The budget deficit after the fuel rise: Back to square one

Andry Asmoro ,  Analyst   |  Wed, 06/18/2008 10:44 AM  |  Business

Oil prices have defied the best of predictions. Three months ago the price of crude oil passed US$100 a barrel for the first time ever. In the four months since, it increased another 40 percent, closing in on $140 per barrel, translating to an 85 percent year-on-year increase.

Nearly every day we see a new record high for the price of crude. If you thought the Indonesian economy was in trouble when the oil price hit $100 a barrel, imagine the consequences should it reach $200 per barrel.

Hence, the fear of an incessantly increasing oil price has become an everyday discussion topic among Indonesian consumers, analysts and policy makers alike. This is particularly true given that oil prices are likely to remain at these high levels for along time, probably through the end of 2008.

Let's delve deeper into Indonesia's budget structure.

The increasing world oil prices create higher government revenue through greater income tax from oil and gas and non-tax revenue from natural resources.

According to the "Budget Outlook", released by the Finance Ministry, an on-average raise in oil price from $95 to $110 will provide an additional Rp 42.8 trillion to the government's revenue while an on-average increase to $122 will yield extra revenue of about Rp 50.2 trillion.

On the other hand, assuming an average oil price of $110 will result in higher spending due to larger subsidies for fuel and non-fuel consumption.

Total subsidies in 2008 will reach Rp 126 trillion, or 2.8 percent of GDP. On top of this will be the additional transfers of revenue from the oil and gas sector to the local governments that are made every time there is a domestic oil price increase.

Thus, taking into account revenue and expenditure, there will be a greater budget deficit. It is worth noting that year-to-date oil prices average $108 per barrel, very close to the government's new $119-per-barrel assumption in the recently revised state budget.

Under the government's current assumption, the budget deficit as a percent of GDP is 1.8 percent, compared to a 2.1 percent budget deficit prior to the average 28.7 percent hike in fuel prices.

Based on our calculations, if oil prices were to average $150 per barrel in the July-December period and if domestic consumption were to reach 40 million kiloliters during the same period, the 2008 budget deficit would reach 2.1 percent again, or back to square one, i.e. before the 28.7 percent increase occurred.

So, what can the government do to overcome this pressure? Since we do not believe in rationing (e.g. the use of the Smart Card program), the government is left with two main plans of action: an energy conversion and a price mechanism.

An energy conversion involves changing the behavior of consumption (subsidized fuel) and a price mechanism allows the price to reach an equilibrium.

Hence, in theory, we agree with the government's plan to raise oil prices gradually by 0.5 percent to 1.0 percent per month in an attempt to completely remove fuel subsidies, bringing domestic prices to match international levels.

In our view, only through this process will the budget and the economy be truly free of price distortions and smuggling.

However, given the still-low GDP per capita of Indonesia and the current weak purchasing power of the consumers at the low end, it is of paramount importance that the government exercise caution in bringing the country to a completely subsidy-free status.

We believe there remains a need to provide subsidies to the poor through the BLT (direct cash transfers) program for longer periods.

Having said that, the government must continuously improve the proper disbursement mechanism, paving the way for the direct cash transfers to reach the right hands.

The writer is a researcher at PT Bahana Securities

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