Indonesia’s economy continues to remain healthy with Q1 2013 GDP growth of 6.0 percent year over year. A probable revival in exports in the latter half of the year is likely to aid the economy, already benefitting from strong consumer spending and investment. However, any slowing of economic growth in China could play spoilsport by pushing commodity prices lower, thereby denting exports. Nevertheless, Indonesia’s large and young population, strategic location in Asia, and investment attractiveness would continue to aid the economy, keeping GDP growth in the 5.5–6.0 percent range over the next few years. In fact, growth could be higher if infrastructure development accelerates and key reforms to ease the labor market and deregulate industries are implemented. In this context, the government’s recent attempt to revamp the fuel subsidy regime assumes importance.
Hike in the administered price of fuel—a step in the right direction
On June 17, Indonesia’s House of Representatives approved a revised budget for 2013. Of particular interest were two key provisions: a 44 percent hike in the price of petrol and a 22 percent rise in the diesel price. This was the first rise in the administered price of fuel in the country in about five years. For years, heavily subsidized fuel prices have burdened Indonesia’s economy—distorting prices (and hence demand) while undermining public finances. Most importantly, the subsidies have prevented government revenues from being directed toward more urgent needs, primarily infrastructure development and poverty alleviation. The new legislation goes a step in changing these unhealthy dynamics. Although similar reforms were earlier met with public protests, this time both consumers and businesses seem to agree on the need to deregulate fuel prices in line with global trends.
Impact of higher fuel prices on inflation—central bank to be proactive in curbing price pressure
The key short-term impact of the rise in fuel prices would be on inflation: The government expects inflation to rise to more than 7 percent this year from 4.3 percent in 2012. Favorably for the economy, Bank Indonesia (BI) is expected to take a proactive stance to counter the threat. In June, BI surprised markets by raising its key policy rate by 25 basis points (bps) to 6 percent, the first hike since 2011, to check inflation expectations and the fall in the currency. The Indonesian rupiah has been weakening steadily against the US dollar since mid-2011, declining by more than 14 percent, due to a deteriorating current account and capital outflows. The latter trend has become prominent, especially after US Federal Reserve chief Ben Bernanke’s comments about a possible winding down of its $85 billion bond-buying program from the latter half of 2013. A weaker rupiah would lead to imported inflation and thereby make BI’s efforts more difficult. In the event that capital outflows continue and price pressures remain, BI would raise rates again, possibly by an additional 25–50 bps in the remainder of the year.
Public finances and external balances likely to improve
The government is expected to save more than $7 billion in energy subsidies due to the hike in fuel prices. Of this, some amount has been earmarked to compensate poor families. Over the next four months, the government intends to distribute about $1 billion to nearly 15.5 million poor households. Some of the remaining funds are likely to be used in infrastructure development and poverty alleviation. The cutbacks would contribute to a stronger budget balance: The deficit is expected to decline to 1.3 percent of GDP in 2013 (from 1.8 percent in 2012), and then further to about 0.5 percent in the next few years. The removal of subsidies would also help to reduce the fuel import bill by lowering demand. As a result, the current-account deficit is set to reduce from 2.7 percent of GDP in 2012 to less than 2 percent over the next two years.
Indonesia’s economy continues to remain healthy with Q1 2013 GDP growth of 6.0 percent year over year. A probable revival in exports in the latter half of the year is likely to aid the economy, already benefitting from strong consumer spending and investment.
Impact on consumers and businesses—real income and profit margins to be hit
Consumers are likely to be hit by a rise in fuel prices, as the resultant increase in inflation would dent real income. As a result, private consumption growth is expected to decline to 4.7–5.1 percent this year from 5.3 percent in 2012. However, consumers remain optimistic about medium- to long-term economic growth and the job market. Also, medium- to long-term growth prospects remain intact. As the impact of the price rise wears off, private consumption growth is likely to move up to more than 6 percent in 2014–15.
Higher fuel prices would hit businesses in the form of increased costs, thereby affecting profit margins. However, they would also force businesses to be more efficient, leading to gains in competitiveness in the medium to long term. Meanwhile, changes in investment plans by the domestic private sector in 2013 are likely to be offset by higher government investment in infrastructure and continued foreign direct investment (FDI) inflows. This is likely to push gross fixed investment up by 5.8–6.0 percent this year. Interestingly, changes to the fuel subsidies are being viewed positively by foreign investors. If they are complemented by efforts to increase business transparency, ease regulations, and tackle widespread corruption, an improvement in sovereign ratings is most likely. This would encourage more FDI inflows.
Precursor to more reforms?
The removal of fuel subsidies might not herald an era of strong reforms. President Susilo Bambang Yudhoyono’s second term in office will come to an end in 2014, and he is prevented by the constitution from running for a third time. Even though the current finance minister has strong pro-market credentials, he has very little time to push other reforms. Also, key reforms to improve competitiveness in the economy, including changes to the labor market, are likely to be more contentious with elections around the corner. The elections have also introduced a whiff of nationalism, especially in policies related to resource-based industries. New regulations in mining restricting ownership rules for foreign investors, a proposed royalty hike for foreign miners, and taxes on mineral ores are likely to keep investors wary of the country’s resource sector. Most importantly, although President Yudhoyono failed to implement major reforms, he had enough public support to carry him through. A new president might not enjoy the same level of support and hence find it tougher to push a reform agenda.