Friday, September 30, 2005

Unrest in Jakarta, and why India needs to pay attention

I've been following with interest and concern the Indonesian fiscal crisis triggered by the spiralling world oil prices. Now by all accounts, the situation in countries like Eritrea, North Korea and the Philippines is much worse, but Indonesia is a very fascinating and peculiar case study, why, I'll explain in a moment.

First, the big news. A few hours ago, the Indonesian government announced a cumulative fuel price hike of nearly 126 per cent! That is extremely radical by any standards, but considering the fact that the toppling of the Suharto government over fuel price hikes a few years ago must be fresh in the minds of Indonesian politicians, the measure is very brave. The fact that Susilo Bambang Yudhoyono was able to sign off on this shows that a) the situation with the fuel subsidy is really grave, and b) the man has strong convictions and is not afraid to take big risks, something that Indian politicians can well learn from. What is going to happen in the next few days will be followed keenly around the world, the demonstrations have already begun, and the big jump in kerosene prices (from 700 rupiah to 2000 rupiah a litre) will hit the Indonesian poor especially hard.

But let's track back to what got Indonesia in this mess in the first place. And that would take us back to beginnings of the glory days of the Indonesian economy in the late 1960s, when oil exploration boomed under production-sharing contracts initiated by the newly formed state oil and gas company Pertamina (from the merger of three existing state companies) and many Western oil companies. Oil exploration had been going on in Indonesia since the late 19th century, but with the new contracts and state control over the oil fields and infrastructure, the state started enriching itself with oil money. And what better way to stabilize a dictatorship and calm discontent than to supply cheap fuel to the populace subsidized by the riches garnered through oil exploration. The 1973 OPEC move to increase oil prices dramatically also helped Indonesia immensely and the economy flourished in the 1980s boom decade.

Throughout this dramatic rise in oil prices and revenue though, the oil fields and infrastructure remained under the control of the state oil firm Pertamina. Now Pertamina is notoriously incompetent in upstream exploration and exploitation (drilling) operations. Pertamina's also notorious for being at the centre of the massive corruption of the Suharto regime, and after the regime's fall, 152 contracts were cancelled by Pertamina to stop the family from milking the company dry. Additionally, the government has trouble raising adequate capital to finance the massive costs of exploration and extraction. So there is considerable dependency on Western oil companies to provide the much needed capital and operational efficiency in exploration. However, after the 1998 monetary crisis there has been reluctance on the part of these Western giants to come forward with investments, primarily due to the following reasons:

Uncertain monetary situation and volatility of the rupiah
Legal uncertainties and adverse decisions against extension of existing contracts of Western companies
Wrangling with Pertamina over terms of production-sharing.

Nothing illustrates this more than the case of the Cepu oil field in Java, that was explored by Pertamina for nearly 30 years and given up as barren and lacking any potential reserves. The exploration rights were sold to Exxon, and in 2001, the company discovered massive oil reserves in the field. Exxon's contract expires in 2010 and starting in 2001 it was stuck in a 4-year battle with Pertamina over the terms of the production-sharing contract, where Pertamina demanded a greater share of the pie, even though it did practically nothing to discover the reserves in the first place. With the fuel subsidy crisis, now the Indonesian government has intervened to give Exxon the exploration rights on favourable terms.

So the point being, as fuel demand soared in Indonesia and the world, exploration started declining and many existing wells started drying up. The subsidies stayed put, and became even more onerous on the government, given runaway inflation. Before today's price hike, Indonesia sold petrol/gas to consumers at 2400 rupiah (23 cents or approx. Rs. 11)a litre, that's nearly 83-84 cents a gallon. Compare that to current petrol/gas prices of approx $ 2.85 a gallon in Los Angeles for the cheapest guzzle (includes a state and federal transportation tax totaling approx 40 cents). Indian petrol/gas prices are higher (Rs. 44 a litre in Delhi after price hike of Rs.3, that's nearly $3.50 a litre), but that's because of a convoluted system of high taxes overriding fuel subsidies. The reason the tax is so high is because income tax realization rates in India are so pathetic, but that's another story.

So demand kept rising, production falling (Indonesia hasn't been able to meet OPEC quotas in the last 2 years at least), and then the final straw that broke the camel's back was the unprecedented oil price rise this year. Suddenly, the currency fell precipitously against the dollar (hurting investment even more), nearly 20 per cent of the budget was spent for fuel subsidies and Indonesia became a net oil importer. The Yudhoyono government's fuel price increases may seem drastic, but it seems that they have little choice if they want to avert another economic crisis.

Now somewhere in this mess is a very grave lesson for the Indian government and its economic planners. Often subsidies are a way of deferring economic shocks that are near inevitable. If you keep supporting subsidies ignoring all economic logic and global conditions, when they invariably do catch up the blow can be very severe. On the other hand a gradual rise in prices can lead to a smoother transition to a world of necessarily higher energy costs. Also crucial is the realization that timely investments in industrial development and infrastructure is essential not simply for economic growth, but to avert future economic crises that may well arise under volatile economic conditions. And of course, the fact that public sector companies can not only hurt the economy with inefficiency and sloth, but actively prevent development in certain sectors with malevolent intervention.

My intention is not to sound alarmist, and certainly the outlook for Indonesia is not bad at all. The country still has considerable oil reserves and some of the biggest natural gas and coal reserves in the world. Once all the necessary reforms are put in place the potential for growth is enormous. But in the short term Indonesia is certainly an exemplary case study of how not to get carried away by short-term windfalls and fail to plan for the future.


Blogger Brice Timmons said...

With regard to the Indian income tax reality (a problem for much of the world, incl. some EU states, I beleive that a more realistic codification of property laws (a la Hernando de Soto) would provid a means of tracking the expenditure of unreported income (thus allowing enforcement of the law) as well as the additional taxation potential of property and luxury taxes. As it stands much of the world owns uncodified (and thus untracalbe) property, a condition that is totally preventative of any serious tax base. Problematically, it also discourages investment in small businesses, thus reducing overall wealth production. Consumption taxes like taxes on fuel, end-user products, or utilities can never generate equivalent government income yet they serve as barriers to the use of infrastructure and products by the poor.

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