When there is uncertainty of future outcomes, risks are involved. Risk in this context can be explained as the uncertainty or variability that has an impact on the returns of futures investments. Exchange rate volatility plays an important role on the debt management policy of countries like Indonesia that hold significant amounts of foreign debt. In 2007, it share 65.53% of GDP and almost 60% consist of the government debt.
The present study empirically analyses the volatility of major currencies that dominate the Indonesian external debt to measure how the risk could affect the value of the portfolio of Indonesian external debt, which will be denoted as foreign exchange risk. The foreign exchange risk is examined by using several Value at Risk (VaR) models that have become broadly implemented in banking and financial institutions especially after it was introduced by lP Morgan in 1994 and announced by BIS-Basel Committee for Banking Supervision on the Basel Accord since 1996. It then will be incorporated into debt sustainability assessment (DSA) models proposed by the IMP (2003) to evaluate the sustainability of Indonesian external debt.
The results shown that the EGARCH(1, t) give a better performance in measuring the foreign exchange risks compare to other VaR models i.e. the 100 days historical simulation, the 260 days historical simulation, the exponential weighted moving average (EWMA), and the GARCH(I,J) based on 1042 days, 260 days and 100 days of observation. Using the DSA, it is found that for the period 2001 to 2006, Indonesian actual primary surplus (deficit) has been lower than the debt-stabilizing primary surplus, although that is not the case for 2007. By incorporating the VaR measures on debt sustainability examination, it is found that foreign exchange risk has a significant impact on Indonesian external debt sustainability. With or without the inclusion of foreign risks on the Indonesian external debt sustainability assessment, it is reported that the Indonesian economy has performed well in term of external debt sustainability.
This study shows the VaR models can be useful for Indonesian external debt management policy, in measuring the risk that arise from foreign exchange market, hence, allows the government to engage in some precautions to eliminate its negative impact.