Indonesia offers bitter lesson in controlling fuel prices

PUBLISHED : Wednesday, 31 August, 2005, 12:00am
UPDATED : Wednesday, 31 August, 2005, 12:00am

Maintaining fuel price controls and subsidies in the face of record crude oil prices is getting painful. Yesterday, Indonesia jacked up interest rates to avert a currency collapse prompted largely by the cost of subsidies. If oil prices stay high, it can only be a matter of time before China, too, is forced to change its policy.

Events in Jakarta brought home just how damaging well-intentioned fuel price policies can be. In a slide reminiscent of the 1998 currency crisis, the rupiah plunged 10 per cent in morning trading, with the US dollar climbing to 11,925 rupiah, its highest against the Indonesian currency in more than four years (see chart).

The sell-off was triggered by eroding confidence in the currency as rupiah holders fretted over the fiscal cost to the government of sustaining its fuel subsidies with crude oil prices hitting record highs at about US$70 a barrel.

As Southeast Asia's largest oil producer, Indonesia has long maintained generous subsidies on petrol, diesel and kerosene used by many for cooking, as a spur to economic growth and as a vital social welfare crutch.

But the subsidies have come at a fearsome cost. Artificially cheap fuel has encouraged profligate consumption. Indonesia burns 3.7 times as much oil to produce each dollar's worth of economic output as the average developed economy, far more even than other inefficient users like Thailand or China.

Worse, that profligacy has helped turn Indonesia from an oil exporter just five years ago to a net importer today. As oil prices have risen, not only has the government had to pay out ever-rising sums to fund its subsidies, but the mounting dollar cost of the country's oil imports has acted as a drain on its foreign reserves. Over the past four months, official reserves have fallen by US$5 billion to US$32 billion, denting faith in the rupiah.

Last year, the cost of Indonesia's fuel subsidies rose fourfold to nearly US$7 billion, or almost 3 per cent of gross domestic product. Jakarta responded by cutting subsidies and raising most fuel prices by 29 per cent at the end of February. But with prices still subsidised by between 40 and 80 per cent, the rise in crude oil prices has more than wiped out any savings, and the government's subsidy bill looks set to soar again to US$13.5 billion this year, threatening a fiscal crisis.

Meanwhile, to soften the blow of reduced subsidies, the government has kept interest rates low despite rising inflation, further undermining confidence in the currency. Yesterday's rout forced the government to act, intervening in the foreign exchange market and raising interest rates by 0.75 percentage point to 9.5 per cent.

It is unlikely to be enough. Although the rupiah strengthened slightly in response, Indonesia's president, Susilo Bambang Yudhoyono, warned yesterday domestic fuel prices would have to rise to reflect higher crude oil prices. Further subsidy cuts will be deeply unpopular, but in the long run, scrapping fuel subsidies will be essential for Indonesia's economic health.

The situation in China is not as serious, but in recent months, the combination of domestic fuel price controls and rising international crude prices has led to heavy losses at the country's refiners and caused fuel shortages in some areas. With international energy prices showing little sign of subsiding, China will have to move towards abolishing its price curbs if it is not to risk the sort of wrenching economic distortions suffered by Indonesia.



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