This blog post is based on research conducted by my coauthors Addisu Lashitew, Rizal Shidiq, Eric Werker, and me, titled “Political Connections and Firm Performance in Indonesia: Evidence from a Novel Dataset on Political Connections.”

Unveiling Indonesia’s Business-Political Connections: The Disconnect Between Access to Debt and Firm Performance

In Indonesia’s dynamic economic environment, the intersection of business and politics raises important questions: How do political connections affect the performance of firms? Consider two firms—one with strong political connections and one without. The politically connected firm often secures better financing terms, reflected in a higher debt-to-equity ratio. These firms tend to have privileged access to loans, enabling them to leverage debt more effectively than their less-connected counterparts. This isn’t just about knowing influential people; it’s about gaining access to financial resources that others may find difficult to obtain.

Rent Seeking or Resource Missallocation? However, an interesting finding of our research is that while connected firms seem to benefit from better access to debt financing, this advantage does not necessarily translate into better performance. Measures of profitability and other key performance indicators do not show consistent evidence of a competitive edge for politically connected firms. Despite their ability to secure more financing, their bottom-line results remain on par with—or even below—those of firms without such connections. This apparent paradox leads us to explore theoretical channels that may explain why better financing does not always equate to better performance. Our research shows that rent-seeking behavior and resource misallocation within politically connected firms can undermine the potential benefits of their financial leverage. Rather than using the additional capital for productive investments, these firms may divert resources toward maintaining political ties or securing further favors, leading to inefficiencies that stifle growth and profitability.

Not All Political Connections Are Created Equal. Ties to ruling parties, specifically the Partai Demokrasi Indonesia Perjuangan (PDIP), the Partai Golongan Karya (PGK), and Partai Hanura (PH), appear to offer significant influence in accessing debt financing. Firms associated with these parties may receive advantages such as preferential loan terms or expedited approval processes. But again, these financial benefits do not consistently lead to better firm performance, reinforcing the idea that political connections can lead to distortions in resource allocation. The impact of political connections also varies depending on their strength and nature. A direct link to a key political figure might provide more substantial benefits than a peripheral association. However, even with these connections, firms often fail to convert their financial privileges into higher profitability or sustained growth, suggesting a deeper issue at play.

The Challenge of Establishing Causality. While there is a clear association between political connections and certain firm outcomes, establishing a direct cause-and-effect relationship remains challenging. Are firms gaining success in credit access because of their political ties, or do better equipped firms naturally attract political attention? We use methods like Difference-in-Differences (DiD) analyses with fixed effects and election interaction terms to disentangle these factors. Our analysis provides a clearer understanding of the nuances involved in this relationship.

Why This Matters?. For businesses operating in Indonesia or considering entry into the market, these findings have significant implications. Recognizing that political connections may not always lead to better performance challenges the conventional wisdom around the value of political ties. Firms might need to think beyond political access and consider how to deploy resources effectively. For policymakers and observers, the research underscores the importance of fostering environments that prioritize transparency, fair competition, and the efficient use of resources.

Looking Ahead: Expanding the Research. Building on this research, our upcoming studies will go deeper into the rich dataset of political connections in Indonesia. We aim to focus on specific industries and political parties, tracking the persistence of political connections and business elites from the pre-Suharto dictatorship era to the present day. By examining how these relationships have evolved over time, we hope to provide a more comprehensive understanding of their impact on Indonesia’s economic landscape.