Financing of infrastructure on the sub-national level: Public funds, municipal credit markets or private equity? The case of Indonesia

Project description

Miscellaneous:
Infrastructure gap

Investments in infrastructure are recognized as a major prerequisite for growth and poverty reduction. Public investments in infrastructure have traditionally been low in Indonesia, compared to other countries in East and Southeast Asia. Consequently, the quality of public services has been low, particularly in the disadvantaged regions outside Java. After the Asian financial crisis in 1997/98 there was a severe retrenchment in public investments, leading to a further depletion of infrastructure. Under the Government of Indonesia’s commitment to meet the Millennium Development Goals (MDGs) infrastructure investments are therefore considered to be of high priority.

By 2005/06 the public financial situation has stabilized, leaving greater fiscal space for public investments. However, despite the availability of a greater volume of public funds there will be a persistent gap between infrastructure needs and the public funds to finance them. Therefore, new financing models are needed.

Decentralization

In a world of decentralized governance the responsibilities of sub-national entities in the delivery of public services and infrastructure investment have increased sharply. Decentralization in Indonesia, comprising the transfer to the two levels of sub-national government (provincial and local governments) of responsibilities, autonomy for decision-making and necessary financial means, became a focus of national policy only very recently. The first laws were adopted in 1999, implemented as of 2001 and revised in 2004. The regional governments (as well as the central government) are still in a learning and transition phase. The legal framework is still incomplete or inconsistent. However, the transfer of substantial responsibilities for key public service, education and health sectors, as well as the accompanying transfer of staff led to an increase in the overall share of the sub-national sector in general government spending to over 30 percent.
Although significant resources have been allocated to the provincial and local levels, the sub-national levels have very limited own revenue-raising authority; they depend on decisions taken by the central government. Such a revenue structure does not create a hard budget constraint, nor does it increase the accountability of local officials to their citizens and taxpayers.

New financing models

Over the medium-to-long-term, the funding for investment that might be available from the central and local budgets will be insufficient to enable local governments to meet their infrastructure needs, not only for water and sanitation, but also for solid waste disposal and treatment, roads and transportation networks, health and education. Therefore, access to long-term financing from the commercial banking sector (and eventually non-bank financial institutions) as well as from private investors is becoming indispensable. To the extent that the richer provinces and municipalities would have better access to commercial funding, the fiscal space of the government to provide public funds for the poorer regions would increase.

There are two major prerequisites for the local capital market becoming a major source of long-term infrastructure funding:

local entities (governments and district enterprises) have to become reliable borrowers, and
the local capital market has to provide long-term funds on suitable conditions.

Both prerequisites are only partly fulfilled at present in Indonesia. Many local governments and local enterprises which have borrowed in the past, are in arrears. Most local enterprises, e.g. in water supply, cannot cover their costs from revenues. On the other hand, most commercial banks are not in a position or are not interested in providing long-term funding for infrastructure investments.

Role of donors

Traditionally, donors have provided a share of infrastructure funding needs, also to Indonesia, mainly in the form of loans on concessionary terms to the government, for on-lending to the sub-national level or to public utilities. Part of the debt arising from this funding has later been rescheduled or forgiven, due to the recurring external debt crises in Indonesia. In the 1990s there were several high-profile private infrastructure investments in Indonesia, funded and managed by foreign investors. They failed, however, mainly due to the uncovered foreign exchange risk of the commercial loans which were used for their financing.

Due to these unfavorable experiences it became clear that external funding for infrastructure is sustainable only under very particular conditions. Therefore, foreign private investors almost completely disappeared from the picture and official donors are switching to a strategy of channeling their funding in a way that would encourage the development of local capital markets, instead of replacing them. Almost all multilateral and bilateral development banks have embarked on strategies of sub-national development which are based on providing long-term funding to either the local banking system or to sub-national development funds with the aim of encouraging the development of local capital markets which would replace foreign funding in the long-term.

German development cooperation in Indonesia with its focal areas of local economic development and decentralization is providing capacity building support to a number of sub-national governments and advising the central government in its decentralization policy. Funds for financing local infrastructure through the local banking system are to be made available, provided the Government of Indonesia is willing to set appropriate framework conditions.

Research approach

The field research, to be carried out in Indonesia from mid-February to end-April 2007, will focus on the bottlenecks on the local level, concentrating on local governments, the local financial sector, and other stakeholders on the local level. For this purpose, the group will carry out empirical research in districts and municipalities in different areas and on different levels of development. Additionally, the programs of the Government of Indonesia and of international donors for sub-national infrastructure financing will be surveyed and practical examples studied.

In combination with a country working group in South Africa on the same topic it is envisaged to contribute to the development of a conceptual framework for local infrastructure financing for countries in different stages of development, thus contributing to the growing international interest in this area of development support.