Realising potential: Jumping the economic hurdles of connectivity and transport

Although the country’s economy is a multi-faceted one, in which energy, agriculture, manufacturing and financial services are key parts of the mix, the attention in 2011 was not on the economy’s heavy hitters, but rather on the playing field in which they operate. The hot topic across the archipelago is improving infrastructure, as fast as possible. Doing it slowly or doing nothing could endanger the compelling growth story that has Indonesia increasingly mentioned along with the BRIC countries as the world’s hottest developing markets. At the heart of Indonesia’s investment policy is people – 240m of them. The country has an emerging middle class that is bigger than the entire population of most countries. The chance to service and sell to that many people in one country makes Indonesia an important destination for multinational companies. The middle class as of 2011 had reached 130m, according to research from Bank Danamon, more than tripling in size since 1999. That brought its share of the population from 25% then to 43% in 2009.

ARRESTED DEVELOPMENT: What is clear now is that the inefficient ports, crumbling roads and patchy electricity grid are not only no longer sufficient to meet the country’s growing needs but threaten the economic growth expected. Manufacturing is an example. Indonesia is an ideal manufacturing centre, as it has raw materials, cheap land and labour, a massive domestic market, and proximity to China and India, two of the three countries with larger populations. But getting goods to market is time-consuming and costly because infrastructure is lacking. It costs less to import oranges from China to Jakarta, for example, than to bring domestic ones from Indonesian Borneo to the capital city, according to data from Pelabuhan Indonesia II ( Pelindo II), a state-owned ports-management company. Other estimates show that gridlock on Jakarta’s winding and damaged road network costs the economy $1.5bn a year through wasted time, fuel costs and even illness.

PRIORITIES: The government has identified 13 priority projects to improve infrastructure, and outlined 79 more it would like implemented. But the sheer volume of improvements needed overwhelms the government’s ability to plan, design, build, outsource and otherwise control the infrastructure sector. Indonesia wants private investors to come in and participate, and is offering long-term contracts in the form of public-private partnerships (PPPs) in hopes of inducing domestic or international builders to sign on.

As with so many investment opportunities in Indonesia, both the potential and the potential pitfalls are easy to spot. “Indonesia is seen as a destination with great investment potential,’’ said Emma Sri Martini, president of Sarana Multi Infrastruktur (SMI), which works to build relations with private investors for infrastructure projects. “However, foreign and domestic investors are well aware of Indonesia’s short history of success in developing PPP projects despite the numerous advances the government has achieved over in recent years.’’ Thus far few projects have reached the implementation phase. Major international construction and engineering companies, now in a position to play the role of arbiter, have expressed concerns regarding process. And because PPPs are typically projects with long gestation periods and thin profit margins, they require large capital investments years before revenue is generated. Few potential investment players have so far been fit to partner with the Indonesian government on a PPP, though many remain interested. Concerns to date are over how to share in the risks, the availability of investment guarantees, potential design flaws in some of the projects, and an overall feeling of uncertainty based on Indonesia’s history of corruption and bureaucratic confusion. The country’s leadership appears sensitive to those fears and has introduced several new measures and agencies to address them. This is an ongoing process, and the hope in Jakarta is that a balance is reached before the moment passes, and all the attention focused on Indonesia shifts elsewhere.

SIZE & SCOPE: Indonesia’s infrastructure needs should be viewed in the context of the Master Plan for the Acceleration and Expansion of Indonesian Economic Growth (MP3EI), which covers the period from 2011 to 2025. The overall goal is to make Indonesia a top-10 economy by 2025 and boost per-capita income to $15,000 a year. That implies economic growth of between 8% and 9% annually, and Indonesia’s leadership knows that it will not happen without a boom in infrastructure. Estimates vary on how much infrastructure spending is needed. The government has about $115bn in projects planned or under construction.

EYES ON GROWTH: According to a report by the British Chamber of Commerce, the country will need to spend $70bn a year for the next five years to keep economic growth at an annual rate of 7% or higher – generally the pace considered necessary to lift meaningful amounts of people out of poverty.

According to a report from Morgan Stanley, public and private investment in infrastructure reached 3.9% of GDP in 2009 and will expand to 5.9% by 2015. The global securities firm’s report, in an indication of need levels, found that during Indonesian President Susilo Bambang Yudhoyono’s first five-year term in office just 125 km of highway was built. In comparison, China added 4710 km of highway in 2009 alone. The government’s diagnosis is that it can afford to pay for about a third of what is necessary, and wants private investment for the rest. The plan is to separate out projects that could generate profits for the private sector, and look for investment partners for them. To encourage private sector interest, the government will provide the so called VGF (viability gap fund) for projects that need to be built but offer slim profit margins. Although the government’s presentation of its PPP-based infrastructure drive is still evolving, Indonesia’s government has settled on a defined process, and is sending out officials to investment fairs to drum up interest.

PROCESS: Government officials are directing interested parties first to the Investment Coordination Board (BKPM). In 2011 BKPM had the responsibility of finding PPP partners for five specific projects near the top of the agenda: a highway on Sumatra, a potable-water plant on Java, a power plant in central Java, a cruise-ship terminal for Bali and a rail link from central Jakarta to the airport. Beyond that role, however, BKPM’s job is to act as a first point of contact, to help potential investors narrow down options. From there the National Development Planning Agency (BAPPENAS) takes over. BAPPENAS is to play a back-office role vis-à-vis BKPM’s front-and-centre position. That means helping possible PPP partners understand the details of projects, and making options known via the publishing of an annual list of PPP projects on offer.

PROJECTS: BAPPENAS has 13 projects at the top of its priority list. Together they are worth $27.52bn, and the planning has already been done, so private partner can simply step in and get to work unless modifications are desired. Past those 13, BAPPENAS has 79 projects on its wish list worth $53.4bn, according to its website. The agency’s role ends at the planning phase. From there, a PPP partner is expected to work with the Ministry of Finance and the government agency relevant to the project selected. If it is a port, for instance, that agency could be one of the country’s several port regulators or the municipal or regional government.

Because the PPP structure is unproven in Indonesia, many potential investors will be looking to what are considered two predictive model PPPs. The first is a collaboration between government agencies, indigenous coal miner Adaro Energy and two Japanese construction firms— J-Power and Itochu. The consortium plans to build a $3.2bn coal-fired power plant in Pemalang in central Java that would provide 2 GW of power. The plant would consist of two 1000-MW units — Indonesia’s largest thus far — and will use ultra-supercritical boiler technology, which reduces coal consumption. The project will be completed according to a buildown-operate-transfer model, with a concession period of 25 years. The plant is expected to be operational by 2017. The Pemalang PPP deal was signed on October 6, making it the first of what Indonesia hopes will be many successful projects. The project will be privately financed for the most part, with the Adaro-J-PowerItochu consortium contributing $600m-700m of the necessary funding, and the Japan Bank for International Cooperation (JBIC) providing a loan worth $2. 4bn-2.8bn. The deal includes a power purchase agreement between the consortium, which was incorporated as Bhimasena Power Indonesia (BPI), as well as the state electricity company, Perusahaan Listrik Negara (PLN). Crucially, the deal is being underwritten by the Indonesia Infrastructure Guarantee Fund (IIGF), which would step in to provide financial guarantees to the investors in the event that PLN cannot meet public obligations.

PPP SCHEMES: It is this guarantee mechanism, and similar instruments of state support, that the government hopes will spur the implementation of future projects and break Indonesia’s infrastructure bottleneck.

According to the office of the coordinating minister for economy, the project’s success “has proved that PPP scheme is an open, competitive, transparent and accountable process in Indonesia”. The World Bank’s finance and advisory arm, the International Finance Corp (IFC), is acting as an advisor on the deal.

The plant is expected to be operational by 2017. In the same vein, a water project in Jakarta’s western outskirts promises to be the first of several water delivery projects undertaken according to a public-private model. Aetra Tangerang, a private Indonesian firm, constructed a delivery system for bringing water to homes and businesses in Tangerang, an industrial centre and bedroom community in Jakarta’s western outskirts. Funding for the Rp520bn ($57m) project was raised privately, but the government has guaranteed the investment and will construct additional infrastructure in the case of a discrepancy in prices.

The Tangerang project was signed in 2008 and went into operation in September 2011. Other water projects are also being looked at as candidates for a PPP, with two major projects being planned for West Java. The $397m Jatigede Water Supply would supply 2.4m people, while the $690m Karian-Serpong Water Conveyance is designed to connect the Karian Dam with the cities of Serang and Serpong.

CONCERNS: Major concerns remain, however, largely around issues of land acquisition, bureaucratic uncertainty, and payments. Regarding the biggest issue, land acquisition, the government has an eminent domain law that allows for private land to be seized for public works projects and former owners compensated. Despite this law, however, the land acquisition process is difficult and lengthy. Compensation is a key problem, as past governments have not kept promises to compensate land owners, making Indonesians reluctant to accept the need to participate in an eminent-domain sale. After years of delay, a new law giving the government more powers, and setting out a clear arbitration process for land owners, was finally passed by parliament in mid-December 2011 and is expected to come into effect in mid-January 2012.

Another issue concerns the level of experience of smaller government agencies in planning PPP projects. “Most of the regional governments lack the skills required to execute and deliver PPP projects,’’ said Scott Younger, president of Glendale Partners, a Jakarta-based consultancy. “There has to be a team of experts working closely with the government to help them develop their capacity and knowledge of how to execute these kinds of complex projects.”

A further cause for concern is that these agencies for the most part will not be the ones paying. When it is time for a private partner to collect from the government they will need to go to the Ministry of Finance. “Often in the past, where PPPs have been successful, one reason has been that the government remains in close contact with the private investor,” said Raj Kannan, founder and managing director of Tusk Advisory, a Jakarta-based infrastructure consultancy firm.

NEW ACTORS: Indonesia has responded by creating a number of new actors to address these issues. SMI was created to be an investment vehicle that will help fund PPP projects through lending or equity stakes.

The IIGF, created by the Ministry of Finance, will provide guarantees. The Indonesia Infrastructure Finance (IIF) is a non-bank financial company established by the government and private partners. Tusk Advisory acted as the interim manager of the IIF, pending the recruitment of the board of directors. The Presidential Delivery Unit, which reports to the executive, was created in 2010 and envisioned as serving mediating role between public and private partners. Many potential private partners have doubts about the efficacy of Indonesia’s proffered solutions, however. Kannan believes it is generally preferable to create one national-level agency to deal with all PPP matters.

Working with one agency would be advantageous because of Indonesia’s reputation for public-sector corruption and bureaucratic hassle. The country slipped from 126th to 129th in the latest World Bank “Doing Business” rankings, which assess countries worldwide based on the ease of operating a private-sector commercial operation – it evaluates categories such as setting up a business, getting licences and legal remedies to problems. Several countries Indonesia benchmarks itself against ranked near the top – Singapore was first, Thailand 17th and Malaysia 18th. Part of the challenge for the government has been determining the right mechanism for government support of infrastructure projects. In Indonesia, a process of deliberation has resulted in the evolution of the IIGF’s role. “Some of the compensation mechanisms included in most PPP concession agreements signed by other countries include longer concession periods, cash compensations or soft loans to make sure that the projects do not default on the project debts, tax incentives or other more developed compensation mechanisms,’’ said Kannan. “In Indonesia, however, before the IIGF was created, investors were only offered an extension for the concession period and adjustment to the tariff rate”.

CHANGE: But this situation is changing, and that is why the IIGF now has a strategic role in addressing the government’s financial contractual obligations under a PPP concession agreement.” For example, the Pemalang project includes a guarantee to ensure investors will be paid if government agencies cannot continue purchasing. In addition, the guarantee funds are helping to ease the costs of financing PPP projects.

Because PPP projects require large amounts of upfront capital but often do not start generating revenue for a decade or longer, partners find it difficult to obtain financing from Indonesian banks. The majority of lenders in the archipelago are unaccustomed to such long-term finance, and generally offer loans lasting no longer than seven years, and only to a small minority of customers. It is also telling that the majority of the financing in the Pemalang project came from a foreign lender rather than from a domestic bank.

CREATIVE SOLUTIONS: The economic imperatives of developing Indonesia’s infrastructure are fuelling the search for creative solutions to the financing dilemma. Debt financing may be one option. Jakarta’s municipal government, for example, plans to sell bonds in 2012, which would make it the first city in the country to do so. According to a report in The Jakarta Post, the city will offer as much as Rp1.7trn ($204m) in debt, and use the proceeds to help fund four infrastructure projects – a hospital, a liquid-waste management facility, low-cost housing and a bus terminal.

Larger still was the bond issuance of PLN, Indonesia’s state electricity firm, which sold $1bn in bonds in the largest Indonesian corporate debt sale to date. Finally, Indonesia has announced that it will become the first country to tap into the newly created ASEAN Infrastructure Fund (see analysis). “Ultimately, more reforms will be necessary to further ease bottlenecked projects. SMI and the IIF are helping some of the PPP projects to be delivered, but they do not penetrate beyond the surface to address deeper systemic issues,’’ said Glendale Partners’ Younger. “The drawing up of regulations — as well as their execution — has in effect stagnated the development of new PPPs.”

OUTLOOK: Private-sector interests gauging an investment in Indonesia usually end up weighing the risks of an uncertain legal and regulatory environment against the massive potential of the country — its 240m consumers, its emerging middle class and its economic promise. This is yet again the case with the PPP-based infrastructure drive. The long-term nature of these types of projects makes their calculations more difficult. However, Indonesia is far from the only developing country struggling to make PPPs work. Others, such as Turkey — another just-beyond-the-BRICs economy — want to draw in capital through PPPs and are finding it to be a trial-and-error process as well.

Indonesia’s infrastructure bottleneck is unlikely to disappear quickly without effective and forceful government and legislative action. However, the process is at least now moving forward with some momentum, particularly with the passage of the land acquisition law. If this momentum continues, the country will be able to take full advantage of its economic potential.