Indonesia's prudent policies get a helping hand from global markets

In a momentous development for the country, the newly elected president, Joko Widodo, followed through on campaign promises to do away with fuel subsidies in Indonesia. In addition to a 30% petrol price hike unveiled in November 2014, the new administration announced it would eliminate the majority of support beginning in 2015, ending a 48-year-old programme that cost the government billions of dollars each year.

Removing subsidies to make room for infrastructure development has been a priority for decades, but Widodo appears to be the first president able to effectively end petrol subvention since it began, thanks in large part to near-perfect timing. When the cuts were announced in November 2014 the global oil market was in the midst of a free-fall that saw prices drop by more than 60% between June 2014 and January 2015, effectively muting the price shocks consumers would have otherwise experienced. The decision will likely have a mixed, but ultimately positive impact on the economy. Although oil prices remain weak, a return to the $ 100-per-barrel days could hit consumers hard, and remains a source of political risk. At the same time, the new fiscal space created has enabled the Widodo administration to announce major investments in much-needed infrastructure – a critical priority as the government seeks to increase exports and curb the trade deficit.

Petrol Prices

The November 2014 price hike was the first step in the plan to eliminate the costly subsidies. Fuel price rises had been under discussion for months, particularly in the lead-up to the July 2014 presidential elections, and economists had long called for a phasing out of subsidies, which were projected to have cost the country $21bn in 2014. The initial increases saw petrol prices climb from Rp6500 ($0.54) per litre to Rp8500 ($0.70), while prices for diesel rose from Rp5500 ($0.45) to Rp7500 ($0.62). In December the new administration announced it would cap the existing diesel subsidy and eliminate all petrol allowances, effective January 1. According to the authorities, retail petrol and diesel prices would be determined on a monthly basis and fluctuate in line with international prices. The diesel subsidy was fixed at Rp1000 ($0.08) per litre, with prices set at Rp7250 ($0.60) in January, while kerosene prices for the month remained unchanged at Rp2500 ($0.21). Petrol prices were pegged at Rp7600 ($0.63) per litre in January.

High Costs

First introduced in 1967 by then-president Suharto, retail fuel subsidies quickly became a policy mainstay and something of a political third rail in the country. Suharto was ousted in 1998 after protests stemming from IMF-mandated fuel subsidy cuts, and former President Susilo Bambang Yudhoyono also faced protests when he moved to raise prices in 2012.

Although subsidies were meant to keep fuel products affordable for the poor and raise household incomes, a 2013 World Bank Institute (WBI) report found that the actual beneficiaries were middle- and high-income Indonesians, as the per-litre savings benefit those who use the most petrol. The top half of households by wealth consumed around 84% of subsidies, while two-thirds of poor and near-poor households did not consume any petrol at all.

Subsidies have also had a substantial impact on public spending, rising significantly since they were first introduced. Between 2001 and 2008 fuel subsidies comprised 10-28% of the national budget, according to the WBI report. The IMF warned that imports would reach record levels in the coming decades, making the country’s fiscal position increasingly vulnerable to global oil fluctuations. Indeed, from the mid-2000s to 2013 Indonesia’s oil spend nearly quadrupled, reaching $39bn, while the cost of fuel subsidies rose from Rp137trn ($11.32bn) in 2012 to Rp246.5trn ($20.38bn) in 2014.

The rupiah has depreciated against the US dollar since mid-2011, declining by 21% in 2013 and falling to a 16-year low of 12,820 in February 2015, which has served to increase the nation’s debt repayment burden. In 2012 the country recorded its first current-account deficit since 1997. A $20bn drop in foreign reserves between 2011 and 2013 – although the reserves still total more than $100bn – has made the subsidies increasingly unsustainable.

At the same time, robust growth and rising domestic consumption have put more cars and motorcycles on the roads. From 2000 to 2014 annual GDP growth averaged over 5%, while estimates of the size of Indonesia’s growing middle class range from 44m to 146m people, with the Boston Consulting Group projecting the number of middle-class and affluent consumers will double by 2020. Infrastructure constraints have remained an obstacle to growth, with fuel subsidies outweighing infrastructure spending threefold in 2013. According to a December 2014 report by the IMF, reforms such as closing the infrastructure gap could raise growth to over 6% in the medium term, compared to 2014’s projected 5.02% increase, a five-year low.

Feedback

When the original price hikes were announced in November, economists praised the government for boosting prices by Rp2000 ($0.17), though many had called for a steeper increase. The price hikes were expected to save the nation $8bn in 2015, but the move to completely eliminate petrol subsidies resulted in $18bn of savings in the revised 2015 budget. These savings will be used to double capital expenditure (see analysis), a critical step towards improving transport links and boosting foreign direct investment and exports. As corporations do not consume subsidised fuels, any potential price shocks will be worst felt by consumers, and an oil market recovery remains a considerable risk factor for the new administration.

“In 2011 fuel prices were Rp4500 ($0.37) per litre. This changed to Rp6500 ($0.54) in 2012, and at the end of [2013] it rose to Rp8500 ($0.70) before dropping to Rp7600 ($0.63) in January [2014], so in less than four years fuel prices have basically doubled. The exchange rate being what it is, fuel is still very cheap compared to other countries; however, for the Indonesian consumer it is still quite an increase,” Dirk Koehnlein, head of automotive at KPMG Indonesia, told OBG.

Shock Absorber

The administration is taking steps to mitigate the impact on low-income Indonesians, pledging cash transfers to families most affected by the increase, in keeping with the prior administration’s proposed strategy. The reforms came in the midst of a global decline in oil prices, which saw Brent crude drop from a high of $115 per barrel in June 2014 to $45 in January 2015. New production from US shale gas fields, as well as the Organisation of the Petroleum Exporting Countries’ decision to maintain production and exports, has led to forecasts that the market will remain depressed until 2016, with Brent crude standing at just under $65 per barrel as of late June 2015.

Thanks to these favourable market developments, even industries that benefitted most under the subsidies have voiced support for their elimination. Prijono Sugiarto, president-director of the country’s largest automobile distributor, Astra International, told media in November that he supports subsidy cuts, as the expected long-term benefits will ultimately outweigh the short-term drawbacks. “It is a mixed scenario. Increased oil prices almost always lead to a reduction in consumer vehicle purchases, and this is the main reason why, in the last quarter of 2014, the purchase of vehicles declined. So we definitely saw an impact at the end of 2014. However, this will most likely be reversed in the beginning of 2015, because the oil price reduction has led to a drop in fuel prices below Rp8500 ($0.70),” Koehnlein told OBG.

Rate of Change

The prospect of higher fuel prices prompted Bank Indonesia (BI) to raise its benchmark interest rate by 25 basis points to 7.75% after the subsidy rollbacks were announced in November 2014. At the time, the deputy governor, Pak Mirza, forecast that higher fuel prices would add as much as 2.6 percentage points to inflation, to reach 7.9% by end-2014. However, inflationary concerns appear to have been overblown. Inflation fell to 6.3% in February 2015, closing in on the central bank’s target of 3-5%, which led the BI to reduce interest rates back to 7.5% in March.

This came as a surprise to stakeholders. BI had been widely expected to further tighten lending in 2015; inflation was still above target at 7% in January, and a rate hike would have helped to soften the blow from the US Federal Reserve’s own rate increases, expected later in the year. However, according to the bank, inflation is likely to fall within the lower end of the targeted range in 2015 and 2016, and lower interest rates will help address the country’s current account deficit. The resulting currency depreciation is set to benefit exporters and raise the cost of imports, signalling that the BI has shifted its stance to favour a weaker rupiah. According to a report in Indonesia Investments, BI also expects that capital inflows stemming from the European Central Bank’s quantitative easing programme, which began in March, will offset the negative impact of an eventual rate hike in the US. While the consumer price risk remains, the benefits of subsidy elimination outweigh the drawbacks, and exporters, politicians and industry stakeholders appear confident that the decision will, at least in the medium term, have a profoundly positive impact on economic growth in the country.