New foreign borrowing strategy for Indonesia

Romeo A. Reyes, Jakarta

The National Development Planning Agency (BAPPENAS) and United Nations Development Programme (UNDP), through the UN Support Facility for Indonesian Recovery (UNSFIR), recently convened a thematic workshop entitled "From Foreign Aid to a Comprehensive Foreign Borrowing Strategy".

The key issue is when to borrow, from whom, for what, and how to borrow smartly to minimize the cost of borrowing and maximize its effectiveness and development impact.

It is important to note that no matter how soft the terms of an Official Development Assistance (ODA) loan might be (it could be interest free with a maturity period of 40 years inclusive of a 10 year grace), it is still a loan and will have to be repaid at some point in the future.

Unless official creditors forgive past loans and/or indefinitely provide new loans at progressively higher amount and/or longer maturity period in the future, official capital flows will ultimately be reversed. This situation had actually been reached even before the economic crisis struck in 1997-1998.

Official capital flows used mainly for financing public investments steadily increased from US$300 million in 1970 to a peak of almost $4 billion in 1983. Thereafter, it began to decline, averaging $2.3 billion annually for the rest of the 1980s, $600 million from 1990 to 1994, and turning to almost nil but still positive in 1995.

This declining trend served notice that reversal of official capital flow was about to happen, i.e. debt service payments will exceed disbursement of new loans. It did happen in 1996 for the first time in decades when the balance of payments registered a negative official capital flow of $663 million.

Official capital flow promptly turned positive when the crisis struck in 1997, thanks to the financial support arranged by the international community, through restructuring of maturing bilateral public and private external debts and provision of new money especially by multilateral financial institutions.

However, a closer look at the numbers presented by UNSFIR at the workshop would reveal that the huge official capital inflow from 1997 to 2000, reaching a peak of $10 billion in 1998, was not enough to finance massive private capital flight, implying a drawdown on international reserves.

Except for a couple of blips in the mid and late 1970s, private capital flow had been positive and generally rising in absolute terms and as a percentage of GDP. Inflow of private capital, including short-term, became particularly heavy from 1990 to 1996.

It averaged $6.3 billion annually, reaching a peak of $11.5 billion in 1996, which represents 7.5 percent of GDP. The situation drastically changed starting in 1997 with massive private capital flight, particularly the short-term type, which may be seen both as a cause and consequence of the crisis. Indeed, short-term capital in search of quick profit often referred to as 'hot money' can quickly fly out as it can fly in.

Private capital flight reached a peak of $13.8 billion in 1998, representing 16.4 percent of GDP. It is not surprising therefore that real GDP contracted by 13 percent at the height of the crisis in 1998, considering the magnitude of the financial hemorrhage that year.

For the next three years until 2001, private capital outflow amounted to between $8 to 10 billion annually. While the amount has declined in 2002 and 2003, the outflow remains unabated, indicating that investor confidence is far from being fully restored.

Even more disturbing is that official capital inflow, which had been financing private capital outflow, had also become negative in 2001 and 2002 (although it became positive in 2003). The sad reality is that the financial hemorrhage that began during the crisis persists many years thereafter, draining the Indonesian economy of much needed capital.

The classical justification for foreign aid derives from the two gap theory. Essentially, it says that at the initial stages of any country's development, two macroeconomic balances or gaps are bound to emerge: The resource (domestic savings-investment) gap and the foreign exchange (export-import) gap.

By national income definition, the two gaps are really two sides of the same coin. Typically, foreign savings in the form of private capital inflow are not sufficient to fill the gap. In order to reduce capital outflow or restore inflow, it is imperative that the Government promptly and effectively absorb ODA loans that have already been committed.

At the workshop, the Deputy Chair of BAPPENAS for Development Funding, Prasetijono Widjojo, disclosed that a total amount of $12.9 billion had been committed by official sources for 267 programs/projects as of March, 31, 2004.

However, only $5.6 billion had been disbursed, thereby leaving an undisbursed balance of $7.3 billion or 56 percent of the total. While Indonesia clearly needs more official capital inflow at this time (in the face of continuing private capital outflow), the absorptive capacity for new ODA loans is apparently reaching its limits.

Absorptive capacity for foreign aid can be limited by factors attributable to the recipient/borrower. It can be due to inadequate capacity to prepare investment projects and to establish their technical and economic feasibility to the satisfaction of the creditor; unclear arrangements and delineation of responsibility for project preparation, appraisal and approval; lack of common understanding on the extent to which financing cost is to be passed on to local governments in light of regional autonomy and devolution of powers and functions, or project implementation bottlenecks such as right of way acquisition and lack of counterpart funds.

But there are also factors attributable to the donor/creditor. These include well meaning conditionalities linked to disbursement of policy based loans and high standards prescribed for competitive procurement and contracting to prevent misuse of funds.

If the fiscal gap is dominant, consideration should be given to improving the tax effort (tax revenue as a proportion of GDP) in an equitable way. Often, new taxes may not be necessary if existing taxes can be collected.

If intensification of collection of existing taxes, imposition of new taxes, or reduction of subsidies, e.g. in fuel, are impossible because of politically sensitivity, internal public debt or private sector financing of investment in public utilities, e.g. in transport and energy, through Build Operate and Transfer (BOT) and similar schemes could be considered.

The ultimate objective of any foreign borrowing strategy must be to reduce dependence on foreign borrowing itself, especially the kind that comes with a host of restrictions or conditionalities.

If in fact fiscal and monetary discipline is needed to restore or maintain financial stability and to sustain economic growth, they could argue that the country should muster the political will to discipline itself even without pressure from the foreign assistance community.

The writer is senior adviser, ASEAN-UNDP Partnership Facility. The views expressed herein are personal and do not necessarily reflect those of the ASEAN Secretariat, any of the member countries, or UNDP.