2007 government budget: Just more of the same?

August 23, 2006
Kahlil Rowter, Jakarta

As the largest single entity in the economy, the government
plays an essential role, at least from a signaling standpoint.
Hence the government budget unveiled every year in August is
critical. Especially now when the economy is bottoming out.

The first and most obvious piece of information we can glean
from the budget is the assumptions. A clarification before
continuing further. Assumptions are needed to generate all other
budget numbers. But they are not government forecasts. Some are
targets the government will try to achieve, and others, beyond
government control, are best guesses. For example, the
government will attempt to boost growth if it is below target by
increasing spending. But global oil prices are certainly outside
the government's hands.

In the 2007 budget, growth is assumed at 6.3 percent, the
average rupiah exchange rate at 9,300 to the dollar, three-month
SBI average at 8.5 percent and world oil price at US$65 per
barrel. With interest rates declining it is reasonable to expect
growth will resume. However, a reduction in interest rates will
take some time to have an effect on lending rates. More
immediate will be its effect of diverting more income into
spending.

Thus we anticipate higher consumer spending later this year and
in early 2007. A sudden rise in government spending in the
second half of 2006 carries inflation risks which could force
the central bank to slow down interest rate cuts. It is
therefore essential that government spending be on schedule to
achieve 6.3 percent growth next year.

Another risk is with global interest rates. Although the U.S.
Fed is looking at a decline in core inflation later this year,
the jury is still out on whether this will take place and
whether they can afford not to raise rates then. If they do
raise rates, the space will rapidly close on how fast Bank
Indonesia can lower its policy rates.

At the moment Indonesia's real interest rate differential
against the US is about 0.30 percent. Should U.S. core inflation
decline to 2.5 percent, and our own to 7 percent, and as long as
the Fed does not increase rates, the present differential will
be maintained if the Bank Indonesia rate is reduced to 10.25
percent. If the Fed does raise rates one more time this year to
5.5 percent, the interest differential will be maintained if the
BI rate is reduced only to 10.5 percent. Only when Indonesian
core inflation declines to around 6 percent next year will we
see BI rates in single digits.

As regards oil prices, raising the assumption to $65 per barrel
from $57 reduces the risk should actual prices remain at the
present levels or rise. Our own simulation shows that if oil
prices average $84 per year, the fuel subsidy here will reach Rp
100 trillion.

Interestingly, at the same time as raising the oil price
assumption to $65, which is 14 percent above the $57 assumption
last year, the amount of the fuel subsidy was only raised 9
percent. The electricity subsidy was actually cut by Rp 500
billion. The difference then is expected to be made up either by
a reduction in consumption or by gasoline and kerosene
substitutes like bio-fuels.

For transportation and electricity generation this will not be
easy given that large bio-fuel production capacity has yet to be
built and transporting large amounts of gas to cities remains a
challenge. For household cooking, the advent of the large-scale
production and distribution of small gas bottles in lieu of
kerosene appears promising. Especially considering kerosene
absorbs a lot of the fuel subsidy.

A lot of disappointment has been expressed over the lowering of
the 2007 budget deficit to 0.9 percent of GDP from 1.2 percent
in 2006. It should first be noted that the rise in the 2006
deficit from its formerly targeted level of 0.7 percent of GDP
was due to a carryover of unspent expenditures in 2005.

In addition, by looking at the deficit from a longer-term
perspective, we can arrive at a more important measure called
structural deficit. This is calculated by dividing the deficit
level to trend GDP. In the case of 2007, the structural deficit
rises to 2 percent of GDP from 1.9 percent in 2006.

Another way to look at the impact of the budget on the economy
is by calculating the share of government consumption and
capital expenditure in nominal GDP. In this regard, in the 2007
budget the share is 14.3 percent compared to about 12 percent in
2006.

From these two measures we see that the 2007 budget is actually
more pro-growth than previous ones. But not all of this is by
design. Historically the pro-cyclical nature of Indonesian
government budgets is due to 1) no built-in unemployment or
social security programs; 2) growth upturns in the past have
resulted in higher than anticipated fuel subsidy; 3) not all of
the increase in GDP is captured by the tax system due to the
large informal sector in the economy.

As regards oil price assumptions, higher than assumed prices
actually reduce the budget deficit, but at the same time the
fuel subsidy will rise. In the past large domestic-overseas
prices differences have induced smuggling and hoarding. This
must not be allowed to happen again.

Other than this we see a more realistic set of assumptions which
reduce risks to the budget. As regards the deficit, a closer
inspection shows that it is actually larger than previous years.
This is expected to boost economic growth.

The main issue facing next year's government budget is not in
the design but its implementation. If the sudden burst of
government spending near the end of June this year, as evidenced
from second quarter GDP numbers unveiled last week, recur in a
smoother manner we can expect the budget to contribute to
economic recovery.

Otherwise uncertainties over when actual expenditures take place
and the debate surrounding them will cloud decision making and
ultimately stop investors from committing.

The writer is chief economist at CIMB-GK Securities. The views
expressed here are personal.