By Sakari Deichsel & George Gorman

Recent regulations in Indonesia have looked to cap foreign ownership in the high-risk mining sector, such as this coal mining operation in the Derawan Islands in the Sulawesi Sea. Source: jaundicedferret's flickr photostream, used under a creative commons license.

Indonesia’s economy saw a confidence-boosting 6.5 percent growth in GDP in 2011 fueled by a strong middle-class consumer demand and surging foreign direct investment (FDI) inflows of $19.3 billion that year. Indonesia has continued to ride a wave of investor optimism in the first quarter of 2012 with a record 30 percent surge in FDI inflows valued at $5.6 billion. With Moody and Fitch having upgraded the country’s credit rating to investment level for the first time since the 1997 Asian financial crisis, optimism about the country’s strengthening economy has prompted optimism that Indonesia is ready to join other emerging economic superstars on the world stage.

This enthusiasm has been tempered, however, by recent protectionist moves, particularly in the mining sector. The Ministry of Energy and Mineral Resources rattled investors March 7 with the announcement of new regulations aimed at restricting foreign ownership in the mining sector to 49 percent. Under the new regulations, foreign companies must gradually reduce their stake in mining enterprises to 80 percent in six years and 49 percent in 10 years. Although domestic private investors will be able to bid on foreign shares, public sector entities will be given priority. Indonesians have long called for such restrictions on foreign ownership of mining and processing out of a sense of resource nationalism, but foreign observers view the new policy as an unanticipated lurch toward protectionism.

Opaque regulatory measures like the new mining law, where no input was solicited from the industry itself, have renewed investor anxiety about the direction of Indonesian economic policy. Such protectionist measures have complex negative reverberations as investors question whether similar restrictions might be levied against the manufacturing and service sectors in the future. Apprehension about the new mining law played a role in Standard & Poor’s decision to forgo upgrading the booming market’s credit rating in response to recent “policy slippage.”

The Indonesian government plans to establish an auction mechanism to handle the divestment of foreign mining shares. It is critical that this mechanism be operated transparently and that foreign investors receive competitive commercial prices for their shares, if the government hopes to allay concerns about investing in Indonesia’s high-risk mining environment.

The Indonesian government needs to take prompt steps to ensure an orderly adjustment to the new regulation, including:

1) Vetting entities looking to acquire stakes in mining operations to ensure their operations will not be disrupted by incompetence.

2) Creating sufficient oversight to make sure these new regulations have their intended effect of benefiting the Indonesian people and proving to foreign investors and Indonesians that the regulations will not just enrich the well-connected.

3) Strengthening conflict resolution mechanisms and corporate law should be a priority. Dispute mechanisms circumventing costly battles in court or through arbitration will be essential if Indonesia wants to burnish its image as an investment hub.

If Indonesia’s policymakers are determined to purse greater nationalization of extractive industries, they can look to other resource-rich nations for lessons on some do’s and don’ts. Politicians in South Africa and Mongolia have flirted with resource nationalism with chilling effects on foreign investment. In contrast, Botswana’s takeover of its diamond mining industry and the successful management of mining operations by a domestic diamond company provide a positive alternative example.

Optimism, particularly in Asia, regarding Indonesia’s investment environment remains quite high despite the new mining regulations. Thus, it is important that the Indonesian government pursues policies that attract foreign investment inflows through stable, transparent governance and a business-friendly environment. How well the government plays its role as an honest broker in the mining sector will mean the difference between perceptions of a one-time protectionist regulation or heavy-handed nationalization.

Mr. Sakari Deichsel and Mr. George Gorman are research interns in the Southeast Asia Program at the Center for Strategic and International Studies.