Indonesia: Aceh growth diagnostic - Identifying the binding constraints to growth in a post-conflict and post-disaster environment

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Executive Summary

Constraints to investment and growth need to be addressed urgently as the end of reconstruction has brought back pre-tsunami low levels of economic growth. Aceh's economy declined by over 8 percent in 2008, with the non-oil and gas economy growing by a meager 1.9 percent, well below over 6 percent at the national level. Growth in Aceh post-tsunami has been dominated by sectors closely linked to the reconstruction effort, such as construction, trade and transport. As the reconstruction effort draws to a close, growth in these sectors has slowed, while the slack has not been taken up by other sectors in the economy (e.g. agriculture, manufacturing). At a time when known oil and gas reserves are rapidly depleting and the post-tsunami reconstruction program no longer drives growth, there is a need for the private sector to become an engine of growth, improving productivity and reshaping the productive sector away from oil and gas, and helping Aceh transition to a modern economy.

Using the growth diagnostic framework, this report identifies the lack of reliable electricity supply as a binding constraint to investment and growth in Aceh. Businesses in Aceh report that electricity supply is interrupted on average 4.3 times per week, more than double the number of interruptions suffered by the rest of the country. In particular, manufacturing and agro-processing suffer adversely when electricity is cut, making some of the smaller businesses that cannot operate their own generators non-viable. In addition to improving the reliability of energy supplies from the Sumatra Interconnection System, the GoA could consider renewing efforts to attract private sector investment in the energy sector by (i) revising pricing of privately generated electricity to be distributed through PLN, (ii) promoting private sector participation in the generation of electricity from renewable energy sources (geothermal, local biomass, solar energy), and (iii) exploring the possibility of public-private partnerships to attract cost effective power producers.

The most binding constraint to investment and growth in Aceh are illegal extortion and security concerns of potential investors. This should be the focus of local authorities in their efforts to attract investment to Aceh. The remnants of conflict in Aceh continue to hamper growth. conflicts can have a fundamental impact on the political, social and economic institutions that underlie growth. These impacts affect the ways in which economies function in the post-conflict period. In addition to their direct destructive effects, they undermine the security of individuals and communities in ways that change behavior, preferences and institutional functioning. Security concerns and negative perceptions outside Aceh seem to act as a powerful deterrent to investment in the province. Illegal extortion and security issues are perceived as significant constraints by businesses: 9.3 percent of them report security and the ease of settling conflicts as a constraint in Aceh, as opposed to 4 percent in other provinces. The districts where most violent incidents have occurred since the MoU tend to be those where firms' performance has been worse. Almost one in four businesses reports paying for extra security. Perceptions of increased risk can also translate into a lack of credit to the private sector. All this increases the uncertainty of doing business in Aceh. Businesses are trying to overcome this uncertainty by teaming up with local businesses or networks that can offer protection and a sense of security, although this may not always be possible.

Addressing the security concerns of potential investors and combating illegal extortion and payments will need a two-pronged strategy: strengthening the rule of law in the province and addressing the underlying causes of violence and security threats. To strengthen the rule of law, the local authorities should improve the capacity of the police to investigate and solve crimes, as well as the capacity of the judiciary system to prosecute and sentence criminals. This is likely to require significant political capital, for which it is equally important to build the necessary constituencies that will support these reforms, through the involvement of civil society and the private sector in discussions and the monitoring of the security situation. In order to address the underlying causes of violence and security threats, local authorities should support economic growth and development in conflict-affected areas, focusing on at-risk and vulnerable groups. If there is only assistance for ex-combatants then this is likely to be less effective and create additional grievances and jealousies.

An improved security situation and the removal of illegal payments and taxes are likely to result in increased investment and growth. As costs related to security and illegal payments decline, firms and individuals will be able to assess costs and benefits of their investments with greater certainty and undertake these investments when clearly viable. Given the limited capacity and political capital that the local authorities will have to carry out these reforms, these should focus initially on sectors that result in inclusive growth through the creation of jobs and wide sharing of benefits.

The inclusive nature of growth becomes particularly relevant in post-conflict situations. Growth should be inclusive, broad-based across sectors and providing benefits to a majority of the workforce, notably the poor as producers. Inclusive growth in Aceh will come from growth in the sectors where a majority of the poor make a living, agriculture and fisheries. Inclusive growth will also derive from job creation in labor-intensive sectors, agri-business, other manufacturing and some services sectors, in particular trade and transport. Particularly in a post-conflict environment such as Aceh, equity concerns and ensuring that potential 'peace spoilers' have a stake in the economic and political stability of the province are crucial. Given that there are a large number of former combatants active in the agriculture sector, there is an additional rationale to focus on removing barriers to growth in agriculture and equipping the poor, through skills and access to assets, to benefit from growth.

Inclusive and widespread growth that benefits the majority of the population, paying particular attention to the opportunities and grievances of potential 'peace-spoilers', should be part of any strategy to preserve peace in the province. Promoting inclusive and widespread growth should be part of a broad strategy to address the issue of security and conflict. Addressing the identified constraints will benefit the population as a whole, increasing the ability of the poor and vulnerable in Aceh to benefit from growth. There are also particular interventions to ensure that growth is inclusive. These include continuing the focus on the agriculture sector (but improving the provision of public services, such as extension services, irrigation, etc.). It also includes redressing existing inequalities in both human and physical capital by improving the skill set of the poor in rural areas as well as interventions that facilitate the access to credit of individuals and small enterprises active in the agriculture and fisheries sectors. Spreading the benefits of growth will give more Acehnese a stake in peace and stability in the province, lowering security concerns and ultimately making any resumption of the conflict less likely.