Fitch: Indonesia fuel subsidy cut would be positive

(10 March 2012) -- If implemented, the Indonesian government?s proposal to raise subsidised fuel prices would be positive for the sovereign ratings: it could limit the fiscal impact of higher oil prices and enhance fiscal flexibility, even if it leads to a rise in 2012 CPI inflation. Indonesia?s heavy budgetary commitment to subsidy programmes has in the past diminished fiscal flexibility and exposed the budget to risks from commodity price volatility.

The proposed 33% increase in subsidised gasoline prices, part of a revised budget submitted to parliament, comes as rising global oil prices and domestic output below the level anticipated in the original budget threaten to push Indonesia?s budget deficit wider. Even with the revisions, which would take effect in April, the government estimates a budget deficit for the current year of 2.2% of GDP, up from a previous forecast of 1.5%.

A rise in inflation is a potential short-term negative result of higher gasoline prices. Bank Indonesia, which kept its key policy rate unchanged at 5.75% on Thursday after 100bp of cuts that began in October, said the government?s energy policy would have a one-off, temporary shock effect on inflation. Even a one-off event can have a disruptive effect, especially as high and volatile inflation is a long-standing weakness in the Indonesian sovereign?s credit profile.

However, Indonesia has sought to strengthen its external buffers against potentially destabilising short-term portfolio capital flows since equity markets fell sharply and official reserves dropped by USD0.9bn in January 2011, following the release of higher-than-expected inflation data.

The accumulation of foreign-currency reserves and sustained basic balance surpluses supported our decision to upgrade Indonesia to ?BBB-? with a Stable Outlook in December 2011. But short-term capital flow volatility remains a source of potential disruption. Our adjusted liquidity ratio for Indonesia, which incorporates portfolio equity liabilities, is 63%, well below the ?BBB? range median of 110%. This suggests the sovereign?s capacity to absorb an external liquidity shock is limited compared with its rating peer group.

Therefore, the willingness and capacity of BI to act to contain potentially higher inflation expectations and second-round effects will be important and could be tested later in 2012. The easing conducted by BI in late 2011 occurred while we were conducting our review that resulted in the upgrade, and the policy steps were factored in by the committee. Although we believe BI will tighten policy settings if necessary, we still consider monetary policy management to be an area of concern due to some growth bias in BI policy. (ends)