Both Indonesian presidential candidates have taken a strongly nationalistic stance on foreign investment in their pre-election campaigning. When one of them takes office in October, will they be 'mugged by reality' and soften their stance? If not, how much does it matter?

When Indonesia achieved independence at the end of World War II, four hundred years of colonial domination weighed heavily on politics and public attitudes. Domestic opinion was unanimous that the Dutch had grown rich by exploiting Indonesia's vast natural wealth, leaving independent Indonesia in poverty. The first two decades of independence deepened this view, with foreign companies nationalised.

This changed in 1967, ushering in three decades of 7% annual growth. Foreign investment was not the sole factor in the transformation but was a key element, bringing investment funding, technology and access to foreign markets.

It would be wrong to see foreigners as having had open slather since 1967. Policy needed to accommodate the residual antipathy to foreign business. After 1967, state-owned enterprises still occupied the 'commanding heights' of the economy, and even today there is a 'negative list' of industries where foreigners are excluded.

The democratic era since 1998 has allowed greater opportunity for venting this suspicion of foreign exploitation. It was perhaps inevitable that, with the incumbent president not running (and therefore not defending the status quo), the two candidates would compete to exploit this sentiment. Whoever is elected next month is likely to be more nationalistic than his predecessors. The question is just how damaging this might be to Indonesia's growth prospects.

The issues are illustrated by the current policy measures to restructure foreign investment in mining. This has always been a sensitive area. Even when foreign investment was first opened up in 1967, it was envisaged that foreign miners would relinquish some ownership to domestic parties (either government or private) over time.

In 2009 this was take a step further, with a law requiring miners to 'add value' to their production. This was to be implemented over time, and many foreign observers assumed the regulations would be softened. In 2012, a tax was also imposed on some ore exports. The crunch came in January this year, with export of nickel ore and bauxite (the ore that becomes aluminium) banned. Other ores (principally, copper) can be exported as ore for the moment, but with an export tax which will rise over time to a level where export will no longer be profitable.

What should we make of all this?

There is some damage to Indonesia's business-friendly reputation: the measures raise the risk perception and therefore the cost of attracting investment. Foreign investment is only around 2% of GDP. This is a small part of overall investment (which is well over 30% of GDP), but foreigners continue to provide the same dynamism and innovation that was instrumental in shaking Indonesia out of its basket-case languor in 1967.

More seriously, these measures seem unnecessarily damaging. It is easy to sympathise with the residual anti-colonial angst and to see today's foreign investors as their legatees (with their Indonesian partners as compradors, in the best Marxian tradition). But the measures will make some production uneconomic. Policy which leaves minerals in the ground doesn't help Indonesia's pressing problems. Nor does it make sense to prioritise high-capital/low-labour investments which have low returns (as these refining processes seem to have), in a country struggling to provide the necessary infrastructure (roads, ports, electricity) for the population at large. And it's not even as if these measures will shift ownership of mines or refineries into Indonesian hands.

In the longer run, the measures are of doubtful economic validity, and in the short run are clearly damaging to Indonesia's finely-balanced current-account position and budget. Moreover, there are much better ways to respond to the historical legacy of colonialism.

To maximise national benefits, Indonesia needs to own the most profitable parts of the process and ensure that the price is as high as the market will bear. For this, it needs a majority stake in the mine itself. Rather than a blanket requirement that all ores be processed domestically, the better policy would be to encourage the ones which lend themselves to domestic refining.

A resource-rent tax would achieve this far better than a blanket requirement for domestic processing. The experience since 2012 has shown there is capacity for existing mines to pay a super-tax. Mining is an industry with huge cyclical price fluctuations, and the tax regime should reflect this volatility, aimed at super-profits. These revenues could be used to buy back ownership, fund new mines or even establish new refining facilities, provided they are economically viable.

If Indonesian economists could devise such a rational plan and persuade the new president to adopt it, it would achieve a dual function. First, it would give Indonesia a growing stake in exploiting its own mineral resources, answering nationalist calls. Second, it would demonstrate that Indonesia's mineral policies are tough but rational.

Photo by Flickr user Randi Ang.