Politics

Indonesia: Talk Of Trade Restriction Spooks Investors

Indonesia: Weekly Geopolitical Report by Kaisa Stucke and Bill O’Grady

The results of the presidential election in Indonesia are final—Joko Widodo (“Jokowi,” as he is generally known) won the election with 53% of the vote. He will be sworn into office on October 20, becoming Indonesia’s seventh president. The election attracted international interest as both Jokowi’s and his opponent’s platforms were nationalistic in focus, including promises of import substitutions,export restrictions and retention of production processes in Indonesia.

Although Indonesia holds substantial growth promise for foreign investors, this talk of trade restrictions is making international observers and companies nervous. Indonesia is uniquely positioned to benefit from global manufacturing and quickly move up the value-added chain, with its large, literate working-age population and easy access to key international sea lanes. Indonesia also holds a bounty of natural resources, and the local government is trying to keep a higher margin of profits from the mining and smelting activity inside the country.

This week we will discuss Indonesia, briefly describing its history, its economy and its political landscape. We will also take a closer look at this election, the promises made on the campaign trail and the implications of the election results on foreign investors.

History

Indonesia is a country of between 13,500 and 18,300 islands depending on different sources. An actual count of the islands is complicated by tidal islands and seismic activity. Roughly 6,000 islands are inhabited, but only 1,000 are permanently inhabited. Approximately 60% of the country’s population of 260 million lives on the island of Java. Although the national language is Indonesian, hundreds of other languages are native to the islands.

Indonesia: Talk Of Trade Restriction Spooks Investors

In Indonesia’s early history, the archipelago geography and the need to share water for agricultural purposes encouraged the formation of numerous autonomous kingdoms. These early kingdoms were Hindu or Buddhist. Through its history, Indonesia has been an active international trader, especially with China and India.

In the early 16th century, the Portuguese set up a colony in parts of Indonesia in order to exports spices to Europe. However, Portugal never colonized all of Indonesia. The Dutch colonized almost all of Indonesia in the late 16th century, setting up the Dutch East India Company. Indonesia was a very valuable asset for the Dutch, contributing to Dutch global dominance in the spice and crop trade. The Dutch made the crop production decisions and the local farmers had to set aside about 20% of their land to grow crops for export. The Dutch government captured the profits while only a nominal sum was paid to the farmer. During World War I, Britain briefly ruled Indonesia, but the region was given back to Holland after the war.

In the early 20th century, the Dutch introduced the “ethical policy,” a development policy that emphasized improvements in living conditions, under which schools, hospitals and other infrastructure were set up. Although some Indonesians became well educated, the living standards remained low, in general. However, the introduction of a formal education system helped form the first nationalistic movement, boosting the call for independence.

During World War II, Japan ruled Indonesia, a move which was initially welcomed by the locals, but soon Japanese rule proved to be just as difficult as Dutch rule. After Japan surrendered, Indonesia declared independence under the leadership of the country’s first president, Sukarno.

Parliamentary Democracy

Sukarno established a parliamentary democracy, but the path of development for the young country proved to be a rocky one due to power struggles among different ideological groups. After a workable government coalition failed to be formed, Sukarno turned to a new system called “guided democracy,” whereby the power of the parliament was greatly reduced. The military also gained significant control over the country, not only by military force, but also economically through acquiring the orphaned Dutch East India’s enterprises. The “guided democracy” was inward-looking, and the country withdrew from the U.N. and the IMF.

During the 1960s, Indonesian economic growth stalled and inflation accelerated. As public discontent grew, an opposition group attempted a coup by kidnapping several military generals. The highest surviving officer, Major General Suharto, took control of the army, quickly shifting the blame for the alleged coup to the communists. A period of communist cleansing took hold and suspected sympathizers were killed (estimates range from 400,000 to 1 million people). Additionally, the unrest caused martial law to be declared, thus giving more power to General Suharto, who eventually put the president under house arrest, effectively taking over the country.

The new president Suharto quickly set up an effective dictatorship, even though elections were still held. Suharto’s new regime was focused on delivering economic growth and restoring international relations. During this period, foreign investment was welcomed in Indonesia. Booming oil exports supplied the government with enough funds to keep protests at bay. Due to its large oil exports, Indonesia joined OPEC in 1961; however, the country withdrew from the group in 2008 due to the country becoming a net importer of petroleum. Corruption and nepotism were widespread, but the regime also delivered impressive growth rates for the economy. During the 1990s, however, the economy stalled and Suharto was forced to resign when the Asian Financial Crisis hit.

The four presidents since the end of Suharto’s rule have included a former vice president, a weak Muslim cleric, the daughter of a former president and a military officer.

Under the current president, Susilo Bambang Yudhoyono, who took office in 2004, economic growth has ranged between 4% and 7% annually, with Indonesia widely seen as having great economic growth potential. One of the major problems for the central government has been the size of fuel subsidies, which make up one-third of the government budget. Additionally, within the last several years, the country has suffered from a depreciating currency and ensuing interest rate hikes.

indonesia interest rate hikes

Presidential Candidates

This year’s presidential election was a historic event. For the first time, a candidate without close ties to the old order was elected.

Indonesia has a multi-party system, with separate parliamentary and presidential elections. The president does not necessarily come from the majority parliamentary party. Jokowi was nominated by the Indonesian Democratic Party — Struggle, which is currently an opposition party in the parliament.

Jokowi comes from humble beginnings. He worked in the furniture industry, later building a successful business. Jokowi entered politics in 2005 at the age of 44, when he won the mayoral election in his hometown of Solo. During his seven years in the mayoral office, he reduced the city’s corruption and implemented policies to invest in infrastructure. When he took office, the city of Solo had a problem with radical Islam, but Jokowi was able to deliver improved living standards for all its residents by being impartial to religions and backgrounds. By 2012, his national reputation as an effective leader was strong enough that his party decided to nominate him as the mayoral candidate of Jakarta, the capital city district. Jokowi has promised to bring his same pragmatic approach on a national scale, growth without the corruption, nepotism and mismanagement of the past.

On the other hand, Jokowi’s opponent, Prabowo Subianto, comes from the old political class. Prabowo’s grandfather started what is now the largest bank in Indonesia, and his father served as Suharto’s trade minister. The family wealth multiplied under Suharto’s regime and the young Prabowo rose quickly through military ranks.

In 1998, when the dictator Suharto was losing control over the country, Prabowo used his position in the military to spearhead a coup. The attempt failed and Prabowo was dismissed from his post on the back of allegations of human rights abuses.

Prabowo was accused of kidnapping and torturing pro-democracy activists, a charge that Prabowo denies. In fact, in 2000, Prabowo was the first person to be denied entry into the United States based on the UN Convention of Torture.

Nationalism

Jokowi’s campaign was mostly built on political transparency and accountability, economic growth, infrastructure investments and social welfare programs.

Jokowi’s comfortable lead over Prabowo during the beginning of the campaign eroded as Jokowi’s nationalist, religious and ethnic leanings were questioned. A smear campaign called him a communist based on the social welfare programs that he implemented as the mayor of Solo. His religious beliefs were questioned based on the inclusive policies that he used in the Islamic-leaning city of Solo. Muslims are the majority, so although a non-Muslim could run for office, it would be unlikely that they would be elected. Jokowi, fearful of losing the nationalist vote, added protectionist rhetoric to his campaign. Additionally, he also made a last minute pilgrimage to Mecca two days before the elections to appeal to the nationalist and Muslim votes.

Prabowo has run on a nationalistic platform from the beginning, with his military past helping to portray him as a strong leader. Historically, public opinion has been favorable for candidates from three backgrounds—the ruling political class, the Muslim clergy and the military.

When Jokowi added the nationalistic language to his platform, foreign investors ecame nervous about the direction of the Indonesian economy. Over the last decade, Indonesia has been slowly moving toward protectionism, but a new and popular president with strong ideas of trade and investment restrictions could create a serious problem for foreign companies invested in the country.

However, we believe that candidate Jokowi’s promises will be different from president Jokowi’s policies. Jokowi may have added the over-exaggeration of national ideologies to his platform to capture the swing vote as his winning margin started to narrow in the polls leading up to the election. Clearly, nationalism is a top priority for the population as Prabowo was able to capture 47% of the vote by mostly appealing to the strong nationalistic movement.

A record number of first-time voters took part in these elections. Both candidates were trying to attract the votes of these 67 million young Indonesians, who seem to prefer an optimistic pro-Indonesian view of the future.

Implications for Foreign Investors Jokowi was the preferred candidate in the eyes of foreign investors on the back of his promises of political transparency and responsibility. Additionally, his other top priorities include national security, infrastructure investment, reducing fuel subsidies, initiating social welfare programs and self-reliance on key goods. Analysts believe that GDP growth would be around 5.5%-6% annually under his rule.

Calls for nationalism have been on the rise as we have seen in the resource sector. Indonesia has imposed export sanctions on metal ores in an attempt to force foreign investors to build smelters in the country. Indonesia is trying to move up the value chain by processing the metals in addition to mining them. The government has imposed other trade restrictions as it would like to become more self-sustaining and keep more of the money in Indonesia. For example, Indonesia has historically mined and exported bauxite and imported aluminum; it now restricts the exports of bauxite.

Other trade sectors have similar restrictions in place. The country has banned the import of smartphones in order to compel technology companies to build plants in the country and hire local workers. Part of the problem is the lack of accountability of local politicians and enforcement of bans. Although the ore export ban was announced years in advance, foreign companies have made little effort to build processing facilities in Indonesia. The usual pattern has been for a general ban to be implemented, but then “special licenses” are granted on an ad hoc basis. Many foreign companies believed that they could acquire a special permit and continue exporting ore. Jokowi calls this practice the “export mafia” and has promised to reform the system.

Indonesia would like to see similar protectionist policies applied to many other sectors. In agriculture, rice, beef, corn, sugar and soybeans are the five key commodities that the country would like to become self-reliant. Jokowi has indicated that he would stop the spread of palm oil plantations in favor of rice harvesting. These policies are likely to lead to inflation, especially in food prices, which could trigger a tightening in monetary policy.

Although Jokowi has identified several restrictive trade and foreign business policies that he would consider, he was by far the more business friendly candidate. During a debate he said that a “contract is a contract,” leading observers to believe that he will not nationalize companies or unilaterally change the terms of contracts already signed. However, Jokowi has to work with a majority opposition parliament, so the developments in Indonesia bear watching closely.

It seems that radical policies, such as nationalization, are not likely under the new president. We do not believe that import substitution will become a major problem for investors, but foreign companies should expect to see their costs of production increase in the country, while higher inflation in general could emerge, leading to an interest rate hike and slowing economic growth.

Kaisa Stucke and Bill O’Grady

September 15, 2014