Costly oil, dearer money

Costly oil, dearer money

Businesses in Indonesia should gear up for costlier credit and
most likely a weaker rupiah due to the combined impact of
persistently high oil prices and the recent increase in the U.S.
Fed funds rate to 2.75 percent.

The expected appreciation of the greenback due to the
tightening of money supply in the United States and the rise in oil
prices to over US$55/barrel (unadjusted for inflation) have again
raised the specter of high inflation. This in turn will force
Bank Indonesia to tighten its monetary policy, meaning raising
interest rates so as to check inflationary pressures.

The proposed amendments to the 2005 state budget, which were
submitted to the House of Representatives last week, did provide
a strong signal of tighter monetary policy. The assumption for
the central bank's average benchmark interest rate for this year
was upped to 8 percent from the 6.5 percent originally envisaged
when the budget was enacted late last year.

The 150 basis-point rise in the interest rate will not only
make credit costlier but will also impose additional costs on
the state budget as the coupon rates on the bulk of the more than
Rp 600 trillion (US$63.8 billion) in government bonds already
issued are floated on Bank Indonesia's short-term interest rate.

Official estimates have shown that every one percentage point
increase in the central bank's short-term interest rate will
impose on the state budget almost Rp 2 trillion in additional
interests costs from government bonds.

The steep rise in international oil prices is stoking
inflationary pressures that may also force tighter monetary
policies in Europe and Japan, and slow down the global economic
rebound, thereby affecting Indonesian exports.

The expected inflationary impact of higher oil prices could
even be much more severe than predicted by the government in the
proposed amendments to the 2005 budget. The revised budget
estimates set the average oil price at only $35/barrel for the
whole year, while the actual price for the first three months has
always hovered above $50/barrel.

No one dares to predict that oil prices will ever again fall
again to below $40/barrel, even with the upcoming northern spring
and summer, in view of the steady rise in demand in China, India
and other major consumer countries, and the severely limited
spare capacity still available among OPEC members.

This means that the budget deficit will be higher due to
bigger fuel subsidy spending and higher interest charges on
government bonds. Even the Rp 40 trillion in fuel subsidy
spending that the government proposed in the budget amendments
after the March 1 fuel price hikes of 29 percent will be much
smaller than what will actually be needed as the figures were
calculated on the basis of an average oil price of $35/barrel.

The damaging effects of costlier oil will reverberate far
beyond the energy industry and percolate down in numerous ways.
The prices of hydrocarbon-based products, such as plastics and
synthetic rubber, will most likely increase as well, thereby
leading to hikes in the cost of packaging materials, their
derivative products and synthetic rubber.

In a way, therefore, the delay in the deliberation of the
proposed amendments to the 2005 budget to early May, after the
House returns from recess, could be a blessing in disguise as it
might allow a more reliable estimate of the average oil price for
the whole year to be agreed upon.

Since the debate will take at least one month, given the
controversy over the March 1 fuel price hikes, the prevailing
prices in May and June-- the period of the year when the demand
for oil is at its lowest level-- will provide better guidelines
for both the House and the government for projecting the average
price for the whole 2005.

The state budget also serves as a communications system,
conveying signals about behavior, prices, priorities, intentions
and commitments.

Predictability is important for efficient and effective
implementation of policies and programs, and the public sector
will perform better if there is stability in macro and strategic
policy, and funding for existing policies.