Batam's business model overtaken by events

BATAM has an unbeatable business proposition. The Indonesian island is 20 kilometres from Singapore, offers much cheaper land and labour, and is connected to its rich neighbour through extensive logistics networks. Over the past decades, Indonesia's leaders have sought to leverage this. In the 1970s, they set up an elite agency to liaise with investors and upgraded Batam's infrastructure. In 1990, they liberalised the island's investment framework. And, in 2009, Batam was made a free trade zone, which allows firms on the island exemptions on import duties and value-added tax.

Over the past 25 years, these attributes and incentives have attracted investment from Singaporean firms and multinational corporations based in the city-state. This occurred first in the electrical and electronics industry, then tourism, and, more recently, ship-building. Through these three "motors", hundreds of thousands of formal sector jobs have been created, and Batam's economy has moved from traditional activities such as fishing to manufacturing and services.

In the process, the island has attracted migrants from all over Indonesia, swelling its population from 250,000 in 1990 to 1.2 million today, making it the economic and demographic centre of the Riau Islands Province. Notwithstanding this rapid population growth, Batam's economy has been able to expand apace, and its residents have a per capita income that's about double the national average.

However, while Batam's economy continues to grow and more tourists visit its shops and shores, there are clouds on the horizon. Exports from the Riau Islands fell 25 per cent from 2013 to 2015. Foreign direct investment (FDI) levels have also dropped considerably. From 2004-2009, the Riau Islands brought in an average of US$1.8 billion per annum in FDI - rivalling West Java and outdoing Central and East Java. Since 2010, FDI levels to the Riau Islands have averaged US$400 million a year, far behind these other investment destinations.

Part of this downturn could be due to the local business environment in Batam and the wider Riau Islands. Investors in Batam have complained of difficulties in finding land for their operations and its one-stop shop has yet to fully integrate all necessary permits and licences. Disputes between the central, provincial and local government over issues such as the leadership and jurisdiction of different agencies, duty exemptions, and land zoning are recurrent, delaying decision-making and generating uncertainty. Batam's large industrial sector has made it an important site for union activities, with periodic demonstrations over wage levels. In 2010, a dispute between local workers and foreign managers led to violence and property damage, resulting in an exodus of more than 30 large manufacturers that same year.

INTENSE COMPETITION

Furthermore, the island's outward, export-oriented model means it is exposed to global headwinds and intense competition. Batam's electronics sector has been hit by cyclical downturns and the phasing out of older products, and its shipping sector has been affected by lower commodity prices and excess capacity. Furthermore, wage levels for manufacturing workers in Vietnam and Cambodia are 40 to 50 per cent lower than their Batam equivalents.

This change in economic dynamics is palpable in Batam. Following the 2010 exodus, the ranks of electronics manufacturers has thinned further, with flagship operators such as Panasonic, Sanyo, and Nidec closing their facilities - in each case laying off hundreds of workers. New arrivals are few, far in between, and smaller than those established in the past. The situation facing the shipping sector is even more dire. Today, a mere 30,000 workers are active in the industry, down from its peak of 250,000 in 2012. At present, the majority of the island's shipyards are idle or have turned to lower-value repair jobs. The Riau Islands' unemployment has jumped to 9 per cent, considerably higher than the national average of 6 per cent.

Despite local-level dysfunctions and adverse global trends, Batam's declining performance may also be linked to the changing nature of investment into Indonesia.

Influential reports such as McKinsey's The Archipelago Economy: Unleashing Indonesia's Potential have argued that the country is on course to be the world's seventh-largest economy by 2030. Rising incomes coupled with increasing urbanisation mean that Indonesia's "consuming class" is expanding considerably and is projected to reach 135 million in 2030 - constituting a very sizeable end market.

The country's increasingly attractive domestic market has led to a change in corporate strategies. Instead of leveraging Indonesia's abundant and low-cost labour to manufacture goods for export to developed economies, many firms are now seeking to produce goods in the country to sell on its domestic market. This is particularly the case for Japanese multinational corporations, a traditionally important source of investment for Batam. A 2016 survey carried out by the Japan External Trade Organization found that more than 80 per cent of Japanese firms operating in Indonesia anticipated increased profits from sales in the local market. In contrast, only 20 per cent of firms anticipated generating greater revenue from export activities.

Yet, Batam is ill-equipped to capitalise on this structural change. Despite the island's well-developed infrastructure, its connectivity with major population centres in Java and Sumatra is not good, with expensive and infrequent domestic shipments. Indeed, it is often cheaper and easier for firms in Batam to send goods first to Singapore and then on to Jakarta, than to wait for a direct shipment. Furthermore, the island's lack of a well-equipped deep-water port is also a hindrance for many types of cargo.

In addition, while Batam is facing increased international competition from other countries, it is also being outdone by other locations within Indonesia. The island's wages have increased significantly over time, with particularly large hikes in 2012 and 2013. At present, Batam's minimum wage is 2.9 million rupiah (S$296), substantially higher than the national average of 1.9 million rupiah. In contrast, the minimum wages of East and Central Java are one million and 910,000 rupiah, respectively.

EFFECTIVE FIREWALL

Furthermore, while Batam's FTZ status has meant firms operating on the island can import components and parts and export goods duty-free, it has also effectively firewalled the island from the country's domestic economy. If firms based in Batam want to sell their merchandise on the local market, they need to pay a duty of 20 per cent. Furthermore, these provisions entail onerous and inflexible reporting requirements for firms. One large European E&E producer based on Batam has been directly hit by this provision, leading it to downsize its operations on the island.

Central government policymakers have begun to debate the island's FTZ status. Aside from the status quo, one alternative is to make Batam a special economic zone, which would entail a slightly different legal status and additional fiscal incentives for firms. However, this would still not facilitate access to the domestic market, as firms in the SEZ seeking to sell locally would still have to pay customs and duties. Another option that has yet to be discussed is for Batam to relinquish any type of special status. Indonesia has signed up to the World Trade Organization's Information Technology Agreement which requires member countries to eliminate all duties on goods such as semiconductors, computers, and telecommunications equipment. At present, the agreement has 81 signatory countries and covers 97 per cent of the world's trade in IT goods. Thus, in theory, most of the imports coming into Batam should be duty-free anyway.

Over the past four decades, the island has enjoyed privileged attention, benefiting from unparalleled resources and incentives. Consequently, its export-oriented sectors have flourished. Now, however, the situation has changed, with investment into Indonesia geared to producing for local consumption. The challenge for policymakers responsible for Batam is to ensure that the island is not facing the wrong way.