World Economy

Why Indonesia struggles to attract foreign investors

Construction site of Indonesia's mass rapid transit in Jakart
Romeo Gacad | AFP | Getty Images

Indonesia's economic positives - ranging from demographics to natural resources - should have made the country an investment magnet, but a slew of obstacles make it a tough sell for foreigners.

"There has not been any significant move to open sectors to foreign direct investment," Credit Suisse said in a note last week, adding OECD indexes indicate policy barriers to foreign direct investment (FDI) aren't just high compared with the region, they've been getting higher.

The roadblocks can start with just getting permission to operate, which historically has taken as much as three years.

Road blocks

"One of the difficulties regularly cited by foreign companies in setting up operations is the length of time and the number of agencies that they have to deal with to obtain the necessary business permits/licenses," Anton Alifandi, an analyst at IHS, said via email.

While new Indonesian President Joko Widodo has moved to set up a "one-stop shop" for approvals, Alifandi hasn't yet heard feedback on how well it's working.

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The approval process can also be changeable, with Alifandi noting protectionism and nationalism can be issues. In 2013, DBS walked away from a $7.2 billion deal to acquire Indonesian lender Bank Danamon, citing regulatory concerns after Indonesia decided in the wake of the Singapore bank's offer to cap foreign ownership of banks.

Another barrier may be in the works: "A number of Indonesian officials and ministers have spoken of the need for foreign employees to pass an Indonesian language test before they can work in Indonesia," Alifandi noted.

That would exacerbate what foreign investors already see as a difficult labor market, despite a strong demographic trend.

Indonesia has some of Asia's most stringent labor regulations, ranking 110 out of 144 on labor-market efficiency in the WEF's 2014 Global Competitiveness report, Credit Suisse said.

Analysts cite high severance pay as a key difficulty, potentially running as high as 30 months of wages. Employees resigning voluntarily are also often entitled to "separation" compensation.

"This has partly contributed to a high share of informal workers, as firms avoid having formal contracts. This, in turn, limits investment in workers' training, which added to the skill shortage problem," Credit Suisse said.

While the country is populous, with high fertility and low old-age dependency, "good core demographics do not necessarily lead to a demographic dividend," Credit Suisse said.

Read More Bakrie Telecom debt ploy exposes new foreign investor pitfall in Indonesia

Hiring skilled workers is difficult as less than 10 percent of Indonesians reaches tertiary level education, nearly the lowest in Southeast Asia, it noted.

Other issues

Others noted worker productivity isn't keeping up with wage growth.

While wages have grown at an average 12 percent a year since 2011 -- possibly the fastest rate in Asia -- productivity growth has only averaged around 4 percent, Capital Economics said in a note Monday.

"There has been no progress on plans to overhaul Indonesia's onerous labor market regulations," it said.

There's another factor keeping foreign investors wary: corruption. Indonesia ranks 107 out of 175 in Transparency International's Corruption Perceptions Index.

Additionally, investors are cautious about the legal system. For example, Indonesia's Bakrie Telecom defaulted on a $380 million bond, but got its debt restructuring approved over creditor objections by loaning itself money so it could also vote on the plan, Reuters reported in February, noting a Jakarta court approved the deal in December.

Reforms eyed, but quick fix unlikely

To be sure, the government is pursuing some reforms to become more attractive to investors, such as cutting expensive fuel subsidies and directing the savings toward much-needed infrastructure, including railroads, electric grids, ports and airports.

Indonesia hasn't built a new railway line since the end of Dutch colonial rule almost 70 years ago, Reuters reported last year.

But analysts don't expect a quick fix.

"It will take a few years at least before there is a notable improvement on the ground," Capital Economics noted.

-- Dhara Ranasinghe contributed to this article.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1