20436 t'~~~~~~~~~~~~~~~V .,,<),~~~~~~~' May 22, 2000 t4 ~~~~~1 ~~ ~ 3 NA~~~~~~~~b nsr*~4 Lg -^F' #bL¢.1! ~~A4 -: * * . 1 J | * ' 2 ' ': X¼- | y ouKfl7es:? o.,C~~~~~~~~~~~~~~~~~~~~~~~~~~r; I v *^5; \o__=_1__W~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~4 1~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ .4_L S ~~~ ~ 1 > Report No. 20436-IND E INDONESIA MANAGING Go VERNMENT DEBT AND ITS RISKS The World Bank East Asia and the Pacific Region May 22, 2000 ii CURRENCY EQUIVALENTS (As of May 22, 2000) Currency Unit = Rupiah US$1= Rupiah 8,297 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank ADF - Asian Development Fund BAPEPAM - Capital Market Supervisory Board BULOG - Agency for Logistics Affairs CAR - Capital Adequacy Ratio DMO - Debt Management Office DSA - Debt Sustainability Analysis GDP - Gross Domestic Product HIPC - Heavily Indebted Poor Country IBRA - Indonesian Banking Restructuring Agency IBRD - International Bank for Reconstruction and Development IDA - International Development Association IFIs - International Finance Institutions IMF - International Monetary Fund 1NDRA - Indonesian Debt Restructuring Agency JBIC - Japan Bank for International Cooperation KKN - Corruption, Collusion and Nepotism KKPA - Credit for Primary Cooperatives Members KUT - Credit for Farmers LIBOR - London Inter Bank Offer Rate MOF - Ministry of Finance NPV - Net Present Value NGO - Non-Govemmental Organization ODA - Official Development Assistance OECD - Organization for Economic Cooperation and Development SBI - Bank Indonesia Certificate TA - Technical Assistance FISCAL YEAR: April 1-March 31 till 2000 FY2000 is 9 months, Apr. 1 to Dec. 31 Same as CY from 2001 onwards Regional Vice President: Mr. Jemal-ud-din Kassum, EAPVP Country Director: Mr. Mark Baird Chief Economist: Mr. Masahiro Kawai, EAPVP Sector Director: Mr. Homi Kharas, EASPR Task Team Leader: Mr. Lloyd McKay, EASPR This report has been prepared by a team including Lloyd McKay, Hana Polackova Brixi, Punam Chuhan, Nunu Hendrawanto, Magda Adriani, Caridad Valdehuesa (ADB consultant) and Nina Herawati. John Underwood and Sara Calvo were peer reviewers. Invaluable review comments and suggestions were also provided by Homi Kharas. Vikram Nehru, Bert Hofinan, Sudarshan Gooptu and John Clarke. iii INDONESIA MANAGING GOVERNMENT DEBT AND ITS RISKS Table of Contents Executive Summary iv Ringkasan Eksekutif vi A. The Problem of Size and Risks 1 Indonesia's Government debt is very large 1 Govemment debt service obligations impose a heavy burden 2 Government finances are exposed to significant risks 3 Key factors affecting the size of fiscal risks 3 Actions needed to make Government debt manageable 5 Growth is a necessary foundation for debt reduction 7 B. How to reduce the debt burden 8 (i) Generate significant primary fiscal surpluses, especially over the next few years 8 (ii) Contain off-budget losses and counteract fiscal risks 10 (iii) Aggressively sell assets and reduce debt 12 (iv) Reschedule existing debt under international rules and seek the best possible terms for new borrowing 12 (v) Build government capacity for strategic debt management 14 (vi) Establish an effective domestic bond market 15 (vii) Conclusion 15 Annex 1 Key Data on Indonesia's Government Debt 16 Annex 2 Market Perception of Risk 19 Annex 3 Established International Guidelines for Rescheduling Debt Service Payments 22 Annex 4 Contingent Liabilities and Fiscal Risks 24 Annex 5 Selected Case Examples of Debt Management 25 iv EXECUTIVE SUMMARY The economic crisis has left Indonesia's again after public confidence in the Government deeply in debt. Government Government's ability to use resources debt has increased from $53 billion (23 well is strengthened. percent of GDP) before the crisis to about 2. Contain off-budget losses and $134 billion (83 percent of GDP) in early counteract fiscal risks. Actions are 2000. Nearly three-quarters of this increase needed to minimize new debt arising is domestic debt to pay for bank from off-budget obligations. These restructuring. This rise in debt is the include state enterprise losses, local combined result of past policy mistakes and goverment spending in excess of the economic crisis, not new spending. revenues, directed credit programs, Debt service obligations (interest and potential additional costs of bank amortization) will be over 40 percent of restructuring, and possible further costs government revenue for several years. This to recapitalize Bank Indonesia. Without will severely constrain fiscal flexibility these actions, efforts to reduce debt can throughout the term of the current be offset by the concurrent creation of government. The Government will need new government debt. Further large new financing (both external and domestic) increases in debt from off-budget losses, in the coming years to meet expenditure such as the bank restructuring cost of the needs. past two years, may have catastrophic Though very large, Indonesia's Government consequences for fiscal management. debt is manageable. Government debt can 3. Aggressively sell government assets to be reduced from about 91 percent of GDP at reduce government debt. Early debt the end of 2000 to 67 percent within five reduction would pay big dividends. So years. and 46 percent within ten years. But IBRA's assets should be sold as quickly achieving this will not be easy. Actions as possible. Rupiah 60 trillion from asset (such as macro-economic stability, improved sales now would reduce debt by about 5 governance, and market-friendly policies) to percent of GDP. IBRA asset sales would rebuild investor confidence, keep real help establish a virtuous cycle, as they interest rates down and renew growth are would spur recovery by building investor necessary. But these alone would not be confidence, increasing the value of sufficient. Actions are also needed in the subsequent sales, and improving following six key areas: efficiency. Similarly, further I1. Generate significant primary fiscal privatization of state owned enterprises surpluses (at least 2 percent of GDP), would also help reduce debt and increase especially over the next few years. efficiency. Any situation where Every one trillion Rupiah more of fiscal individuals may have acquired state surplus would reduce debt by the same assets through corrupt practices should amount. Tax revenues need to be be examined thoroughly. Wherever increased, subsidies that are not evidence of wrongdoing is found, those incrategicallyfocused, subsidiesorresponsible should be prosecuted and the strategically focused on the poor government compensated. reduced, and non-essential expenditures deferred. Expenditures can be increased v 4. Reschedule existing debt under will be needed to manage debt well, deal international rules and seek the best with fiscal risks, and ensure that public possible terms for new borrowing. A resources are used well. High and very heavy debt service burden could potentially volatile debt service delay recovery and threaten the political payments call for a strategy to manage sustainability of planned actions. Even risks and develop new borrowing with a successful second Paris Club instruments. The Government needs rescheduling, new lending will be needed strong analytical and oversight capacity to mitigate the annual cash requirements in a Debt Management Office. of debt servicing. The Government 6. Establish an effective domestic bond needs to seek concessional loans and market. This will provide goverment grants, ensure productive use of with more options for strategic debt borrowed and other public resources, and management, making it easier to smooth smooth the profile of future debt service domestic debt service payments that are payments. expected to peak in 2004 and then again 5. Build capacity to manage debt well in 2008. Vigorous institutional capacity building Vi RINGKASAN EKSEKUTIF Krisis ekonomi telah membuat Pemerintah Tindakan-tindakan juga dibutuhkan dalam Indonesia terbelit hutang yang berat. Hutang enam bidang utama berikut ini: pemerintah telah bertambah dari $53 milyar 1. Hasikan surplus fiskal primer yang (23 persen dari PDB) sebelum krisis menjadi signifikan (paling tidak 2 persen dari sekitar $134 milyar (83 persen dar PDB) di PDB), khususnya selama beberapa tahun awal tahun 2000. Hampir tiga perempat dar mendatang. Setiap satu trilyun Rupiah pertambahan mi merupakan hutang dalam tambahan surplus fiskal akan negeri yang harus dibayar untuk mengurangi hutang sampai sejumlah restrukturisasi perbankan. Kenaikan jumlah yang sama. Penerimaan pajak perlu hutang ni merupakan akibat gabungan ditingkatkan, subsidi yang tidak secara kesalahan kebijakan masa lalu dengan krisis strategis ditujukan pada kalangan miskin ekonomi, bukan karena pengeluaran baru. dikurangi, dan pengeluaran-pengeluaran Kewajiban-kewajiban penutupan hutang yang tidak esensial ditangguhkan. (bunga dan amortisasi) akan melebihi 40 Pengeluaran-pengeluaran dapat diting- persen dari penerimaan pemerintah selama katkan kembali setelah kepercayaan beberapa tahun. Ini akan sangat membatasi publik kepada kemampuan Pemerintah fleksibilitas fiskal selama masa pemerintahan untuk menggunakan sumber daya dengan sekarang ini. Pemerintah akan baik telah kuat kembali. membutuhkan pembiayaan baru (baik luar 2. Tahan kerugian-kerugian luar maupun dalam negeri) di tahun-tahun aha ankerugiko-risiko fsar mendatan untuk mmenuhi kbutuhananggaran dan atasi risiko-risiko fiskal. mendatang untuk memenuhi kebutuhan Tindakan-tindakan dibutuhkan untuk pengeluaran. meminimalkan hutang baru yang timbul Meskipun sangat besar, hutang Pemerintah dari kewajiban-kewajiban luar anggaran. Indonesia dapat dikelola. Hutang Ini mencakup kerugian-kerugian BUMN, Pemerintah dapat dikurangi dari sekitar 91 pengeluaran pemerintah daerah yang persen dari PDB pada akhir tahun 2000 melebihi penerimaan, program-program menjadi 67 persen dalam waktu lima tahun, kredit yang diarahkan, biaya tambahan dan 46 persen dalam waktu sepuluh tahun. yang mungkin timbul untuk Tetapi untuk mencapai hal ini tidak mudah. restrukturisasi perbankan, serta Perlu tindakan-tindakan (seperti kestabilan kemungkinan tambahan biaya lebih makro-ekonomi, pengendalian pemerintah lanjut untuk rekapitalisasi Bank (governance) yang lebih ditingkatkan, serta Indonesia. Tanpa tindakan-tindakan ini, kebijakan-kebijakan yang bersahabat upaya-upaya untuk mengurangi hutang terhadap pasar) untuk membangun kembali bisa disamai oleh pengadaan hutang baru kepercayaan investor, mempertahankan pemerintah pada waktu yang bersamaan. tingkat bunga nyata pada tingkat yang Pertambahan-pertambahan besar lebih rendah dan memperbaharui pertumbuhan. jauh dalam jumlah hutang akibat Tetapi hal-hal ini saja tidak akan cukup. kerugian-kerugian luar anggaran, seperti biaya restrukturisasi bank-bank dua vii tahun terakhir, bisa berakibat bencana Club kedua, pinjaman baru akan terhadap pengelolaan fiskal. diperlukan untuk meringankan 3. Jual ecaraagresf ase-asetpemerntahkebutuhan uang tunai tahunan guna Jual secara agresif aset-aset pemerintah menutupi hutang. Pemerintah perlu untuk mengurangi hutangs pemerintah. mengupayakan pinjaman-pinjaman lunak Pengurangan hutang secara dini dapat serta dana bantuan, memastikan menghasilkan keuntungan besar. Maka, pertaudan yan tif atastikan aset-aset IBRA perlu dijual selekas penggunaan yang produktif atas sumber mungin.Sejulah60 trilyun Rupiah daya pinJaman maupun sumber daya mungkin. Sejumlah 60 trin Rupah publik lainnya, dan memperlancar profil dari penjualan aset sekara-ng ini dapat pembayaran penutupan hutang di masa mengurangi hutang kira-kira 5 persen p an p dari PDB. Penjualan aset IBRA akan depan. membantu membentuk suatu siklus yang 5. Bangun kapasitas untuk mengelola baik, karena akan merangsang pemulih- hutang dengan baik. Peningkatan an dengan membangun kepercayaan kapasitas kelembagaan secara giat akan investor, menambah nilai penjualan diperlukan untuk mengelola hutang selanjutnya, dan meningkatkan efisiensi. dengan baik, menanggulangi risiko- Demikian pula, privatisasi BUMN lebih risiko fiskal, dan memastikan bahwa lanjut juga akan turut mengurangi hutang sumber daya publik digunakan dengan dan meningkatkan efisiensi. Setiap baik. Pembayaran penutupan hutang situasi di mana orang-perorangan mung- yang tinggi dan sangat tidak menentu kin telah memperoleh aset negara membutuhkan suatu strategi untuk melalui praktek korupsi perlu diperiksa mengelola risiko dan mengembangkan dengan saksama. Di mana saja instrumen-instrumen pinjaman baru. ditemukan bukti perbuatan salah, mereka Pemerintah membutuhkan kapasitas yang bertanggung jawab perlu diusut dan analisis dan pengawasan yang kuat pemerintah diberi kompensasi. dalam suatu Instansi Pengelolaan 4. Jadwal ulang hutang yang ada Hutang. berdasarkan aturan-aturan inter- 6. Bentuk suatu pasar obligasi dalam- nasional dan upayakan syarat-syarat negeri yang efektif. Ini akan terbaik untukpeminjaman baru. Beban memberikan pemerintah lebih banyak penutupan hutang yang sangat berat pilihan bagi pengelolaan hutang strategis dapat menunda pemulihan serta dan akan mempermudah usaha mengancam keberlanjutan politik untuk memperlancar pembayaran hutang dalam melaksanakan program-program yang negeri yang diperkirakan mencapai telah direncanakan. Bahkan dengan puncak pada tahun 2004 dan sekali lagi keberhasilan penjadwalan ulang Paris di tahun 2008. I MANAGING GOVERNMENT DEBT AND ITS RISKS A. THE PROBLEM OF SIZE AND RISKS 1. Indonesia's Government debt is very Table 1. Indonesia: Government Debt Outstanding large. Total government debt has risen from (US$ billion, end of period) 23 percent of GDP in March 1997 to 83 (US$_billion,_end_of_period) percent of GDP in 2000 (see Table 1). Almost .Y96197 FY-9798 EY9 899 PY99100 -000 three quarters of the increase in debt is new I -ro eton, domestic debt arising from the financial crisis; Total 52.6 51.2 78.1 134.2 157.2 $72 billion in bonds issued to recapitalize Domestic a/ 0 0 18.9 71.5 91.5 banks and to compensate Bank Indonesia for External 52.6 51.2 59.2 62.7 65.7 liquidity credits (see Table 2). Only $8 billion Memo items (%/6): of this domestic govermment debt is held by Total/GDP 22.9 61.9 67.3 83.3 90.7 the private sector, $33 billion is held by state external/GDP 22.9 61.9 51.0 38.9 37.9 banks, and $31 billion by Bank Indonesia. Source: Bank Indonesia, MOF and World Bank estimates. a/ Assuming an exchange rate of Rp 7,000 per US dollar for 2000. 2. Contrary to common perception, the government's external debt has risen Table 2. Domestic Government Debt modestly, from $53 billion in March 1997 to (Cumulative, Rupiah trillion) an expected $63 billion in March 2000. New : - T foreign borrowing accounts for only 13 - t : : in:-xed bonds percent of the increase in government debt. At donds bonds :bods its peak of 62 percent of GDP, government Dec-98 0 0 100 0 20 external debt in Indonesia was comparable Mar-99 0 0 165 0 165 with the total external public debt of Mexico Jun-99 95 9 218 0 322 and the Philippines in the late 1980s (see Sep-99 95 9 218 0 32 Table 3). Foreign borrowing of the rest of the Sep-99 95 9 218 0 322 public sector has also been modest compared Mar-00 204 53 218 25 500 with this rise in domestic debt. Bank Mar-00 20 53 218 25 500 Indonesia has borrowed about $10 billion from the IMF and external debt of state-owned Source: MOF and World Bank estimates. enterprises has remained relatively stable at about $9 billion (see Annex I for details). Table 3 : External Public Debt (end of period, % of GDP) 3. Government borrowing has : -- 1990 1-99 1996 1998 traditionally relied heavily on official sources of finance - bilateral and multilateral - with Japan being by far the largest single creditor (see Annex 1). The currency composition of inconesia Z'4 42 36 26 62I/ the Government's external debt is largely Korea, Rep. 18 7 7 9 18 denominated in US dollars and Yen (see Table Malaysia 47 27 21 16 25 4). Most of foreign borrowing has been long- Mexico 60 29 19 29 22 term, with average maturity of 22 years and Philippines 69 54 51 32 43 grace period of seven years. The average interest rate is 5 percent, which reflects Source: World Development Indicators, 1999. concessional terms of some foreign loans. As I/ Central Govemment debt only a result, the net present value 2 (NPV) of government external debt is 12 percent percent of government tax revenues in lower than the nominal value of the FY1999/00, compared with only 24 percent government's external debt. The NPV of before the crisis. They are expected to peak at government external debt was about $51 billion 45 percent of government revenue in 2000 and at the end of 1998, compared with a face value are projected to remain above 40 percent for of $58 billion (see Table 5). several years. Interest payments will be 35-40 percent of government revenue for the next few Table 4. Currency Composition of External years. Interest payments on domestic bonds Government Debt (March, 1999) alone will be 25-30 percent of government US$ 5- t2iigXbiiansg ; (%revenues per annum.' Principle repayment on Total 59.2 100.0 domestic bonds peaks at $5.8 billion equivalent Yen 23.0 38.9 in 2004 and $9 billion equivalent in 2008. US dollars 26.5 44.8 Table 6. Government Debt Service Payments (USS billion) ... Other 9.6 16.2 Source: Bank Indonesia and World Bank staff Actual - Projection- estimates. Actuai ------ Projection ------- Total 6.1 8.8 9.8 12.9 15.6 4. This large increase in stock of domestic External 5.5 5.6 3.7 5.4 7.6 government debt is partly offset by a concurrent Principal a/ 2.9 2.7 1.4 2.5 5.1 rise in government assets. In particular, the Interest 2.6 2.9 2.3 2.8 2.5 Government received shareholdings in industrial Domestic 0.6 3.2 6.1 7.6 8.0 enterprises, equity in banks, real estate and loan ond maturities .6 .2 . . 0.8 portfolios in exchange for bank restructuring Interest 0.6 3.2 6.1 7.6 7.2 bonds. It is very difficult to be put a precise Memoitems: value on these assets, but IBRA has estimated Total/revenue (%) a/ 38.8 36.4 44.9 41.8 42.6 thalueto they seould generats, abot IB s billn i Total/GDP (%) 5.9 6.3 8.5 8.2 9.4 that they could generate about $30 billion in External/exports (%) 10.5 9.4 8.3 8.9 12.0 revenue from asset sales over the next five years. BI to IMF (US$ bil): 0.3 0.4 0.3 2.3 2.8 Srubtracting this from the stock of government Source: Bank Indonesia and World Bank staff estimates. debt suggests that "net government debt" in a/ This reflects rescheduling under the quasi-Paris Club. March 2000 was about $104 million (54 percent bl This is the nine month fiscal year, April till December, 2000. of GDP) compared with gross government debt of $134 million (72 percent of GDP). 6. External debt service payments were kept down to 22 percent of government tax revenues for FY99/00 by the quasi Paris Club oabler5. N et Present Valuelof External agreements. Without the second quasi Paris Government Debt (USS billion, end-1998) y Club rescheduling, exteral debt service payments would have risen to a projected 28 Total 58 51 percent of government revenue in the 2000 fiscal Multilateral 18 18 year before falling back to 25 percent in 2001 o.w. IBRD I I I I and 21 percent in 2002. Total debt service Bilateral 35 28 obligations would have been about $15 billion o.w. Japan 21 17 per annum (half on external debt and half on Other 5 5 domestic debt interest payments) if there had Source: Bank Indonesia data and World Bank staff been no second Paris Club. Bunching of estimates. principle repayments and possible volatility in the cost of debt service, which we discuss 5. Government debt service obligations below, calls for a careful borrowing strategy to impose a heavy burden. Debt service payments avoid excessive pressures on government budget will severely constrain public expenditures and at this critical time. the flexibility of overall fiscal and monetary policy for at least the life of the current government. Total government debt service Excluding the inflation indexed part of bonds obligations (external and domestic) absorbed 36 issued to bank Indonesia, as this is capitalized. 3 7. Assessing the manageability of debt expected 207 trillion Rupiah2 from IBRA service obligations is akin to assessing fiscal asset sales and to privatize state owned sustainability. Hence, before turning to enterprises. It is also critical for renewed explicitly address the question of debt growth, keeping interest rates down, sustainability, we first look at key factors achieving government tax revenue targets affecting government expenditures and and establishing a successful domestic bond revenues. market. Investor confidence, in turn, will depend on prudent fiscal and monetary 8. Governmentfinances are exposed to policies, sound market institutions, and significant risks. Indonesia's government transparency in government decision expenditures are exposed to two key risks - making3 sudden increases in debt service costs and unexpected spending pressures. Sudden * Domestic interest rates affect the cost of increases in debt service costs may arise from debt service and the size of likely off-budget an increase in domestic interest rates, new losses. A one percentage point increase in debt needed to account for past or new policy the SBI rate would increase the cost of mistakes, depreciation of the Rupiah, and servicing domestic debt by about 0.3 percent inflation. Unexpected spending pressures may of GDP annually (4 trillion Rupiah). An infltion Unepectd spndin presure mayincrease in domestic interest rates would arise from social or political pressures and weaken gomenterest rames and from off-budget obligations associated with weaken government credit programe and finncal nsituios,state-owned enterprises, increase likely corporate and banking sector financial institutions, stt-we nepie,losses that could in turn increase independent government agencies, and sub- govemment oblda inse national governments. The likelihood of these government obligations. risks actually resulting in additional * Political actions are likely to alter the size government expenditures depends heavily on of off-budget obligations and the revenue the Government's commitment to prudent and from asset sales. A soft stance vis-a-vis transparent fiscal management. large banks or enterprises would be likely to result in further bank recapitalization costs 9. The fiscal risk matrix (Box 1) and would reduce IBRA revenues 5. illustrates sources of future possible pressures Indirectly, a lack of political will would tend on government expenditures. Government to undermine the return of investor debt may rise if any of these explicit (legally confidence. substantiated) and implicit (politically and morally grounded) contingent liabilities are realized. The largest contingent liabilities 2 Book value of IBRA assets is reported to be 533 relate to the banking sector (government trillion Rupiah, but average expected recovery guarantee on interbank claims, implicit rate is only about 30-35 percent. commitment to recapitalize large state-owned 3 Investor confidence in Indonesia has yet to fully banks and maintain a stable financial system). recover. Annex 2 illustrates that, for Indonesia, Box 2 summarizes potential sources of debt secondary market spreads on international bonds reduction. remain high, and sovereign credit rating low. In 2000-01, the government is expected to face a 10. Key factors affecting the size offiscal contingent liability of about 28 trillion Rupiah on risks. The leading factors affecting the credits outstanding. For most credits, such as risks. ~ Th .edn atr fetn h KUT and KKPA, the government explicitly potential costs arising from these risks and the KTadKP,tegvmetepiil potential costs arising from heserisksandthecovers default risk. Average maturity of these Government's capacity to meet them are credits is 12 months and average default risk 40 summarized below: percent. Investor confidence is vital for the This relationship has already -surfaced through Government to successfully obtain the asset management companies in a number of countries (including Mexico and the Philippines) and also in Indonesia. IBRA reported a significant drop in debt collection rates following the Bank Bali scandal. 4 Box 1. Fiscal Risk Matrix Explicit * Sovereign debt (domestic and external, * Blanket guarantee on bank depositors (cost 600 trillion Government loans contracted and securities issued by Rupiah during 1997-1999) liability as Government) * Guarantee on interbank claims recognized | Expenditures - non-discretionarv and |Umbrella govemment guarantees for non-sovereign by a law or legally binding in the long term (salaries borrowing by small and medium-sized enterprises, farmers, contract and pensions of civil servants, minimum BULOG. and other entities benefits under the pay as you go pension stem) * Trade and exchange rate guarantees (via the Export Bank., sYstem) INDRA and other entities) Implicit * Future recurrent costs of public investment I * Losses associated with take-or-pay contracts of public utility A moral projects and other discretionary companies obligation of expenditures * Support to enterprises (government possibly covering losses Government and assuming non-guaranteed obligations of state-owned or that reflects private enterprises) public and Subsidies related to the pricing of rice and regulated oil interest- products (via BULOG and PERTAMINA programs) pressures t * Possible need for further recapitalization for any banks that l t + ~~~~~~~~~~~~~fail to reach the 8 percent CAR by end-2001 * Possible need for further recapitalization of Bank Indonesia i * Possible spill-over of sub-national government obligations to _____________ I * the central government Kource: WVorld Bank staff Box 2. Potential Sources of Debt Reduction Explicit * IBRA assets recovery * Government revenues from oil and gas Sources based on (workout and sales of non- * Tax revenues less revenue committed to sub-national governments govemment legal performing loans and sales of Savings from cuts of discretionary expenditures, such as subsidies powers (ownership) equity) and the right to raise * Privatization of state-owned * Hedging instrumcnts and (re-)insurance policies purchased by the revenues enterprises and other public government from financial institutions resources * Recovery of loans made by govemment to public enterprises Implicit * Future profits of state-owned enterprises and agencies under Sources not under govemment control direct govemment * Possible positive net worth of Bank Indonesia (adjusted for control currency structure and liquidity of reserves) ource: World Bank staff. 5 * Policy actions directly affect government 11. Actions needed to make government revenues (e.g. through tax exemptions), debt manageable. Achievable macroeconomic current expenditures (e.g. subsidies on and fiscal developments would reduce the debt petroleum products, electricity and rice) to GDP ratio to 67 percent of GDP within 5 and potential future expenditures (e.g. years and about 46 percent of GDP within 10 potential liabilities arising from credit years.8 But this cannot be achieved without bold programs, BULOG's operations, and power and sustained actions by government. Renewed projects). A failure to maintain fiscal growth, conservative fiscal policies, and asset discipline, as could happen with the sales are all essential if this potential reduction implementation of fiscal decentralization, in debt is to be realized. Future shocks and would increase government debt. losses of investor confidence must be avoided too. This reduction in debt as a share of GDP * Operational risks pervade fiscal and debt deesdictyo:()heifrnebtwn management arrangements. A shortage of depends directly on: (a) the difference between trained staff in many aspects of fiscal risk GDP growth and the average interest rate paid and debt management, together with on government debt; and (b) the primary fiscal inadequate informan ge rsurplus", capital revenues (e.g. IBRA's asset inadequate info-lation, gives rise to the sales) and off-budget losses.10 Anv attempt to lielihood of misjudgments and poor implementation r inflate away part of the domestic debt would not only undermine investor confidence, but its * Changes in the Rupiah affect external debt effectiveness would be severely limited by the service payments, exchange rate guarantees fact that about 90 percent of domestic debt is provided by the Export Bank and INDRA, subject to a variable interest rate or has its and liquidity and solvency problems of "interest rate" indexed to the rate of inflation. banks with large foreign debts. This effect on expenditures is partly off-set by changes 12. Figure 1 illustrates this achievable in oil revenues and the market value of decline in the government debt to GDP ratio. It export companies under IBRA control. assumes that government succeeds in Deregulation of domestic fuel prices would undertaking, the needed difficult policy actions, increase the offsetting effect that oil price that investor confidence returns and that has on fiscal balances. Cross-currency risk, renewed growth is achieved. The key particularly the risk of yen appreciation, is assumptions underpinning this scenario are significant, as 39 percent of government shown in Table 7. This scenario demonstrates foreign debt is denominated in yen and that Indonesia's debt is sustainable. But it also Indonesia has a large ($1 billion) deficit in demonstrated how difficult this challenge is and Yen-denominated trade. A 10-percent how long it will take. appreciation of the Yen would increase government debt by nearly 2.3 billion dollars. s A debt level is technically sustainable if the * Commodity price changes, particularly for ratio of debt to GDP is falling over time. oil and rice, affects government finances. 9 The primary fiscal surplus is the overall fiscal The budget deficit falls by about 0.1 balance plus interest payments. It could be percent of GDP for every I dollar rise in interpreted to include quasi-fiscal revenues. the oil price.6 An increase in the price of The change in the ratio of government debt to rice affects the government budget through GDP (dt) = d, (i, - gd - primary fiscal surplus, - BULOG losses.7 capital revenue, + new off-budget debt, where i is the average nominal interest rate paid on government debt, g is the nominal growth of GDP, primary fiscal surplus is the fiscal 6 surplus plus interest payments, capital revenue World Bank, Indonesia, Public Spending in a is government resources from the sale of assets Time of Change, 1999. (IBRA and state enterprises), and new off- BULOG procures domestically produced rice at budget debt is additions to debt arising from a price fixed by the government and distributes off-budget losses (e.g. contingent liabilities). rice to the poor and the army at low prices. All except i and g are ratios to GDP. 6 Government Figure 1. An Achievable Scenario of Declining Government Debt Debt/GDP (%) 100 90 .0 Dom.debt/GDP 80 . Ext.debtfGDP 70- 50- 40- 30- 20- 10I 0 () ~ ~ ~ 0 0 L ( X Oco 0~ CD X " LO Ol c0 0 0 On A.) C) C) C) C) C; C) C) c ) C) -n V) O' c] a) C. X C; C E [1, T CD or = o O O O : Source: Bank Indonesia and World Bank projections. Table 7. Key Outcomes and Assumptions Underlying Debt Reduction (°/) FY1999/00 3.0 -0.9 1.5 0.0 2000 d/ 3.5 7.8 1.5 2.9 13.5 2001 4.5 9.9 2.2 3.8 1.3 2002 5.0 9.4 2.5 3.4 0.3 2003 6.0 9.3 2.2 3.1 0.2 2004 6.0 9.3 2.0 1.2 0.2 2005 6.0 9.3 2.0 0.5 0.1 2006 6.0 9.3 2.0 0.3 0.1 2007 6.0 9.3 2.0 0.3 0.1 2008 6.0 9.3 2.0 0.2 0.1 2009 6.0 9.2 2.0 0.2 0.1 2010 6.0 9.2 2.0 0.2 0.1 Source: Bank Indonesia, Ministry of Finance and World Bank projections. The exchange rate is assumed to be Rp 7,000 per US$ in 2000 and thereafter remains constant in real terms. The average inflation rate is assumed to be 5 percent and the oil price is assumed to be $20 per barrel. Note: a/ The average real interest rate on non-indexed variable rate domestic bonds is assumed to be about 4.5 percent. The average nominal interest on extemal debt is assumed to remain at 5 percent. b/ Capital revenue includes the assumed sale of IBRA's Rp 207 trillion in assets over the next five years plus the progressive privatization of state owned enterprises to yield between 0.8 and 0.1 percent of GDP per annum. c/ New off-budget losses are expected to come from directed credit programs and further recapitalization of state banks to complete the program currently under way and to raise their CAR to 8% by end 2001. d/ This is for the nine months, April to December. 7 13. In this scenario. the debt to GDP ratio 15. But the very challenging nature of rises further in 2000 due to additional bank policy actions needed to achieve this reduction restructuring costs more than offsetting in Indonesia's government debt means that revenues from asset sales. Even in 2001 new there is no room for complacency. Potential bonds issued to achieve the target capital reductions are not real until they are actually adequacy ratios to 8 percent for all banks will achieved. And this will take effective and largely off-set the capital revenues from IBRA sustained implementation of painful policy asset sales. But an anticipated primary budget actions. Actions that will need broad political surplus will begin to reduce the debt burden. and social support and strengthened From 2002 to 2004, the debt to GDP ratio implementation capacity. The simple fact that declines quite quickly due to the combined debt service obligations are likely to account effect of primary fiscal surpluses of over 2 for 50 percent of government revenue, or percent of GDP, renewed growth of 6 percent more, for the next few years highlights the per annum, IBRA asset sales, further pressure that reducing debt will impose on the privatization and little new off-budget losses. budget process. Even when the net change in After that, the decline slows down because debt is modest, there is still a need to ensure capital revenues from asset sales decline. that resources are available when needed to meet the actual cash requirements of debt 14. Such a decline in government debt servicing on schedule. This can be would not be unique as several countries have particularly difficult when there is not a well achieved such a decline. Indonesia managed developed domestic debt market, as is the to cut its government debt to GDP in half current situation in Indonesia. between 1988 and 1997 (from 54 percent to 26 percent). This was achieved through rapid 16. Growth is a necessaryfoundationfor GDP growth and sustained conservative fiscal debt reduction. Without rapid growth, policies. Malaysia achieved an even more reducing government debt from over 90 dramatic reduction in debt. They reduced percent of GDP is extremely difficult. Growth government debt from about 103 percent of helps by reducing the debt burden (the ratio of GDP in 1987 to 33 percent 10 years later by debt to GDP) without actually reducing the growing rapidly and maintaining modest fiscal nominal amount of debt. And it helps provide surpluses (see Figure 2). a growing pool of resources from which to meet current expenditure needs and a surplus with which to reduce the actual stock of debt. Gom,*Mn Figure 2. Malaysia's Governnient Debt to GDP This is illustrated in Figure 3 by simulating the DO/ effects of half as much growth (i.e. 3 percent 120 per annum rather than 6 percent), one percent 100 of GDP smaller primary fiscal surplus each year, and only half as much revenue from the 80 privatization of state owned enterprises. Revenue for IBRA asset sales is assumed to 60 5remain the same. Sound macroeconomic 40 management is, in turn, essential to generate this necessary rapid growth, to avoid a rise in 20 interest rates and to maintain fiscal surplus.' , . . .P L G ~ ~ ~ 0 G' G' Cl) G' G' 0' C Source: Global Development Finance, 1999. A one percent increase in domestic interest rates would increase debt service cost by about 0.5 percent of GDP. 8 Figure 3. The Importance of Renewed Growth and govemment's access to debt markets and to GoM-ernncent Good Macroeconomic Management new financing is limited. Third, risks such as 120.0 120 exchange rate depreciation are only partly o0.o- ........ 00 offset by changes in oil revenue. And, fourth, - 7.......... the government does not yet have much risk 80.0 \ ker mac80conomic management capacity. Shocks and sudden mngement 60.0 - 60 pressures on government finances are thus / /Baselikely to result in disruptions to government 40.0 / 7ase Scenario 40 expenditure programs, with serious 20.0 20 consequences for the country's social 0.0 o0 development. This highlights the importance of reducing debt to increase the flexibility for _! - - - - - - C C O i- fiscal management. B. HOW TO REDUCE THE DEBT BURDEN 19. For fiscal management to contain risks and hence ensure that the reduction in debt is sustained, the Government needs to build 17. There are no easy actions available to intttoa ara emnt an'aaiis government that could reduce the debt burden istitutional arrangements and capacities. to pre-crisis levels within five or even ten Transparency and public accountability are years. As noted above, macro-economic crucial for effective debt and fiscal stability, good governance, and market- management. The fact that responsibility is srility good governanc an mrket- currently divided between several parts of the friendly policies are essential to rebuild Miisr ofFnneadBn.noei investor confidence, keep real interest rates Ministry of Finance and Bank Indonesia inv cnfdene, keep real is ate militates against well coordinated transparent down and renew growth. But this IS notg sufficient to reduce the debt burden. debt management. It is important that Concerted action is also needed in six essential government establish an integrated debt areas: management unit in the Ministry of Finance and support this unit with clear and objective * Generate significant primary fiscal criteria/guidelines for debt creation for all surpluses, especially over the next few levels of government. years. * Contain off-budget losses and counteract (i) Generate signif7cant primary fiscal fiscal risks. surpluses, especially over the nextfew years * Aggressively sell government assets to 20. As part of any effective strategy to reduce government debt. reduce the debt burden, it is vital that the * Reschedule existing debt under Indonesian government maintain a substantial international rules and seek the best primary fiscal surplus. The larger the surplus, possible termns for new borrowing. the quicker the reduction in debt, so primary * Build capacity to manage debt well. fiscal surpluses of at least 2 percent per annum * Establish an effective domestic bond in the next few years are particularly market. important. In fact, the larger the fiscal surplus in the next few years, the smaller the overall 18. At present, the Government of fiscal surplus needed to achieve any given Indonesia has a low ability to absorb fiscal reduction in the debt to GDP ratio. An extra risks. First, the government lacks adequate one trillion Rupiah in fiscal surplus and debt liquid contingency reserves. Second, reduction now would be equivalent to at least government debt is already high and the two trillion Rupiah of budget resources in ten 9 Government Debt/ GDP (%) Figure 4. The Importance of Primary Fiscal Surpluses 100.0 - 100 90.0 1 percent smaller 90 primary fiscal surplus 80.0 - 80 70.0- 70 50.0 - 50 40.0 - Base Scenano 40 30.0 - 30 20.0 1 percent larger 20 primary fiscal surplus 10.0 - 10 0.08 "I I I , . I,KO cw c: on o o c c o oo C7 cs7 CD CD C.) D CDD CD C) co - C. C., u years time. In practical terms, generating 22. A detailed discussion of revenue and fiscal surpluses requires government to: expenditure options is beyond the scope of this study but there are some glaring opportunities 12 * increase revenues by improving tax for increased revenues that deserve mention. administration, tax policy (e.g. Doubling the forestry resource royalty rate and reducing tax exemptions and forward enforcing compliance could yield about 0.5 a carry-overs), and efficiency of state percent of GDP in additional revenue. And owned enterprises and logging would still be quite profitable.'3 Abolishing all import tax exemptions now that * Iower expenditures by reducing the tariff rates are virtually all below 20 subsidies and price controls, re- percent would increase customs revenue a focusing its role, and deferring non- little'4, and simplify administration without essential expenditures. creating a large disincentive to invest. 21. In Indonesia, the appeal of generating large primary fiscal surpluses for the next few years is reinforced by lingering concerns 12 For a detailed discussion of revenue and regarding the capacity of public institutions to expenditure options, see the 1998 and 1999 ensure that resources are well used. Public World Bank Public Expenditure Reviews ensure that resources are wellc used Public (Indonesia, Public Spending in a Time of expenditures could be constrained now and Change) and the IMF recent tax study. relaxed once institutional strengthening 13 Such an increase in taxation would still only provided greater confidence that the resources collect about 60 percent of the economic rent will be well used. in log harvesting. 14 Import duty revenue is currently only 0.2 percent of GDP and falling as rates fall. 10 23. One critical aspect of fiscal way to clarify Bank Indonesia's assets and rmanagement over the coming few years will liabilities and therefore the extent of any be ensuring that decentralization does not further calls on government resources is also undernine the attainment of primary fiscal important in this context. With credit surpluses. It is vital that the devolution of programs, arrangements should include a revenues to regional or local government be sharing of risks with the borrower, lender, and matched by the concurrent transfer of program manager. Government guarantees expenditures responsibility. Otherwise, it will should not be provided to cover obligations or be virtually impossible for the Central risks that are under control of the borrower Government to generate the primary fiscal and lender. Commercial risks are one such surplus needed to reduce its debt burden. example, though some degree of guarantee for trade credit may be justified because of its 24. The importance of maintaining a fiscal importance to economic recovery. The surplus is illustrated in Figure 4 by simulating contingent liability arising from the the effect of a one percentage point change in guaranteed procurement price of rice needs to the primary fiscal surplus. Maintained for 10 be contained. One option would be to reduce years, a one percentage point increase in the it whenever there is a large harvest or low primary fiscal surplus would reduce the debt world prices. burden by about 10 percent of GDP. 27. As the crisis-induced rise in (ii) Contain off-budget losses and government debt over the past two years counteract fiscal risks demonstrates, a blanket government guarantee of depositors coupled with inadequate bank 25. Without actions to contain fiscal risks, supervision and an exchange rate exposed to efforts to reduce- the debt burden could be in buffeting from large capital flows exposes the vain, as new debt could emerge to offset hard government to a very large contingent won reductions in existing debt. The creation liability. Bank portfolios have been cleaned of additional new debt needs to be limited to up as part of the bank recapitalization accounting for past mistakes, not the result of program, but until capital adequacy ratios are new mistakes. The earlier analysis (Boxes I increased from the present 4 percent to and 2) indicates that policy actions are needed something like 12 percent, bank supervision in many areas to offset fiscal risks and secure strengthened, and the blanket government sustained debt reduction. A particularly guarantee replaced by a self-financing deposit important concern is the possibility of a insurance scheme, the possibility of further renewed loss of confidence giving rise to new increases in government debt from corporate government debt. losses and poor bank performance remains. 26. To minimize the risk of further 28. Plans to generate primary fiscal increases in debt, contingent liabilities need to surpluses are exposed to commodity price be avoided wherever possible. Where (e.g. oil) and exchange rate risks and to government does assume contingent liabilities, changes in economic performance. These actions should be taken to provision for the affect government revenue through business risk and spread the risk by sharing it. and income taxes and expenditures on Contingent liabilities to other parts of the subsidies and relief programs. Tools, such as public sector - state owned banks, non- derivative instruments and re-insurance financial public enterprises and Bank policies, to hedge such risk exposure are not Indonesia - need to be transparent and yet available to the Indonesian Government. contained. Restructuring of state banks to Second, as mentioned earlier, efforts to avoid further losses is critical. Analysis under I1 Government Figure 5. The Importance of Avoiding Adverse Shocks Debt / GDP (%) 140.0 - 140 A sudden drop in investor 120.0- confidence \ , - - 120 100.0 - , - 100 80.0 80 60.0 - 60 40.0 - Base Scenario 40 20.0 - 20 0.0 - ,, t 0 DD CD X0 C s - u '