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.