6 July 2007

Doing Business in Indonesia:

legal and bureaucratic constraints

Ross H. McLeodIndonesia Project

Australian National Universityross.mcleod@anu.edu.au

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 Indonesia

Procedures (number) 19

Time (days) 224

Cost (% of income per capita) 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 doesn’t extend to extra-legal 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

115

145Time 570 days 134Cost (% of debt) 127% 151

116Time 5.5 years 133Cost (% of estate) 18% 99Recovery rate (% of amount owed) 13% 119

Ease of doing businessMatters relying heavily on the courts

Enforcing contracts

Closing a business

Indicator Rank(among 155 countries)

Ease of Doing Business in Indonesia:

Selected Sub-indices and Components

115

144Time 151 days 149Cost (% of income per capita) 102% 121

120Difficulty of Hiring Index (0-100) 61 122Rigidity of Hours Index (0-100) 40 63Difficulty of Firing Index (0-100) 70 131Hiring cost (% of salary) 10% 53Firing costs (weeks of wages) 144.8 weeks 150

Indicator Rank(among 155 countries)

Ease of doing businessMatters involving the bureaucracy

Starting a business

Hiring and firing workers

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).

We’ll 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 French-civil-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 sub-periods…– 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 (%)

-100 0 100 200 300 400 500 600 700 800

Congo, Dem Rep (F)

Zimbabwe (E)

Nigeria (E)

Brazil (F)

Algeria (F)

India (E)

Indonesia (F)

Thailand (E)

Malaysia (E)

E = English Common Law; F = French Civil LawData 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 Indonesia’s 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

Soeharto’s ’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

6 July 2007

Doing Business in Indonesia:

legal and bureaucratic constraints

Ross H. McLeodIndonesia Project, ANU

ross.mcleod@anu.edu.au