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JUNE 3, 1999: WHERE THERE'S SMOKE, THERE'S KRETEK: THE CIGARETTE INDUSTRY IN INDONESIA

SUMMARY

1. Cigarette makers in Indonesia have weathered the economic turmoil of the past 20 months in reasonable condition. Cigarette sales are highly inelastic and have remained strong. As a result, local cigarette manufacturers are among the best performers in the recent stock market surge. Yet the industry is in a state of transition. The tax and pricing regime has recently been altered. Indonesia is a very price-sensitive market, and the companies are trying to reposition themselves in the wake of the economic crisis. Large kretek producers appear to be the biggest beneficiaries of the new system.

The Players

2. Large clove cigarette (kretek) manufacturers dominate the Indonesian cigarette industry. Kretek cigarettes, which utilize a blend of cloves and tobacco, are unique to Indonesia. They have been smoked here for generations, but have never found a major export market. Kretek sales represent over 85 percent of the Indonesian cigarette market and the three biggest firms, Gudam Garam, Djarum, and Sampoerna, control approximately 65 percent of that. Although total kretek production fell by three percent in 1998, resulting in some shortages, overall kretek sales have remained relatively steady throughout the period of the economic crisis. The two kretek stocks listed on the Jakarta Stock Exchange, Gudang Garam and Sampoerna, have seen their share prices increase by 46 percent and 280 percent respectively in the past ten months. The industry, which is centered in East Java, plays a key role in the Indonesian economy. It provides tens of thousands of jobs around the archipelago (Gudang Garam alone employs 40,000 people) and is the major customer of Indonesia's clove and tobacco farmers.

3. On the white (standard) cigarette side, British American Tobacco (BAT) has a 50-percent market share, while Rothmans and STTC (a domestic company from Sumatra) each hold 10-11 percent. BAT and Rothmans are in the final stages of a worldwide merger. The combined company will produce 22 billion sticks per year in Indonesia, making it the second largest cigarette company in the country, behind only Gudam Garam. Philip Morris, which up until now has produced and marketed only its premium "Marlboro" brand in Indonesia, is the fourth-largest producer, but has less than a one-percent market share. White cigarette sales are dominated by lower-priced brands, such as Rothman's "Kansas" and BAT's "Ardath".

4. The dominance of kreteks makes the Indonesian cigarette market different from any other. In many markets, including most Asian countries, key issues for foreign producers are market liberalization and overcoming government-controlled monopolies. Indonesia is different. It does not have a cigarette monopoly, but rather a large number of independent producers, including foreign companies that have been present since the colonial era. For the white cigarette manufacturers the challenge is in gaining market share, not against a dominant local producer, but against a completely different product. Moreover, both white and kretek producers describe brand loyalty as low, saying that customers switch smokes regularly and are motivated most strongly by price.

5. White cigarettes are primarily an up-market, urban product in Indonesia. The economic downturn has exacerbated the price-sensitivity of relatively affluent consumers and driven them toward less expensive kreteks. As an example, in an attempt to make up for lost dollar revenue due to the weakened rupiah, in late 1997 Philip Morris increased the price of Marlboros from Rp 2000 to Rp 6000 a pack. The result was an 80 percent drop in sales volume. To compensate, Philip Morris has introduced "Longbeach", a mid-price "value-for-money" brand, to Indonesia to regain market share. BAT has taken the opposite tack by recently bringing in Pall Mall and marketing it as an upscale brand.

The Tax and Pricing Scheme

6. The old excise tax system differentiated between whites and kreteks. Kreteks were taxed according to production volume and have been subject to ever-increasing minimum prices, based on company size, since 1991. Kreteks were sub-divided into machine-rolled and hand-rolled with the machine-rolled version taxed more heavily and assigned minimum prices that were 70 to 125 percent higher than the hand-rolled variety. By contrast, taxes on white cigarettes were based on retail prices and, with lower government-mandated minimum prices than kreteks, their retail taxes remained down.

7. Given this tax and pricing structure, the largest kretek manufacturers were assured of having higher minimum prices and paying the highest taxes in accordance with their high production volumes, which meant their cigarettes often cost more at the point of sale. The result to the consumer was that a pack of 20 premium white cigarettes cost less than a pack of 16 high-end kreteks. Through the first half of the 1990s, the white cigarette manufacturers saw their market share grow partially due to price advantages resulting from this system, although that growth has slowed recently.

8. To protect small hand-rolled manufacturers, the Finance Ministry applied lower taxes and mandated lower minimum prices for their products. The tax rate and the minimum prices, combined with minimal overhead, made hand-rolled kreteks extremely profitable, with margins up to 40 percent higher than the machine-rolled variety. The large kretek companies, the majority of whose production is machine-rolled cigarettes subject to higher minimum prices and volume-based tariffs, bought up small firms to sub-contract the manufacture of kreteks to take advantage of the lower tax and pricing rates. The Finance Ministry closed that loophole with Ministerial Decree (SK)104/1997, which prohibited "special relationships", including ownership, between cigarette manufacturers and gave the companies until March 1999 to end any existing relationships. Despite the deadline, few, if any, divestitures took place.

9. The whole system changed with the implementation of Ministry of Finance Decrees (SK)124/1999 and (SK)125/1999. Under (SK)124, the tax and price regimes for kretek would be applied to whites as of April 1, 1999. At the same time, (SK)125/1999 revoked (SK)104, thus again permitting the ownership of small kretek producers by large ones. The white manufacturers protested against the changes, arguing that it was unfair to impose the new tariffs in one swoop and that they at least needed to be phased in. The government gave some ground and agreed to a three-year phase-in of the new regime. The kretek manufacturers are not impressed by the white cigarette companies’ complaints, pointing out how kretek tax rates and minimum prices had gone up in recent years. As one kretek producer said, "we had to raise our prices five-fold in two years and we survived. This should be easy for them."

10. The government has also adjusted the tax rates on kreteks. Under the old system, a small manufacturer could set a premium price for a kretek, but because the company had a low production volume, it could pay a lower rate than a larger producer. That option is gone under the new system. Now a small producer's products get taxed based production or retail price, whichever puts them in a higher bracket. There has also been talk about ending all minimum pricing requirements, for both white and kretek cigarettes.

11. Another possible change is linking taxes on kreteks to tar levels, a policy advocated by the Ministry of Health. One non-filter, hand-rolled kretek delivers over 50 milligrams of tar to the smoker, according to the Ministry of Health. By contrast, a full-flavor white cigarette such as Marlboro or Lucky Strike (both available in Indonesia) delivers approximately 18 milligrams of tar. Even with such health concerns, however, any changes in the excise tax regime will likely have to have a neutral effect on revenues. Kretek Company executives have said this is not the first time such suggestions have been raised and, since there is no time-frame for such a transition, they are taking a wait-and-see attitude. Industry sources agree that any move to tar-based taxation would be a gradual process, taking years.

The Upshot

12. White cigarette manufacturers claim the new tax and price policy will raise their prices to the point that Indonesian consumers will desert their products. They point out that kretek manufacturers have several advantages against which they cannot compete. Aside from the lower tax rates on hand-rolled cigarettes, white cigarettes can only be sold in packs of 20 sticks while kreteks can be sold in packs of any number. Kreteks, which use cloves and more tobacco than whites, can be as or more expensive per stick than whites. Because they can be sold in packs of 12 or 16, however, kreteks can be sold for less per pack, which gives them a key advantage.

13. The white manufacturers have managed to wring talk of concessions from the government since the new law took effect. Sources at the Ministry of Finance confirm press reports that the new tax parity is under review and may be altered if the burden on white cigarettes proves to be too high. The government's agreement with the IMF allows for review of cigarette tariffs in order to meet fiscal targets. Industry sources have estimated that white cigarette sales could shrink by two-thirds under the new system, to only 5 percent of the Indonesian cigarette market. This would likely result in an excise shortfall as smokers move to cheaper brands that generate less excise revenue, which may force the government to reexamine the new tax structure.

14. The new tax system will affect the kretek manufacturers in two ways. Any decline in white consumption will result in consumers switching to cheaper, especially hand-rolled, kreteks. The new volume and price system on the kreteks themselves will primarily hurt a few small manufacturers of high-priced, hand-rolled kretek who lived on the high-end, low-tax strategy. They will now have to choose between cutting prices to move into a lower tax bracket or keeping prices steady and watching the higher taxes eat into their margins. In either case, their profitability will suffer.

15. The large kretek firms, who dominate the high-end market, will be the primary beneficiaries of the new tax system. With both boutique kretek and white manufacturers facing higher tariffs in a highly price-sensitive market, and the end of restrictions on their ownership of small firms, the big kretek producers are clearly the ones with the most to celebrate.

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