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

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The Need, Capacity and Willingness of Regional Governments to Finance Public Infrastructure from Long-Term Loans Building Capacity for the Development of Sub-National Government Capital Market for Municipal Bonds June 2011


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

Background. As part of an ongoing program of activities to encourage long1 term borrowing for public infrastructure by regional governments , the Government of Indonesia (GOI) has recently issued Government Regulation 2 30 of 2011 on regional borrowing (PP30/2011). Unlike its legal predecessor PP54/2005, the new regulation allows regional governments to borrow longterm 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 international 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

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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 infrastructure that:  are presently not undertaken by the private sector because expected (riskadjusted) 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), 3

 constitute a regional government responsibility according to PP38/2007 , 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 variation 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 longterm 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 Pemerintahan Antara Pemerintah, Pemerintahan Daerah Provinsi, dan Pemerintahan Daerah Kabupaten/Kota

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

 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 macroeconomic 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 five4 year period 2011-2015. Limitations to estimating the need for long-term loans using a microeconomic 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 mediumterm 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 longterm 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.

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

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 5 rate of at least 6 percent per year). Table 2 REGIONAL GOVERNMENT INVESTMENT IN FIXED ASSETS, 2004-2007* IDR trillion

2004**

2005

2006

2007

165.1

196.7

279.0

305.0

- 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%

Total revenue Investment in fixed assets

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 6 surpluses (Table 3). 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.

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

Table 3 FINANCING OF REGIONAL GOVERNMENT INVESTMENT IN FIXED ASSETS, 2004-2007 IDR trillion

2004

2005

2006

2007

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

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

Provincial governments (n=15)

District governments (n=113)

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

22

48

80

118

163

430

Need for long-term loans 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 7 average, 25-30% of their total capital investments from DAK. 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.

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

 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 8 the end of 2015. 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 9 330 trillion (or IDR 60-70 trillion per year).

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.

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

Table 5 NEED FOR LONG-TERM LOANS FOR INFRASTRUCTURE, 2011-2015, SECTORAL METHOD IDR trillion

Sector

2011

2012

2013

2014

2015

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

5

5

6

6

6

28

Total

162

172

184

198

217

934

Financed from surpluses

108

120

133

147

163

670

54

52

51

51

54

263

Traditional markets

Need for long-term loans

TOTAL

Source: Consultant, based on BAPPENAS (2007)

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

2 Capacity to Repay Long-Term Loans Limits to regional government borrowing. Borrowing by regional governments 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 Debt Service

> 2.5

[2-1]

Non-earmarked revenue is the sum of PAD, DAU and DBH (excluding 10 DBHDR). 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 Debt Service

> 2.5

[2-2]

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.

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

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.

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

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 11 government (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.

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

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

Same in all years of principal repayment

First year 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 12 PDAMs and other regional government enterprises within one year. ) 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 macroeconomic 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

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

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 IDR 430 trillion (macro-economic method) IDR 188 trillion IDR 263 trillion (sectoral method) NEED

? CAPACITY

WILLINGNESS

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 governments 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

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

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 13 as “on-lending�) was governed by PP2/2006. In practice, the implementation 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 14 PP2/2006 by PP10/2011. 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 onlending 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

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

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 egovernment 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 longterm 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.

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The Need, Capacity and Willingness of Regional Governments to Finance Public Infrastructure 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 2 kabupaten government with a population density of at least 750 persons/km ),  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 710 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.)

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

Figure 2 CURRENT AND PROPOSED LOAN CHANNELING ARRANGEMENTS Project Loan (foreign currency)

CURRENT

Foreign Lender LenderA

Sub-Loan (foreign currency or Rupiah)

Government (MoF) Government (MoF)

Regional Govt A

Foreign Lender LenderB

PROPOSED Program Loan (foreign currency) Foreign Lender LenderA

Foreign Lender LenderB

Regional Govt B

Ministry of Finance Government (MoF) Municipal Development Fund (MDF)

MDF Loan (Rupiah) Regional Govt A

Regional Govt B

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 expenditures 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 governments 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).

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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

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

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 + Road (Jl. Puncak II, rehab), bus IDR 750b), three terminals, irrigation bus terminals systems, markets (for sanitary reasons)

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, Kab. Karangasem: water supply, Market + hospital electricity, telecoms (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. Access roads, Yogyakarta urban transport

Acceptable; lack of Access roads to DPRD support is key open up areas constraint with tourism potential, urban transport (procurement of buses), area traffic control system

Kota Sectors where Samarinda 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

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

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

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

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Final Report (June 2011)

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Kebutuhan, Kemampuan dan Keinginan

Pinjaman Jangka Panjang untuk Pemerintah Daerah

ANNEX 2 Powerpoint Presentation

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4. Rekomendasi

3. Keinginan Daerah utk Meminjam

2. Kemampuan Daerah utk Meminjam

1. Kebutuhan utk Pinjaman Jangka Panjang

Agenda

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Kemampuan: Terbatas

Kebutuhan: Tidak Terbatas

Keinginan: Sangat Terbatas

Kebutuhan dibanding Kemampuan dan Keinginan

1. Kebutuhan

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Sumber: Pembiayaan Pencapaian MDGs di Indonesia (BAPPENAS, 2007)

Kebutuhan Investasi utk Tiga Sektor (Rp trilyun)

Kesimpulan #1 – Kebutuhan Sangat Tinggi

1. Kebutuhan

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

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Final Report (June 2011)

Relokasi Kawasan Industri Pasar, Dermaga, Rumah Sakit, Air Minum Lapangan Terbang, O&P Jalan Kolektor Jalan Akses ke Daerah Pariwasata

Kota Samarinda

Prov. Bali

Prov. SulTeng

DI Yogyakarta

Juni 2011 | Decentralization Support Facility

Jalan Puncak II, Terminal Bus

Kab. Bogor

Sumber: Survei DSF / Kemenkeu (2011)

Kebutuhan Infrastruktur Utama

PEMDA

Kesimpulan #2 – Kebutuhan Sangat Bervariasi

1. Kebutuhan

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3. Kebanyakan daerah mengusulkan proyek investasi bersifat strategis (yang tidak bisa diprediksikan berdasarkan statistik dasar)

2. Untuk kebanyakan PEMDA belum ada hubungan antar biaya investasi tahunan dan RPJM-D

1. Kebanyakan PEMDA belum punya RPJM-D dengan perkiraan biaya investasi

Kesimpulan #3 – Kebutuhan tidak Bisa Dihitung

1. Kebutuhan

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Minimum dari Batas #1 dan Batas #2

Batas pinjaman maksimal:

2. Jumlah pinjaman (yg ada + yg diusulkan) menyebabkan bahwa DSCR > 2,5 (Batas #2)

1. Jumlah pinjaman < 75% penerimaan umum APBD tahun sebelumnya (Batas #1)

PP30/2011, Pasal 15:

Batas Pinjaman Jangka Panjang

2. Kemampuan

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- Perlu data yang biasanya tidak tersedia (yaitu jadwal pembayaran semua pinjaman jangka menengah dan jangka panjang yg ada)

- Perlu proyeksi sampai akhir jangka waktu pinjaman baru yang diusulkan (15-25 tahun)

Kesulitan dengan perhitungan Batas #2:

#2. Berdasarkan data historis dan proyeksi

#1. Berdasarkan data historis (PAD+DAU+DBH)

Perhitungan batas:

Perhitungan Batas Pinjaman Jangka Panjang

2. Kemampuan

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\

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- Hampir selalu kemampuan meminjam PEMDA jauh lebih kecil daripada usulan pinjaman PEMDA (bila tidak, PEMDA diminta untuk menyiapkan data utk menghitung Batas #2 secara terinci)

- Metode perhitungan mudah dan cepat

Manfaat Batas Maksimal Indikatif:

Menggunakan asumsi sangat konservatif untuk menghitung Batas Maksimal Indikatif

Usulan untuk Perhitungan Batas #2:

Usulan untuk Menghitung Batas #2

2. Kemampuan

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Belanja wajib: proyeksi sama dengan realisasi rata-rata selama 3 tahun terakhir

Pokok pinjaman, Bunga, Biaya Lain untuk pinjaman yang ada: semua pinjaman yang ada akan dilunasi dalam tahun proyeksi pertama (tapi < batas maksimal pemotongan DAU/DBH)

Pokok pinjaman, Bunga, Biaya Lain untuk pinjaman baru: sesuai dengan jadwal pembayaran yang telah dihitung

-

-

-

Juni 2011 | Decentralization Support Facility

PAD, DAU, DBH, DBHDR: proyeksi sama dengan realisasi rata-rata selama 3 tahun terakhir

-

Asumsi utk Menghitung Batas Maksimal Indikatif:

Perhitungan Batas Maksimal Indikatif

2. Kemampuan

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- Keperluan dana pendamping - Keperluan PerDa tentang pinjaman

- Proses persiapan pinjaman tidak sinchron dengan proses penganggaran

- Proses penilaian lama dan kurang jelas

- Peraturan yang belum tersosialisikan dgn baik

- Intervensi DPRD

Faktor yang membatasi pinjaman jangka panjang:

Hasil Survei tentang Keinginan utk Meminjam

3. Keinginan

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4. Memperbolehkan pelunasan pinjaman sebelum akhir jangka waktu (bebas denda)

3. Memperbolehkan pengembalian dalam annuitas (pembayaran konstan selama jangka waktu)

2. Menghapus keperluan PerDa (untuk menghindari intervensi DPRD)

1. Menghapus keperluan dana pendamping (dan mengganti dengan daftar negatif)

Opsi untuk Meningkatkan Persyaratan Pinjaman:

Peningkatan Persyaratan Pinjaman

4. Rekomendasi

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5. Menilai aplikasi pinjaman dalam maksimal 6 bln -> menghindari SLA (tapi program loan OK)

4. Minta PEMDA utk mengirim aplikasi di Nov-Des untuk maksimal waktu dalam siklus anggaran

3. Menghapus keperluan untuk PerDa ttg pinjaman

2. Menghapus keperluan dana pendamping (selain dari keperluan utk pembelian tanah)

1. Menerbitkan proses penilaian di kemenkeu.go.id (biar proses transparan kepada PEMDA)

Opsi untuk Meningkatkan Proses Penilaian:

Peningkatan Proses Penilaian

4. Rekomendasi

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1%

Pemerintah (Kemenkeu)

Government (MoF)

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Pemberi Pinjaman B

Foreign Lender

Pemberi Pinjaman A

1%

3% Municipal Development Fund (MDF)

Government (MoF)

Pemerintah Daerah B

Pemerintah Daerah A

2%+TB

2%+TB

Pemerintah Daerah B

Pemerintah Daerah A

Pinjaman kepada Daerah (Rupiah)

1%+Tb

3%+TB

Pinjaman yg Diteruskan kepada Daerah (Rupiah)

Kementerian Program Loan Keuangan RI (mata uang asing)

Foreign Lender

USULAN

Pemberi Pinjaman B

Foreign Lender

Pemberi Pinjaman A

3%

Project Loan (mata uang asing)

Foreign Lender

SAAT INI

Menuju Municipal Development Fund (MDF)

Program Loan untuk Mendanai MDF

4. Rekomendasi

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Terima Kasih!

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

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