While advanced economies adjust to a “new low growth equilibrium” following the “Lehman Collapse,” Indonesia has “landed successfully” after recovering from the 1997/8 Asian financial crisis, according to Darmin Nasution, the governor of country’s central bank, Bank Indonesia. Economic growth in the world’s fourth-most populous country has averaged above 5% in the last decade as strong domestic consumption helped offset falling exports. Inflation has also been kept under control averaging about 5% in the last two years.

 Indonesia’s economic expansion will average 6.4% from 2013 to 2017, equal to that recorded in the two decades before the 1997 Asian financial crisis, the OECD said in a November report. Over the past decade, Indonesia has had the lowest volatility in economic growth among any advanced economy in the OECD or the BRICs plus South Africa, according to McKinsey Global Institute’s report “The Archipelago Economy: Unleashing Indonesia’s Potential”.

A growing middle class is continuing to fuel domestic demand and property prices, prompting investors such as Taspen, the state institution that manages Indonesian civil servants’ retirement funds, and private equity firms to seek opportunities in real estate investments.

President Director of Taspen, Agus Haryanto says: “The Indonesia market has an opportunity to keep growing consistently, supported by a sustainable economic growth and a lower inflation rate.

“The government has also implemented a systematic policy to minimise the impact of the structural problems.”

Taspen, which manages about $10bn as of September 2012, says the real estate market holds promise in the coming years due to the country’s strong economic growth, supported by local consumption, and falling interest rates for mortgage loans.

Amid the strong domestic market, Taspen’s portfolio is 100% invested in Indonesia and the fund’s long-term return target is more than 9%. Haryanto says while there are no immediate plans to invest overseas, the company plans to hire an external fund manager next year. Currently, as much as 80% of the company’s portfolio is invested in fixed income, between 10% and 12% in insurance policies and the remaining in time deposits.

Constraints and Corruption
Despite its strong economic performance, Indonesia’s “Doing Business” ranking in 2012 fell to 129th from 126th in 2011, based on a World Bank survey. A shortage of skilled labour, a lack of infrastructure and an onerous and complex regulatory framework that creates opportunities for corruption are three major obstacles to business expansion.

Last year’s high-profile corruption scandal featured the president’s own Democratic Party Treasurer, Muhammad Nazaruddin. Even President Susilo Bambang Yudhoyono admitted that corruption is on the rise and is threatening economic growth. Yudhoyono handily won presidential elections in 2004 and 2009 on a platform of zero tolerance for corruption. He has pledged to build more highways, airports and ports to improve infrastructure and meet a growth target of an average 6.6% by the end of his second term in 2014.

Under Yudhoyono, Indonesia’s growth has outperformed every major Asian economy, except for China, as strong domestic demand, which accounts for over half of the country’s GDP, helped to offset weaker exports of coal and palm oil. According to Mckinsey, an additional 90 million Indonesians could join the global consuming class by 2030. Only China and India are likely to surpass this increase in absolute terms.

Looking forward, institutions are scaling back their exposures to high-risk equity and bond holdings amid concerns over expensive valuations and uncertainties surrounding the 2014 elections.

Currently the 16th-largest economy in the world, Indonesia has the potential to be the seventh biggest by 2030, surpassing Germany and U.K., according to Mckenzie. However, the country has to overcome three major challenges. It needs to boost productivity, ensure a more even distribution of growth and wealth and remove infrastructure and resource constraints as an expanding consuming class drives economic growth, says Mckinsey.

World Bank’s Enterprise Surveys show that Indonesian firms identify an inadequately educated workforce and high rates of informality as two of the top 10 constraints to investments. One of the key causes of this high rate of informality in Indonesia is the heavy regulatory burden borne by firms, which create opportunities for corruption and bribes.

In January 2012, Indonesia Corruption Watch reported the country has lost as much as IDR2.13trn ($221m) to corruption in 2011. According to the study, embezzlement accounted for most of the money lost and that “government investment was the sector most prone to graft.”

In December, Munich-based insurer Allianz SE was reported to pay more than $12.3m to settle US Securities and Exchange Commission claims that the company made improper payments to government officials in Indonesia during a seven-year period through “special purpose accounts.”

The Democratic Party’s treasurer, Nazaruddin, was implicated in a scandal involving the construction of athletes’ dormitories for the South-East Asia Games, to which Indonesia was playing host. On 20 May, the constitutional court’s chief justice reported that Nazaruddin had offered a court official an unsolicited payment of $100,000 last year as a “gift”.

Aburizal Bakrie, Chairman of the Golkar Party, Indonesia’s second-biggest political party and a contender for the 2014 presidential election, is currently involved in a spat with financier Nathaniel Rothschild over the unwinding of a two-year deal that created a London-share listing for two Indonesian coal companies. The dispute stemmed from Rothschild’s concerns over corporate governance and “potential financial and other irregularities” at the two coal mines. The Bakries, one of Indonesia’s most wealthy and powerful families, own stakes ranging from palm oil estates, coal mines to properties.

Based on Transparency International’s Corruption Perceptions Index, Indonesia’s ranking in 2012 has slipped 12 places to 118. One commentator goes as far as saying that during the dictatorship of Soeharto, corruption was a “one-stop-shop.” As the archipelago transitions into a democracy after the fall of Soeharto in 1998, the new system is “so chaotic that you never know who to pay to get things done.” As the allure of growing spending power in a nation of about 240 million people becomes harder to resist, how does a company avoid the pitfalls of corruption?

“Corruption is an issue that exists in almost every market in Southeast Asia,” says John Van Oost, the managing partner of Yishan Capital Partners, a real estate investor and asset manager whose Jakarta office was established in 2011, “We have a number of principles we have adhered to in Europe and they fully apply in Southeast Asia.”

One of the principles, according to Van Oost, is “never to buy land or bid for anything that is government related.”

“We never put ourselves in consortium or a joint venture with any groups or conglomerates that depend on favours to obtain planning permissions for a piece of land or anything of that sort and yes, we may lose a number of opportunities,” says Van Oost. “But there are enough opportunities out there.”

Yishan is currently invested in landed houses, residences and small offices. The company expects suburban shopping centres and warehouses to benefit most from Indonesia’s economic growth and strong consumer spending. Van Oost says there are investors who believed the company should be associated with well-connected conglomerates or decision-makers. However, “being connected often meant to be able to influence decisions through various means that are often corrupt.”

Yishan also prefers to create its own teams on the ground rather than enter into local partnerships. “One of the reasons is control and by having control, you know who you recruit and you can put processes in place.

“Another reason is that we do a much better job when we have our own teams developing assets and managing them when they are being built.”

The 2014 Elections
As the 2014 presidential elections loom amid the country’s economic prosperity, fund managers are turning cautious.

“It has been a very strong story but the problem is that if you keep focusing on that story, you are really talking about the last eight years,” said Kenneth Akintewe, a portfolio manager at Aberdeen Asset Management, who specialises in bond trades. “I wouldn’t say the party is over. At this point in time, may be you want to scale back some risks.”

Akintewe says the investment community has yet to see the rise of any credible candidates. Yudhoyono is constitutionally barred from seeking a third term.
Besides Bakrie, other high-profile contenders include former president Megawatti and general-turned-businessman Prabowo Subianto.

As the daughter of former President Sukarno, Megawati was revered by many in Indonesia. However, while she was president between 2001 and 2004, corruption was rampant, unemployment soared and the country faced increasing threat from Islamic militants.

Recent polls put Subianto, the leader of one of Indonesia’s smallest parties, at the front of the race to succeed Yudhoyono. However, human-rights activists have said Subianto isn’t fit to head the country because of his alleged associations with violent crackdowns during the Suharto era.

“A bad leader can literally cripple the key institutions,” said Akintewe. “The candidates bring so much uncertainty that you could end up having a partial unravelling of the story that Indonesia has had for the last eight years.”

However, the outcome of the election for the governor of Jakarta was regarded as positive. Joko Widodo, a relative outsider and the former mayor of Solo in Surakarta, defeated the candidates supported by the ruling elite. The voting public viewed Widodo as a clean politician who has helped transform Solo into an efficient city. “This shows that the political system in Indonesia has become more flexible and mature,” says Maarten-Jan Bakkum, Global Emerging Market equity strategist at ING Investment Management.

Taspen’s Haryanto says: “Politically, the majority of Indonesians have matured. This is a fundamental factor that has helped sustain the Indonesian economic growth.”

A minefield?
Investors’ key concern is whether a change in government will result in the continuity of the existing policies or lead to changes that will cause instability in the investment environment. Despite Indonesia’s robust economic growth, issues that remain unresolved include the government’s disproportionately high spending on energy subsidies, its lack of infrastructure, a shortage of skilled labour, corruption and confusing regulations.

“The positive news is that Indonesia has over the years built fairly strong institutions,” says Atkinewe. “The central bank and the ministry of finance have fairly high quality people. This will provide some buffers in the event of a more adverse political change.”

In Indonesia, approximately 3% of ethnic Chinese own approximately 70% of the country’s businesses and control around 80% of the biggest companies. These businesses often have strong connections with the ruling elite and their fortunes could be tied to whoever is elected.

“If the tide changes, they may fall out of favour,” says James Thom, an investment manager at Aberdeen Asset Management. While political uncertainty is a risk, Aberdeen’s investment approach is “to stick to what we are good at, which is picking the best-run companies and try not to pay too much for them, rather than attempting to navigate through that sort of changes at the macro level.”

As the world’s balance of power shifts to Asia amid the region’s rising consuming class, urbanisation and rapid development, Indonesian’ growth is likely to outpace some of its neighbours.

For potential investors, the country’s size, youthful population, resources, and geographical location are key assets. Factors that could limit growth are the pace of reforms in key areas such as infrastructure, fuel subsidies, and skilled labour. As smaller cities grow, Mckenzie estimates the country will require $150bn of investment in infrastructure such as housing, water, commercial building, and transportation to keep pace with urban demand. Indonesia needs to spend more than its current 4% of GDP on infrastructure, says Mckenzie. Its investment is significantly less than China’s 7%.

As traffic jams, corruption and Islamic militants dominate international headlines alongside economic progress and foreign investments, Indonesia offers a myriad of diverse developments. While developed economies in the western world stagnate, investments from Europe and the US are rising but for the foreign investor who is used to more advanced systems, Indonesia can be a minefield.