Living with inflation, capital inflows, poor infrastructure

Vincent Lingga, The Jakarta Post, Jakarta Tue/12/21/2010 Opinion

The biggest policy challenges for the Indonesian government in the year ahead include how to cope with rising inflationary pressures, ensure less volatile and sustainable capital inflows and accelerate the development of infrastructure.

Certainly, the large role portfolio investment plays in total capital inflows and the ensuing risks of asset price bubbles pose challenges for controlling inflation, especially in case of sudden capital reversals.

The year may end with a cumulative inflation of at least 6.2 percent, much higher than last year’s 2.78 percent. But this would not prompt the central bank to immediately raise its benchmark interest rate, which has remained at 6.5 percent since August 2009, because the rise in food prices, caused by weather anomalies that reduced supplies, was the main driver behind the increase in the consumer price index.
The reluctance to hike interest rates, at least until the end of the first quarter, also stems from great concern that a further widening of interest rate differentials would attract more short-term capital inflows, further complicating the central bank’s liquidity management efforts.
But the risks to the inflation outlook have increased due to the combination of persistently strong domestic demand, supply disruptions caused by weather anomalies and inflationary pressures due to capacity constraints and inefficient logistics.
The government measure to gradually phase out fuel subsidies starting in April will also aggravate inflationary pressures next year.
The growth of gross domestic product in the third quarter surprised on the downside, coming in at 5.8 percent year-on-year, down from 6.2 percent in the second quarter due to the unusually wet weather which adversely affected mining, construction and exports.

But, persistently high domestic consumer confidence will still enable the economy to close this year with a minimum expansion of 6 percent.

Consumer spending will remain the main driver of economic growth, which is estimated at between 6.3 and 6.5 percent next year, due in part to the positive wealth effect from the stock market and rising wages.

“ Since infrastructure development consists mostly of multi-year projects, the highest growth the economy may achieve next year is 6.5 percent. A faster expansion may cause the economy to burst at the seams.”

Bank Indonesia will continue the use of a mix of monetary policy and macro-prudential measures to deal with inflation risk, strong capital inflows and high excess onshore liquidity by setting higher compulsory reserve requirements, including on dollar deposits, and regulating vostro accounts (rupiah demand deposit accounts held by non-residents in domestic banks).

The central bank will use more liquidity management tools rather than the policy rate. Hence, Bank Indonesia’s first line of defense will continue to be liquidity withdrawal by raising the dollar reserve requirement and further lengthening the maturity of the term deposit facility to lock in additional liquidity for longer durations.

The 6.25 percentage point interest rate differential, and substantial improvements in Indonesia’s economic fundamentals, will continue to be magnets of both foreign direct and portfolio investment to the country.

According to the International Monetary Fund in Jakarta, foreign direct investment in the first nine months of 2010 alone totaled US$6.77 billion, compared to a mere $1.92 billion in all of 2009, while portfolio capital reached $14.45 billion against $10.36 billion last year.

Most portfolio capital inflows this year went to buying government bonds ($10 billion), Bank Indonesia’s SBI debt papers ($2.37 billion) and shares ($2.1 billion) as of early October.

Certainly, the best approach to cope with the torrent of short-term capital inflows, and to gain the greatest benefit from them, is to convert the funds into direct investment and initial public offerings (IPO) through the stock exchange and lengthen the maturity of capital inflows, thereby reducing the volatility.

But this requires significant improvement in the overall investment climate, reducing infrastructure bottlenecks and further improving capital market infrastructure to encourage more IPOs and corporate bond issuance.

Inadequate infrastructure has been one of the biggest drags on economic expansion over the past few years. In fact, the country lags behind most major Southeast Asian economies in the adequacy and quality of infrastructure.

Lack of inter-connectivity between major islands has caused wide regional economic disparities.

Infrastructure, such as roads and port facilities, in many provinces has crumbled due to an acute lack of maintenance under severe fiscal restraints. Power shortages and rotating blackouts continue to hit several provinces.

Inadequate infrastructure impairs the competitiveness of the economy because production and distribution costs are made much higher than those in other countries.

Studies by the University of Indonesia School of Economics concluded that inadequate infrastructure and the crumbling condition of existing infrastructure have made the costs of logistics in the country among the highest in Asia, or 14 percent of total production costs, compared to four to five percent in other countries.

The biggest barrier to private investment in infrastructure is land acquisition. The arduous, complex procedures for land acquisition make this component the biggest factor of uncertainty for project cost.

Yet more discouraging is that the government is still drafting a law on land acquisition for infrastructure that should have been completed early this year.

The most optimistic view now is that the bill would be enacted in the first half of 2011, at the soonest. However, because the new law has yet to be supported with government regulations stipulating technical details for its enforcement, more investor-friendly land acquisition legislation can be expected only later next year, or even early 2012.

The government has set up several supporting facilities to help expedite infrastructure financing, such as the infrastructure finance company in a joint venture with the World Bank and Asian Development Bank and an infrastructure fund guarantee.

But don’t expect any substantial improvement in the infrastructure sector unless a strong regulatory framework for a more expeditious land acquisition system is already in place.

The government built only about 120 kilometers of toll roads over the past five years and completed even less than 40 percent of the 10,000 megawatts in new power generation capacity launched under a crash program in early 2006 to cope with the power crisis.

Since infrastructure development consists mostly of multi-year projects, the highest growth the economy may achieve next year is 6.5 percent. A faster expansion may cause the economy to burst at the seams.

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Commentary: Stopping subsidies for private cars could be the best policy of the year

Vincent Lingga, The Jakarta Post, Jakarta | Tue, 12/14/2010 10:47 AM | Headlines

Want to know what an incompetent government looks like?

You’re looking at it.

As early as December 2007 then chief economics minister Boediono, who is now the Vice President, announced after a Cabinet meeting that the government was preparing a program that would restrict the sales of subsidized gasoline only to public transport vehicles and motorbikes, thereby forcing private cars to use fuel sold at international prices.

But the program, which would be phased in initially in Jakarta, West Java and Banten provinces, was eventually buried under the indecisiveness of the government and opposition from the House of Representatives.

Tens of billions of dollars in taxpayers’ money continued to be burned annually into carbon-based emissions by private-car owners.

The government revived the same idea in June but the plan was again shelved due to the acute leadership of the government and resistance from politicians in parliament.

The same song played again in October when fuel subsidies became an increasingly heavy burden on the state budget.

But two weeks before the program was supposed to be initiated in Jakarta and its surrounding towns on Jan. 1, the pathetic government had not shown the House technical details on how the policy measure, which would affect tens of millions of people, would be implemented.

Even state owned oil company Pertamina, which controls more than 95 percent of the distribution of subsidized fuels, has not started logistics preparations.

The question then is how will the government be able to gain a national political consensus for a policy measure that is so strategically important to the nation?

The House would surely not want to be made the culprit for approving a policy that could potentially cause chaos in fuel distribution due to a lack of infrastructure and the inadequate institutional capacity of both Pertamina and gasoline stations.

Having said all that, I don’t mean to say the energy policy is not good.

Instead, I think the move to stop subsidizing fuel to private cars could become one of the best economic policies of the Yudhoyono government.

Technically, socially, economically and politically, the measure is the best option available.

Technically, the measure is not completely new because fuel for industrial users has long been floated on international market prices. Hence, the move will only extend the enforcement of the same fuel-pricing policy to private-car owners.

Since the restriction will start only in Jakarta and its surrounding towns, the program will not likely cause major supply disruptions to private-car owners because most of the gasoline stations in these areas have been selling unsubsidized, high-octane gasoline from Pertamina, Shell, Petronas and Total.

A one-year transition before the policy becomes effective in the rest of Java and Bali and other major islands of Sumatra, Kalimantan and Sulawesi seems adequate for Pertamina and gasoline stations to make adjustments to their storage facilities and logistics arrangements.

Economically, the measure is also the most feasible and one that poses the least risks, yet immediately with the greatest impact, because Jakarta and surrounding towns account for almost 20 percent of subsidized fuel consumption, Java and Bali 40 percent, Sumatra 18 percent and the other islands the remaining 22 percent.

The move also is socially and politically acceptable because it will affect mostly better well-off households or families who own cars.

Hence, the new fuel policy, if approved, will by one stroke generate multiple great benefits to the nation because energy subsidies actually have been a missed opportunity for investment in health and education, reducing poverty and building up infrastructure.

Since almost 55 percent of fuel subsidies have been enjoyed by private-car owners, this budget spending is simply a gross misallocation of scarce resources and a future tax and burden on the economy.

It has been too long for the government’s fiscal management to be held hostage by fuel subsidies. The policy will give investors certainty as to the future direction of the energy policy. Such a long-term perspective and policy guidance is key to wooing investment in alternative, renewable energy such as biofuel and in energy conservation and efficiency programs.

Moreover, as long as the differences between domestic gasoline prices and those in our neighboring countries such as Singapore remain large, it is rather impossible to prevent export smuggling from Indonesia, the vast archipelago country with such long porous coastal lines.

If the House members use their intelligence and reasoning properly, they should approve the new fuel policy, though under a more flexible implementation schedule — say starting next July, instead of next month as originally planned — to allow more time for infrastructure development and logistics preparations.

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