The Impacts of Commodity Price Shocks on Indonesia and How to Manage Them

March 14, 2011

Vivi Alatas

By: Vivi Alatas, a senior economist at the World Bank office in Jakarta

This is the third in a series of articles by Indonesia-based World Bank economists drawing on analytic work done by the World Bank in collaboration with local partners, on the impact of commodity prices on the Indonesian economy. This article looks at the impacts of higher commodity prices on Indonesia’s overall economy and ways of managing future price shocks.

It is often assumed that poor people in developing countries have been harmed by the increased price of commodities in international markets over recent years. However, a recently published report by the World Bank in Jakarta, entitled Boom, Bust and Up Again? Evolution, Drivers and Impact of Commodity Prices: Implications for Indonesia, reaches the opposite conclusion in the case of Indonesia. The World Bank’s research indicates that the effects of the commodity price increases between 2005 and 2008 were generally positive for the Indonesian economy and also for Indonesia’s poor. Indonesia is the largest producer and second-largest exporter of crude palm oil, and one of the largest producers of rubber. It is also one of the largest producers of spices, and an increasingly important world supplier of cocoa, tea, and specialty coffee. The positive effects for the poor stemmed from increases in agricultural wages and returns to machinery owned by poor farmers. Although the price of commodities consumed by the poor increased, these negative effects were outweighed by the benefits they received on the income side combined with the fact that the rice price remained relatively stable during this period. With the exception of resource-poor Jakarta and Banten province, all provinces benefited from the commodity price increases, as seen in simulated regional GDP figures using a general equilibrium model of the Indonesian economy. Anecdotal evidence seems to support this, with impressive increases in the purchasing of cars and motorcycles outside Java.
However, even in net commodity producing and exporting countries such as Indonesia, sudden spikes in fuel and food prices still have a serious impact on poor consumers and on producers, particularly those that make intensive use of commodity inputs. Therefore, the government has an important role in mitigating the negative impacts of price fluctuations. The question is: what are the most effective ways of protecting the poor and some vulnerable producers against price fluctuations? In the past, since the 1960s, the Indonesian government has used a range of policies to stabilize the prices of crucial commodities, but often with mixed success and in some cases significant unintended and negative consequences. For example, the prolonged use of fuel subsidies has benefited non-poor consumers at the expense of other public needs, such as health and the revitalization of agriculture and infrastructure. Experience both within Indonesia and elsewhere also shows that measures such as quantitative controls over exports and artificially controlled prices are often ineffective or not cost efficient.

Instead, policy instruments to manage the impact of price increases should be designed carefully with three goals in mind: they should protect only vulnerable consumers; they should maintain and create incentives for producers; and they should be financially sustainable. As we have seen, fuel subsidies do not meet these criteria because they are not pro-poor and risk becoming fiscally unsustainable at times of high oil prices. Universal subsidies can become a burden on the state budget and also increase inflation without necessarily contributing to an expansion of production. Likewise, prolonged public price stabilization can be costly and lead to parallel black markets. Lastly, permanent import quotas and bans promote the development of an uncompetitive domestic sector and force domestic consumers to pay higher prices.

Compared with past practices, going forward Indonesia would need to establish a more predictable, better targeted, less costly and more effective approach to mitigate the impact of price shocks. To achieve this, the government could develop a framework for action to allow for the methodical monitoring of prices; assessing their impact on the economy; assessing the available policy options through proper cost-benefit analysis; and then implementing and monitoring the adopted measures.

Such a framework should therefore involve four main components. The first is an effective price-monitoring system that shares timely information between different public and private stakeholders. The second is a system to assess which segments of the population or which producers are adversely affected. The third component of the framework involves assessing and deciding effective policy instruments and program responses. The fourth component of the framework would be a monitoring system to track the implementation of the adopted policy and program responses to assess their impact. Policies should only be implemented when it is possible to review and reverse them if they are found not to be having the desired impact.

What are the best options for mitigating the impact of price shocks, especially for the poor? With around 65 percent of the poor working in agriculture, intense revitalization of agriculture productivity is a must to ensure the poor can benefit more from commodity price increases. This requires access to quality seeds, improvement in post-harvest production and the innovative use of ICT to disseminate technology and price and market information. Agricultural productivity would also benefit from increased investment in irrigation systems, rural roads and extension services, while intensifying market-based instruments such as warehouse receipts would help poor producers to mitigate price fluctuations.

But short-term responses are needed to help vulnerable households immediately. Options are likely to involve a mixture of social safety net programs, such as cash-for-work programs, targeted cash transfers to poor households, and the smart use of trade policies and import regulations, such as tariff cuts and relaxation of import restrictions, together with prudent fiscal management. They also include measures to reduce price volatility across Indonesian regions, such as improved infrastructure (ports, roads and distribution networks) and private-sector stocking, and the development of mechanisms to benefit small-holders, such as index-based weather insurance.

In the wake of another surge in commodity prices, and given the likelihood that they will remain high, Indonesia needs to ensure that it fully utilizes its natural resources for sustainable growth for all. Commodity price increases should become a blessing for Indonesia, but this will only truly be the case if Indonesia ensures that vulnerable households are supported.