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Tuesday, May 31, 2011

Subsidies – an ‘opium’ habit hard to break

Indonesia and Malaysia can ill afford to spend more to keep energy costs artificially low.

By Emily Kaiser

SINGAPORE: Governments in Southeast Asia have a narrow window of opportunity to pare back politically popular fuel subsidies on their own schedule before budgets or bond holders force their hands.

The wild card, as always, is oil prices. If crude climbs back toward 2008′s record highs, as many private economists predict, Indonesia and Malaysia look particularly vulnerable as subsidies consume a bigger share of public spending.

Both countries have massive infrastructure needs to ensure their economies can sustain rapid growth, and they can ill afford to spend more to keep energy costs artificially low.

Both also know they must eventually change their ways.

Malaysia has a healthy current account surplus and a little bit of budgetary wiggle room that will give it time for a brief delay. Indonesia boasts a modest deficit that is the envy of some Asian neighbours, but foreign investors are big holders of its government bonds, and may not be patient if oil spikes.

Indonesia and Malaysia are not the only subsidisers in the region, but they have some of the lowest retail prices for diesel and gasoline across Asia. Indonesia’s are less than half those of China’s, for example.

Malaysian Prime Minister Najib Tun Razak said earlier in May that subsidies were “like opium” and kicking the habit was hard but necessary. Just a week later, however, his government
unexpectedly backed away from raising fuel prices.

The about-face highlights how difficult it will be for countries to change before the fiscal cost becomes unbearable.

Yesterday, Malaysia said it would raise electricity prices by about 7%, but it has much more work to do on the much larger issue of gasoline and diesel subsidies.

Politics trickier

The economic case for curbing the subsidies is simple: they drive up deficits and divert money from much-needed investment, and they disproportionately benefit wealthier households, exacerbating income inequality strains.

The politics are trickier. The more expensive oil gets, the more voters demand subsidies. But the consequence of keeping them is worsening public finances, which can alarm bond holders and scare away private investors who are vital to growth.

Malaysia’s next general election isn’t due until 2013 but analysts said Najib could call for snap polls this year to secure his mandate after assuming power in 2009.

Najib said his government had budgeted RM11 billion (US$3.6 billion) for fuel subsidies this year, but the actual figure is now expected to be around RM18 billion because of high crude oil prices.

Hak Bin Chua, an economist who tracks Malaysia for Bank of America Merrill Lynch, said the country could partially offset higher subsidy costs with stronger tax revenues and proceeds from privatisations.

The deficit may come in “slightly higher” than the government’s planned 5.4% of gross domestic product (GDP), but probably would not shoot past 6%, he said.

Anthony Nafte, senior economist with CLSA, said Malaysia’s current account surplus means it can afford to wait a bit longer before raising fuel prices, even though he expects the cost of subsidies to reach 2.3% of GDP – double Malaysia’s initial estimate.

Indonesia is a somewhat different story. It has a much smaller current account surplus, leaving it
more dependent on government debt to cover its budget deficit, which is currently modest but would swell if subsidy costs keep growing. If bond holders sense that subsidies are swamping the budget, borrowing costs could spike.

Indonesia has had no difficulty attracting buyers for its debt, thanks to a growth rate expected to hit 6.5% this year and next and a strong rupiah. But roughly 30% of its debt is held by foreigners, putting it at risk should investor sentiment suddenly sour.

Breaking point

Nafte expects Jakarta to hit a breaking point in the next few months where the cost of sustaining subsidies outweighs the political pain of reducing them.

“They’re not going to have the money for infrastructure spending,” Nafte said. “To us it’s pretty clear that they’re going to be forced to have a domestic fuel price hike.”

Indonesia’s next election isn’t until 2014, so a subsidy cut this year might be nothing more than a distant memory when voters head to the polls.

Indonesia budgeted 187.6 trillion Indonesian rupiah (US$21.9 billion) for fuel subsidies, amounting to 15% of total government spending. But the budget, released in October, assumed an average oil price of US$80 per barrel, versus current levels of more than US$100. The last time oil was under US$80 a barrel was in early September 2010.

Nafte said fuel subsidies currently amount to about 2.5% of GDP, a level he called a “stress point” that would probably push the government to move. If oil rises to US$140 a barrel and the rupiah strengthens against the dollar, the cost of sustaining subsidies would hit 3% of GDP, he said.

Indonesia’s finance ministry plans to release a revised budget in June or July, which will almost certainly include a higher oil price forecast. That could also be an opportune time to announce some sort of a subsidy trim. It postponed indefinitely a plan to stop private cars from using subsidised fuel because of inflation concerns.

Risk to fiscal stability

Michael Spencer, chief Asia economist for Deutsche Bank, said he expected a 10% subsidy cut in July but pointed out that Indonesia was among “the most virtuous” Asian countries when it comes to fiscal balance and was far from facing a budget-driven deadline.

Indeed, even with higher fuel subsidy costs Indonesia’s deficit will probably remain around 2% of GDP, according to Milan Zavadjil, the International Monetary Fund’s senior resident representative for Indonesia.

“In the short term, I don’t think fuel subsidies are a risk to fiscal stability,” Zavadjil said at a conference on Indonesia organised by IHS Global Insight. “In the medium term, unless it is dealt with, it is a terribly unproductive use of the government’s taxes.”

Ari Soemarno, an oil and gas consultant and former chief executive of Indonesian state oil company Pertamina, said the heavy subsidies exact another less visible toll on Indonesia’s economy. They suppress margins for oil companies, giving them less incentive to invest in developing the country’s resources.

By raising the minimum fuel price to 6,000 rupiah per litre from 4,500 rupiah, the government could save US$2 billion that could be used for infrastructure, he said.

Soemarno held out little hope that the government would act as aggressively as he would like, and lamented that Indonesia tended to “learn the hard way – from failures”.

But he pointed to one recent success as a possible template. In 2007, the government and Pertamina launched a programme to switch consumers to LPG instead of heavily-subsidised kerosene.

Soemarno said that saved US$3 billion in subsidies.

“This is an example that mindset can be changed with strong leadership, a good planned programme, and consistent execution,” he said.

-Reuters

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