Slashing the fuel subsidy

Slashing the fuel subsidy

Barring any major disturbances to Indonesia's social and
political stability, the market should react positively to the
government's bold move last week to raise domestic fuel prices by
an average of 125 percent, which in turn will lead to improved
confidence in the country's economic outlook.

While bold this policy will be painful for the majority of
Indonesians, as the cost of living will rise steeply and
inefficient businesses that depend on subsidized fuel might have
to close down, leaving more people out of work.

The fuel price increases can be expected to initially trigger
disproportionately steep hikes in the prices of basic foods such
as rice, fish and vegetables and in transportation fares, lifting
inflation to as high as 11 percent this year, above the earlier
projection of 9 percent.

The prices of goods and services will rise, especially with
Ramadhan days away, the Idul Fitri holiday next month and
Christmas in December.

However, if the government manages to maintain adequate
supplies and ensure the smooth distribution of goods, the rate of
general price increases should be proportional to the role of
fuel in the respective production costs of the goods. Any panic
can be expected to recede after a few weeks, with the market
returning to a new equilibrium after absorbing the impact of the
higher fuel prices.

The pain of the new fuel policy can be contained if the
government fully implements its package of fiscal incentives and
reform measures introduced on Saturday.

But it is simply a relief now to know that by cutting the
massive fuel subsidy, the government will be able to channel
more funds directly to the poorest segment of society through
direct cash payments and increased spending on basic health
services, education and rural infrastructure.

The short-term pain of this policy is better than allowing the
wasteful fuel subsidy to lead the economy into a new crisis that
could be much more devastating than the economic fiasco of 1998,
because of an unsustainable fiscal deficit that would increase
the sovereign risks of the government.

Higher sovereign risks would damage market confidence in the
Rp 650 trillion (US$65 billion) worth of bonds the government has
thus far issued, including over Rp 400 trillion to recapitalize
banks, and depress the prices of the Rp 56.3 trillion worth of
new bonds the government plans to float this year to plug the
budget hole and shore up the rupiah exchange rate.

Many observers believe the fuel price increases announced last
week are too steep to be absorbed given the current economic
conditions.

However, the government has a good reason to raise the prices
of regular gasoline and automotive diesel oil to as high as 80
percent of market prices. This will discourage export smuggling
by narrowing the differences between domestic and market prices,
and will make it easier gradually to increase fuel prices fully
to market prices by January 2007.

The market will reward the government's boldness with a
virtuous circle, because the smaller fuel subsidy will enable the
government to improve overall economic efficiency through larger
investments in infrastructure, public services and utilities.

The protests, the criticism by analysts and the outright
opposition by many students to the new fuel price policy were
expected. This is what democracy is all about.

The public debates should serve to educate the public about
the economics of commercial energy, to help people realize that
sooner or later they will have to pay for fuel based on its
economic costs or suffer supply disruptions.

Protracted, raucous street demonstrations will only divert the
attention and resources of the government from the much more
urgent tasks of managing the distribution of funds to the poor
and maintaining the smooth distribution of essential commodities
to control the inflationary impact.

If the opponents of the new fuel policy care about the
interests of the people they should help oversee the distribution
of the funds for the poor, and should see to it that the
government fully implements its Oct. 1 package of deregulation
and reform measures to help people and businesses weather the
difficult months ahead.