The Grasberg mine in Papua, Indonesia, is the largest gold mine and second-largest copper mine in the world. Operated by PT Freeport Indonesia, a subsidiary of United States mining giant Freeport McMoran Inc, it was part of the initial wave of foreign investment that ensued after Indonesia liberalised its investment regulations in 1967.

Today, Grasberg mine is at the heart of a dispute between Freeport and the Indonesian government that will test the country's ability to implement new industrial policies aimed at developing downstream industries in the mining sector. The mine's production has now halted.

The dispute can be traced to Law No. 4/2009 on Mineral and Coal Mining (New Mining Law) unveiled eight years ago, and its effect on mineral and coal mining. The main goal of the law was to reform the old practice of resource extraction, by encouraging mining companies to build smelters to develop the downstream industry. This, it was hoped, would increase the amount of value added in the mining sector.

For decades, Indonesia has been relying on its rich natural resources as a key source of export earnings and fiscal revenues, and mining companies have become a major source of tax revenue for the government.

Under President Joko "Jokowi" Widodo, Indonesia has decided to stop the old practice of exporting mineral ore. Since 2014, the Jokowi administration has tightened the export of raw mineral ore, including copper, nickel, bauxite, gold, silver and tin. This export ban has caused a significant contraction in the mining sector, with growth falling from 4.3 per cent in 2011 to -3.4 per cent by 2015.

As a consequence, mineral export earnings have fallen and, in turn, this has lead to a significant tax shortfall for the country.The timing of this law was also unfortunate, as it was unveiled after the end of the commodity boom period.

It is no secret that the sector lacks transparency and is perceived as a source of corruption. The current administration, which is trying to make the management of natural resources more transparent and accountable to the public, deems reform as moving too slowly.

However, further relaxation of the mandate of the 2009 law will erode the government's reform credibility and create uncertainty for investors in the downstream business.

Freeport's existing contract of work was made in 1991, granting the company the right to operate until 2021. But the government thinks the old contract needs to be converted to be in line with the 2009 mining law.

It requires Freeport to change its contract of work to a special mining licence (IUPK) in order to continue exporting copper concentrate.

Freeport argues that the old contract cannot be arbitrarily changed by one party and the government must honour it.

The new regulations include measures that require Freeport to divest 51 per cent of its Indonesian unit's shares, construct a smelting plant of its own, and pay an export tax with rates linked to the progress of smelter construction. Those conditions will create uncertainty for Freeport's long-term investment plan.

As the dispute has not been resolved, Freeport has stopped production. The company, which employs around 32,000 people in Papua, has laid off 10 per cent of its expatriate workforce and plans to dismiss more contract workers if the production halt continues.

Both Freeport and the Indonesian government understand that negotiation will provide the best "win-win" solution. Freeport must realise that the old practice of mining activities may need to go, given the changes in political and legal circumstances. By supporting reform in the sector, Freeport will improve its rather negative reputation in the country as a symbol of US economic imperialism in Indonesia.

Likewise, the government must also realise that building smelters is capital-intensive and costly, with substantial long-term risks. So it needs to offer sufficient incentive for mining companies to embark on such an expensive and high-risk investment. Moreover, setting a divestment condition of 51 per cent may discourage more investment in this risky sector.

There is concern that the Freeport saga will affect the investment climate.

This is a test for the government to show that it is serious about reforming the sector. Reforming mining policy is challenging, as past governments had not been able to achieve it. There are many entrenched groups pushing for stopping the reform process altogether. If the country can enforce the reform agenda in this sector, this will send a clear signal to investors - which may arguably improve Indonesia's overall investment climate.

The case of Freeport shows that the current administration has more determination to provide legal certainty and law enforcement in the mining sector. However, for Indonesia, further relaxing the 2009 law will create uncertainty and make investors wary about the country's seriousness in reforming the mining sector. Eventually, this will come at a high political cost for the government.

•The writer is a fellow at the ISEAS - Yusof Ishak Institute.

•S.E.A. View is a weekly column on South-east Asian affairs.