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How Indonesia Can Improve Its Defense Investment Climate

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How Indonesia Can Improve Its Defense Investment Climate

If the country wants to expand its domestic defense manufacturing sector, it needs to make itself a more attractive market for foreign arms contractors.

How Indonesia Can Improve Its Defense Investment Climate
Credit: Depositphotos

On November 2-5, after a four-year hiatus due to the COVID-19 pandemic, the Indonesian Ministry of Defense once again held the Indo Defence Expo & Forum. Featuring more than 900 exhibitors from 59 countries, the biennial forum is said to be one of the largest arms expos in Southeast Asia. The event not only provided a great opportunity for Jakarta to directly explore thousands of procurement proposals; but it also served as a means for the government to demonstrate its commitment to bolstering Indonesia’s defense posture and independence in an increasingly unstable regional and global geopolitical climate. This is all the more important given that the Indonesian National Armed Forces (TNI)’s current modernization program, the Minimum Essential Force (MEF), has experienced significant delays and is expected to only be 65-70 percent of the fulfillment rate by its final year in 2024.

This demonstration becomes even more important considering that on several occasions President Joko “Jokowi” Widodo has expressed his ambition to turn defense spending into defense investment, mainly by fostering the growth of Indonesia’s domestic defense industry. One of the keys to achieving this is by finding foreign partners who are willing to invest and share their technologies as well as set up production lines in Indonesia. This will heavily depend on how well they regard Indonesia’s potential as a defense market, and there are several reasons why they might not see the country as ready.

First is Indonesia’s limited military budget. For at least the last two decades, the annual defense budget has remained below 1 percent of the Gross Domestic Product (GDP), when it should be at least 1.5 percent. In 2023, the budget stood at $8.6 billion or only around 0.6 percent of 2023’s projected GDP. Additionally, every year more than half of the defense budget (some say up to 70-80 percent) will go to personnel expenditure, hence leaving an even narrower fiscal scope for badly needed arms modernization.

The low figure for weapons procurement is a crippling factor, especially given the fact that the defense market is a monopsony, in which the government is the sole buyer. One impact of this financial constraint is that Indonesia can only purchase arms in relatively small quantities. At the same time, based on Law No. 16/2012 on Defense Industry, the purchase of foreign-made defense equipment must be followed by a transfer of technology and/or other offsets. This is where the problem arises.

Logically, it is difficult for a foreign original equipment manufacturer (OEM) to share a technology it has expensively developed over the years if Indonesia only purchases a small number of its products. Meanwhile, even though it can only be acquired in small quantities, TNI still needs the system or platform to which the technology is attached. As a result, confusion arises both on the producer and user sides on how to simultaneously fulfill the mandatory offset clause and the military’s operational needs.

As a result, it is often heard that transfer of technology (ToT) or offset programs originating from imports of foreign-made defense equipment do not bring significant outcomes, including in the country’s level of domestic defense industrial capacity.

The second factor is the uncertainty of contract fulfillment. Until now, Jakarta has continued to procure defense equipment from within and outside the country. However, it is not uncommon for a procurement or research program to be canceled or delayed even after a contract has been signed.

For example, since 2017, Indonesia has been criticized for its negligence in paying South Korea the cost share of the development of the KF-21 fighter (formerly known as KFX/IFX) with total arrears of around 800 billion won (about $564 million), according to recent news reports. More recently, on September 15, the National Research and Innovation Agency (BRIN) announced the termination of the Black Eagle unmanned combat aerial vehicle (UCAV) development project. This had been developed together by a domestic consortium, which included the Indonesian Ministry of Defense and Air Force, and foreign partners including the Turkish Defense Industries Research and Development Institute (SAGE).

Other examples abound. In 2019, Indonesia signed a contract for the procurement of seven CL-515 and CL-415EAF seaplanes from Canada, a deal that has not been heard of since. Similarly, in 2021, the country signed two contracts for the acquisition of 10 frigates (two Arrowhead-140, two Maestrale, and six FREMM) from the United Kingdom and Italy, but the construction process is reportedly yet to begin. Then, in February of this year, Indonesia and France signed a memorandum of understanding for the construction of two Scorpene-Class submarines, another contract that has not been put into effect.

The above conditions are red flags for foreign defense OEMs because even before the Indo Defence expo, many Indonesian arms procurement programs were already in limbo. This is especially the case for KF-21 and Black Eagle UCAV, whose continuity should have been guaranteed by presidential regulations No. 136/2014 and No. 109/2020. Meanwhile, due to their strategic value, submarines have also been included as one of the seven technologies or platforms that must be mastered by the national defense industry.

Coupled with budget constraints, this footloose behavior might raise questions for foreign partners about whether if they invest directly in Indonesia, for example by forming a joint venture with a domestic defense firm, there will be guaranteed long-term contract allowing them to achieve a return on investment and/or economies of scale. This anxiety is especially felt by those who have been waiting for months or even years for their contracts to be fulfilled and now, have to watch Jakarta signing even more procurement agreements (including during the Indo Defence expo) with other companies.

If this track record continues, it is feared that in the future it will be increasingly difficult for Indonesia to convince foreign partners to provide optimum defense equipment and investment offers. This might hinder the government’s vision of turning the defense budget into a source of investment.

The good news is that efforts have been made by the government to improve this condition. Currently, the Ministry of Defense is said to be formulating a 25-year arms modernization master plan entitled Archipelago Shield Trident. Ideally, this document will provide a long-term arms procurement commitment that is much awaited by both foreign and domestic industry firms. As a matter of fact, on September 9, the contract for six Rafale fighters from France has been put into effect (paid), thus slightly reducing the country’s arms procurement contract backlog.

Such good news needs to be continued with the immediate implementation of various contracts or other procurement agreements, considering that in addition to the already sorry state of the military and deteriorating geopolitical conditions, starting next year Indonesia will enter a political year with the start of the 2024 General Election process.

During the run-up to elections, the investment climate tends to cool as the risk of political instability increases. In addition, the transition period for a new administration might also affect – if not change – various policies, including those related to the TNI’s modernization agenda and Indonesia’s development of a national defense industry.

In other words, if the current administration does not immediately resolve the accumulated ineffective contracts and assuages the uncertainty and anxiety of foreign partners regarding the future of signed contracts, it could eventually hamper both the TNI’s modernization drive and the revitalization of the country’s domestic defense industry. In practice, the offset and ToT process from foreign arms procurement must be done gradually since local stakeholders also have limited human resources, facilities, and production capacity if they have to absorb all offsets simultaneously.

The views expressed in this article are personal.