2008 state budget: Is fiscal spending going up in smoke?

Helmi Arman , Analyst | Wed, 02/27/2008 12:08 PM | Business

Last week, the draft revision of the 2008 state budget was laid out. Amid an increase in global oil prices, expenditures will outstrip revenue by another 18 percent from the initial budget, to around Rp 86 trillion. This is equivalent to around 2 percent of the country's economy, or gross domestic product, from 1.7 percent initially.

The bond market has recently been pondering how the wider fiscal deficit will be financed. Officials insist additional bond issuances needed to finance the shortfall are still consistent with the market's capacity, and that no crowding out will occur as a result.

Plans to diversify sources of financing were conveyed in a timely manner, although more convincing needs to be done judging from the recent decline in government bond prices.

In spite of that, financing is really not the major issue to worry about, in our view. The market's concerns about an oversupply of bonds are likely to be temporary.

When put in perspective, the need for an additional Rp 25 trillion in bonds to finance the deficit is not that overwhelming. Once bond yields adjust to a new equilibrium, market appetite may eventually recover.

The wider deficit target also doesn't represent a threat to fiscal sustainability. The deficit is still small relative to other countries.

India and Malaysia's fiscal deficits, for example, are expected to exceed 3 percent of GDP this year, a much higher level. Furthermore, even with our higher deficit target, the stock of government debt in relation to GDP -- which is a key indicator of fiscal sustainability -- will still decline from last year by several percentage points.

So what's to discuss? From an economist's point of view, it's hard to cope with the idea that the nation must accumulate more debt and face burgeoning interest payments (through higher bond yields) just to finance spending on subsidies.

Note that in the new budget, capital expenditure will actually be cut by more than 15 percent from originally planned. Officials argue that the halted projects are non-priority in nature, and capital spending will still be higher compared to 2007.

However, it is still regrettable that the savings from the cut-back is not used to finance other productive spending. Instead, it will be used to finance ballooning subsidies on fuel and food.

Spending on subsidies (energy and non-energy) will be doubled from the initial budget; i.e. to around Rp 208 trillion. This is equivalent to approximately one-quarter of domestic revenue.

As another Rp 94 trillion will be spent on interest payments, the amount spent on both subsidies and interest payments thus adds up to 44 percent of domestic revenues, enough to make a few jaws drop.

Just for comparison, the amount of spending allocated for the Education Ministry is just in the region of Rp 42 trillion, or 5 percent of domestic revenue.

Think of a bond investor as a bank (and some bond investors actually are) that is considering whether or not to make a loan to a company. The bank will lend as long as it thinks the loan can be used productively; i.e. to generate returns sufficient to pay off the interest rate and principal on the loan.

The bank will have to think twice if it knows the company will use the loan to finance handouts and cash giveaways.

High oil, as well as food, prices is a global phenomenon which appears to be here to stay. Sooner or later, the country will eventually have to find a way to deal with it.

The focus now should be on letting the economy cope with higher oil prices in a gradual manner; i.e. through slowly making consumers pay more for their fuel. The cap should be on the subsidy, not on the fuel price.

It makes little economic sense to keep fuel prices artificially low (although it does make obvious political sense). Delays merely heighten the risk of another abrupt adjustment in fuel prices -- as witnessed in 2005 -- which would be more detrimental to the economy and would have implications that are much harder to predict.

Maybe when the horizon is lengthened after 2009 will common sense prevail.

The writer is an economist at PT Bahana Securities.

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