FOCUS : INVESTMENT OUTLOOK IN INDONESIA 2006

INDONESIAN COMMERCIAL NEWSLETTER

August 2006

FOCUS

INVESTMENT OUTLOOK IN INDONESIA

The sign of investment recovery already showing

The sign was quite distinct in 2005. The Capital Investment Board (BKPM) reported the realization of foreign investment projects increased by no less than 93.8% by value and 67.1% by number of projects. Domestic investment was no less spectacular which increased by 100.9% by value and 65.9% by number of projects.

This development took place when the GDP grew quite favorable (5.6%) but interestingly it occurred under high inflation pressure (17.1%). Further investigations revealed that the high investment growth rate was enjoyed by the investment in non - oil mining sector which covers coal and metal minerals in line with their highly hiking prices in global market.

The year 2005 was also marked by a very significant increase in he value of foreign investment in non-oil mining approved by BKPM,. which was by almost ten times over 2004. This increase was spurred by very highly rising prices of coal and metals in the last two years in the world market, partly due to highly rising demand in China. The value of approved foreign investment projects in transportation and communication also increased very significantly by no less than 150.7%. Construction investment projects performed no less significantly

by an increase of 84.3%. It is particularly interesting to see agricultural sector was able to attract many foreign investors and the value of their projects increased by 77.2%, which used to be rather neglected in previous years. Palm oil plantation is believed to be the mosy attraction for foreign investors.

In the first half of 2006, the recovery sign is still showing, although there are some doubts, because Indonesian economy is slowing down in the first half 2006 as indicated by low GDP growth rate and high inflation rate. In this regards, however, BKPM is still optimistic. In its report, BKPM disclosed that realized domestic investment in the first half of 2006 increased by 43.6% in term of value to Rp 11.2 trillion from Rp 7.8 trillion in the same period last year. Comparable figures for foreign investment increased by 6.9% to US$ 3.62 billion from US$ 3.29 billion.

Recent interests by foreign companies indicate that Interest in investment continued to simmer. The Malaysia's Khazanah Nasional Bhd has expressed its interest to invest in infrastructure projects including toll road and power plants. Talks had already been held with PT. Jasa Marga, the state owned toll road company.

South Korea's Daeju Construction Engineering disclosed that it will invest US$ 500 million in a shipyard project in Karimun island in Riau Province.

Daeju is one of seven local and foreign companies that signed investment agreements recently with the government of Riau Island province. The seven companies plan to invest a total US$ 543.2 million in the islands of Batam, Bintan, and Karimun. Singaporean Tiong Woon Co. Ltd. will invest $20 million in projects ranging from port management services, logistics, warehousing and shipping services to manufacturing. Five remaining projects will be set up in the area's main island of Batam, with the development of a US$ 15 million shipyard by Indonesia-Singapore joint venture firm, PT Indo Multi Sarana the largest investor in Batam island.

The signing of joint operation agreement (JOA) in September 2005 was marking the beginning of cooperation between the giant oil company ExxonMobil and the state owned oil-gas company Pertamina to operate Cepu oil-gas field in East Java. This . was a very important investment development for Indonesia because of two reasons. At peak production, Cepu would provide Indonesia's government about US$ 2 million in revenue and add 180,000 barrels oil per day in production and eliminate gas shortage in East Java for petrochemical industries and power plants. More importantly, this occasion is expected to improve foreign investors' confidence to invest in Indonesia.

Foreign investors' confidence in 2006 has been also shown by several other major foreign companies, such as Freeport, Newmont, Inco and Newcrest which continue performing profitable operations and increasing their investment in their mining projects.

Economic outlook in 2006 - 2010

Despite all natural disasters, political as well as economical problems and obstacles faced and experienced in 2005, Indonesian economy was expanding by 5.6% compared to 4,1% in 2004, although in 2005 it was peculiarly hampered by high inflation (17.1%) and high interest (12.7%) rates.

In early 2006, however, economic activity slowed down again as a result of fuel price and interest rate adjustments implemented in the fall of last year in order to restore financial market confidence. After peaking at 18% in October 2005, inflation has moderated as the tight monetary stance has constrained domestic demand growth. High interest rates also triggered significant capital flows in early repayments to the IMF. While Indonesia was initially hard hit by the turmoil in emerging markets in May/June, the rupiah and stock prices have recently recovered a part of their losses.

Real GDP is projected to pick up in the second half of the year and for the entire 2006 the GDP growth will be 5.2 percent. Supported by a gradual reduction in

interest rates and an acceleration in government spending from the very low levels in 2005; the central government's deficit is expected to reduce by 1 percentage point to 1.2 percent of GDP. At the same time, inflation is on track to reach the lower bound of Bank Indonesia's 7-9 percent target range. The current account is expected to remain in surplus in 2006, partly as a result of lower oil imports following the fuel price increase which has resulted in reduced fuel consumption.

In the meantime, there are some short-term downside risks to this generally favorable outlook. Further tightening in global financial markets could prevent the planned easing in domestic interest rates and the government needs to substantially accelerate spending in support of domestic demand. Higher international oil prices could also have an unfavorable impact on the budget, growth and inflation.

In the banking sector, performance has been on a steadily improving trend and private banks appear to have weathered the recent slowdown in growth and rise in interest rates quite well. Banks are on average well capitalized. However, nonperforming loans (NPLs) at the two largest state-owned banks rose substantially in 2005 and governance remains weak. To address weaknesses in the financial system, the government released in July a package of financial sector reforms that will help resolve state banks' NPLs, foster improvements in banking supervision, and facilitate the development of the nonbank financial sector. For the medium term, the government has adopted a comprehensive reform agenda to strengthen public institutions, improve the business climate and boost growth. If implemented, these reforms will remove some of the main obstacles to private investment, and contribute to a more flexible labor market and more efficient public administration, thus contributing to an acceleration in growth.

To reach Indonesia's potential GDP growth rate of 6 - 7% per year in the following years, it is important to implement statement reforms to enhance the investment climate. In this regard, the IMF supports Government's efforts to enhance infrastructures investment, improve tax administration, simplify custom procedures and faster greater labor market flexibility, which are the key components of the strategy to strengthen investor confidence and attract new domestic and foreign investment.

IMF expects oil prices to remain in the $65-70 dollar per barrel range for the foreseeable future, although with continuing geopolitical tensions, there is a risk of even higher prices. If prices were to rise significantly further, pressures on inflation, the budget, and the balance of payments in Indonesian economy could reemerge, requiring timely policy adjustments. Recent, financial market developments also provide an indication of the kind of impact a tightening in

global financial market conditions could have. According to IMF, a further significant tightening could put further downward pressure on the rupiah and international reserves, as well as on domestic equity and bond prices. While the risks described above should be manageable with prompt policy action, especially in view of increased foreign exchange reserves, they would inevitably result in a higher inflation rate and lower growth. On the domestic policy side, lack of progress in implementing structural reforms is a key risk to growth over the medium term. IMF forecast of Indonesia's mid term economic development as presented in the following table.

Investment outlook and Prospect

Unfavorable investment climate has been always branded as main obstacles to expand investment in Indonesia.

The government of Indonesia has realized its shortcomings, and it has set up a draft a package of investment policy improvement since early 2005.

The long awaited investment policy package that was promised to boost investments was announced on 2 March 2006. Presidential Instruction No. 3 of the year 2006 aims to strengthen services provided by investment institutions; synchronize laws and bylaws between the national government and local governments; improve rules and regulations pertaining to tax, customs, manpower, and Small and Medium Scale Enterprises (SMEs) and cooperatives; as well as ascertain rules and regulations on the environment. The package specifies target dates and clear measures to be taken by government to improve Indonesia's investment climate.

The new policy includes the simplification in processes to establish a new company and to obtain an operating license. This targets a gradual cut in the entire red type, to be considerably shortened from a lengthy 150 days to a mere 30 days. And, in order to achieve this target, the government decided to delegate authority to approve company license to the Provincial office of the Department of Law and Human Rights.

The minister in Finance explainer through simplifying customs regulations it is hoped to fast track the creation of a ingle window service, through modernization efforts.

Which will include increasing the number of companies to be given the green line priority, that will greatly reduce inspection of goods. Other measures include: a) strengthening the role of bonded areas; b) continue the fight against smuggling; and c) further reduce bureaucratic intervention in customs.

In the area of Taxation, measures include:

a) tax incentives for investments;

b) implementation of the self-assessments system to be executed more consistently;

c) revise value-added tax to promote exports;

d) protect the rights of companies and persons being taxed; and

e) promote transparency and disclosure.

In the area of Manpower, measures include: a) create an improved industrial climate to support expansion for increased labor opportunities; b) protect and increase placements of workers overseas; c) solve industrial conflicts fast, cheaply and fairly; d) accelerate the process in the issue of permits for labor; f) create breakthroughs in the development of transmigration projects, aimed to increase and expand opportunities for labor.

In the area of Small and Medium Enterprises and Cooperatives, the government will further empower and increase the units of small and Medium Enterprises and Cooperatives.

The new policy package has been well responded by business community. Foreign investors, however, are still waiting for the issuance of new investment law. Under improved investment climate after the implementation of the new policy, investment is expected to grow faster. The Chairman of the Investment Board forecasts an investment growth of 15.2% in 2006, higher than the initial estimate of 8%. Japanese Manufacturing Companies made a forecast that the best investment in Indonesia at present would be in automotive and chemical industries.

Data Consult' s mining industry surveys conclude that in 2006, foreign investors are more optimistic to invest in metal mining industries as disclosed by Freeport, Newmont, Inco and Newcrest, as their operation have been profitable and they have been able to overcome protests and criticisms from different parties.

Infrastructure projects started attracting foreign investors, such as in Cileunyi - Sumedang and Sadang Dawuan toll road projects, in a number of gas pipeline projects. Dubai Islamic Bank is interested in a number of various development projects, including the Jakarta Monorail project.

Huge investment will be realized geotherplant in North after the signing of ExxonMobil - Pertamina cooperation in exploiting Cepu oil and gas fields is expected to boost investment in oil and gas exploration and exploitation after the slump development in the last 5 years.

Last but not least, huge investment of around US$ 600 million will be installed to build a huge Sarulla geothermal power plant by a consortium led by Medco Energy International in North Sumatra. There are more investment to be made to build other geothermal power plants, including Darajat III and Lahendong.

Improvement of investment climate is the key to favorable investment development. Therefore it is essential for the Government to stick to its investment policy package.