RI's new govt: A diagnosis and a prognosis
RI's new govt: A diagnosis and a prognosis
Kahlil Rowter
With so many economic initiatives brewing it is necessary to shift direction from mere reaction to pressure. But the big bang eludes us. Either there was never one planned or the reality of the economy-polity nexus necessitates a more gradual approach.
However, the speed chosen should not risk the momentum already gained. With the right nudges we expect growth to rise gradually. This paints an even brighter picture for the stock market. And with money continuing to flow into longer-term instruments, the upside of fixed income markets will remain.
We were excited to see the President, after only a few days in office, visiting the police, attorney general's and tax offices. The performance of these frontline agencies is crucial if credible and successful reform is to take place. It turned out that this visit was insufficient to jolt tax officers into action and it took harsh criticism by two ministers, followed by a contract on the tax office's performance, to make it shift gears.
Unprecedented? Yes, but these measures are appropriate when there is unprecedented impatience and hopes are high. Recently, the President called in key security and law-enforcement officials to demand the capture of a few elusive criminals. This shows that the President reads newspapers and, sensing the public's impatience, is actually trying to rise to the occasion.
Infrastructure and all that
The amount of talk about infrastructure shows that there is an awareness of excess demand and the fact that we have not yet recovered from the crisis. Infrastructure projects require huge funding, have long payback periods and entail huge risks.
Furthermore, there is a requirement for universal service that could result in non-commercial services. These features naturally lend infrastructure for the government to play a leading role, running the spectrum from total ownership to merely regulating industry.
Given the huge funding requirements private sector participation will be needed, domestic as well as foreign. Certainly, the private sector's contribution will only be to projects that are commercially feasible. It is, therefore, natural to expect that the first commercial projects will be located in economically developed areas like Java.
The basic question is: If such projects are so lucrative, why have they not been undertaken already? Aside from the obvious reasons, two other important factors are: the unwillingness or inability of the government to grant enough incentives and the reluctance to open up these sectors to competition. Natural-monopolies arguments are usually invoked as rationale. But such reasoning runs thin in these days of flexible funding structures and technological developments.
What about those projects or areas that desperately need investment but are commercially (which is really a political argument) unviable?
Some have suggested that investors in commercially viable areas be obliged to also invest in areas that are not commercial, much like the obligations on domestic airlines and telecommunications companies. In practice this means that an incentive for non-commercial activities would have to be given as compensation. This translates as an additional burden on users in these commercially viable areas. Therefore, the government will most likely fund these projects from the state budget.
It is also important to ensure good coordination between the central and regional governments to avoid duplication. Attention to only the central government's role could put at risk efficiency and effectiveness.
Proper planning is also needed to avoid too rapid a rise in demand that could result in overheating. Presently, the Indonesian economy is like a complex but rusty machine. Pushing too hard on one lever could result in friction and heat, if not damage.
Fuel prices, inflation and interest rates
Domestic fuel prices are almost certain to be raised next year. The size of fuel subsidies is the main rationale, not the budget deficit itself. Fuel subsidies, debt service and principal payments and transfers to regions eat up almost all of the central government's spending. On a more abstract level, low domestic fuel prices skew resource use and underwrite inefficiency. Exasperated economists (some of them my friends) have even cited fuel smuggling as an additional rationale for reducing the cross-border price differential. I view it as unfair to burden economic policy design with the failure of law- enforcement. Such practices dilute policy effectiveness.
Raising LPG and fuel for high-end vehicles (Pertamax and Pertamax Plus) is just the first step. And, although, the impact on inflation is yet to be reported by the Central Statistics Agency (BPS), the government is already busy deflecting finger- pointing. Given the supposed cut-throat competition in the retail food sector, one would expect that rising energy costs would eat into margins and not all be passed on to consumers. But perhaps competition is already too tight for producers to do just that. Another factor is the uneven degree of competitiveness along the production chain.
Hence, when gasoline and kerosene prices are raised in the first quarter of 2005, we expect to see both margin compression and the rising prices of food and other products. Mandiri Sekuritas estimates that the impact will be an additional 1 percent to 1.5 percent on top of the reigning inflationary level raising overall inflation to at least 7.5 percent by the end of 2005. This depends on how prices are hiked. If prices were to be raised gradually, the impact on inflation would be greater. Down- line producers may have to raise prices more than is warranted to reduce uncertainty.
Although rising inflation usually entails rising interest rates, this may not be the case next year. First, the rise in inflation is supply-pushed. In this case, raising interest rates to reign-in demand is inappropriate. Second, while higher inflation eats into real interest rates, lower real rates might not directly weaken the Rupiah while the U.S. Dollar is on a declining trend. And third, raising interest rates increases the risk of Bank Indonesia incurring a deficit, because it pays for Bank Indonesia promissory notes (SBI) interest rates from its own pocket.
Another important question then is, if SBI rates increase will this automatically raise deposit rates? Not necessarily. Competition in the deposit market is currently low. In fact major banks have reduced their deposit levels to lower funding costs. With a continued low loan to deposit ratio when SBI & Fasbi rates are low and government bond yields have declined we do not expect to see a quick end to this situation. Hence, it is possible to see a greater difference between SBI rates (the 3-month rate being the government's guarantee ceiling) and deposit rates paid out by major banks.
Growth & the financial markets
These inflation and interest rates developments will bode well for the stock and bond markets, as well as general economic growth. Gross domestic product (GDP) growth has gained momentum, partly resulting from continued consumption growth, albeit at a slower rate, and rising investment activities.
Shining sectors include property, financial -- especially banking -- and trading and services. Although it might be difficult to precisely pinpoint which sectors will grow substantially next year, most sectors should expect enthusiasm. Political stability, confidence and a low-interest environment will remain the key ingredients.
With regard to the stock market, a country undergoing reconstruction is always good news. In fact, most firms had experienced lower leverage, better earnings and better cash flows before the recent stock market boom took place. Further confirmation of continued improvement in the overall economic environment -- especially rising investment -- will certainly further boost the index performance, subject as always to episodes of profit-taking.
It is reasonable to question whether rising interest rates, although riding a very even slope, mean one should avoid the fixed income market. With the low probability of rising deposit rates, we expect that the demand for higher yielding, longer-term dated instruments will continue. And remember that the supply of government bonds is limited, particularly for fixed rate ones. Therefore, although the height of the yield curve (the difference between one-month SBI rate to five-seven year government bond yield), have declined substantially to 3-3.5 percent the difference is still substantial enough to attract money flow to fixed income mutual funds, particularly with its tax benefit. We do not expect this trend to reverse anytime soon. However, it must be noted that there is a limit to the decline in height of the yield curve. A difference, say of 2 percent between SBI rates and longer-term government bonds would signal that these bonds have become too expensive. At the same time, it points to a saturation of government bonds based on fixed income funds.
Bottom line
The slow takeoff of government initiatives means that we have to be more patient. But early signs of progress have been observed. Infrastructure is the centerpiece of the efforts revealed so far. With enough political strength and the willingness to apply it, removing investment impediments and providing enough incentives to private investors becomes feasible.
The stock market, despite its recent rise, should continue on an upward trend next year based on further improvement in corporate financial performance. And the fixed income market will continue to see inflows on the back of difference between short and longer-term asset yields.
Hence, we should end next year even happier than we are this year. Happy New Year.
Head of Research, Mandiri Sekuritas, *) Personal Opinion