Improving the Government Debt Market Quality by Determining the Optimal Structure of Government Debt Portfolio

Recently, there is anupward tendency for switching external debts to domestic borrowings in many developing countries. While the domestic government bonds market development could reduce the sovereign exposure to currency risk, there are also potential risks faced by the government; namely: higher domestic interest rates, maturity mismatch, and crowding out effect to the private issuers. In this paper we develop a simple general equilibrium model to determine the optimal share for domestic and external government bonds in a sovereign country. We emphasize the important role of the demand side in forming the optimal structure of government bonds. We found that, at ceteris paribus, domestic government bond correlates negatively to external government bond at a constant rate. In addition, the back testing simulation results that the government has to reduce the level of its external debt. Through a dynamic recursive simulation, it is suggested that, in the long run, the Indonesian government must not hold any external debt while the Debt-to-GDP ratio shall be maintained at 16%-17% level.