Indonesia’s fuel hike may put kibosh on ‘fragile’ tag

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Indonesia may put the kibosh on its membership in the "fragile five," as its new president took bold action to eliminate much of the country's expensive fuel subsidy.

"It will be a big positive for Indonesia's economy," said Kunal Kumar Kundu, an economist at Societe Generale, in a note Tuesday. "It will lead to a major improvement in the fiscal deficit and provide the government with ample fiscal space to focus more on developmental expenditure."

Read More Fuel inflation a risky juggle for this Asia heavyweight

On Monday, President Joko 'Jokowi' Widodo, inaugurated just a month ago, took the likely deeply unpopular step of raising subsidized gasoline prices by around 30 percent to 8,500 rupiah, or $0.70, a liter and increasing diesel prices by around 36 percent to 7,500 rupiah a liter, effective immediately. Previous fuel hikes have spurred large-scale unrest.

The central bank, Bank Indonesia, has called an extraordinary meeting for later Tuesday, although it didn't indicate whether it expected to increase interest rates to counter any increase in inflation.

Less vulnerable

Last year, Indonesia was tagged as one of the "fragile five" countries most likely to take a big hit as the U.S. Federal Reserve tapered its asset purchases and began gearing toward an eventual rate hike. Large current account deficits made all five countries vulnerable to foreign capital outflows as liquidity tightened.

The fuel subsidies are the main culprit behind Indonesia's current account deficit, which came in at 4.3 percent of gross domestic product (GDP) in the second quarter. The cost, at around 20 percent of total government spending, has also long dogged the country, crowding out other spending, including much-needed infrastructure projects.

"Artificially low market prices of fuel encourage inefficient fuel consumption, and given Indonesia's status as a net oil importer, they put pressure on trade and current accounts," CIMB said in a note Monday.

The fuel-price hike will shave around $7.5 billion off the 2015 oil subsidy budget, which was expected to be around $22.6 billion without a price rise factored in, Kundu estimated, although he noted that falling oil prices will also help to lower the cost, likely increasing to savings to a total of $11 billion. That compares with the second quarter's current account deficit of $9.1 billion.

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Jokowi serious about reform

The higher fuel prices are set to lower Indonesia's import bill and narrow its current account deficit, Gareth Leather, an economist at Capital Economics, said in a note Monday.

"The recent fall in global oil prices has made subsidy cuts less of an urgent issue. The fact that Jokowi still pressed ahead with today's subsidy cuts is therefore encouraging since it suggests he is serious about economic reform, and is even prepared to take steps that may prove unpopular in the short-run," Leather said.

Analysts don't expect the higher fuel prices and resulting inflation will impact growth much as the subsidies largely benefited middle and upper class Indonesians using private transport, rather than the poor who generally rely on public transportation.

Read More Five reasons Indonesia may hike fuel prices

"If the money the government saves on subsidies is put to good use, such as spending more on infrastructure, today's subsidy cuts could be the trigger for faster long-run growth," Leather said.

CIMB estimates that "insufficient" investment in sectors including energy, transportation and communications have shaved around 1.5 percentage points from Indonesia's current real GDP, which was 5.8 percent in 2013. Indonesia needs around $43 billion in infrastructure outlays over 2015-19 to reach its "high-watermark" growth target of 7.5 percent by 2019, CIMB said. The combined budget room from the subsidy cut and oil price fall would provide around half the annual budget shortfall for the infrastructure financing needs, it estimated.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1