In 1825 a Javanese prince named Diponegoro touched off a five-year, ultimately unsuccessful, war of resistance against the Dutch colonial government. As detailed by Peter Carey in his biography of Diponegoro, one of the causes was a land-rent system imposed by the Dutch on the Javanese sultanate of Yogyakarta. Under this system, landowners were encouraged to rent their estates directly to European plantation owners for the production of cash crops. This had a disruptive effect on the local economy and the Governor-General ordered it halted. But there was a catch. As the land-rent system was unwound, the Javanese landowners were forced to buy out the plantation owners in order to get control of their land back.
Many had already used the rents to buy imported luxury goods, and they fell into debt paying out large and often inflated sums to the plantation owners. The sultan was expected to back-stop these debts using payments he received from the Dutch for granting them the right to collect revenue on the kingdom’s toll roads. This created a situation where a Javanese merchant travelling from Yogyakarta to Semarang had to pay fees to the Dutch toll road agents. A portion of those fees then went to the sultan, who used them to back-stop debts being incurred by Javanese landowners as they bought back their own land back from European plantation owners.
This circular system of financial exploitation in which nearly all the revenue somehow flowed to outsiders was imposed upon the sultanate and its princes nearly 200 years ago. Yet in some ways it still exists, only now in the more subtle form of international capital flows that often disadvantage emerging economies for the benefit of global creditors.
In the beginning of the Covid-19 pandemic there was widespread agreement that governments needed to get cash out the door and into the hands of businesses, healthcare systems and consumers as fast as possible. But this quickly revealed a structural inequality in the global financial system. Governments in the US, Europe and UK can tap their central banks to underwrite bottomless fiscal bazookas via monetization, where the central bank buys government bonds directly. This allows them to, among other things, borrow at extremely low rates of interest even as they run big deficits. Emerging markets, on the other hand, are still expected to observe rules imposed by global investors – maintain balanced budgets, low debt to GDP ratios, modest current account deficits and healthy foreign exchange reserves.
There is a clear policy paradox here – emerging markets are being called on to pump cash into their economies to forestall catastrophe. But the reduction in economic activity means a big loss in revenue, leaving borrowing as the most immediate option to plug fiscal gaps. Capital markets typically punish emerging economies that borrow too much, forcing up the cost of borrowing or downgrading their credit rating based on the presumption that the investment is now riskier. The end result is that creditors receive a higher yield, while the borrower has to make critical decisions based on what the market will support rather than what is actually needed to prevent an economic or health catastrophe.
India is a case in point, announcing in May that it would cap its rescue package at $60 billion to avoid a ratings downgrade. A month later, Moody’s downgraded it anyway. The logic of downgrading a country’s sovereign credit rating during a once-in-a-generation global pandemic requiring large outlays of short-term spending is questionable. But that is nevertheless the way the bond market is structured – for emerging markets the more you need, the more it costs. And as in 19th century Java, there’s a structural inequality baked into the whole thing that keeps emerging market borrowers on the back foot.
Even the IMF appears to have accepted that emerging markets will be forced to finance their fights against COVID-19 by running deficits for the short-term. But this is still contingent on the willingness of creditors to absorb the debt. So far in Southeast Asia they appear willing to do so, with capital flows remaining relatively healthy. It would appear that for the moment investors concur with Brad Setser of the Council on Foreign Relations that increases in debt due to COVID-19 policies “do not pose substantial risks to most of Asia’s key economies; only Indonesia may need support and the scale would be manageable.”
Let’s take a closer look at Indonesia. The country is expecting to run a deficit of 6.34% of GDP this year (although that target keeps moving) and the puzzle for monetary authorities is how to pay for it. Conventional wisdom would be that if the government issues too much debt, investors will demand higher yields and at a certain point the ability to raise capital will reach a natural limit determined by market forces.
Indonesian policymakers looked at that state of affairs and apparently found it wanting. The government is now charting a more innovative course in dealing with this crisis, one that places it less at the mercy of investors. In April, Bank Indonesia began buying government bonds in direct auctions rather than on the secondary market, essentially embracing the same kind of monetization as central banks in more mature economies.
This did not sit well in some quarters, a Bloomberg column even calling it “terrifying.” If that was terrifying, than what they are currently doing must really be something. Those initial efforts were relatively small, likely as a way of testing the waters. Now Bank Indonesia and the Ministry of Finance have massively ramped up the program, reaching agreement on a “burden sharing” scheme in which the central bank will directly purchase up to $40 billion in government bonds in the second half of 2020, if the market cannot absorb them.
This makes clear that the technocrats at Bank Indonesia and the Ministry of Finance are serious about taking unconventional steps to plug the fiscal hole and equip the government with financial resources to combat COVID-19. And in some ways it is also a repudiation of the global financial system, in which central banks in mature economies can monetize their public debt in times of crisis, while emerging markets are expected to fight the same battle on a budget, and at the mercy of what capital markets will support. If the market demand isn’t there for these bonds, at the rates the government is willing to pay, then the Indonesian monetary authorities decided to simply do an end-around.
The fear is that by monetizing its public debt, Indonesia will unleash inflationary pressure and debase its currency, making existing dollar-denominated debt unsustainable, burning through forex reserves and creating economic mayhem. But there actually is a logic to all of this. Denominating these bonds in domestic currency ensures that Indonesia will not default – when a country borrows in its own currency it can always make the payments. And when millions are being devastated by business closures and job losses due to a pandemic, inflation should be way down on the list of concerns. That mainly leaves the risk of capital flight – that investors will be spooked by Bank Indonesia’s monetary experiment or unhappy with yields and dump assets, driving down the value of the rupiah.
Finance Minister Sri Mulyani and Bank Indonesia director Perry Warjiyo are taking a calculated risk here. They have likely concluded that given the low-yield environment in Europe and the US, there will be an appetite for Indonesian government debt where the benchmark interest rate is 4%, and that yields will remain low in traditionally “safe” markets for some time, reducing the risk of capital flight while Indonesia carries out this monetary experiment to underwrite its rescue efforts. If the rupiah does come under pressure Bank Indonesia’s reserves are near their all-time high, which will allow them to intervene to defend the currency in the event of a sell-off. In fact, some policy-makers likely consider a weaker rupiah to be a good thing as they are looking to juice exports as part of the recovery.
Nevertheless, this is a gamble. If the rupiah does slide too far too fast as a result of the government monetizing its debt in this way, it would be disastrous for cash-strapped companies that owe a lot of money in dollars (such as, for instance, the state-owned power utility). But the truth is emerging market currencies are nearly always at risk of capital flight, often from events that are completely outside of their control. Interest rate movements by the US Federal Reserve or a global rush to buy dollars have touched off capital flight in Indonesia before. At least in this scenario, Bank Indonesia will be the architect of its own fate.
And that autonomy is likely an important element of this policy choice. The Indonesian government needs to get cash out to keep companies from going bankrupt and people from going hungry. They want to do so without placing themselves entirely at the mercy of market forces and foreign creditor sentiment. Under such conditions, it becomes almost a moral choice for the government to take matters into its own hands and push back against a system of global capital that, in some ways, hasn’t moved the needle all that much over the last two centuries.