The Effect of Twin Shock on Fiscal Sustainability in Indonesia

Abstract

This paper analyzes the behaviour of fiscal sustainability in Indonesia by using stationarity and cointegration tests and analyzing fiscal reaction function in Indonesia during the period of 2001-2016. It employed economic fluctuations and unanticipated exchange rates to observe the effect of twin shock on fiscal reaction function. In addition, it applied VECM (Vector Error Correction Model) to cover and estimate the behaviour of fiscal reaction function in Indonesia. The VECM is a restricted VAR specified for use with cointegrated series and has nice interpretation with short-and long-run relationships. Based on the stationarity test, cointegration and fiscal reaction function, the results indicate that there is the fiscal sustainability of the variables used, namely the foreign debt and the public sector primary deficit in the short and long term. The study indicates that the primary deficit is a key determinant of the external debt. These findings also reveal that the efforts of fiscal authorities to optimize the domestic financing sources should be supported because they can reduce the external debt and maintain the fiscal sustainability. In addition, in the long term, economic fluctuations and foreign exchange rate fluctuations have a positive effect on the external debt in Indonesia.