Higher oil prices and Indonesia's political stability

Jusuf Wanandi, Jakarta

It has been a traditional reaction in Indonesia that some protest is going to happen every time higher oil prices are announced. If paired with other very negative political developments, as happened in 1965 or 1998, when the legitimacy of President Sukarno and President Soeharto were at their lowest, the protests could have serious implications, and in those two cases, they did in fact lead to a change of regime.

That is why the Susilo Bambang Yudhoyono government's drastic reduction of subsidies has been a brave act. Only a major cut in the subsidies could have brought fuel prices up to the market level in the near future. This is critical to building a healthy economy in the future.

The policy of subsidizing oil-based fuels was adopted as Indonesia was an oil-producing and exporting country, and the subsidies were meant to alleviate the burden on the public from higher oil prices. It was also adopted to some extent for populist reasons.

The subsidies have been taken for granted by the people. It was never easy for the government to take back what it had given. All governments after Soeharto have experienced and worried about the effects of mass protests. As a result, the subsidies have been compounded, particularly as a result of high international oil prices. Indonesia has become an oil importing country since 2004, and domestic consumption has continued to grow rapidly.

If we include LNG exports, Indonesia is still a net energy exporting country, but the surplus only stands at one billion U.S. dollars.

In the meantime, because of the three-fold increase in oil prices from a little above the US$20 per barrel mark to over $60 in mid 2005, the projected subsidy spending for 2005 increased by more than 50 percent, from $8 billion to $14 billion. That means 50 percent more than the whole of the development budget of Indonesia, amounting to around 25 percent of the total budget. That is definitely unsustainable as there is no additional income to cover the increase available unless we amend the budget to take money away from education and health. This is undesirable as the allocations on these areas are already minimal. If subsidies are not cut, overall macroeconomic objectives will be endangered because of the ensuing higher budget deficit. The government must also adopt a set of other policies designed to promote conservation, the development of alternative resources and increased production of crude and refined products.

Discussions over the past three months or so, involving most economists, Indonesian and foreign, showed that there was no alternative than to start cutting the subsidies.

The private sector, despite its complaints about the sudden rise in the price of diesel for commercial use in March, has supported the policy too, because it realizes that the sector will suffer greatly from a collapse of the economy. They are trying to hold on as long as possible.

For the poor, estimated at about 15 million households, compensation payments will be provided to assist them in dealing with the higher prices, especially of kerosene and diesel.

Kerosene was not affected by earlier subsidy cuts as it is the main source of energy for the poor (especially for lighting). Thus, it was being sold at Rp 700 per liter, about a third of its price in the Philippines.

At this juncture, the successful implementation of the compensation scheme will be critical for the success of the government's program of cutting subsidies. This is not only because it is the poor who are most effected by the removal of the subsidies, and their needs are desperate, but is also due to the public sense of justice. And if this is attended to seriously, opposition to government's policy from the poor and the desperate can be alleviated. And even the opposition from the middle and upper income brackets will be lessened. Other immediate actions are also important, especially to rid Pertamina, PLN and the Department of Energy of corruption.

The cuts of over 80 percent in the fuel subsidies on average were meant to gradually bring prices up to market levels over the next one or two years. The big distortions in energy prices in Indonesia have also wreaked havoc in other fields of the economy.

The policy of reducing fuel subsidies is serious surgery on our economy and as such will have other impacts and side effects. Inflation will increase, perhaps to between 12 percent and 13 percent. It will also cause strains for the private sector as it struggles to adjust to the new prices of fuel and higher costs of production. Therefore, the government must do its utmost to eliminate the many other factors that lead to a high-cost economy, such as excessive bureaucracy, corruption, over- taxation, etc. For the rest of this year and next year, the public will have to tighten their belts. But there is no other alternative to this. In the mid to long term, starting in 2007, Indonesia can look forward to much healthier and more sustainable economic growth, which will benefit the Indonesian public at large.

The writer is co-founder & member of the Board of Trustees and a Senior Fellow at the Centre for Strategic and International Studies (CSIS), Jakarta.