Indonesia fundamentals after fuel price hike
Indonesia fundamentals after fuel price hike
David E. Sumual
Indonesia's financial markets have been shaky in recent weeks, raising scores of questions about the country's economic fundamentals. A volatile financial market typically indicates there is a battle of views being waged in the market.
Such volatility usually marks an inflection point in regard to which direction the market will head. In other words, the recent volatility raises the question as to whether the volatility is only a short-term phenomenon that will not affect the fundamentals, or is a sign of a sudden change in sentiment, which could put the country's economic fundamentals at risk.
The market, and thus the economy, have indeed been driven by expectations. And two of the early warning indicators that reflect expectations are the Jakarta Composite Index (JCI) and the rupiah exchange rate (IDR).
Both financial indicators move in advance of the economic fundamentals, and it appears the fluctuation of both indicators has been affected in part by the government's intention to raise fuel prices in the February-April period next year. This plan may concern the market, as it could sour the near-term outlook and even affect Indonesia's economic fundamentals.
Over the last three years, there has indeed been a remarkable improvement in the country's fundamentals, as seen by the relatively stable IDR, falling inflation and lower interest rates that have made fiscal consolidation easier. Although the economic foundations are quite solid, some impediments to higher economic growth remain. For example, in terms of attracting foreign direct investment (FDI), Indonesia still lags well behind other countries in the region.
The current economic growth rate is below its optimal level as it hinges primarily on domestic consumption. Investment, which hovered at about 30 percent of GDP before the crisis, has since fallen to its lowest level of 18.5 percent in Q3 2004. Despite the ebbing political risks following the smooth presidential election this year, foreign investors' appetite for investing in Indonesia is still weak. The latest data shows that FDI approvals in the January to November period fell 29.6 percent year-on-year (yoy) to US$9.58 billion.
Moreover, Indonesia has seemingly been unable to tap the growing world trade that helped Korea, Thailand and Malaysia achieve higher economic growth. Indonesian exports rose only 9.9 percent yoy in the January-October period in 2004, failing to keep pace with the other ASEAN 4 countries (Singapore, Thailand, the Philippines and Malaysia), which saw exports grow at an average of 21.7 percent in the same period (Chart 1). In fact, weak exports reflect the post-crisis lack of investment and banking disintermediation in the country.
As such, foreign portfolio investment is the only big source of foreign capital inflow into the country at this time. In the equity capital market alone, total net buying by foreign investors since the beginning of the year up to the third week of December 2004 stood at Rp 19.3 trillion ($2.07 billion), up 95.6 percent compared to the same period last year.
Nonetheless, the inflow of portfolio investment could easily be reversed. This is especially true if regulatory, law enforcement and security risks, and problems of excessive red tape remain unresolved.
Another indicator of the lack of confidence is the dependence on short-term funding in the banking sector, which is vulnerable to external shocks. Although slightly down from 62.3 percent in August 2004, data from October 2004 still shows that 59.9 percent of time deposits bear one-month maturities (Chart 2).
It is quite the opposite of pre-crisis data, in which six- month and one-year maturities constituted an average of about 80 percent of the outstanding time deposits in the banking system. This demonstrates that a smooth transition from the government's bank deposit guarantee scheme to an insurance deposit system is needed to maintain investor confidence.
Given such conditions, the rupiah may remain under pressure in the weeks ahead as FDI remains at roughly the same level. A recent improvement in export performance may not help the domestic currency much since Indonesia has not adopted an export repatriation policy like Thailand or Malaysia, so exporters can still place their funds from exports abroad. Also making the rupiah more vulnerable is the excess liquidity of about Rp 200 trillion in the banking system, which easily could be used in speculative transactions if the business environment turns unfavorable.
Due to the turbulence in international oil markets, the rupiah also has been very volatile of late as a result of the lack of demand management by the central bank of foreign currency purchases for oil imports. The ups and downs in oil prices will thus affect the real demand for U.S. dollars to buy fuel, which is estimated at nearly $1 billion per month. And Bank Indonesia's policy of staying out of the market may continue in the medium- term, as it maintains its policy of accumulating foreign reserves from oil sales to help finance the government's debt repayments.
On a positive note, there are signs of incoming foreign direct investment, as seen by the more than $4.2 billion worth of new oil and gas contracts signed recently. The new deals will certainly become a source of growth in the years ahead, although the income flow could be unstable due to the volatility of world resource prices. Furthermore, investment in natural resource exploration does not create many jobs. As such, the tougher challenge lies in how to attract manufacturing businesses and infrastructure investors (sectors that are labor-intensive) rather than resource-based industries.
The government's plan to raise domestic fuel prices early next year also could affect investor confidence as it may change the economic fundamentals. The government said that hike in fuel prices would occur between early February and April, which is a period for agricultural harvests. This would indeed alleviate inflationary pressure.
However, what is more important than the timing is the extent to which the government will cut fuel subsidies. Unfortunately, there is no clear information on the size of the fuel price increase or on whether the government will cut subsidies sharply or in a gradual fashion.
In an apparent sign of a lack of coordination, State Minister for National Development Planning Sri Mulyani Indrawati said the government would announce a single, sharp increase in domestic fuel prices, while Minister of Energy and Mineral Resources Purnomo Yusgiantoro said the government aimed at gradually eliminating fuel subsidies by 2010.
Historically, increasing fuel prices is not a popular move and is politically risky in Indonesia. Street protests may mount, while workers in the transportation sector could also bring the country to a halt if they call for a nationwide strike (as recently occurred in the Philippines).
The social risks may be even higher if fuel prices are hiked at the same time the government announces the revision of the labor law. And despite the new political landscape as a result of Vice President Jusuf Kalla's victory over Akbar Tandjung to become Golkar's new leader, the extra-parliamentary movement is still threatening in nature in terms of social and security risks.
However, it seems that the size of the fuel price hikes is of significance in terms of the reaction that is incurred. A sudden and sharp increase in fuel prices by an average of 36.6 percent in May 1998 triggered widespread rioting in Jakarta that eventually led to the downfall of Soeharto's New Order regime. But fuel price hikes of less than 20 percent in 2001 and of 14.7 percent in January 2003 only provoked sporadic student demonstrations across the country.
Impact on fundamentals
The immediate impact of fuel price hikes on economic fundamentals will be higher inflation. However, its impact on inflation will depend greatly on the percentage of the fuel price increase. The Danareksa Research Institute's calculations show inflation would rise by 0.7 percent for every 10 percent increase in fuel prices. However, it does not take into account the middle-term impact of a cost-push inflation spiral.
There are several factors that could create a cost-push inflation spiral. First, we should expect higher inflation in the months before the announcement as opportunistic traders raise their prices, as is already happening.
Second, the fuel price hike will induce companies to pass on the increase to consumers, eating into consumer purchasing power and thus affecting the revenue of businesses.
Third, although the direct impact on foodstuff prices is likely to be minor, as the hikes will be announced during the harvest, higher transportation costs would lift the prices of foodstuffs to some extent. And the impact of this would be significant, as foodstuffs account for 38 percent of Indonesia's inflation basket.
Fourth, in the medium term, the fuel price hike may also trigger increases in other administrative prices such as electricity, water and telephone charges.
In fact, what is of greater significance is how the people react to the fuel price hike, which we believe will greatly depend on the size of the increases. A single sharp increase may evoke an emotional response from the people that would put pressure on the JCI and thus the IDR. Indonesia's less robust and more open capital account compared to other countries in the region would make the rupiah even more vulnerable.
As such, there is a risk that a fuel price increase may trigger capital outflow, which would cause a structurally weaker IDR. Given the close link between inflation and the exchange rate in Indonesia, the IDR depreciation would create another cost-push inflation spiral. Based on the IMF's estimations, a 10 percent depreciation in the IDR would -- all things being equal -- be expected to lead to about an additional 3 percent in the inflation rate within three quarters.
Having said that, pressure on inflation and the exchange rate would likely prompt Bank Indonesia to follow the U.S. Federal Reserve in increasing rates. As such, it appears that Bank Indonesia's one-month SBI promissory note has bottomed out at 7.4 percent and will begin climbing again in 2005.
However, although we assume the situation after the increase in fuel prices will remain under control, deposit rates are still likely to increase slightly with stiffer competition among banks to amass funds from depositors. Banks may need extra funds to meet a higher borrowing appetite from the corporate sector, as lending rates are expected to fall slightly due to tighter competition.
At the same time, the government also plans to launch a Rp 200 trillion infrastructure spending program starting next year, which will certainly absorb liquidity in the banking system.
As such, the government should wisely consider the ramifications of cutting the fuel subsidies and provide clear information on how it is going to cut them. By finding the right level for the fuel price hike that does not jeopardize the budget and does not shock people living on the poverty line, the people might be able to accept the increase.
This is especially true if the government gives meaningful signals of its continued determination to eradicate corruption and introduce a frugal lifestyle among government officials to confer a sense of justice to the general public.
To date, the public is quite disillusioned with the new administration's performance, as the only concrete steps it has taken so far are increases in the prices of Pertamax and Liquefied Petroleum Gas. It appears that the administration has failed to grasp what the public desires -- the eradication of corruption, the elimination of red tape, and a total reform of the tax and custom offices and law institutions.
Moreover, the general public knows few of the details of the government's economic programs. Whether this is intentional or not, vague economic programs will lead to a moral hazard because the public cannot judge and review the effectiveness of these programs.
The views expressed in this article are strictly personal
Chart 1.
Comparison of Indonesia and ASEAN 4 Export Performance (January- October Cumulative)
Chart 2.
Composition of Rupiah Time Deposit in Banking System
The writer is an analyst at the Danareksa Research Institute