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The Need, Capacity and Willingness of Regional Governments to Finance

Public Infrastructure from Long-Term LoansBuilding Capacity for the Development of

Sub-National Government Capital Market for Municipal BondsJune 2011

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The Need, Capacity and Willingness of the Regions to Finance Public Infrastructure from Long-Term Loans

1 Final Report (June 2011)

Background. As part of an ongoing program of activities to encourage long-

term borrowing for public infrastructure by regional governments1, the

Government of Indonesia (GOI) has recently issued Government Regulation

30 of 2011 on regional borrowing (PP30/2011).2 Unlike its legal predecessor

PP54/2005, the new regulation allows regional governments to borrow long-

term for public infrastructure projects that are indirectly revenue-generating,

such as roads and flood control systems. Until the late 1990s, a major

portion of long-term loans to regional governments was financed by inter-

national financial institutions, mainly the Asian Development Bank (ADB) and

the World Bank. In view of the need to increase investments in public

infrastructure, and the absence of a domestic market for long-term financing,

GOI is currently considering re-opening this window by establishing a

Municipal Development Fund (MDF) in the Ministry of Finance. Against this

background, the Directorate-General of Fiscal Balancing in the Ministry of

Finance (MoF) has requested the Decentralization Support Facility (DSF) to

recruit a consultant to assist the Directorate-General with a review of the

need for long-term loans by regional governments, and an analysis of the

potential constraints to channeling such loans to the regions.

Objectives and Contents of this Report

Objective. The objectives of the Consultant’s assignment are to:

review the need for long-term loans to regional governments,

assess the capacity of regional governments to repay long-term loans,

identify existing constraints to long-term borrowing by the regions, and

recommend options for removing or mitigating the existing constraints.

A desktop study was undertaken to review regional government borrowing

needs and repayment capacities. The identification (and possible resolution)

of constraints to long-term borrowing was based on focus group discussions

with officials of five regional governments, each of which was deemed to

have a substantial borrowing capacity: Kabupaten Bogor, the Province of

Central Sulawesi, the Province of Bali, the Special Region of Yogyakarta, and

Kota Samarinda (refer to Annex 1 for details on these field visits).

Structure of this report. Chapter 1 presents an assessment of the need for

investments in public infrastructure by regional governments. Chapter 2

contains a conservative estimate of the total borrowing capacity of regional

governments, based on a definition of the maximum borrowing limit (batas

pinjaman maksimal) derived from PP30/2011. Chapter 3 gives an overview

of current constraints on long-term lending to regional governments, and

recommends options to mitigate the adverse impacts of these constraints.

Disclaimer. The contents of this report do not necessarily reflect the views of

the DSF or the Government of Indonesia.

1 In this report, the term “region” or“regional government” refers to a province, kota or

kabupaten. 2 Peraturan Pemerintah Nomor 30 Tahun 2011 tentang Pinjaman Daerah

The Need, Capacity and Willingness of Regional Governments

to Finance Public Infrastructure from Long-Term Loans


1 Need for Long-Term Loans

Definition of need for long-term loans. This report defines the need of

regional governments to finance public infrastructure from long-term loans

as: “the total amount of funds needed to finance investments in public infra-

structure that:

are presently not undertaken by the private sector because expected (risk-

adjusted) returns do not outweigh expected costs,

have an economic lifetime of at least ten years (this rules out the financing

of, for example, solid waste collection equipment),

constitute a regional government responsibility according to PP38/20073, and

cannot be financed from regional government budgets (APBD)”.

Constraints to estimating the need for long-term loans. Estimating the

need for long-term loans by regional governments is fraught with difficulties,

including but not limited to:

Uncertainties about private sector interest. These is considerable varia-

tion in private sector interest in financing public infrastructure, both over time

(foreign direct investment has picked up in recent years, but remains below

levels achieved in the early 1990s), and across regions (for example, the

private sector remains interested in financing piped water supply in large and

metropolitan cities, but not in smaller cities or rural areas).

Uncertainties about financing responsibilities of regional governments.

There is presently a lack of consensus and clarity about the relationship

between central, provincial and kabupaten/kota responsibilities for providing

and financing public infrastructure (for example, Kota Samarinda was

required to co-finance its new airport, even though it will be managed by the

Ministry of Communications as a national airport).

Lack of recent financial data. There are no recent data on aggregate

regional government investments in public infrastructure (the latest available

data were taken from BPK reports for 2007).

For these reasons, the estimates presented in this chapter are indicative only

and should be interpreted as such.

Methods for estimating the need for long-term loans. In view of the

abovementioned difficulties to prepare a reliable estimate of the need for long-

term loan financing, the Consultant decided to use two qualitatively different

methods in order to obtain a range of estimates:

Macroeconomic method. This method estimates the need for long-term

loans in two steps. It first estimates the need for regional investments in public

infrastructure by comparing required and actual investment levels (which are

both expressed as a percentage of GDP). It then estimates the portion of the

required increase that may realistically be financed from internal revenue

(APBD). The remainder is defined as the need for long-term loans.

3 Peraturan Pemerintah Nomor 38 Tahun 2007 tentang Pembagian Urusan Pemerin-

tahan Antara Pemerintah, Pemerintahan Daerah Provinsi, dan Pemerintahan Daerah Kabupaten/Kota




Sectoral method. This method estimates required investments by regional

governments in major infrastructure sectors (or uses estimates from existing

sources) that are needed to achieve pre-defined policy targets, such as the

achievement of MDGs by the end of 2015. The portion of investments that may

be financed from APBD is the same as the amount identified by the macro-

economic method; the remainder is defined as the need for long-term loans.

For both methods, the need for long-term loans was estimated for the five-

year period 2011-2015.4

Limitations to estimating the need for long-term loans using a micro-

economic method. The Consultant was unable to prepare realistic estimates

of the need for long-term loans based on detailed information provided by

regional governments visited in June 2011, mainly because of:

Absence of investment cost data. Focus group discussions revealed that

most regional governments do not prepare cost estimates for their medium-

term development plans (Rencana Pembangunan Jangka Menengah

Daerah or RPJMD).

Major differences between actual and planned investment programs.

Regional governments routinely undertake investment projects that are not

listed in their RPJMD, often because of overriding short-term political

considerations. In other words, even if a regional government had prepared

investment cost estimates, these estimates would not necessarily reflect its

needs for public infrastructure or long-term loans.

Major differences in composition of investment programs. Focus group

discussions revealed substantial differences in the composition of regional

government investment programs (Table 1). Apart from new access roads,

which were proposed by most regional governments, there was no common

sectoral focus of proposed investment projects. As a result, the findings of

the field visits could not be meaningfully extrapolated to obtain an estimate of

regional government infrastructure needs (and thereby of the need for long-

term loans) for the country as whole.

Table 1

HIGH-PRIORITY INFRASTRUCTURE PROJECTS IN SELECTED REGIONS

Region High-Priority Infrastructure Projects

Kab. Bogor Local road (Jalan Puncak II), bus terminals

Prov. SulTeng* Local airports, rehabilitation of roads, teaching hospital

Prov. Bali* Local hospitals, traditional markets, piers, bulk water supply, toll roads, port development

DI Yogyakarta Access roads to open up areas with tourism potential, urban transport (procurement of buses), area traffic control system

Kota Samarinda Access roads to industrial areas, relocation of shipbuilding industry, port development

Source: Consultant, based on focus group discussions held in June 2011 * Including infrastructure projects proposed by kota and kabupaten in that province

4 It is necessary to define a planning period, because the need for long-term loans

would become infinite without such a boundary.




Macro-Economic Method: Estimated Need for Long-Term

Loans as a Percentage of GDP

Current vs. required investments in public infrastructure. In 2007, the

most recent year for which data are available, regional governments invested

approximately IDR 72 trillion in fixed assets, which accounted for about 24%

of total revenue in that year (Table 2). According to recent research, regional

governments need to double their spending on infrastructure from about

1.5% to 3% of GDP to increase total public investment on infrastructure to

5% of GDP (a level that would be necessary to secure an economic growth

rate of at least 6 percent per year).5

Table 2

REGIONAL GOVERNMENT INVESTMENT IN FIXED ASSETS, 2004-2007*

IDR trillion

2004** 2005 2006 2007

Total revenue 165.1 196.7 279.0 305.0

Investment in fixed assets

- Provincial governments NA 10.8 18.3 22.1

- District governments NA 20.8 63.8 49.7

Total investment in fixed assets 22.4 31.6 82.1 71.8

Gross investment as % of revenue 14% 16% 29% 24%

Sources: Consultant, based on BPK (2004-2007), WB (2007) and MoF (2008) * Gross investment in nominal prices, net of asset sales ** World Bank (2007), other data calculated from BPK audited financial reports

Financing of required increases in public infrastructure investments. A

detailed analysis of the public finances of a sample of 15 provinces and 113

kabupaten/kota suggests that, during 2004-2007, regional governments

financed investments in fixed assets almost exclusively from operating

surpluses (Table 3).6 Because few regional governments have borrowed

long-term in recent years, it was assumed that this situation has remained

unchanged. It is unlikely that regional governments will be able to finance a

major increase in public infrastructure investments from an increase in their

operating surpluses. If, for example, regional governments were to double

their investment in fixed assets in 2007 and finance the entire amount from

internal revenue, gross investment in fixed assets would account for almost

half of total revenue. This situation is clearly untenable, as many regional

governments would be unable to meet salary and other essential payments.

For this reason, it was assumed that operating surpluses would increase at

the same growth rate as GDP. The remainder of the required increase would

be financed from long-term loans.

5 World Bank. 2004. Averting an Infrastructure Crisis: A Framework for Policy and

Action. World Bank: Jakarta, Indonesia. 6 B. Lewis and A. Oosterman. 2010. Sub-National Government Capital Spending In

Indonesia: Level, Structure, and Financing. Public Administration and Development.




Table 3

FINANCING OF REGIONAL GOVERNMENT INVESTMENT IN FIXED ASSETS, 2004-2007

IDR trillion

2004 2005 2006 2007

Provincial governments (n=15)

Operating surplus 6.41 8.95 6.98 10.70

Investment in fixed assets 4.98 5.67 7.48 8.72

% Investment financed from surpluses 100 100 93 100

District governments (n=113)

Operating surplus 7.01 9.60 17.65 20.14

Investment in fixed assets 6.15 6.79 12.76 17.65

% Investment financed from surpluses 100 100 100 100

Source: Consultant, based on Lewis and Oosterman (2010)

Results of the macro-economic method. Assuming a price inflation rate of

5.5% per annum and a real economic growth rate of 5% per annum, regional

government investments in infrastructure must increase from about IDR 72

trillion in 2007 to over IDR 320 trillion in 2015 (Table 4). The total required

investment during 2011-2015 is about IDR 1,100 trillion, of which IDR 670

billion would be financed from operating surpluses. This implies a total need

for long-term loans of (1,100-670=) IDR 430 trillion, or appr. US$50 billion.

Table 4

NEED FOR LONG-TERM LOANS FOR INFRASTRUCTURE, 2011-2015, MACRO-ECONOMIC METHOD

IDR trillion

2011 2012 2013 2014 2015 TOTAL

Required investment 130 168 212 265 326 1,100

Financed from surpluses 108 120 133 147 163 670

Need for long-term loans 22 48 80 118 163 430

Source: Consultant

Sectoral Method: Estimated Need for Long-Term Loans for

Key Infrastructure Sectors

Identification of key infrastructure sectors. PP38/2007 identifies no fewer

than 31 government activities and services for which central, provincial and

kabupaten/kota governments are collectively responsible. The majority of these

is classified as “mandatory affairs” (urusan wajib), the most important of which

are: education, health, public works, environment, development planning,

spatial planning, telecommunications and IT, social affairs, and community

empowerment. Unfortunately, regional governments do not publish a sectoral

breakdown of their investments. It is known, however, that regions finance, on

average, 25-30% of their total capital investments from DAK.7 In 2010, four

infrastructure sectors accounted for 75% of total DAK allocations:

7 A. Oosterman. 2011. Proposals for Reform of the Special Allocations Grant (DAK).

ADB: Jakarta, Indonesia.




roads and bridges

basic education

public health, and

water supply and sanitation.

At the request of MoF, the “traditional markets” sector was added to this list

of sectors for which investment requirements were estimated. All five sectors

require long-term investments for which regional governments are

responsible and that are unlikely to be co-financed by the private sector.

Estimation of required investment by infrastructure sector. In 2007,

BAPPENAS published a research report that contains detailed estimates of

investments needed to achieve Millennium Development Goals (MDGs) by

the end of 2015.8 These estimates were used for the basic education, public

health, and water supply and sanitation sectors (adjusted for price inflation).

In the absence of similar policy targets for the other two sectors, it was

assumed that each regional government would, from 2011-2015, also invest

in:

the repair of roads classified as “broken” or “very broken” (at an average cost

of IDR 2 billion per kilometer),

the expansion of the length of their road networks by 5% (at a cost of IDR 10

billion per kilometer), and

the construction or rehabilitation of one traditional market (at an average

cost of IDR 50 billion per market).

Results of the sectoral method. The total required investment in the five

sectors during 2011-2015 is estimated at about IDR 934 trillion, mostly for

roads and education (Table 5). Of this, IDR 670 trillion would be financed

from the regional government’s operating surpluses (this is the same

estimate as was used for the macro-economic method). This means that the

total need for long-term loans is estimated at (934-670=) IDR 264 trillion, or

almost US$30 billion. Because regional governments are also responsible for

other infrastructure sectors, it is not surprising that the estimated need for

long-term loans is lower than the estimate generated by the macro-economic

method (which implicitly considered all sectors).

Summary: need for long-term loans. During 2011-2015, regional

governments will need to invest approximately IDR 1,000 trillion in public

infrastructure. They will be able to finance at most IDR 670 trillion from

internal revenue. This implies a need for long-term loans in the order of IDR

330 trillion (or IDR 60-70 trillion per year).9

8 BAPPENAS. 2007. Pembiayaan Pencapaian MDGs di Indonesia – Laporan Kajian.

BAPPENAS: Jakarta, Indonesia 9 This estimate is exclusively based on a comparison of infrastructure needs and

available financing from internal revenue, and admittedly ignores limitations to the implementation capacities of regional governments.




Table 5

NEED FOR LONG-TERM LOANS FOR INFRASTRUCTURE, 2011-2015, SECTORAL METHOD

IDR trillion

Sector 2011 2012 2013 2014 2015 TOTAL

Local roads 77 82 86 91 96 432

Basic education 42 44 46 49 52 232

Public health 21 24 27 30 34 136

Water and sanitation 17 17 19 23 30 105

Traditional markets 5 5 6 6 6 28

Total 162 172 184 198 217 934

Financed from surpluses 108 120 133 147 163 670

Need for long-term loans 54 52 51 51 54 263

Source: Consultant, based on BAPPENAS (2007)




2 Capacity to Repay Long-Term Loans

Limits to regional government borrowing. Borrowing by regional govern-

ments is regulated by PP30/2011. Article 15 of the new PP states that a

regional government must meet four conditions before it may take on a loan

with a term of at least one year (such loans include municipal bonds and

central government loans financed from foreign sources):

its total outstanding long-term debt (TOLTD) does not exceed 75 percent of its

non-earmarked revenues in the previous budget year,

its debt service coverage ratio (DSCR) must be not fall below a ratio to be

defined by the central government (this report assumes a ratio of 2.5, as was

the case in PP54/2005, the legal predecessor of the current PP)

it is not in arrears on outstanding central government loans, and

it has obtained approval from its parliament (DPRD) to apply for the loan.

All limits should hold in any given year throughout the term of the proposed

borrowing. The capacity of a regional government to repay long-term loans is

defined as the maximum amount that the region can borrow before it violates

any one of the four limits.

Limit #1: TOLTD < 75% of non-earmarked revenue in previous year.

Non-earmarked revenue is the sum of own-source revenue (Pendapatan Asli

Daerah or PAD), the general allocation (Dana Alokasi Umum or DAU) and

shared tax and non-tax revenue (Dana Bagi Hasil or DBH). Taken together,

these three sources normally account for over 90% of regional government

revenue. Stated differently, a typical regional government could absorb a

long-term loan with a value of approximately (90% x 75% =) 67.5% of its

revenue in the previous year before violating Limit #1.

Limit #2: DSCR > 2.5. The clarifications to Article 15 of PP30/2011 define

the DSCR as (Non-earmarked Revenue – Obligatory Expenditures) / Debt

Service. If a regional government wishes to borrow long-term, it must ensure

that the following condition holds during the term of the proposed loan:

Non-Earmarked Revenue – Obligatory Expenditures > 2.5 [2-1]

Debt Service

Non-earmarked revenue is the sum of PAD, DAU and DBH (excluding

DBHDR).10

Obligatory expenditures consist of civil servant salaries, which

usually account for up to 60% of total regional government revenue. Debt

service consists of projected repayments and financing charges (including

interest payments) on outstanding and new loans. The DSCR is usually

lowest in the first year of repayment (in which the outstanding principal on the

loan is highest). Equation [2-1] can be rewritten as follows:

PAD + DAU + DBH – DBHDR – Salaries > 2.5 [2-2]

Debt Service

10 DBHDR stands for Dana Bagi Hasil Dana Reboisasi. This is a portion of a regional

government’s revenue share that is earmarked for reforestation.




Limit #3: no arrears on central government loans. In theory, PP30/2011

only applies to loans extended to regional governments. It does not apply to

loans taken on by enterprises owned by regional governments, such as

PDAMs. In practice, however, the Directorate-General of Treasury in the

Ministry of Finance is reluctant to lend or on-lend funds to a regional

government who owns a PDAM (or other municipal enterprise) with arrears

on central government loans. This is highly relevant, because arrears on

PDAM loans account for a major share of total arrears on central government

loans to regional governments and their enterprises.

Limit #4: DPRD approval. Experience with regional governments indicates

that securing DPRD approval for a loan is a time-consuming process. This is

especially the case for sub-loans (i.e. foreign loans channeled to regional

governments through the Ministry of Finance). DPRD members are often

reluctant to sign a standard letter, which forms part of a standard sub-loan

agreement prepared by the Ministry of Finance, stating that the Ministry

retains the right to settle the late payment or non-repayment of debt service

charges by a reduction in DAU transfers, even though this provision is

explicitly mentioned in Law 32/2004.

What about macro-economic lending limits? According to Law 17/2003

on State Finances, outstanding loans of the central government should not

exceed 60% of Gross Domestic Product. Some regional government officials

believe that the “60%-limit” also applies to individual regions, even though

Law 17/2003 explicitly refers to the central government’s budget. In practice,

the limit would be largely irrelevant because a regional government would

normally breach Limit #1 (“TOLTD <75% of previous year’s non-earmarked

revenue”) long before its total long-term outstanding debt would exceed 60%

of its gross regional domestic product (GDRP). This is because few regions

have a revenue of at least (60% / 75% =) 80% of GDRP.

Methodology for estimating debt repayment capacity

Overview. The debt repayment capacity of a regional government is defined

as the maximum amount that the region can borrow before it violates any of

the four limits mentioned in PP30/2011. Assuming that the DPRD of a

regional government would be willing to approve a new loan, the debt

repayment capacity of a regional government is the lowest of the following

three amounts:

Limit #1: 75% of non-earmarked revenue (PAD+DBH+DAU) in the previous

year (in the absence of recent data, DBHDR was assumed zero).

Limit #2: the amount a regional government is able to borrow before its DSCR

drops below 2.5 in any year during the repayment period of the new loan.

Limit #3: zero in case the regional government is in arrears on loans from the

central government (it is not clear if Limit #3 also applies to central government

loans to regional government enterprises), and the next lowest value in case

the region is not in arrears

The calculation of the amounts associated with Conditions #1 and #3 is

straightforward. The calculation of the maximum amount a region is able to

borrow whilst maintaining a DSCR of at least 2.5 is discussed below.




Assumptions. To estimate regional government debt repayment capacities

for 2011, it is necessary to forecast non-earmarked revenues, obligatory

expenditures and debt service during the term of a proposed loan. Each of

these items was estimated based on two highly conservative assumptions:

Non-earmarked revenues and obligatory expenditures will remain at the 2010

level (in reality, non-earmarked revenues will normally increase at a higher rate

than salaries)

Debt service on existing loans is equal to the maximum amount the central

government may intercept in case a regional government would default on a

loan to the central government; this amount is 10%, 15% or 20% of the sum of

DAU and DBH allocations, depending on the fiscal capacity of the regional

government11

(this is again a highly conservative assumption, because debt

service usually accounts for less than 5% of regional government revenue)

After rearranging terms, equation [2-2] becomes:

Debt Service < 0.4 (PAD + DBH + DAU –Salaries) 2010 [2-3]

where:

Debt Service = Debt Service NEW + α (DBH + DAU) 2010 [2-4]

α: intercept parameter (10%, 15% or 20%)

Loan types. Because equation [2-3] must hold during any given year, and

because it was assumed that the term “0.4 (PAD + DBH + DAU –Salaries)

2010” remains constant throughout the loan term, the debt repayment capacity

of a regional government is constrained by the maximum debt service

payment during the term. Maximum debt service depends on the loan

conditions, and especially on the type of loan. Two types of loans were

considered: (i) decreasing debt service payments (equal installment method),

and (ii) constant debt service payments (annuity).

Maximum debt service by loan type. Table 6 shows maximum debt service

payments by loan type, expressed as percentage of the total drawdown. For

both loan types, the following conditions were assumed:

drawdown of the full loan amount in 2011,

interest rate: 10% per year, including management fee,

commitment fee: 0.25% per year on the undisbursed balance,

grace period: 5 years (on principal only), and

principal repayment period: 20 years.

Assumed loan type. The Ministry of Finance normally offers “equal

installment” loans to regional governments. The underlying repayment

schedule is more conservative than that of the annuity method (which yields

higher debt repayment capacities). Under the equal installment method, the

debt repayment capacity (DRC) of a regional government can be expressed

as (1 / 15.2% =) 6.56 times the maximum debt service. In formula:

11 As stipulated in Peraturan Menteri Keuangan Nomor 129 Tahun 2008 Tentang

Tata Cara Pelaksanaan Sanksi Pemotongan Dana Alokasi Umum dan/atau Dana Bagi Hasil Dalam Kaitannya Dengan Pinjaman Daerah dari Pemerintah Pusat. The value of α is 10% for regions with a fiscal capacity index (FCI) of less than 0.5, 20% if the FCI is more than 1, and 15% in all other cases.




DRCTOTAL = 0.4 (PAD + DBH + DAU – Salaries) 2010 6.56 [2-5]

Adjustment for debt services on existing loans. Regional governments

will need to use part of their debt repayment capacities to service existing

loans. As expressed in [2-3], these debt service charges were conservatively

estimated at 10-20% of the sum of DAU and DBH in 2010. Because the

minimum DSCR of 2.5 also applies to these amounts, the portion of the DRC

that can be used for new loans is:

DRCNEW = DRCTOTAL – 2.5 α (DBH + DAU) 2010 [2-6]

Table 6

COMPARISON OF KEY FEATURES OF SELECTED LOAN TYPES

Equal Installment Annuity

Principal repayments Constant Increases over time

Interest payments Decrease over time Decrease over time

Total debt service Decrease over time Constant

Maximum debt service / Drawdown 15.2% 12.0%

Year of maximum debt service First year of principal repayment

Same in all years of principal repayment

Source: Consultant

Results of the analysis

Compliance with Limit #1. According to preliminary MoF data for all 523

regional governments that existed at the end of 2009, total non-earmarked

revenue of regional governments was approximately IDR 343 trillion in 2010.

Because regional governments are not allowed to have total long-term

outstanding debt of more than 75% of this amount, Limit #1 limits the total

debt repayment capacity of regions to (0.75 x 343=) IDR 257 trillion.

Compliance with Limit #2. Based on the “minimum DSCR” method, the

total debt repayment capacity of all regional governments is estimated at IDR

281 trillion. For 165 of 523 regions the repayment capacity generated by this

method exceeds the “75% limit” (unless the region is in arrears).

Compliance with Limit #3. In the absence of data on arrears, this limit was

not considered. It should be noted, however, that most regions with arrears

would clear these arrears in one year if the central government were to apply

the maximum intercept amount, as was assumed for the estimation of Limit

#2. (According to a study commissioned by MoF in 2008, all but 12 regions

were able to repay all arrears on regional governments loans and loans to

PDAMs and other regional government enterprises within one year.12

)

Summary: capacity to repay long-term loans. In 2010, the total debt

repayment capacity of all regional governments was conservatively

estimated at IDR 188 billion. This amount was equivalent is about 44% of the

total need for long-term loans for 2011-2015 according to the macro-

economic method (and 71% in case the sectoral method would be applied).

12 A. Oosterman and E.D. Woodward, Operationalizing the Central Government

Transfer Intercept Mechanism - Interim Report, DSF, Jakarta, April 2008




3 Willingness to Use Long-Term Loans

Willingness compared to need and capacity to use long-term loans. As

described in the preceding chapters, the need for long-term loans to regional

governments is substantial (up to IDR 430 trillion during 2011-2015). A

conservative estimate of sub-national borrowing capacities indicates that

regional governments are able to repay a significant portion of the required

loan funds. However, they are generally unwilling to take on long-term loans,

especially those offered by the central government. Why is this so?

Figure 1

NEED, CAPACITY AND WILLINGNESS TO USE LONG-TERM LOANS, 2011-15

Source: Consultant

Causes of limited willingness to borrow. Focus group discussions (FGDs)

with regional government officials indicate that regions have a demonstrated

need for infrastructure financing (as evidenced by a large number of

unfunded project proposals) and are aware that a substantial portion of their

borrowing capacities remains unused. FGD participants offered a large

number of explanations to account for the fact that most regions nonetheless

remain reluctant to borrow from the central government (who is currently the

only provider of long-term loans the regions). These explanations were

grouped in three root causes, each of which will be discussed below in detail:

opposition from DPRD,

lengthy loan preparation time, and

uncertainty about loan conditions.

It should be noted that the three root causes are mutually reinforcing. For

example, because of very lengthy loan preparation times (of sometimes

almost two years), some regional governments lost the support of DPRDs

who initially supported loan applications. Similarly, some regional govern-

ments decided not to pursue applications for central government loans after

changes to counterpart fund requirements and interest rates.

Opposition from DPRD. According to all five regions interviewed by the

Consultant, lack of support by the local parliament (Dewan Perwakilan

Rakyat Daerah or DPRD) is the primary constraint to regional government

borrowing. It appears that the decisions of many DPRD members are largely

guided by short-term political considerations. To protect the interests of the

party they represent, they usually oppose long-term loans if the proceeds of

these loans would be used to finance a project that was either developed by

NEED WILLINGNESS CAPACITY

IDR 188 trillion

?

IDR 263 trillion (sectoral method)

IDR 430 trillion (macro-economic method)




the predecessor of the current mayor, or may be undertaken by his or her

successor (this may also explain why DPRD approval for long-term loans is

usually granted in regions where the mayor and the majority of the DPRD

members are from the same party). For defensive reasons, DPRD members

tend to oppose proposals for long-term loans (and presumably any similar

proposal) if a regulation exists that may be used against the interests of the

DPRD. This may explain why many DPRD members do not wish to formally

accept that MoF will apply the DAU/DBH intercept mechanism in the event of

a default on loan repayments, even though this mechanism is already

enshrined in law. FGD participants also reported cases in which DPRD

rejected long-term loan proposals because of apparent inconsistencies

between PP54/2005 and Minister of Home Affairs Decree 37/2010 (even

though Indonesian law clearly states that the PP should be applied in such a

case) and a requirement to issue a by-law to confirm that the regions would

repay a proposed loan according to the agreed loan repayment schedule.

Lengthy loan preparation time. Historically, most long-term loans to

regional governments have been financed from the proceeds of loans from

international financial institutions, mainly the World Bank and ADB. Until

recently, the channeling of such loans to regional governments (also known

as “on-lending”) was governed by PP2/2006.13

In practice, the implementa-

tion of this regulation was so complicated, and involved such a large number

of parties, that regional governments could only obtain such loans at the

expense of very lengthy preparation times (ranging from 6 to 24 months).

Many regional governments lost interest during the lengthy preparation time,

or found that a newly elected mayor or parliament was no longer interested

in pursuing a regional infrastructure project initiated by a predecessor (see

Box 1 and Box 2 for examples). In January 2011, the Government replaced

PP2/2006 by PP10/2011.14

Because the provisions for the channeling of

foreign loans to regional governments remains virtually unchanged from

those prescribed in PP2/2006, there is no reason to believe that loan

preparation times will be reduced, as long as MoF would mainly use the on-

lending mechanism to finance long-term loans to the regions.

Box 1

WATER SUPPLY AND SANITATION PROJECT

Originally, this ADB-supported project envisaged the on-lending of US$

100 million to 12 municipal water enterprises (PDAMs). After three years of

project preparation, all PDAMs had withdrawn, except the PDAMs of

Kabupaten Bandung and Kabupaten Tapanuli Tengah, with a combined

financing requirement of US$ 30 million. In 2007, the local parliament of

Kabupaten Bandung stated that it would not be willing to sign a letter an

agreement to the DAU/DBH intercept in the event of default. ADB decided

not to pursue a project with Kab. Tapanuli Tengah as the only participant.

Source: Consultant

13 Peraturan Pemerintah Nomor 2 Tahun 2006 tentang Tata Cara Pengadaan

Pinjaman dan/atau Penerimaan Hibah serta Penerusan Pinjaman dan/atau Hibah Luar Negeri

14 Peraturan Pemerintah Nomor 10 Tahun 2011 tentang Tata Cara Pengadaan Pinjaman Luar Negeri Dan Penerimaan Hibah




Box 2

URBAN SECTOR DEVELOPMENT REFORM PROJECT

In 2005, GOI signed a US$35 million loan agreement with the World Bank

for the financing of full cost-recovery urban infrastructure projects in 13

district governments throughout the country (mostly bus terminals and

markets). The preparation of this project (the Urban Sector Development

Reform Project or USDRP) required more than two years, and cost over

US$2 million. As of May 2010, less than 50% of the loan was been

disbursed compared to the estimated disbursement rate of 90%, partly

because of lengthy loan applications procedures. For example, in 2009,

Kota Manado applied for a USDRP-funded sub-loan to co-finance an e-

government project. Over eighteen months later, in June 2011, the kota

had not received a formal reply to its application.

Source: Consultant

Uncertainty about loan conditions. Focus group discussions revealed that

regional governments are usually unaware of the conditions that apply to long-

term offered by the central government. More importantly, loan conditions may

change during the loan preparation process, which tends to undermine

discussions with DPRD members and other decision-makers at the regional

government level. The following conditions are of particular concern:

Interest rates. Regional governments strongly favor fixed interest rates,

because a repayment schedule based on fixed rates is perfectly predictable

and will therefore not require a budget revision. Since 2005, the Ministry of

Finance offers variable interest rates only. (In addition, the Ministry does not

give regional governments the option to repay loans using the equal

installment method, which would presumably be favored by regional

governments because of the ease in budgeting such amounts.)

Counterpart fund requirements. FGDs indicate that regional governments

accept that certain costs (notably land acquisitions and overheads) are not

eligible for financing from the proceeds of central government loans. However,

regional governments oppose the requirement to finance a pre-agreed

percentage of the cost of a project from counterpart funds (and especially a

change to such a percentage, because this may trigger a budget revision).

Administrative requirements. Participants to FGDs strongly indicate that the

preparation of a loan is adversely affected by the need to obtain DPRD

approval. For this reason, regional government officials strongly support loan

conditions that avoid the need for a local by-law (Peraturan Daerah or PerDa)

or a budget revision.

Recommendations for improving regional government

willingness to finance infrastructure from long-term loans

Recommendations aimed at reducing opposition from DPRD. Even

though opposition from DPRD is the main impediment to the willingness of

regional governments to finance infrastructure needs from long-term loans, this

reports accepts that the DPRD must be responsible for approval of regional

government budgets, including budget financing from long-term loans.




#1a Target regional governments where DPRDs are most likely to support

long-term loans. These are regional governments:

with a high degree of urbanization (defined as all kota governments, and

kabupaten government with a population density of at least 750 persons/km2),

where the mayor was recently elected (regions with upcoming elections are

normally not interested in long-term loans),

where the mayor is of the same party as the majority of the DPRD,

without arrears on central government loans (including arrears on BUMDs

owned by the regional government),

without an request for territorial subdivision (pemekaran) under consideration

by DPRD, and

without an unresolved conflict about the separation of assets and liabilities

arising from past pemekaran.

#1b Target regional governments shortly after preparation of annual budget.

Regional governments need to include loan drawdowns and debt service

payments in their annual budget. Approaching regional governments in

November and December (when annual budgets will have been already

approved) maximizes the time for regional governments to discuss long-loan

proposals and incorporate the financial impacts into next year’s budget.

#1c Allow regional governments to (partly or wholly) repay a loan ahead of

the repayment schedule without imposing a penalty. This loan condition,

which is currently not included in loan agreements between MoF and the

regions, may encourage DPRDs to approve long-term loans (because it

gives DPRD the option to effectively reverse the decision at a later date).

#1d Disseminate newly issued laws, regulations and decrees to regional

governments and their DPRDs.

Recommendations aimed at reducing loan preparation times.

#2 Establish a Municipal Development Fund (MDF) to channel loan funds

to regions in a timely and equitable manner. Most central government

agencies, development partners, and regional governments have concluded

that the on-lending mechanism – as described in PP10/2011 and previously

in PP2/2006 – does not work. At present, however, regional governments do

not have the option to finance infrastructure needs from domestic sources,

because the Indonesian capital markets does not offer maturities beyond 7-

10 years. To address this market failure, it is recommended that MoF

establish a Municipal Development Fund (MDF) that provides long-term

loans to regional governments using more flexible procedures than the

current mechanism. It is envisaged that the MDF would be co-financed with

the proceeds of multilateral program loans. However, the program loan funds

would be on-lent at conditions set by the MDF, and not at conditions that are

(virtually) identical to those imposed by foreign lenders on MoF (Figure 5).

This would give GOI the additional benefit of being able to channel funds to

the regions at conditions that are equitable to all instead of determined by the

conditions of the foreign loan from which a particular sub-loan is financed.

(MoF is considering to establish an MDF in Pusat Investasi Pemerintah,

although this decision was not confirmed at the time of writing.)




Figure 2

CURRENT AND PROPOSED LOAN CHANNELING ARRANGEMENTS

Source: Consultant

Recommendations aimed at increased transparency of loan conditions.

#3a Publish loan conditions on the MoF website. This recommendation is

made to inform regional governments in advance of the conditions that apply

to long-term loans extended by MoF, and to discourage the past practice of

making undocumented changes to loan conditions.

#3b Remove the condition that regions must finance a fixed percentage of

the project cost from counterpart funds. Instead, it is recommended that

the loan conditions published on the MoF website clearly stipulate which

expenditures are not eligible for long-term loan finances (all other expen-

ditures would, in principle, by eligible for 100% long-term loan financing).

#3c Remove the condition that regions must issue a PerDa to implement a

loan agreement. Such a by-law is redundant (because the loan agreement

already stipulates the obligations of the regional government) and will

needlessly slow down the loan preparation process at the regional level.

#3d Provide long-term loans in Rupiah only. It is recommended that the

Ministry of Finance will lend only extend long-terms denominated in Rupiah,

not only because regional governments do not receive income in foreign

currency, but also because regions do not have any experience with

managing foreign exchange rate risks.

#3e Provide long-term loans at fixed interest rates only. Regional govern-

ments have a strong preference for loans with a fixed (as opposed to

variable) interest rate, mainly because such loans do not carry interest rate

risk, but also because fixed interest rates do not require revisions to

budgeted interest payments. For administrative reasons, lending at fixed

interest rates is also preferably to MoF (among other things, it avoids the

need to send updated interest payment schedules to regional governments).

Government (MoF)

Foreign Lender

Regional Govt A

Project Loan (foreign currency)

Sub-Loan (foreign currency

or Rupiah)

Government

(MoF)

Foreign Lender A

Foreign Lender

Regional Govt B

Foreign Lender B

Government (MoF)

Foreign Lender

Regional Govt A

Municipal Development Fund (MDF)

Foreign Lender A

Foreign Lender

Regional Govt B

Foreign Lender B

Ministry of Finance

PROPOSED

CURRENT

Program Loan (foreign currency)

MDF Loan (Rupiah)

ANNEX 1 Description of Field Visits


Overview. From 6 to 28 June 2011, the Consultant visited five regions,

together with Ministry of Finance officials, in order to obtain views of regional

government officials on financing public infrastructure from long-term loans.

This annex summarizes the findings of these field visits.

Methodology

Interview methodology. The Consultant conducted focus group discussions

with the head of the regional planning board (Badan Perencanaan Daerah or

Bappeda) and one or more heads of departments responsible for the

implementation of activities that might be financed from the proceeds of a

long-term loan. Each interview covered at least the following topics:

planned investments in infrastructure in the short and medium term

level of interest to finance part of the planned infrastructure investments from

long-term loans,

level of acceptability of long-term loan conditions,

potential constraints to long-term borrowing, and

other issues related to long-term borrowing.

The focus group discussions were facilitated by the use of a questionnaire, of

copy of which is included in this annex.

Selection of regional governments. To ensure that the field visits would

give a balanced view on DAK utilization at the local level, the Consultant

selected five regions from 30 regions with the largest borrowing capacity

according to the method described in Chapter 2. In addition, regions were

selected from various parts of the country, with two regions in Java, and one

each in Kalimantan, Sulawesi and Bali (Table A1.1).

Table A1.1

REGIONAL GOVERNMENTS VISITED

Region Date of

Visit Key Participants

Kab. Bogor 6 June 2011 Head of Bappeda

Prov. Sulawesi Tengah

8 June 2011 Head of Bappeda, heads of relevant line departments (incl. public works, health, education, and finance)

Prov. Bali 14 June 2011 Assistant to the Regional Secretary, representatives from nine kabupaten/kota

Prov. Yogyakarta 22 June 2011 Vice-head of Bappeda, Head of Finance Department

Kota Samarinda 27 June 2011 Head of Bappeda

Source: Consultant




Table A1.2

SUMMARY OF FOCUS GROUP DISCUSSIONS WITH SELECTED REGIONAL GOVERNMENTS

Region Sectors with

Potential for LT Loan Financing

Project with Potential for LT Loan Financing

Comments on Proposed Loan

Conditions

Kab. Bogor Roads (new + rehab), bus terminals, irrigation systems, markets (for sanitary reasons)

Road (Jl. Puncak II, IDR 750b), three bus terminals

Wants land to become eligible for long financing Prefers zero counterpart fund requirement MoF process of 6 months is too long (problems with budgeting process)

Prov. Sulawesi Tengah

Roads, local hospitals, local airports, water supply and sanitation (Kab, Tojo Una-Una and Kep. Banggai only)

Kabupaten airports (Morowali, Tojo Una-Una), O&M of major connector road with high maintenance cost

Prefers long period of up to 25 years Prefers counterpart fund requirement of max. 5%

Prov. Bali Transport, roads, water supply, electricity, telecoms

Kab. Karangasem: Market + hospital (IDR 100b), Kab. Klungkung Market + pier (IDR 790b), Kab. Bangli: Market, hospital (no data given)

Prefers zero counterpart fund requirement and short processing time (prefers PPP and BPD loans to avoid long and unpredictable process of MoF loans)

Prov. Yogyakarta

Access roads, urban transport

Access roads to open up areas with tourism potential, urban transport (procurement of buses), area traffic control system

Acceptable; lack of DPRD support is key constraint

Kota Samarinda

Sectors where private investors need supporting infrastructure

Relocation of shipbuilding industry (IDR 100 b), port development

Strongly prefers short processing time, regulatory uncertainty remains problematic

Source: Consultant










ANNEX 2 Powerpoint Presentation


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us k

ep

erlu

an

dan

a p

en

dam

pin

g

(sela

in d

ari kep

erlu

an

utk

pem

belian

tan

ah

)

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si u

ntu

k M

en

ing

katk

an

Pro

ses P

en

ilaia

n:

1.

Men

erb

itkan

pro

ses p

en

ilaia

n d

i kem

en

keu

.go

.id

4.

Rekom

endasi

4.

Min

ta P

EM

DA

utk

men

gir

im a

plikasi

di

No

v-D

es

un

tuk m

aksim

al w

aktu

dala

m s

iklu

s a

ng

garan

3.

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gh

ap

us k

ep

erlu

an

un

tuk P

erD

a t

tg p

inja

man

(b

iar p

ro

ses t

ran

sp

aran

kep

ad

a P

EM

DA

)

5.

Men

ilai

ap

likasi

pin

jam

an

dala

m m

aksim

al 6

bln

-> m

en

gh

ind

ari

SLA

(ta

pi p

ro

gram

lo

an

OK

)




Ju

ni2

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tralizati

on

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ort

Facilit

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an

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nic

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l

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lop

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nt

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nd

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mb

eri

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jam

an

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reig

n L

en

der

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me

rin

tah

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rah

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be

ri

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jam

an

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en

teri

an

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an

ga

n R

I

US

UL

AN

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AT

IN

I

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+T

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gra

m L

oa

n

(ma

ta u

an

g a

sin

g)

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jam

an

ke

pa

da

Dae

rah

(R

up

iah

)




Ju

ni2

01

1 | D

ecen

tralizati

on

Su

pp

ort

Facilit

yTerim

a K

asih

!

Documents

The Need, Capacity and Willingness of Regional Governments ...documents.worldbank.org/curated/en/100851468284353383/pdf/684580... · The Need, Capacity and Willingness of Regional