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.