The nexus between foreign exchange and external debt in Indonesia: evidence from linear and nonlinear ARDL approaches

Abstract

We examine the long- and short-term effects of foreign exchange on Indonesia's external debts. Employing an autoregressive distributed lag (ARDL) bounds testing on quarterly data from 2010 to 2019 and testing for effect asymmetry, we found a long-run cointegrating relationship between the two variables. We also found a slow adjustment to an equilibrium state following a shock. Foreign exchange demonstrates a positive long-run effect on Indonesia's external debt, while in the short-run the effect is negative. Furthermore, we found an asymmetry in the elasticities of external debt with respect to rupiah-to-US dollar exchange rate fluctuations. The positive effect of Indonesian rupiah volatility on Indonesian external debt would be more severe when the rupiah appreciates against the dollar compared to a situation of rupiah depreciation. Therefore, although a depreciation of rupiah against the US dollar under a floating foreign exchange regime adopted by Indonesia since 1997 would in the long-run increase external debt, the impact is moderate. Any short-run movement of Indonesia's external debt following a shock would be pulled back to its long-run equilibrium path. We recommend that Indonesia should maintain a floating exchange regime and allow rupiah to depreciate at a moderate rate in the long-run.