A drastic reduction of fuel subsidies confuses ends and means.(Indonesia)

Publication: ASEAN Economic Bulletin

Publication Date: 01-APR-06

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COPYRIGHT 2006 Institute of Southeast Asian Studies (ISEAS)

I. Introduction

Rising world oil prices have posed difficult policy choices for oil importers and exporters alike. With oil consumption continuing to surge and production stagnating, if not falling, Indonesia has recently become a net oil importer, a trend that has been predicted by many analysts back in the 1990s. Traditionally, surging oil prices would have caused import bills to rise (affecting the trade balance) and put a burden on government budget through rising subsidies (fiscal balance). For Indonesia, the latter is more critical. This is the main reason why within a period of less than a year, the government has decided to slash oil subsidies twice, once in March and another time in October 2005. The latter move was drastic, constituting an enormous cut that led to a more than 120 per cent increase in the average fuel prices. This has caused widespread domestic protests and criticisms, deteriorating socioeconomic conditions, and to some extent also political instability. On the other hand, some international organizations, the International Monetary Fund (IMF) in particular, praised the policy.

I argue in this paper that an alternative policy of cutting a fraction of the principal and interest payments on domestic debt or recap bonds (in essence, subsidies to the banking sector) could complement the cut on fuel subsidies in order to reduce the fiscal pressure. If the saved money were targeted towards agricultural-related infrastructures, the income distribution and poverty conditions would have also been favourable without deteriorating the macroeconomic stability or injuring investors' confidence. The important implication is that the policy of a drastic and massive cut on fuel subsidies is unnecessary. Reducing subsidies is inevitable to maintain the country's fiscal health, but if it is welfare-reducing and creates more hardships to most people, it confuses means and ends.

The much publicized compensating income policy, i.e., direct handing of cash to the poor households takes up only a small fraction of the saved money from subsidies cut. More seriously, by neglecting the general equilibrium impacts of the fuel price increase, the consequences of a massive subsidy cut are more dire than expected. The open unemployment rate has reached 10.84 per cent, and inflation has hit double-digits. These figures will likely worsen following the subsidies cut. By using a new measure of poverty based on fourteen criteria (not using calories intake/day), a recent survey conducted by the statistical office CBS reveals that the number of poor has reached a staggering 62 million, or around 15.5 million households, about twice the poverty headcount figure based on the National Survey (Susenas) data. The very concept of handing cash directly under the assumption that the administrative or institutional capacity is ready to deliver the programme has proven ill-advised. They also spoil and damage social unity as revealed by a series of serious incidents that even involved the loss of some human lives. (1)

The organization of the paper is as follows. Section II presents the results of simulations showing the macroeconomic impacts and socioeconomic consequences of a scenario in which the government cuts a fraction of the subsidies to the banking sector including the recap bonds. Results of another set of simulations capturing a scenario in which the saved money from the subsidies cut is spent on agricultural-related infrastructures are discussed in the subsequent section.

II. Recap Bonds: A Misguided Policy

Among the early policies advocated by the IMF to the Indonesian Government during the Asian financial crisis was the decision to liquidate sixteen banks. With no deposit insurance system in place, such a policy caused widespread panic. Depositors shifted their assets to state and foreign banks. At the same time, fears over the fluctuating rupiah led to a sizeable amount of currency substitution. As a result, many domestic private banks suffered from a liquidity crunch, resulting in exorbitant inter-bank rates.

As a "lender of last resort", Bank Indonesia injected liquidity funds known as Bantuan Likuiditas Bank Indonesia (BLBI) to a number of private banks. By the end of 1997 the injected amount swelled to reach 7 per cent of GDP. This policy caused the currency value to weaken further. What made it worse was that most of the funds were not properly used by recipient banks; some were gambled away in the foreign exchange or securities markets, others were used to expand bank operations, staff, branches, and services. A considerable amount was also transferred to bank owners' accounts abroad or lent recklessly to businesses within the banks' own group (potentially non-performing). (2) While conceptually BLBI represents a standard liquidity support to illiquid but not insolvent banks, the actual implementation was seriously flawed. In some cases, the amount of central bank's extended credit even exceeded the recipient banks' total assets.

The IMF prescription to tighten the budget and raise the already high interest rates failed to restore market confidence. On the contrary, social uprising flared and the number of bankruptcy cases rose dramatically. Banks' balance sheets worsened, many suffered from a negative net worth. By March 1999, the capital equity of banking sector had reached minus Rp245 trillion.

Upon the recommendations of the World Bank and the IME the government implemented a blanket guarantee programme, in which BLBI was taken over by the government and new bonds were issued to the central bank (both amounted to Rp220 trillion). (3) In addition, the government issued a huge amount of recap bonds (estimated at Rp405 trillion) to the troubled banks by enforcing certain criteria including the initial level of bank's capital adequacy ratio (CAR). (4) The whole premise of the policy was that, as banks' balance sheets have improved, a large portion of bonds would be converted into credits so that the intermediation function can be gradually resumed. In reality, this did not happen. Banks preferred holding non-risky government bonds to secure high CAR.

Thus, the intended outcome of the policy did not materialize, while the costs have been enormous. Eventually, this put a substantial pressure on government budget. Figure 1 shows the principal and interest payments on recap bonds measured as a percentage of total domestic revenues. In 2002, total debt payments took up more than one-fifth of domestic revenues. Compare this figure with the oil subsidy that was over 10 per cent. As the oil prices surged in 2004, however, the subsidy began to dominate but payments related to domestic debt remained high. In 2005, about a third of domestic revenues would have to be spent on these two items (after the cut of fuel subsidies). With rising routine expenditures and foreign debt payments, this leaves a limited room for other development expenditures. As depicted in Figure 1, the relative share of development expenditures including those for regional governments has been declining. It constitutes less than half of domestic revenues since 2004.

[FIGURE 1 OMITTED]

Prior to the oil price increase, the government implemented the following strategies concerning the domestic debt (mostly recap bonds): (1) Buyback programme, in which some of the non-matured bonds are repurchased (essentially an asset-bond swap); (5) (2) Reprofiling debt to make it consistent with the development of the secondary market and government's capacity to create a surplus in the primary balance. Having determined bank's liquidity requirement, the government will exchange the bank's idle bond with new bond that has a longer maturity. But this scheme could be exercised in limited scope and applied to only banks that are still under government control (prior to divestment); (3) Debt-switching which is intended to lengthen the maturity profile of the debt (exchanging maturity and altering liquidity of the bonds). The main difference between this approach and the reprofiling scheme is that, the terms of bond exchanges are determined by the market, not set unilaterally by the government; (4) Refinancing matured bonds by issuing new bonds; and (5) Reducing government's contingent liabilities, among others by phasing out the notorious blanket guarantee programme. This could be done through the improvement of the banking sector and by strengthening macroeconomic stability so as to...

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