Fuel price hikes: Short-term pain, long-term gain

Fuel price hikes: Short-term pain, long-term gain

David E. Sumual, Jakarta

After creating uncertainty since elections last year, the
government finally announced hikes in fuel prices by an average
of 29 percent. The average price increases can be regarded as
moderate with only a slim chance that they will harm the economic
fundamentals. As the magnitude is less than 40 percent (and less
than the sharp increase of 36.6 percent in May 1998 that
triggered rioting in Jakarta), the market sees that the social-
political risk is low.

The average 29 percent fuel price hikes are expected to prompt
only sporadic protests, and will not bring about excessive
inflationary pressure in 2005. Hiking fuel prices in March can
also be considered as the right timing since data shows that
March's inflationary pressure has been seasonally low, even
experiencing deflation.

As such, although the fuel price hikes obviously do not please
everyone, the financial markets reacted favorably -- at least,
for now. The market had anticipated the news and even viewed it
as a favorable development as it has removed one of the country's
economic uncertainties. Historically, the rupiah and the Jakarta
Composite Index (JCI) have not moved much in the first week after
the announcement of fuel price hikes.

However, the financial indicators, especially the local
currency unit may come under some pressure in the medium term if
the fuel-price-hikes issue becomes a political football as has
occurred in the past. Nonetheless, so far, the rupiah is still
stable at US$9,270 and the JCI remains in higher territory at
around 1,090 within a week after the announcement.

However, slashing fuel subsidies does by no means indicate
that the budget deficit will decrease to the government's
estimation of 0.8 percent of the GDP in 2005. There is no large
injection of funds into Indonesia's national budget, as Rp 17.8
trillion of funds must be transferred to spending on antipoverty
measures. Even worse, all these funds are not currently in the
government's coffers.

And to plug the country's budget deficit the government still
needs to take on additional debts from the Consultative Group on
Indonesia (CGI) or issue more government bonds. Moreover, the
government only revised its oil price assumption up to $35 per
barrel in the 2005 budget, resulting in an estimation of fuel
subsidies at around $4.3 billion in 2005. This estimate is too
conservative since the average crude oil price is likely to range
from $35 to $40 per barrel in 2005. Moreover, Indonesia's crude
oil production is likely to continue declining naturally by
around 7 percent in 2005.

As such, with the moderate cut in fuel subsidies in 2005, the
government may have to push up fuel prices again. But due to
political and economic factors, the increase may only happen
early next year at the earliest.

Given the prevailing conditions, the central bank may not
raise the benchmark rates significantly in 2005, but only raise
them slightly to maintain the real interest rate at the current
level. The signal of upholding the current monetary policy has
been given by the central bank, as it stated that the increase of
Bank Indonesia Promissory Notes (SBI) rates is only the last
resort, as in the case of a plunging rupiah. And it appears that
the rupiah's direction will hinge much on how the domestic social
and political developments in regard to the fuel price hikes
evolve in the near term.

Even though several House factions plan to use their
interpellation rights to get the fuel price hikes annulled, the
balance of political clout in parliament suggests that the issue
will not develop into a prolonged political deadlock. The
question now is whether the sporadic demonstrations that have so
far been staged will escalate over the next few days to disrupt
the socio-political climate.

We believe that although the majority of Indonesians may be
mentally prepared for the increase, the next development will,
however, depend greatly on the government's capability to
anticipate its political-economic ramifications. This includes
the government's ability to distribute the allotted Rp 17.8
trillion of low-income assistance funds effectively and
transparently and to anticipate issues such as a scarcity of
kerosene that has reportedly happened in several areas.

Also crucial is the ability to look out for any structural
bottleneck problems especially in regard to the distribution of
foodstuffs. Last but not least is the government's ability to
maintain the people's confidence, which at least could be
monitored by its tenacity to maintain communication with the
parliament members and the people in general.

Learning from the past, battling the plunging rupiah by
increasing interest rates amid increasing political risk is
ineffective. It only eases the symptoms, but the core non-
monetary problems remain unsolved. From another economic
perspective, the inflation ignited by the fuel price hikes is
cost-push in nature, not because the economy is operating at
beyond its capacity.

As such, hiking interest rates could have a negative impact on
the real sector since the hikes would alter producer
expectations. So from the monetary policy aspect, the central
bank should at least not increase the benchmark interest rates
significantly. In fact, rather than targeting interest rates, the
central bank should instead focus on improving the banking
intermediation and using the growth of money supply as the basic
parameter to control the country's monetary environment.

Moreover, regular press meetings with a certain central bank
spokesperson would be a good idea to hinder any conflicting
statements in regard to the direction of the country's monetary
policy. Otherwise confusion might arise and potential
conflicting statements could be perceived as inconsistency in the
central bank's monetary policy, which would be risky especially
at critical junctures such as when the government raises fuel
prices.

Moreover, the central bank's openness would contribute to the
low level of financial indicators volatility and the narrow
spread between the yields on government bonds and riskier
corporate bonds. Higher predictability of monetary authority
objectives will remove a lot of the guesswork for business
players.

The writer is an analyst of Danareksa Research Institute. This
article is strictly a personal view