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An Expanded Argument for FDI

By now it should be well known that, to achieve the growth it seeks, the current administration has set a target of Rp. 2,000 trillion per year in investment. Around 55% of this figure is expected to come from private capital, while the balance is expected to come from household consumption (25%), government spending (14-15%), and financial institutions (7%).

The share of investment expected to be borne by private capital is enormous and frankly cannot be filled by domestic sources alone.

Foreign direct investment (FDI) is by necessity needed to help close the financing gap. While the level of FDI in Indonesia has only recently begun to show an upswing since the massive outflows of capital after the financial crisis of 1997-98, much remains to be done in the way of improving the investment climate before Indonesia can compete against her neighbors for a larger share of FDI.

The list of reforms that Indonesia must execute to more effectively draw FDI is fairly extensive but by no means unfeasible. In fact, while foreign investors always insist on sanctity of contract and zero tolerance on corruption, many privately concede that steps such as the reduction of conflicting regulation and the relaxation of land and labor laws would go very far toward welcoming FDI.  

Indonesia’s Investment Coordinating Board (BKPM) recognizes the task at hand. It is drafting a blueprint, entitled FDI Strategy Paper 2010, that outlines a package of reforms designed to assure foreign investors of certainty, consistency and credibility within the regulatory environment. Some of these long overdue changes have just been implemented, such as the one-stop service for licenses (PTSP) and the electronic automation portal (SPIPISE), while others will shortly follow, such as the further opening of the negative investment list (DNI) and the centralization of appointments to BKPM’s regional offices.

Part of the aim of this paper, informed by the routine consultation BKPM has had and continues to have with foreign investors, chambers of commerce and industry associations, is to demonstrate how serious Indonesia is about deepening the commitment to her partnership with foreign investors.

All this fuss over FDI encompasses a larger concern that eclipses financing needs. Empirical evidence has shown that FDI can offer a bundle of extra-financial benefits to host economies. Cognizant of this ever-expanding literature, Indonesia targets not only greater quantity but also better quality of FDI.

For Indonesia, quality is strictly defined as FDI that accomplishes one, some or all of the following:

  • A reduction in unemployment through skilled job creation
  • An alleviation of poverty, especially by lifting households straddling the poverty line
  • An improvement in social welfare, as measured by pertinent indicators

If FDI is viewed simply as capital originating from overseas, the question as often is posed is how can FDI achieve these clearly desirable outcomes? Generally, there are two main ways by which FDI offers more bang for the buck.

Firstly, FDI acts as a signal. Because it is highly mobile and can locate in any host economy it chooses, FDI can speak volumes about the competitiveness of Indonesia’s investment climate. This, in turn, produces the pull necessary to further rev up Indonesia’s development engine.

Increased inflows of FDI compel non-governmental organizations, multilateral institutions and rating agencies to compare Indonesia favorably to other investment destinations and create a positive buzz. In addition, otherwise hesitant foreign investors start to take a closer look at Indonesia, in part due to what economists call a crowding-in effect. Improved perceptions of sovereign risk expand access to and lower the cost of capital, which would get many development projects off the ground.

Secondly, FDI can induce positive spillovers, including greater productivity, higher wages, broader formal sector employment, and knowledge and technology transfers. Of course certain country conditions must hold before such benefits can generally accrue to host economies. Still Indonesia’s record shows that FDI has been for the most part carrying this deeper social impact.

Now as Indonesia reaches for middle-income status, by seeking to move away from a commodity-based to an industrializing and thereafter a knowledge-based economy, the role of FDI has become even more important to policy design. Countries do not typically undergo this transition without a healthy influx of FDI precisely because it often strengthens domestic capacity. Successful attraction of FDI for this reason is clearly in Indonesia’s strategic interest.

But the window for Indonesia to capture a larger share of FDI for her development goals will not remain open indefinitely. A recent World Bank report finds that Indonesia’s so-called “demographic dividend”, the advantage Indonesia has in terms of a youthful population (of which over 50 percent is 30 years of age or younger) and low dependency ratio with respect to her work force, will last for another decade.

Figure: Indonesia’s “Demographic Dividend”

By 2020 Indonesia will then face a decline in consumer spending and increase in government outlays for entitlements as the population ages faster than the decrease in birth rates and increase in employment. To offset the potential strain on the state treasury, a reorientation from consumption, which has fueled Indonesia’s growth for decades, toward investment is needed now if Indonesia wants to restructure the composition of and safeguard the contributors to the economy.

To help Indonesians understand the salubrious effects of FDI on Indonesia’s development goals and the sense of urgency required to make it part of the realization of Indonesia’s development strategy, BKPM has launched an intensive socialization campaign, particularly in the provinces where local communities host FDI projects. After visiting 21 out of 33 provinces in less than two months, BKPM has selected as its first batch seven provincial governments (Riau, South Sumatera, West Java, East Java, East Kalimantan, West Nusa Tenggara and Papua) to serve as champions in part to help raise this critical consciousness.

As more stakeholders become aware of FDI’s importance to Indonesia’s future economic performance, Indonesia would be far better positioned to attract the level and type of FDI it seeks.

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