A scan of international media reporting on Indonesia reveals a somewhat downbeat picture of the country. Last week’s violent protests against parliamentary approval of the “Omnibus” reform bill were reported prominently with ominous connections made to religious extremists who might be behind the agitation. Other reports reminded readers of the persistently high levels of the Covid-19 infections in Indonesia and there were some uncomplimentary references to Indonesia’s substantial palm oil industry.
For sure, there are reasons to be concerned but we believe that, taking the good with the bad, Indonesia is getting some important things right with this Omnibus bill. If it is implemented well, and if other remaining weaknesses are also tackled, this reform could even prove to be transformational.
Why does Indonesia need these reforms so badly?
Compared to developing countries with similar populations such as Brazil, Pakistan and Nigeria, Indonesia has done well. It has grown around 5% a year for the past decade, has brought inflation under control, managed its fiscal position well, kept its currency largely stable and has avoided the sort of balance of payments difficulties that trip up many of its peers. That is a pretty good track record.
But is it good enough? Indonesia’s performance relative to the more successful Asian economies such as Vietnam or Bangladesh is less sparkling. Indonesia is underperforming what it is capable of achieving. More worryingly, the current growth rate is not enough to generate the demand for jobs needed to absorb all the roughly 2 million new entrants to the workforce each year in good quality jobs and to allow wages to rise quickly. At current growth rates, the demand for labour will not rise robustly enough to produce high wage growth. Indonesia used to regularly clock in economic growth rates of 8–9% a year in the heady days of 1988–1996. Now, it struggles to replicate that impressive record. And that is the case even though its demographic advantages remain plentiful, its natural resource endowment the envy of many, and the size and likely expansion of its consumer market are still as enticing as ever.
Moreover, economic growth remains underwhelming even after much effort by President Joko Widodo to address perennial bugbears of investors in his first term in office. The President has introduced more than a dozen deregulation packages that have boosted Indonesia’s ranking in the World Bank’s Ease of Doing Business study from 114th in 2014 to 73rd in 2019. President Joko has also raised infrastructure spending massively. The roads, ports and other transport infrastructure that are being built will go a long way to addressing a major constraint on growth. Yet, foreign investors still complain that their plight has barely improved. Clearly a lot more needed to be done.
So, what is holding it back?
The primary reason why Indonesia is not performing better is that both domestic and foreign investors find its business ecosystem intimidating. A big reason for that is how onerous labour market regulation is. Retrenchment benefits are multiples of what they are in competitor economies. Businesses lack the flexibility to right-size their work forces in line with changing business conditions while other provisions are seen as highly unreasonable. For example, an employee caught stealing red-handed cannot be fired unless he is first convicted in court. Even then, that crooked employee must still be paid severance.
There are other features of the business environment that also scare away investors. There are many layers of government in Indonesia — central, provincial and regency — which issue sometimes contradictory regulations. Many enterprises face outsized tax bills imposed on profits earned several years in the past. Securing permits and licences could take ages as well.
This unhelpful business environment imposes huge costs on Indonesians. Companies avoid formal hiring and prefer to recruit workers through informal schemes which leaves the bulk of the work force unprotected by any laws and enduring low pay. Quite often, the employers have little incentive to provide training to these workers which is one reason why productivity growth remains anaemic.
Worse still, Indonesia is missing out on one of the most lucrative opportunities to accelerate economic development that any emerging economy can ever hope for — the massive relocation of production facilities out of China. This once-in-a-generation opportunity for growth is bypassing Indonesia in favour of poor emerging economies such as Vietnam, Cambodia and Bangladesh as well as higher-cost ones like Thailand and Malaysia.
What difference does the Omnibus Bill make?
The reform bill is one of the most impressive in Indonesian history. It enables, at one go, amendments to 79 separate laws and covers a wide range including labour laws, taxation, business registration and regulations such as environmental laws. Even after some compromises were made to overcome parliamentary opposition, the changes will improve the business eco-system substantially as seen in the following three examples:
A labour market that will be more supportive of growth: The maximum severance pay borne by employers has been reduced to 19 months of salary from 32 months. More flexibility in work arrangements is allowed such as easier use of contract workers. The new law exempts SMEs from minimum wage requirements, which means that they are more likely to boost hiring.
Better regulation to make investment easier: The government has drastically reduced the list of industries where private investment is banned from more than 300 to just six. The Investment Coordinating Board is now empowered as the central authority to issue business permits, doing away with the previous and confusing multiple layers of issuers. In a similar vein, the central government now has the sole authority over land use and permits and can more easily resolve overlapping claims. Securing environmental permits has also been made easier. Government officials are now required to decide on business applications within 10 days. An application will be legally deemed to be approved if the government department does not respond within that timeframe.
Taxation system improved as well: The corporate income tax rate will be gradually reduced to 20% in 2023 from 22% in 2020. In addition, dividend taxes are scrapped where the funds are reinvested locally. The new law also gives the central government authority to overrule taxes and levies imposed by local governments where the central government feels these are impediments to economic development.
These changes may not go as far as some had hoped but they do represent a substantial improvement for investors:
The biggest impact is likely to be to make Indonesia more competitive in attracting investments. These reforms will nudge more businesses, both domestic as well as foreign, to invest in Indonesia. While foreign investment has flowed into industries manufacturing for domestic consumption, global firms have been more hesitant about using Indonesia as a base for exporting to the rest of the world. Yet, it is export-oriented manufacturing that is the key to accelerating economic growth. Manufacturing for export forces businesses to keep improving their competitiveness, refining processes and honing the skills of their workers. Without the spur of international competition, the improvements in productivity tend to be less. With this development, Indonesia now has a realistic chance of wooing more factories that want to relocate out of China.
With more foreign and domestic investment coming in, the result is likely to be a higher investment-to-GDP ratio. So long as that additional investment is productive, that should result in higher economic growth. President Joko’s ambition to raise Indonesia’s economic growth to a sustained pace of 7% a year for a long period of time is more likely to be achieved now.
Despite the seeming reduction in protections for workers currently in the regulated formal sector, the net effect is likely to be positive for all workers. More jobs will be generated in the formal sector. Indonesia will now have a better opportunity to bring down youth unemployment, currently running at around 17%. The central government will also set up an unemployment fund to provide more protection to workers and will also pay six months’ worth of wages to retrenched workers — in other words while the burden on employers is reduced, part of that burden is now borne by the government so workers do not lose out so much.
There is still some work to do before the full benefits can be reaped
However, there is still some work to be done before Indonesia is able to reap these benefits. First, the administration needs to issue something in the region of 500 derivative regulations to bring the new law into full force. This can take time and there is the risk that poorly worded regulations might weaken the force of the reforms, as has happened in the past.
Second, the political backlash was greater than expected. It seems to us that mischievous elements exploited the protests by students and unions and caused the escalation into violence. Still, it seems unlikely that these violent protests will weaken President Joko’s resolve to press ahead to implement the reforms. The violence has died down now and we are confident that the security services will eventually crack down on the source of agitation.
Indonesia is getting there but we need to be patient
These reforms have received a relatively muted response so far. For example, the government bond auction held the day after the reform bill was passed saw tepid interest by investors. The reason is the continued rise in Covid-19 infections and the one-off imposition of restrictions on activity which continue to depress the economy.
The hard truth is that the pandemic has exposed some weaknesses in Indonesia which have caused investors to pause. The authorities were hesitant in their initial response to the pandemic — unlike Vietnam which took swift and decisive action which has impressed investors no end. With a limited social safety net, Indonesian leaders realised that they could not impose the stringent controls that other countries could — the government simply did not have the money to compensate low income people who would lose their livelihoods as a result. Indonesia’s fiscal position did not allow the kind of massive stimulus that other countries in the region such as Thailand, Malaysia and Singapore could mount. Concerns over potential weakness in the Rupiah held the central bank back from aggressive rate cuts. Moreover, coordination between the central government and local governments was not as smooth as it should have been.
Still, Indonesia is gradually coming to grips with the pandemic. Once the crisis is over, the structural improvements in Indonesia’s economy brought about by the Omnibus bill will be better recognised and we are likely to see an acceleration in Indonesia’s economic performance.
Manu Bhaskaran is CEO of Centennial Asia Advisors
