Indonesia's Woes Prompt Downgrade

And the outlook for the island republic's ratings remains negative, given its serious fiscal and political problems

On May 21, Standard & Poor's lowered its long-term sovereign credit and senior unsecured debt ratings on the Republic of Indonesia. The long-term local currency ratings were downgraded to single-'B'-minus from single-'B'. The long-term foreign currency ratings were downgraded to triple-'C'-plus from single-'B'-minus. At the same time, the rating agency affirmed its single-'C' short-term sovereign credit and senior unsecured debt ratings on Indonesia. The outlook on the long-term sovereign ratings remains negative.

The downgrades reflect:

--Inadequate fiscal adjustment. Political instability, institutional weakness, and the specter of geographic disintegration are reducing policy coordination, straining official creditor relationships, and unsettling financial markets. While parliament and the executive test the limits of their authority in the new political framework, the judiciary and police remain weak, and law and order fragile. These factors, and vacillating monetary policy, point to another extended period of high nominal domestic interest rates, which, in turn, will increase primary budget surplus requirements, further testing the government's fiscal resolve.

--Heavy public indebtedness. The public sector's net debt burden, including debt to the IMF, Sertifikats Bank Indonesia (SBIs, central bank promissory notes), bank recapitalization bonds, Frankfurt Agreement guarantees, and the domestic and external liabilities of the nonfinancial public-sector enterprises, is now expected to peak at about 90% of GDP at year-end 2001, but could rise further depending upon exchange rates and other variables. The public sector's net external debt burden, expected to crest at about 60% of current-account receipts at year-end 2001, generates an onerous amortization profile, with over US$8 billion due each year in 2001-2005.

--Budget financing uncertainties. Policy disruptions have prompted key multilateral and bilateral creditors to cut back on new and existing loan commitments, widening the financing gap. With determined implementation of upcoming budget revisions, Indonesia could reverse such a process and secure further Paris Club rescheduling next year; with weak implementation, it could relapse into an inflationary spiral. The first scenario could include further, isolated syndicated-loan defaults (to satisfy Paris Club burden-sharing stipulations); the second could include a general sovereign default.

Indonesia's ratings are supported by:

--Continued official-creditor engagement. Conscious of their heavy exposures to Indonesia, the IMF, the World Bank, the Asian Development Bank, and the Japan Bank for International Cooperation continue to influence Indonesia's economic policies. Mutual interest in rules-based solutions to Indonesia's sovereign debt problem could spur needed fiscal correctives, including cuts in petroleum subsidies, the initiation of a Treasury bill program for budget financing, and--possibly--a comprehensive bilateral debt renegotiation. These and other measures, however, will remain dependent upon favorable political developments.

--Ongoing asset recovery. Despite legal and other impediments, sales by the Indonesian Bank Restructuring Agency (IBRA) of government-owned loans, equity, and fixed assets generated recoveries worth almost 2.5% of GDP in 2000, with another 2.5% of GDP targeted in 2001, at an average recovery rate of about 35%. IBRA's remaining asset book could support similar magnitudes of recoveries through 2003, supplemented by annual proceeds worth over 0.5% of GDP from the privatization of non-IBRA public-sector enterprises.

--Structural improvements in the real economy. The export-oriented skill sets and fixed assets of Indonesia's private-sector manufacturing base are increasingly being deployed by small- and medium-scale enterprises operating outside the conglomerate umbrella. This, combined with expected increases in the foreign ownership of bank and corporate assets, could help deepen integration into world trade and financial systems, improve the quality of savings allocation, and support a medium-term real GDP growth trend of about 3.5% per year.

The negative outlook reflects expectations that policy disruptions will persist at least until current parliamentary proceedings to impeach the president have run their course. Going forward, political commitment to primary budget surpluses of 3%-4% of GDP--at the consolidated general government level--and to divestment proceeds of 2%-3% of GDP, will be central to Indonesia's sovereign debt-management strategy and credit standing. Indonesia's capacity to deliver such fiscal results is doubtful, according to Standard & Poor's.

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