Indonesia works through employment protection

Author: Sulistiyo Aridyono, ANU

Indonesian export and foreign direct investment (FDI) inflows have slowed over the last two decades despite the robust performance of neighbouring Southeast Asian countries. To attract FDI and streamline its regulatory environment, Indonesia enacted the Omnibus Law in November 2020.

To revive domestic competitiveness and create more jobs, the Omnibus Law reformed Indonesia’s labour-related regulations. But while the relaxation of labour laws can induce higher private investment, it can also harm workers.

The competition between countries to attract FDI is influenced by the locational preferences of multinational firms. In Southeast Asia, Vietnam is a success story. Its long-term economic reforms have attracted significant FDI inflows, especially after the country’s WTO accession in 2007. From 2005–2021, Vietnam’s FDI per capita increased seven times from approximately US$270 to US$2000.

Vietnam’s rise as an FDI destination has had a negative spillover effect on Indonesia. From 2010–2015, firms in labour-intensive industries, such as apparel, footwear and furniture, relocated from Indonesia to Vietnam to benefit from the more competitive wages and flexible labour regulations.

Before the Omnibus Law, the Indonesian government tried to calibrate an optimal minimum wage, but their policy changes were not in favour of business. Surveys conducted by the Japanese External Trade Organization reveal that the primary concern of Japanese-affiliated firms in Indonesia from 2015–2019 was increasing wages. This concern escalated in 2013 after minimum wages in Jakarta increased by 44 per cent. At the same time, global firms perceived Indonesia’s productivity to be among the lowest in ASEAN at comparable wages.

To balance the demands of labour unions and businesses, the Omnibus Law revised the minimum wage formulation and dropped sectoral wages — policies that were a primary concern for multinational firms. Minimum sectoral-wages, in which a standard wage rate is set differently in some specific industries, have rarely been adopted in countries similar to Indonesia.

Another business concern is flexibility in hiring and firing. To maintain costs and optimise profits, firms hire more labour when demand rises and reduce their labour force when demand drops. But firms cannot adjust their labour supply under stringent hiring and firing regulations — forcing them to accept lower profitability and productivity.

Firms locate themselves in countries with more relaxed hiring and firing regulations to avoid this inflexibility. That is especially the case for developing countries where labour-intensive industries still dominate the economy. Still, stringent dismissal laws can benefit innovation-intensive industries by preventing firms from arbitrarily firing talented employees.

The Omnibus Law tries to bring Indonesia’s hiring and firing regulations in line with its neighbours by amending the regulation of termination payments, fixed-term contracts and overtime pay.

Regulation No. 35/2021 reduces the compensation required for dismissed workers with five years of experience from 36–60 weeks of salary to just 24 weeks. The new dismissal cost is now closer to the standard in other ASEAN countries — a 17-week salary in Malaysia and a 22-week salary in the Philippines and Vietnam. The limit for fixed-term contract renewal has also been extended from one to two years, bringing Indonesia’s regulations closer to Vietnam’s.

But while the relaxation of labour regulation laws gives more flexibility to investors, it also reduces labour protections. To tackle this unfavourable impact, the Omnibus Law introduced an employment insurance scheme which provides job information, training and cash compensation to dismissed workers.

The cash compensation is equivalent to eight weeks of salary, making up a total severance payment worth 32 weeks. That is lower than the previously mandated compensation of 36–60 weeks’ worth of salary but higher than termination costs in Vietnam, the Philippines and Malaysia. The policy change is one such compromise offered by the Omnibus Law to labourers and investors.

The problem is that the provision of training and job-search matching will not benefit workers unless it meets the demands of the private sector. Vocational training programs are more impactful when they are provided by the private sector, which understands the skills demanded in the labour market.

Another policy suggestion is to streamline business regulations, allowing entrepreneurs to thrive and create jobs. Indonesia, with a regulatory environment that is less competitive than its neighbours, still has much to learn in this arena. Improving business regulation can boost the growth of formal (as opposed to shadow) business and investment without compromising labour standards.

While FDI creates jobs and improves productivity in developing countries, competition to attract FDI can lower labour standards. The key to avoiding this trap for Indonesia is to transform its economy from one reliant on low-skilled labour to one that is knowledge-based. In the medium term, unemployment protections through vocational training and job-search matching in the Omnibus Law could boost workers’ employability if they help meet the labour demands of the private sector.

The next step is to improve business regulations in Indonesia. That requires significant bureaucratic reform at the national and subnational levels without further lowering labour standards.

Sulistiyo Aridyono is a PhD Candidate at the Crawford School of Public Policy, The Australian National University.

The post Indonesia works through employment protection first appeared on East Asia Forum.

from East Asia Forum