July 18, 2017 11:00 am JST
FT Confidential Research

Caution required on Indonesia's plan for Batam

Issues with implementation mean that pay-off is likely to take several years

  • Expectations of resurgent growth in Indonesia's Riau Islands province, stemming from plans to shift its designation from a free-trade zone (FTZ) to a special economic zone (SEZ) should be tempered, at least in the near term. Legal and regulatory issues will take several years to fully resolve, which is likely to drag on investment.
  • Uncertainty from the shift and continued weakness in global demand are likely to limit the recent resurgence in manufacturing investment in the province, but the service sector is likely to perform better due to growing demand from companies keen to expand beyond nearby Singapore.
  • Companies ramping up residential property development, banking on a boom from the relaxation of foreign ownership rules, may be jumping the gun, but strong consumption growth is likely to support commercial development.

Indonesia has big plans for Riau Islands province as it seeks to reverse a slowdown in GDP growth and push its companies up the value chain. The province is already the country's largest FTZ but the government is looking to broaden its development from a focus on exports to make it a world-class manufacturing hub that will serve growing domestic demand.

Batam, the province's largest city and economic fulcrum, has attracted investment primarily by offering zero trade tariffs, cheap labour and access to the global supply chain via nearby Singapore.

Authorities hope to inject fresh impetus into a provincial economy for which annual GDP growth slid from 7.6 per cent in 2012 to 5 per cent last year. But near-term expectations should be tempered, given significant legal and regulatory issues both in terms of existing regulatory overlap and in driving the planned transition - a process that could take years.

Opening up the domestic market

The government plans to change the island's status to an SEZ as early as this year, with the FTZ concept, which simply eliminated trade tariffs, no longer sufficient to attract investment and drive the level of growth it hopes for in the province.

As an SEZ, new investments in Batam will benefit from a range of fiscal incentives, including:

  • income tax cuts of 20-100 per cent for up to 25 years;
  • exemption from VAT;
  • removal from Indonesia's negative-investment list, which denotes industries from which foreign investors are barred;
  • postponement of import duty on capital goods, equipment and materials for industrial processing.

The conversion will open up access to the domestic market, attracting a new type of investor aiming to capitalise on the rapid growth of Indonesia's consumer class. Foreigners will be allowed to own leasehold property for a maximum of 80 years, subject to tenure renewals. Major property companies such as Agung Podomoro, Ciputra and Lippo are already developing projects in Batam, with land prices rising to new highs.

Regulatory hurdles to overcome

The process, however, will be complicated, involving the harmonisation of conflicting laws and regulations and the transition of power from Batam Indonesia Free Zone Authority (BIFZA) to local governments.

This will take years, creating a climate of uncertainty that is likely to slow economic growth in Batam and the province as a whole, which has already suffered as a result of weak global demand over the past five years (see chart).

In that period dozens of factories have closed or relocated to industrial enclaves elsewhere in Southeast Asia, as well as to China and India, hitting exports from the province (see chart). The shipbuilding industry has been badly affected: only 20 per cent of the 140 shipyard companies operating in Batam in 2012 are still present.

But this is not just a consequence of weaker global demand. Many investors in Batam bemoan recurring regulatory uncertainty from overlapping jurisdictions between the local governments and BIFZA - mostly over business licences and labour affairs, particularly regarding the minimum wage.

President Joko Widodo signed a decree early last year establishing a national council, chaired by coordinating economic minister Darmin Nasution, to oversee the gradual dissolution of BIFZA and reassignment of powers to the Riau Islands Province and Batam City government, setting a target of three years to achieve a full transition to SEZ status.

But our recent visit to BIFZA revealed that this transition process has not even started, highlighting Indonesia's persistent struggle to turn policy into action. In an interview with FT Confidential Research, BIFZA officials said the process would not be as straightforward as Jakarta seems to think. Batam's status as an FTZ, as well as BIFZA's role as its administrator, were designated by law, which is superior to a presidential decree or government regulation and in Indonesia's ponderous House of Representatives can take years to change and then implement.

The transition to an SEZ will be highly complicated and time consuming. The regulatory uncertainty will hit investor confidence and drag on the recent uptick in investment in manufacturing in Batam (see chart).

Services sector outlook brighter

Though investment in the service sector in Batam has been weak relative to manufacturing over the past couple of years, we expect it to pick up. There is growing interest in Batam among regional and global services companies looking for a cheaper alternative to Singapore.

BIFZA data show foreign investment in the service sector reached $383m in the past five years, almost four times that of the preceding five years. The increase was led by investment in airline maintenance, repair and operations (MRO), hospitality, information technology, film-making and animation.

Industrial land developers in Batam have responded by reallocating some of their land to warehousing, office space and residential and commercial property. Kabil Integrated Industrial Estate, for example, traditionally focused on the oil and gas and energy industries, is working with the country's largest property developer, the Ciputra Group, to turn 10 per cent of its 520-hectare (ha) land holdings into a township with warehousing facilities and a residential area.

Elsewhere, Citramas Group is working with Singapore's Economic Development Board to develop a so-called digital park that will include apartments and an incubator for tech start-ups. The $700m project is located on a 200ha parcel of land in Batam's Nongsa area that already features a golf course and a marina, with Singapore just 40 minutes away by ferry.

Proximity to Singapore is not the only selling point for the digital park. We believe the project will benefit from Indonesia's large pool of programmers with lower salary demands than in Singapore. The Association of Computer Science Higher Education Institutions (Aptikom) estimates that Indonesia produces 40,000 to 50,000 IT graduates each year.

Risk in residential property buildout

While we are positive on the prospects for commercial property developments, given robust growth in household consumption - which has held steady in a range of 6.7 per cent to 7.1 per cent over the past five years even as economic growth has slowed - we are far more circumspect on those for residential developments.

In addition to Ciputra and Citramas, developers such as Panbil Industrial Estate are banking on a residential boom in the Batam area, on the expectation of foreign property ownership rules being relaxed in the SEZ.

We think this is a gamble, as we do not expect foreigners to be allowed to own a house or apartment in Batam before 2020 at the earliest. According to the 2007 FTZ Law and the 1965 Agrarian Law, land management rights over the entire island are controlled indefinitely by BIFZA, which offered right-to-build certificates to companies or individuals for a limited time.

Both laws would have to be amended or annulled by the House of Representatives to transfer land rights to the city government. Predicting when the House will be able to pass such amendments is tricky, especially when it already has 49 bills to discuss before its term ends in 2019, and its productivity will fall in the run-up to the 2019 general election.

The danger of residential property oversupply is therefore rising in Batam, echoing developments in Johor on the other side of Singapore.

This article was first published on July 4 by FT Confidential Research.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. A team of researchers in these key markets combine findings from proprietary surveys with on-the-ground research to provide predictive analysis for investors.

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