Oil Levies: The Economic
Implications
BACKGROUND
The combination of weakening oil prices and the failure of Congress to deal with the budget deficit by cutting spending led some to see the possibility of achieving two objectives at once: (1) protecting U.S. oil producers from “cheap” foreign competition and (2) reducing the budget deficit. The solution was an oil-import fee or tariff. A tax on imported crude and refined products that matched a world oil-price decline, for example, would leave oil and refined-product prices in the United States unchanged. Thus, it was argued, such a tax would have little effect on U.S. economic activity. It merely represents a transfer of funds from foreign oil producers to the U.S. Treasury. Moreover, it would provide some price relief to struggling U.S. refineries and encourage the production of U.S. oil. Finally, at the current level of imports, a $5/barrel tariff on foreign crude oil and a separate tariff of $10/barrel-equivalent on refined products would raise more than $11.5 billion a year.
Q
UESTIONS1. Suppose the tariff were levied solely on imported crude. In an integrated world econ-omy, who will bear the burden of the import tariff? Who will benefit? Why? What will be the longer-term consequences?
2. If a $10/barrel tariff were levied on imported refined products (but no tariff were levied on crude oil), who would bear the burden of such a tariff? Who would benefit? Why? What would be the longer-term consequences? 3. What would be the economic consequences of
the combined $5/barrel tariff on imported crude and a $10/barrel tariff on refined oil products? How would these tariffs affect domestic con-sumers, oil producers, refiners, companies com-peting against imports, and exporters?
4. How would these proposed import levies affect foreign suppliers to the United States of crude oil and refined products?
5. During the 1970s, price controls on crude oil— but not on refined products—were in effect in
the United States. On the basis of your previous analysis, what differences would you expect to see between heating oil and gasoline prices in New York and in Rotterdam (the major refining center in northwestern Europe)?
President Carter Lectures
the Foreign Exchange
Markets
At a press conference in March 1978, President Jimmy Carter—responding to a falling dollar—lec-tured the international financial markets as follows:
I’ve spent a lot of time studying about the American dollar, its value in international monetary markets, the causes of its recent deterioration as it relates to other major currencies. I can say with complete assurance that the basic principles of monetary val-ues are not being adequately addressed on the cur-rent international monetary market.*
President Carter then offered three reasons why the dollar should improve: (1) the “rapidly increas-ing” attractiveness of investment in the U.S. econ-omy due to high nominal interest rates, (2) an end to growth in oil imports, and (3) a decline in the real growth of the U.S. economy relative to the rest of the world’s economic growth.
Q
UESTIONS1. How were financial markets likely to respond to President Carter’s lecture? Explain.
2. At the time President Carter made his remarks, the inflation rate was running at about 10% annually and accelerating as the Federal Reserve continued to pump up the money supply to finance the growing government budget deficit. Meanwhile, the interest rate on long-term Treasury bonds had risen to about 8.5%. Was President Carter correct in his assessment of the positive effects on the dollar of the higher interest rates? Explain. Note that during 1977, the move-ment of private capital had switched to an out-flow of $6.6 billion in the second half of the year, from an inflow of $2.9 billion in the first half.
Case Studies
3. Comment on the consequences of a reduction in U.S. oil imports for the value of the U.S. dol-lar. Next, consider that President Carter’s energy policy involved heavily taxing U.S. oil production, imposing price controls on domes-tically produced crude oil and gasoline, and providing rebates to users of heating oil. How was this energy policy likely to affect the value of the dollar? Explain.
4. What were the likely consequences of the slow-down in U.S. economic growth for the value of the U.S. dollar? for the U.S. trade balance? 5. If President Carter had listened to the financial
markets instead of trying to lecture them, what might he have heard? That is, what were the markets trying to tell him about his policies?
Rescuing the Indonesian
Rupiah with a Currency
Board
On January 9, 1998, the Indonesian rupiah hit an historic low of 11,000 after a record low of 9,900 the previous day (see Exhibit A). It was down from 2,450 in July 1997 before the Asian currency crisis
began. Jakarta’s Stock Exchange Index plunged 12%. As news of Indonesia’s troubles spread, stock mar-kets around the world were battered; the Dow Jones Industrial Average fell more than 240 points to 7560.74. The rupiah’s plunge threw hundreds of banks and companies that had borrowed heavily abroad into bankruptcy (collectively, Indonesian businesses are estimated to be saddled with $74 bil-lion in foreign debt).
President Bill Clinton spoke to President Suharto and urged him to implement tough eco-nomic reforms to stop the deepening crisis from getting out of control. A senior Indonesian official said that Suharto agreed with Clinton’s assessment and promised to implement serious reforms. A senior U.S. economic delegation accompanied by the IMF’s top two officials was sent to Jakarta. Investors took a dismal view of Indonesia’s prospects; from July 1997 when the Asian crisis began through the end of January 1998, the Jakarta Stock Exchange lost more than 84% of its value in dollar terms (see Exhibit B).
The drop in the Indonesian stock market and the rupiah began the week before, when Suharto announced a draft budget that contained wildly unrealistic projections (GDP growth of 4%, inflation remaining at 9%, the rupiah doubling in value from
13-Mar-98 10-Mar-98 5-Mar-98 2-Mar-98 25-F eb-98 20-F eb-98 17-F eb-98 12-F eb-98 9-F eb-98 4-F eb-98 30-J an-98 27-J an-98 22-J an-98 19-J an-98 14-J an-98 9-J an-98 6-J an-98 31-Dec-97 26-Dec-97 22-Dec-97 17-Dec-97 12-Dec-97 9-Dec-97 4-Dec-97 1-Dec-97 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000
Rupiah exchange rate on July 1, 1997
Planned currency board rate
IMF and U.S. lobby against currency board
Currency board may be dropped Speculation mounts that
Suharto will adopt a currency board Suharto announces for 7th term Suharto agrees to IMF reforms
Suharto talks to Hanke about setting up currency board IMP threatens
to cut off aid Indonesia releases unrealistic budget Doubts over Suharto's
health emerge
IMF may delay $3 billion disbursement Rumors that Habibie selected
as Suharto's successor
Rupiah per dollar (in
v
e
rted scale)
its current level, and a balanced budget based on pro-jections of a 10% increase in non-oil tax receipts) and reneged on taking any of the tough structural reform measures it agreed to in October 1997 in return for a $43 billion IMF-led rescue package. Specifically, Suharto had promised to restructure the banking sys-tem, maintain a tight monetary policy, raise sales taxes, cut food, fuel, and electricity subsidies, end government funding of several huge, money-losing investments (including projects to design and manu-facture a national car and a national airplane), and disband domestic monopolies, cartels, and special entitlements that had enriched his children and cronies.
Most analysts viewed the budget as an attempt to maintain the status quo at a time that Indonesia was on the brink of disaster (private economists fore-cast a decline in GDP of 15% and inflation of 55%). They had hoped for austerity, a blueprint for the han-dling of cash-strapped and insolvent companies and banks, and repeals on foreign-ownership limits on property and financial institutions. Instead, Mr. Suharto pledged a 32% increase in government spending, including a 13 trillion rupiah increase in subsidies for fuel and food. The budget also allocated funds for the development by Suharto’s eldest
daugh-ter of a new power plant on Java, even though Java already had an electricity surplus.
In response, the IMF threatened to pull the plug on its $43 billion bailout program for Indonesia. IMF officials said they could understand Indonesia’s desire to place a high priority on social and human-itarian concerns in its budget but they criticized the government for doing so without making a good-faith effort to implement the agreed-on structural eco-nomic reforms. Under the IMF-led rescue plan, Indonesia was required to achieve a budget surplus of 1% of GDP. However, IMF officials said they were will-ing to renegotiate the fiscal targets provided Indonesia implemented such reforms. The heightened tensions sent the rupiah plummeting and led to a sharp rise in food and other prices (see Exhibit C).
Citizens began hoarding food, and fears of unemployment and social unrest were spreading. The threat of political instability was not taken lightly by its neighbors and others. Indonesia, with 200 million people, is the fourth-most-populous nation in the world. However, the income distribu-tion is skewed, with the 4% of the populadistribu-tion that is ethnic Chinese controlling about 60% of the nation’s wealth. In the 1960s, Indonesia was torn by bloody ethnic riots that led to a change of power, when
EXHIBIT B ●Indonesia’s Stock Market Index in U.S. Dollars: January 1995–March 1998 Inde x v alue (J an uar y 1, 1995 = 100) 12/30/94 2/28/95 4/28/95 6/30/95 8/31/95 10/31/95 12/29/95 2/29/96 4/30/96 6/28/96 8/30/96 10/31/96 12/31/96 2/28/97 4/30/97 6/30/97 8/29/97 10/31/97 12/31/97 2/27/98 160 140 120 100 80 60 40 20 0
Suharto deposed his predecessor, President Sukarno. An estimated 500,000 Indonesians died in those riots, many of them ethnic Chinese.
The long economic boom since then, with GDP growing at an average rate of 7% annually (see Exhibit D for growth rates since 1980), helped salve the ethnic antagonisms, but they always lie just beneath the surface. So it was predictable that with the economic hardships anti-Chinese riots became more common.
Political stability also was threatened by Indo-nesia’s endemic corruption and the autocratic regime’s resulting lack of popular support. Not to put too fine a point on it, President Suharto’s regime was a kleptocracy, run for the financial benefit of his family and friends. They exploited to the full the opportunities for corruption and profit that their connections gave them. The scale of corruption was breathtaking; Suharto and his six children had an estimated net worth of $40 billion. Since Indonesia’s economic meltdown began in 1997, President Suharto’s actions appeared designed to protect his family’s financial interests and preserve his power rather than to promote the public good. With 7% real economic growth, enough prosperity reached the streets to keep the populace quiescent, if not happy. Authoritarianism, nepotism, and outright
corruption were tolerated as long as Suharto deliv-ered the goods. But there was no reservoir of popu-lar support to carry President Suharto and his regime through the price increases and other painful reform measures mandated by the IMF and necessi-tated by the current crisis. Moreover, there was no obvious successor to the 76-year-old Suharto, whose health was a question mark.
On January 15, 1998, Suharto agreed to the sweeping economic reforms he had reneged on the week before. In return, the IMF agreed to begin dis-bursing funds to Indonesia. The rupiah and Jakarta stock exchange staged a modest recovery.
Immediately after making these promises, Indonesia began pursuing contradictory policies that led to a sharp selloff in the rupiah. The central bank agreed to compensate depositors in 16 closed banks, while printing rupiah (ultimately more than 100 trillion rupiah) to keep the remaining 220 afloat. Rumors also began circulating that Suharto intended to appoint Bucharuddin Habibie, the minister of research and technology, as his next vice president and likely successor. These rumors drove the rupiah down on January 22, at one point to 17,000 to the dollar, largely because Mr. Habibie was the man behind many of Indonesia’s contro-versial spending programs—programs (such as the Consumer price index (food only)
Consumer price index (all items) 200 190 180 170 160 150 140 130 120 110 100 Composite pr ice inde xes (J an uar y 1, 1995 = 100) Mar-98 J an-98 No v-97 Sep-97 J ul-97 Ma y-97 Mar-97 J an-97 No v-96 Sep-96 J ul-96 Ma y-96 Mar-96 J an-96 No v-95 Sep-95 J ul-95 Ma y-95 Mar-95 J an-95
EXHIBIT C ●Inflation Accelerates in Indonesia
attempt to build a national aircraft industry from scratch) whose financing President Suharto had just agreed to cut.
Most controversially from the IMF’s stand-point, President Suharto began to flirt with the idea of establishing a currency board that would tie the value of the rupiah to the dollar. He was introduced to the idea of a currency board by Steven Hanke, an American economist who pointed to the experi-ences of Hong Kong, Argentina, and other countries as demonstrating that such a system would stablize the currency and bring down soaring interest rates. By pegging the rupiah at a rate of 5,500 to the dollar, about twice its current value, President Suharto and his advisers became convinced that Indonesia could stop the rupiah’s slide, rein in soaring prices, and restore the confidence of local and foreign investors—all without resorting to the IMF’s bitter economic medicine. As word of the currency board spread, the rupiah soared in value.
U.S., IMF, and EU economic officials, however, contended that a currency board is a quick fix that won’t work. They argued that it could lead to disas-trously high interest rates, further troubles for the Indonesian banking system, and increased social unrest. In addition, many currency traders believed that a currency board would soon fail, taking much of the banking system with it. The government was
guaranteeing all bank deposits, which it could not do under a currency board (because it could issue rupiah only if there were dollars to back them). Banks might suffer a run as depositors rushed to convert rupiah into dollars. Critics also complained that Suharto was only interested in a currency board because raising the rupiah’s value would rescue his associates who have dollar-denominated debt.
The IMF responded by delaying a disburse-ment scheduled for March 15. It then promised flex-ibility, especially on food and electricity subsidies. Most observers felt that the IMF had no choice: Between a poor harvest, massive unemployment, and soaring prices, there was a real fear of a human-itarian, social, and political disaster.
During February, food riots and looting erupted in dozens of towns across Indonesia. Most of the violence was directed at shops owned by the ethnic Chinese. Students and other political protest-ers staged peaceful demonstrations against the gov-ernment. Worse, Suharto appeared to have lost the support of many of Indonesia’s middle class, who tolerated him and his family as long as he delivered economic growth and a rising standard of living.
Only the Indonesian armed forces appeared to stand in the way of anarchy. Its half million men were supposed to protect the state against internal threats as well as external ones. In practice the army 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% Real GDP g ro wth r ate 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
EXHIBIT D ●Growth in Indonesia Real Gross Domestic Product: 1980–1996
had done the president’s bidding. In return, its offi-cers profited from the numerous opportunities for corruption that their pervasive presence in the country’s administration gave them. As long as Suharto retained the loyalty and support of the army, his grip on power was secure. However, if the social unrest got out of hand, the soldiers might decide that killing hundreds or even thousands of their countrymen to perpetuate his reign was not worth the personal cost. Such bloodshed would also make the army unpopular for years to come and threaten its privileged role in Indonesian society.
To President Suharto and some of his eco-nomic advisers, the idea of a currency board promised a way out of the crisis without making the fundamental changes demanded by the IMF. They estimated that there were enough foreign exchange reserves to immediately restore the value of the cur-rency to about 5,500 rupiah to the dollar. This jump in the rupiah’s value would reassure investors that their Indonesian investments would retain their value. It also would reduce the inflation that was eat-ing away at the purchaseat-ing power of the average Indonesian’s wages and would make it easier for Indonesian companies and banks to service their foreign debts (overseas borrowing gave them capital at about five percentage points less than at home). With the time bought with a currency board, Indonesia’s natural economic strengths could reassert themselves. It produces all its own oil and exports billions of dollars’ worth, and its manufacturing industry exports goods worth more than double its energy exports.
Skeptics pointed out that what worried investors most was not inflation eating away at their wealth but that many of the country’s businesses and financial institutions could go bankrupt, or even that the coun-try could descend into the chaos of the 1960s. At the same time, committing Indonesia’s reserves to a cur-rency board meant they would be unavailable to pay for imports or debt service. The debt service alone was enormous, given the $140 billion that Indonesia’s public and private entities had borrowed abroad, much of it short term (for example, Indonesian com-panies had $43.2 billion in foreign debt due within one year). In addition, critics claimed that a rupiah fixed at 5,500 to the dollar would give the nation’s wealthy elite, including President Suharto’s children and associates, a chance to trade their rupiah for dol-lars and deposit them overseas. Indonesia’s dollar reserves would disappear, interest rates would
sky-rocket, and the economy would be battered even more. Supporters, however, dismissed these con-cerns, claiming that money would flow into Indonesia, not out, thanks to new international con-fidence in the currency and country.
Another option being discussed—possibly in conjunction with a currency board—was a debt moratorium. A moratorium would presumably sup-port the rupiah because debtors no longer would have to buy dollars to service their foreign debts.
Q
UESTIONS1. What monetary policies could Suharto follow that would restore the rupiah’s pre-crisis value? What problems would those policies face? 2. What were the costs and benefits of an
Indonesian debt moratorium?
3. How did undermining the social contract between Suharto and the middle class affect the value of the rupiah?
4. How did a weak banking system affect the prospects for a currency board?
5. Should the IMF have withheld disbursements if Indonesia did not honor its commitments? What were the pros and cons?
6. Did the IMF’s prescription for Indonesia make sense? Explain.
7. Why had Suharto found it so hard to imple-ment the IMF’s provisions?
8. What suggestions do you have for stemming the rupiah’s slide and strengthening its value? 9. Did cuts in fuel and food subsidies make sense? 10. Should Indonesia have established a currency
board? What considerations would you weigh in that decision? If you decide against a currency board, what alternative would you suggest?
