Indonesia's debt burden: A case for forgiveness

By Sidhesh Kaul

JAKARTA (JP): With each passing day, Indonesia's debt burden seems to get heavier and with the murky political environment acting as a retardant to progress, there seems to be no end in sight to this misery.

At last count Indonesia's total external debt stands at US$144 billion while the government's domestic debt stands at about $75 billion.

As a proportion to the gross domestic product (GDP), external debts today almost equal or exceed the GDP of the country while debt service would be at levels of almost 20 percent of the GDP (with the extremely questionable assumption that there would be no additional borrowing) for the next few years.

It is more than obvious that the problem is slipping beyond the realm of the government and that today Indonesia presents a strong case for debt forgiveness.

Debt rescheduling is only part of the solution and coupled with a gradual decrease in new obligations, it could go a long way in infusing new life and liquidity into the economy.

The classical approach for indebted countries has been to seek rescheduling while at the same time decreasing its reliance on external funding as a source of sustaining the economy.

The underlying assumption to this strategy being that any increase in liquidity, brought about by a reduction in obligatory expenses, would be efficiently deployed to increase the country's servicing capacity in ensuing cycles.

Theoretically it makes sense but in practical terms and given the shambles that Indonesia's infrastructure is in, and the poor climate for real growth, it appears a distant mirage.

To the government's credit, it has successfully rescheduled its debts at the Paris Club and London Club forums although some of these gains have been eroded away by the recent borrowing of US$4.8 billion at the Consultative Group on Indonesia (CGI) meeting in October of this year.

It is not difficult to imagine that a constrained Indonesian government would soon be tempted to utilize this temporary period of relief and liquidity to jump start the economy.

This could be achieved through a combination of several measures that includes, among others, revitalizing the small and medium enterprises by providing soft loans to this sector through commercial banks (who would be hopefully revived and functional by then), boosting exports (while keeping one eye on the current account deficit), encouraging import substitution and curbing or postponing expenditures to later cycles.

All these measures would be heavily dependent on an efficient, honest and reliable delivery mechanism, the likes of which, given the colossal task of sweeping away the debris from decades of abuse, would take several years to establish.

The government, from the first day of the economic crisis, was quick to realize that rebuilding investor confidence was an imperative precondition that would subsequently lead to large doses of fresh foreign equity into the country.

However, this strategy is fraught with perils as well. The upheavals in the economy, the weak coalition government that seems to be staggering from one embarrassment to another, delayed structural reforms, ethnic violence and separatist movements in several parts of Indonesia is keeping investors at bay.

The gentle trickle of foreign funds that is currently coming in (other than new external borrowings by the government) is mostly from asset sales that are being sold, not surprisingly, at huge discounts.

It is going to be a while before any serious investment by way of fresh equity injections is likely to happen in Indonesia.

Juxtapose this predicament with the condition that the government must sustain growth in the economy in order to sustain the debt servicing capacity.

All these factors strengthen the case for the need of a boost in real liquidity that stems from the reduction in obligatory payments and that such a situation can only come about if the government actively pushes for debt forgiveness.

In the 70s and early 80s, creditors took a case-by-case approach to the debt crisis. By the mid-80s many policy makers had initiated debt relief plans and amongst the most famous were the Baker Plan (1985) which stressed expanded lending for LDC (Least Developed Countries) debtors and the Brady Plan (1989) that emphasized debt write-offs and write-downs in conjunction with cancellation, rescheduling and debt exchange.

During the debt crisis in the early 80s, the U.S. government took the position that debtors should pay the full interest due to American banks.

The year 1985 saw the U.S. government retracting on this strategy as they saw the limitations the debt crisis placed on Latin American growth. Also considered were the constrictions that such impositions placed on the demand for U.S exports, the pressure that any debtor cartel would place on American banks should they bunch up together to ask for write-offs.

The Latin American countries were indeed threatening to do just that at that point in time, and it was this background that gave birth to the Baker Plan.

The Baker Plan provided for new credits to be injected to the indebted middle-income economies under severe restraints (the real inspiration behind the International Monetary Fund's structural adjustment lending). This was done with the condition that all lending would be centralized under the IMF (so that fresh injections were not used to pay off other creditors).

These measures were aimed at keeping growth high but to be deployed in conjunction with budget restraints, tax and other structural reforms, liberalized trade and foreign investment and privatization of state-owned enterprises.

Over a short horizon, the plan did succeed in maintaining growth and forestalled a major debt write-off of third-world debts that threatened major U.S. banks in the early 80s.

It also helped in dissuading the Latin American debtors from forming a cartel whilst giving time for the U.S. Federal Reserve and bank regulators to support U.S. money-center banks through measures such as increased reserve requirements.

By averting a widespread debtor's default the Baker Plan succeeded in enabling the top creditor banks to reduce their LDC- debt exposure, so they could enjoy the luxury of boycotting any meetings that propose rescheduling of existing debt or new-money packages and instead insist on full servicing by the LDC while no longer fearing their own collapse. This new-found immunity from LDC default, in turn, ironically led to the demise of the Baker Plan.

The Brady Plan, following on the heels of the Baker Plan, basically asked the commercial banks to reduce their LDC exposure through voluntary debt reduction or write-offs whereby banks exchanged LDC debt for cash or newly created bonds partly backed by the IMF or the World Bank, or debtor countries converted or bought back debt on the secondary market.

Debtor countries preferred debt reduction to new money since any enlargement of their indebtedness stymies growth and leads to a whole host of other problems.

Moreover buying back debt at a discount with foreign exchange is not feasible for most LDC debtors, given the paucity of free foreign exchange available. Also, replacing commercial debts with IMF/World Bank funds reduces the flexibility for recipients.

The precedent for defaulting on debt began in the 1930s. Countries that stopped paying their debt recovered from the Great Depression more quickly than countries that resisted default without diminishing their access to post World War II capital markets.

In the 1980s about 20 LDCs unilaterally took the step of defaulting on their debt rather than undertaking domestic adjustment or timely repayment. Looking back in time, it appears that it was the best option open for debtors at that point in time.

Today the LDCs face a virtual oligopoly of international commercial banks that hold the majority of share of LDC international reserves, dispense LDC credit and maintain close contact with each other, in coordination with the IMF and the central banks of developing countries.

This oligopoly now insists on a case-by-case discussion thus increasing their bargaining with debtors. Some economists (Jeffrey Sachs leading the pack) have maintained that the best strategy for the IMF would be a program based on partial and explicit debt relief that could serve as a carrot for political and economic reform. However, the "policy bribe" approach has proved to be equally ineffectual.

Be it rescheduling or cancellation of debt, there is now enough evidence to point at the fact that the creditor nations deploy the debt mechanism as a tool for foreign policy leveraging.

In 1988, amidst much fanfare, the G7 countries announced the Toronto Terms that, on first appearance, gave the impression of new found benevolence amongst the rich countries to the economically distressed countries but in reality prolonged the agony.

The Trinidad Terms proposed by John Major in 1990 was the first real effort toward forgiveness but met with stiff resistance from U.S. and Japan, forcing Britain to unilaterally adopt these terms (though in late 1994, enough wisdom dawned on G7 and the Paris Club to adopt the Trinidad Terms).

The run-up to the Trinidad Terms reinforced the view that most of the LDC creditors were using indebtedness as a foreign policy implement.

In 1990 the U.S. government did not even bat any eye before it canceled US$6.7 billion in military debts to Egypt (this was a "debt for war" swap done during the Persian Gulf War) or $2.66 billion debt of Poland (under pressure from the large Polish- American communities in Chicago and other politically important northern states).

Compare this generosity with the foot dragging over canceling debt in extremely impoverished sub-Saharan regions. The lessons from history are clear. Debt forgiveness is a prerogative of the rich lenders in exchange for tangible political gains.

Debt reduction is the only way out for Indonesia and the current economic czars must focus their efforts on building international and regional opinion (at this point I am tempted to suggest "cartelization" of similarly affected regional debtors as a mild pressure point) as opposed to seeking new indebtedness.

In fact large debt overhang is going to diminish Indonesia's economic performance and diminish the creditor's expected return.

Just as in bankruptcy, decentralized market processes rarely result in efficient fulfillment of obligatory claims and it is more pragmatic to preserve the cash-generation ability of the debtor through a concerted action of creditors who unilaterally agree to debt reduction as a means to recovering their claim.

A major objective in debt reorganization is to reverse investment and productivity declines that are direct consequences of poor credit worthiness.

For Indonesia, debt reduction may be the only option available as new money packages are going to be extremely difficult to come by. To add misery to this suffering is the fact that the government faces a difficult domestic environment that makes it impossible to adopt tough reforms.

The developed countries can best support Indonesia by backing moderate leadership through a scheme of debt reduction that serves as an incentive for reform.

The Indonesian government has to take a hard and realistic look at the limited options that confronts the country. Rescheduling of debt is going to have a marginal impact on the net available cash.

Repurchase of debt is a difficult option since precious foreign exchange would have to be deployed during times when the country needs it the most.

Additional borrowings would contribute to the already imposing mountain of unserviceable debt. In the meanwhile the government has to rein in inflationary pressures while still sustaining growth.

The writer is a commentator on regional economic and political affairs based in Jakarta.