While the rest of the world struggled with staggering inflation, Indonesians enjoyed relatively mild price pressures thanks to government subsidies absorbing the shocks of rising costs. For example, in the first half of 2022, Indonesians paid half the actual price of gasoline at the pump as the government paid the difference in production costs. Indonesian leaders have been angry at weaning the democratic country’s 270 million residents from energy subsidies: the usual subsidies have resulted in fuel consumption a staggering 13 percent higher than the global average, and fuel prices are weighing heavily on average household consumption.
But the strategy of keeping prices in check has become unduly costly amid the ongoing energy crisis, prompting the government to raise the price of petrol for the first time in eight years.
The Indonesian government has rightly taken this controversial step, despite protests and possible higher inflation, and should go further to wean the country off costly subsidies. So far this year, the government has nearly tripled the subsidy budget – from 207 trillion Indonesian rupiah ($14 billion) to 502.4 trillion rupiah ($34 billion) – as production costs have soared above subsidized selling prices. In fact, the government estimates that even with the increased subsidy budget, the subsidy cost would rise to 653 trillion rupiah ($44 billion) even if the price of crude oil fell.
This budget squeeze is crowding out much-needed government investment into projects that boost productivity, such as those that bolster Indonesia’s ailing infrastructure. An analysis of Indonesia’s infrastructure supply shows that it is insufficient not only compared to developed markets but also to its regional peers such as Malaysia and Vietnam in terms of roads, air travel, electricity, railways and broadband infrastructure. To make matters worse, Indonesia will need to invest even more to keep up with these demographic changes as it becomes more urbanized and has a growing population. To do this, it needs to reduce the level of subsidy spending to expand the allocation to investment, which is currently geared towards subsidies for gasoline spending rather than investment.
Now is a good time for Indonesia to address this issue. President Joko Widodo’s ratings are high and presidential elections aren’t due until 2024, meaning that while the rate hike has caused turmoil, it’s unlikely to overthrow his government. Indonesia is also currently benefiting from the energy crisis thanks to increased demand for its coal and other fossil fuel exports. The trade balance is in surplus, boosting income flows. Foreign direct investment (FDI) inflows are also at an all-time high, in part because Indonesia is rich in mineral resources needed for the energy transition — particularly hydrogen and nickel, which are critical to electric vehicle batteries are. Income streams from these favorable trading conditions should offset some of the purchasing power deterioration expected from higher fuel prices.
Finally, the rise in fuel prices underscores the need for Indonesia to move away from populist policies that are only patching up the cost-of-living crisis. Instead, the government needs to focus on the real solution: improving formal employment opportunities and raising wages for ordinary Indonesians. The labor force of 131 million people is underutilized, with more than 60 percent of employment in the informal sector and 32 percent in agriculture. Such underutilization means Indonesia is leaving most of its citizens behind as formal employment opportunities are still limited. My calculation of quantity, quality and regulations suggests that Indonesia is still not attractive in simple or advanced labor intensive manufacturing. New policies such as easing restrictive FDI policies, enforcing rigid labor laws (in progress via the stalled Omnibus Act), upgrading workers’ skills and improving fragile infrastructure are needed to attract more labor-intensive manufacturing sectors.
To solve these problems, Indonesia needs to make room in its budget to allocate more spending to investment rather than tripling its already excessive subsidy budget. Apart from rising prices, Indonesia needs to completely wean the population off costly subsidies and focus on expanding job opportunities by investing in infrastructure to take advantage of its favorable demographic shift.