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High oil prices could cause a temporary setback for the Indonesian economy though the impact will be more moderate than that suffered in 2005, according to Deyi Tan and Chetan Ahya, writing in Morgan Stanley's latest Global Economic Forum. In October 2005, oil prices crossing the US$65 a barrel mark led to a "mini-crisis" in Indonesia, with the government forced to raise fuel prices by 126% in October 2005 and to hike policy rate by 42bp in the second half of the year. What does the country face now with headline inflation at 7.4% and oil prices hitting beyond US$100 a barrel?

Tan and Ahya analyze the three broad areas affected by oil prices:

1. Inflation and purchasing power: Inflationary pressures are a concern: the impact of a 10% hike in fuel prices would lead to a 0.3 percentage point rise in headline inflation (first round impact), and would affect consumer discretionary spending power by 0.6% of GDP.

2. Fiscal balance: High oil prices impact both on government revenue (through oil and gas income taxes) and expenditure, as well as raising fuel and electricity subsidies. Tan and Ahya elaborate on the complexity of the pass-through:

Variations in the structure of the oil and gas PSCs (production sharing contracts) complicate the sensitivity analysis on the revenue side. However, assuming a common simplistic PSC framework, we estimate that each US$10/bbl increase in oil prices raises oil and gas revenue by 0.6% of GDP. On the expenditure side, if retail fuel prices are unchanged, the oil and electricity burden will increase by 0.67% of GDP for each US$10/bbl rise in price and revenue sharing will increase by 0.09% of GDP. Hence, with each US$10/bbl increase in the oil price, the fiscal deficit is likely to deteriorate by about 0.15% of GDP, putting little pressure on public debt levels.

For 2008, the government has revised the fuel and electricity subsidy and fiscal deficit estimates to 4.1% and 2.1% of GDP, respectively, assuming an oil price of US$95/bbl. If the oil price average is US$110/bbl, we believe that the total fuel and electricity subsidy burden would increase to 6% of GDP (US$29 billion) in 2008 and the fiscal deficit would be 2.3% of GDP.

3. Current account balance: High oil prices have a negative impact on the refined oil balance. The effect on crude oil balance is negligible, argue Tan and Ahya.

Morgan Stanley recognizes that Indonesia has been one of the strongest domestic demand growth stories in the ASEAN region, attributable partly to the steady decline in the cost of capital, stemming from a sharp decline in public and external debt and an improvement in the current account surplus.

In conclusion:

While we like Indonesia’s structural growth story, we believe that rising oil prices combined with higher food prices and increased global financial turbulence have increased the risk of a temporary pushback in the domestic demand story. However, in our view, the adverse impact of higher oil prices will be lower than that suffered in 2005. The fuel price hike, if necessary, is likely to be smaller this time around. In addition, the current account balance is now more comfortable at 2.5% of GDP in December 2007 than in 2H05. The adverse impact of higher refined oil product imports on the current account should be absorbed more easily. This reduces the risk of extreme volatility in the exchange rate if capital inflows remain weak.

Source: High Oil Prices Could Pose a Setback for Indonesia