Indonesia's economic fundamentals after fuel price hike
Indonesia's economic 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