Monday, September 06, 2010 06:46 AM
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A doomsday scenario resulting from the recent electricity tariff hikes appears to be more fiction than fact. However inflation expectations will become a crucial indicator to monitor going forward.
Controversy regarding the recent electricity tariff hike continues to make headlines. Last week a number of business interest groups complained of their electricity bills rising by 30-80 percent, with some claiming to see production costs rising by up to 40 percent. Speculation was rife over spiking inflation and massive layoffs going forward.
But how realistic actually are these doomsday scenarios?
Naturally while governments have a tendency to downplay the likeliness of adverse events, businesses have a tendency to exaggerate it. However as in most cases, the reality usually lies somewhere in between. To find where in between, we must dig deeper.
Let’s start with some enlightening facts and figures from the medium-large manufacturing industry statistics, which is published by the Central Statistics Agency (BPS).
Firstly, on average, electricity costs make up around 4 percent of total costs for manufacturing industries. This doesn’t look too big; however we must note that there are several economically significant industries which have electricity cost ratios substantially higher than the average. For example inorganic chemicals and cement have electricity cost ratios at close to 20 percent, while textile spinning mills have it at around 12 percent.
Secondly many industries have alternative sources of electricity, meaning their electricity costs are not perfectly correlated with the government’s tariff hike. In fact an average 25 percent of electricity consumption for medium-large manufacturing industries is sourced from non-PLN sources. For industries such as steel rolling, non-PLN electricity can contribute some 40 percent of their electricity needs. The figure can go up to as high as 80 percent for automotive component manufacturing.
Thirdly, some industries do have an extraordinary portion of PLN electricity costs; however many of them are industries relatively small in size.
One example is ice cube manufacturing, whereby PLN electricity costs make up close to 60 percent of total costs. Recall that this high degree of electricity dependence for ice manufacturers has been widely cited in the media, as if it is reflective of conditions throughout other industries. Rarely is it mentioned that ice manufacturing only accounts for 0.02 percent of total manufacturing output. And as a product, ice is not highly-weighted in the consumer price index (CPI).
Now, let’s go back to the potential inflationary impact.
What we did was quite simple. We look at the cost structure of various industries and calculate the effect of a 30 percent electricity tariff increase to their total costs. Thereafter we assume price increases of various goods in the CPI which correspond with the estimated cost hikes faced by the industries producing them. Separately, data from an input-output table is used to approximate the energy cost structure of services industries.
Then after approximating the weights of various items surveyed in the CPI, we estimate what the impact towards CPI inflation would be.
Of course as in any methodology, ours is prone to drawbacks.
Inter-linkages among industries are not very well captured in our exercise. For example a price increase in industries producing intermediate goods, such as inorganic chemicals, doesn’t directly affect the CPI in the model (as output is mostly not used for final consumption). However in reality the industries that use the chemicals as inputs (e.g. fertilizers, textiles manufacturing, etc.) would face a rise in non-electricity costs which in turn can affect the final selling prices of their products thus the CPI.
To compensate for this flaw, we apply conservative assumptions in the degree to which industries pass-on the electricity cost increases to their product prices. We assume full pass-through whereas firms are more likely to only do partial pass-through, if any.
Recall that last year many industries saw their profit margins rise following a decline in raw material costs (due to the commodity bubble collapse). This leaves room for many firms to first absorb cost increases before passing them on to selling prices.
So the results of our exercise are as follows. The overall inflation impact of a 30 percent electricity tariff hike for industries is estimated to be 0.47-0.57 percentage points. This consists of a direct impact of about 0.2 percentage points, and so-called second round effects which could be spread out over a number of months.
What if the electricity tariff hike for industries is capped at 18 percent as promised by the government? The inflation impact accordingly would be lower at around 0.30-0.40 percentage points.
In perspective, these figures look small compared to the impact of the fuel price hikes of May-2008, for example, which at least caused a 1.5 percentage point spike in inflation.
So on a stand-alone basis, it doesn’t look like the electricity tariff hikes justify serious worries over spiking inflation or massive layoff caused by a decline in economic growth. In short, there should be no doomsday scenario.
It could however bring us one step closer to a rise in interest rates; i.e. assuming we have a forward looking central bank. The positive spread between interest rates and the inflation rate will indeed narrow going forward. And inflation expectations can be damaged if left unchecked. Mind that we still face other inflation triggers such as weather anomalies and food supply shortages — apart from continued scaremongering by the media.
The writer is an economist at Bank Danamon Indonesia, the views expressed are his own.
