3-IJAEBM-Volume-No-1-Issue-No-1-The-Cost-of-Public-Debt-Services-014-024 by ISERP ISERP

Haryo Kuncoro et al. / (IJAEBM) INTERNATIONAL JOURNAL OF ADVANCED ECONOMICS AND BUSINESS MANAGEMENT Vol No. 1, Issue No. 1, 014 - 024

The Cost of Public Debt Services The Case of Indonesia Haryo Kuncoro

Faculty of Economics, State University of Jakarta, Indonesia har_kun@feunj.ac.id Furthermore, Easterly and SchmidtHebbel [4] argued that the relationship between fiscal deficits and interest rates is a complex one because countries finance their deficits in different ways. On the one hand, under a repressed financial sector, taxes on financial assets are a major source of revenue for the government. On the other hand, in a liberalized financial system, where the government finances its deficits via domestic borrowing, public sector will compete with the private sector for loans. This puts upward pressure on interest rates. Many studies have been devoted to analyze the unit cost of public debt services (see for instance: [5]; [6]; [7]; [8]; [9]). In general, they show that a stronger primary balance is associated with a lower cost of debt servicing. Consequently, the interest cost of servicing the public debt is the key both to its sustainability and to the burden it places on the public finances and the economy. In developing countries, the external debt has steadily increased in recent decades, making the analysis of the role of external debt in financing the development process particularly important. Therefore, the question of adequate “exit-strategies” represents probably one of the most important questions in public finance to be resolved in the coming years. Indonesia provides a unique opportunity to examine the nature of fiscal sustainability and debt services payment. Given the significance of huge debt stock accumulated by the previous regimes, whether the state budget can finance all spending in the long term without loosing budgetary functions is a key political and economic issue. The main objective of this paper is to reassess the effect of fiscal deficits and public debt on long-term interest rates. It complements and extends the existing literature by exploring in particular the effects of large fiscal deterioration and initial fiscal conditions, the impact of countries’ institutional set up, and the likely spillovers from global financial markets. Although there is a significant existing literature exploring the relationship between deficits, public debt, and interest rates, there is a diversity of findings, and several of the

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Abstract  This paper is designed to analyze the cost of public debt services in the case of Indonesia over the period of 1999-2009. First, we explore the literature of the debt dynamic. Second, we develop a model to capture some factors determining the cost of public debt services. Finally, we estimate it empirically. Unlike the previous studies, we concern with the real rather than nominal cost of public debt services. Based on the quarterly data analysis, we conclude that the cost of domestic debt services is more expensive than that of foreign debt. However, the usage efficiency of domestic debt is higher than the latter. They imply that the central government should carefully manage her debts including re-profile, re-schedule, and restructure them in order to spread the excess burden in the future to maintain solvency. Also, the other domestic financial resources should be mobilized in order to get the cheaper debts. Keywords: fiscal deficit; public debt; primary balance; implicit interest rates

I. INTRODUCTION Fiscal sustainability has been a subject of intensive discussion among the macro economists in recent years both in developed and developing countries. The central issue of the theory and empirics of public finance is whether there is a tendency for the fiscal deficits to grow faster than the increase in public debt so that the debtor countries become insolvent. Or instead, are there tendencies for the debt services to get bigger, so that the primary balance surplus tends to tighten over time? The recent sharp increase in fiscal deficits and public debt in many countries raises a number of important issues regarding their impact on long-term interest rates. The unsustainable state budget could influence the economic stability in several ways. When the deficit is financed by domestic resources, it could become financial repression and crowding out effect indicated by the low interest rates, saving decline, and unproductive investment [1]; [2]. Similarly, the foreign financed budget deficit is characterized by persistent exchange rate depreciation, balance of payment distress, and high inflation [3]. Eventually, the debtor country experiences unstable economic growth.

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The government debt increased due to PERTAMINA (oil and gas state-owned company) was largely expanded. BULOG (Logistic Agency) took foreign debt to realize food self-resilience. As a result, the debt service ratio in the 1980s, especially in 1988 and 1989 rose to an average 40 percent. In 1992, the IGGI was removed to be the CGI (Consultative Group on Indonesia). When the Asian financial crisis, in the mid 1997, the external debt increased significantly from more than US$ 136 billion in 1997 to more than US$ 151 billion in 1998, mainly due to the depreciation of Rupiah. Since that, Indonesia has experienced the decrease in government revenue and the increase in government spending to undertake the socioeconomic impacts. As a result, the Indonesian’s government collapsed under heavy debt burden to cover deficit the state budget (Figure 1). The government debt increased to three to four-fold and almost three-quarters of those is domestic debt for bank restructuring [12]. In the reformation era, government and parliament made a political decision that the most deficits should be finance by domestic financial resources. Accordingly, the CGI was disbanded in 2007. As a result, the amount domestic debt stock has been ten times (100 trillion in 1998 to 1.000 trillion Rupiah in 2009). Only in one decade, the domestic debt has been higher than the foreign debt. Consequently, the public debt services have been sky rocketing (Figure 2). The domestic debt service payment was two-fold than that of foreign debt. Most government external debts were due in early 2000s. In relative term, the interest rate and amortization payments was about 40 percent of the total outlay. The other important expenditures were subsidies for fertilizer and energy (20 percent) and transfer to lower-layer governments (26 percent). Those outlays composition above, of course, severely limited to the fiscal space. The state budget problems then shifted from the stimulus to fiscal sustainability [13]. Conceptually, the state budget is said to be sustainable if it has the ability to finance all spending in the long term without endangering budgetary functions [14]; [15]. The issue of the sustainability is an integral part of the discussion of the government's long-term ability to repay debt [16]. To maintain the fiscal solvency, the surplus of the state budget is a must [17]. Even though the debt ratio has been decreasing, the new financing from both foreign and domestic financial resources are still required in

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specific issues explored in this paper have not been examined before. First, it explores cost of both domestic and foreign debts. Second, it also delivers implicit real interest rates instead of government bond nominal yields. The remainder of the paper is organized in six sections. Section II analyses the impact of fiscal variables on primary balance; Section III examines the possible responses of the primary balance to changes in the debt-GDP ratio; Section IV discusses the relation between fiscal sustainability and dynamic efficiency and Section V briefly looks at stock flow adjustment. Finally, some concluding remarks and implications are drawn.

II. INDONESIA’S STATE BUDGET: OVERVIEW Since the Old Order regime, Indonesia has used foreign borrowing to finance development. The foreign debt was utilized during the first period of 1966 to reconstruct economy after political turbulence. After that, the New Order regime had a permanent donator countries grouped in the IGGI (Intergovernmental Group on Indonesia). Every year, the IGGI provided fund (from ADB, World Bank, IMF, UNDP, and some major developed countries) to finance development expenditures designed in the state budget. During oil boom in 1970s the foreign debt increased unevenly to foster economic growth. The higher oil price the higher debt taken. As one of the oil exporting countries, Indonesia had a windfall profit as “collateral” to obtain new soft loan form the creditor countries [10]. The high foreign debt and the oil revenue, in fact, had been successfully promoting economic growth. In that period, the economic growth rate booked the highest record, on the average 20 percent a year. Surprisingly, declining oil prices in the first half of the 1980s resulted in the rapid accumulation of debt. World economic recession and trade protection imposed by most countries were the main causes. Percentage of total external debt on GDP increased from 26.8 percent in 1980 to 53.6 percent in 1986. In that period, Indonesia’s government, in one hand, introduced a new tax system to boost domestic revenues. On the other hand, Indonesia’s government reduced substantial central expenditures and reswitched numerous development programs [11]. Furthermore, in the late 1980s and mid 1990s, during Indonesia’s economic boom, the long-term foreign debt was incurred by the especially state-owned and private enterprises.

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forthcoming years to meet the expenditure needs. The main problem of the Indonesian budget sustainability is the existing large deficit. The Law No. 17/2003 Article 12 states that deficit and the total debt is no more than 3 and 60 percent respectively. The question is then how to keep the budget deficit at a safe level so that the deficit can be financed. It is well known that the change in the debt level can be larger or smaller than the government deficit. This difference between the change in the outstanding debt stock and the yearly deficit flow is known as the stock-

flow adjustment (SFA). The analysis of SFA has become more important as the budgetary surveillance may have provided incentives for shifting items from the deficit to the SFA [7]. A high negative SFA shows the tendency to improve temporarily the debt development in some years. In this case, is there any systematic explanation of variations in the cost of debt servicing over time in Indonesia? The next sections will examine the influence of fiscal variables on borrowing costs in Indonesia over the period of 1999-2009.

TRILLION RUPIAH

1,200.00 1,000.00 800.00 600.00 400.00 200.00 0.00

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DOMESTIC AND FOREIGN DEBTS OF CENTRAL GOVERNMENT

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 YEAR

Domestic Debt

Foreign Debt

Source: Debt Management Office, Ministry of Finance Figure 1 Central Government Public Debt

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CENTRAL GOVERNMENT DEBT SERVICES 1998-2009 80,000.0

BILLION RUPIAH

70,000.0 60,000.0 50,000.0 40,000.0 30,000.0 20,000.0 0.0

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10,000.0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 YEAR

Domestic Debt

Foreign Debt

Source: Financial Notes and Budget State, Ministry of Finance Republic of Indonesia Figure 2 Central Government Debt Services

III. EMPIRICAL EVIDENCE A key channel through which large fiscal deficits could be expected to have an impact on long-term interest rates, in a broader sense, occurs via the impact on national savings. In the standard neoclassical model, fiscal deficits (other things given) reduce national savings and increase aggregate demand [18]. This creates an excess supply of government debt, leading to higher real interest rates. The yield curve is also expected to become positively sloped in anticipation of continuing large fiscal deficits. Although short-term real interest rates reflect cyclical conditions and the stance of monetary policy, and influence real mediumand long-term rates, the latter are likely to raise more in response to the anticipated worsening of fiscal deficits and debt [19]. Large deficits and debt, particularly if combined with uncertainties relating to the pace of economic activity, could also raise concerns about the government’s ability to service its debts. This would raise credit risk premium and government bond yields. In addition, the emergence of contingent fiscal risks emanating, say, from the financial sector could exacerbate sustainability concerns. The existing literatures could be divided for two generations in terms of their conclusions. The first generation concludes there is no significantly positive association between budget deficit or government debt and interest rates, and they attribute this discussion

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to the Ricardian equivalence proposition. For instance, [20]; [21] and [22] show no significant effect of fiscal variables on longterm interest rates. However, [23], [24], and [25] pointed out some problems in their methodology. The second generation emphasizes that not current but expected budget deficit or government debt affects current long-term interest rates. This generation of studies consists of two groups: (1) to use published forecasts of budget deficits as a proxy for market expectations [23]; [26]; [27]; etc.; and (2) to use “event analysis” of news reports or announcements of budget projections [28]; [29]; [30]; etc. Both types of studies show there significantly positive association between projected budget deficits or government debts and current long-term interest rates. The fiscal variables, including the primary fiscal balance, have had the influence on borrowing costs in industrial countries [5]; [6]. In particular, an improvement of the primary balance is associated with a significant reduction in debt servicing costs, amplifying the effects of primary adjustment on the state of public finances. The cost of debt servicing depends on the variables that determine the debt dynamics: primary balance, outstanding debt, inflation, and economic growth. Ardagna [31] and [32] evaluated the relative importance of the two explanations. She provides evidence that the composition of the stabilization policy matters for economic

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interest rate depending on the debt maturity. The longer maturity has the smaller effect. Meanwhile, most of the researches conducted in Indonesia have been devoted to assess the economic impacts of external debt (see for examples: [38]; [39]; and [40]). They found that external debt has marginal impact on economic growth regarding the inadequate domestic revenues generated by the debt. PPE UGM and BAF [41] conclude that Indonesia's foreign debt has been large because the borrowing costs are cheaper than the cost of domestic debt. However, the state budget has been relatively safe to be default. Soelistijaningsih [42] obtains that the external debt burden could be reduced by diversifying the currency. This result is supported by the findings of [43]. The state budget sustainability can only be maintained if there is no heavy depreciation. Ulfa and Zulfadin [44] obtain ambiguous results. Some fiscal policies (i.e. budget reforms) reduced the sovereign debt. On the other hand, some fiscal policies (i.e. blanket guarantee) enlarged the contingent liabilities. Hanni [45] concluded that some external macroeconomic variables become the key determinants for achieving fiscal sustainability. Unfortunately, she did not incorporate the oil price in her analysis. Jha [46] found that the oil price has a significant effect to the sustainable state budget related to the subsidies liabilities in the case of selected Asian countries including Indonesia.

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growth mainly through labor market effect induced by moderate wage agreements. The size of the fiscal contraction is the key when it comes to fight rising debts. Ardagnaâ&#x20AC;&#x2122;s empirical findings indicate that when governments engage in sizeable fiscal adjustments, the probability of success in the sense of a long-lasting debt reduction almost doubles. In an extension to the literature, [33], {34], and [35] provide a non-mutually exclusive explanation for a successful fiscal stabilization. They show that expansionary fiscal consolidations are more likely and sustainable if they are relying primarily on spending cuts. Even in the case where the adjustments are of the same size in terms of reducing the primary budget deficit, cutting back spending induces a more promising consolidation than tax increases. In addition, they argue that the composition of spending cuts matters. Especially successful deficit-toGDP and debt-to-GDP reductions are associated with cuts on government transfers, welfare spending, and government wages. Laubach [24] explores the relationship between long-horizon expectations of both fiscal variables and interest rates in the United States. Conway and Orr [36] for seven major advanced economies also find that the impact of public debt on long-term bond yields depends on initial debt levels. Higher public debt raises the perception that governments will be less able to service their liabilities and therefore increase credit risk. Also, countries with large debt accumulation tend to be more at risk of inflationary pressures raising nominal short-term interest rates. These factors affect the long end of the term structure and raise borrowing cost for long-term government securities nonlinearly. Baldacci and Kumar [8] reexamines the impact of fiscal deficits and public debt on long-term interest rates, taking into account a wide range of country-specific factors, for a panel of 31 advanced and emerging market economies. Izak [7] conducts the same study for post-socialist countries. They find that higher deficits and public debt lead to a significant increase in long-term interest rates, with the precise magnitude dependent on initial fiscal, institutional and other structural conditions, as well as spillovers from global financial markets. The association between budget deficits, government debt, and interest rates in Japan are analyzed by [37]. Estimating the reduced form for the long-term interests derived from the neo-classical frameworks finds that an increase in projected deficit-to-GDP raises

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IV. DEBT DYNAMICS The empirical researches above provide the same basic idea that fiscal sustainability requires controlling interest rate, economic growth, fiscal deficit, primary balance surplus, and the change in current debt level. In term of interest rate, the fiscal sustainability can be achieved as long as the government conducts fiscal discipline so that cost of public debt would be reasonable to bear a particular economic circumstance fluctuation. In term of current debt level, the amount of debt accumulation in particular time can be traced to the debt dynamics. The debt dynamics solely also explain the fiscal sustainability. The accounting approach is based on the rules that connect the options of financing government spending (G). If the domestic revenue, R, is not sufficient to cover G, the available financing option is debt (D) and money printing (seigniorage, S). (Rt â&#x20AC;&#x201C; Gt) = Dt + St

(1)

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The debt accumulation in the next period (t+1) will be D itself plus the interest rate (r): Dt+1 = (1 + r) Dt + (Rt – Gt) + St

(2)

The term of (R – G) is the primary balance (PB), total government expenditures excluding the interest rate payments. It can be rewritten as Dt+1 – Dt   Dt = r Dt-1 – PBt + St (3)

1 Dt =  –––––––– { Dt+1+k – PBt+k + St+k } (7) (1+r)1+k The limit value for an infinite time of the first term in equation (7) will be asymptotically equal to zero. The equation remains 1 Dt =  –––––––– { – PBt+k + St+k } (8) (1+r)1+k

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According to this approach, the state budget sustainability can be achieved if there is no debt. Even if the government takes debt, the fiscal sustainability can be maintained as far as the additional debt must be proportional to the PB surplus [47]. Equation (3) if disclosed further in the relative form to national income (Y) will be

is moving away from a fiscal solvency position. Based on (2), one can impose discount factor to re-examine the fiscal sustainability:

 [D / Y]t = r [D / Y]t-1 – [PB / Y]t + St (4a)  RDt = r RDt-1 – RPBt + St

(4b)

In this context, the fiscal sustainability holds if the current primary balance position increases greater than the increase in the debt ratio [48]. The fiscal sustainability also explains the solvency. Based on (4), dividing to Y requires that the rate of growth of Y should be taken into account. If the income increases constantly (suppose at g percent overtime), the additional debt will be (5)

r–g  RDt = ––––– RDt-1 – RPBt + St 1+g

When there is no new additional debt (RDt=0), then

r–g RPBt = ––––– RDt-1 + St 1+g

(6)

In this case, the budget surplus is required to attain fiscal solvency if the real rate of interest exceeds the output growth, i.e., (r–g) > 0. The public sector has to make debt service payment at least equal to PB, or equivalently, it should have a primary surplus equal to PB. A primary fiscal surplus less than that amount (or a primary fiscal deficit) in that case implies perpetual public sector borrowing and debt accumulated indefinitely. For a country whose rate of output growth exceeds the real rate of interest, (r–g) < 0, incurring a primary deficit is till consistent with solvency. However, a deficit higher than PB implies that the country

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Equation (8) states that the amount of government debt at a given time must equal the present value of the primary balance deficit in the future [49]. This means that the debt growth should be lower than the interest growth rate in order to be sustainable [50].

V. THE PROPOSED MODEL FOR INDONESIA There is no study in Indonesia so far that integrates all of the external economic factors. This study closes the fiscal policy empirical gap in Indonesia by synthesizing them. Abstracting from monetary financing that is by the law forbidden in Indonesia the general government budget deficit is the sum of the primary deficit and of debt service. To finance the deficit the government must borrow and issue new debt ΔD: Δ Dt = Gt – Tt + r Dt

(9)

Dividing both sides of (9) by real GDP Y: Δ(D/Y)t = (G/Y)t – (T/Y)t + r (D/Y)t (10) Taking into account that ΔY/Y = g and inserting for ΔD/Y into (10) we obtain: Δ (D/Y)t + g (D/Y)t = (Gt – Tt)/Yt + r (D/Y)t (11) and rearranging: Δ (D/Y)t = (Gt – Tt)/Yt + r (D/Y)t – g (D/Y)t (12) The change in the debt-GDP ratio (left side) equals to the primary budget deficit-GDP ratio (the first item on the right side) and the debt service-GDP ratio (the second item) adjusted for GDP growth rate (the third item). Isolating the debt service on the left side:

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r (D/Y)t = Δ(D/Y)t + (Tt – Gt)/Yt + g (D/Y)t (13) From (13) is evident that to stabilize the debtGDP ratio, ΔD/Y = 0, the primary balance and the growth rate times the debt-GDP ratio must be able to finance the debt service. Last but not least we can express the debt service in nominal terms: r (D/Y)t = (Tt – Gt)/Yt + g (D/Y)t + π (D/Y)t + Δ (D/Y)t (14)

r = f ( RPB, g, π, ΔRD )

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where π is the inflation rate. In short, the average implicit interest cost of the debt equation is (15)

Inflation enters implicitly into equation (15) in two ways: through the nominal interest rate via the usual Fisher effect and through the growth rate of nominal GDP. Thus, inflation worsens the debt dynamics by necessitating higher nominal interest rates to provide investors a given real return, and improves it by raising the nominal growth rate. Another important determinant of the debt dynamics that appears in equation (15) is the primary fiscal balance. In general, large primary deficits are part of the story behind the accumulation of public debts -- although even once primary adjustment has taken place these imbalances can take on a life of their own due to large outstanding debts and high interest rate spreads. It is useful to express the cost of debt services in real term: (r – π) = f ( RPB, g, ΔRD )

(16)

In the case of Indonesia, oil lifting (OL), instead of oil price as suggested by [46], is quite important determining factor to government budget either through non tax revenue or oil subsidies. For Indonesia’s government, oil lifting is rather undercontrolled than oil price which is exogenous variable to determine overall fiscal deficits. As explained previously, the change in the debt level can be larger or smaller than the government deficit. Therefore, it is reasonable to incorporate them into the proposed model: (r – π) = f ( RPB, g, ΔRD, OL, RDEF) (17) Regarding to the types of debt, equation (17) is estimated for domestic debt, foreign debt, and total debt.

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Unlike the previous studies in Indonesia (which generally used annual data), the model are estimated with quarterly data during the post-crisis period (1999-2009). The data for this study have already been available on a quarterly basis except the primary balance as well as deficits. The data is then interpolated linearly from annual basis to fit the other data on the model. In general, the data obtained from IMF, World Bank, Central Bank of Indonesia, Ministry of Finance (i.e. Debt Management Office), and Central Board of Statistics. Variables that will be used are specified as follows. Debt that is analyzed here is the central government debt only (excluding Central Bank of Indonesia, state-owned enterprises, local government-owned enterprises, or local government debts). Foreign debt is denominated in US dollar and then transformed into Rupiah using official exchange rate. Depreciation is calculated as a percentage change of the Rupiah against the US Dollar. Similarly, economic growth is calculated as the percentage change in GDP at constant prices in 2000. Inflation rate is derived from the relative change in GDP deflator. The latest is also used to convert all variables into the real values. VI. DISCUSSION Table 1 presents that the elementary statistics covering mean, median, and extreme values. The mean and median values of nominal interest rate for total debt (IRTOT), depreciation rate (DEP), primary balance ratio (RPB), overall deficit ratio (RDEF), and total debt ratio (RDTOT) are almost the same respectively. Those preliminary indicate normal distribution. Except inflation rate (INF) and economic growth rate (EG), the null hypotheses that the series data is normally distributed can be accepted in 95 percent confidence level using the JB (Jarque-Bera) test. The lower tail of the economic growth rate distribution is thicker than the upper tail (indicated by the negative value of skewness) and the tails of the inflation rate distribution are thicker than the normal (indicated by the kurtosis coefficient greater than 3). The table also delivers standard deviation. Statistically, a set data is said to be volatile if its CV (coefficient of variation, e.g. ratio of standard deviation to mean) is more than 50 percent. Based on the empirical rule, inflation, depreciation, and economic growth rates are the most volatile indicated by the highest CV.

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Table 1 Descriptive Statistics EG

Mean

IRTOT 13.6870

INF 4.1795

DEP 0.7252

1.0514

1.1459

RPB 1.7726

RDEF -1.3420

RDTOT 23.0818

Median

13.7024

2.6050

1.0050

2.0500

1.0800

1.6607

-1.3141

22.5210

Maximum

25.0292

111.0000

24.6800

16.2900

1.5200

4.6150

1.2482

38.7533

Minimum

5.3663

-13.3300

-22.5600

-38.9600

0.9400

-0.0116

-4.6197

11.7140

Std. Dev.

3.6403

16.9809

8.5993

7.4822

0.1834

1.0594

1.1633

8.6543

26.60%

406.29%

1185.74%

711.67%

16.00%

59.76%

-86.68%

37.49%

J-B

2.6217

2405.8340

2.3284

621.7590

4.3795

0.7036

2.0566

3.4430

Prob.

0.2696

0.0000

0.3122

0.0000

0.1119

0.7034

0.3576

0.1788

Skewness

0.3325

5.7944

-0.0496

-3.2346

0.5918

0.3088

-0.4384

0.3286

Kurtosis

3.9939

37.3216

4.1226

20.2421

2.0060

2.9503

3.5942

1.7974

Variable to be tested RDD RDF RDTOT EG OL (IRD-INF) (IRF-INF) (IRTOT-INF) DEP RPB RDEF

Level -2.16695 -1.01394 -1.68839 -4.65644 -2.04747 -18.18338 -28.05540 -22.67623 -10.36004 -2.90723 -3.89751

Table 2 Unit Roots Tests ADF First Difference -5.98128 -9.30373 -3.83114 -4.32276 -6.35022 -9.23583 -37.65963 -26.61991 -2.90595 -5.84746 -4.63906

Table 3 displays the results of Johansenâ&#x20AC;&#x2122;s co-integration test. Rank order for 5 variables in the implicit real interest rate for domestic debt service model has at least 4 co-integrated variables in 95 percent confidence level. The implicit real interest rate for foreign debt has Domestic Debt

Hypothesized No. of CE(s) None ** At most 1 ** At most 2 ** At most 3 ** At most 4 * At most 5

Level -1.93178 -1.54154 -0.42020 -34.00936 -3.24531 -14.43330 -20.71344 -16.78454 -10.19797 -2.28904 -2.68776

Trace Statistic

The following section presents empirical results for a quarterly time series data for 1999 to 2009 to avoid uneven depreciation rates. Table 4 highlights estimates of equation (17) for the three models specification, namely

First Difference -3.16913 -9.56435 -6.61045 -34.57056 -6.35159 -54.98620 -40.15417 -52.62805 -23.61606 -7.97459 -4.71217

co-integrated for all variables rank. The total debts service models has at least 5 cointegrated variables. They imply that the all variables have a long-run relationship. As a consequence, they can be modeled to find out the parameter estimate using empirical data.

Table 3 Multiple Co-integration Tests Foreign Debt

Hypothesized No. of CE(s) 171.0007 None ** 121.0231 At most 1 ** 78.6000 At most 2 ** 46.4100 At most 3 ** 19.3816 At most 4 ** 3.2657 At most 5 ** At most 6 ** *(**) denotes rejection of the hypothesis at the 5% (1%) level

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hypothesis is rejected even at the 1 percent level of significance for all of them in their first differences. This indicates that stationary is achieved for them after the first differencing i.e. all the series are I(1). The non-rejection of the null hypotheses of unit root may be the result of shifting deterministic trend.

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Table 2 shows the results of Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) unit roots tests for the underlying data series in levels and first differences. The null hypothesis of existence of unit root cannot be rejected for each of the variables (except the three types of debt) in the level and thus it is concluded that the series are non stationary. However, the null

Trace Statistic

217.8390 162.0633 117.6211 81.5476 51.3750 21.5117 6.8133

Total Debt Hypothesized No. of CE(s) None ** At most 1 ** At most 2 ** At most 3 ** At most 4 ** At most 5 * At most 6

Trace Statistic

221.7210 160.1709 114.3329 74.2765 43.7738 19.9295 3.5802

domestic debt, foreign debt, and total debt. Regression (17) is individually estimated with ordinary least squares (OLS) because there is no simultaneous relationship among variables in the model.

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currency diversification can help the government to decrease the sovereign burden. Both flow and stock variables have an impact: using the change in public debt as an explanatory variable suggests that an increase in the debt ratio of 1 percentage point of GDP leads to an increase in bond yields of around 25-63 basis points. The initial level of fiscal deficit ratio (RDEF) also has a similar and statistically significant impact, although its size varies over time (2.5-6.9 percent). It seems that the Indonesia’s government conducts prudent fiscal policy, i.e. the change in debt is proportional to meet the fiscal deficit so that the impact on real interest rates almost equals. The results confirm the relevance of fiscal variables to borrowing costs. For all three specifications, a government running a primary surplus faces significantly higher interest costs. The magnitude of the coefficients is also large: a one-percentage-point increase in the primary surplus-to-GDP ratio associated with a reduction in the unit cost of debt servicing of roughly 34-76 basis points. For a government with a large debt, like Indonesia, this would provide an important additional reason for fiscal adjustment. To sum up, the primary balance is regarded as a target for fiscal adjustment to secure fiscal sustainability. The government should run a sufficiently large primary surplus to ensure that it has a positive or zero net wealth. The differential interest rate-economic growth together with the debt-GDP ratio determines the primary surplus government needs to run to prevent a change in the ratio. As the economic growth greater than real interest rates, the Indonesia’s government cannot run a primary deficit to avoid high inflation (and in turn depreciation) with putting upward pressure on the debt-GDP ratio. As a result, the government has a sustainability constraint.

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The estimation results show that the unit cost of domestic public debt is more expensive than foreign debt service. This is indicated by constant term. On the average the unit cost of domestic debt is about 53 percent compared to foreign debt (about 16 percent). Totally, the average of public debt is about 41 percent. This finding is in line with the result of [41]. The cheaper cost of foreign debt is a source of explanation why the Indonesia’s government foreign debt becomes massively accumulated. The rate of growth of the economy tends, as predicted, to induce the cost of debt and the effect is statistically significant (even greater than unity) in the three model specifications. In addition, the economic magnitude of the effects is rather small. For example, increasing the real growth rate by 1 percentage point increases the unit cost of debt by about 16-21 basis points. This may reflect the errors-invariables bias associated with the including quarter growth rates when long-run growth rates are relevant to the debt dynamics. The increase in oil production lightens the cost of debt payment for about 5-44 percent. As a net oil importer country, Indonesia faces the dilemma when the world crude oil price increases. In one hand, the central government revenue increases substantially. On the other hand, the central government has to spend more subsidies to avoid the increase of domestic fuel prices. When Indonesian oil lifting could be promoted, the state budget can save 4-5 trillion Rupiah which can be used to pay debt services. Depreciation also makes the burden of debt service payment slightly reduces. Even though the impact of monetary crisis 1997 has been getting lower, the effect of depreciation rate is still material. The magnitude of its effect is about 35-91 basis point. It is notable that most of outstanding foreign debt is denominated in US dollar. This finding is supported to the studies of [42] and [43] that

Table 4 OLS Estimates for Cost of Public Debt (1999-2009) Dependent Variable: Implicit Real Interest Rates Independent Variables Domestic Debt Foreign Debt Total Debt Coeff. t-stat Coeff. t-stat Coeff. t-stat C 53.04326 6.16641 16.40625 2.92272 41.88074 6.91481 EG 2.10419 14.85388 1.59753 12.44417 1.83415 14.41444 OL -0.05579 -6.32717 -0.17059 -2.96963 -0.44066 -7.40830 DEP -0.91611 -4.04053 -0.34611 -2.09631 RPB 7.63372 6.33212 3.42383 4.28119 6.05700 6.41246 RDEF -6.88138 -6.46367 -2.52914 -2.88914 -4.95034 -5.44371 2.51588 1.73001 6.34219 5.04412 2.92267 3.69862  Debt Ratio R-sq 0.90336 0.91920 0.91760 Adj R-sq 0.89064 0.90610 0.90424 F 71.04137 70.15609 68.67557 DW 1.60143 2.02517 1.73181 SEE 6.72640 5.18917 5.61905 N 44 44 44 The complete diagnostic tests can be found from the author on request

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domestic and international factors are likely to determine the magnitude of this impact. They are quite vulnerable. However, they can systematically explain well the implicit real interest rates. On the other hand, a budget consolidation that predominantly relied on tax increases, or on modest and gradual measures – even it was successful and led to lower deficits and debt levels – did not have an influence on interest rates. In the longer term, the central government should carefully manage her debts including re-profile, re-schedule, and re-structure them in order to spread the excess burden in the future to maintain solvency. Also, the other domestic financial resources should be mobilized in order to get the cheaper debts. These results are significant and are robust to a variety of specifications and alternative models. We thus conclude that financial markets only seem to value strict and decisive measures. Therefore, expenditure cuts are a clear sign that the government’s pledge to cut the deficit is credible. Since financial markets participants cannot foresee whether the adjustment will be successful and carried out as announced, they will continue to demand higher yields unless the government sends a clear signal by cutting expenditure.

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VII. CONCLUDING REMARKS This paper focuses on periods of fiscal adjustments in the case of Indonesia. It shows that historically, the governments have employed different fiscal adjustment strategies when confronted with high deficits and rising debt. Accordingly, these measures not only differ in duration, size, and composition, but also in their success. Controlling for various economic, fiscal, and political factors, we find that the size and the composition of a fiscal adjustment significantly affect real interest rates. Large adjustments and those that mainly depend on expenditure cuts lead to substantially lower interest rates. The factors influencing the debt service in real terms and analyzed from quarterly data during 1999 to 2009 in this paper are primary balance, overall deficit, growth rate of real GDP, economic growth, depreciation rate, oil lifting, and the change in debt level. The negative overall balance and cheap cost of foreign debt have been contributing to the increase of huge debt. Meanwhile, oil lifting has a marginal significant contribution to lighten cost of public debt services. The evidence shows that large deficits and debt can have a marked adverse impact on implicit real interest rates, but that a variety of

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