour, business competition and financing to be more serious than corruption, unofficial roadblocks and unreliable public services. Table 13.3 compares the Indonesian mean scores for 10 factors from the 1999–2000 World Bank survey and the 2001 Indonesian national survey. THE COSTS OF CORRUPTION The negative impact of corruption on economic development is well documented in the literature.4 The 2001 Indonesian national survey provided some

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Table 13.3 Mean Score Comparison of 10 Factors Affecting Business Growth Factor

Indonesian National Surveya Score

1 2

Availability of financing Macroeconomic factors including inflation and exchange rate fluctuations 3 Political instability 4 Regulatory environment including high taxes and complex regulations 5 Insufficient and unstable demand 6 Costs 7 Infrastructure 8 Corruption (both public and private) 9 Ineffective courts and police 10 Crime, theft and disorder (including street crime and organised crime)

Rank

World Bank Surveyb Score

Rank

3.6

1

3.6

3

3.6 3.3

2 3

4.1 3.9

1 2

3.3 3.2 3.2 3.2 3.0 3.0

3 4 4 5 7 8

3.2 – – 3.5 3.3 2.2

7

3.2

6

3.3

6

4 5 8

a The 2001 Indonesian national survey replies were measured on a five-point scale, with 1 indicating no effect on business growth and 5 a high effect on business growth. b The 1999–2000 World Bank survey mean scores were converted from a four-point scale to a five-point scale for comparison with the 2001 Indonesian national survey. Source: PGRI (2001); World Bank (2000b).

evidence for this negative effect. Approximately 35 per cent of businesses cited high corruption-related costs as a reason for not investing in new projects in the previous year. However, 74 per cent of business enterprise respondents gave the uncertain economy as the main reason, followed by high input costs (66 per cent) and business downturn (66 per cent), ahead of corruption (PGRI 2001). In terms of the direct costs of corruption, a 1999 report estimated that 20 per cent of business costs in Indonesia were payments to bureaucrats.5 The 1999– 2000 World Bank survey found that 25 per cent of firms in Indonesia paid more than 10 per cent of sales revenue in bribes (Arvis and Berenbeim 2002). Find-

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Figure 13.1 Size of Unofficial Payments by Company Size (% of monthly company revenue) 100 80 60 40 20 0

Small company Less than 5%

Medium company 5 to 10%

Large company More than 10%

Source: PGRI (2001).

ings from the 2001 Indonesian national survey were similar: 27 per cent of businesses reported paying at least 10 per cent of company revenue in unofficial payments. Figure 13.1 shows the percentage of monthly company revenue spent on unofficial payments by size of company. Corruption also generated indirect costs to companies through management time spent on paperwork and bureaucratic red tape. The 1997 World Economic Forum survey found that companies that reported higher levels of bribery consistently spent more management time dealing with bureaucratic red tape, for example, negotiating licences, signing documents, obtaining permits and paying taxes.6 The 2001 LPEM–FEUI study found a direct correlation between the frequency of bribe payments and the amount of time spent in dealing with government bureaucracy (Basri 2003). In the 2001 Indonesian national survey, 24 per cent of companies reported that senior managers spent more than 5 per cent of their time dealing with government officials in relation to laws and regulations affecting their businesses. The relationship between the amount paid as bribes (as a percentage of company revenue) and the indirect cost of management time was not statistically significant, but the direction of the relationship can be seen in Figure 13.2: in

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Figure 13.2 Extent of Unofficial Payments by Amount of Time Spent by Senior Managers in Dealing with Government Officials (% of managers’ time) 100 80 60 40 20 0

No payments No

Payments 0%

Less than 5% Payments less than 5% Less than 1%

1 to 5%

More than 5% Payments more than 5% More than 5%

Source: PGRI (2001).

companies that spent more than 5 per cent of company revenue on unofficial payments, managers also spent more than 5 per cent of their time in dealing with government officials. This result is consistent with the LPEM–FEUI study, which found that higher levels of bribery do not necessarily translate into less time dealing with government bureaucracy. CHARACTERISTICS OF CORRUPTION The 2001 Indonesian national survey covered five types of corruption: active corruption (bribery or the giving of favours);7 passive corruption (the receiving of favours);8 misappropriation and fraud; grand corruption; and petty corruption. The survey did not include the abuse of public power for private gain, illegal political party financing, embezzlement, money laundering, favouritism (cronyism and nepotism), extortion, abuse of discretion or conflict of interest.9 In the 2001 Indonesian national survey, respondents were asked for their reaction to some hypothetical scenarios concerning corruption. The first of

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Table 13.4 Respondents’ Reactions to Scenario of Bribing a Judge to Win a Case Response

No.

Percentage

Feel angry and not pay Feel angry but pay Accept as normal but not pay Accept as normal and pay Feel relieved and pay Don’t know

247 76 37 26 6 8

61.8 19.0 9.3 6.5 1.5 2.0

Total

400

100.0

Source: PGRI (2001).

these involved a situation where they had to bribe a judge to decide in favour of their legal case. Table 13.4 shows that 27 per cent of the business enterprise respondents indicated that they would pay the bribe in this situation. However, 81 per cent reported ‘feeling angry’ at the situation; only about 17 per cent accepted the situation as ‘normal’.10 It seems that companies may engage in active corruption, but do not view such payments with approval – at least in relation to judicial corruption. A second scenario concerned the acceptance of a bribe – the acceptance of a big gift from a supplier just before Idul Fitri, the religious holiday marking the end of Ramadan. Approximately 85 per cent of business enterprise respondents indicated that they would accept the gift and 5 per cent said that they would even help the supplier (Table 13.5). Only 14 per cent reported ‘feeling angry’ at being offered the gift and said they would reject it. There appeared to be a discrepancy in the business perception of what constituted bribery: most respondents (80 per cent) did not equate acceptance of the gift with having to do favours for the supplier even though acceptance implies an expectation of reciprocity (Steidlmeier 1999). To summarise, there is a clear difference between active corruption (27 per cent pay) and passive corruption (85 per cent accept), with more opposition to active corruption (75 per cent feel angry) than passive corruption (14 per cent feel angry) (PGRI 2001). Policy-makers need to provide clear definitions of the types of business practices that constitute corruption and provide suitable policy guidelines to control the limits of gift-giving.

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Table 13.5 Respondents’ Reactions to Scenario of Accepting a Gift from a Supplier Response

No.

Percentage

Feel angry, not accept and shout back Feel angry, not accept and do nothing Accept as normal and ignore Accept as normal and do nothing for supplier Accept as normal and help supplier Don’t know

14 41 127

3.5 10.3 31.9

192 21 5

48.0 5.3 1.3

Total

400

100.0

Source: PGRI (2001).

A third scenario concerned the situation where a government official offers to let a business owner win a supply contract by marking up the contract price by 10 per cent in return for 20 per cent of the contract price. The results are shown in Table 13.6. Forty-seven per cent of business enterprise respondents regarded this situation as ‘normal’; 54 per cent indicated that they would pay the extra in order to win the contract. There was no consensus on whether the practice was acceptable: 48 per cent reported ‘feeling angry’ about the situation, but 54 per cent would pay to win the contract. The responses to this corruption scenario provided an indication of not only the prevalence of price inflation on government procurement contracts, but also the frequency of collusion on such contracts. The corruption that occurs in the bidding for government procurement contracts is a level of ‘grand corruption’ that leads to other abuses such as the aforementioned fraud through inflated prices and bid rigging (Arvis and Berenbeim 2002). In the 2001 Indonesian national survey, approximately 43 per cent of business enterprise respondents indicated that government procurement contracts were not generated in a clear and efficient manner; 30 per cent stated that this was ‘never’ the case. This was in contrast to 20 per cent of respondents who considered government procurement contracts to be frequently or always generated in a clear and efficient manner. In the 2001 Indonesian national survey, 41 per cent of businesses reported that 5–20 per cent of procurement contracts involved unofficial payments; 11

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Table 13.6 Respondents’ Reactions to Scenario of Marking up a Price to Win a Contract Response

No.

Percentage

Feel angry and not pay Feel angry and but pay Accept as normal but not pay Accept as normal and pay Feel relieved and pay Don’t know

115 75 58 128 12 12

28.8 18.8 14.5 32.0 3.0 3.0

Total

400

100.0

Source: PGRI (2001).

per cent reported unofficial payments in more than 20 per cent of procurement contracts. Thirty-six per cent of businesses paid below 5 per cent of the contract price in unofficial payments; 39 per cent paid 5–10 per cent; 15 per cent paid 10–20 per cent; and 10 per cent paid more than 20 per cent (PGRI 2001). Sixty-five per cent of business enterprise respondents considered ‘connections’ to be even more important than unofficial payments in winning government procurement contracts; 32 per cent of respondents considered unofficial payments to be an important factor. Seventy-nine per cent of respondents considered the qualifications and competitiveness of bidders to be the most important factors. While the direct impact of grand corruption is limited to the unsuccessful bidders for the contract, there is a deeper detrimental effect on the general integrity of the entire bidding system. As Langseth (2003) argued, corruption neutralises competition based on innovation and efficiency and skews contracts away from a merit-based system. The other major form of corruption is petty corruption that involves facilitating payments or small payments to low-level bureaucrats to help speed up slow-moving public services such as customs clearance and the provision of licences, or to avoid certain costs (Arvis and Berenbeim 2002). In the 2001 Indonesian national survey, respondents were asked about a scenario that involved paying uang rokok (cigarette money) to the lurah (village head) for a kartu tanda penduduk (resident identification card) and one that involved bribing a policeman to avoid a ticket. Sixty-three per cent of respondents considered the first scenario to be a ‘normal’ or common situation, compared with 45

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per cent for the second scenario. The different responses reflected distinctions in the seniority of those involved and whether the corruption was institutionalised or occasional (Langseth 2003). While it is recognised that petty corruption cannot be completely eliminated and that practicality dictates whether small, nominal, facilitating payments are tolerated (Arvis and Berenbeim 2002), the extent of petty corruption in the public sector cannot be underestimated. Table 13.7 shows the private sector’s experience with public sector corruption in terms of frequency of contact, unofficial payments and the average amount of bribe paid. In the 2001 Indonesian national survey, businesses reported that most contacts involving unofficial payments were with the police (68 per cent) and customs (55 per cent), followed by licensing authorities (38 per cent) and the courts (35 per cent). The maximum bribe paid was reported to be Rp 500 million (to the courts and tax department), followed by Rp 100 million for a safety inspection and Rp 30 million to customs. The three highest average bribes paid were to the courts (Rp 42.8 million), the tax department (Rp 9.7 million) and regulatory agencies (Rp 2.1 million). In this respect, there is a cumulative effect of systemic petty corruption: it is not a one-off phenomenon but rather a recurring one that can lead to larger payments as other companies engage in ‘competitive bribery’ leading to blackmail and extortion.11 Business enterprise respondents considered licensing and taxation to be the two most difficult government requirements to meet. The licensing authorities had the third highest proportion of unofficial payments (Table 13.7). An average of five weeks was required to process a business license for 79 per cent of respondents; 13 per cent required up to 10 weeks and 9 per cent needed 12 weeks or more. Furthermore, for the 86 companies that imported goods (22 per cent of the sample), a regression analysis estimated that the actual time required to clear goods through customs was 3.6 days longer than the official time.12 In addition, Figure 13.3 suggests that, while paying some amount of bribe seemed to reduce the amount of time needed to clear goods through customs, paying too much seemed to increase the time required. MANAGEMENT OF CORRUPTION Do private sector business practices or public sector demands fuel corruption? The 2001 Indonesian national survey did not provide a clear answer. Twentyseven per cent of business enterprise respondents mentioned that a public official had directly requested the payment or that a third-party ‘middleman’ had facilitated the process. Fifty-four per cent of business enterprises reported knowing the payment method and amount of payment beforehand; and even the

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Table 13.7 Frequency of Contacts, Contacts Involving Unofficial Payments and Average Amount, by Public Institution Public Institution

Police Customs Licensing authorities a Courts Tax department Regulatory agencies b Government procurement agencies Social servicesc Utility providers d Postal services

No. of Contacts

278 127 246 54 321 215 51 212 757 257

Contacts Involving Unofficial Payments

(no.)

(%)

11 25 48 7

21.6 11.8 6.3 2.7

189 70 94 19 74 49

68.0 55.1 38.2 35.2 23.1 22.8

Average Amount of Unofficial Payments (Rp thousand) 271 1,184 449 42,816 9,726 2,123 292 140 497 20

a Licensing authorities included the Department of Trade and Industry, Investment Coordinating Board (BKPM) and Capital Market Supervisory Agency (Bapepam). b Regulatory agencies included safety and standards inspections and environmental assessment boards. c Social services included hospitals, public health care and education. d Utility providers included telephone, electricity and water providers. Source: PGRI (2001).

19 per cent of respondents who voluntarily offered a payment indicated that the ‘system’ was well known. These results suggest that corruption is entrenched and part of the ‘normal business practices’ that facilitate business activities. But the ambiguity of the findings of the 2001 Indonesian national survey suggests that there is no support for the hypothesis that corruption smooths the wheels of commerce. Approximately 43 per cent of respondents said that service delivery and problem resolution would be rendered neither more nor less certain with an unofficial payment. About 33 per cent said that there would be certainty with the unofficial payment, while 13 per cent said that there would be less certainty and 11 per cent said that it would depend on the case at hand.

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Figure 13.3 Effect of Unofficial Payments on Import Processing Times (no. of days) a 12 10 8 6 4 2 0

No payments No

Payments

Actual time

Less than 10% Payments less than 10% Official time

More than 10% Payments more than 10% Difference

a ‘Actual time’ is the actual number of days required to clear goods through customs; ‘official time’ is the stated number of days required to clear goods through customs; ‘difference’ is the difference between the actual time and the official time (all as averages). Source: PGRI (2001).

Furthermore, only 45 per cent of business enterprise respondents stated that sometimes there would be recourse to corruption without an unofficial payment, that is, that there may be a solution to a corruption demand that does not involve the payment of a bribe. Approximately 42 per cent stated that this was rarely the case; only 12 per cent indicated that it might be possible to go to another official to receive correct treatment. While the interaction between the private and public sectors appeared to be well established, a bribe payment did not ensure that a service would be delivered or a problem resolved. The equivocal responses of business enterprises in the 2001 Indonesian national survey underscore the challenge of managing corruption in the private sector. If corruption is not clearly seen as a major obstacle to business growth, and unofficial payments do increase the certainty of service delivery about a third of the time, the detrimental impact of corruption will not be fully acknowledged or appreciated. This ambivalence in the private sector’s attitude towards

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Table 13.8 Money Spent on Unofficial Payments and Additional Tax (% of company revenue) % of Company Revenue 0 1–5 >5

Total

Money Spent on Unofficial Payments to Public Officials

Money Spent on Additional Tax to Eliminate Corruption

18 54 28

44 41 15

100

100

Source: PGRI (2001).

corruption is further illustrated in the comparison between the amount of company revenue spent on unofficial payments and the amount of revenue a company was willing to pay as additional tax to eliminate corruption. In the 2001 Indonesian national survey, approximately 56 per cent of respondents indicated a willingness to pay additional taxes in order to eliminate corruption, even though 82 per cent of respondents reported paying a percentage of company revenue in unofficial payments to public officials (Table 13.8). Furthermore, although 28 per cent of business enterprise respondents reported spending more than 5 per cent of company revenue on unofficial payments, only 15 per cent of those agreeing to pay additional taxes were willing to spend more than 5 per cent of company revenues on them. In relation to corruption activities, the interaction between the private sector and public sector corruption appears to be well established, as both sides seem to know what to do. In contrast, the results of corruption are not as evident: there is no certainty that services will be delivered and little opportunity for recourse if things go wrong. Hence, fewer companies were willing to pay more in the form of taxes to reduce corruption. In this sense, corruption has yet to be perceived as a more detrimental extraction to business development than legal mechanisms such as taxation (Arvis and Berenbeim 2002). CONCLUSION Since the 2001 Indonesian national survey, the view has spread in Indonesia that corruption has become ‘even more entrenched in society over the last four

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years’.13 External indicators point to the negative impact of corruption on economic development. There was a 23 per cent decrease in domestic investment approvals to Rp 11.7 trillion as of July 2003 (from Rp 15.3 trillion in the same period in the previous year); and real foreign direct investment (FDI) levels decreased to $2.1 billion as of July 2003 even though FDI approvals actually increased to $4.7 billion (most approvals concerned existing companies switching status to domestic investment companies).14 Although several factors may explain this decline, corruption is likely to be one. For example, the Investment Coordinating Board (BKPM) estimated that more than 100 companies intended to relocate their operations away from Indonesia in 2003, and singled out ‘rampant illegal fees’ as the greatest contributor to the deterioration of the investment climate.15 The Consultative Group on Indonesia (CGI)16 has warned that Indonesia’s economic growth continues to be held back by corruption and the lack of progress in re-establishing the rule of law.17 The Anti-corruption Commission that was stipulated by Law No. 30/2002 and that was to be established by the end of December 2003 had not been formed at the time of writing, even though respondents to the 2001 Indonesian national survey ranked it the most useful institution to fight corruption (PGRI 2001). From the business perspective, the problem of corruption had not reached a critical point at the time of the 2001 Indonesian national survey. The ambiguity of responses on several issues summarised the position. • • • • • •

Corruption was not considered the most serious obstacle to business growth. Corruption was not seen as the major reason not to invest in a new project. More respondents were opposed to active corruption than to passive corruption (75 per cent and 14 per cent respectively). More respondents would pay to win a procurement contract than would not (54 per cent and 43 per cent respectively). More respondents indicated that paying bribes would increase the certainty of a service delivery or problem resolution than not (33 per cent and 13 per cent respectively). More companies were prepared to pay bribes than to pay additional taxes to eliminate corruption (82 per cent versus 56 per cent).

But there was empirical evidence for the negative impact of corruption on business. •

Spending more on bribes did not reduce bureaucratic inefficiency, as companies that spent more than 5 per cent of company revenue on unofficial payments also spent more than 5 per cent of management time dealing with government bureaucracy.

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Similarly, petty corruption in customs increased the actual clearance time for imported goods by 3.6 days, but paying more in bribes also increased the time required. Grand corruption in government procurement contracts diminished the integrity of the procurement system, with 52 per cent of respondents indicating that some unofficial payments were required in procurement contracts but 79 per cent stating that qualifications and competitiveness were the most important factors.

The ambiguity of the findings could be due to sample bias and the time at which the survey was undertaken. But it would appear that more awareness is needed to minimise the discrepancy in the perceptions of active and passive corruption; and there is a need to inform the business community that corruption leads to negative returns and uncertainty in terms of management time, importing time and certainty of service delivery. The empirical evidence from the 2001 Indonesian national survey can serve as the platform from which to address the ambivalent attitude of the private sector in dealing with public sector corruption. NOTES The author wishes to thank the Partnership for Governance Reform in Indonesia, in particular Debbie Palmer, Anti-corruption Advisor, for providing funding support for the research. The contribution of Travis Chromiak for the statistical analyses and graphical presentations is gratefully acknowledged. All errors and omissions are the responsibility of the author. 1 2

3 4 5 6 7

The Partnership for Governance Reform in Indonesia is a coalition of government, civil society, the private sector and Indonesia’s international development partners. The seven industries were agriculture; mining; manufacturing; construction; trade and restaurants; transportation; and financial institutions. The eight cities were Jabotabek (Greater Jakarta, including Jakarta, Bogor, Tangerang and Bekasi); Surabaya; Bandung; Semarang; Medan; Denpasar; Batam; and Ujung Pandang (Makassar). The 2,300 respondents consisted of 1,250 households, 650 public officials and 400 business enterprises. See, for example, Arvis and Berenbeim (2002) and Andvig and Fjeldstad (2000). See Business for Social Responsibility, . See Business for Social Responsibility, . Article K.3.2 of the Treaty of the European Union on corruption in the private sector defines active corruption as the deliberate direct or indirect promising, offering or giving of an undue advantage in the course of business activities such that the individual should perform or refrain from performing an act in breach of one’s duties. See .

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8 See footnote 7. 9 See Langseth (2003) and Business for Social Responsibility at . 10 The 2001 Indonesian national survey used the the words biasa and wajar to mean something common, usual or a habitual occurrence and not to imply approval or condoning of the behaviour. 11 See Arvis and Berenbeim (2002) and Business for Social Responsibility at . 12 The equation was based on a linear regression between the official time to import goods as the independent variable and the actual time as the dependent variable. The estimates of the coefficients were statistically significant at