Problems of debt standstill and capital controls

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.