Tue, 15 Jan 2002

The macroeconomic fix: Just say no to debts

H.S. Dillon, Jakarta and S.R. Tabor, Leiden, The Netherlands

Commenting on the evils of drug addiction, former president Ronald Reagan declared: "Just say no". Indonesia's leadership may be well advised to heed the sage advice of America's great communicator.

Indonesia's drug of choice has long been "debt". Government and the private sector have long demonstrated a prodigious ability to borrow madly, consume badly and ignore the consequences. This lingering addiction has trapped the economy in a sort of long-lasting stupor, which some euphemistically describe as "a crisis".

Over-borrowing, and serious, addictive over-borrowing like that which took place in the go-go 1980s and early 1990s, eventually catches up to you. Like any long binge, it leaves you vulnerable, strung-out and thirsty for more.

Over-borrowing surely caught-up with Indonesia in the late 1990s. Once the financial markets adjusted, Indonesia found itself with a mountain of bad debt that it could hardly service, much less even consider repaying.

The first instincts of government were to run out for a fresh fix -- it borrowed more big time! Massive government recap debt was created to bail out dodgy banks and sleazy corporates, or as their spin doctors rather accurately put it -- injecting liquidity to provide the private sector with breathing space. Massive new domestic borrowing by government, combined with a tight interest rate policy, brought the national debt load to new and hitherto unsurpassed heights.

The view from the top of Indonesia's debt mountain is terrifying. According to the World Bank's handy Internet site, the Indonesian government's domestic debt increased from about Rp 100 trillion ($13 billion) at the end of 1998 to Rp.657 trillion (US$68 billion) in October 2001.

Government's external debt was estimated at between $80 billion and $85 billion, for the past two years. As 2001 draws to a close, domestic and external public debt combined hovers around $153 billion, or about the same size as gross domestic product.

More than two decades ago, Milton Friedman declared that a public debt of 60 percent of GDP was the line that governments dare not cross. Seems there was something to that! Despite the breathing space accorded by the Paris Club, government's debt service expenditures rose from 1.5 percent of GDP in 1996 to 6.1 percent of GDP in 2001, or just over a quarter of all public expenditures.

More was spent by government in 2001 on keeping their creditors at bay than on educating Indonesia's children, improving agriculture or combating contagious disease. One can only wonder how a maleducated, sickly generation of poor farmers will repay the junk-loans their ancestors took on?

But it is not only the public sector that finds itself tarred with the brush of being a bum debt-junkie. Private external debt was estimated at $54 billion in September 2001, down modestly from a high of $58 billion in December 2000. Creditors who haven't been repaid for the past few years might have a higher tally, but for illustrative purposes, $54 billion to $55 billion is probably in the right ballpark.

Since much of this debt remains overdue, Indonesia's biggest corporates are classified by their creditors as distressed. In street lingo, that's how financiers describe a burned-out debt junkie!

Right now, the debt overhang is the main, over-riding constraint to macro-stability and economic recovery. As long as this mountain of bad debt casts its ugly shadow over the nation, no amount of confidence building reforms are going to win back the hearts of investors -- after all, the big visible foreign investors know that some companies profits will need to be tapped to repay old junk-debt. And the foreign bankers know better than to pour too much fresh money into countries which can't repay what they already owe.

The IMF has the debt problem squarely in its sights, but they are also trying to keep the problem somewhat hush-hush. No sense declaring the situation hopeless. The Fund's strategy (or at least that spelled out in the latest series of agreement letters) rests on having the private sector sort out its own bad debts, nudging government on IBRA sales, endorsing small fiscal deficits and encouraging government to refinance its domestic debt on better terms.

With fiscal deficits projected at 2 percent to 3 percent of GDP, and economic growth at 3 percent to 5 percent per annum, Indonesia might well be able to trim its public debt back to 60 percent of GDP in about 20 years time. Meanwhile, the creditor's clubs keep Indonesia on a narrow leash, pushing the debt burden into future years, with a sprinkling of grace here and there.

All the structural reform in the world -- democracy, rule of law, anti-corruption, human rights and even pro-poor reforms won't have much of a lasting economic effect as long as the shadow of bad debt still hangs over the country. Meanwhile, the bad borrowing practices, or debt addiction, that got the economy where it is now, is still largely in place, only now local government gets to share in this folly.

For the last few years now, Indonesia's government has been spending 5 percent to 6 percent of GDP to service its debt, despite Paris Club relief. Writing in the bible of Sovereign Debt (International Debt Reconsidered), William R. Cline concludes that governments which spend more than 3 percent to 4 percent of GDP on debt service typically are unable to meet these obligations and maintain political stability.

The "internal transfer" problem arises when governments have to mobilize more money to pay back (or pay down) their debts and cut back on essential services simultaneously. Low-income populations simply become fed up when governments spend too much of their current resources servicing past debts, especially if that borrowing was for dubious purposes.

Cline also finds that the bad debts of the private sector eventually migrate to the public purse, even in those countries in which governments swear that they will not guarantee private debt. Once bad private debts contaminate the banking system, or once big companies with lots of employees go under, the company's bad debts tend to be socialized by the state.

With any dangerous addiction, one can try a course of treatment aimed at gradually weaning the patient from their addiction. That is the Fund approach right now, but it has yet to show any signs of success. Note that this course of treatment has not worked terribly convincingly for most other debt junkies -- Algeria, Russia and Argentina are just the most recent public failures.

The other (tougher) option is "cold turkey". This means that the government has to "just say no" to new borrowing, and "just say no" to its existing creditors. The sky doesn't fall in when that happens, despite what external creditors might predict.

A refreshing unilateral pause in debt service payments can be used to inspire creditors to step in line for coordinated debt reduction and relief, on terms that probably best serve their interests and the nations in the long run.

For the creditors (and even the official ones) it's better to recover 50 cents on the dollar than nothing; and for the nation, it is surely easier to attract investment and grow when the legacy of a crushing public (domestic and external) and private external debt is trimmed back to manageable proportions.

Does Indonesia have leaders brave enough to face down this mountain of debt, renounce their addiction and just say no? Economists like to make simple problems rather complex and formalistic, but in this instance, the economic choice is quite clear-cut -- just say no, or live with unfulfilled expectations and shaky confidence for many years to come.

Indonesia needs a clear strategy for reducing public and private debt to manageable proportions. The longer this is left hanging, the longer the economy, the currency and Indonesia's people will sadly dangle in the wind.