Commodity and Energy Boom: Double-Edged Sword

The world never run out of problems. When there was hope that the pandemic could turn into an endemic, the Russo-Ukrainian war broke out, bringing new problems that are no less complicated.

The conflict has result in an increase in food and energy prices around the world, including in Indonesia. And like currencies, the increase in food and energy prices has two sides: it not only increases the terms of trade (ToT), but it also has a negative impact on vulnerable groups.

For natural resource producing countries, such as Indonesia, rising commodity and energy prices will help increase exports, which in turn stimulates economic growth. This is called the wealth effect. Unfortunately, the price increase only occurs in one sector: natural resources. If the natural resource boom is long enough, investment and factors of production will shift to this sector.

The reason: it provides greater benefits than other sectors. As a result, the production of sectors outside of natural resources—especially the labor-intensive manufacturing industry—will decline. An increase in ToT—which reflects the appreciation of the exchange rate in real terms—will also make the price of our manufactured goods more expensive. As a result, they will be uncompetitive.

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This phenomenon is called Dutch disease. The natural resource boom has led to deindustrialization, but we actually want to encourage the manufacturing industry by reducing dependence on natural resources. In short, the increase in ToT due to the natural resource boom in the short term will have a positive impact on the Indonesian economy. However, if you are not careful in its management, in the long term, it can cause Dutch disease.

The increase in food prices has also pushed up inflation, which is rising. The return to normal mobility has revived economic activities. Demand is increasing again. Unfortunately, the increase in the production side is not as fast as in the rise in demand. Inflation increases. In the case of developed countries, especially the United States, the demand has increased significantly as the result of large financial stimulus.

This combination can encourage stagflation.

Harvard University Economics professor Larry Summers warned from the beginning that too large a fiscal stimulus, and a delay in the increase in the US Federal Reserve interest rates, would trigger inflation in the US. The situation is further exacerbated by rising energy and commodity prices as well as supply chain disruption due to the pandemic. This combination can encourage stagflation.

In Indonesia, signs of economic recovery are visible. The economy grew 5.01 percent in the first quarter of 2022. Almost all growth engines have moved. We see there is a hope. However, the challenge is not easy. The increase in global inflation will affect growth in many countries.

In Indonesia, inflation at the consumer level, the consumer price index (CPI), as of April 2022 reached 3.47 percent. In fact, it is relatively low compared with inflation in the past, or compared with many other countries, such as the US, where inflation rose to 8.3 percent in April 2022. However, we need to note: producer price inflation had already reached 9.06 percent in the first quarter of 2022.

It means that although production costs have increased, producers have not raised their prices as the buying power is still weak. What producers could do is to reduce their profit margins, however, the high price cannot be maintained for a long time so finally prices have to be raised. When this happens, inflation at the consumer level also increases. To anticipate this, Bank Indonesia may also raise interest rates. Liquidity will tighten, interest costs will be more expensive and investment may decline.

Fiscal management

The natural resource boom will indeed have a positive impact on Indonesia in the short term through the wealth effect. Economic growth will increase and the current account will record a surplus. However, in the long term this can encourage deindustrialization. Inflationary pressures can also disrupt the acceleration of economic growth. What to do?

There are several things that need special attention. First, fiscal management is very important. Windfall income from rising commodity and energy prices must be utilized as well as possible. In April, Harvard University hosted the Harvard Ministerial Leadership Forum for Finance Ministers. Participants or "students” comprised finance ministers from developing countries, especially Africa. I happened to be adjunct faculty for the program. Finance Minister Sri Mulyani Indrawati was also a key speaker at the forum. We shared Indonesia's experience in managing fiscal and economic crises.

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In a discussion panel, I, along with former Tanzanian president Kikwete, former Mozambican prime minister Diogo, former Chilean finance minister Nicolas Eyzaguirre, spoke about the importance of fiscal rules to prevent crises. Eyzaguirre, who made the fiscal standard in Chile, said that Chile, like Indonesia, was a producer of natural resources.

When the price of copper rises, state revenues also rise, and vice versa when it falls. There is a risk here as the fiscal policy is procyclical: it becomes expansionary when the economy is good and will be contractionary when the economy is bad. In fact, fiscal policy should be countercyclical (expansion when the economy declines and vice versa). Chile has introduced a formula that stipulates that during a natural resource boom some of the earnings must be saved, so when commodity prices fall, the savings are there to be used.

That is why the proper use of additional income due to rising prices and energy will be the key.

With this, fiscal policy is countercyclical, and economic growth can be maintained at a stable level. He jokingly said such a fiscal standard was not new at all as it had existed since the time of Prophet Yusuf (Joseph) interpreting the king's dream. What Eyzaguirre said was very relevant to the Indonesian case. How should we take advantage of this commodity boom?. We know this boom won't last forever. This “windfall” should be allocated to finance infrastructure, health, education or sectors that have a high multiplier effect. It must be inclusive, and on target. A sound fiscal allocation will help mitigate the adverse effects of the Dutch disease. That is why the proper use of additional income due to rising prices and energy will be the key.

Protection of vulnerable groups

Second, the protection of vulnerable groups. The increase in food prices risks pushing vulnerable groups into poverty. Fiscal policy priority should be given to helping the vulnerable. The pandemic has caused a deep scar (scarring effect). Going forward, fiscal policy must be more inclusive. The increase in oil prices results in an increase in fuel electricity subsidies. Of course it is the burden of the people.

What will happen if this windfall income is used to cover fuel and electricity subsidies? Here we have to be careful. Why? One day the commodity and energy boom will end. However, subsidies for fuel and electricity — as opposed to an unconditional cash transfer (BLT) social aid scheme, which are temporary in nature — are politically difficult to remove. It is true that the burden of subsidies will decrease when the natural resources boom ends. However, it means that there will be a decline in spending as the result of the decline in state revenues. It is procyclical. Fiscal space remains unchanged and its ability to stimulate economic growth is limited.

We know that state revenue is volatile if it comes from natural resources, yet spending tends to be stable or increasing. This means that when revenues fall and spending remains constant, the fiscal deficit will increase. In fact, we have to reinstate the budget deficit cap of 3 percent of gross domestic product (GDP) in 2023. This means that the government must cut spending, carrying out a fiscal contraction, at a time when Bank Indonesia is also raising interest rates. This will affect economic growth.

The government clearly needs to give priority to protection to vulnerable groups, but it must be effective and targeted. It is more effective if subsidies are given in direct form, such as the BLT, Family Hope Program (PKH) or a cash labor intensive program, rather than fuel subsidies. I call this policy triple wins: good for vulnerable people, good for fiscal status, and also good for the environment because it will reduce the consumption of fossil fuels. My study with Rahardja (2011) showed that reducing fuel subsidies would make Indonesia's fiscal policy a countercyclical one, thus providing fiscal space that will in turn encourage economic growth. In this context, the fiscal standard becomes more important and relevant.

My article in Project Syndicate (19/5/2020), co-written with Harvard University's Rema Hanna and Massachusetts Institute of Technology’s (MIT) Ben Olken, shows that, historically, fuel subsidies have been very popular in developing countries. The reason is that the informal sector is relatively large and data on the poor are limited. As a result, it is difficult for the government to identify who is poor.

Fuel subsidies provide a way out for this problem because everyone, including poor households, can benefit if they buy fuel. However, a 2015 International Monetary Fund (IMF) study showed that middle-class and wealthy households benefited more as they tend to buy more fuel. The richest 20 percent of households receive six times more benefits in fuel subsidies than the poorest 20 percent.

That is why subsidies for vulnerable groups in the form of fuel subsidies are not efficient. It will be better if the subsidies are given directly to vulnerable populations in the form of direct subsidies, such as the BLT or PKH, or to allocate funds for investment in health, micro, small and medium sized enterprises (MSMEs) or vulnerable households to buy cooking oil. Expand the scope, for example, not only the poor, but also the aspiring middle class (those who are close to becoming the middle class), which according to the World Bank amounts to 115 million.

It must continue to be improved. Take advantage of digital technology, mobile phones and mobile banking services, or the post office.

If necessary, expand its coverage to 160 million people. If we provide direct subsidies to 120 million or 160 million residents, it means that the household coverage must be expanded to 30 million or 40 million households (assuming one family consists of four people including father and mother and two children). Subsidies like this will more effectively reach the targeted recipients and will be less expensive than providing fuel subsidies that will be enjoyed by everyone, including the rich. Of course, the data of the targeted households is the key. It must continue to be improved. Take advantage of digital technology, mobile phones and mobile banking services, or the post office.

This policy is also good for tackling climate change. Coady et al (2019) estimated that removing oil and gas subsidies alone could reduce global carbon emissions by 5-6 percent in 2015, and by 28 percent if coal subsidies were also removed.

There is a chance. The increase in commodity and energy prices must be utilized as well as possible. This additional income must be allocated for inclusive development targets and sectors that have a large impact on economic growth. However, politically it is not easy. The government is indeed placed in a difficult position. Good economic policies often receive little respect, but they will prevent us from economic stagnation. A government is remembered for its legacy of useful policies long after it has ended, not for its fleeting popularity. I took the one less traveled by,/ and that has made all the difference, wrote Robert Fros in his poem “The Road Not Taken”.

KOMPAS/HERU SRI KUMORO

Muhamad Chatib Basri

Muhamad Chatib Basri,lecturer at the School of Economics and Business, the University of Indonesia

(This article was translated by Hendarsyah Tarmizi)