Local Government Borrowing

260 Sebastian Eckardt and Anwar Shah

socially desired level ofequalization in fiscal capacity,and following from that,minimum standards ofaccess and quality ofpublic services are needed across Indonesia.21 Such a political consensus is difficult to reach in an atmosphere ofpolitical 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 ofsome countries,among them Brazil and Argentina in the 1980s,show that,in the absence offiscal conservatism and market discipline and with the expectation ofbailouts, 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 ofregional 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. Inaddition,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 ofrevenues minus necessary expenditures22 and debt service is limited to 35 percent ofrevenues minus necessary expenditures.

Short-term borrowing (less than one-year maturity) is limited to onesixth ofcurrent 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 oflocal 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 ofDAU grants ifsubnational governments fail to meet their

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debt-service obligations (Government Regulation 107/2000).Local governments do not have direct access to capital from international sources but can borrow from foreign sources through on-lending through the Ministry of Finance.Law 33/2004 explicitly states that there is no sovereign guarantee for regional government bonds,but the law remains unclear on regional government loans that are in default.In practice,a decree ofthe Ministry of Finance suspended the implementation ofthese rules and effectively eliminated local borrowing until 2004.Although this restriction was abolished by Law 33/2004,borrowing oflocal government has not picked up,because parts ofthe legal framework (for example,sovereign guarantee and the meaning of revenue-generating infrastructure) remain unclear.The Ministry ofFinance is currently revising implementing regulations for local borrowing.

Regional government debt in Indonesia has been insignificant by international standards.The cumulative subnational debt-to-GDP ratio for 1978–2004 is 0.33 percent ofGDP,significantly lower than,for example,in Mexico (4.9 percent ofGDP),South Africa (4.0 percent ofGDP),or Brazil (18.8 percent ofGDP) (Lewis 2003a;Lewis and Pradhan 2005).As can be seen in figure 7.6,borrowing has not recovered since the sharp drop during the financial crisis in 1998.In the aggregate,local borrowing accounted for a mere 0.2 percent oftotal subnational revenues in FY 2001 to FY 2003.This low level was mainly a consequence ofthe uncertain legal environment, which potentially undermined both demand and supply for municipal credit.In the same vein,the market for local government bonds remains underdeveloped.Since 1991,six local government development banks (Bank Pembangunan Daerah) that are jointly owned by provincial and local governments have issued municipal bonds,with medium- to long-term maturities ranging from three to seven years,to finance local infrastructure projects.

As can be seen in figure 7.7,most local government debt is indirect debtofmunicipal enterprises—mainly regional water suppliers (Perusahan Daerah Air Minum)—accounting for more than three-quarters ofthe outstanding debt.Figure 7.7 also indicates that repayment performance is poor,with only about halfofpayments due being settled.Lewis (2003a) has shown that repayment problems are largely a function ofregional unwillingness,rather than inability,to repay debts.23 In addition to the legal complications,limited creditworthiness hampers the expansion ofcredit access for subnational governments.In effect,the low level ofsubnational borrowing potentially constrains infrastructure development,efficient public service delivery,and economic growth.Ifmanaged properly,raising capital through loans and the issuance ofmunicipal bonds could enhance