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Sebastian Eckardt and Anwar Shah
socially desired level of equalization in fiscal capacity, and following from that, minimum standards of access and quality of public services are needed across Indonesia.21 Such a political consensus is difficult to reach in an atmosphere of political mistrust. Technical questions can be managed relatively easily by focusing on fiscal capacity equalization and by assuming that per capita expenditure needs are similar. Fiscal need compensation is better addressed through output-oriented sectoral grants that use service population in the distribution criteria. Indonesia was a pioneer in the design of such grants and had well-designed Inpres grants for primary education, health, and roads in the prereform period (Shah 1998b).
Local Government Borrowing Access to capital markets can help local governments better match expenditures with revenues and can increase efficiency in financing investments that generate long-term benefits. The experiences of some countries, among them Brazil and Argentina in the 1980s, show that, in the absence of fiscal conservatism and market discipline and with the expectation of bailouts, local borrowing can entail considerable macroeconomic and fiscal risks (Fukasaku and de Mello 1997). In Indonesia, concerns about macroeconomic instability have led the government to carefully regulate the access of regional governments to capital markets. Both Law 25/1999 and Law 33/2004 allow for regional borrowing from both domestic and international sources and allow rupiahdenominated municipal bonds to be issued on domestic capital markets. In addition, regional governments may also guarantee third-party debt. The related government regulation on regional borrowing sets tight limits on debt-revenue and debt service–revenue ratios: the total debt is limited to 75 percent of revenues minus necessary expenditures22 and debt service is limited to 35 percent of revenues minus necessary expenditures. Short-term borrowing (less than one-year maturity) is limited to onesixth of current spending and can be used only for cash-flow management. Long-term borrowing (more than one-year maturity) can be used only for capital expenditures in projects with the potential for cost recovery. Any long- or medium-term borrowing of local governments requires approval by both the local representative council (the Dewan Perwakilan Rakyat Daerah, or Regional People’s Representative Council) and the Ministry of Finance. The regulation also gives the central government the right to intercept the transfer of DAU grants if subnational governments fail to meet their
