Indonesia: The darling of investors, but for how long?

By Shaun Levine

It is befitting that Indonesia has become the latest darling of the investment community, drawing private equity firms, retail and consumer giants, and the world’s largest automakers to its shores. Even in a depressed global economy, the world’s fourth most populated country continues to grow strongly, perhaps by as much as 6.2 percent in 2012. Indonesia is also blessed with natural resources, shipping its coal, nickel, copper, and gold to supply many of Asia’s giants, including China and Japan, with the precious materials they need for their own economic engines.

Indonesia’s stubborn affinity for subsidies, however, remains a major impediment to its longer-term growth.  President Susilo Bambang Yudhoyono’s government remains committed to unsustainable funding for subsidies, which will potentially consume up to 20 percent, or $30 billion, of the 2013 budget-nearly the amount spent on education. The largest portion of this spending, nearly $20 billion, will be allocated to fuel subsidies, which the government acknowledges largely benefit the country’s more affluent households.

Indonesia’s current high growth rates mask the problems that, if left untouched, will likely make the country an example of a booming emerging market economy that never quite reaches its potential.  Without a realignment of spending priorities away from subsidies and toward vital infrastructure and education, investors are likely to take their dollars elsewhere.

Unfortunately, the political context is not conducive to a reduction in subsidies in the near term, despite external pressure from ratings agencies, the World Bank, and the IMF. Subsidies remain highly popular with a large portion of the voting population, and given this reality, Yudhoyono appears reluctant to press for reforms any time soon. Such a move would certainly dampen his party’s electoral prospects: Recent polling suggests that if the 2014 parliamentary election were held today, Yudhoyono’s PD would lose its top ranking, ceding substantial ground to rivals Golkar and PDI-P. Parliament also appears to reject subsidy reform, and political parties want to make sure it would be Yudhoyono’s prerogative to reduce popular subsidies ahead of the 2014 elections.

But subsidy spending will shrink Indonesia’s growth potential. Improving the country’s decrepit infrastructure remains paramount: Even though parliament boosted Yudhoyono’s planned infrastructure spending by $3 billion to $20 billion in 2013, that number is dwarfed by spending on subsidies, which offer no return on investment. Indonesia’s backlogged and rickety ports, crumbling road and rail networks, and antiquated system of airports remain a large handicap for this country of 17,000 islands. Despite the size of its economy, Indonesia’s level of spending on infrastructure, at nearly 2 percent of GDP, remains far below that of another favorite of investors-neighboring Vietnam (9 percent-10 percent).

At the moment, though, investors appear to be placated by government pledges to improve Indonesia’s infrastructure. The country has reported record foreign direct investment thus far into 2012, perhaps a yearly total of more than $22 billion; investment officials proudly boast of having $75 billion more in the pipeline. New laws have been passed helping to ease the process of land acquisition, and spending continues to increase. But how long can Indonesia squeeze growth out of a flawed model before the darling of investors becomes the disappointment?

Shaun Levine is an analyst with Eurasia Group’s Asia practice.