SECTOR ASSESSMENT (SUMMARY): INDUSTRY AND TRADE

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1 Stepping Up Investments for Growth Acceleration Program- Subprogram 2 (RRP INO 48134) SECTOR ASSESSMENT (SUMMARY): INDUSTRY AND TRADE 1. This sector assessment describes the binding constraints to achieving higher investment and economic growth, and the government s agenda to address these binding constraints. It also discusses ADB support of the government s reform agenda. 1. Sector Performance, Problems, and Opportunities 2. The Indonesian economy is going through structural adjustment as a result of the collapse in commodity prices. The challenge for the government is to facilitate a structural adjustment so that investments go to job-creating industries. However, current investment trends suggest that resources are not being allocated efficiently. For example, Indonesia s incremental capital output ratio (ICOR), a common measure of investment efficiency, is high at 5.5 in This means that $5.5 spent on investment produces only $1.00 of income compared with Malaysia s ICOR at 4.6, the Philippines at 3.7, Viet Nam at 5.2, and India at 4.9 (Table 1). Based on various private sector surveys, the main identified structural and policy impediments to investment and higher growth are a weak regulatory framework, inadequate infrastructure, a shallow capital market, emerging mismatch of skills in the economy, and stringent labor regulation. This assessment is in line with International Monetary Fund (IMF) paper showing that enhancing monetary policy to reduce uncertainty, improving the business environment, enhancing financial access, and developing infrastructure could all support investment. 1 Table 1: Average of Incremental Capital Output Ratio and Investment Rate in Indonesia and Selected Countries Country ICOR Investment Rate Indonesia % Malaysia % Philippines % Thailand % Viet Nam % India % Turkey % ICOR = incremental capital output ratio. Source: The World Development Indicators database. 3. High cost of regulatory regime. For an emerging market economy, Indonesia ranks low in the World Bank Group s Doing Business 2016 rankings (109 out of 189 economies). The rank is below the regional (East Asia and Pacific) average and that of peer countries, such as Malaysia (18), the PRC (84), Thailand (49), and Viet Nam (90). The biggest factor that causes the low rank is the time needed to start a new business (48 days, which is higher than the 38-day average of East Asian and Pacific countries). Of the 48-day period, 15 days are needed to obtain a business trading license and company registration certificate, resulting in a convoluted and complex process that is the biggest obstacle to starting a business in Indonesia. The high cost of the regulatory burden has also forced companies to become informal. The World Bank s Enterprise Surveys show that Indonesian firms identify high rates of informality as one of the top 10 constraints to firm investment. In fact, nearly 30% of firms in Indonesia start operations without being formally registered. 1 IMF What Determines Investment in Indonesia? Article IV Selected Issues Paper. Washington, DC.

2 2 4. Ineffective rule-making process. The Government of Indonesia has had a growing awareness and understanding of the role of regulatory reform in facilitating economic development. However, it does not have an explicit and coordinated whole-of-government policy to ensure that the economic, social, and environmental benefits of regulation justify the cost. This creates unpopular policies that are rarely implemented properly because of public opposition. The national government has started improving the regulatory quality of regulatory framework through Law No. 12, 2011, on the establishment of laws and regulations. The law introduces mandatory ex-ante assessment of regulatory proposals for laws and subnational regulations, and has broadened public consultation to the executive branch of government (from the legislative branch). However, the mandatory ex-ante assessment is only for draft laws not for implementing regulations. Indonesia has 42,000 regulations (including the subnational level). The government, at both central and subnational levels, issued an average of 1,477 regulations per year from 2011 to 2014, with close to 86% of the new regulations at the subnational level. 5. Restrictions on investments. Foreign investors can hold up to 100% ownership in selected industries, but equity restrictions exist in a number of job-creating sectors, such as services, ranging from 45% to 75%. In 2014, Indonesia s score on the foreign direct investment (FDI) Regulatory Restrictiveness Index of the Organisation for Economic Co-operation and Development (OECD) was the fourth worst of the 58 countries surveyed, with retail and media being particularly inaccessible, even by non-oecd standards. The 2014 and 2016 negative investment list has reduced the number of sectors closed to foreign investors from 20 in 2010 to 15. While the new list is more open to foreign investment in infrastructure related to connectivity and in services, some sectors (such as mining and oil) continue to be restricted to foreign investors. 6. Lack of private sector participation in public private partnerships. Indonesia has been relying on public private partnerships (PPPs) to have more private participation in public infrastructure projects. However, progress has been slow. Indonesia ranks lower than expected in PPPs, given the population and size of its economy. Since the adoption of the 2005 PPP framework, 31 PPPs were financially closed in Indonesia, amounting to about $26.0 billion or $3.3 billion per year on average. Of these, only one project went through the 2005 PPP framework (the Central Java 2,000 megawatt coal-fired power plant) while the rest used relevant sector frameworks. The main challenges have been a weak regulatory and legal framework for PPP, lack of an integrated framework on public participation in infrastructure, lack of an effective decision-making body on PPPs, the presence of state-owned enterprises, and lack of an anchor government PPP unit. The government has begun to meet some of the challenges by improving the policy framework to support more PPPs, addressing the financial and fiscal risks arising from PPPs, providing clear guidance on the role of state-owned enterprises in PPP, improving the decision-making process for PPP, and beginning to link private participation in infrastructure investments to the capital markets. 7. Inefficiencies in public procurement. Public procurement in Indonesia has limited the delivery and quality of public infrastructure projects. The main issues are lack of capacity and the weak institutional setup in public procurement within both the central and local governments, inadequate alignment with budget execution policies, project fragmentation, an uncompetitive market, and corruption. This leads to a concentration of about 45% of project disbursements during the last 2 months of the year. 2 Project fragmentation is also common practice. For example, as of August 2015, the Ministry of Public Works and Housing had 3,266 road 2 Data are taken from the National Public Procurement Agency (LKPP) monitoring and evaluation system.

3 3 contracts, with a total value consistent with the Ministry s annual budget. 3 In addition, transparency deficiencies remain in the procurement process and have elevated governance risks in public procurement. According to Indonesia s Corruption Eradication Commission (KPK), 60% of total corruption investigations in 2014 were related to public procurement. 8. Other issues related to investment climate reform. Access to finance, shallow capital market, energy shortfalls, poor quality of education institutions, and mismatch in labor supply also pose as major challenges in improving Indonesia s investment climate. For example, less than half of all Indonesians have access to formal financial sector services and less than 20% have ever borrowed from a bank. Indonesia s energy sector also underperforms which constrains the country s ability to provide power for industrial and commercial users. The quality of tertiary education is also low and the learning achievement of most students is inadequate. This resulted in difficulty of firms in Indonesia to find qualified staff to fill in professional and management positions. 2. Government s Sector Strategy 9. National Medium-Term Economic Plan, focuses on poverty reduction in the context of making the growth process more inclusive. It targets closing the growing gap in consumption per capita between different income groups, and reducing poverty from 11% in March 2014 to 7% 8% in By 2019, the government plans to address the structural reform agenda by creating more job opportunities in job-creating industries, improving the investment climate, and enhancing infrastructure quality to improve service delivery, particularly in the eastern part of Indonesia. To operationalize the National Medium-Term Economic Plan (RPJMN), the government has issued 12 economic packages since September Economic packages. The packages aim to support the government s structural reform agenda. The agenda includes simplifying or eliminating 147 regulations by eliminating redundancies and inconsistencies; simplifying procedures to obtain a license to invest in industrial estates; improving the formula for setting minimum wages; providing tax holidays for investment in special economic zones; simplifying the process for importing medicines and medicinal raw materials; providing legal certainty for private companies that operate drinking water supply systems; eliminating import duties on airline spare parts; instituting a one-map policy to ease the land acquisition process for infrastructure projects; reducing logistics costs through policies that establish electronic billing for port services and expanding national single window system operations; introducing new negative investment list restrictions that open 34 sectors; and improving the ease of doing business. 11. Reform of public private partnerships. The government has made progress on three fronts: strengthening the institutional framework of PPPs, addressing fiscal and financial risks arising from PPP, and expanding infrastructure modalities. It has revised the PPP legal framework to enable PPPs in social infrastructure and introduce availability based scheme for PPP projects. To improve the institutional settings to facilitate delivery of the PPP program, the Ministry of Finance established an anchor PPP unit, which has facilitated the preparation and transaction of one water supply, one rail, and one telecommunications PPP project. The government has also enabled the private sector to fund the acquisition of land on the government s behalf, and reduced the time frame for certain initial land acquisition steps from 44 days to 10 days. 3 D. Ray and L. Yan Ing Addressing Indonesia s Infrastructure Deficit. Bulletin of Indonesian Economic Studies. 52 (1). pp.1 25.

4 4 12. Longer term engagement in public private partnerships. Reforms to develop a more conducive environment for more private participation in PPP require the government s commitment and institutional capacity to implement them. To have a more conducive environment, the government needs to address issues related in (i) land acquisition, (ii) legislation (including off-take agreements) to enable PPP projects, (iii) liquidity in the banking system to support domestic investments, and (iv) incoherent and inconsistent policies at the national and subnational levels. Capacity building will come after the government addresses these four issues. 13. Reform of public procurement. The government has expedited the public procurement process by expanding the use of e-procurement, which is now mandatory and includes e- purchasing and e-tendering. To allow more private sector participation, including from overseas, the government has introduced international competitive bidding documents for the procurement of goods and works. 3. ADB Sector Experience and Assistance Program 14. Development partner support. Development partners are assisting the government in investment and trade reform, PPP reform, and public procurement reform. The World Bank has been managing a multi-donor trust fund to support reform of the investment climate and PPP. The Government of Australia has supported the Australia Indonesia Partnership for Economic Governance program, through which it supported the government s PPP reform agenda and trade and investment reform. The Government of the United Kingdom, through its embassy in Jakarta, is also assisting at the national and subnational level in improving the rule-making process. The United States is supporting the government to increase the capacity of public procurement offices through the Millennium Challenge Corporation program. 15. ADB support of investment climate reform. Given the cross-sectoral nature of investment climate reform, ADB has been using an integrated sector approach. The proposed program aims to strengthen the institutional part of the reform, while other reforms, such as financial inclusion and energy sector reforms, 4 look at access to finance and energy. In 2016, ADB is preparing an education sector reform program with the government aimed at improving the quality of education and addressing the youth skills mismatch in the labor market. 5 ADB is also preparing an engineering project for delivery in 2017, which aims to improve the quality and timely start-up of public infrastructure projects ADB Report and Recommendation of the President to the Board of Directors: Proposed Programmatic Approach and Policy-Based Loan for Subprogram 1 to the Republic of Indonesia for the Financial Market Development and Inclusion Program. Manila; and ADB Report and Recommendation of the President to the Board of Directors: Proposed Programmatic Approach and Policy-Based Loans for Subprogram 1 to the Republic of Indonesia for the Sustainable and Inclusive Energy Program. Manila. The proposed program is called the Education Sector Improvement Program. ADB Concept Paper: Proposed Technical Assistance Loan to Indonesia for Accelerating Infrastructure Delivery through Better Engineering Services Project. Manila.

5 5 Problem Tree Low economic growth impedes achievement of development objectives Low private sector investments Low public sector investments Unfavorable investment climate and high cost of doing business Inadequate infrastructure Restrictive foreign investment regime Complex regulatory framework for direct investments Complex regulatory environment for doing business Poor coordination among central government agencies Ineffective coordination between central/local government and private sector Low private investment in infrastructure due to lack of credible public private partnership (PPP) project pipeline Inefficient institutional PPP setup (e.g., lack of anchor PPP center, weak PPP capacity and/or systems in government contracting agencies, fragmented legislation) Strong role of stateowned enterprises in infrastructure provision Low infrastructure investment by local governments due to: Weak capacity of local governments to access capital markets for infrastructure funding Lack of central government s cofinancing mechanisms to catalyze local government infrastructure investments Unclear responsibility on infrastructure investment by local governments Low infrastructure investment by central government due to: Large social transfers budget Lack of project-related debt instruments Low utilization of budgeted resources for infrastructure due to: Conditional appropriations due to insufficient information on projects at budget approval stage 1-year appointment of project management staff Complex public procurement process due to: Inadequate alignment with budget execution policies Lack of capacity and weak institutional setup in public procurement at central and local levels Conducive to abuse of objection and appeal process Inadequate policy and operational coordination between central and local governments Source: Asian Development Bank. Land acquisition delays Inadequate coordination on infrastructure planning and spending between central and local governments Complex and rigid budget adjustment process Complex land acquisition process

6 6 Sector Results Framework (Trade and Industry Investment Climate, ) Country Sector Outcomes Country Sector Outputs ADB Sector Operations Outcomes Indicators Outputs Indicators with Planned and Ongoing ADB with ADB with Targets with ADB Incremental Targets Interventions Contribution and Baselines Contribution Improved enabling environment for more private and public sector investments Ratio of net flows of foreign direct investment to GDP increased to at least 3.0% of GDP (2012 baseline: 2.2%) More predictable and open business environment Creating an efficient market for infrastructure through PPPs Faster and more transparent public procurement Foreign ownership in the service industry expanded Regulatory impact assessment implemented Number of licenses issued by one-stop shops increased Adequate viability gap funding for PPP projects provided PPP regulatory framework to enable social sector and availability based payment reformed Use of e-procurement expanded Planned key activity areas Introducing a regulatory impact assessment as part of the regulatory making process Implementing ease of doing business at local level Improving access to finance Improving access to electricity Pipeline projects Subprogram 3 of the Stepping Up Investments for Growth Acceleration Program Ongoing projects with approved amounts Loan for Stepping Up Investments for Growth Acceleration Program, Subprogram 1 ($400 million) Loan for Financial Market Development and Inclusion Program, Subprogram 1 ($400 million) Loan for Support for Inclusive Energy Program, Subprogram 1 ($500 million) ADB = Asian Development Bank, GDP = gross domestic product, PPP = public private partnership, SNG = subnational government. Source: Asian Development Bank. Main Outputs Expected from ADB Interventions Planned key activity areas Policy-based and capacity development support to improve investment climate and increase infrastructure investments Pipeline projects Strengthen capacity to improve investment climate Develop regulatory impact assessment capacity Increase financial modalities for infrastructure investments for national government and SNGs Ongoing projects Improve starting a business and paying taxes at local level Strengthen financial management capacity of SNGs to enable them to issue municipal bonds Mainstream e-catalog at SNGs Introduce PPP concept at SNGs