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NEWS UPDATES Asean Affairs        31  May 2011

Asean governments need to forego fuel subsidies

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Asean governments have a narrow window of opportunity to pare back politically popular fuel subsidies on their own schedule before budgets or bond holders force their hands.

The wild card, as always, is oil prices. If crude climbs near 2008’s record highs, as many economists predict, Indonesia and Malaysia look particularly vulnerable as subsidies consume a bigger share of public spending.

Both countries have massive infrastructure needs to ensure their economies sustain rapid growth, and they can ill afford to spend more to keep energy costs artificially low. Both also know they must eventually change their ways.

Indonesia and Malaysia are not the only subsidizers in the region, but they have some of the lowest retail prices for diesel and gasoline across Asia. Indonesia’s are less than half those of China’s, for example.

Malaysian Prime Minister Najib Razak said earlier this month that subsidies were “like opium” and kicking the habit was hard but necessary. Just a week later, though, his government unexpectedly backed away from raising fuel prices. The about-face highlights how difficult it will be for countries to change before the fiscal cost becomes unbearable.

The economic case for curbing the subsidies is simple: they drive up deficits and divert money from much-needed investment, and they disproportionately benefit wealthier households, exacerbating income inequality.

The politics are trickier. The more expensive oil gets, the more voters demand subsidies. However, the consequence of keeping them is worsening public finances, which can alarm bond holders and scare off private investors.

Malaysia’s next general election is not due until 2013, but Najib could call for snap polls this year to secure his mandate. Najib said his government had budgeted 11 billion ringgit ($3.6 billion) for fuel subsidies this year, but the actual figure is expected to be around 18 billion ringgit because of high crude oil prices.

Anthony Nafte, a senior economist with CLSA, said Malaysia’s current account surplus meant it could afford to wait a bit longer before raising fuel prices, even though he expects the cost of subsidies to reach 2.3 percent of GDP, double its initial estimate.

Indonesia is a different story. Its current account surplus is smaller, leaving it more dependent on government debt to cover its budget deficit, which is modest but would swell if subsidy costs keep growing. If bond holders sense subsidies are swamping the budget, borrowing costs could spike.

Indonesia has had no difficulty attracting buyers for its debt, thanks to a growth rate expected to hit 6.5 percent and a strong rupiah. Roughly 30 percent of its debt is held by foreigners, though, putting it at risk should investor sentiment suddenly sour.

Nafte expects Jakarta to hit a breaking point in the next few months where the cost of sustaining subsidies outweighs the political pain of reducing them.

Indonesia’s next election is not until 2014, so a subsidy cut this year might be a distant memory when voters head to the polls. Indonesia budgeted Rp 187.6 trillion ($21.9 billion) for fuel subsidies this year, equal to 15 percent of total government spending. However, the budget assumed an average oil price of $80 per barrel, versus current levels of more than $100. The last time oil was less than $80 per barrel was September 2010.

Nafte said fuel subsidies currently amounted to about 2.5 percent of GDP, a level he called a “stress point” that would probably push the government to move. If oil rises to $140 per barrel and the rupiah strengthens against the US dollar, the cost of sustaining subsidies would hit 3 percent of GDP, he said.

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