Doing Business in Indonesia: legal and bureaucratic constraints

Ross H. McLeod Indonesia Project Australian National University

ross.mcleod@anu.edu.au
6 July 2007

The Doing Business reports rationale

What gets measured, gets done. Low rankings provide clear signal to policymakers of where scope exists for improvement in the business environment And they provide useful ammunition for outsiders pushing for better government performance

The Doing Business reports rationale

In principle, this seems a worthwhile exercise, but The methodology is not free from defects Constructive criticism should lead to more meaningful measurement over time This paper contributes to this effort

The Doing Business reports methodology

Overall ease of doing business ranking is based on 10 broad topics Each topic has 3-6 component indicators After evaluating all countries, each is given a percentile ranking for each component indicator Its score for a given topic is the simple average of its percentile rankings for each component indicator for that topic Its overall ease of doing business index is the simple average of its 10 topic scores

Problems with the Doing Business methodology (1)

Distinguishing legal/regulatory inputs and business outcomes: Indicators such as the time taken to establish a standardised business are objective measures of red tape (albeit subject to measurement error) Indicators such as the existence or lack of a public credit registry or private credit bureau to assist lending institutions reflect the researchers presumption that such things should exist, in all countries Indicators such as measures of investor protection reflect the researchers presumption that such protection is necessary, and that the best form for it to take, in all countries, is similar to that in the US

Problems with the Doing Business methodology (2)

Arbitrary relative importance of topics and their components Each topic carries equal weight Each component indicator carries equal weight within its topic
But the number of components varies from 3 to 6 per topic So the weightings of components vary by a factor of 2 (from 1/60 to 1/30), for no obvious reason
Score sheet

Problems with the Doing Business methodology (3)

Some components are redundant
For example, if we know the total cost of a licence and the time taken to obtain it, the number of procedures is irrelevant

Indicator Procedures (number) Time (days) Cost (% of income per capita)

Indonesia 19 224 311

Problems with the Doing Business methodology (3)

Some components are simply duplicated
In the Hiring & Firing Workers topic, one component (Rigidity of Employment) is actually an average of three other components In the Protecting Investors topic, one component (Investor Protection Index) is actually an average of all other components In the Getting Credit topic, the Credit Information Index will be zero if public/private credit bureaus do not exist (involving double penalty for countries without these)

Problems with the Doing Business methodology (4)

Coverage of data doesnt extend to extralegal costs (bribes) Overall time taken (e.g.) getting a licence might be greatly reduced with a bribe Need to focus on actual (typical) times and costs, not those if we play by the rules

Doing business in Indonesia: a closer look

If we focus more on the things that really matter to business, how does the legal and regulatory environment compare with that in other countries?

Ease of Doing Business in Indonesia: Selected Sub-indices and Components

Indicator Ease of doing business Matters relying heavily on the courts Enforcing contracts Time Cost (% of debt) Closing a business Time Cost (% of estate) Recovery rate (% of amount owed) 570 days 127% 5.5 years 18% 13% 134 151 116 133 99 119 Rank (among 155 countries) 115 145

Ease of Doing Business in Indonesia: Selected Sub-indices and Components

Indicator Ease of doing business Matters involving the bureaucracy Starting a business Time Cost (% of income per capita) Hiring and firing workers Difficulty of Hiring Index (0-100) Rigidity of Hours Index (0-100) Difficulty of Firing Index (0-100) Hiring cost (% of salary) Firing costs (weeks of wages) 151 days 102% 61 40 70 10% 144.8 weeks 149 121 120 122 63 131 53 150 Rank (among 155 countries) 115 144

Indonesia looks very poor on the important Doing Business indicators, yet it grew very rapidly for three decades under Soeharto. (These days it is not doing quite so well, although not too badly).

Well come back to this later

The debate on legal heritage

The flavour of the law and finance literature
Common-law countries give both shareholders and creditors the strongest, and French-civil-law countries the weakest, protection. French civil law countries have both the weakest investor protections and the least developed capital markets, especially as compared to common law countries. The quality of law enforcement is lowest in Frenchcivil-law countries. Taken together, [the empirical] evidence describes a link from the legal system to economic development.

The debate on legal heritage

This literature seems unpersuasive Consider the relative economic growth performance of five countries representing the main families of legal heritage
In the last three decades of the 20th-century, the US was the standout performer But France outperformed the UK (slightly) And both outperformed Germany and Sweden (with supposedly better legal systems than France)

The debate on legal heritage

Breaking this into two equal subperiods
The US was still the standout performer But France and the UK swapped their positions And both still outperformed Germany and Sweden (which also swapped their positions)

Some developing country comparisons

Figure 10 Real GDP Growth in Select Developing Countries 1971-2003 (%)

Malaysia (E) Thailand (E) Indonesia (F) India (E) Algeria (F) Brazil (F) Nigeria (E) Zimbabwe (E) Congo, Dem Rep (F) -100 0 100 200 300 400 500 600 700 800

E = English Common Law; F = French Civil Law Data for Zimbabwe are for 1971-2002.

Is legal heritage important?

Probably not
Relative growth performance not clearly related to legal heritage Legal systems tending to converge over time? Developing countries pick and choose from legal and regulatory approaches elsewhere

Doing Business findings biased by researchers views as to what is good law

What may work well in the US is not necessarily appropriate in countries at earlier stages of development

Is legal heritage important?

In Indonesias case, the poor quality of the judiciary/legal system and the bureaucracy is much more a legacy of the Soeharto franchise than of the Dutch colonial system (and French civil law) of six decades ago

Soeharto built up a system that enabled him to exploit the coercive power of government in his own interest for more than three decades

He created and maintained a monopoly on political power, through a franchise system of government

Soehartos franchise system

Full title: multi-branch, multi-level franchise Branches:
Legislature (MPR/DPR/tame parties) Judiciary/legal bureaucracy Military/police Bureaucracy (including non-department agencies, esp. Bulog, Bank Indonesia) State-owned enterprises (SOEs)

Soeharto as franchise owner

Election system rigged so that he could not lose: the essential political monopoly Potential troublemakers in the army bought off with senior positions in bureaucracy, judiciary, SOEs, and by grant of privileged access to natural resources, especially timber Harsh action against actual troublemakers
Jail, violence, banishment to backwaters

Roles of the branches

Each branch of the franchise was nominally intended to serve the interests of the general public, and did so to some extent But the interests of the franchise came first in cases where there was conflict The main branch roles of relevance to the Doing Business reports involve the bureaucracy and judiciary:

Roles of the branches

Judiciary/legal bureaucracy
Deflect legal challenges to the regime and the actions of franchisees Impose legal sanctions on opponents of the regime Protect the interests of privileged firms and individuals in the private sector

Roles of the branches

Bureaucracy
Implementation of economic policies conducive to rapid growth Implementation of policies to generate rents for privileged companies and individuals Implementation of policies intended to generate mass support for the regime
e.g. Subsidy schemes for farmers, small business e.g. Increasing access to education and health for the poor

Returning to the Conundrum

Indonesia ranks very poorly according to the recent Doing Business reports And it probably would have ranked just as poorly during the Soeharto era Yet during that era it maintained sustained high growth for decades How to reconcile poor legal and regulatory environment with excellent growth performance?

Returning to the Conundrum

The Doing Business reports overlook the important distinction between insider and outsider firms, which still exists (albeit less clearly)
The low ranking of Indonesia on most indicators is relevant to outsider firms But insider firms escape extortion by the bureaucracy/judiciary/military/police, and benefit from dealings with SOEs And much of the economic action is with the insiders, which lead growth and structural transformation

In Indonesia, at least, legal heritage is of little importance relative to the Soeharto legacy
In any case, the legal heritage aspect has disappeared from Doing Business reports beyond the first one (in 2004) It is no longer even possible to download data on the classification of countries by their legal heritage

Doing Business in Indonesia: legal and bureaucratic constraints

Ross H. McLeod Indonesia Project, ANU
ross.mcleod@anu.edu.au

6 July 2007