February 10, 2014

Public or private: Indonesia’s recipe for investment

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The Indonesian government is pushing ahead with a $US 468bn infrastructure investment plan intended to facilitate the country's rise to the world's top economic table. However, the suitability of the private investment model touted by the government to deliver these projects remains in question, as Kevin Smith discovered during a visit to Java.

JAKARTA is a city of contrasts - from swanky beach resorts on the Java Sea in the north to colourful but poverty-stricken neighbourhoods full of life throughout the city. However, a sweltering climate and chronic road congestion makes getting around an uncomfortable and often frustrating experience.

Many pedestrians have resorted to wearing face masks to block out fumes and pollution as they navigate street after street of gridlocked traffic. There is no let up at any time of the day, with even the simple act of crossing the road feeling perilous.

With a metropolitan population of 26 million including a rapidly expanding middle class, the Indonesian capital is the largest city in the world without a mass rapid transit system. Its commuter rail network is extensive, but connections between services are often poor and some areas of the city remain difficult to reach. Buses are also affected by the traffic despite the presence of some dedicated lanes. So without a car, or more often a motorbike or scooter, a vast proportion of the population finds it very difficult get around.

The transport situation in the capital is reflective of the rest of Java. Approximately 135 million people live on what is the world's most populated island, which also accounts for 60% of the country's economic output. Yet transport infrastructure remains far behind what is required. Other cities like Bandung, Semarang and Surabaya suffer from similar congestion problems, while the railway network that links them is hindered by largely single-track infrastructure and ageing rolling stock and signalling.

This means that two single-carriageway roads are the lifeblood of Java's economy. However, this has pushed the cost of logistics up to 17% of a company's total expenditure compared with an average of less than 10% in western countries. It has also led to inflationary pressure on domestic goods. And with a single accident or incident of road construction capable of causing miles of tailbacks, this structure is extremely vulnerable.

Economic potential

Indonesia's population of 250 million makes it the world's fourth largest country behind only China, India and the United States, yet it is the world's 16th largest economy, earning it the label of the sleeping giant of Asia.

The country's economic potential is reflected not just in its vast and young population but its geographical location, strong links to China and status as a commodity producer. It was recently grouped with Mexico, Nigeria and Turkey, as part of the so-called "Mint" economies which are all predicted for substantial development over the next 20 years. However, delivering on this potential is heavily dependent on building new infrastructure.

While annual growth is 6-6.5% at present, economists estimate that this could be as high as 7-9% if basic infrastructure is improved. The government invested around 8% of GDP in infrastructure in 1995-96 but since the Asian recession of the late 1990s total investments have never recovered to these levels, with just 2.1% invested in 2011.

Investment did rise to around 4% in 2012 and this figure is expected to increase further through projects and initiatives identified in both the National Medium-Term Development Plan 2010-2014, which is worth around $US 150bn, and the Masterplan for the Acceleration and Expansion of Indonesia's Economic Development. This programme is worth an overall $US 468bn and aims to increase the country's GDP to around $US 4.5 trillion by 2025, which will establish it as one of the world's top 10 economies.

Among the masterplan's priorities is a $US 75bn investment in transport infrastructure, including $US 47.2bn for 49 railway projects across the archipelago over the next 11 years.

"In 2014 the budget for railways will be highest in the Ministry of Transportation, which is a shift in our policy priorities to share the burden of roads," Dr Bambang Susantono, Indonesia's vice minister for transportation, told IRJ in Jakarta.

"In the past our transportation policy has been biased towards road development and as a consequence we are facing overloading on several key highways in Indonesia, particularly on Java. This means we have to catch up with the development of several routes which is important not only for passenger movement but also for freight. Our vision is to have a railway network as the backbone of passenger as well as freight transport."

A major step towards this objective will occur next month when traffic begins operating on a 727km double-track corridor from Jakarta to Surabaya following the completion of a project to install 465.5km of new double-track, which is expected to increase rail capacity between Java's two largest cities by up to 300%.

"There are 2 million TEUs transported by road between Jakarta and Surabaya per year. We want to shift 1 million of these onto the railway," says Mr Hanggoro Budi Wiryawan, director of railway traffic at the Indonesian Railway Directorate, who was speaking on the sidelines of an event in December to mark the completion of the Pekalongan - Semarang section of the track-doubling project. "At present the railway is only transporting 200,000 TEUs per year, and this project is very important to help us to realise our ambition to increase rail's current 1% share of all freight traffic to 15% by 2030."

Wiryawan adds the attractiveness of railfreight transport will soon improve through direct access to ports in Jakarta, Cirebon, Semarang and Surabaya. "By the end of 2014 we will have access to the new port at Jakarta, which is a major step," he says.

Increased capacity on the line is also being aided by a signalling upgrade project being conducted by PT Len Railway Systems, while plans exist to purchase additional rolling stock for use on the revamped corridor as well as other lines throughout the archipelago.

The track-doubling programme is one of a number of essential projects included in the masterplan that will improve the country's basic infrastructure and are deemed non-cost recovery government investments. Other schemes that fall into this bracket include electrification and station improvements. Susantono says government expenditure on such schemes is vital in areas where traffic is not projected to be high, but it is important to provide a link, such as on a proposed new railway lines included in the Trans-Sumatra project.

SemarangHowever, the government is expected to foot the bill for only 30% of the transport projects in the masterplan. Private investment is being sought in particular for mass transit projects which have strong potential for a return, and to develop infrastructure to support Indonesia's commodity industries.

Susantono says the government has established three methods of encouraging private sector investment: the first is through a public-private partnership (PPP) concession model under which the government will provide access to the public railway but allow operations to be managed by the private sector, which is suitable for mass rapid transit undertakings. He says these projects would be tendered with the party asking for the lowest proportion of government support for a specific project likely to succeed, adding that this model provides the opportunity for two types of fiscal support: the Ministry of Finance can subsidise a project through a viability gap fund (VGF) so it is commercially viable; or the government can provide guarantees through the Indonesian Infrastructure Guarantee Fund for a project backed by both domestic and international private financiers.

Secondly the government has established Special Economic Zones (SEZ) or Free Trade Zones (FTZ). These offer tax incentives for private infrastructure investments, relaxed restrictions compared with other regions and simplified licensing through the FTZ/SEZ administrators.

Thirdly, Susantono says the government can grant operating licenses for special-purpose private infrastructure projects. Under this structure he says private companies permitted to develop their own infrastructure at their own expense but are required to meeting specific safety and security standards. This is particularly attractive to companies looking to transport commodities from existing or future mining sites where it is easy to project extraction rates and expected revenues.

"We understand that if it is only a fiscal reason to invite the public sector then usually it does not work very well," Susantono says. "We want to invite the private sector to utilise their knowledge, efficiency for advancement reasons. This is more sustainable than only asking for a monetary contribution. And as long as our laws are open to that, which is the case right now, then the opportunity is open."

Since altering the law in 2009 to allow these types of developments, several 1435mm-gauge railway projects have been put forward for Kalimantan and Sumatra. Indeed, the government has reported record interest from international companies in its private investment schemes across all aspects of its infrastructure not just railways in the past few years.

However, the project to build the 250km railway from PT Bukit Asam's mine in Tanjung Enim to a new port at Tanjung Api-Api, collapsed in July 2013 after Indian investor Adani Group pulled out of the $US 1.65bn undertaking citing permit issues and a rise in construction costs to $US 2.4bn. Fluctuations in the export market for Sumatran coal may have also contributed to the decision.

This failure exemplifies the difficulties that remain in attracting and retaining private investment in infrastructure projects even with recent changes to laws. Susantono says problems with land acquisition in particular have long been a hindrance to developing projects especially in densely-populated cities. But following a change in the law in November 2012, which forced landowners to surrender land required by the state, this process is improving.

"Although the price is still negotiable between the landowner and the government, the development cannot be halted by the process," Susantono says. "Normally you allocate the money in the court and wait for the court decision and while this happens the development in the field can continue."

This legislation though only applies to projects which commenced after it was introduced. Most of the proposed schemes were up and running before this date and as a result are still facing problems. The law also permits a 583 day period in which land acquisition takes place so it is impossible to judge its success at this stage.

Mr Michael Horn, a lawyer specialising in Indonesian projects, also questions the requirement to secure only 75% of the land before a project proceeds. Horn, an ADB-appointed PPP transportation advisor to the Indonesian government in the mid-1990s, helped to draft Indonesia's original PPP regulations from 1998, and is currently a Singapore-based partner of Clyde and Co, a global law firm specialising in transport infrastructure development and financing.

"Proceeding only when 100% of the land is secure is certainly the lower risk approach," Horn says. "25% of the necessary land is likely to be a material part, and dealings with owners may still delay projects. Add to this the possibility of uncertain title, made more likely after last year's Constitutional Court case recognising native title of communities in "adat" forests. Squatters, land speculators and overlapping use claims - such as mineral and agrarian rights - may further complicate the picture."

Horn adds that Indonesia's current private investment ambitions are held back by insufficient capacity in government to handle what are complex undertakings. He says a general lack of experience among government officials in executing railway projects contributes to many of the schemes' struggles to get off the ground.

"Some of the problems with executing these projects, and Indonesian infrastructure projects in general, can be traced to the growth of regional autonomy in the late 1990s," Horn says. "Local governments now have a lot more say in what is going on but they do not have the experience or expertise, particularly in the railway sector, to meet the demands of the project. Unfortunately this isn't just an Indonesian problem, but is something experienced worldwide due to the complexity of these undertakings."

This lack of experience is also evidnet in the financial structures on offer. Horn says the government, mindful of budget constraints, is taking a conservative approach to guarantees, and without customary risk allocation, protections and support available in other countries, some serious investors have been put off. "As a result, 'Winner's curse' risk increases as those with limited experience will accept deals that are less likely to succeed because too much risk has been pushed onto the private sector," Horn says. "In addition many bidders in Indonesia have focused on securing the concession without firming up an adequate financing structure. Bankability needs to feature earlier in the project development cycle."

Viability gap funding

In November the government announced its intention to commence work this year on 56 infrastructure projects, including eight railway schemes, worth $US 35bn. Of the projects, 32 are expected to involve private partners, and to counter fears about their viability, chief economic minister Mr Hatta Rajasa said that incentives would be available to attract sufficient private interest "by making the PPP models more transparent and accountable by adopting international best practice." Among the changes is the introduction of VGF which will allow the government to allocate state funds to cover up to 49% of the total value of an infrastructure project using the PPP scheme on a case-by-case basis.

Horn says this is a positive development and demonstrates a greater willingness from the government to support these undertakings. Yet he questions whether 49% is too low for some economically viable, but commercially unattractive projects, and whether funds should be available to subsidise operations which is essential for transit projects that need to set low fares to compete with inexpensive taxis. Horn also notes that VGF must be used in as single budget year.

"VGF is 'use it or lose it' funding," Horn says. "If VGF funds are not used in the 12-month state budget approved window, they revert to the state. Funds needed for construction costs falling after 12 months can be drawn before the deadline, but only if the project company provides a third party guarantee for those funds. As this is likely a cash-collateralised bank guarantee, the negative carry cost will add to total project costs and may push up tariffs."

Of the major railway projects that are going ahead at the moment, the track-doubling project is entirely funded by the government, while the Jakarta MRT is a government-to-government funding scheme in the form of a soft loan. Horn sees a trend here and argues that in the current financing climate state-owned enterprises are more likely to take on the schemes that have the better chance of succeeding, which he does not necessarily believe is a bad thing.

"Eventually something is going to get built," Horn says. "I don't think it is important that it is an entirely privately-owned railway system. Something tells me that the state-owned enterprises, which have local experience developing infrastructure projects, will continue to feature, possibly in partnership with local government acting as minority equity. This would not be a surprising result. They have experience of building new infrastructure in Indonesia, and here, as is the case elsewhere, essential service infrastructure is and likely will remain chiefly a public sector undertaking."

Domestic industry

The masterplan emphasises that government investments in infrastructure should benefit domestic industry. For example it states that up to 85% of the products used should include local content and 90% should be supplied by Indonesian companies. Yet to achieve the plan's objectives with the required timescale it is inevitable that foreign expertise is utilised.

At present government regulations require that international companies partner with domestic firms when working on a particular project, which is evident in the transit and heavy-haul projects now underway, and Susantono says it is essential for the domestic railway industry to take a step-by-step approach to catch up with developments in technology.

"I think we are already learning a lot of things by allowing international companies to work in Indonesia, not only the good practices but the bad practices as well." Susantono says. "By learning from both the bad and the good we can have a leapfrog situation which will enable us to catch up with the latest developments with the objective of eventually introducing our own state-of-the-art technology."

One particular scheme where securing international expertise is imperative is the proposal to develop a high-speed line between Jakarta and Surabaya. The Japan International Cooperation Agency (Jica) has agreed to carry out a three-year study into a proposed 150km project between Jakarta and Bandung which will examine costs, passenger demand, and funding opportunities, and consider options to extend the service to Surabaya with the aim of completing the project by 2030.

While this project is a long-term aim, it is evidence that the government is shooting for the moon in its infrastructure ambition. The focus for now remains on its transit and mainline schemes. And while the delays and problems with financing are unlikely to be resolved in the near term, Susantono is certain that even with a presidential election looming later this year, any new government will continue to support the goals of the programme. Indeed some domestic commentators feel that failure to complete a sufficient number of infrastructure projects will cost the party which leads the current administration in the upcoming elections.

"People only feel confidence in the railway developments," he says. "There are no political debates on that. They know now that road is overburdened and that we have to shift the traffic to rail or to coastal shipping. The cabinet of the next administration will also see this as an opportunity, because the people want it to happen, not just the government."

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