Debt standstill and capital control

Debt standstill and capital control

D.A. Simarmata
School of Economics
University of Indonesia
Jakarta

Something surprising came out of the IMF headquarters in
Washington last November. The new number two at the International
Monetary Fund, Ann Krueger, proposed a temporary suspension of
debt payments for indebted countries, accompanied by momentary
capital controls. It was startling, because such an idea had
until then been unthinkable.

According to Krueger, her proposal is the missing link needed
to bridge a yawning gap in the international financial
architecture. The IMF has attracted a lot of critics, who accuse
the prestigious institution of mishandling the financial crises
in many developing countries. But any mention of canceling debt
payments had until now been considered taboo. In order to be
thought of as well-behaved debtors, countries took great pains to
avoid any attempt to delay debt payments, even though those
payments imposed an excessive burden on their citizens. Has
Argentina taken the Krueger plan to heart? Maybe.

The new scheme is said to complement existing mechanisms,
which compel the international community to bail out private
creditors. Such an environment surely provides fertile ground for
moral hazard on the part of private creditors and borrowers.
Unfortunately, the burden falls upon poor and innocent taxpayers.

The virtue of Krueger's proposal is that it could act as a
catalyst to encourage debtors and creditors to sit down together
and consider ways of restructuring unsustainable debts in a
timely and efficient manner. It is now understood that the
reliance on domestic bankruptcy courts is an illusion. Allowing a
debt standstill and the imposition of capital controls will
encourage the two sides to reach an agreement, because the debtor
countries will be better protected.

Creditors would have a more favorable view of a debtor
country's capacity to honor its obligations because there would
be no capital flight. But the scheme requires that debtor
countries demonstrate good faith, by putting in place workable
policies that would prevent a similar problem from arising in the
future. Instead of relying on IMF bail outs, the proposal urges
both sides to reach a solution of their own making. However, the
IMF would continue to play a vital role through its examination
of debtor country policies, and its firm backing for the new
system.

The global financial architecture is now in limbo. From the
debtor-countries' point of view, international debt resolution
procedures are currently biased toward the interests of
creditors, both private and official. The IMF's recent
prescriptions for dealing with the crisis in Indonesia seem
doomed to failure. They have worsened the country's financial
position due to the freefall of the rupiah in tandem with capital
flight. The two phenomena occurred as a result of the adoption of
a regime of free capital flows and a freely-floating exchange
rate. The expected spectacular rise in exports resulting from the
rupiah's weakness failed to materialize. Instead, asset values
have declined, leading to the insolvency of both the country and
corporations. Hence, exchange rate stability or at least a
sustainable depreciation of the currency is crucial to the
sustainability of a country's total debt load.

Under the IMF charter, the organization is in fact obliged to
maintain stable exchange rates in order to promote international
trade. Exchange rate instability leads to uncertainty about the
prices of goods traded internationally. This is turn causes
uncertainty about a country's true level of competitive
advantage. Uncertainty in international trade can disrupt sources
of foreign exchange, leading in turn to uncertainty about the
capacity of some countries to repay debts that are denominated in
foreign currencies. Hence, exchange rate stability is in the
interests of all countries, both creditors and debtors alike.

Article 23 of Indonesia's 1945 Constitution obliges the
government to maintain the stability of the rupiah's value. But
this is not the same as a fixed exchange rate. So, the IMF
charter and the Indonesian Constitution preach the same idea:
Stable exchange rates. Unconditional demands for the free flow of
capital, especially short-term capital, is not amenable to this
objective, especially at times of financial crisis, as was the
case in Indonesia in 1997-1998. Ann Krueger's recent proposal
could prove a viable remedy for the defects currently afflicting
the global financial architecture.

The government has made numerous patriotic statements about
its intention to fulfill all its international debt obligations.
Judging from these official statements, even debt hair-cuts seem
to be taboo. The members of the country's economic team still
dream of winning back the confidence of the international
community. But with a credit rating of CCC-, or selective
default, there is nothing more to be gained from simple good
behavior. Right now, the best thing Indonesia can do is fight
for the implementation of the Krueger proposal. A simple
calculation shows that the temporary suspension of the debt
payments would raise the country's productive capacity at a rate
more than sufficient to offset the debt accumulation due to the
suspension.