Parta 1 of 2: The 2006 state budget: Out of wonderland?

Parta 1 of 2: The 2006 state budget: Out of wonderland?

Kahlil Rowter, Jakarta

It has always been risky to put out government budget
numbers, but now this is a perilous exercise. Forecast accuracy
is an elusive goal. What we need is better risk management. Only
then will we be convinced that the current difficuties are
temporary.

The government is still optimistic in putting 6.2 percent as
2006 gross domestic growth (GDP) rate. This will work if we
believe the inflation-inspired rise in interest rates will
reverse course. Inflation this year is expected to rise to at
least 8.5 percent mainly on the back of rise in energy prices.
Depending on when fuel prices will be increased again, the effect
might very well carry over to next year.

Hence for inflation to tame down again will take a few more
quarters in 2006. Even when interest rates are cut when this
becomes evident, growth will not pick up again so fast. If we
factor in an investment increase, perhaps from infrastructure
related activities, its impact on inflation will come first
before any growth effects appear. And in this construct we are
already assuming smooth sectoral adjustments. Something not
always wise to assume, especially for financial sector.

The rupiah assumption also hinges on taming down present
pressures stemming from fuel importation. To some extent this is
conceivable when domestic fuel price matches its international
counterpart. The wild cards are consumption-production deficit
and rupiah movements. With higher domestic fuel prices usage will
eventually become more efficient. But the deficit itself will
take longer to disappear along with increase in oil production
and refinery. Both will take longer than one year to achieve.

Overall we see the assumptions as becoming more realistic,
with a few caveats. The glaring exception is, of course, putting
US$40 as oil price assumption. With current oil prices
approaching $70 it is heroic to see next year's level at $40.
Assuming $55-$60 is more realistic.

However, if the central government assumes higher oil price
it is will be forced to surrender more revenues to oil producing
regions while at the same time bearing the full brunt of fuel
subsidy. Hence it is politically easier to put a lower estimate
now, lock in the regional government revenue handovers, and then
raise fuel prices later.

Economic rationality would like to see a higher oil price
assumption and demand regions to bear part of the subsidy. But
economics is and will always be a slave to political expediency.
This will mean a fuel price increase sometime in 2006, which
jeopardizes the inflation-interest-growth scenario.

On the revenue side, tax revenue reveals a ratio to Gross
domestic product (GDP) of "only" 13.4 percent which is marginal
improvement from the trend in recent years. With a value added
tax rate of 10 percent, its current revenue level of less than 4
percent to GDP is a far cry from collection efficiency, even when
we grant that a few goods are exempt from VAT.

A lot more needs to be accomplished to increase revenues from
VAT and other types of taxes. In fact a strong initiative from
the tax office can bring light onto hitherto "hidden" parts of
the economy.

The oil subsidy, as discussed above, hinges on assuming oil
price of $40 per barrel. If we simply use a discounted level to
today's price at $60, this could mean reversion of oil subsidies
to that estimated this year at around Rp 120 trillion. It will
also open up the possibility of raising the budget deficit to
current levels of at least Rp 26 trillion.

The question then becomes how flexible is the budget to come
up with the extra money to cover this? Otherwise we will be left
with another uncertainty as to when domestic fuel prices will
again be increased.

In itself this will raise expectations that inflation will
again rise, probably bringing another interest hike from the
central bank and consequently economic growth decline down the
road.

From these risks, we see a repeat of what took place in 2005,
with no lessons learned. If only we can expect market players to
be soothed once fuel prices are hiked this year. Unfortunately by
looking at the 2006 assumptions and expecting another hike, this
may not be possible.

More likely players will connect the dots and simply assume
at least a linear increase in inflation and interest rates from
this to next year. Worse, if they start to question credibility
of government budget making, the dot connecting exercise could
end up with exponential rise in inflation and interest rates.
This is something the government is well advised to avoid.

Perception about budget and overall economic policymaking is
not helped by government officials at odds in the public about
crucial assumptions, outcomes and policies. It is time to face
the music, disclose the actual difficulties faced by the
government and to come up with a better plan hopefully in a more
coherehent and cohesive manner.

The writer is Head of Economic and Fixed Income Research
Mandiri Sekuritas. This article is personal opinion.