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3 IJAEBM Volume No 1 Issue No 1 the Cost of Public Debt Services 014 024

3 IJAEBM Volume No 1 Issue No 1 the Cost of Public Debt Services 014 024

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Published by: iserp on Apr 26, 2011
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The Cost of Public Debt Services
The Case of Indonesia
Haryo Kuncoro
Faculty of Economics,State University of Jakarta, Indonesiahar_kun@feunj.ac.id
This paper is designed to analyze the cost of public debt services in the case of Indonesia over the period of 1999-2009. First, we explore theliterature of the debt dynamic. Second, we develop a model to capture some factors determining the cost of public debt services. Finally, we estimate itempirically. Unlike the previous studies, we concern with the real rather than nominal cost of  public debt services. Based on the quarterly data analysis, we conclude that the cost of domestic debt services is more expensive than that of foreign debt. However, the usage efficiency of domestic debt is higher than the latter. They imply that the central government should carefully manage her debts including re-profile, re-schedule, and re- structure them in order to spread the excess burden in the future to maintain solvency. Also, the other domestic financial resources should be mobilized in order to get the cheaper debts. Keywords
 fiscal deficit; public debt; primary balance; implicit interest rates
I. INTRODUCTIONFiscal sustainability has been a subject of intensive discussion among the macroeconomists in recent years both in developedand developing countries. The central issue of the theory and empirics of public finance iswhether there is a tendency for the fiscaldeficits to grow faster than the increase in public debt so that the debtor countries becomeinsolvent. Or instead, are there tendencies for the debt services to get bigger, so that the primary balance surplus tends to tighten over time?The recent sharp increase in fiscal deficitsand public debt in many countries raises anumber of important issues regarding their impact on long-term interest rates. Theunsustainable state budget could influence theeconomic stability in several ways. When thedeficit is financed by domestic resources, itcould become financial repression andcrowding out effect indicated by the lowinterest rates, saving decline, and unproductiveinvestment [1]; [2]. Similarly, the foreignfinanced budget deficit is characterized by persistent exchange rate depreciation, balanceof payment distress, and high inflation [3].Eventually, the debtor country experiencesunstable economic growth.Furthermore, Easterly and Schmidt-Hebbel [4] argued that the relationship between fiscal deficits and interest rates is acomplex one because countries finance their deficits in different ways. On the one hand,under a repressed financial sector, taxes onfinancial assets are a major source of revenuefor the government. On the other hand, in aliberalized financial system, where thegovernment finances its deficits via domestic borrowing, public sector will compete with the private sector for loans. This puts upward pressure on interest rates.Many studies have been devoted toanalyze the unit cost of public debt services(see for instance: [5]; [6]; [7]; [8]; [9]). Ingeneral, they show that a stronger primary balance is associated with a lower cost of debtservicing. Consequently, the interest cost of servicing the public debt is the key both to itssustainability and to the burden it places on the public finances and the economy. Indeveloping countries, the external debt hassteadily increased in recent decades, makingthe analysis of the role of external debt infinancing the development process particularlyimportant. Therefore, the question of adequate“exit-strategies” represents probably one of themost important questions in public finance to be resolved in the coming years.Indonesia provides a unique opportunityto examine the nature of fiscal sustainabilityand debt services payment. Given thesignificance of huge debt stock accumulated by the previous regimes, whether the state budget can finance all spending in the longterm without loosing budgetary functions is akey political and economic issue. The mainobjective of this paper is to reassess the effectof fiscal deficits and public debt on long-terminterest rates. It complements and extends theexisting literature by exploring in particular theeffects of large fiscal deterioration and initialfiscal conditions, the impact of countries’institutional set up, and the likely spilloversfrom global financial markets.Although there is a significant existingliterature exploring the relationship betweendeficits, public debt, and interest rates, there isa diversity of findings, and several of the
Haryo Kuncoro et al. / (IJAEBM) INTERNATIONAL JOURNAL OF ADVANCED ECONOMICS AND BUSINESS MANAGEMENTVol No. 1, Issue No. 1, 014 - 024ISSN: 2230-7826@ 2011 http://www.ijaebm.iserp.org. All rights Reserved.Page 14
specific issues explored in this paper have not been examined before. First, it explores cost of  both domestic and foreign debts. Second, italso delivers implicit real interest rates insteadof government bond nominal yields. Theremainder of the paper is organized in sixsections. Section II analyses the impact of fiscal variables on primary balance; Section IIIexamines the possible responses of the primary balance to changes in the debt-GDP ratio;Section IV discusses the relation betweenfiscal sustainability and dynamic efficiencyand Section V briefly looks at stock flowadjustment. Finally, some concluding remarksand implications are drawn.II. INDONESIA’S STATE BUDGET:OVERVIEWSince the Old Order regime, Indonesia hasused foreign borrowing to financedevelopment. The foreign debt was utilizedduring the first period of 1966 to reconstructeconomy after political turbulence. After that,the New Order regime had a permanentdonator countries grouped in the IGGI(Intergovernmental Group on Indonesia).Every year, the IGGI provided fund (fromADB, World Bank, IMF, UNDP, and somemajor developed countries) to financedevelopment expenditures designed in the state budget.During oil boom in 1970s the foreign debtincreased unevenly to foster economic growth.The higher oil price the higher debt taken. Asone of the oil exporting countries, Indonesiahad a windfall profit as “collateral” to obtainnew soft loan form the creditor countries [10].The high foreign debt and the oil revenue, infact, had been successfully promotingeconomic growth. In that period, the economicgrowth rate booked the highest record, on theaverage 20 percent a year.Surprisingly, declining oil prices in thefirst half of the 1980s resulted in the rapidaccumulation of debt. World economicrecession and trade protection imposed bymost countries were the main causes.Percentage of total external debt on GDPincreased from 26.8 percent in 1980 to 53.6 percent in 1986. In that period, Indonesia’sgovernment, in one hand, introduced a new taxsystem to boost domestic revenues. On theother hand, Indonesia’s government reducedsubstantial central expenditures and re-switched numerous development programs[11].Furthermore, in the late 1980s and mid1990s, during Indonesia’s economic boom, thelong-term foreign debt was incurred by theespecially state-owned and private enterprises.The government debt increased due toPERTAMINA (oil and gas state-ownedcompany) was largely expanded. BULOG(Logistic Agency) took foreign debt to realizefood self-resilience. As a result, the debtservice ratio in the 1980s, especially in 1988and 1989 rose to an average 40 percent. In1992, the IGGI was removed to be the CGI(Consultative Group on Indonesia).When the Asian financial crisis, in the mid1997, the external debt increased significantlyfrom more than US$ 136 billion in 1997 tomore than US$ 151 billion in 1998, mainly dueto the depreciation of Rupiah. Since that,Indonesia has experienced the decrease ingovernment revenue and the increase ingovernment spending to undertake the socio-economic impacts. As a result,theIndonesian’s government collapsed under heavy debt burden to cover deficit the state budget (Figure 1).The government debtincreased to three to four-fold and almostthree-quarters of those is domestic debt for  bank restructuring [12].In the reformation era, government and parliament made a political decision that themost deficits should be finance by domesticfinancial resources. Accordingly, the CGI wasdisbanded in 2007. As a result, the amountdomestic debt stock has been ten times (100trillion in 1998 to 1.000 trillion Rupiah in2009). Only in one decade, the domestic debthas been higher than the foreign debt.Consequently, the public debt services have been sky rocketing (Figure 2). The domesticdebt service payment was two-fold than that of foreign debt.Most government external debts were duein early 2000s. In relative term, the interestrate and amortization payments was about 40 percent of the total outlay. The other importantexpenditures were subsidies for fertilizer andenergy (20 percent) and transfer to lower-layer governments (26 percent). Those outlayscomposition above, of course, severely limitedto the fiscal space. The state budget problemsthen shifted from the stimulus to fiscalsustainability [13].Conceptually, the state budget is said to be sustainable if it has theability to finance all spending in the long termwithout endangering budgetary functions [14];[15].The issue of the sustainability is anintegral part of the discussion of thegovernment's long-term ability to repay debt[16]. To maintain the fiscal solvency, thesurplus of the state budget is a must [17].Eventhough the debt ratio has been decreasing, thenew financing from both foreign and domesticfinancial resources are still required in
Haryo Kuncoro et al. / (IJAEBM) INTERNATIONAL JOURNAL OF ADVANCED ECONOMICS AND BUSINESS MANAGEMENTVol No. 1, Issue No. 1, 014 - 024ISSN: 2230-7826@ 2011 http://www.ijaebm.iserp.org. All rights Reserved.Page 15
forthcomingyears to meet the expenditureneeds. The main problem of the Indonesian budget sustainability is the existing largedeficit. The Law No. 17/2003 Article 12 statesthat deficit and the total debt is no more than 3and 60 percent respectively. The question isthen how to keep the budget deficit at a safelevel so that the deficit can be financed.It is well known that the change in thedebt level can be larger or smaller than thegovernment deficit. This difference betweenthe change in the outstanding debt stock andthe yearly deficit flow is known as the stock-flow adjustment (SFA). The analysis of SFAhas become more important as the budgetarysurveillance may have provided incentives for shifting items from the deficit to the SFA [7].A high negative SFA shows the tendency toimprove temporarily the debt development insome years. In this case, is there anysystematic explanation of variations in the costof debt servicing over time in Indonesia? Thenext sections will examine the influence of fiscal variables on borrowing costs inIndonesia over the period of 1999-2009.
DOMESTIC AND FOREIGN DEBTSOF CENTRAL GOVERNMENT0.00200.00400.00600.00800.001,000.001,200.001998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009YEAR
   T   R   I   L   L   I   O   N   R   U   P   I   A   H
Domestic Debt Foreign Debt
Source: Debt Management Office, Ministry of FinanceFigure 1Central Government Public Debt
Haryo Kuncoro et al. / (IJAEBM) INTERNATIONAL JOURNAL OF ADVANCED ECONOMICS AND BUSINESS MANAGEMENTVol No. 1, Issue No. 1, 014 - 024ISSN: 2230-7826@ 2011 http://www.ijaebm.iserp.org. All rights Reserved.Page 16

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