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Analysis: Fuel price hike: the higher, the better
As a country, Indonesia needs to prepare for the US Federal Reserveâs rate hike
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As a country, Indonesia needs to prepare for the US Federal Reserve's rate hike. This can only be done by improving Indonesia's economic fundamentals through a substantial increase in the price of subsidized fuel, in our view. With Rp 291 trillion (US$25 billion) in fuel subsidies projected to be paid out next year, it is imperative that the new government takes the hard political step in implementing the removal of the subsidy. A prerequisite for this unpopular decision would be the formation of a clean and credible Cabinet with non-affiliated technocrats having the political will to implement tough reforms.
Based on history, we note that since 2005 the Indonesian government has implemented fuel price increases four times (Table 1). What is interesting to note is that the higher the fuel price hike the faster the Indonesian equity market (as measured by the Jakarta Composite Index) recovered ' for example, after the 96 percent increase imposed in October 2005 it recovered in two months.
In this regard, we concur with the central bank that a 50 percent increase in domestic fuel prices is warranted in order to improve the country's fundamentals. However, this will require a great deal of political courage by the new government to accomplish and at this stage, we are not optimistic that a fuel price hike of this magnitude could be implemented.
Apart from the magnitude of the fuel price hike, we think that the timing would also be crucial in shoring up investors' confidence. We believe that the fuel price hike must be implemented swiftly, with the new government taking advantage of the positive momentum brought about by the establishment of the new transition team and also by the creation of the new Cabinet.
With that said, we think that the best time to implement a fuel price hike would be in the beginning of November 2014, coinciding with Indonesia's agricultural harvest time, which is usually a low inflationary phase during the year.
If the aforementioned 50 percent fuel price hike is deemed too unpopular by the new government, we believe that a minimum Rp 2,000 per liter subsidized fuel price is required in order to make a positive impact on the state budget. However, this would mean that in 2014 inflation would rise to 9 percent with 2015's level coming down to around 6.3 percent (Table 2). On economic growth, we expect the 2014 gross domestic product (GDP) to decelerate to around 5.1 percent from our base level of 5.25 percent, before leveling off to 5 percent in 2015. The economic slowdown would be caused partly by our expectation that Bank Indonesia would further tighten by 75 basis points to 8.25 percent next year in an effort to contain domestic inflation and fend off a capital flight on the back of the Fed's rate hike.
Technically speaking, the impending fuel price hike could result in a 6 to 7 percent correction in the market, in line with index support at the 4,850 to 4,900 levels. Sectors sensitive to interest rates, such as the banking, property and automotive sectors, have the tendency to underperform in the market in the lead up to a fuel price hike.
Thus, amid an upcoming market correction, investors should take cover in defensive sectors, like telecommunications and consumer, which have the propensity to outperform the market.
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The writer is Senior Associate Director/Head of Equities and Research of PT Bahana Securities
