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December 15, 2010

Fanning Out The Risk: Assessing Fiscal Sustainability Under Uncertainty in Indonesia

Posted by Nina Budina

Indonesia’s public debt outlook is stronger than in many advanced and emerging economies. Nevertheless, Indonesia, like many other emerging economies with relatively low debt levels, is still exposed to shocks. Increased volatility in macroeconomic variables has the potential to increase uncertainty around projected public debt paths. For example, recent econometric evidence suggest that higher debt levels in advanced countries are likely to be accompanied by higher long˗term real interest rates, which could adversely affect emerging markets financing conditions.[1] In Indonesia, like in many oil exporting countries, volatile natural resource revenue can further add to vulnerabilities and risks. Finally, with rising fuel consumption, volatile oil prices, and oil production uncertainties, delaying subsidy reforms could also increase fiscal risks in the future. The attached paper presents considerations for a medium-term fiscal strategy in Indonesia, aimed at maintaining sustainability, while managing uncertainties and risks.

To better manage fiscal risks, including risks from volatile oil prices, the medium-term framework plans for gradual fiscal consolidation and further public debt reduction. The framework is to be supported by enhancing non-oil and gas tax revenues through improvements in tax administration and other broadening of the tax base, while reorienting spending toward development of infrastructure while phasing out energy subsidies.

This paper uses a stochastic simulation approach to assess risks to the public debt outlook, incorporating oil and gas revenue volatility. Specifically, the framework uses Monte Carlo simulation techniques to derive the probability distribution of future debt stocks (“fan charts”), based on stochastic properties of key risk variables. The paper also assesses the impact of oil and gas revenue volatility and implications of delaying fuel subsidy reforms in the context of rising fuel consumption, volatile oil prices, and oil production shocks. Finally, implications of an endogenous fiscal policy reaction function—which adjusts the primary balance to deviations from baseline level debt stocks in stochastic simulations—are also discussed.

Stochastic simulations confirm that a medium-term fiscal consolidation strategy, based on subsidy reduction and revenue administration reforms—in line with the authorities’ fiscal strategy, is sustainable and robust to macroeconomic and oil price shocks in the medium term.

Other interesting conclusions of the paper are that:  

Over the longer term, lack of investments could result in stagnating gas production and declining oil production and an associated revenue drop. Fiscal risks are still manageable in this scenario but uncertainties are higher. The impact of exogenous shocks will be smaller if the government can commit to take deliberate corrective actions as its debt stock rises. An endogenous fiscal policy reaction rule, which implies partially adjusting the primary balance to past deviations from the baseline debt level, could be used to would lower risks. The relatively robust outcomes for debt parameters are only possible when the fiscal strategy is supported by fuel subsidy reforms. Stochastic simulations reveal that delaying subsidy reforms could increase fiscal vulnerabilities in the context of rising fuel consumption, volatile oil prices, and oil production shocks.

[1] See IMF (2010), Fiscal Monitor.

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