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.