Past is Prologue: Indonesia’s Foreign Debt and the Pandemic

As of February 2021, Indonesia had accumulated nearly US$422.6 billion in foreign debt, making it one of the 10 largest borrowers in the world, according to the World Bank. There has been a steady increase in Indonesia’s foreign debt since at least 2006, when it was recorded at US$132.6 billion.

Proponents of the dependency theory have called the current level of debt a symptom of Indonesia’s Covid-19 recession. Other economists, however, have argued that foreign debt is not necessarily harmful to the economy. Offshore financing is a valuable source to bridge gaps in human capital and infrastructure. It also could promote job creation, structural and financial reforms, and transfers of knowledge and technology.

How worrying is Indonesia’s foreign debt? And what does foreign debt mean for Indonesia’s economic development post Covid-19?

China and Singapore are examples of economies where large investments in human capital have contributed to their rapid economic growth. With the right economic and business policy prescriptions, this financing will prepare Indonesia to be Asia’s new economic giant.

The government foreign debt has been even more critical during Covid-19 as it facilitated remote learning and kept the stretched healthcare system afloat. A cut in foreign debt could result in fiscal austerity and reverse the government’s ongoing efforts to mitigate the economic impact of Covid-19 and speed recovery (e.g. by widening the 3 percent budget-deficit cap, allowing banks to relax their loan-quality assessment and restructuring policy, and injecting capital into state-owned enterprises).

Foreign debt does not always threaten a country’s economy. Rolling back foreign debt, especially during the Covid-19 recession, could create a ripple effect and trigger a wave of corporate bankruptcies, worsening the recession. In the 1990s, the government’s decision to limit external borrowing squeezed local banks’ liquidity. During the 1997 Asian financial crisis (AFC), the foreign debt ceiling (coupled with weak corporate governance and poor banking regulation and supervision) doomed local banks and corporate borrowers, which had become “too big to fail”, to suffer a systemic banking crisis and contagious corporate defaults and bankruptcies. By 1998, Indonesia entered into recession.

A recent government proposal suggests that it intends to accrue a large sum of foreign debt. Capital is limited, especially during Covid-19. If this new debt is not used to generate any sources of revenue, there will be a trade-off – the financing could either compromise every dollar spent to speed up the Covid-19 economic recovery or stretch the government’s current fiscal deficit.

Indeed, foreign debt is a double-edged sword. It requires good corporate governance, prudential banking regulation and supervision, and clean government and public financial accountability. Without these, it is impossible to imagine how a country can manage and monitor its foreign debt (not to mention its domestic debt) well. Such a country would get trapped by its own misjudgment – whether by defaults, bankruptcies or capital flight.

In the 1970s, foreign indebtedness increased dramatically in developing economies. At the time, Indonesia accumulated US$65.7 billion, making it one of the five largest borrowers in the world. To control spiraling external debt, the Indonesian government at the time issued two presidential decrees, one in 1972 on foreign borrowing and the other in 1991 on the coordination of foreign commercial borrowing. Both decrees essentially required any Indonesian borrower to report and the Indonesian government to approve foreign-debt obligations. Today, only the 1972 decree remains in force.

The AFC was never purely caused by foreign debt. It began when the Thai government in July 1997 allowed the baht to float in response to its ballooning foreign debt. Instead of controlling the foreign debt, the Thai baht collapsed. This currency crisis created a contagion effect and spread to Indonesia and other Asian economies.

In Indonesia, the AFC was a wake-up call for overdue structural and financial reforms. After these were eventually implemented, market confidence returned, leaving the country better able to weather the 2007 global financial crisis, which left few scars on the economy. These structural and financial reforms ranged from the banking regulation and supervision to public financial accountability. With these reforms, the Indonesian economy today has been much better positioned to face the Covid-19 recession than it was in the 1990s.

As of February 2021, the IMF only accounts for 0.7 percent of Indonesia’s foreign debt. The US remains Indonesia’s largest foreign creditor. Within the past 10 years, the US has quadrupled its credit. Japan and China rank second and third. But this does not tell the whole story – Japan has halved its credit to Indonesia over the past decade. Within the same period, China has increased its credit sevenfold.

While critics have claimed that China’s foreign-credit arrangements, particularly within its signature Belt and Road Initiative, are a debt trap, others have argued that a recipient country’s ability to service its debt depends first on clean government and public financial accountability. After all, external debt in most cases is one option for a country rather than its only available source of financing.

Latin America is an important case study. As the emerging economies, they obtained foreign credit to boost development. But the 1980s turned into a lost decade for many of the countries in the continent. Argentina and Ecuador, for example, have become serial defaulters, whether to lenders or bondholders. And with their credit ratings plumbing the depths, capital flight has been a fact of life.

Indonesia should learn from Latin America’s debt crises. They prove that, despite promising prospects for economic development, poor debt management will raise doubts about a country’s creditworthiness, triggering widespread defaults, bankruptcies, and capital flight. These risks would derail any hopes a country might have for achieving social and economic progress.

But a foreign-debt crisis and an economic one are not the same. The key for Indonesia is to speed up its structural reforms. With sound macro and microeconomic policies, a sustainable foreign debt can finance what Indonesia needs to do to recover from the Covid-19 recession and emerge stronger after the pandemic subsides. If it manages its foreign debt shrewdly, cleanly and with the right purposes, this could usher in an Indonesian Golden Age by the time of the 2030 demographic dividend.