Fuel subsidy and global trade imbalances

 On Senin, 14 April 2014  

Fuel subsidy and global trade imbalances

Rangga Cipta  ;   An economist at PT Samuel Sekuritas Indonesia
JAKARTA POST, 14 April 2014
The fuel subsidy is expected to exceed its budget allocation this year as the rupiah exchange rate, oil lifting and domestic fuel consumption have gone beyond the government’s overoptimistic assumptions. Indonesia, the world’s third-largest fuel subsidy spender after Saudi Arabia and Iran, has been, once again, forced to revisit the policy, which has been in place since 1967.

The policy is not only flawed because it has led to fiscal instability but also because it is responsible for the chronic economic imbalances. With the global trade disparity plaguing big economies like the US, China, Japan and eurozone, the threat of a global financial crisis is a ticking time bomb.

When policymakers allow such a significant difference between domestic- and international-fuel prices, overconsumption is inevitable. The government must provide enough fuel supply while at the same time absorb the risks from currency and oil price shocks. The fact that Indonesia has been a net-oil importer country since 2002 has increased the risks, which will haunt its fiscal and trade balances.

The government could easily raise taxes to counterbalance the higher fuel subsidy but it will send the subsidy cost back into the economy, hurting growth.

Alternatively, the fuel subsidy burden could be mitigated by reducing other spending. But if it means a reduction in productive spending, the impact is economically harmful. For every rupiah of fuel subsidy spent, the opportunity to have higher infrastructure and education spending gets lower. Ranked 44th in 2007, Indonesia fell to 53rd among 160 countries on the 2014 Logistics Performance Index of World Bank — a measure of performance on trade logistics. Awful infrastructure transforms a country into a high-cost economy. The extra production costs industries have to pay look like a hidden corporate tax.

The opportunity to enjoy better human resources with higher productivity will also be missed if the fuel subsidy consistently expands. Currently school enrollment in secondary education is only 77 percent of the population while for tertiary it only stands at 23 percent. Thus, it comes as no surprise that Indonesia is 121st among 185 countries on the Human Development Index of United Nations in 2013.

Low productivity of labor is another form of hidden corporate tax for firms, especially if the government continues to support workers’ pay increases.

Another way to deal with the fiscal problem is to raise debts. However, this action may not need the government to sacrifice other spending; every additional debt issued will push borrowing costs higher for firms. The so-called “crowding out effect” acts like a corporate tax.

Behind strong, yet artificial, household consumption, all those hidden taxes have quietly reduced the competitiveness of manufactured goods. According to World Trade Organization (WTO), Indonesia’s share of merchandise goods exported to global markets has remained frozen at 0.8-1 percent for the last 64 years. Together with its huge middle-aged population and strong domestic demand, uncompetitive products have made Indonesia a potential market for other countries. At this point, the global trade imbalance story starts to play its part.

Many studies have revealed that some of Indonesia’s main trade partners like Japan, China or even South Korea have conducted government intervention to grab a bigger trade share in global markets. Most policies in those countries are aimed at supporting the corporate sector at the cost of the households.

Regulations allow firms to enjoy low borrowing costs and low labor costs, which are far below the normal level, therefore, lowering the overall production cost. The competitive products are easily distributed to global markets, of course with the addition of help from the central bank to keep the currency weaker than it has to be.

Meanwhile, households are forced to receive wages less than what their productivity level should get and savings interest rates below the equilibrium level. Along with expanding exports, depressed household purchasing power helps the country to enjoy an abnormal yet persistent trade surplus. A trade surplus generally corresponds to a higher savings rate, a phenomenon that most people mistakenly think is because of the hard-working and wise-spending population.

But the surplus will not last long if trade partners do not play the opposite role and delay the economic rebalancing. To make sure that market-provider countries have strong enough exchange rates to maintain purchasing power, the trade surplus — read: savings — must be invested abroad.

Some facts are worth noting: Japan is the main contributor to Indonesia’s foreign direct investment. Together with China and South Korea, Japan recently supported Bank Indonesia (BI) with a currency swap facility amounting to US$48 billion. It is not a coincidence that all those countries are also the main source of Indonesia’s imported goods.

For Indonesia, the existence of abundant raw materials — and their export — has covered up the impact of economic imbalances, especially during the high commodity price period. But the end of the commodity boom in mid 2011 started to reveal the true impact of economic imbalances; with the trade balance falling drastically into the deficit zone.

The commodity boom has also consistently pushed up the role of the primary sector in the economy. Raw commodities are now occupying around 50 percent of all exports. Also that during the high trade surplus period, the stronger rupiah further deteriorated the competitiveness of manufactured goods. The so-called “Dutch Disease effect” forced BI to stockpile excessive foreign currency reserves to prevent too strong a rupiah, injecting unnecessary liquidity into the economy, creating another kind of instability.

It is clear that the fuel subsidy plays a great role in creating imbalances inside the economy and it also plays a part in supporting trade partners’ imbalances. Economic rebalancing will eventually come and will certainly bring misery for every country involved in global trade imbalances. Most importantly, it could come without warning, like most disasters do.
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