RI needs debt reduction from Paris Club

Francis Lemoine, European Network for Debt and Development (EURODAD), Brussels

Indonesia is certainly the country that bore the greatest costs from the financial crisis. Public debt, which had until then been kept at sustainable levels, more than doubled to reach over 100 percent of gross domestic product. Due to an equally sharp increase in private debt, total foreign debt also stands at more than 100 percent of GDP.

Where did it all come from?

The roots of the debt problem lie in the corruption and nepotism that characterized the New Order. When the crisis finally hit in 1997, the devaluation and subsequent outflows of capital turned the boom into a bust from which the country still has to recover. The crisis primarily hit through its already weak financial sector when it became clear that companies and private banks were no longer in a position to repay their debts contracted in foreign currencies.

These very high stocks of debt exert a strong pressure in the short term on the budget, which devotes half of its fiscal revenues to debt service, while commitments for social expenditures such as education or health have steadily decreased since the onset of the crisis.

Before the crisis, Indonesia's public debt was considered sustainable with a ratio of debt-to-GDP of about 25 percent and concessional interest rates. It is now worth more than US$130 billion, slightly over 100 percent of GDP.

Current debt stock levels exert an enormous pressure on the government's budget. Debt service now accounts for about half of the state's revenues and is scheduled to take up to 30 percent to 40 percent of revenues for several years.

The magnitude of the debt burden and the need for external finance to fund the budget and ease the constraints on the balance of payments, has also weakened the bargaining power of local authorities with the IMF and other creditors -- as witnessed by the weak agreements held with the Consultative Group on Indonesia (CGI) or the Paris Club.

The creditors' community has not been prepared to grant more than modest rescheduling terms to Indonesia, ruling out any reduction in the value of their claims. Worse, Indonesia also a faces a private debt overhang. Total private debt is now about $100 billion of which, $80 billion is denominated in dollars.

These debts exert extra pressure on Indonesia's balance of payments and further restrain investors' willingness to commit new resources, given the high rate of default that still characterizes Indonesian companies.

This assessment is corroborated by International Financial Institution (IFI) analyses that define current debt levels as "technically sustainable". Yet the projections rely on overly optimistic assumptions that are unlikely to be met throughout the projection period. This projection also fails to take into account the costs incurred by sustaining such high levels of indebtedness over an extended period.

Since the crisis, Indonesia has been to the Paris Club twice, in 1998 and 2000. Principal repayments falling due up to two years after the agreement were rescheduled over 20 years at market interest rates. These agreements, however, did not lead to any sizable reduction in the present value of debt.

Also, creditors fear that granting a sizable debt reduction to Indonesia would loosen the pressure on the government to implement the reforms set by the IMF and the CGI.

The World Bank and the International Monetary Fund (IMF) projections for future debt sustainability are still overoptimistic. Their degree of optimism however declined repeatedly as the recovery to pre-crisis growth and income levels proved ever more remote and problematic.

More surprisingly, the IMF and the World Bank also fail to give any guidance on the level at which debt is or might become unsustainable. Past evidence on debt sustainability suggests that this point was reached in 1999, and that Indonesian debt has been unsustainable since then.

Indonesia fails every test for sustainability. Debt burdens are not only unsustainable relative to government's fiscal revenues but also in the constraints on the balance of payment. More worryingly, it also seems likely that debt will remain unsustainable for most of the decade, if foreign and domestic investment fails to materialize in the coming years.

This human development approach to debt sustainability shows that only half of the total debt should be repaid if the country it is to devote sufficient resources to poverty reduction and human development.

We propose the use of a poverty-focused debt sustainability criterion. It starts with an assessment of the resources that a given country will need to achieve poverty reduction and human development.

Given the importance of these other expenditures, particularly in promoting higher growth rates, no more than a third of remaining resources should be allocated to debt servicing.

Indeed, the Indonesian government can only afford to pay less than half of its current debt service if it is to devote sufficient resources to poverty reduction and social development.

This estimation of the maximum affordable debt service level should thus be taken as an upper bound of what government can afford to pay to external creditors. Thus, we believe that a reduction by half of current debt service would provide the financial cushion necessary to sustain these development expenditures in case of unpredicted shocks.

Following the implementation of the Heavily Indebted Poor Countries Initiative (HIPC), the international community has incorporated the importance of the human development criterion in assessing the severity of the financial constraints faced by developing countries. It has also been acknowledged that the treatment of unsustainable debts should not only result in a trade-off between minimizing moral hazard and maximizing economic growth, but also take into considerations the standards of living of the population whose sovereign debt problems are being assessed.

Providing such debt relief implies for Paris Club creditors to cancel up to 79 percent of their current claims.

Reaching the debt service reductions spelled out above can be done in two ways:

Firstly by rescheduling debt repayments over an extended period at reduced interest rates and with an appropriate grace period to cushion the government's liquidity constraints.

This was the solution retained when Indonesia came to the Paris Club in 1966-1968. After an original rescheduling agreement with the Paris Club, over eight years and with three years grace, a second agreement was reached, resulting in a 30 year repayment period with three years grace, and no amortization of interest.

Secondly by reducing the net value of the stock of external debt to a level consistent with the levels of "affordable" debt service computed above. Assuming that the reduction in debt service needed over the next 10 years is achieved by reducing the present value stock of debt by the same amount, this would result in a 50 percent write-off of Indonesia's external debt.

Given Paris Club's institutional setting, only part of Indonesia's external public debt is eligible for debt treatment. In fact, only debts owed to official bilateral creditors -- 48 percent of total external public debt will be treated at the upcoming negotiations.

Paris Club agreements, however, are also to be binding (although not legally) on other unofficial bilateral and private creditors. If the involvement of these creditors in the implementation of the agreement is indeed insured, the proportion of eligible debt jumps to 63 percent.

Hence the reduction needed by the Paris Club to halve Indonesia's external public debt would reach 79 percent. Under which rescheduling terms could this reduction be implemented?

A more credible solution would be for bilateral creditors to grant a debt reduction to Indonesia along the lines of Naples terms, the additional reductions needed to reach the 50 percent reduction being supported by multilateral creditors. So in addition to bilateral debt reduction of nearly 67 percent, multilateral creditors would need to cancel 32 percent of their debts.

This ad hoc framework would enable a more realistic burden sharing between bilateral and multilateral creditors.

Whereas Indonesia would not be eligible to the HIPC initiative after receiving Naples terms, the burden of debt reduction should be shared between bilateral and multilateral creditors. One credible solution to implement such workout would be for Paris Club creditors to cancel debt up to 67 percent under Naples terms and for multilateral creditors to cancel the remaining stocks necessary to reach the 79 percent threshold.

The above is condensed from the writer's presentation at the International Conference on Alternative Solutions for Indonesia's External Debt in Paris on Monday. It was held by the Jakarta- based International NGO Forum on Indonesian Development (INFID) in conjunction with the Paris Club talks focusing on Indonesia's debts.