Will Indonesia’s Omnibus reforms bolster recovery from COVID-19?

Author: Roland Rajah, Lowy Institute

Indonesia’s new ‘Omnibus Law on Job Creation’ was marred by the public controversy that surrounded its passage late last year. The government nonetheless hailed the law as a major regulatory overhaul that would attract foreign investment and create jobs. In reality, it lacks important detail, meaning its success will ultimately depend on the vagaries of implementation.

The first batch of implementing regulations released this year however show some promise — introducing important steps to liberalise the labour market while notionally cutting away a plethora of restrictions on inward foreign direct investment (FDI). Notwithstanding important limitations, this represents the first set of serious liberalising reforms to be introduced under President Joko Widodo after almost seven years in power.

While sixteen so-called ‘reform packages’ were released during Widodo’s first term, these were not ambitious enough to yield much in accelerating economic growth and generating more formal sector jobs. Nor did they succeed in attracting greater foreign direct investment (FDI) or capturing international supply chains relocating from China, which mostly went elsewhere in Southeast Asia.

The latest measures significantly moderate two longstanding problems in the labour code for Indonesia’s international competitiveness, while otherwise leaving strong worker protections mostly intact.

First, severance payments that firms must provide when laying off workers have been substantially scaled back, effectively reducing these costs by roughly half. This should bring Indonesia broadly in line with its Asian peers, after having previously had one of the highest severance requirements in the world.

Second, the rules governing minimum wage increases have been significantly tightened. This will help to contain the rapid increases that have been eroding Indonesia’s external competitiveness while nonetheless failing to serve as an effective safety net for workers. Over the past decade, Indonesia’s manufacturing labour productivity has risen by less than 20 per cent while nominal minimum wages have doubled.

Future minimum wage increases will be based on either local inflation or real economic growth (whichever is higher), rather than the sum of the two — as had been the case since 2015 when Widodo last sought to tighten the rules. This is another decent step forward. However, because minimum wage increases can still outpace growth in labour productivity, it remains a partial solution.

The recent FDI reforms are potentially more transformative, at least on paper. Indonesia previously had one of the most restrictive FDI policies among the 84 economies assessed by the OECD. The reforms cut the number of business lines subject to FDI restrictions dramatically from 528 to 215, including in areas important to industrial upgrading such as telecoms, e-commerce, transport, vocational training and health.

Indonesia’s investment environment is however notoriously complex, not only because of rent-seeking and corruption, but also due to inconsistencies between the central FDI policy regime and protectionism embedded at the sectoral level.

The final outcome will therefore probably vary considerably across areas. For instance, mining is now fully open to foreign ownership, but existing mining sector policies still mandate gradual divestment to majority local ownership. Given the government’s proclivities towards resource nationalism, the inconsistency is probably intentional. But in other areas such as telecoms and construction, follow-up sectoral reforms may be more likely. A lot will also depend on specific regulatory decisions and practices in individual industries, for example medical services.

The latest reforms could ultimately be stymied by protectionist forces. Yet, World Bank analysis suggests that past liberalisation of the central FDI policy regime did indeed result in higher FDI inflows — providing some hope that the latest reforms will also see some follow through.

A host of other barriers remain to attracting substantially greater investment — from infrastructure deficiencies to the proliferating mass of non-tariff barriers that limit access to the best inputs and make it difficult to participate in complex supply chains criss-crossing international borders. In the immediate term, overcoming the pandemic and reviving the domestic economy are an absolute necessity — especially as Indonesia’s large domestic market is a key point of attraction for foreign investors.

Indonesian policymakers are nonetheless right to look more seriously to FDI as a key part of the recovery strategy. Not only does FDI usually confer important productivity benefits but, in the wake of the pandemic, other avenues for financing Indonesia’s growth and development will be heavily constrained. Banks, state-owned enterprises and private firms will all be left financially damaged, inhibiting investment. And while fiscal policy should be used to support the recovery, the capacity to do so will be checked by rising debt service payments and the imperative to bring the budget deficit back within the normal 3 per cent of GDP legal limit in due course.

As domestic demand recovers, the current account deficit could also return as a key macroeconomic vulnerability. The US Federal Reserve will eventually look to unwind its crisis policy settings. That could threaten a re-run of the 2013 ‘taper tantrum’ but at a potentially more damaging moment. With such risks on the horizon, relying more on FDI instead of unstable portfolio flows would be a real advantage.

Roland Rajah is Lead Economist and Director of the International Economics Program at the Lowy Institute.

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