Construction and real estate driven by Indonesia's expanding infrastructure

Following several years of robust expansion supported by the launch and implementation of a major public infrastructure programme emphasising significant new transportation, utilities and social infrastructure builds, Indonesia’s construction industry is set to remain on a rapid growth path. State-owned enterprises (SOEs) continue to dominate the country’s construction landscape, although the government has increasingly sought private sector participation in new builds, with over 20 large-scale projects set to be developed under a public-private partnership (PPP) framework in 2017. Adopting new finance models to support SOE-backed construction should also see project implementation accelerate in the coming years.

Rapid construction growth has brought new challenges, however, including recent legal reforms to the Construction Law of 1999, which could significantly dampen investor sentiment. Many major transportation projects have been delayed by land acquisition challenges, while rising demand for construction materials could squeeze contractors already grappling with regulatory red tape and late payments.

The administration of President Joko Widodo is addressing these challenges, relaxing and simplifying rules regarding affordable construction permits, adopting a new land purchase finance model and increasing foreign ownership limits for certain types of construction companies to attract new investment. This should help keep the industry on an upward path in 2018.

BACKGROUND: Indonesia’s public sector is the most important pillar of its fast-growing construction industry, and it has benefitted significantly from President Widodo’s infrastructure development agenda, which is part of the National Medium-Term Development Plan (RPJMN), running from 2015 to 2019. The plan’s infrastructure agenda includes the construction of 3650 km of new roads, 15 new airports, 24 new seaports and 3258 km of rail lines – including 1099 km of urban rail – in addition to mass rapid transit systems in six cities.

It also calls for construction of 49 dams, improvements to 1m ha of irrigation networks, two new oil refineries with a total capacity of 600,000 barrels per day, five new floating storage regasification units, 75 natural gas fuelling stations and new power plants adding 35,000 MW to the national grid. ICT development includes plans to connect 100% of the population to a national fibre-optic network. The Palapa Ring project – which aims to expand domestic broadband coverage throughout the whole country – was developed under a PPP framework and will form the backbone of the country’s fibre-optic network.

Social infrastructure is also a major focus of activity. Indonesia’s affordable housing shortfall was estimated at 13.5m units in mid-2016, with the World Bank reporting in March 2017 that it is rising by 1m units annually. The RPJMN calls for construction of more than 5000 apartment block towers with space for over 515,000 families, while President Widodo promised construction of 10m new affordable units by 2019 (see analysis).

RECENT GROWTH: Statistics Indonesia (BPS) reports that the construction industry’s contribution to GDP at current prices rose by 13% from Rp712.2trn ($53.7bn) in 2011 to Rp805.2trn ($60.7bn) in 2012, by 12.5% in 2013 to Rp906trn ($68.3bn), by 15% to Rp1042trn ($78.5bn) in 2014 and by 14.5% to Rp1193.4trn ($90bn) in 2015.

London-based economic research consultancy Timetric reports that the industry’s output grew by 6.2% in 2016, and recorded a compound annual growth rate (CAGR) of 6.5% between 2012 and 2016. Sector CAGR is projected to hit 7.7% between 2017 and 2021.

Although investment in the sector has also risen sharply in recent years, it dropped off significantly in 2016, according to BPS data, which shows that foreign investment realisation based on capital investment surged from $239.6m in 2012 to $1.38bn in 2014 but sank to $186.9m in 2016, a seven-year low. Global consultancy firm PwC reported that foreign direct investment in infrastructure-related activities dropped by 67% year-on-year (y-o-y) during the first half of 2017 to $1.97bn, compared to $6.02bn in the first half of 2015.

BPS reports that the total number of construction projects launched by foreign investors in Indonesia trended in the opposite direction in 2016, rising to hit a seven-year high of 437 projects, from 63 in 2011 and 358 in 2015, while PwC has reported an increase in foreign-financed deals reaching financial close during the first nine months of the year (see analysis).

STATE PLAYERS: The largest state-owned construction companies in Indonesia are Wijaya Karya (WIKA), Waskita Karya, Pembangunan Perumahan and Adhi Karya. All are listed on the Indonesia Stock Exchange and benefit from preferential treatment in public sector contract awards. This has proven extremely beneficial for these firms, as public infrastructure spending rose by 51% to Rp209trn ($15.7bn) in 2015, 51.7% to Rp317trn ($23.9bn) in 2016 and a further 22.2% to Rp387.4trn ($29.2bn) in the 2017 state budget.

President Widodo’s administration has also moved to bolster SOEs’ financial foundations and accelerate infrastructure development with a series of capital injections. It allocated Rp48trn ($3.6bn) to SOEs under the 2015 supplementary budget, and in supporting a cut to long-standing fuel subsidies freed up $18bn of new fiscal space. Capital injections eased to Rp36.2trn ($2.7bn) in 2016, and Rp7.2trn ($542.7m) in 2017.

STRONG PERFORMANCE: Construction SOEs’ recent financial results show promise. WIKA – which leads the consortiums that are developing a high-speed rail line connecting Bandung to Jakarta, a new terminal and runway upgrades at Jakarta’s Soekarno-Hatta International Airport, and parts of the Surabaya-Mojokerto Toll Road – reports that its total equity rose by 129.8% in 2016 to Rp12.5trn ($942.2m), while the value of its order book rose by 71.7% to Rp83.29trn ($6.3bn). New contract values jumped up by 117.1% to Rp54.76trn ($4.1bn) during the year, while the number of sales increased by 16.8%, coming to a total of Rp19.98trn ($1.5bn).

Waskita Karya, which was also involved in Soekarno-Hatta International Airport’s new terminal construction, as well as projects including a planned new terminal at Surabaya’s Juanda Airport, the Suramadu Bridge and numerous toll-road projects, reported that revenues rose 68.1% y-o-y to hit Rp23.8trn ($1.8bn) in 2016, while net income increased by 63.5% to Rp1.71trn ($128.1m). Excluding extraordinary items, dividends per share and earnings per share recorded 145.3% and 63.5% y-o-y growth, respectively.

PRIVATE FIRMS: In the private sector, major domestic players include Nusa Raya Cipta (NRC) and Total Bangun Persada (TBP), which have recorded similarly robust recent growth, supported by commercial property development. NRC reports that gross profits hit Rp253.1bn ($19.1m) in 2016 from the Rp324.2bn ($24.4m) and Rp301.6bn ($22.7m) gross profits recorded in 2015 and 2014, respectively. TBP reports it signed Rp2.79trn ($210.3m) of new contracts in 2016, with revenues rising from Rp2.27bn ($171.1m) in 2015 to Rp2.38bn ($179.4m). Gross profits increased from Rp342.3bn ($25.8m) in 2015 to Rp420.2bn ($31.7m). Many large multinationals based in Japan and China have a strong foothold in the Indonesian market. The Indonesia Contractors Association (AKI) reported that 69% of its members are private Indonesian companies, 8% are SOEs and 23% are based overseas. Most registered firms are small and medium-sized enterprises (SMEs) which cannot deliver large-scale projects, and the market is set for significant consolidation in the coming years as competition increases, particularly in the wake of ASEAN Economic Community integration in January 2016, which created a single ASEAN trading bloc and integrated regional market.

“The government should give more opportunities to the private sector to participate in infrastructure projects around the country,” Donald Sihombing, president director of Totalindo, told OBG. “One of the problems is that a private company needs to own a significant amount of construction equipment to participate in a government project. Private firms are not willing to make this level of investment because the chances that they will ultimately be awarded the tender are slim.”

DOMESTIC PROTECTION: This has led both the AKI and smaller companies to call for government protection against larger players and rising foreign competition. These concerns were reflected in a recent revision to the country’s foreign negative investment list, which closed micro and SME construction contractors and consultancies to foreign ownership (see analysis).

In April 2017 the government also proposed sweeping changes to the industry’s legal framework, with Construction Service Law No. 2 of 2017, or the New Construction Law, replacing the previous legislation promulgated in 1999. According to an analysis published by Asialaw, a firm providing research and analysis of the legal services market in the Asia-Pacific region, one of the most significant changes under the new law concerns tender requirements for public services. Tenders to appoint a construction contractor are no longer required for privately funded projects, only those that are funded under the state budget, which should support accelerated implementation.

FOREIGN REGULATIONS: Other changes have been criticised by industry stakeholders, such as a stipulation that in the event of discrepancies between Indonesian and foreign-language contracts, including English contracts, the Indonesian version will be accepted as the valid contract. This could cause significant problems in the event of international arbitration, while foreign banks will be less likely to lend if there are ambiguities in Indonesian-language contracts.

The law also stipulates that the use of local content must take priority over foreign content, although specific details of local versus foreign parameters were not included in the draft bill. Overseas companies will also be required to provide knowledge-transfer and technology-transfer programmes to operate in the country.

Furthermore, when establishing new enterprise, a foreign firm must establish a joint operation with a certified national business entity, while the head of the joint entity must be an Indonesian citizen. AsiaLaw reports that the new law’s regulations are expected in 2017 or 2018, and must be in place by January 12, 2019.

PPP PROGRESS: The new law could pose a major challenge given the country’s infrastructure spending shortfall. With the Asian Development Bank reporting in February 2017 that Indonesia’s annual infrastructure spending shortfall will likely stand at $51bn annually in the years up to 2030, the government has been keen to increase private investment and private sector participation in major construction projects. The National Development Planning Agency (BAPPENAS) is tasked with developing dozens of planned PPPs in coordination with other ministries, and it launched its Committee for Acceleration of Priority Infrastructure Delivery in late 2015 with a mandate to develop 30 PPPs by 2019.

BAPPENAS’s 2017 PPP book lists seven projects currently under construction in Indonesia. Chief among these is the Central Java Power Plant, valued at Rp54trn ($4.1bn). An additional 22 projects are listed as “under preparation” and slated for future development, with the Rp718bn ($54.1m) Bandar Lampung water supply project considered ready to offer, while another project valued at a total of Rp81.43trn ($6.1bn) is listed as having reached financial close. BAPPENAS reports that the number of PPP projects under development fell from 87 in 2009 to 27 in 2013 (see Infrastructure chapter).

NEW FINANCE FRAMEWORKS: PPP development is legislated by Presidential Regulation No. 38 of 2015 and various related regulations, known collectively as the PPP Regulations, which set out operational, procurement and finance model guidelines, and introduced the availability payment scheme (APS) as a new model for infrastructure development in the country.

APS provides performance-based repayments to private investors in user-fee-based infrastructure schemes. The viability gap fund has been established to provide financial support for construction costs to economically viable PPP projects, helping them reach financial feasibility. BAPPENAS reported in 2017 that it hopes to increase PPP development to cover 40% of the country’s future infrastructure funding needs.

SOEs and other public actors are also set to adopt a broader range of financing models – emphasising bond issuance – in the coming years, including the non-state budget infrastructure financing scheme, known as the PINA model, and enhanced government guarantees for construction-related borrowing and bond issuance.

The latter has already been deployed by several large SOEs to finance new builds, including the New Priok Port in Jakarta and Soekarno-Hatta International Airport ‘s new third terminal (see Transport chapter). Adhi Karya announced in May 2017 that it was preparing to offer bonds worth a maximum of Rp3.5trn ($263.8m), and totalling Rp5trn ($376.9m), under the first phase of its shelf offering II, which will run until 2019. The papers will have a five-year tenure and a yield of between 8.75% and 9.5% per annum. The company is also developing a light rail transit project in Jakarta, with the government stating in February 2017 that it hopes to see it invest in the project and serve as its contractor.

CHALLENGES: Although larger players have reported substantial growth and profits since Indonesia’s latest infrastructure agenda launched, contractors are also facing a set of serious challenges that are exacerbated by rapid recent industry growth, most notably land acquisition issues, regulatory red tape, rising demand for construction materials and late payments.

Although the country rose to 72nd place overall on the World Bank’s “Doing Business 2018” report, it only ranked 108th in the dealing with construction permits category, however, that is up several places from its 116th ranking in 2017. The report says it takes 17 procedures and an average of 200.2 days to obtain a construction permit in Indonesia, while the East Asia and Pacific average is 15.2 procedures and 138.2 days.

Construction material costs also could be set for a sharp price increase, and while domestic cement production is sufficient for current consumption levels, forward movement on large-scale infrastructure projects should see demand surge in the coming years, while recent measures aimed at supporting domestic production could drive up costs.

CEMENT: The Indonesian Cement Association (ASI) reports that with 62m tonnes of sales in 2016, Indonesia is now the largest cement market in the Asia-Pacific region, ahead of Vietnam, South Korea, Thailand and Japan. Cement sales have risen sharply in the country since 2008, increasing from 38m tonnes to 48m tonnes in 2011, 58m tonnes in 2013 and 61m tonnes in 2015.

Although stakeholders have warned that with 100m tonnes of annual installed capacity, the market is at risk of significant oversupply, ASI reports that the property sector accounted for 40m tonnes, or 64.5% of total sales in 2016. As infrastructure implementation moves forward, cement demand is expected to surge.

Demand projections led Indonesia’s largest cement producer, state-owned Semen Indonesia, to announce plans to construct Rp7trn ($527.6m) plants in Padang and Rembang in May 2017, which should add 6m tonnes of domestic capacity per year and bring the company’s total production levels to 30m tonnes annually. Indocement Tunggal Prakarsa, the country’s second-largest producer, also announced plans to invest $150m in two new plants in Central Java and North Sumatra in August 2014, which should boost its total production capacity from 18.6m tonnes in 2014 to 24m tonnes when the facilities come on-line in 2018. Global Business Guide (GBG) reported that a total of $6.7bn would be invested in increasing cement capacity in 2016 and 2017, while in early 2017 ASI reported that $1.1bn was invested in the industry by both local and foreign companies in 2016.

STEEL: Steel demand has also surged in recent years, although a supply glut in China has concurrently flooded the Indonesian market with cheap imports, negatively impacting the domestic industry and prompting the government to introduce measures to protect it.

Steel sales have grown steadily in recent years, rising from 11.3m tonnes in 2015 to 14m tonnes in 2016, with Indonesia Investments, a subsidiary of Dutch investment firm Van der Schaar Investments, reporting in December 2016 that sales are forecast to rise by 7% in 2017 to 15m tonnes, driven by infrastructure development and lower gas prices. However, GBG reports that domestic production stood at just 7m tonnes in 2013. Although total production capacity rose to between 8m and 9m tonnes in 2016, cheap Chinese supply has driven many contractors to procure imported steel.

This could change following the promulgation of Ministry of Trade Regulation No. 82 of 2016, which restricts imports of iron, steel, alloy steel and its derivatives. Importers must now obtain import approval and a surveyor certificate, although these will be restricted and granted only to steel producers and general importers.

Through Ministry of Finance Regulation No. 65 of 2013 on Anti-Import Duties, the government also set import tariffs ranging from 7% to 55.6% on steel imports from China, Japan, South Korea, Taiwan and Vietnam. While these policies support local industry and domestic production – Indonesia Investments reports that domestic steel production is expected to rise to 10m tonnes annually by 2025 – they also present a risk to contractors’ development costs and profitability.

LAND ISSUES: Land acquisition has also been a challenge, and large-scale projects including the Central Java Power Plant in Batang, the high-speed rail line and new runways at Soekarno-Hatta International Airport and Juanda airport have resultantly been delayed, with landowners reluctant to sell to developers. Land prices have risen during the construction of large-scale projects, as with the 2800-km Trans-Sumatra Highway toll road. A new Land Acquisition Law (No. 2 of 2012) aimed to expedite the acquisition process by revoking land rights in cases where it served the public interest, setting time limits on each procedural phase and providing safeguards for land owners, but the deeply unpopular legislation was not implemented or enforced.

However, in April 2017 the Ministry of Finance’s State Asset Management Agency (LMAN) assumed responsibility for land acquisition for strategic national projects, following the promulgation of a presidential regulation expanding its mandate in 2016. LMAN will fund and use land banks and pay for land acquisition. It received Rp32trn ($2.4bn) of funding in the 2017 state budget, a 100% increase from Rp16trn ($1.2bn) in 2016.

“Issues with consistency of regulation and land acquisition remain the biggest burdens for the development of the property sector,” A H Marhendra, president director of property developer Springhill Group, told OBG. “We don’t feel that this is properly being addressed by the authorities in order to solve the problem.”

LATE PAYMENTS: Despite an overall surge in public infrastructure spending, contractors have increasingly reported late client payments as a significant obstacle to doing business. In its “Payment Practices Barometer Indonesia 2016” report, published in October 2016, Dutch trade-risk-management firm Atradius reported that 88% of suppliers surveyed in Indonesia, including construction suppliers, reported having experienced late invoice payments from domestic and foreign business-to-business (B2B) clients over the past year.

Atradius reported that B2B clients in the construction industry take the longest to pay overdue receivables, or an average of 41 days after the invoice due date, compared to the country’s average of 27 days. Suppliers in Indonesia request payment within 29 days of invoice submission on average.

Atradius reports that a “staggering” 72% of suppliers surveyed expected payment delays to increase over the next 12 months, which could further weigh on growth, profitability and project delivery in the sector.

Some 14% of Indonesian suppliers consider late payments and lack of an accurate view of risk arising from clients’ portfolio to be the greatest challenge to business profitability in 2017. The New Construction Law has a provision for the establishment of a dispute board in the event of a conflict.

OUTLOOK: While recent protectionist legal reforms have dampened the outlook for foreign participation in construction, the sector is poised for another year of rapid expansion in 2018, as public spending rises and new finance models are adopted.

Measures aimed at protecting and bolstering local industrial capacity could exert near-term pressure on contractors, although an anticipated surge in domestic production of cement and steel should keep materials inflation in check over the next several years.

While land acquisition and late payments will likely remain a challenge for construction stakeholders in 2018, the sector should register another positive performance that year, as a whole host of new infrastructure and transportation projects move forward.