Economic Resilience and Fuel Subsidy

REUTERS/BRENDAN MCDERMID

A trader stands in front of a monitor broadcasting the Fed Rate hike on June 13, 2018 at the New York Stock Exchange (NYSE) in New York City.

The Federal Reserve, the central bank of the United States, has indicated that it will raise its benchmark interest rate for the third time in September, although the rate increase will unlikely be higher than 75 basis points. The increase will be smaller than the market expectation of a 100 basis-point increase because some early indicators, such as the housing market, have shown that the recession in the US will take place early.

The US economic growth for the second quarter of 2022 was recorded at negative 0.9 percent. Technically, the US has entered a recession because it has recorded negative growth for two consecutive quarters. The Fed may raise its reference rate by less than 75 basis points due to the fall in the inflation rate to 8.5 percent in July from 9.1 percent in June.

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However, with the positive employment data in July, during which the economy added 528,000 jobs, there is still a possibility that the Fed will continue to raise its rate at a faster pace.

Global impact

The above situation has created euphoria in the world of the oil-futures market because the less hawkish Fed has reduced fears of a world recession. The price of WTI crude, which dropped from US$108 per barrel at the end of June to $94 per barrel, has begun to increase again. However, the increase to above the psychological barrier of $100 per barrel will not last long.

After reaching $98, the crude price fell below psychological level of $90 per barrel, and then fluctuated within this price level. It occurred because of the reality of the recession in the US and the disruption of the economic growth in China due to the Covid-19 lockdown.

The fall in the world oil prices was followed by a decline in the prices of other commodities, thereby reducing global inflationary pressures. Regarding wheat, the agreement between Ukraine and Russia to open an export corridor from ports on the Black Sea to Turkey to the rest of the world has also led to the decline in prices.

In five weeks, the price of wheat fell from $9 per bushel to $7.48. The price of the crude palm oil (CPO) also dropped from 5,000 Malaysian ringgit (US$1,114) per tonne in late June to about 4,000 ringgit in mid-August 2022.

The prospect of an increase in the Fed's interest rates, coupled with the lack of interest in investing in oil and other commodities, has led portfolio investors to seek financially safe assets denominated in US dollars. The US dollar index, which had fallen to around 105.8 in the first week of August, increased to 108.3 in the third week of August.

The fluctuation of the US dollar index affects the rupiah-exchange rate. However, there are several domestic factors that have helped the rupiah not to depreciate too quickly toward Rp 15,000.

As a result, the rupiah exchange rate against the US dollar, which had strengthened to Rp 14,600 per US dollar, weakened back to about Rp 14,800. The fluctuation of the US dollar index affects the rupiah-exchange rate. However, there are several domestic factors that have helped the rupiah not to depreciate too quickly toward Rp 15,000.

Bank Indonesia reported a net-foreign buy of around Rp 900 billion (US$60.36 million) of Indonesian shares, which led to the increase in the Jakarta Composite Index (JCI) by 0.26 percent to 6,968.78. Foreign funds are also active in the Government Securities (SBN) market after almost two consecutive months of net selling. In the 4th week of July 2022, along with the announcement of the second Fed rate hike, incoming funds were recorded at Rp 3.28 trillion. This combination makes the rupiah quite resilient.

Economic-growth resilience

Indonesia recorded an annual growth of 5.44 percent in the second quarter of 2022 amid global uncertainty. The growth rate is the second highest since the second quarter of 2021, which was recorded at 7.07 percent. Despite the pandemic situation, world recession and suppressed global inflation due to the energy and food crisis, with this growth rate, it means that Indonesia has been able to maintain its positive growth path for three consecutive quarters. As predicted by the Phillips Curve with higher growth than the previous quarters, inflation will also be higher, as evidenced by inflation in July, which amounted to 4.94.

In addition to exports, which grew by 19.74 percent, the growth in public consumption of 5.51 percent was inextricably linked to the increase in the purchasing power of the Indonesian middle class in large and medium-sized cities in Indonesia. With the expansion of toll roads in Java and Sumatra, the demand-and-production sides are more integrated. With toll-road access, industry can be located almost anywhere.

The highest growth on the production side was recorded by mobility-based sectors such as transportation and warehousing (21.27 percent); accommodation and food and drink were in the second position (9.76 percent).

Not to forget, micro, small and medium enterprises (MSMEs) located in remote areas can now sell their products to cities via both offline and online platforms, as well as urban-middle-class buyers who often come directly to production sites. This is consistent with the increase in GDP, both in terms of production and expenditure. The consumption is driven by spending on relaxation services, such as travel, hotels and restaurants. The highest growth on the production side was recorded by mobility-based sectors such as transportation and warehousing (21.27 percent); accommodation and food and drink were in the second position (9.76 percent).

This phenomenon illustrates the preferences of the middle class after two-and-a-half years of being trapped by the pandemic. Travel to remote parts of the country also helped boost business sectors dominated by MSMEs, such as trade, accommodation, culinary and light manufacturing.

Policy dilemma

The problem is that the growth based on the above mobility is supported by the government’s fuel subsidies (BBM) which has amounted to Rp 502 trillion, bringing a heavy burden to the state budget. Thus, there is a tradeoff between growth and budget resilience.

Another question is how much the fuel subsidy should be reduced so that demand destruction does not occur in mobility-based sectors.

Every policy will always have a dilemma or trade off. If the policy of reducing fuel subsidies due to socioeconomic considerations cannot be implemented in the short term, non-price rationing can be used. This separating equilibrium policy can be carried out based on the types of vehicles, public transportation and logistics, engine CC and others.

This policy is a strategic waiting game with the possibility that oil prices will be in the range of $80 to $90. In fact, there is a possibility the oil price will drop to below $80 per barrel as predicted by Citigroup (Cheong, Bloomberg, July 2022) due to the US and world recession.

The Fed's plan to keep increasing the benchmark interest rate several times in the future may increase the chances for a longer recession period. It must be noted that the resilience of the state budget determines the time frame for moving to the next option (pivotal point), namely increasing domestic fuel prices, if the crude oil price amounts to above $90 per barrel.

KOMPAS/HERU SRI KUMORO

Ari Kuncoro

ARI KUNCORO,Rector of the University of Indonesia.

(This article was translated by Hendarsyah Tarmizi)