INDONESIA STILL VULNERABLE TO RISING OIL PRICE

UNCLAS SECTION 01 OF 02 JAKARTA 001033 SIPDIS SENSITIVE DEPT FOR EAP/MTS AND EB/IFD/OMA TREASURY FOR IA-SETH SEARLS COMMERCE FOR 4430/KELLY DEPARTMENT PASS FEDERAL RESERVE SAN FRANCISCO FOR CURRAN DEPARTMENT PASS EXIM BANK SINGAPORE FOR SBAKER TOKYO FOR MGREWE USDA/FAS/OA YOST, MILLER, JACKSON USDA/FAS/OCRA CRIKER, HIGGISTON, RADLER USDA/FAS/OGA CHAUDRY, DWYER USTR WEISEL, EHLERS E.O. 12598: N/A TAGS: EFIN EINV ECON EAGR ID SUBJECT: INDONESIA STILL VULNERABLE TO RISING OIL PRICE REF: Jakarta 1023 ¶1. (U) Summary: Government of Indonesia (GOI) senior economic adviser Chatib Basri stated that the GOI raised the price of subsidized fuel on May 24 to stop smuggling, restore confidence within the international investor community and increase the amount of government funds available for social spending, during an open forum at the Jakarta Financial Club. Other market analysts at the forum applauded the GOI policy decision, but challenged officials to use the savings to tackle significant economic problems such as infrastructure investment. As the GOI opted to retain a price cap rather than implementing a market-based price, further world oil price increases could encourage renewed smuggling and bring the budget under additional pressure. The GOI plans to begin rationing subsidized oil this year and is considering gradually requiring owners of private vehicles to pay market prices for gasoline, according to Basri. End Summary. Smuggling, Confidence, Budget Worries Prompt Increase -------------- -------------- ¶2. (U) The massive gap between world oil prices and subsidized domestic fuel has encouraged large-scale smuggling, eroded investor confidence and pressured government finances due to the rising cost of fuel subsidies, according to GOI advisor Chatib Basri. These factors led the GOI to raise subsidized fuel prices on May 24 by an average 28.7%. As the price gap rose to roughly 4500 per liter ($0.50; Rp 9,000/USD) in 2008, subsidized oil consumption significantly outpaced growth in economic activity, suggesting large-scale oil smuggling. Investor concerns about the size of Indonesia's subsidy bill and future inflation have resulted in poor stock market performance, a weaker Rupiah, and an increase in bond yields in 2008. The Rupiah is the only major currency in the region to depreciate against the US dollar in 2008, according to Basri. The cost of government bond issuance has already risen by roughly 2.5-3.5% this year in response to investor concerns, increasing the future interest burden on the budget. With the fuel and electricity subsidy bill threatening to absorb more than a quarter of the budget, fuel subsidy spending had also begun to significantly crowd-out other government priorities such as health, education and infrastructure (reftel). Vulnerabilities Remain -------------- ¶3. (U) Most analysts at the Financial Club Forum praised the GOI decision to increase subsidized fuel prices -- a decision that the cabinet made despite accelerating inflation, the threat of economic slowdown, and a rapidly approaching election season. The decision underscored Indonesia's commitment to maintaining macroeconomic stability. Basri noted that the first 2005 fuel price hike, which was roughly 30%, did not result in a prolonged dip in consumer confidence, retail sales, or industrial slowdown. The first 2005 price hike also had limited impact on investment growth in Indonesia. If the international price of crude oil reverts to close to $110 a barrel, further price hikes will not be necessary. ¶4. (U) The GOI also launched its pro-poor policy package, which includes a cash transfer program for 19.1 million households and lower rice prices, to offset much of the burden of the fuel price increase on poor households (reftel). The GOI modeled the new cash transfer program on a similar plan in 2005 that successfully offset the cost of higher fuel costs for the poor. ¶5. (SBU) Nevertheless, macroeconomic and policy risks from high world oil prices remain significant. The GOI increased the price cap on subsidized fuel rather than moving to a market-based price, leaving the budget vulnerable to a rising subsidy bill if world oil prices increase. The GOI expects the current fuel price hike to raise inflation to at least 11%, increasing the need for the central bank to significantly raise rates in the coming months. Additional fuel hikes would further exacerbate inflation in Indonesia. The JAKARTA 00001033 002 OF 002 initial 2005 fuel price hike had a limited impact on consumer confidence, domestic demand and investment. However, the second 2005 fuel price hike, which increased fuel prices 114%, had a prolonged negative impact on all of these indicators. Analysts at the forum also noted GOI promises in 2005 that they would divert the savings from fuel price hikes to longer-term development goals such as infrastructure spending. The GOI has been slow to implement these plans once the immediate crisis had subsided. GOI to Focus on Rationing -------------- ¶6. (U) Since the international oil price remains 33% higher than Indonesia's subsidized fuel price, the GOI plans to introduce new policies over the next six to nine months to discourage overconsumption of subsidized fuel, according to Basri. Officials plan to use smart cards to ration individual fuel consumption and to encourage households to convert from kerosene to LPG stoves. Some observers have questioned the wisdom and feasibility of the smart card system, given that the system will be complicated to implement and introduce additional market distortions. The GOI is also considering gradually excluding private vehicles from using subsidized fuels in an effort to focus the subsidy on poorer families who use buses and motorcycles as their primary means of transportation. HEFFERN