Weighing the Costs of Indonesia’s Export Ban

The Straw that Breaks the Camel's Back?

Two events that will unfold in the wake of the country's export ban will play a far more significant role in determining the future of Indonesia's mining industry than the ban itself.

On Sunday, January 12, 2014, in what was a surprise event for the country's mining industry, the Government of Indonesia moved forward with its plans to enforce a ban on the export of raw minerals from the country's ports. Put forth as law in 2009 following four years of public consultation, January's export ban had long been public knowledge; part of the country's movement to internalize a greater share of the gains associated with its natural resource sector.

The ability of the Government to enforce such a requirement, however, had been doubted since the ban's introduction, many being unconvinced by the economics of domestic smelters. At a point in time when Indonesia's current account deficit was at a historic high and raw ore remained one of the country's most important trade commodities, implementation of the ban seemed all the more unlikely.

Logic, however, failed to give way to the Indonesian Government's determination. Though less stringent than initially conceived (as many of Indonesia's principal mineral commodities were exempted in a last minute Presidential decree), the ban, which still applies to nickel and bauxite, was enforced amidst much uproar. Police took to the country's ports to preempt protests. Speculators considered the impact that the ban might have on global commodities prices. Indonesia accounts for between 18% to 20% of the global supply of nickel, and between 9% to 10% for bauxite.

Though significant, far more important than the impact that the country's export ban will have on Indonesia's economy immediately will be in the way in which several issues attached to the ban's enforcement play out. The most significant of these events will be the way in which many of Indonesia's largest miners are forced to comply with new requirements suggested by former President Susilo Bambang Yudhoyono's (SBY) decree.

In structuring the decree, which exempted many mines from the ban, SBY barely back-stepped from requiring domestic miners to construct smelting facilities. For those miners involved in the production of copper, iron, lead, zinc, and magnetite, exports of raw ore can continue until 2017, at which point in time processing facilities must be established. Until 2017, a progressive tax on all exported commodities will be applied: 25% in the first year for copper 20% for all other commodities thereafter escalating to 60% for all minerals in 2016.

Aimed at punishing the country's mining industry for failing to comply with the Government's initial mandate, the imposition of this tax strikes at the heart of Indonesia's current struggle to integrate many of the country's oldest mines into the new legal framework. Built under a different political administration, mines such as Freeport-McMoRan's Grasberg and Newmont's Batu Hijau offered their investors concessions that would have not been granted later. The legal document governing each mine, their Contract of Work (CoW), was set forth as law; all subsequent legislation affecting the country's mining industry was to be inferior to these pre-established contracts. This included Indonesia's IUP licensing system, which, introduced in 2009 with the 2009 Mining Law, created a new framework for foreign investment into mining and introduced Indonesia's mineral processing requirement. Though CoWs would terminate at a certain point of time, until this point was reached, they were to be considered untouchable.

The Indonesian Government's imposition of the country's IUP system on the country's oldest mines, through requiring CoWs to establish mineral processing facilities and by creating a new tax regime to which their exports will be subject, is the second assault that the Indonesian Government has waged on the sanctity of the CoW in the past six months. In October of 2013, it was announced that all foreign miners would be required to comply with a set of divestment requirements whereby over a 10-year period all mines currently in production that failed to build integrated mineral processing facilities would be forced to divest 51% of their equity to a local stakeholder. While these events have been noticed by the industry, their recourse has not been fully felt.

This could change, however, with the implementation of Indonesia's new set of export taxes. Estimated by some analysts to cost Freeport-McMoran up to $5 billion over three years, the price of SBY's export tax could be far larger for both the country and the industry. Bill Sullivan, licensed foreign advocate at Christian Teo Purwono & Partners, explained: "The Government has chosen to pursue its CoW objectives through bilateral negotiations. If, however, this ceases to be true and the Government seeks to unilaterally impose additional obligations on CoW holders, it is quite possible that then a number of the larger CoW holders might seriously consider pursuing arbitration against the Government, although this would be very much seen as a strategy of absolute last resort."

Though generally taxation disputes are one of the few matters within CoWs that cannot trigger international arbitration, the enforcement of an export tax could prove to be the straw that breaks the camel's back for the industry's largest miners, prompting an escalation of discussions as to the legality of other impositions on the industry, such as mineral processing or divestment requirements, to international courts. While Freeport recently finalized their CoW renegotiations, this could still happen for Newmont, which in June filed for international arbitration against the Indonesian Government. Should the Government of Indonesia lose, the current political administration could lose the driving force behind its push to force others to establish mineral processing facilities. Should the Government win, more drastic measures, such as the use of a full shutdown of the country's largest mines as a political bargaining chip, could be taken.

The implications of such a shutdown would be far reaching: widespread job losses and the descent of several regions into poverty. Ir. Syahrir Abubakar, executive director of the Indonesian Mining Association, explained that in such a scenario wherein the country's largest miners would elect to close, "Freeport-McMoRan anticipates a loss of 22,000 laborers: for Newmont, 8,000. The impact of these losses would be highly regionalized. In West Sumbawa, the area surrounding Newmont's Batu Hijau mine, and Mimika, the area surrounding Freeport's Grasberg mine, 45% and 25% of the region's inhabitants are employed through mining. Yet the effect of a full shutdown is far larger than this. In the case of Grasberg, if Freeport were forced to halt production, PT Smelting, one of Indonesia's four smelters, would shut down, which would in turn prohibit them from supplying Petrokimia Gresik with an important byproduct produced through refinement, in effect causing one of Indonesia's largest fertilizer producers to decrease production. This would, in turn, translate into widespread job losses across East Java."

Makoto Miki, president director of PT Smelting said: "If PT Smelting were to shut down, it would be quite ironic. Through enforcing a policy that seeks to encourage mineral beneficiation, one of the country's few smelting facilities would close."

Following a shortfall for the supply of copper resulting from the suspension of operations at Newmont's Batu Hijau and production decreases at Grasberg, which has cut production by 60% since the enforcement of the ban, this possibility of forced closure has grown ever more real. Miki notes that this could happen as soon as January 2017.

A second event that will unfold in tandem with these discussions will be the success or failure of Indonesia's efforts to establish mineral processing facilities for bauxite and nickel. In differentiating nickel and bauxite from those mineral commodities exempt from the export ban, the Government of Indonesia reasoned that international interest in the construction of nickel and bauxite processing facilities was stronger than for copper or iron ore. Furthermore, nickel and bauxite smelters could more easily be established immediately. The economics of establishing integrated mineral production and processing facilities for both commodities certainly cause the closure of several hundred smalland medium-sized mines. Infrastructure is weak in many of the regions best suited for such facilities; rates of electrification are low, and access to water, roads and ports, poor. Rahmat Soemadipradja, partner at Soemadipradja & Taher, said: "The state electricity company has confirmed that in certain areas it can provide the energy needed for infrastructure projects, but other areas will have to go about finding that energy in other ways."

Though the Indonesian Government has slated $35 billion in infrastructure spending starting in 2014 in part to address this, it is highly unlikely that many of these projects will proceed prior to the establishment of these facilities, Should these projects fail to materialize by 2017, the government of Indonesia will lose a key point of leverage for requiring other commodities to establish mineral processing facilities. Many of the problems experienced by Indonesian miners are a result of the country's rapid decentral ization. Decentralization propagated corruption, leading to cases like that of Churchill Mining. Decentralization obfuscated permitting. In the view of some, SBY's Export Ban is an attempt by the central government to rectify the problems created by decentralization through the central government reasserting control over the industry.

Karlheinz Spitz, president commissioner of PT Env Indonesia, a consultancy special ized in environmental permitting and risk management in Indonesia, noted: "The central government realizes that too much authority was devolved to local governments. Power, though, is much more easily given than rescinded. Indonesian President Susilo Bambang Yudhoyono's Export Ban is quite an elegant way of the central government wrestling back some of the authority that was conferred upon local governments. Many of the small mining operations that sprung up post-reformasi will close. The focus of the industry will, once again, return to large-scale mining projects; projects that once fell under the purview of the central government."

Others argue that resource nationalism has been the overriding driver of the ban. Simon Birch of Resindo Resources Indonesia, a domestic consultancy, notes said: "The Indonesian government has put considerable thought into developing the piece of regulation that governs the country's export ban. Although naturally the Government may initially be lenient in its enforcement, granting certain exceptions, the ban itself will be enacted: it plays an important role in encouraging the development of mineral beneficiaron facilities. The export ban plays an important role in forcing upgrading in remote areas, in the development of local ecosystems - schools, businesses that arise to support these projects. It is a tool for economic development."

The lucre of the country's mining industry has certainly been disproportionally appropriated by foreign mining companies. In spile of its mining industry, Indonesia is indigent. The Government's effort to build mineral processing facilities is a bold attempt to use the country's natural resources for greater control in international commodity markets and, ultimately, to generate domestic wealth. This could never have been attained easily and without stepping on toes, but, the logic backing the Government's decision is understandable and many within the domestic mining industry may even agree with it in principal.

The larger criticism that can be made of the Indonesian Government is of the way in which they have proceeded with the enforcement of the ban, which reveals other, more political motives. This is observed in the urgency with which the Government has moved to enact this ban. Four years, regardless of the length of the period of public consultation preceding the implementation of the law, is insufficient to prepare any country - especially a country as ill-equipped by way of infrastructure as Indonesia - for the undertaking of such an ambitious project.

Rahmat Soemadipradja said: "The government is attempting to make the export ban a political issue. It is important to note, though, that the way the government has behaved is not new. The government has put the industry in a tough position, but it has traditionally approached policy making by necessity."

This would also explain the country's use of a blanket piece of regulation forcing all miners to develop smelting facilities, irrespective of the potential profitability of those facilities and the implications that forcing these companies to do so would have on trust in the country's legal system. Demagoguery and any potential upside generated through the creation of such facilities, however, cannot justify the way in which this ban was enacted. The cost of the ban on the country's industry and integrity is too great.

Though, since January, the government of Indonesia has proposed a revised export fax which could lessen the impact of the export ban on the country's miners, specifically those investing in smelting facilities, much could still change once Indonesia's new president, Joko "Jokowi" Widodo, as sumes office. Ratih (Ipop) Nawangsari, counsel at O'Melveny & Myers, an international law firm with a presence in Indonesia, remarked: "Jokowi is known for his focus to solve the short-term/immediate issues first. Thus, while he will respect and uphold the requirements that have been set out under the laws, he will be open to consider some helpful measures to give mining companies a bit of a breathing room. That does not mean he will lift the export ban completely, but he will probably set some less restrictive requirements so that at least production activities can be restored."

Michael Carl, foreign legal consultant at SSEK, a full service Indonesian law firm speculates on the several scenarios that could come about. "Assuming that there is no major financial crisis, we will see a system in which two situations could occur, potentially together. The first is the entrance of Indonesian entrepreneurial-type players who are not necessarily mining specialists, but have access to foreign capital. The question is then whether these Indonesian entrepreneurs need the technical expertise to build a large mining house or if they can buy it.

The second possibility is that some of the state-owned entities will begin to take more of a center-stage in developing local mining houses. State owned enterprises have technical expertise and can acquire financing, but they have government and political constraints that can make it difficult for them to be able to move effectively in developing opportunities. In regard to foreign players, their role is unclear if there is no significant regime change. It is too soon to tell what will take place, but Indonesia is determined to remove itself from the middle income trap and wants to make certain that the development of its resources is done in a way that will help the country to develop."

Regardless of the outcome, Indonesia's best days do lie ahead. How soon the country will reach them though, will depend upon the approach the country's next leader takes in engaging domestic industry.

Smelting

As the Government of Indonesia has taken steps to strongly encourage producers to construct mineral processing facilities, proposed projects have materialized. To date, the BKPM, Indonesia's foreign investment coordinating board, has issued 28 permits for the construction of such facilities, three of which will smelt bauxite, five of which will smelt iron ore, 14 of which will smelt nickel, and three of which will smelt copper. Through these investments, the BKPM expects to grow foreign investment into the country by 15% in 2014. These facilities are speculated to bring in $12.4 billion of investment into the country over the course of the next three years.

Though some have speculated how many of these facilities the industry will see developed, citing infrastructure concerns and rationalizing that perhaps many of the proposed facilities are companies attempts at buying time, some maintain that these projects are economic Simon Birch of Resindo Resources Indonesia, a domestic consultancy, explains that, "The development of smelting facilities in the country requires a large amount of resources, however, these facilities are feasible and are economic for certain groups. We have seen serious interest in nickel. In spite of some arguing that Indonesia lacks a sufficient resource base to develop these facilities, we believe that for certain commodities, especially nickel, we will see smelters developed."

Indonesia has moved to lock in those that would propose the development of such facilities. The country has issued a regulation stating that all those intending to build smelters domestically must pay a 5% guarantee on their investment. In 2014, Indonesia will see three smelters enter production: one involved in processing bauxite into chemical grade alumina, and two involved in processing iron ore.

Among the most interesting of Indonesia's proposed smelters is that of Asia Minerals Corp. (AMC) in so far as it represents the direction in which the Indonesian Government would like for domestic mining to head: smelting acting as part of the company's license to operate. Currently involved in the trade of raw manganese ore in West Timor. AMC plans to use the funding generated through gradually increasing exports, which the firm plans to expand from 250,000 mt in 2014 to 500,000 mt in 2015, to fund the development of first a manganese smelter and then later an iron ore mine. Regardless of the politics that will continue to surround Indonesia's export ban, AMC proves that smelting, if approached properly, can be attractive.