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.