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Scrapping of Fuel Subsidies a Landmark, Boost for Indonesia

Drivers line up for fuel at a state-owned Pertamina petrol station in Jakarta, Indonesia, Nov. 17, 2014.

Drivers line up for fuel at a state-owned Pertamina petrol station in Jakarta, Indonesia, Nov. 17, 2014.

The announcement came without fanfare, in line with Indonesian President Joko Widodo's style, but his decision to let petrol prices float freely is the most significant move to stabilize Southeast Asia's largest economy in years and shows his resolve to promote reform.

On January 1, Widodo's government scrapped subsidies for petrol, letting pump prices rise and fall in line with the cost of crude oil.

“It took some guts,” said economist Wellian Wiranto at OCBC in Singapore.

The subsidy reforms could be the start of more market liberalization, including in domestic fuel sales. This could bring resistance from state oil company Pertamina, which would have to compete with foreign oil firms, who so far have failed to get much market share because of subsidies.

Widodo hasn't spelled out other plans, but some analysts think he intends to pursue reform of Indonesia's daunting bureaucracy and how multiple business sectors are regulated - where vested interests might block the way.

Many citizens expect the government to protect them for the sharp end of free-market capitalism. But Widodo's quick move on subsidies - taking advantage of tumbling world oil prices - shows “how serious he is about reform,” Wiranto said.

Pertamina previously sold petrol at 8,500 ($0.68) rupiah per liter. Now the government will adjust pump prices each month based on the global oil price.

Freeing up billions

Widodo kept subsidies for diesel, but fixed them at 1,000 rupiah per liter, so the government no longer picks up the bill when oil prices spike.

The changes free up nearly $20 billion in 2015 for spending on productive things such as infrastructure and education.

By itself, the moves won't spark rating agency upgrades, but it sets a good tone for Indonesia, which has been battling capital flight and a sinking currency because of its current-account deficit.

Widodo's moves are “credit positive” and give the government “more fiscal flexibility,” said Atsi Sheth from Moody's Investors Service.

Owing to a 52 percent plunge in the price of crude oil since mid-June, Widodo was able to make the changes while cutting petrol prices for consumers by 10.5 percent to 7,600 rupiah a liter.

Since Indonesia became a net oil importer in the mid-2000s, fuel subsidies introduced by President Suharto in the 1970s have become unaffordable.

Far smaller subsidy

The 2015 budget presented in September by Widodo's predecessor said fuel subsidies would cost $22 billion and be 19.8 percent of central government spending.

Now, the subsidy this year should be 83 percent less, Finance Minister Bambang Brodjonegoro said on Monday.

Previously, Indonesia's fiscal policy was held hostage by global oil markets.

“In good times, the oil price soared and they had to spend money on subsidies, which resulted in a big budget deficit, which is the opposite of what you want to happen,” said Dan Martin at Capital Economics.

“Hopefully now they'll be able to manage fiscal policy in a much more sensible way.”

Monetary policy should also get a lift. The previous policy of making steep, one-off increases to pump prices made inflation rates volatile.

“Before you had a situation where inflation was capped artificially low until - boom - they hiked fuel prices and you had double-digit inflation,” said OCBC's Wiranto.

This made things difficult for Bank Indonesia.

Agressive rate hikes

“The central bank never really knew how to respond,” said Martin. “Sometimes it would raise interest rates aggressively, other times it wouldn't.”

“Now the inflation environment should be more stable and monetary policy more stable,” he added.

The true test of the new pricing policy will come when oil prices start to rise again, said Kevin O'Rourke, a political analyst.

“At that point, public dismay with rising petrol prices will place pressure on the government to re-introduce subsidies,” he said in a note.

Fuel prices have been a combustible issue. Protests over hikes contributed to Suharto's fall in 1998.

For now, though, Widodo has policy flexibility without facing opposition, thanks to cheap oil.

For policy management, “it's going to be good all round,” said Martin.