Controlling inflation expectation has become a crucial factor in the government's management of fiscal risk sine it has become increasingly dependent on the domestic debt market to plug the deficit and repay foreign debts.
Expectation of high inflation will certainly increase the government's borrowing costs, and consequently its debt interest payment burdens, because investors will demand higher yields on bonds.
The financial notes to the draft 2009 state budget show government debts outstanding as of July 2008 totaled Rp 1,464.1 trillion (US$158.82 billion) consisting of Rp 582.7 trillion in foreign debts, Rp 779 trillion in rupiah bonds and $11.2 billion in dollar bonds.
Since almost all domestic debt consists of government bonds, debt interest payments are highly vulnerable to inflation expectations which in turn influence the yield on government bonds.
For example, the expectation of higher inflation rates, especially after the 29-percent increase in fuel prices last May, will increase the government's debt interest payments throughout this year to an estimated Rp 94.8 trillion because investors asked for higher yields on government bonds.
During the first semester of 2008 alone, government bond yields rose from 2.86 to 4 percentage points due to the cascading impacts of the U.S. subprime mortgage crisis, sky-high energy and commodity prices and the consequent international credit crunch.
High inflation expectation will also be the main contributor to estimated increases in government debt interest payments next year to Rp 109.3 trillion.
It is therefore vitally important that fiscal and monetary authorities improve their cooperation and coordination in controlling inflation so the 6.5-percent inflation target set for the 12-month period of 2009 could serve as a credible anchor for investors as they determine the yields they will demand for government bonds in 2008.
As President Susilo Bambang Yudhoyono said in his National Day speech last week, the government plans to raise Rp 108.3 trillion through rupiah and dollar bonds next year to finance its fiscal deficit and pay down on foreign loans.
In fact, according to the debt profile as revealed by the finance ministry, government debt repayments (excluding interest payments) during the next five years will be rather heavy, averaging around Rp 89.2 trillion a year, most of which will reduce foreign debt principals.
This is because almost 22 percent of the government's total debt will mature within the next three years, another 40 percent within four to 10 years and the remaing 38 percent after more than 10 years.
Debt interest payments and debt amortization have become two of the most inflexible expenditure items in the state budget as it will become impossible for the government to decrease, let alone postpone, this spending.
In contrast to the period before the 1997 economic crisis when the government's liabilities consisted wholly of foreign debt, the government's 1998-99 bailout of the banking industry and the steady increase in rupiah bond issues since 2004 has exploded domestic debt to a much larger proportion than foreign debt.
Nor can bond redemption be rescheduled, otherwise public trust in government creditworthiness will collapse taking the banking industry down with it. The most the government can do is issue new bonds with a longer maturity to replace the short-term ones now maturing.
The bigger role of bonds in debt financing obviously requires prudent debt management through an adequate scheduling of bond issues, the restructuring of bond maturities through debt switching or buyback and maintaining an appropriate ratio between foreign and domestic bond ownership and between floating- and fixed-rate bonds.
Too high a proportion of bonds in the hands of foreign investors poses significant fiscal risk because a sudden reversal of capital flows could kick in at the slightest rumor or sign of trouble.
Fortunately, according to the Finance Ministry, foreign investors held only around 18 percent of total government bonds as of July. But this ratio could change significantly because the steady increase in Bank Indonesia's benchmark interest rate has now widened the interest rate differential with the U.S. federal funds rate to seven percentage points.
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