Bill Guerin, Jakarta – As Indonesian President Susilo Bambang Yudhoyono enters his third year in office, the world's most populous Muslim country is widely viewed simultaneously as one of the region's most stable democracies yet one of its most unpredictable economies.

Yudhoyono's pro-business government has successfully stabilized the country's macroeconomy. The Indonesian rupiah has gained almost 7% against the US dollar so far this year, inflation is now hovering at a manageable 7%, foreign-exchange reserves are up around US$42.3 billion, and the government is set to repay the final $3.2 billion installment it owes to the International Monetary Fund about three years ahead of schedule.

At the same time, economic growth has failed to keep pace with the improving macroeconomic fundamentals because of lingering foreign and local investor concerns about the country's overall direction. Consider: this year foreign direct investment in the nine months to September plunged by 43.85% year on year to $4.29 billion compared with $7.64 billion over the same period in 2005, according to data released by the state-run Investment Coordinating Board (BKPM).

The decline indicates a precipitous drop in both the value of new projects and expansions of ongoing business concerns. The falling figures, some analysts say, can be chalked up to a lingering lack of confidence in the microeconomic environment, including encumbrances to doing business such as endemic red tape, the marriage of relatively high wages to the low productivity levels of Indonesian workers, inadequate infrastructure – especially in terms of electricity supply – and legal uncertainty surrounding the protection of foreign investments.

William Wallace, the World Bank's lead economist for Indonesia, contends that overall business optimism has improved but that investors are still waiting for policy certainty on tax and customs, labor rules and administrative simplification. "The key issue now is the revival of investment," he said.

An Indonesian Survey Institute (ISI) poll in September found that 51% of the country's eligible voters would vote for Yudhoyono for president if elections were held this year (the next polls are scheduled for 2009). However, the survey also rated his government's performance as "bad" on economic issues such as poverty and unemployment reduction.

Unemployment is a growing problem with serious social-stability implications. As of June, unemployment was 10.6%, or 11.6 million of the 106-million-strong national labor force. That's a significant 2% increase on the 9.5 million people recorded at the end of 2005. Moreover, there are more than 43 million workers classified as underemployed, defined as working less than 35 hours a week. According to the Central Statistics Agency (BPS), almost 40 million people live below the poverty line of about 60 US cents per day.

Need for speed

Economic reforms unveiled this year have so far failed to stimulate a new cycle of investment-driven growth. Nor has progress been made in passing crucial tax reforms designed to simplify tax laws and reduce tax rates. Even if eventually enacted by the legislature, a proposed cut in the corporate-tax rate would not take effect until 2010.

Yudhoyono's proposed business-friendly amendments to the 2003 labor law, which he later shied away from after rambunctious labor unions took to the streets in protest, remain a hot-button issue for investors. Haryo Aswicahyono, of the Center for Strategic and International Studies (CSIS), said: "The labor situation has swung from being oppressed by the government to workers having too much power."

The business community contends that wages have risen too fast, and that with highly generous severance-pay requirements and strict regulations on contracting and outsourcing, that they are reluctant to expand their operations and payrolls. US Agency for International Development (USAID) figures show that severance pay in Indonesia is three to five times as high as in China, India, South Korea and Malaysia.

John A Prasetio, vice president of the Indonesian Chamber of Commerce and Industry (KADIN), says the hard economic reality is that "mainstream Indonesian elites seem not to be too concerned about catching up with our competitors. Without more flexible labor laws, many jobless youths trying desperately to move out of poverty are denied entrance to the formal [economy]."

Vice President Jusuf Kalla, a strong supporter of the proposed labor-law revisions, told members of the US-ASEAN Business Council in Washington last month that Indonesia's investment and labor laws were in the process of being "re-engineered". He said he was confident that a number of pro-business reforms would be finalized by early 2007.

Economists estimate that for the country to absorb new workers entering the labor pool each year while keeping unemployment levels steady requires annual economic growth of about 6%. Yet last year's 5.6% growth rate was the highest the country had recorded since the 1997-98 Asian financial crisis ravaged the local economy and pushed tens of millions of people back into poverty.

The Indonesian central bank estimates that the economy will grow by just above 5.5% this year, a respectable clip compared with other regional economies. But that's simply not fast enough for Indonesia, where an estimated 2.5 million people enter the labor force every year. Meanwhile, recent job losses in the manufacturing sector, particularly textiles, have resulted in near-non-existent job creation in the formal sector. Labor-intensive industries slashed more than a million jobs in the last three months of 2005, according to official data.

Hat in hand

The government desperately needs new foreign investment to help fund a planned $150 billion national infrastructure upgrade and to meet its annual average 6.6% economic-expansion target for the period spanning 2004-09. Investment in infrastructure has shrunk from 6% of gross domestic product in the late 1990s to a paltry 2% at present partially because of government paralysis.

The country's first-ever infrastructure conference in January 2005 was attended by hundreds of domestic and foreign investors who were invited to bid on 91 infrastructure projects worth a total of $145 billion. Yet since then there has been only limited progress in actual groundbreaking, because of regulatory and legal obstacles as well as indecisiveness on the government's part over how best to apportion risk-sharing for ventures.

Poor infrastructure, besides being one of the biggest hurdles to attracting foreign investment, now badly impairs the country's overall economic competitiveness through comparatively high costs to production and distribution. Sofyan Wanandi, chairman of the Indonesian Manufacturers Association, says the country's faltering infrastructure, particularly crumbling road and rail networks and sputtering electricity plants, have significantly increased logistics costs, which in turn leads to higher-priced, less competitive products than those made in neighboring countries.

KADIN chairman M S Hidayat, while acknowledging the progress made in macroeconomic stability, warns that "this will be rendered useless if it does not touch upon the microeconomic aspects". KADIN wants the government to accelerate this year's budget spending to kick-start major infrastructure spending projects, including the construction of toll roads, power plants and rural infrastructure.

Infrastructure Summit II, to be held in Jakarta next week, will see about $4.5 billion worth of projects on offer to potential investors, including contracts to build new toll roads, power stations and water-supply systems. In pre-event marketing material, the government organizers claim that 24 infrastructure projects worth $6 billion have already "gone under transaction" since the January 2005 summit, including 17 toll-road projects, two gas-pipeline projects, one power-generation project and four water-supply projects.

However, the Asian Development Bank in a report last month claimed that the only contracts awarded so far have been for three gas pipelines, one power plant and three toll roads, reflecting, as the agency puts it, a "continuing incapacity to follow through on policies or regulations rather than problems with the policy framework itself".

Previous BKPM chairman Theo Toemion candidly admits that the Indonesian government has never had a clear indication of just how much is realized from the many investment approvals the agency issues. He estimates that the actual investment realized, where projects proceed to fruition, is less than 40% of foreign-investment approvals and less than 50% of approved domestic investment.

However, the slow take-up is not all the fault of the central government, which at the beginning of this year expedited budget transfers to finance regional developments in provincial areas.

Flush with development funds, many provincial governments have parked that cash in Bank Indonesia certificates (SBIs) rather than pumping it into development schemes, whereby nearly Rp45 trillion (more than $4.9 billion) is now on deposit, said Industry Minister Fahmi Idris during a recent interview with local media. SBIs severely restrict lending for domestic investment and expansion purposes, and many provincial authorities prefer to park their deposits at high interest rates paid by the central bank rather than take the risk of lending to businesses in the real sector.

Faced with these difficulties, Yudhoyono has struggled to meet his earlier policy pledges to cut poverty by one-half, keep inflation in check and create more jobs. Yet the need for strong economic stewardship is reaching a crucial juncture.

Growing unemployment and poverty carry huge political risks, not only of jeopardizing Yudhoyono's bid for re-election in 2009, but also of broad social stability across the crowded archipelago. Some reforms that have underpinned macroeconomic stability have at the same time increased economic suffering – most notably his government's tough decision last year to slash fuel subsidies.

The ultimate benchmark of Yudhoyono's political success will be a return to rapid economic growth. Increasingly it seems that won't be unattainable within the time left in his term. Moreover, a growing number of economic analysts fear that the country's improving macroeconomic fundamentals risk complacency on the economic-reform agenda, despite government denials. But if Yudhoyono fails to lure in more foreign funds to stimulate a new cycle of self-sustaining investment-led growth, the once immensely popular premier's days could be numbered at the 2009 democratic polls.

[Bill Guerin, a Jakarta correspondent for Asia Times Online since 2000, has been in Indonesia for 20 years, mostly in journalism and editorial positions. He has been published by the BBC on East Timor and specializes in business/economic and political analysis related to Indonesia.]