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