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span class="inline inline-left">The Indonesian mining sector is at a crossroads as we enter 2014. The current downturn in commodity prices globally, combined with recent regulatory activity to implement key articles of the 2009 Mining Law are causing mining investors, domestic and foreign, to reassess their investment plans. Of particular note are the recent confirmation of the ban on the export of unprocessed minerals, the requirement for divestment of foreign interests in mining concessions and the ongoing renegotiation of existing contracts of work held by some of the largest mining producers. All this at a time when the Indonesian economy is being buffeted by the winds of global economic challenges, highlighted by outflows of foreign capital, with the resultant impacts on equity markets and the rupiah.

There is no doubt that the mining sector has been one of the key sectors supporting Indonesia'€™s economic growth for a number of years. The sector makes a significant contribution to Indonesian gross domestic product (GDP), exports, government revenues, employment and, perhaps most importantly, the economic development of the remote regions where mining operations are located. This has been true even during the ups and downs in commodity prices during the past five years '€” from the mining boom of 2007, through the global economic downturn of 2008-2009, moderate recovery in 2010-2011, and a return to downward pressures from 2012 to the present. Over this period, increases in production volumes for most mining products, driven by long-term positive views of the sector, have offset the negative impact on revenues. As we enter 2014, however, there is some doubt as to whether investors remain bullish on the long-term prospects of the industry in Indonesia.

It is clear that mining investors continue to rate Indonesia highly in terms of the abundance of its mineral resources '€” whether coal, copper, nickel or tin '€” and judged purely on this factor, Indonesia would be a highly attractive destination for mining investment. This is borne out in both PricewaterhouseCoopers'€™ (PwC) most recent survey of the Indonesian mining sector (released in May 2013) and the February 2013 report of the Fraser Institute. However, both these surveys conclude that the perceptions of the regulatory environment remain a key challenge. Even though we saw some increases in investment in the Indonesian mining sector after the global economic downturn of 2009-2010, expenditure on exploration activities, specifically in greenfield sites, is still disproportionately low. In fact, average expenditure on exploration in Indonesia over the past 10 years represented less than 2 percent of global exploration expenditure, while at the same time investor perceptions of Indonesia continued to deteriorate. The Fraser Institute survey ranked Indonesia lowest (96 out of 96 countries analyzed) in terms of its policy potential index, which gauges how friendly government policy is in the mining sector. This represents a significant drop from its ranking of 85 out of 93 countries in the previous year'€™s survey. This negative perception, together with the decrease in commodity prices, has contributed to the decline in the value of listed mining companies in Indonesia.

Stock market indexes

The global economy is also undergoing changes and two key developments should be of concern to stakeholders in Indonesia'€™s mining sector, including the government of Indonesia. The expected tapering of the quantitative easing policy of the US Federal Reserve is likely to continue to see foreign capital outflows from Indonesia. At the same time, there is a general view that China will grow more slowly in the medium term. In Indonesia, these factors have contributed to foreign capital outflows, which have in turn pushed down equity prices and the value of the rupiah, heightening inflationary pressure. The rate of growth of foreign direct investment has declined in recent quarters while the trade deficit has reached 4 percent of GDP. This is a significant concern if Indonesia cannot attract more long-term investment to fund its imports.

With the end of the period of easy money, now is the time for Indonesia to attract long-term foreign direct investment '€” the type of long-term capital that comes with large infrastructure and mining projects '€” which cannot be withdrawn with the same ease as investments in financial instruments, shares, property and the like. The question is whether the recent regulatory action around unprocessed ore exports, foreign divestment and contract renegotiation are of benefit in attracting such long-term investments, at such a critical time.

In line with the objectives set out in the 2009 Mining Law, the Indonesian government has issued several regulations, which have been perceived by some as nationalistic in nature. This has culminated in a higher level of uncertainty, which is impacting the investment plans of mining investors. The apparent objectives of the law, in particular the desire to create added-value to Indonesia'€™s mining activities through the onshore processing of minerals, or to retain more of the benefits of the country'€™s mineral resources in Indonesian hands, are not unreasonable in themselves. However, the method of implementation is of concern, given the significant financial impact it has on mining projects in which investors have already made significant commitments.

The divestment rules as set out in a ministerial regulation issued in September 2013 are likely to discourage new mining investment in Indonesia, particularly in the large-scale, long-term projects that are so important. The requirement for foreign investors to divest at least 20 percent and 51 percent of their stakes by the fifth and 20th years of production, respectively, will potentially result in many projects being economically unfeasible (other than projects with very short mine lives or payback periods). The arbitrary divestment dates, which are applicable to all minerals, do not take into account the different nature, for example, of a coal development versus a copper mine. Neither is it consistent with the requirement for in-country mineral processing '€” while foreign investors are required to double or even triple their investment in order to build smelters, they are at the same time obliged to divest their controlling stake after 10 years. It also remains unclear whether the domestic financial markets have the significant equity and debt funding capacity needed to fill the gap left by a significant reduction in foreign equity interests, whether for mining exploration or building processing facilities and related infrastructure.

On the other hand, the domestic processing requirement faces many challenges of its own, such as the lack of infrastructure, power supply and fiscal incentives. These factors have contributed to there being no new downstream processing capability in place by the five-year deadline set out in the 2009 Mining Law, which fell on Jan. 12, 2014. Government plans to relax the domestic processing deadline for mining companies that had a clear commitment to build a smelter in the future had not been realized at the time of writing, ostensibly due to opposition in the House of Representatives.

As of early December 2013, plans for around 100 smelter projects had reportedly been submitted to the government, but only 28 have reached the groundbreaking stage and only one has reached commissioning (Aneka Tambang'€™s chemical grade alumina plant). As such, no new smelters are in full operation as of January 2014. This will result in an immediate and significant impact on the Indonesian economy through:

'€¢ Reported reduction of approximately US$4 billion per year in state revenues from ore exports, putting further pressure on the balance of trade and the rupiah;

'€¢ Almost inevitable job losses as many mining companies consider the impact of reduced profits;

'€¢ The drying up of cash flows from ore exports to fund construction, for those companies committed to building smelters;

'€¢ A significant drop in regional revenues where mine sites are located, impacting regional development and economic activity.

It can be argued that in the longterm, the Indonesian economy will benefit from the ore-export prohibition through more domestic processing. It may well lead to an increase in global commodity prices, more jobs and increased investment in smelters. However, at this point in time, considering current global economic conditions, the current trade balance and unfavorable rupiah exchange rate, there is little doubt that if the export ban comes into full force it will adversely impact the Indonesian economy in the short to medium term. This is likely to mean that mineral production will fall in the next few years, but commodity prices may increase due to Indonesia'€™s reduced exports, ultimately resulting in a higher cost of imported processed materials for Indonesian consumers. Given the consequences, many in the mining investment community had hoped for a last minute change in stance by the government, delaying the full implementation of an export ban on unprocessed minerals. At the time of writing, no such waiver was evident, but at the 11th hour prior to the Jan. 12 deadline, the government announced the issuance of a new regulation reducing the minimum grade of mineral content required for export from that initially proposed for some types of minerals '€” it is unclear whether this will allow sufficient exports to continue to offset the economic impact of the reduction in exports of unprocessed ores.

It is worth noting that the coal mining business appears to be largely unaffected by this regulation. Supported by a number of positive factors, including increased demand from domestic power plants coming online and continued demand from other parts of Asia, Indonesia'€™s coal production is likely to continue to grow over the coming years. While a much talked about potential ban on the export of low-rank coal has not eventuated, investors will continue to watch government plans around domestic market obligations for coal producers, and specific quotas for coal-fired power plants. The main challenge for coal producers is the lack of transportation infrastructure in remote areas where much of the large reserves are now located '€” reserve replacement may be affected if such infrastructure is not prioritized.

The ongoing renegotiation process of the terms of existing contracts of work, in line with the requirements of the 2009 Mining Law, is also a significant challenge for the industry. After two years of negotiations, it has been reported that only two of 37 contractors have agreed to the amendments proposed by the government, and that no revised contract has been signed to date. The main sticking points have been around the insertion of clauses requiring downstream processing of raw materials in Indonesia, divestment requirements and reductions in the size of mining areas. The government'€™s commitment, in line with the principles of the 2009 Mining Law, is to fully respect the current contracts until expiry or renegotiation. However, the long process to conclude negotiations and the government'€™s attempts to impose obligations, such as downstream processing on existing contracts, have caused uncertainty and resulted in many large contractors delaying plans for expansion. This is of significant concern, as the majority of Indonesia'€™s production of coal and minerals continues to come from the large contract of work holders, rather than licenses issued under the 2009 Mining Law.

The regulatory upheaval in recent years has cast Indonesia'€™s mining sector in a negative light. This is compounded by the political risks inherent in the lead up to an election year as policy-making takes on a populist flavor. This results in a '€œwait-and-see'€ approach by investors, the last thing that is needed given the current global economic environment, in which countries are competing for scarce investment funds.

It will be unfortunate if Indonesia cannot make the best use of its vast resources for the sustained wealth of its citizens. To be sure, the regulatory challenges in Indonesia, together with a lack of coordination among various government agencies, inadequate infrastructure and other risks, have hampered the entry of investors into the Indonesian mining sector, despite its great geological potential. Given the capital-intensive and long-term nature of the mining business, investment will be needed from the global market to fund the exploration and mine development required to boost government and export revenues, spur economic growth and expand regional prosperity. The government should therefore prioritize clear, consistent, business-friendly policies to demonstrate that the Indonesian mining sector is indeed a good place to invest.