The 2005 state budget: Are we in wonderland?

The 2005 state budget: Are we in wonderland?

Kahlil Rowter, Jakarta

Like Alice, our initial reaction is astonishment at the
proposed 2005 budget that the government unveiled last week.

No, this is not in the same category as the Soeharto budget
early in 1998 or the Habibie economic report in 1999, but a
distance between reality and imagination exists here too. It
appears that the first thing the next government (whoever wins)
must do is to both inject more reality and impose a sense of
direction for the economy into the 2005 government budget.

The budget structure itself does not deviate much from the
2004 budget. The assumptions, however, appear problematic. Take
the growth figure. Moving from 4.6 percent to 5.4 percent might
not seem such a huge jump, especially if we use the new gross
domestic product (GDP) figures from the Central Agency of
Statistics (BPS). But one must question where the source of
growth will come from. Unless investment picks up significantly
it is difficult to imagine this being possible. Investment, in
this case, really depends on foreign sources in direct or
portfolio flows.

Although there is hope that there will be a diversion of the
funds currently being absorbed by China, one must bear in mind
that neighboring countries are currently a lot more attractive.
And with the world economy on a cooling trend, exports can hardly
be expected to grow substantially. Consumption, the mainstay of
growth in recent years, is also showing signs of tapering off.

The inflation and interest rates assumptions also raise
questions. Unless Bank Indonesia raises rates more aggressively,
the current inflation level of around 7.2 percent appears set to
rise, mainly driven by the weak and potentially weaker rupiah.
More importantly is the widespread expectations that inflation
will rise in the near future. Mandiri Sekuritas expects inflation
to reach 7.5 percent by December and 6.5 percent next year.

But if we look at the GDP growth and inflation assumptions in
combination, it might just work! Real GDP growth (5.4 percent)
plus inflation (5.5 percent) becomes the nominal GDP growth (10.9
percent). So if both miss their targets, say growth remains
around 4.5 percent and inflation stays at 6.5 percent, the total
is still around 11 percent. And this will make the nominal GDP in
2005 at about the level assumed. The result: Tax revenues will
probably be realized. As long as the two total up to around 11
percent there really is no need to worry.

Higher inflation entails higher interest rates. So if
inflation is expected to hover around 6.5 percent, it is
reasonable to expect that SBI (Bank Indonesia promissory notes)
rates too will remain at the current level of a little below 7.5
percent. Every one percent increase in the SBI rate increases the
interest burden on floating rate government bonds by about Rp 2.2
trillion (US$256 million). But this must be balanced against the
increase in interest tax of Rp 1 trillion.

We come now to the most glaring difference between assumption
and market reality: The oil price assumption. The current world
oil price is US$48 per barrel. Ignoring the difference between
oil price benchmarks, this is double that used in the budget
assumption.

For every dollar that the world oil price is above the
assumption, the impact will be between Rp 100 billion to Rp 150
billion in extra expenditure requirement, according to the
finance ministry. This is because the central government pays for
all of the fuel subsidies, while revenues must be shared with
regional administrations. Oil analysts maintain that the
political premium of world oil prices currently stands at about
$9-10 per barrel. Therefore the "normal" world oil price should
be around $38-39 per barrel.

So what is the extra expenditure requirement if both the
interest rate and the oil price assumption are incorrect? Adding
the extra interest expenditure requirement of about Rp 1.2
trillion, plus the extra cost of oil -- about Rp 2.25 trillion --
we get Rp 4.45 trillion. Not a huge number in a Rp 380 trillion
budget. Even if we increase the SBI rate to 8.5 percent and the
oil price averaged $40 per barrel next year, the additional cost
is "only" a little less than Rp 6.5 trillion.

Another item that is sensitive to the assumptions is the
payment of foreign debt, which stands at Rp 47.8 trillion. Taking
out the disbursement of foreign loans of Rp 26.6 trillion, we are
left with a net payment of a little over Rp 20 trillion. We have
to add to this to the interest on foreign loans of about Rp 25
trillion.

As a simplification, where we ignore the impact of currency
movements on income (import-export taxes etc.) every time the
rupiah depreciates Rp 100 over the assumed level of Rp 8,600, the
additional loan payment burden rises by about Rp 523 billion.
Should the rupiah weaken significantly, say to Rp 9,200 the
government will have to come up with an extra Rp 3.2 trillion.

These simple exercises using published figures shows that the
additional burden from missing several targets are substantial
but not alarming. It is true that one has to wonder where the
government can find the extra money to cover these additional
expenditure requirements.

One source would be a stronger effort toward privatization, no
matter the political difficulty of doing so. Another source would
be to up-size the issuance of government bonds, already at a
record high of around Rp 20 trillion. These are the easy steps.

More difficult, but more important in the long term, is to
increase efficiency of revenue collection, especially tax ratios,
which by international comparison is very low. Several non-tax
revenue sources should also be enhanced.

A friend recently reminded me that value-added tax revenue is
too low considering that the rate is at 10 percent. Increasing
just this one item to near its potential can easily solve the
presently planned deficit and cover fiscal shortcomings if the
assumptions are wrong.

We are not in wonderland. That is for sure. But if one is
looking for inspiration in the 2005 proposed budget, look
elsewhere.

The writer is the Head of Research at Mandiri Sekuritas. This
column was written in a personal capacity to enhance public
debate.