Why Indonesia has not captured more of the ‘China +1’ diversification

Why Indonesia has not captured more of the ‘China +1’ diversification

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In 2019, the World Bank issued a report that sparked deep consternation among Indonesia’s political elite. In the seismic shift in global manufacturing supply chains sparked by US-China trade tensions, Indonesia had apparently failed to grasp the opportunity.

The World Bank noted at the time that of more than 30 Chinese companies that had announced plans in June to August of that year to expand overseas, none planned to do so in Indonesia. Foreign direct investment into Indonesia as a percentage of gross domestic product decreased between 2012 and 2019, compared with rises by its regional peers including Vietnam, Malaysia, the Philippines and Thailand. Most FDI to Indonesia was channelled to non-manufacturing sectors.

A frustrated president Joko Widodo sprung into action. The following year he introduced his signature “omnibus law” with sweeping changes to more than 70 labour, tax and other laws to cut red tape and make the country more appealing. Though the law received a fair amount of backlash for eroding worker rights, companies cheered the lowering of corporate tax rates, loosened labour laws and more streamlined business rules.

The omnibus law underlined Indonesia’s ambitions to become a more integral part of the international supply chain. The country has a huge domestic market with the world’s fourth largest population, is Asia’s fifth-biggest economy and has an abundance of natural resources. Yet it has long punched below its weight.

Under Widodo, who came to power in 2014, many foreign investors hoped for the structural reforms needed to address opaque red tape and often corrupt business interests in the country that have held it back. This “hidden entrance cost” had long made Indonesia a tough sell for many global investors, said Evan Laksmana, a senior fellow at the International Institute for Strategic Studies (IISS) in Singapore.

There are also broader structural problems. Power outages, transport failures and inadequate water supply are frequent problems across the Indonesian archipelago — a deterrent for many multinational groups needing reliability to operate factories. Many industries still badly need innovation and more efficient production.

A lack of talent is another impediment Widodo has tried to address. Indonesia’s education system needs improving, acknowledges Nadiem Makarim, a tech entrepreneur installed as education minister in 2019 to reform the school system. Literacy and numeracy levels have long lagged behind Indonesian neighbours,

Indonesia needs to “start at the lower end of the supply chain and move up slowly before switching to high-end tech manufacturing. If you have no precedent for those industries here, how can you attract them?” Makarim says.

Foreign companies still today struggle with a business environment where regulation can change in a matter of days. TikTok owner ByteDance discovered this the hard way in September when it was abruptly forced to suspend its online shopping service in Indonesia. There is also the matter of prohibitive foreign ownership laws, which often require a local business partner. Moreover, projects inexplicably stall and crucial applications can be left unsigned and unapproved for months.

All of these issues contribute to the fact that Indonesia is still trailing behind its south-east Asian peers when it comes to exploiting the dramatic rerouting and diversification of global supply chains away from China, especially in high-tech manufacturing.

There is cause for optimism. Geopolitics, particularly the US attempts to deepen its ties with Asian governments as a counter to China, are increasingly in Jakarta’s favour. After a bilateral meeting between US president Joe Biden and Widodo in Washington last week, the US said it was considering Indonesia as a partner to create a global semiconductor value chain.

Another bright spot is the commodities sector. Indonesia’s record FDI of $22bn last year was dominated by metals and mining. And the country has become a hub for the global electric vehicle supply chain thanks to its abundant reserves of nickel, a key industry need. Ford, Hyundai, Vale and Tsingshan are among the companies building domestic battery and EV manufacturing plants.

But as Indonesia heads to a crucial national election early next year, corruption and vested interests remain a major deterrent to business and investment. That is the obvious area that needs to be tackled more forcefully if Indonesia’s huge economy is to realise its potential to leapfrog its neighbours.


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