Indonesia offers bitter lesson in controlling fuel prices

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.