Oil Levies: The EconomicImplications

BACKGROUND

The combination of weakening oil prices and thefailure of Congress to deal with the budget deficit bycutting spending led some to see the possibility ofachieving two objectives at once: (1) protecting U.S.oil producers from cheap foreign competition and(2) reducing the budget deficit. The solution was anoil-import fee or tariff. A tax on imported crude andrefined products that matched a world oil-pricedecline, 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 onU.S. economic activity. It merely represents a transferof funds from foreign oil producers to the U.S.Treasury. Moreover, it would provide some pricerelief to struggling U.S. refineries and encourage theproduction of U.S. oil. Finally, at the current level ofimports, a $5/barrel tariff on foreign crude oil and aseparate tariff of $10/barrel-equivalent on refinedproducts would raise more than $11.5 billion a year.

QUESTIONS

1. Suppose the tariff were levied solely onimported crude. In an integrated world econ-omy, who will bear the burden of the importtariff? Who will benefit? Why? What will bethe longer-term consequences?

2. If a $10/barrel tariff were levied on importedrefined products (but no tariff were levied oncrude oil), who would bear the burden of sucha tariff? Who would benefit? Why? Whatwould be the longer-term consequences?

3. What would be the economic consequences ofthe combined $5/barrel tariff on imported crudeand 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 affectforeign suppliers to the United States of crudeoil and refined products?

5. During the 1970s, price controls on crude oilbut not on refined productswere in effect in

the United States. On the basis of your previousanalysis, what differences would you expect tosee between heating oil and gasoline prices inNew York and in Rotterdam (the major refiningcenter in northwestern Europe)?

President Carter Lecturesthe Foreign ExchangeMarkets

At a press conference in March 1978, PresidentJimmy Carterresponding to a falling dollarlec-tured the international financial markets as follows:

Ive spent a lot of time studying about the Americandollar, its value in international monetary markets,the causes of its recent deterioration as it relates toother major currencies. I can say with completeassurance 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 whythe 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 endto growth in oil imports, and (3) a decline in thereal growth of the U.S. economy relative to the restof the worlds economic growth.

QUESTIONS

1. How were financial markets likely to respondto President Carters 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 Reservecontinued to pump up the money supply tofinance the growing government budget deficit.Meanwhile, the interest rate on long-termTreasury bonds had risen to about 8.5%. WasPresident Carter correct in his assessment of thepositive effects on the dollar of the higher interestrates? 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

* President Canute, Wall Street Journal, March 8, 1978, p. 16.

3. Comment on the consequences of a reductionin U.S. oil imports for the value of the U.S. dol-lar. Next, consider that President Cartersenergy policy involved heavily taxing U.S. oilproduction, imposing price controls on domes-tically produced crude oil and gasoline, andproviding rebates to users of heating oil. Howwas this energy policy likely to affect the valueof the dollar? Explain.

4. What were the likely consequences of the slow-down in U.S. economic growth for the value ofthe U.S. dollar? for the U.S. trade balance?

5. If President Carter had listened to the financialmarkets instead of trying to lecture them, whatmight he have heard? That is, what were themarkets trying to tell him about his policies?

Rescuing the IndonesianRupiah with a CurrencyBoard

On January 9, 1998, the Indonesian rupiah hit anhistoric low of 11,000 after a record low of 9,900 theprevious day (see Exhibit A). It was down from2,450 in July 1997 before the Asian currency crisis

began. Jakartas Stock Exchange Index plunged 12%.As news of Indonesias troubles spread, stock mar-kets around the world were battered; the Dow JonesIndustrial Average fell more than 240 points to7560.74. The rupiahs plunge threw hundreds ofbanks and companies that had borrowed heavilyabroad into bankruptcy (collectively, Indonesianbusinesses are estimated to be saddled with $74 bil-lion in foreign debt).

President Bill Clinton spoke to PresidentSuharto and urged him to implement tough eco-nomic reforms to stop the deepening crisis fromgetting out of control. A senior Indonesian officialsaid that Suharto agreed with Clintons assessmentand promised to implement serious reforms. Asenior U.S. economic delegation accompanied bythe IMFs top two officials was sent to Jakarta.Investors took a dismal view of Indonesiasprospects; from July 1997 when the Asian crisisbegan through the end of January 1998, the JakartaStock Exchange lost more than 84% of its value indollar terms (see Exhibit B).

The drop in the Indonesian stock market andthe rupiah began the week before, when Suhartoannounced a draft budget that contained wildlyunrealistic projections (GDP growth of 4%, inflationremaining at 9%, the rupiah doubling in value from

13-M

ar-9

810

-Mar

-98

5-M

ar-9

8

2-M

ar-9

825

-Feb-

9820

-Feb-

9817

-Feb-

9812

-Feb-

989-

Feb-

984-

Feb-

9830

-Jan-9

827

-Jan-9

822

-Jan-9

819

-Jan-9

814

-Jan-9

89-

Jan-9

86-

Jan-9

831

-Dec

-97

26-D

ec-9

7

22-D

ec-9

717

-Dec

-97

12-D

ec-9

7

9-De

c-97

4-D

ec-9

7

1-D

ec-9

7

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 rateIMF and U.S. lobby

against currency board

Currency boardmay be dropped

Speculation mounts thatSuharto will adopt a

currency boardSuharto

announces for7th term

Suharto agreesto IMF reforms

Suharto talks to Hanke aboutsetting up currency boardIMP threatens

to cut off aid

Indonesia releasesunrealistic budget

Doubts over Suharto'shealth emerge

IMF may delay $3 billiondisbursement

Rumors that Habibie selectedas Suharto's successor

Rup

iah

per d

olla

r (inv

erte

d sc

ale)

EXHIBIT A The Rupiah Rides a Rollercoaster

its current level, and a balanced budget based on pro-jections of a 10% increase in non-oil tax receipts) andreneged on taking any of the tough structural reformmeasures 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 salestaxes, cut food, fuel, and electricity subsidies, endgovernment funding of several huge, money-losinginvestments (including projects to design and manu-facture a national car and a national airplane), anddisband domestic monopolies, cartels, and specialentitlements that had enriched his children andcronies.

Most analysts viewed the budget as an attemptto maintain the status quo at a time that Indonesiawas 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 andbanks, and repeals on foreign-ownership limits onproperty and financial institutions. Instead, Mr.Suharto pledged a 32% increase in governmentspending, including a 13 trillion rupiah increase insubsidies for fuel and food. The budget also allocatedfunds for the development by Suhartos eldest daugh-

ter of a new power plant on Java, even though Javaalready had an electricity surplus.

In response, the IMF threatened to pull theplug on its $43 billion bailout program for Indonesia.IMF officials said they could understand Indonesiasdesire to place a high priority on social and human-itarian concerns in its budget but they criticized thegovernment 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 of1% of GDP. However, IMF officials said they were will-ing to renegotiate the fiscal targets provided Indonesiaimplemented such reforms. The heightened tensionssent the rupiah plummeting and led to a sharp rise infood and other prices (see Exhibit C).

Citizens began hoarding food, and fears ofunemployment and social unrest were spreading.The threat of political instability was not takenlightly by its neighbors and others. Indonesia, with200 million people, is the fourth-most-populousnation in the world. However, the income distribu-tion is skewed, with the 4% of the population that isethnic Chinese controlling about 60% of the nationswealth. In the 1960s, Indonesia was torn by bloodyethnic riots that led to a change of power, when

EXHIBIT B Indonesias Stock Market Index in U.S. Dollars: January 1995March 1998

Inde

x va

lue

(Janu

ary

1, 1

995

= 10

0)

12/3

0/94

2/28

/95

4/28

/95

6/30

/95

8/31

/95

10/3

1/95

12/2

9/95

2/29

/96

4/30

/96

6/28

/96

8/30

/96

10/3

1/96

12/3

1/96

2/28

/97

4/30

/97

6/30

/97

8/29

/97

2/27

/98

12/3

1/97

10/3

1/97

160

140

120

100

80

60

40

20

0

Source: Morgan Stanley Capital International.

Suharto deposed his predecessor, President Sukarno.An estimated 500,000 Indonesians died in thoseriots, many of them ethnic Chinese.

The long economic boom since then, withGDP growing at an average rate of 7% annually (seeExhibit D for growth rates since 1980), helped salvethe ethnic antagonisms, but they always lie justbeneath the surface. So it was predictable that withthe economic hardships anti-Chinese riots becamemore common.

Political stability also was threatened by Indo-nesias endemic corruption and the autocraticregimes resulting lack of popular support. Not toput too fine a point on it, President Suhartos regimewas a kleptocracy, run for the financial benefit of hisfamily and friends. They exploited to the full theopportunities for corruption and profit that theirconnections gave them. The scale of corruption wasbreathtaking; Suharto and his six children had anestimated net worth of $40 billion. Since Indonesiaseconomic meltdown began in 1997, PresidentSuhartos actions appeared designed to protect hisfamilys financial interests and preserve his powerrather than to promote the public good. With 7%real economic growth, enough prosperity reachedthe streets to keep the populace quiescent, if nothappy. 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 hisregime through the price increases and other painfulreform measures mandated by the IMF and necessi-tated by the current crisis. Moreover, there was noobvious successor to the 76-year-old Suharto, whosehealth was a question mark.

On January 15, 1998, Suharto agreed to thesweeping economic reforms he had reneged on theweek before. In return, the IMF agreed to begin dis-bursing funds to Indonesia. The rupiah and Jakartastock exchange staged a modest recovery.

Immediately after making these promises,Indonesia began pursuing contradictory policiesthat led to a sharp selloff in the rupiah. The centralbank agreed to compensate depositors in 16 closedbanks, while printing rupiah (ultimately more than100 trillion rupiah) to keep the remaining 220afloat. Rumors also began circulating that Suhartointended to appoint Bucharuddin Habibie, theminister of research and technology, as his nextvice president and likely successor. These rumorsdrove the rupiah down on January 22, at one pointto 17,000 to the dollar, largely because Mr. Habibiewas the man behind many of Indonesias contro-versial spending programsprograms (such as the

Consumer price index (food only)Consumer price index (all items)

200

190

180

170

160

150

140

130

120

110

100

Com

posit

e pr

ice

inde

xes

(Janu

ary

1, 1

995

= 10

0)

Mar

-98

Jan-9

8

Nov

-97

Sep-

97

Jul-9

7

May

-97

Mar

-97

Jan-9

7

Nov

-96

Sep-

96

Jul-9

6

May

-96

Mar

-96

Jan-9

6

Nov

-95

Sep-

95

Jul-9

5

May

-95

Mar

-95

Jan-9

5

EXHIBIT C Inflation Accelerates in Indonesia

Source: Central Bank of Indonesia

attempt to build a national aircraft industry fromscratch) whose financing President Suharto hadjust agreed to cut.

Most controversially from the IMFs stand-point, President Suharto began to flirt with the ideaof establishing a currency board that would tie thevalue of the rupiah to the dollar. He was introducedto the idea of a currency board by Steven Hanke, anAmerican economist who pointed to the experi-ences of Hong Kong, Argentina, and other countriesas demonstrating that such a system would stablizethe 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 andhis advisers became convinced that Indonesia couldstop the rupiahs slide, rein in soaring prices, andrestore the confidence of local and foreigninvestorsall without resorting to the IMFs bittereconomic medicine. As word of the currency boardspread, the rupiah soared in value.

U.S., IMF, and EU economic officials, however,contended that a currency board is a quick fix thatwont work. They argued that it could lead to disas-trously high interest rates, further troubles for theIndonesian banking system, and increased socialunrest. In addition, many currency traders believedthat a currency board would soon fail, taking muchof the banking system with it. The government was

guaranteeing all bank deposits, which it could notdo under a currency board (because it could issuerupiah only if there were dollars to back them).Banks might suffer a run as depositors rushed toconvert rupiah into dollars. Critics also complainedthat Suharto was only interested in a currency boardbecause raising the rupiahs value would rescue hisassociates 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 lootingerupted in dozens of towns across Indonesia. Mostof the violence was directed at shops owned by theethnic Chinese. Students and other political protest-ers staged peaceful demonstrations against the gov-ernment. Worse, Suharto appeared to have lost thesupport of many of Indonesias middle class, whotolerated him and his family as long as he deliveredeconomic growth and a rising standard of living.

Only the Indonesian armed forces appeared tostand in the way of anarchy. Its half million menwere supposed to protect the state against internalthreats as well as external ones. In practice the army

10%

9%

8%

7%

6%

5%

4%

3%

2%

1%

Rea

l GDP

gro

wth

rate

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: 19801996

Source: International Financial Statistics, various editions.

had done the presidents bidding. In return, its offi-cers profited from the numerous opportunities forcorruption that their pervasive presence in thecountrys administration gave them. As long asSuharto retained the loyalty and support of the army,his grip on power was secure. However, if the socialunrest got out of hand, the soldiers might decidethat killing hundreds or even thousands of theircountrymen to perpetuate his reign was not worththe personal cost. Such bloodshed would also makethe army unpopular for years to come and threatenits privileged role in Indonesian society.

To President Suharto and some of his eco-nomic advisers, the idea of a currency boardpromised a way out of the crisis without making thefundamental changes demanded by the IMF. Theyestimated that there were enough foreign exchangereserves to immediately restore the value of the cur-rency to about 5,500 rupiah to the dollar. This jumpin the rupiahs value would reassure investors thattheir Indonesian investments would retain theirvalue. It also would reduce the inflation that was eat-ing away at the purchasing power of the averageIndonesians wages and would make it easier forIndonesian companies and banks to service theirforeign debts (overseas borrowing gave them capitalat about five percentage points less than at home).With the time bought with a currency board,Indonesias natural economic strengths could reassertthemselves. It produces all its own oil and exportsbillions of dollars worth, and its manufacturingindustry exports goods worth more than double itsenergy exports.

Skeptics pointed out that what worried investorsmost was not inflation eating away at their wealth butthat many of the countrys businesses and financialinstitutions could go bankrupt, or even that the coun-try could descend into the chaos of the 1960s. At thesame time, committing Indonesias reserves to a cur-rency board meant they would be unavailable to payfor imports or debt service. The debt service alonewas enormous, given the $140 billion that Indonesiaspublic and private entities had borrowed abroad,much of it short term (for example, Indonesian com-panies had $43.2 billion in foreign debt due withinone year). In addition, critics claimed that a rupiahfixed at 5,500 to the dollar would give the nationswealthy elite, including President Suhartos childrenand associates, a chance to trade their rupiah for dol-lars and deposit them overseas. Indonesias dollarreserves would disappear, interest rates would sky-

rocket, and the economy would be battered evenmore. Supporters, however, dismissed these con-cerns, claiming that money would flow intoIndonesia, not out, thanks to new international con-fidence in the currency and country.

Another option being discussedpossibly inconjunction with a currency boardwas a debtmoratorium. A moratorium would presumably sup-port the rupiah because debtors no longer wouldhave to buy dollars to service their foreign debts.

QUESTIONS

1. What monetary policies could Suharto followthat would restore the rupiahs pre-crisis value?What problems would those policies face?

2. What were the costs and benefits of anIndonesian debt moratorium?

3. How did undermining the social contractbetween Suharto and the middle class affect thevalue of the rupiah?

4. How did a weak banking system affect theprospects for a currency board?

5. Should the IMF have withheld disbursements ifIndonesia did not honor its commitments?What were the pros and cons?

6. Did the IMFs prescription for Indonesia makesense? Explain.

7. Why had Suharto found it so hard to imple-ment the IMFs provisions?

8. What suggestions do you have for stemmingthe rupiahs slide and strengthening its value?

9. Did cuts in fuel and food subsidies make sense?

10. Should Indonesia have established a currencyboard? What considerations would you weigh inthat decision? If you decide against a currencyboard, what alternative would you suggest?