JOURNAL | INDONESIA 360 By: McKinsey Global Institute
By 2030, nearly half of the world’s economies could be driven by their resource riches. Indonesia, with significant endowments of mineral and energy resources, is one of these resource-driven economies. It is the world’s largest producer and exporter of palm oil, the largest exporter of coal, the second-largest producer of cocoa and tin, and it has the fourth and seventh-largest reserves of nickel and bauxite, respectively, according to government data.
Like other resource-driven economies, it is vital for Indonesia’s future economic prospects that it translate this subsoil wealth into long-term prosperity. It is equally vital that resource companies in Indonesia find a way to effectively partner with the national government in this quest, and avoid the zero-sum game where companies and governments are constantly at odds. The stakes are too high to let that happen.
Because of rising resource prices and a shift into new regions of the world, the number of economies driven by resources has already soared from 58 countries in 1995 to 81 in 2011. A new report by the McKinsey Global Institute (MGI), “Reverse the Curse: Maximizing the Potential of Resource-Driven Countries,” estimates that between $11 trillion and $17 trillion in new investment in oil, gas and minerals will be needed to meet demand for natural resources and replace existing sources of supply by 2030.
But resource-driven countries such as Indonesia will miss this opportunity if they don’t rethink the way they handle these sectors. MGI’s report highlights three imperatives for creating successful resource-driven economies: effectively developing the resources sector, capturing value from it and transforming that value into long-term development. MGI’s report looks at six aspects within these imperatives: institutions and governance, infrastructure, competitiveness and fiscal policy, local content, spending a resources windfall, and economic development.
There are opportunities for extractive companies and the Indonesian government to work together to improve the country’s performance across all six of these dimensions. For instance:
Institutions and governance. Our analysis suggests that no single model of government participation works best in all countries – those that have taken the same approach have experienced vastly different levels of success. The best approach depends on the context. Regardless of the model chosen, three guiding principles are vital for successful state participation. First, governments need to establish a stable regulatory regime with clear rules and well-defined roles for each player in the sector. Second, it is important to ensure that there is competitive pressure by exposing national operators to private sector competition, strongly benchmarking performance, or imposing other market disciplines such as scrutiny from private shareholders or bondholders.
Finally, the state needs to play a central role in attracting and retaining world-class talent into the sector, which becomes even more important if the state chooses to play a more active operational role. There are clear opportunities for Indonesia to improve here. For example, a 2012 government decree reducing long-term foreign ownership in Indonesia’s mining industry from 80 percent to 49 percent contributed to instability in the regulatory regime, which can deter investment.
Infrastructure. Extractive company and government interests often coincide more than each side might think. Infrastructure is an example. Resource-driven countries could need annual investment of more than $1.3 trillion during the next 17 years to sustain growth. Extractive companies need infrastructure to go about their business effectively. So in many instances it can make enormous sense, with the right design and cost-benefit analysis, to share infrastructure. To capture this opportunity in Indonesia, the government and extractive companies need to work together to identify which types of infrastructure are most amenable to sharing, and put in place appropriate governance models. Overall, it appears that power projects are good candidates for sharing as the benefits are high and coordination costs low. But port and rail projects, while often having substantial benefits, can create high costs related to sharing and therefore must be carefully reviewed.
Competitiveness and fiscal policy. To attract investment, governments must ensure that their resource sectors are as globally competitive as possible, an issue of particular interest among Indonesian policy makers. Yet Indonesia is ranked 20th out of 32 countries in resource sector competitiveness. It is not the taxation rate alone that matters: the appropriate size of government imposts needs to be carefully calibrated with regard to where the country lies on the overall curve of production costs, and the risks companies face when investing in the country. For example, the mining industry has voiced concerns that the new decree banning exports of unprocessed ore creates additional costs.
By taking action on all aspects of competitiveness, Chile, which like Indonesia has large deposits of copper, attracted $12 billion in foreign direct investment into its mining sector between 2003 and 2012. Chile lowered production by investing heavily in a power grid, which meant that even when demand for electricity soared between 1995 and 2000, the cost of electricity fell. The government reduced risks for investors by putting in place attractive foreign investment rules and forewent mining royalties until the mid-2000s to enable the sector to grow.
Today, mining is the largest contributor to Chile’s gross domestic product and accounts for 60 percent of total exports. Government revenues from the mining sector increased by $12.9 billion between 2001 and 2011, nearly as much as the state spent during those same years on health and education, whose budgets tripled. Previous McKinsey research has found opportunities to improve the competitiveness of the resources sector by almost 50 percent through targeted government and private sector collaboration in areas such as supply chain management, infrastructure sharing and streamlining regulatory requirements.
Local content. There are also significant opportunities to create jobs and capture more resource value by building a competitive local supply chain in these industries. Globally, between 40 percent and 80 percent of revenues created in the oil and gas and mining sectors is spent on the procurement of goods and services, exceeding the value of tax and royalty payments in some cases. More than 90 percent of resource-driven countries have some form of regulation regarding the proportion of goods and services procured locally – local content – but much of it is badly designed.
Indonesia ranks 23rd out of 67 countries in local content, reflecting gaps in the quality of local supply chains. To improve this, Indonesia could identify areas of the resources value chain where it has the opportunity to build world-class expertise, and then support their development with an appropriate mix of regulatory and capability development initiatives. Norway, for example, set up education and research infrastructure on a large scale, including the University of Stavanger and RF-Rogaland Research, to boost skills and develop new technologies.
The private sector also has a crucial role in building local content. BHP Billiton helped the Chilean government increase the ratio of exports to imports in the mining sector from 7 percent to 50 percent in only 10 years. Cooperation between the company and government was crucial to this success. BHP’s objective was to elevate 250 local suppliers to world-class status by 2020 and certify them. To do this, it launched a program in 2009 in Chile’s Antofagasta region. The company chose seven key sectors that supplied its operations and targeted local suppliers in each. The program helped spur a number of improvements. For example, the lifetime of locally sourced digger cables improved by 40 percent. BHP was also able to benefit from the government’s creation of industrial development zones. The Chilean government benefited from transparency regarding the kinds of skills it needed.
Spending the windfall. History is littered with examples of countries squandering resource windfalls, either through corruption or simple mismanagement. Such waste can, and must, be avoided. To avoid such waste, countries should carefully manage expectations, ensure that spending is transparent and benefits are visible and keep government lean. There are many opportunities to boost the efficiency of government spending and delivery in Indonesia, which currently ranks 45th out of 71 countries in the IMF’s Public Investment Management Index.
Economic development. Driving long-term prosperity requires improving productivity. The McKinsey Global Institute’s past work in Indonesia highlighted several opportunities to boost productivity in different sectors. In retail trade, for example, accelerating the expansion of modern format stores and improving their in-store processes could increase productivity. In retail banking, removing overlapping regulations would improve efficiency. In agriculture, there are many opportunities to improve crop mix and yields, and reduce food waste.
Much recent discussion has focused on the sensitive and politically charged issue of beneficiation – that is, attempts by countries to move down the value chain of resources in order to do more value-adding tasks such as smelting and manufacturing. Some argue that this approach can raise productivity and increase economic growth. It is easy to appreciate the attractiveness of beneficiation to resource-driven countries, in particular those with lower average incomes that are keen to drive economic development through capturing value from their resource endowments, create jobs and even secure the supply of a resource that is critical to their own economic progress.
In China, for example, cheap coal has been used to generate power to produce a range of products from stainless steel to various manufactured goods. However, there are potential downsides to beneficiation. If the activity is not intrinsically economically feasible, an approach centered on regulation through mandates on resource companies or export barriers may undermine the competitiveness of the extraction sector more than it supports downstream activity, leading to an overall net loss in both value and employment.
For example, one analysis of Botswana’s policies aimed at capturing the cutting and polishing of diamonds for domestic players found they were equivalent to a $31.17 per carat tax on processors. In 2009, this would have imposed a total annual cost of more than $15 million, or $4,800 per job, not counting the additional cost of numerous grants from the government to move production. Recent research has found that very few countries succeed in exporting both raw and processed materials, or manage to make the transition to greater processing. The World Bank has warned that Indonesia risks losing $6.5 billion in government revenues up to 2017 from its recent bans on the export of unprocessed ores.
So how can resource-driven countries usefully think about capturing additional value from their resource wealth and avoid past failures? Indonesia should consider the following five key lessons:
Understand the potential value of moving downstream. Moving downstream can add considerable value and create jobs, but the amount varies significantly among resources. Hence, the attractiveness of moving downstream also varies significantly among resources and over time. For many resources, most value often lies either upstream (in initial mining activities) or at the far end of downstream processing. Both opportunities require distinctive and different capabilities to capture incremental value. That said, mid-stream commodity processing is vulnerable to margin erosion. For example, margins in the steel industry have been reduced considerably because of overcapacity and rising energy costs.
Understand the fit with local capabilities. Too often, resource-driven economies have launched beneficiation strategies without a rigorous assessment of the country’s potential to be competitive in the new area. They should consider four factors. First, for many resources, the presence of a large nearby market, either domestic or international, for the final product is important for where activity takes place. For example, in thermal coal, the more advanced stages of beneficiation will typically be located closer to final demand, blending needs to be near multiple sources of coal and a power plant.
Second, resource-driven countries need to consider the fit of beneficiation efforts with their local skills base and business environment. In the case of Indonesia, being able to provide the energy to support smelting and refining activities could prove a significant challenge. Third, scale is often important because setting up a new location for a sector, particularly one based around physical goods, often involves large fixed costs. And fourth, countries need to understand transport logistics. Some goods, including natural gas and bulk minerals, have relatively large transport costs, and it therefore saves money if the final product is sold close to the site of extraction.
Establish supporting regulations. Given the potential value at risk from poorly designed beneficiation policies, any regulatory intervention must be fact-based. As with local content policy, governments need to understand the opportunity cost of regulation. Regulation is clearly justified in cases of market failures. Addressing information failures that leave local firms without a proper understanding of the viability of potentially profitable economic opportunities is one example. Governments can also play a useful role when there are coordination or network failures, and an investment becomes viable only if other entities also invest to capture economies of scale. For example, a government could consider coordinating private sector players to encourage investment in the energy infrastructure needed to support refining and smelting processes, or take the lead itself in such investment.
Don’t just regulate – build enablers. The local environment is critical to the success of beneficiation. Identifying skills gaps and developing technical courses in order to fill them are necessary, as is a constant focus on improving infrastructure including reliable energy supply and transportation. In Malaysia, for example, two pilot programs – the Pilot Internship Program for Engineering Consultancy Services and the National Talent Enhancement Program – provide tax incentives for participating companies to provide on-the-job training.
Monitor and enforce, but build in flexibility. It is often difficult for policy makers to monitor the implementation and impact of beneficiation policies. Government should strive to make procedures simple, create incentives to enforce compliance, coordinate different institutions so that monitoring is effective, engage closely with the relevant private-sector players and adjust the approach as necessary to ensure that the competitiveness of the resources sector is not put at risk by policy changes.
In Brazil, a new regulatory body was established to monitor and enforce progress on localization in the oil sector and support improvement by developing the local skills base.
Indonesia has not hit a ceiling. There is a definite opportunity to derive even greater economic benefits from its resources. It’s been done before – take Norway as an illustration. Norway only discovered oil in the 1960s and had very few skills in this sector. Yet today, through highly effective regulation, thoughtful policies on local content, an economy-wide productivity drive, budgetary rules that helped to insulate the economy from volatility in oil revenues and the building of a highly successful sovereign wealth fund, Norway is now a world-beating source of oil field services and has oil companies working around the world.
Similar examples exist in mining, with countries including Chile and Australia. No country can afford to stand still, as the competitiveness in the resources sector can change quickly. A word of warning: due to several changes including tax increases and rising energy prices, Chile fell to 23rd in the Fraser Institute’s 2012–2013 “policy potential” ranking.
This essay was adapated from a new report by the McKinsey Global Institute titled “Reverse the Curse: Maximizing the Potential of Resource-Driven Economies."