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   1  Political Economy of Local Investment Climates:  A Review of the Indonesian Literature PAPI Background Paper 'Political Economy of the Local Investment Climate in Indonesia' Project *  Arianto A. Patunru Siti Budi Wardhani †  June 2008 A look into investment climate in Indonesia will not be sufficient without a careful elaboration on its political economic ambience. Indonesia is the only country in Asia that radically reformed both its economic and political system in a big bang manner: abandoning both its authoritarian and centralized system and embracing democratic and decentralized system in an abrupt way. Not surprisingly this has significant impact on the political and economic stability. The ability of the government to attract foreign investment to Indonesia is highly dependent on political stability and the ease of doing business in the country (Basri and Patunru, 2008). Political instability, labour problems and local taxes can increase the cost of doing business in Indonesia (LPEM-FEUI 2002a, 2007). Furthermore, there is a growing tendency by the government to collect extra money according to the ability of businesspeople to pay. Parallel with the distribution of power in the bureaucracy through the policy of autonomy, corruption has also been decentralised (Basri, 2004). Although the amount of bribery may be less than in the *  For a general literature review, see von Luebke (2007). †    Arianto A. Patunru , Director of Research, Institute for Socio-Economic Research, Jakarta, Indonesia; Siti Budi Wardhani, Researcher, Institute for Economic and Social Research, Jakarta, Indonesia; We thank Christian von Luebke   and Neil McCulloch .     2Soeharto period (i.e. pre-decentralization), it fails to reduce the transaction costs due to the increasing number of officials who have to be bribed. Consequently, business uncertainty increases, the investment climate becomes less predictable, and hence is far from being conducive. High logistics costs, particularly related to customs clearance for imports and exports, reduce the profitability of the tradable sectors, especially manufacturing. In fact logistics costs, including transportation costs and weighting station charges, comprise of 14% of total production costs (LPEM–FEUI, 2005a). Unfortunately, manufacturing exporter cannot pass-through the high cost economy completely to consumers, because they are price takers in the world market. As a result, many businesses have to reduce its capacity, lay off its employees, or simply shut down. As for import competing producers, they also suffer from bribery, transportation and weighing station cost which reduce their profitability. As important as it is, one should however not over-emphasize the role of investment climate in explaining the performance of the industry in Indonesia. As Basri and Patunru (2008) argue, improving investment climate is necessary but not sufficient condition. A case study by LPEM-FEUI (2005b) found that Korean companies performed better than Japanese companies in Indonesia despite the fact that both were facing the same problem of poor infrastructure, labor-related impediments, high-cost economy and corruption. As it turned out, a more efficient supply chain management had helped the Korean companies to fare better. While a survey by LPEM-FEUI (2007) found that the perception of business agents regarding the constraints to investment in Indonesia between 2005 and 2007 and between mid-2006 and mid-2007 has improved, the biggest obstacles as perceived by the respondents remained to be macroeconomic instability,   3transportation, corruption and economic policy uncertainty. Whereas the perceptions of infrastructure quality, financial access, and land procurement worsened, certain microeconomic indicators of the business environment showed improvement, particularly in terms of harassment visits and bribes to local officials, as well as the FDI approval time. The deterioration of the investment growth during the first six months of 2006 was therefore mainly driven by macroeconomic instability rather than deterioration of the investment climate itself. In addition, the study reports that the decline in harassment visits and bribes suggests that the on-going anti-corruption campaign might be having an impact at the local level. Furthermore, competition between regions might also help reduce the cost of doing business in those regions. Asian Financial Crisis as the Turning Point The Asian Financial Crisis that took place in 1997 has helped shaping up new paradigm in the Indonesian political economy. The economic crisis had caused the collapse of Suharto’s regime and prompted the change from an authoritarian regime into more democratic regime and from a centralized to decentralized country. Prior to the crisis period, the relationship between the government and business group was relatively inclusive. However, when the crisis took place, policy and business uncertainty were very high. This led to a decrease in trust of the business sector towards government and hence caused massive capital flight. Compared to other Asian countries such as Malaysia, Indonesia has a very different political result due to the financial and economic crisis that took place in 1997 (Haggard 2000). In 1998, Indonesia experienced a clash between two groups of ethnics, Chinese and radical Islamic groups. Both represented different position   4within the economy, the Chinese was perceived as the core of the business society and have a close tie with the former President Suharto; while Islam was seen as the group that has more access to the government via Soeharto’s successor, Habibie. This situation was considered a key factor that brought up the uncertainty in the business community and resulted in the high capital outflow from Indonesia (and out-migration of many Chinese Indonesian business people). The vulnerable position felt by Chinese conglomerate was foreseen as the lack of trust from the business society to the current government capabilities to solve the crisis, which in turn jeopardized government economic policy. After the collapse of New Order Regime, the opportunity of and demand for a more democratic environment were granted by the issuance of “much democratic” laws and regulations, such as those dealing with freedom in journalism, anti-corruption and elections. This democratization also went so far to reshape the relation between central and local governments in the spirit of decentralization, stipulated by the pressure of regional demand for local authorities to govern themselves, free from Jakarta control. The decentralization was started since the issuance of Law No 22 of 1999 (Regional Autonomy Law) and Law No 25 of 1999 (Fiscal Balance between the Centre and Regions). The urge to adopt a decentralized system was a result of a lengthy discussion around the imbalanced economic growth in Indonesia. Prior to the decentralization era, the development program was considered to concentrate on Jakarta and caused a high welfare gap between Java and outside Java. According to Simarmata, the centralized system adapted by New Order regime had destroyed the social system: “…the New Order politics of centralized power – as set out in Law No. 5 of 1974 on Regional Government – had a very destructive impact on local communities and institutions throughout the country.   5The national government hierarchy was extended to the village level by Law No. 5 of 1979 on Village Government, which assigned sole authority for village government to the Village Head (Kepala Desa), a government official. The Village Head and Village Secretary were by law also placed in charge of the Village Community Council (LMD, the village parliament), and the Village Community Resilience Council (LKMD, the village development authority). Under this law, the “village” was identified as a unit of government, and not a social organization.” (Simarmata 2002: 3). The other aspect to the demand for adopting decentralization, according to Simarmata, also rooted in the unfair treatment felt by the regions with natural resource abundance whereby all the revenues from these resources had been collected by central government and districts only received back a limited amount. The international donor institution such as the World Bank also supported the view of decentralizing the politic and economic system (Hadiz 2003). By delegating the authority to the local government, it would bring the public service closer to the people. Decentralization was also viewed as a way to ensure good governance and participatory planning. However, Hadiz argued that those who are in favor for decentralization have failed to capture the political dynamics in the local regions, which later have complicated the decentralization implementation. The dynamics between the central government that tried to maintain the authority and the local government that insisted to be left alone have somehow jeopardized and confused the implementation of regional autonomy:
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