If the government wants to help lower long-term interest rates,energy subsidy reforms must continue.
Recently, the government proposed a 15 percent electricity tariff hike, scheduled for July, in its revision of the 2010 fiscal budget.
The plan has sparked protest from various sectors, including the business community.
The move is unpopular and perceived as a threat to economic recovery, which has only just begun to gain momentum.
Besides, oil prices are now still at around US$80 per barrel, which is not yet a very hazardous level for the government budget.
Yet one need not look too far back to recall the troubles faced in mid 2008.
Oil prices reached $145 per barrel and the price of government debt fell sharply, making it very costly to finance the state budget. Inthe end, domestic fuel prices had to be raised abruptly, triggering double-digit inflation rates.
There is indeed a lesson to be learned from that: The budget’s susceptibility to oil prices is a flaw that should be gradually fixed.
The substitution of subsidized kerosene with LPG in various regions last year, for example, was a good start and a step in the right direction.
However we can never be too careful. Oil prices won’t remain at $80 forever; so the relative calm today should be taken as an open window to get things right before they go wrong.
In today’s dynamic and globalized world, the Finance Ministry is more than an administrator of the country’s finances. It is also a risk manager.
If stress tests reveal potential problems to the budget in the event of sharp oil price increase, action should be taken to mitigate the risks.
In that regard I was somewhat relieved to hear from the minister of finance herself last Friday that the government still has subsidy reform on the agenda.
The ministry’s main plan is to gradually replace the various price subsidies on fuel and electricity with direct subsidies for the needy.
This has nothing to do with neoliberalism or an evil desire to see people suffer. Subsidy reform is necessary for the long-term health of the economy.
Indonesia faces the problem of high long-term interest rates and the current system of energy price subsidies has played a key role in sustaining this fault. With domestic energy prices capped and the
government’s budget deficit susceptible to oil price movements, inflation becomes harder to predict and is prone to “tail events”.
Accordingly, financial markets have been putting a hefty risk premium on long-term bonds.
Structural issues, for example, food production and infrastructure deficiencies, also play a role in contributing to Indonesia’s volatile inflation rate.
The extreme double-digit inflation episodes over the past decade, in 2005 and 2008, cannot be forgotten and were both preceded by abrupt adjustments in fuel prices.
So what’s wrong with having high long-term interest rates?
I remember the view of one presidential candidate during last year’s campaigns about the importance of low interest rates in providing a favorable business climate.
Unfortunately, his recommendation was more interventionist, which may have worked in the 1970s, but is obsolete in today’s Indonesia - one that has an actively traded government debt market.
Bank Indonesia only has control over short-term interest rates, so any unscrupulous downward move in its policy rate would only lead to a wider gap between short- and long-term interest rates.
The reason for this is that long-term interest rates won’t see a sustainable decline as long as long-term inflation expectations remain elevated. So this expectation problem represents a key issue that needs to be addressed.
Energy subsidy reform may initially require measured price increases, such as the forthcoming electricity tariff hike, which could lead to higher inflation and interest rates in the short-run.
Nonetheless, these small adjustments today may well save us from extreme adjustments in the future, which in turn helps to reduce the risk premium on long-term bonds.
Unsurprisingly, the reaction of 10-year bond prices shortly after the government’s electricity tariff hike announcement was not negative, it was actually positive.
I believe that over the medium- to long-term, yields will on average be lower if the government commits to its subsidy reform agenda.
Many view the bond markets as just a concern for the trading books of banks and capitalists.
It is often forgotten that long-term bond yields are used to value many long-term projects, such as infrastructure, which the economy badly needs.
Let’s hope this time politics don’t get in the way.