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Political and Economic Environment

For background information on the political and economic environment of the country, please click on the link below to the U.S. Department of State Background Notes: http://www.state.gov/r/pa/ei/bgn/2748.htm

Political Environment

A. Nature of the Political Relationship with the United States

The United States and Indonesia have enjoyed good relations in recent decades. The third most populous democracy in the world and the largest nation in Southeast Asia, Indonesia has pursued cooperative relations with its neighbors, thereby contributing to peace and stability in the region. Through its membership in the Non-Aligned Movement (NAM), the Organization of Islamic Conference (OIC), the Association of Southeast Asian Nations (ASEAN), the ASEAN Regional Forum, and the Asia-Pacific Economic Cooperation (APEC) forum, Indonesia wields substantial influence on a number of security and economic issues of importance to U.S. interests. Indonesia traditionally has acted with a view more to regional consensus than to consistency with U.S. positions, especially in multilateral fora. On the bilateral economic front, the United States is one of the largest investors in Indonesia, when natural resources and financial services are taken into account, and is a major market for Indonesia's exports.

The United States assumed a leading role in the international community's response to the economic crisis that struck Indonesia in 1997-1998. Working with international financial institutions, the United States contributed to Indonesian efforts to implement needed financial reforms and doubled economic assistance in support of social safety net programs designed to cushion the impact of the economic downturn on poorer Indonesians. Thanks in part to long-standing relationships with Indonesian non-governmental organizations, the United States was well placed to provide substantial technical and financial assistance to support Indonesia's June 1999 parliamentary balloting, the country's first free elections in over four decades, and to contribute to the country's democratic transition. The United States provided similar support in 2004 for national legislative elections, and for Indonesia’s first direct presidential election, a major democratic milestone.

Promoting respect for human rights and strengthening democratic institutions, particularly the justice sector and the rule of law, are prominent features of U.S. policy toward Indonesia. The Government of Indonesia (GOI) has taken steps to promote respect for human rights. Human rights advocates remain pleased that Indonesia began trying major human rights cases, such as the 2004 murder of human rights activist Munir Said Thalib, and established a permanent human rights court. The Commission on Truth and Friendship (CTF) report placed institutional responsibility on Indonesian security forces for human rights violations in East Timor and recommended additional human rights training to prevent future abuse. Recently, a number of senior-level officials have been investigated for corruption.

The media now generally report developments freely and routinely publish a wide range of opinions on sensitive issues. The government has allowed new political and social organizations to form freely, and promulgated labor union laws that have permitted more than 70 new labor union federations and hundreds of new unions to form, replacing the single union federation allowed under the Suharto government. Human rights concerns, however, remain, particularly the lack of accountability for past security force abuses in Aceh and Papua.

B. The Political Situation in Brief

Indonesia held its first pluralistic and competitive parliamentary elections in 44 years in June 1999. The election campaign was generally peaceful, the voting process went relatively smoothly, and, although there were some allegations of fraud, the major parties accepted the results. As in 1999, national legislative elections in 2004 proceeded in a generally free and fair manner, and were exceedingly peaceful and orderly. Some domestic observers complained of irregularities, and the Constitutional Court, in accordance with its mandate, adjudicated numerous disputes, adjusting the allocation of seats in the national and regional parliaments. The country elected a new 550 member House of Representatives (DPR) and 128 member House of Regional Representatives (DPD) as well as regional legislatures. Twenty-four political parties participated in the election. The Golkar party, closely identified with Suharto-era governance, regained a plurality in the DPR, winning approximately 23 percent of the vote and 128 DPR seats. Then-President Megawati’s Indonesian Democratic Party – Struggle lost its plurality, receiving under 20 percent of the vote and 109 DPR seats. Five other parties won at least 45 DPR seats, while ten smaller parties also have representation in the DPR. After the 2004 national elections, the DPR consisted solely of elected legislators, another democratic advance. Previously, institutional representatives of the Armed Forces and the Police were allocated seats in the parliament.

The 2004 elections also brought into existence the DPD, a parliamentary body whose members are elected in an individual capacity (not from a party list). Four DPD members represent each of Indonesia’s 32 provinces. Although originally intended to function as an upper house, like the U.S. Senate, the DPD currently only has a consultative role. True lawmaking authority rests solely in the DPR.

Indonesians directly elected their President and Vice President for the first time in 2004. Five tickets competed in a July first-round election, headed by incumbent President Megawati Soekarnoputri; retired General Susilo Bambang Yudhoyono; retired General Wiranto; People’s Consultative Assembly (MPR) Chairman Amien Rais; and incumbent Vice President Hamzah Haz. Corruption, the state of the economy and leadership qualities were principal campaign issues. Since no candidate received more than 50 percent of the vote, a runoff election between the top two candidates – Megawati and Yudhoyono – was held on September 20. Yudhoyono won slightly over 60 percent of the national vote and was inaugurated as Indonesia’s sixth President in October 2004. Both domestic and foreign observers described the presidential elections as free and fair. There were no legal challenges to the final result.

The GOI has faced an array of challenges. Most prominent have been sporadic separatism in Aceh and Papua (formerly known as Irian Jaya), social unrest, corruption, complications associated with implementing decentralization, and restoring the Indonesian economy. Indonesia has made significant progress combating terrorism. The country has not witnessed a major terrorist attack since 2005, although extremist groups still exist in the region. On December 26, 2004, a massive earthquake and tsunami hit Aceh and North Sumatra, leaving over 200,000 people dead or missing. After the disaster, the government and the separatist Free Aceh Movement (GAM) began negotiations to find a settlement to the armed separatist struggle in Aceh that has been ongoing for almost three decades. The resulting Memorandum of Understanding the government and GAM signed on August 15, 2005 to end the insurgency ended the conflict has led to GAM's surrender of weapons and the departure of non-local government troops from the province and the prospect of a lasting peace.

The DPR has vigorously asserted its constitutional prerogatives, including its right to review government-proposed legislation, to question and challenge the President and members of the cabinet, and to provide a forum for public debate and presentation of grievances. However, the DPR has proven slow in passing legislation, even that concerning important political, economic, and security matters. The DPR is currently focused on creating and implementing internal reforms which will address this and other issues. Golkar legislator Agung Laksono currently chairs the DPR.

Direct election of provincial governors, regents (county level executives) and mayors began in the summer of 2005. Previously, those officials were indirectly elected by local assemblies. According to a January 2009 Constitutional Court decision, voters will also more directly elect legislative candidates to DPR seats in the April 2009 legislative election. Previously, parties allocated parliamentary seats they won to candidates according to their rank on internal party lists, rather than the proportion of the public vote they received.

C. Major Political Issues Affecting the Business Climate

The government faces great challenges in consolidating Indonesia's democratic transition, restoring the country's economic momentum, and in bringing the benefits of development to all Indonesia's citizens. Among the key political issues with economic implications are periodic outbreaks of communal violence around the country, particularly in Central Sulawesi; demands for greater autonomy or independence in Papua; the presence of the regional terrorist organization Jemaah Islamiyah (JI); and deep-seated weaknesses in the rule of law at all levels throughout the country.

In January 2001, the government began an ambitious and massive decentralization of political and economic authority to the districts. While well intentioned in theory, the implementation of decentralization has been uneven, and many issues involving power- and revenue sharing between the central and local governments remain unresolved. In light of these experiences, the government is discussing revisions to the regional autonomy laws.

Continuing allegations of high-level corruption, especially in the judiciary, point to the need for comprehensive reform and implementation of good governance practices. In this regard, far more effective mechanisms will be required to enforce commercial, criminal, and administrative laws.

Economic Trends and Outlook

Strong Growth in 2008, Despite Food, Fuel and Global Financial Crises

Indonesia weathered food, energy and global financial markets crises reasonably well in 2008. Strong macroeconomic fundamentals and a robust policy response enabled Indonesia to achieve real GDP growth of six point two percent (est.), nearly matching decade-high six point three percent growth in 2007. A commodity boom in the first half of 2008 and 30 percent credit growth fueled economic growth, which moderated in late 2008 as commodity prices plummeted and global demand slowed. Analysts expect Indonesia to face more serious economic challenges in 2009, particularly rising job losses. Estimates for 2009 GDP growth vary widely given uncertainty about recovery of global demand. Government forecasts of four point five to five point five percent growth exceed market projections of one point nine to four percent.

Tighter monetary policy, reflected in six quarter-point hikes in the overnight policy interest rate from May to October 2008, gave way to monetary easing in December 2008. Inflation, which peaked at 12.1 percent in September, declined gradually to 11.1 percent year-on-year (yoy) in December, and is projected to fall to five to seven percent in 2009. Direct investment increased by 20 percent to over US$17 billion in 2008, according to the Investment Coordinating Board (BKPM), but remains below pre-Asian financial crisis levels of 30 percent of GDP. Foreign direct investment roses nearly 44 percent yoy, while domestic investment fell by over 41 percent. The outlook is for slowing investment in 2009, as tight credit markets and low demand have prompted many firms to cancel or delay planned investment.

Indonesia’s financial markets experienced significant volatility during the fourth quarter of 2008 and remain vulnerable to risk aversion. The Indonesia Stock Exchange (IDX) declined sharply, with the key JCI index falling by 50.6 percent (yoy) and market capitalization down by 46 percent. In early October, responding to market panic, the IDX closed trading for two and one-half days. Shares of several firms affiliated with the Bakrie Group were suspended from trading for several weeks after share prices fell steeply and the Group attempted to restructure its debt. These developments and a number of cases allegedly involving fraudulent activity by securities firms challenged regulators’ ability to protect the investing public. Markets showed signs of increasing stability by year’s end. The value of the rupiah fell by more than 14 percent against the U.S. dollar, but recovered from 10-year lows of more than Rp.13,000/USD after authorities took measures to improve liquidity, increase the level of government deposit guarantees 20-fold, and discourage currency speculation. Bank Indonesia (BI) reserves declined from to US$60.5 billion in July to US$51.6 billion in December 2008, as BI intervened selectively to support the rupiah. Government bond yields, which spiked to over 20 percent, moderated to 11.6 percent by year’s end.

Indonesian banks remain well capitalized, but face increasing non-performing loans in 2009. Failures of two Indonesia-related banks in late 2008 briefly raised concerns about the banking system. Bank Century, the first commercial bank to fail in Indonesia since the 1997/98 Asian financial crisis, was taken over by Indonesia’s Deposit Insurance Corp. Netherlands banking authorities closed Bank Indonesia-owned Bank Indover when it defaulted on obligations and Bank Indonesia failed to gain legislative approval to inject additional capital.

President Yudhoyono has pursued a “pro-growth, pro-job and pro-poor” economic reform agenda since taking office in 2004. His administration has made progress in a sustained anti-corruption campaign and extensive tax and customs reform, laid the foundation for judicial and civil service reform, and strengthened the campaign against human trafficking and for protection of migrant workers. As 2009 began, President Yudhoyono retained strong public support, with his approval ratings recovering from mid-2008 lows, when rising inflation, driven by high food and fuel prices, weighed heavily on the more than 100 million Indonesians living on less than $2 per day. The government’s decision to raise energy prices by an average of 29 percent in May 2008, while deeply unpopular, relieved strain on the budget and helped prevent cuts in priority spending areas. Direct cash transfer payments to some 19 million poor household implemented in mid-2008, falling energy prices and moderating food prices in the second half of 2008 prevented significant public unrest.

With parliamentary and presidential elections scheduled for April and July 2009, the GOI is focused on minimizing effects of the global financial crisis on Indonesia’s real economy. Falling world energy prices allowed the government to reduce subsidized fuel prices in December 2008 and January 2009. The government initiated a monthly review of subsidized fuel prices, which should improve its ability to adjust prices in line with global markets, though price caps for subsidized fuels remain in place for 2009. With export revenues falling and expected lower private investment and remittances, the government proposed a fiscal stimulus package with a large infrastructure component to support domestic demand. The program’s success will depend on the government’s ability to disburse funds quickly. As elections approach and parties jockey for political advantage, government actions face greater scrutiny. In December 2008, the House of Representatives rejected a government regulation which established a legal framework to assist authorities in preventing and resolving financial crises. Government revisions to the 2009 budget and proposed fiscal stimulus also face opposition.

The government’s financial and monetary policy response to the crisis reflects a high degree of cooperation between technocratic leaders at the Coordinating Ministry for Economic Affairs, the Ministry of Finance and Bank Indonesia. When capital market conditions deteriorated, the government reduced its financing needs (robust revenue collection enabled it to reduce the 2008 budget deficit to zero point one percent of GDP, from an initial one point nine percent of GDP) and halted government bond issuances from October through the end of 2008. It moved quickly to secure alternative stand-by financing for 2009 from the World Bank, Asian Development Bank and bilateral donors. Indonesia’s solid debt management track record and diversified sources of funding were keys to that effort. In 2008, the government successfully issued bond on the global market and issued its first domestic Islamic bond (sukuk). Some economic policies, including a new Mining Law approved in December 2008 and several trade and investment measures, reflect growing economic nationalism and protectionism, and a lack of broader economic policy coordination.

Indonesia achieved a major economic reform milestone when the Parliament approved a new income tax law (36/2008, effective January 1, 2009), which significantly reduced income tax rates. Key changes included increasing non-taxable income to Rp.15.84 million, establishment of four individual income tax rate tiers (reduced from five) as follows: annual taxable income of up to Rp.50 million (five percent income tax rate); from Rp.50 million to 250 million (15 percent); from Rp.250 million to 500 million (25 percent); and above Rp.500 million (30 percent, down from previous top rate of 35 percent). Income from dividends is taxed at 10 percent (down from previous rates of up to 35 percent). The corporate income tax rate was lowered from 30 percent to 28 percent in 2009. Public companies with at least 40 percent of shares held by at least 300 shareholders, with a maximum five percent share held by any single shareholder, receive a further five percent reduction in corporate income tax rates. Small and medium enterprises and cooperatives receive a 50 percent reduction of corporate tax rates. Reform champion Finance Minister and Acting Coordinating Minister for Economic Affairs Sri Mulyani Indrawati also advanced internal reforms at the Ministry of Finance (MOF) to improve performance and transparency. Tax administration reforms, including a limited tax amnesty program which spurred millions to register and become taxpayers, produced significantly higher tax revenues and broadened the tax base.