Unrealistic 2006 budget: The damage has been done

David E. Sumual, Jakarta

In a well-constructed speech, President Susilo B. Yudhoyono unveiled the 2006 budget proposal in his first annual address to the nation last week. Unfortunately, his impressive speaking style cannot of course be a panacea for the country's economic problems, particularly high oil prices.

As mentioned in the president's speech, the major risk in the 2006 budget would be the stubbornly high global oil prices that will force the government to further cut domestic fuel subsidies.

Despite the risk of fuel subsidies blowing out the budget, there is however no dramatic change in the government's fiscal priority in 2006. The government is likely to spend as much as Rp 68.4 trillion, or about 12 percent of the budget, on the fuel subsidies -- or more than twice the amount budgeted for education expenditures. And considering the government's optimistic assumption on global oil prices, outlays for fuel subsidies could be much higher than the expected projection if world oil prices still hover way above the US$40/barrel, assumed for 2006.

The national budget, as well as foreign exchange reserves and Indonesia's economic growth in 2006 will thus remain vulnerable and increasingly at the mercy of international oil-price fluctuations.

More worryingly, such a condition might last at least to the medium-term with Indonesia being a net oil importer. Moreover, the government has sent a signal that further cuts in consumer fuel subsidies will only occur at the beginning of 2006. As such, like a deja vu, Indonesia's economy may again face similar problems to the ones the country faced when fuel prices were raised in March 2005.

The impact of higher fuel prices on business spending plans, inflation and monetary policy in Indonesia will be like those in the second quarter of 2005. As reported by the Central Statistics Agency, both rising fuel prices and higher interest rates have created headwinds and slowed the growth momentum in the second quarter. Second quarter GDP growth slowed to 5.5 percent from 6.2 percent in the first quarter as consumers apparently felt the inflationary pinch and curbed their spending.

At the same time, higher oil prices also weighed on business investment. With inflation starting to creep up, the central bank had no other option but to tighten its monetary stance -- Bank Indonesia has gradually raised its benchmark rates from 7.42 percent when the government decided to hike fuel prices to 8.75 percent now.

And when interest rates started to rise, more and more private businesses postponed their investment in capital goods, thus taking some of the steam out of the second quarter economic growth.

Meanwhile, the government's plan to raise consumer fuel prices again in January 2006 has hit the financial markets. The damage has been done in the stock and bonds market. The Jakarta Composite Index has tumbled 8.8 percent over the past two weeks to its lowest level of 1087.9 in almost three months. At the same time, the rupiah, which hit a three-and-a-half year low of 9,975 to the dollar on Aug. 19, has lost 6.8 percent of its value against the dollar this year. Even worse, the rupiah depreciation took place although the monetary authority has sacrificed around 15 percent of its foreign exchange reserves since April 2005 to defend the local unit.

Although fuel price hikes make sense from a fiscal and economic standpoint, the president may still harbor concerns over the political backlash and the negative impact on his popularity. Given his personal traits, Susilo will not want to break his earlier pledge to the public that the government would endeavor not to raise fuel prices again this year. However, this does not change the unpalatable reality of fiscal distress if it still bears the higher cost of oil to cushion Indonesians from external developments.

Assuming an average oil price of $60/barrel, the country's fuel subsidies could reach Rp 126 trillion in 2005 and the budget deficit would reach Rp 45 trillion. Under the $65/barrel scenario, fuel subsidies would swell to Rp 140 trillion, or nearly double the Rp 76.5 trillion budgeted for in the 2005 budget.

To cover the around Rp 21-27 trillion financing gap (assuming oil prices hover around $60-65/barrel till the end of the year), the government plans to take a number of measures including the issuance of new bonds, privatization and asset divestment. However, issuing bonds, privatization and sales of state assets in a bearish financial market are not supposed to be a priority.

This is a risky option. If investors are uninterested in the government's plans to issue bonds and sell assets, Indonesia might again suffer oil shortages in the fourth quarter at the latest as the country would not have the funds to finance oil imports.

It appears that the financial markets may continue to remain under pressure in the next five months prior to the government's actual decision to raise fuel prices. In the time being, the uncertainties in terms of the size and the exact timing of fuel price hikes may prompt "speculative motives" with rogue traders piling up subsidized fuels and opportunist traders raising their prices.

Accordingly, such speculative behavior would create a cost- push inflation spiral in the months before the announcement, forcing the central bank to jack up benchmark interest rates beyond the 8.75 percent level today.

Given the heightening uncertainty, there is also the risk that the capital outflow from foreign portfolio investors would cause the rupiah and the country's reserves to tumble further. With Bank Indonesia continuing to intervene in the currency market in the next five months, the country's reserves could plunge below $30 billion, creating a negative perception that the forex reserves are not sustainable and would not be enough to defend the rupiah.

At the same time, domestic companies may reschedule their investment plans, waiting for inflationary developments -- at least until the second quarter of 2006 after the government cuts the fuel subsidies.

The infrastructure summit that will be held in November may again fail as the first one early this year as investors are still in wait-and-see mode. Due to the prospect of heightening inflation and a beleaguered rupiah, most infrastructure investment may hinge on Indonesia's political and economic developments beyond January 2006. As such, expectations that infrastructure investment will pour into the country in 2006 will be as unrealistic as the previous hopes that it would materialize in 2005.

As such, it would actually be better for the government to cut the fuel subsidies sooner rather than later. The economy is subject to high risks if the government leaves the budget open and unhedged against world oil price fluctuations.

Equally important, reverting again to the MOPS (Mean of Platts Singapore) as was done in 2003 to allow fuel prices to fluctuate in reference to the international standard should be a medium term objective. A strategic energy policy that may determine Indonesia's existence in the future should not again be exploited as a catalyst to boost popularity at the expense of the country's economic sustainability.

The writer is an analyst at the Danareksa Research Institute. This article represents his personal views.