Originally Published by The Jakarta Post, December 13, 2006

By James Castle

Although Indonesia's stock market has been one of the best performing in the region for the past three years and there has been over US$12 billion in highly successful bond offerings -- public and private -- in the past two years, Indonesia cannot shake its image as a difficult and sometimes dangerous place to do business. What's the real story?

A magnet for foreign capital in the boom days of the mid 1990's, Indonesia has been unable to regain its investment allure since the spectacular collapse of its government and economy in 1998. Indonesia's economy was clearly the hardest hit by the financial tsunami which swept through Asia's newly industrialized countries in 1997 and 1998, with its GDP dropping an incredible 13 percent in 1998.

As a result, the thirty-year autocratic reign of the redoubtable Soeharto collapsed with many pundits expecting the country to do likewise in short order.

Indonesia has clearly disappointed the pessimists who foresaw a Soviet Union-style political disintegration. It is now the world's third-largest democracy and one of its most dynamic, and has regained its place among the fast growing Southeast Asian economies. Nevertheless, it has been unable to regain the aura that attracted billions of dollars of foreign direct investment (FDI) in the 1990's.

Foreign investment approvals, which averaged US$30 billion per annum in the years leading up to the crisis, have averaged less than $10 billion a year since 1997 according to the Indonesian Investment Board (BKPM). Overall investment is also down sharply, from a robust annual rate of 25-30 percent of GDP in the pre-crisis era to an anemic average of less than 20 percent since.

Several sectors that attracted major amounts of foreign capital in Indonesia's boom years are now virtually dormant. For example, Indonesia used to attract over 5 percent of global expenditure on mining exploration annually. It now receives less than 0.5 percent, according to mining experts.

The exploration picture in oil and gas is only moderately better. Crude oil production has dropped from a peak rate of 1.4 million barrels a day to fewer than 900,000 today and the country has become a net oil importer.

Meanwhile, however, the Jakarta Stock Exchange Index is up over 300 percent since January 2001. And the Indonesian bond market remains very robust, despite a recent discouraging ruling by the Indonesian Supreme Court against holders of a $500 million 1994 private company bond that is in default.

The Indonesian government or government entities have successfully sold over $5.4 billion of public debts this year. Meanwhile, Indonesian spreads are increasingly tight.

The obvious question becomes why has foreign direct investment remained so low while portfolio investment is at record highs?

The answer is simple. Indonesia's GDP growth is solid, its prospects are good and investors are more than willing to put their money into liquid assets like bonds and listed equities because these assets can be sold in a heart-beat if the market turns sour.

Conversely, investors are reluctant to put their capital into Indonesia for long term, illiquid projects, i.e. bricks and mortar for green field manufacturing, infrastructure and natural resource exploration and development.

Although its macroeconomic stability, excellent growth prospects, low public debt, growing foreign exchange reserves, declining inflation and the political stability provided by a popular and directly elected President, Susilo Bambang Yudhoyono are all conditions that should have direct investors lining up at the door, the unfortunate truth is that investing in Indonesia remains an intimidating prospect for those who are not intimately familiar with its complex and often predatory regulatory environment.

Direct investors, especially new-to-market investors with limited or no local experience, are unwilling to expose their capital and technology to Indonesia for the long term because of weak rule of law and the inability to enforce contracts and agreements via any type of transparent legal process.

Even the new direct investors who have recently entered the market are primarily interested in acquiring proven operating assets, rather than in building new capacity, for example, Phillip Morris' $5.2 billion March 2005 acquisition of domestic cigarette-maker, Sampoerna, the largest takeover in Indonesian corporate history.

Historically, investment in Indonesia has produced extremely high returns and portfolio investors are quite willing to invest in the companies that have already taken the risks and developed the systems and savvy necessary to succeed on the ground, but they will only do so in the form of liquid paper that can be sold at the first sign of trouble.

There is cause for optimism that the discouraging direct investment climate may change in the near future if we remember that Susilo Bambang Yudhoyono swept to an overwhelming electoral victory on a pro-business reform platform just two years ago.

The President's platform promised a simplified and more transparent regulatory environment for business, with clear proposals for reform of tax and labor regulations that are considered among the region's most restrictive and uncompetitive.

Yudhoyono also indicated his strong desire to improve the investment law and prioritize the mobilization of private investment in Indonesia's antiquated infrastructure sector, sharply reducing the corrupt and incompetent dominance of state-owned enterprises which have consistently failed to provide infrastructure adequate to support economic growth and job creation and keep pace with its better-managed ASEAN neighbors, Thailand, Malaysia and Singapore.

Even new tiger, socialist Vietnam, has proven more aggressive and efficient in upgrading its public services .It is now growing more rapidly and attracting more direct investment than Indonesia.

Since taking power in October 2004, the Yudhoyono administration has made significant progress in reducing corruption at the national level and improving order and discipline in a number of important institutions like the Police Force, the Investment Coordinating Board (BKPM) and the Tax Department.

On the other hand, it has been singularly unsuccessful in pushing its legislative agenda through parliament. It has also failed to streamline the government's cumbersome, opaque procurement system and produce transparent tender documents for infrastructure projects with terms and conditions that are reasonable and bankable.

Despite these difficulties and delays, however, the government leadership has not become dispirited or defensive. The key senior officials remain fully and publicly committed to reform. As a result, it is highly likely that infrastructure investment will increase substantially over the next two years as the government increases public spending and some of its reforms-in-progress take hold.

The real Indonesia today, then, is the one that offers high rewards for agile traders, and is setting the stage for another wave of direct investment that will spark a decade of high growth. Private investment should soon begin to return in more substantial volumes. When this happens, annual growth will reach 7 percent and alert companies that are either already in the market or closely monitoring it will be the ones best-positioned to participate and reap the rewards.