Oil dilemma: The ramifications of fuel price hikes

Purbaya Yudhi Sadewa ,  Analyst   |  Thu, 05/22/2008 11:02 AM  |  Business

In response to rises in global crude oil prices, the government has announced it will soon increase fuel subsidies. This has fueled concerns inflation and interest rates will follow suit, leading to weaker purchasing power, and slower economic expansion.

However, careful analysis of the situation suggests there will not be significant reduction in Indonesia's economic growth rate in the immediate future.

In 2007, the average price of WTI -- a global benchmark for oil prices -- was US$72.3 per barrel, while ICP (Indonesian Crude Price) averaged $69.9 per barrel.

In early 2008, oil prices started to rise, before falling slightly in late January, and climbing sharply again in mid-February 2008. In May 2008, WTI surpassed $120 per barrel.

In the January-May period, WTI averaged $104.1 per barrel, with ICP at $98.7 per barrel.

The sharp increases have threatened the sustainability of the 2008 state budget, which assumes ICP to be $95 per barrel (on average, ICP is $5 below WTI).

The government has subsequently had to allocate around Rp 126.7 trillion ($13.6 billion) for fuel subsidies.

As the budget deficit (currently planned at around 2.1 percent of GDP) has continued to increase, the Indonesian bond and equity markets have grown nervous.

Fortunately, there is some budget flexibility as the House of Representatives has cleared room for the government to raise fuel prices should oil exceed $100 per barrel. In doing so, they have significantly reduced the threat to the state budget.

With little hope global prices will fall below $100 per barrel, the government announced it would raise fuel prices in early June in an effort to prevent fuel subsidies from ballooning.

The finance minister has suggested the government is likely to raise subsidized fuel prices in June by an average of almost 30 percent.

The planned increases suggest the government assumes ICP will stay at around $110 per barrel (and WTI at $115 per barrel) during the May to December 2008 period.

With the price increases, the fuel subsidy would be capped according to the already approved 2008 state budget, thus eliminating the uncertainty of the impact of high global oil prices on the state budget.

The announcement has already helped restore investor confidence in the state budget. The JCI (Jakarta Composite Index) has risen sharply since the government's announcement, and Indonesian bonds have also gained.

So, what of the impacts on inflation, interest rates and economic growth?

According to our calculations, a 10 percent rise in the price of subsidized fuel would increase inflation by 0.7 percent. Thus, a 30 percent increase in fuel prices in June would increase inflation 2.1 percent.

The year-on-year inflation rate could rise to 11.3 percent in June, while this year's rate is expected to reach 10.66 percent.

The central bank will likely increase its benchmark rate, although we do not believe the rise will reach a level that would hurt the economy. By the year's end, we expect the central bank to have increased its BI rate to 9.0 percent, with little impact on economic growth.

As long as the BI rate holds below 10 percent, the economy should continue to expand healthily.

In the 2003-2006 period, Danareksa's Coincident Economic Index or CEI (an index that tracks current economic conditions) rose when the BI rate was below 10 percent. A slight increase in the BI rate did not affect CEI's gain, suggesting the economy continued to expand.

However, as soon as the BI rate hit 10 percent, CEI held firm. When the BI rate moved beyond 10 percent, CEI started to fall, suggesting the economy started to contract.

The behavior of the economy has not changed significantly over the last five years. As such, CEI is likely to continue increasing (i.e. the economy shall expand) as long as the BI rate remains below 10 percent.

In March 2005, the government increased fuel prices by 30 percent on average, and by 126 percent in October 2005. Our calculations show every 10 percent rise in fuel prices will reduce GDP growth by 0.02 percent.

The 30 percent planned fuel price increases are therefore likely to reduce GDP growth by 0.06 percent. Thus, we expect the economy to grow 6.28 percent in 2008, or slightly less than our original forecast of 6.34 percent.

The writer is an economist at Danareksa Sekuritas.

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