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Feb 6, 2012 | 12:07 GMT

Indonesia's Fuel Subsidy Problem

ROSLAN RAHMAN/AFP/Getty Images
Summary
Indonesia intends to reshape its economy from one based primarily on low value-added sectors such as raw-material exporting to one based on refining natural resources. With this modernization would come higher domestic consumption and less reliance on government subsidies. Attracting foreign direct investment (FDI) is a primary means of funding such a transition, and in order to reassure investors Indonesia will have to rein in a budget deficit caused in large part by fuel subsidies. But previous attempts to reduce subsidies have resulted in social instability, which can scare off the very investment Indonesia is hoping to attract by reducing its budget deficit.

Indonesian Deputy Energy Minister Widjajono Partowidagdo said in an interview with Reuters on Jan. 31 that Jakarta was considering raising the price of subsidized fuel by as much as 44 percent in 2012. Partowidagdo added that the issue would be discussed by the parliament, which, along with the country's president, must approve any price change before it goes into effect.

Indonesia already has the largest economy in Southeast Asia, growing at a rate of 6 percent in 2011 based largely on low value-added activities like exporting raw materials, subsidizing domestic consumption and government-led investing. Indonesia hopes to transition its economy to more modern activities such as refining natural resources and create a robust domestic-consumer base.

This will require additional foreign direct investment (FDI), and in order to establish an attractive investment climate, Indonesia must do two things: first, cut its budget deficit, which has been generated in large part by government spending on fuel subsidies; and second, demonstrate its ability to maintain social stability. In the past, however, cutting fuel subsidies has resulted in political and social upheaval. With Indonesian consumers accustomed to paying only half the market rate for fuel, the proposed price increase — in effect a subsidy cut — could jeopardize stability and threaten Jakarta's economic ambitions.

Indonesia's Energy Picture

Possessing energy reserves estimated at 4.2 billion barrels of oil and 3.1 trillion cubic meters of natural gas, Indonesia was a net energy exporter for much of the 20th century. But because of booming demand caused by the growth of a large middle class, Indonesia became a net energy importer in 2004 — for both crude and refined oil products. Indonesia left OPEC in 2008 because of its net-importer status and disagreements on OPEC quotas, and today it is the largest gasoline importer in Southeast Asia.

Since 1967, shortly after former President Suharto took power, the Indonesian government has subsidized fuel as a way to ease the burden on consumers and facilitate economic growth. Over time, these subsidies became the single-largest government expenditure, totaling 38 percent of the state budget in 2011. In a way, this issue has been compounded by the country's recent economic successes — as more people move into the middle class, the number dependent on (and accustomed to) low fuel prices increases.

Efforts to curb the subsidies have been politically treacherous. When fuel subsidies were cut after the 1998 Asian financial crisis at the urging of the International Monetary Fund, the resulting social upheaval contributed to Suharto's ouster. More recently, when current President Susilo Bambang Yudhoyono attempted to increase the price of subsidized fuel by 30 percent in 2008, the initiative caused massive public protests and riots.

Investment as a Key for Modernization

While Indonesia's economic outlook is by no means bleak — in January Moody's and Standard and Poor's rating agencies raised the country's credit rating to investment-grade for the first time since the Asian financial crisis — its projected growth for 2012 has already been revised from 6 percent to 5.7 percent due to concerns over slowing export demand and high oil prices. These concerns also affect Jakarta's intention to cut the budget deficit, which is projected to be 1.5 percent of gross domestic product in 2012. Sustaining the relatively low deficit is critical for attracting foreign direct investment (FDI), and, given the considerable spending put toward fuel subsidies, reducing those subsidies will have to be part of any reduction in the overall budget shortfall.

Even if the parliament and president approve the price hike for subsidized fuel, Jakarta will still need to address the rising costs of imported crude. Production at the country's main oil fields has been decreasing for years, and with consumption growing by approximately 4 percent each year, Indonesia has had little choice but to pay the market rate for its additional energy needs. Paying the higher price for imported oil in addition to the money the country spends subsidizing fuel significantly increases the overall costs to the government and makes cutting the deficit more difficult.

One of the ways the government may tackle this issue is by reducing exports and keeping more domestic oil production for use at home. This would keep more capital circulating throughout the domestic economy instead of sending it abroad, but the country would need to increase downstream investments to boost its domestic refining capacity. As long as so much of the country's budget is earmarked for subsidies, it is unclear where the capital needed to improve this infrastructure would come from. (It is also possible the government brought up the prospect of reducing exports to prod the countries that receive Indonesian oil, such as South Korea, China and Japan, into investing in Indonesia's domestic production and processing capacity.)

The domestic energy industry is only one of many sectors in need of investment in Indonesia, including infrastructure and education, but as long as a significant part of the government's budget is devoted to fuel subsidies, the government will be unable to afford expenditures on more productive activities without foreign investment. Such foreign investment may not be forthcoming in the amount Indonesia needs to modernize its economy without cuts to the budget deficit and thus to fuel subsidies. And cutting fuel subsidies would likely lead to the social instability that could make the country a less attractive destination for FDI.

Given this paradox, Jakarta is in a difficult position and has no obvious solutions at hand. Though reserving more of the country's oil production for domestic use could help mitigate the problem in the near term, it would not address the issue of subsidies substantially cutting into government revenues. With the country's reserves in decline, this would not be a long-term solution.

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