The recent growth in oil prices has revealed why fuel subsidies in Indonesia and India are a structural obstacle to economic growth. Until they are resolved, fund managers say debt investors in Asia should be wary.
Asian bond investors who have watched the market sell-off since May (see chart, below) will have anxiously followed the accompanying weakening of local currencies against the dollar. (One dollar now buys you 26% more Indian rupees and 12% more Indonesian rupiah than it did at the beginning of May.)
But they may not have noticed the longer-term challenges created by the high price of oil. (The price of the benchmark Brent Crude Oil futures contract has grown by nearly 16% over the same period.)
Whereas previous emerging market sell-offs, such as during the financial crisis, saw oil prices tank with other assets, this time oil has remained resolutely expensive on the back of ongoing concerns about the situation in North Africa and the Middle East, notably Syria and Egypt (see BBC chart below).
The double whammy of weaker currencies and higher oil prices could present real obstacles to mid-term growth for both Indonesia and India. These large oil importers have seen their costs spiral.
“Governments in these countries are paying 25-30% more than they were before May,” says Arthur Kwong, head of Asia-Pacific equities at BNP Paribas Investment Partners. “If this situation continues and these countries have to borrow money to pay for their oil, they will have a lot less to spend on their economy.”
At the heart of the problem for India and Indonesia is a deep-rooted structural issue that both countries have been slow to resolve: fuel subsidies.
Herald van der Linde, head of equity strategy for Asia-Pacific at HSBC, believes that the countries are now paying the price for stalling (in the case of Indonesia) or failing entirely (India) to reform these, when a more benign economic environment gave them the chance.
“The recent shift [out of emerging market assets] has taken the varnish away in Asia, revealing the fact that, when the times were good, these governments failed to make the right reforms,” he says.
Indonesia finally cut its subsidies in June, effectively raising gas prices 44% and diesel prices 22%. But this is the first fuel rise since 2008 and at $0.66 per litre, the country still has some of the lowest prices in the world. President Susilo Bambang Yudhoyono had attempted to slash subsidies last May, but had to give up due to violent protests. Subsidies still cost the government around $20 billion per year, or 3% of GDP.
In India, meanwhile, Van der Linde estimates that about a fifth of the total government budget goes on fuel subsidies and the IMF estimates that fuel subsidies cost the government 1.9% of GDP every year. The subsidies remain despite the urging of India’s central bank to remove them.
The costs are especially galling since Indian subsidies may be inequitable, favouring richer car-owning families who consume more fuel and are relatively easy to replace.
An IMF working paper in May found that the top 20% of Indian households capture six times more in benefits from fuel subsidies than the poorest 20%. It also claimed that 40% of families could be fully compensated for the move to market prices for less than a fifth of what the Indian government now spends on fuel subsidies, leaving significant savings to invest in roads, schools and hospitals.
Bond investors should urge on reform efforts. “The infrastructure spending made possible by the saved money will be good for economic growth, benefitting bonds,” notes Van der Linde.
But equity investors should be hurt, he adds. The opening of a market that would follow an end to artificially low fuel input costs would likely lead to much greater foreign competition for Indian firms, which could disrupt their earnings potential.
Many existing domestic firms that have built their business around a subsidised fuel price may struggle to compete with foreign rivals if the cost of this key input increases.
AsianInvestor is due to host its second annual Borrowers and Investors Forum for Southeast Asia in Singapore on October 30 and 31, in association with sister titles FinanceAsia and The Corporate Treasurer. The event will cover ground ranging from origination to DCM credit and investment.
For more details about attending, sponsoring or speaking, please contact Stuart Wadsworth, head of conferences for Haymarket Financial Media, on tel: 3175 1954 or email: email@example.com