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Economy

Stephen Grenville: Better financing can turn Indonesia's infrastructure mess into an opportunity

Commercial charges and 'value capture' are needed to kick-start project financing

In October 2018, Indonesia will host the annual meetings of the International Monetary Fund and the World Bank in the Balinese resort area of Nusa Dua. This is an important occasion: These annual talks take place outside Washington only every third year and involve thousands of high-level participants from across the globe.

When announcing that Indonesia would host the 2018 gatherings, IMF Managing Director Christine Lagarde noted that it would be "a great opportunity to showcase Indonesia's impressive economic and social achievements."

But what will those attending make of the Indonesian economy? Some participants will note that nearly two decades have passed since the Asian financial crisis, which began in July 1997. The crisis did enormous harm to Indonesia, and the scars still show.

In the three decades before the crisis, growth in gross domestic product averaged 7% a year. Since then, macroeconomic policy has been more cautious and foreign markets have remained unhelpfully skeptical; they were, for example, ready to include Indonesia among the so-called Fragile Five economies when the U.S. Federal Reserve started to review its unorthodox monetary easing policies in 2013.

The emergence of the current democratic political system after President Suharto resigned in 1998, and the associated devolution of power from Jakarta to the local level, have presented additional challenges for those who craft economic policy. Nevertheless, Indonesia has maintained a steady growth rate of 5-6%. This does not match either China or India, but it is enough to double GDP every 15 years, giving rise to confident predictions that Indonesia will be the world's fourth-biggest economy by the middle of this century.

In that sense, Lagarde's positive sentiment is justified. But to showcase Indonesia's economic and social achievements, visitors must go beyond the artificial confines of the Nusa Dua enclave. This area -- part of the almost self-contained Bukit Peninsula at the southern end of Bali -- is a miracle of urban planning in a country characterized by unremitting urban chaos.

But how will the conference attendees observe Indonesia's "impressive economic and social achievements" from the disconnected world of Nusa Dua? They will have to cross over the isthmus into Bali proper, beyond the airport freeway that slices through a formerly pristine mangrove lagoon. Here they will find a different Indonesia, where the vibrant commercial economy has run far ahead of infrastructure capacity.

A visitor's first impressions will be of choked roads, where motorcycle taxis are the surest way of reaching destinations on time because they can weave their way among the pedestrians on the footpath when the road is gridlocked. While traffic jams may be the infrastructure deficiency most apparent to foreigners, they will hardly notice the greater problem of electricity shortages. All their hotels are equipped with "emergency" generators whose routine use keeps the air conditioners going. Similarly, the visitors will be largely unaware of the near-universal water supply and sewage deficiencies, except for the standard warnings not to drink the tap water.

SKIMPY SPENDING During the Suharto period, Indonesia spent around 4% of GDP on infrastructure. This fell drastically with the 1997 crisis, leading, in particular, to the cancellation of large power generation projects. Even with the subsequent economic recovery, infrastructure spending is running at only 2.5% of GDP -- half the pace judged necessary by the latest Asian infrastructure report from the Asian Development Bank.

The canceled electricity projects may have been questionable, but their output would have found a ready market. Similarly, Jakarta's abandoned urban rail program would have offered an alternative to the efficiency-sapping traffic jams that continue to afflict the capital.

Let us be more positive. This massive infrastructure deficiency might be seen not just as a problem, but as an opportunity. In a world concerned by secular stagnation and demand deficiency, Indonesia has a multitude of good infrastructure investment opportunities.

While questionable projects are put forward from time to time, there is very little chance that any mainstream infrastructure project -- whether in power, transport or telecommunications -- would turn out to be a white elephant for lack of demand. Any extra capacity will have a high social return.

President Joko Widodo has made infrastructure a priority. Much has been done (or is in process) to expand electricity capacity. Much more capacity is needed; electricity requirements account for more than half of the additional infrastructure identified by the ADB.

Indonesia's per capita electricity consumption is just 10% of the level in the Organization for Economic Cooperation and Development, a club of mostly rich countries. A limited mass rail system is, at last, under construction in Jakarta, although an adequate network is still many decades away. Meanwhile, new tollways have sped up some journeys -- at least until drivers return to the regular road system.

Of course, finance is a challenge. The ADB approach is to estimate what could be safely financed from the government budget, and assume (or hope?) that the private sector will come up with the balance. But this gives too large a role to public-private partnerships. Past experience has shown that the problem with PPPs is that the private sector will shoulder the funding risk only if it is extravagantly rewarded. In the absence of such excessive remuneration, the usual response of the private partner is to shift the risk back to the public sector, privatizing profits while socializing losses.

One key to addressing this is to go back a step to identify projects that can be made financially viable by getting those who will benefit to pay. In the absence of infrastructure provided by the state, many consumers have gone ahead and provided their own water, sewage and electricity facilities. This is inefficient and costly for the individual providers. That, surely, is evidence of both capacity and willingness to pay.

No doubt customers who are accustomed to having subsidized water and electricity would not like being asked to pay commercial prices, but the poorest could be accommodated with targeted subsidies while the rest -- Indonesia's burgeoning middle class -- pay the full price.

When new infrastructure raises the value of nearby land, the solution is, once again, at hand: "Value capture" can ensure that beneficiaries of higher land values fund a good part of infrastructure costs. This is how American railways were built in the 19th century, and London's underground rail and sewage systems.

Of course, this is not politically or organizationally easy. But regular reports of infrastructure deficiencies (such as the ADB's latest publication), with their lists of projects, huge estimates of funding costs and pious hopes that the private sector will come to the funding party, are pointing policy in the wrong direction. Those who could benefit from better infrastructure should not be bamboozled by the promise of subsidized supply, funded by the private sector, which is a mirage.

Politicians should offer them a realistic promise: If they pay a commercial user price and accept "value capture" where land values appreciate substantially, they will get services that are, in net benefit terms, hugely positive for them. The alternative is to go on sitting in traffic jams for hours each day.

LOTS OF HURDLES Needless to say, there are other challenges. Infrastructure projects are often huge, complex and require organizational and engineering skills of a high order. Thus, the list of properly researched "shovel-ready" projects is short. Land acquisition is painfully slow. Some projects are socially beneficial, but users and landowners are not the only beneficiaries. Toll roads do not benefit only those who use them; other drivers can travel more swiftly on other roads freed up by the availability of the tollway.

In the end, some budget subsidies will be needed, and some high-value projects will have to be undertaken by the government or by state-owned enterprises. Currently, more than half of Indonesia's infrastructure is funded from the government budget, with SOEs providing about a third, leaving the private sector contributing a tenth.

Those who cross over from Nusa Dua's infrastructure-heavy hotel enclave to look at the real Indonesia will witness everywhere a small-scale entrepreneurial vibrancy that refutes the World Bank's ranking of the ease-of-doing-business there -- 91st out of 190 countries. If only the government could get its act together on infrastructure, Indonesia could easily shift up a gear, increasing the rate of growth to the 6-7% seen in China and India. This small acceleration would be worthwhile: 7% growth would double GDP every decade.

Stephen Grenville is a nonresident fellow at the Lowy Institute for International Policy in Sydney and a former deputy governor of the Reserve Bank of Australia.

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