Fuel for thought: Petroleum subsidies are a hot election issue

As a net oil importer, Indonesia’s most pressing fiscal challenge remains its large subsidy bill, which at around 20% of the 2013 budget – some $30bn – accounts for as much spending as education. Although there is widespread agreement that the subsidies are wasteful and disproportionately benefit more affluent Indonesians – the World Bank estimated in 2011 that the richest half of households consumed 84% of subsidised fuel – the politics of raising prices have been daunting. Well-publicised efforts to lift subsidies on electricity and fuel stalled by March 2012, but the government has given itself room for manoeuvre in 2013. As electricity prices rise in 2013 the government will act secretively on any potential fuel price increase to avoid a repeat of the high inflationary expectations witnessed in the first half of 2012. While higher fuel prices would combine with rising minimum wages to increase inflation, lower budgeted spending on subsidies would free up resources for targeted support of lower-income earners and investment in infrastructure development. High oil imports and a reduction in the value of the currency, which kept the value of imports and the current account deficit high in late 2012, have added to the urgency of reforming Indonesia’s subsidy structure.

POLICY-MAKING: The government’s efforts at raising fuel and power prices in 2012 remained frustrated by the need for elusive parliamentary approval; total energy subsidies accounted for 19% of government spending in 2012 according to the Organisation for Economic Co-operation and Development (OECD), down from 22% in 2011. The lion’s share of the subsidy bill is spent on fuel and electricity: 55% of total subsidies in 2011 were for fuel, or Rp130trn ($13bn) in 2011, while Rp66trn ($6.6bn) were for electricity. Much of the subsidised fuel is used for wasteful private transportation purposes rather than for productive capacity. Over 90% of subsidised fuel is used for transport purposes according to the Ministry of Energy and Mineral Resources, with 53% used by private vehicles and 40% by motorcycles. Subsidised fuel consumption has been growing apace, with the fuel quota 44.04bn litres in the revised 2012 budget standing some 4.04bn litres above the original 2012 budget quota. On a purchasing power parity basis meanwhile Citigroup estimates that Indonesia’s oil consumption per unit of output is higher than the Philippines and South Asia. Closing the gap between domestic and international oil prices would, therefore, institute a pricing regime that more closely resembled the market risk-opportunity cost, while also improving the commercial viability of alternatives to fuel.

DISCUSSING SUBSIDIES: The original plan in 2012 had been to raise electricity prices by 15% and fuel prices, fixed at Rp4500 ($0.45) per litre, by Rp1500 ($0.15) a litre, or one-third. Although legislative approval of electricity price hikes has always been mandatory, it has only been in the last two years that the Cabinet has had to submit to parliamentary approval to lift fuel prices. With the ruling Democrat Party controlling roughly 60% of votes, including allied parties, it has faced intense negotiations to enact such legislation, which requires a two-thirds majority in parliament. While parliament set a threshold of international oil prices remaining above $115 a barrel for three consecutive months as a precondition for lifting fuel subsidies – an onerous level only seen fleetingly in 2008 – opposition parties rejected electricity price increases in 2012. However, the debate itself caused inflation expectations to adjust to higher prices, resulting in a temporary heating of inflationary pressure in the first quarter of 2012.

Learning its lessons, the government succeeded in amending the rules for subsidy adjustments in the 2013 budget. The first success was parliament’s approval of a 15% electricity price increase for 2013, although it remained unclear in December 2012 whether the price rises would be implemented on a gradual, more politically acceptable, basis (either monthly or quarterly) or all at once to reduce the inflationary impact. Lower-income power consumers, using 450 volt-ampere to 900 volt-ampere subscriptions, will be exempted from the 15% price increase. The Cabinet also regained full authority for lifting fuel subsidies, allowing it to raise prices unilaterally as it had done in 2005, 2008 and 2009. “Given the rise in inflation expectations we saw in the first half of 2012 as people expected fuel prices to rise Rp1500 ($0.15) a litre even though this did not happen, the government will act more secretively in 2013 if and when it raises prices,” Luky Alfirman, head of the Ministry of Finance’s centre for macroeconomic policy, told OBG. Yet, it remained unclear in early 2013 whether and how fuel prices would be raised.

POLITICALLY SENSITIVE: With presidential elections looming in 2014 the political considerations of a cut in subsidies remain substantial - while President Susilo Bambang Yudhoyono will not be seeking re-election his ruling Democrat Party will field another candidate and will likely be cautious in endangering its chances at re-election. Yet with a growing business lobby in favour of channelling subsidy spending towards more productive purposes, analysts see a window of opportunity for the raising of fuel prices during the first half of 2013, which allows sufficient time before the election campaign begins in earnest.

“If oil prices breach $115 a barrel in 2013, the government will have to lift fuel subsidies,” Anton Gunawan, chief economist at Bank Danamon, told OBG. Others doubt there is sufficient political will for such a politically sensitive move in the absence of significant new fiscal pressure. “It seems unlikely the government will lift fuel subsidies in the run-up to the 2014 election, particularly barring any fiscal crisis that seems unlikely given subdued oil prices and the state’s comfortable position,” Fauzi Ichsan, managing director and senior economist at Standard Chartered Bank, told OBG.

ACCEPTABLE IMPACT: Based on an oil price assumption of $100 a barrel, the 2013 budget still allocates some Rp274.74trn ($27.4bn) to energy subsidies, higher than budgeted spending on infrastructure of around Rp210trn ($21bn) according to the OECD. With power consumption rising some 10% a year, the 15% price increase will reduce power subsidies to Rp41trn ($4.1bn) of government spending, down from Rp55.1trn ($5.5bn) in 2010 according to the Ministry of Finance. Meanwhile, a fuel price increase of only Rp500 ($0.05) a litre would save the treasury some Rp20trn ($2bn) out of a fuel subsidy bill of some Rp193.8trn ($19.3bn) in 2013. These savings would be an encouraging first step in reducing the fiscal burden.

More significant for investors, the impact of subsidy cuts on inflation may nudge the consumer price index above 5% for the first time in the last year. “The only potential impact of fiscal policy on inflation pressure is through the partial lifting of subsidies on electricity, and perhaps cuts to fuel subsidies, in 2013,” Bimo Epyanto, senior economic analyst at Bank Indonesia, told OBG. The electricity price rise is expected to add 50 basis points to the headline inflation figure according to Bank Danamon calculations. A rise of Rp500 ($0.05) a litre in the fuel price would add 70 to 80 basis points to inflation, while a Rp1500 ($0.15) a litre price hike would add up to 270 basis points, according to Bank Danamon. With the more drastic price increase the least likely, the potential impact on inflation is not expected to be excessive. By late 2012 most banks had priced in a mere 25 basis points increase in the central bank’s benchmark interest rate in 2013.

While the politics of subsidy reform remain perilous, the government has gained some leeway in raising domestic power and fuel prices in 2013. The impact of such cuts will be broadly positive for the country as the government gains more fiscal space to develop much-needed infrastructure, while inflationary pressures will be largely contained. As the government’s efforts to reduce fuel consumption and better target subsidies to the more vulnerable segments of the population will take a longer gestation period, it will need all its political courage to enact reform on fuel subsidies in 2013.