Subsidy cuts create fiscal space to boost infrastructure spending in Indonesia

In 2014 Indonesia elected a new president, Joko Widodo – a development of significant interest to both national and regional stakeholders, as well as global investors and economists. A self-made businessman whose background and policies have resonated with Indonesians, Widodo ran on a platform that included cracking down on corruption, improving the quality of life outside the country’s major urban centres, boosting foreign direct investment (FDI) and increasing government expenditure on critical infrastructure. After being elected, Widodo announced the government would eliminate billions in fuel subsidies, creating the fiscal space to increase public spending.

New Leader

Widodo ran on a nine-point platform of reform and growth, known as Nawa Cita, which promised to overhaul bureaucracy, improve public services and spending, and increase investment in infrastructure. It also included plans to create a one-stop shop for investors to streamline the process for issuing business permits. Unveiled in January, the new administration’s revised 2015 budget reduced spending by 2.7%, to Rp1984trn ($164bn), despite projections for oil and gas non-tax revenues being cut by nearly two-thirds since the September version of the budget. Targeted tax revenues were up 7.9% at Rp1489trn ($123.11bn), for a budget deficit of 1.9% of GDP, below the 2.21% forecast in the prior draft. The revised budget plans to nearly double capital expenditure, a move made possible by an earlier decision to reduce and eventually scrap fuel subsidies on low-octane petrol. A more than 30% price hike was announced in November 2014, with subsidies on a variety of fuels almost completely scrapped as of January 1, 2015 (see analysis).

Fiscal Space

Around Rp230trn ($19.01bn) was saved as a result of these cuts, 60% of which was allocated to infrastructure development. A portion was used to pay a Rp25trn ($2.07bn) carry-over subsidy to the state-owned energy company, Pertamina, in addition to electricity subsidies for the state utility company, Perusahaan Listrik Negara. Social security and direct transfers to villages are set to receive a boost, while some Rp39.92trn ($3.3bn) will be used to fund 35 state-owned enterprises. The subsidy cuts bode well for development. In 2012 the government spent three times as much on subsidies as it did on infrastructure or health care, with subsidy costs estimated at $21bn in 2014. Initially forecast to account for 13% of total spending in 2015, fuel subsidies have been reduced to just 1%. After more than four decades of subsidies, this is a major policy shift for the country, facilitated by the drop in oil prices in the second half of 2014.

Infrastructure Surge

In the revised budget, capital expenditure will reach Rp290trn ($23.97bn), an increase from Rp139trn ($11.49bn) in the previous version. Infrastructure will receive Rp281.1trn ($18.03bn) in 2015, part of an estimated Rp5519.4trn ($456.23bn) in planned investment over the next five years, according to Andrinof Chaniago, minister of the State Ministry of National Development Planning. Infrastructure-related ministries, such as the Ministry of Transportation (MoT), Ministry of Public Works (MPW), Ministry of Public Housing (MPH) and the Ministry of Agriculture (MoA), will benefit the most, with the minister of finance, Bambang Brodjonegoro, urging them to focus on ready-to-build infrastructure projects, emphasising the timely development of critical works.

The MPW and MPH will receive a total of Rp33trn ($2.73bn) that is expected to be used on construction of dams, water facilities, housing and roads, which will help to reduce the cost of electricity and regional transportation. The MPW’s 2015 budget stands at Rp117trn ($9.67bn), up nearly 40% over the prior draft. This should help support the timely development of the $30bn, 2700-km Trans-Sumatra toll road project, scheduled for completion in 2025. The MoT will use its Rp65trn ($5.37bn) budget to develop railway networks, seaports and airports – a welcome step for the nation’s exporters. “Infrastructure, transportation and logistics costs are very high. From central Java to Jakarta, a 600-km journey, the shipping cost for one container is $1000. Shipping that same container from Jakarta to Shanghai costs $200,” Ade Sudrajat, the chairman of the Indonesian Textiles Association, told OBG. “At one point Indonesia had nearly 7000 km of rail lines, and now we have only 3400 km. So we are very hopeful the rail lines will be upgraded soon.”

Air & Sea

The MoT plans to build and upgrade regional airports and create capacity to handle larger aircraft. Airport upgrades have gathered pace in recent months. According to the Centre for Aviation, the MoT’s airport public-private partnership programme was ready to launch its first phase in late April 2014, opening management bids for the Bandar Lampung Radin Inten II, Komodo and Palu Mutiara regional airports – the first three of 10 expected to benefit from the programme.

In November 2014 Widodo announced plans to invest $6bn to expand the country’s ports. In January 2015 the state-run port operator Pelindo I revealed a $2.7bn programme to modernise and expand five of its ports over the course of the year. The facilities scheduled for upgrades include the Malahayati, Belawan Kuala Tanjung, Dumai and Batam ports.

The boost in expenditure has been welcomed by many stakeholders. The construction industry will almost certainly benefit, while toll-road operator Jasa Marga, port contractor Pembangunan Perumahan and cement firm Indocement Tunggal Prakarsa are all expected to show significant earnings growth in 2015, according to Anthony Yunus, equity analyst at Nomura Indonesia.

Revenue Sources

The government will still face challenges in terms of implementing its new budget. Underspending has been a consistent obstacle to development. In 2014, for example, actual expenditure fell 6% short of budget targets as a result of slow project implementation and falling global commodities prices, while only 84% of infrastructure funding was dispersed, due to delays in the tendering process. “In the past, increased expenditure has always been in the budget plan, but in reality, expenditure is never as much as the target,” Didik Rachbini, economist at the Institute for Development of Economics and Finance, told OBG.

To avoid a repeat of past performance, the Widodo administration plans to increase tax collection in 2015. The revised budget targets Rp1489trn ($123.11bn) in tax revenues in 2015, compared to around Rp1380trn ($114.07bn) in the original budget. The government hopes to increase the ratio of taxation to GDP from around 12% to 16%, bringing the country more in line with Singapore (14%), Malaysia (15.5%) and Thailand (17%). Tax revenues will be particularly important in the wake of a steep decline in oil prices and a ban on the export of certain raw materials, enacted in January 2014, which will impact revenues from the energy and mining sectors. However, given the fact that tax collection missed the target by nearly 8% in 2014, creating a Rp103trn ($8.5bn) shortfall, and in first-quarter 2015 tax collection was down 12% compared to fourth-quarter 2014, questions about the likelihood of meeting the 2015 target remain. This is a potential weak spot in the proposed spending plans, though the creation of an autonomous tax agency, expected to begin operating in 2016, could yield efficiencies (see analysis).

FDI Boost

In addition to improving taxation, the government is also working to reform the current investment legislation in a bid to attract more FDI, increase exports and reduce the trade deficit. In February 2015 Brodjonegoro announced the government would revise regulations on tax allowance and incentives in special economic zones in a bid to promote more investment. These reforms have been under way since 2014, when the Ministry of Finance (MoF) floated the idea of granting tax incentives to companies that reinvest earnings in Indonesia and broadening the scope of industries eligible for tax breaks. In 2014 FDI increased by 13.5% to reach Rp307trn ($25.38bn). The MoF is also considering easing the requirements for current tax holidays, which offer a five- to 10-year tax break for companies that invest a minimum of Rp1trn ($82.66m).

Bright Forecast

In the near term it will be difficult to quantify the benefits of new infrastructure investment. The life cycle of major projects will likely entail increased imports in their early stages, and infrastructure deficiencies will continue to hamper timely progress on new builds. At the same time, export growth remains limited by lack of value-added production and processing facilities, making industrial investment another critical priority for the new government. However, given Indonesia’s track record of strong GDP growth, its rapidly expanding middle class, rising FDI levels and significant allocations for infrastructure development, optimism for both the new budget and new president remains high, painting a promising picture for growth.