Indonesian Municipal Bonds Limited as Infrastructure

UNCLAS SECTION 01 OF 04 JAKARTA 000347 SIPDIS FROM AMCONSUL SURABAYA 0009 DEPT FOR EAP/IET, EB/IFD/OIA COMMERCE FOR 4430-GOLIKE DEPT PASS OPIC, EXIM, TDA DOE FOR TOM CUTLER/PI-32 AND COURTNEY GILLESPIE/PI-42 TREASURY FOR IA-ANDY BAUKOL SENSITIVE SIPDIS E.O. 12958: N/A TAGS: EFIN EINV ECON ENRG PGOV KCOR ID SUBJECT: Indonesian Municipal Bonds Limited as Infrastructure Financing Option Ref: 06 Jakarta 13236 ¶1. (SBU) SUMMARY. East Java leaders are considering issuing municipal bonds to finance development of desperately needed infrastructure in the province. Guntur Pasaribu, managing director of the Surabaya Stock Exchange (SSX),predicts strong local demand for the bonds, once issued. An immature regulatory environment and strict underwriting and accounting standards limit most local governments from using municipal bonds as an infrastructure financing option. Many local governments prefer to wait for limited infrastructure funding from the central government rather than subject themselves to higher levels of financial scrutiny by bond investors. The GOI considers municipal bonds as a part of the national debt and fears local mismanagement will ultimately doom a municipal bond issue. END SUMMARY. Need For Municipal Bonds Apparent -------------- ¶2. (SBU) In November 2006, the GOI held a conference describing the lack of infrastructure as a primary hindrance to economic growth development. Indonesia needs $150 billion of infrastructure investment over the next five years to support desired levels of economic growth (reftel). Since 2004, East Java leaders have been discussing municipal bonds as a means to finance much needed new infrastructure in the province. In a recent speech, East Java governor Imam Utomo reaffirmed the need for a bond issuance to, "finance major provincial infrastructure projects such as the Surabaya - Madura Bridge, toll road extensions, an agribusiness center, and other projects." Municipal bond supporters in the East Java government argue that they are the best alternative to finance strategic infrastructure projects at the local level. Most local governments wait for limited local tax revenues and block grants from the central government to pay for large capital projects, but never amass the sufficient funds. "The inability of local governments to finance major infrastructure projects has been a major failing of decentralization", stated Eddy Wahyudi, East Java parliament member. Municipal Bond Demand Prospects Good -------------- ¶3. (SBU) Guntur Pasaribu, Managing Director of the Surabaya Stock Exchange (SSX),the exchange handling all bond transactions in Indonesia, sees a huge market potential for municipal bonds issued in East Java and several other Indonesian provinces. Third-party funds in East Java banks totaled $13.3 billion (Rp 122.03 trillion) in September 2006, 80% held by individuals. More than half of these deposits sit idle, as loan-to-deposit (LDR) ratios in the province hover below 50%. Pasaribu is bullish on municipal bonds and projects an East Java municipal bond offering would price at coupon rates at a premium to bank deposits or national debt instruments, enticing bank customers to move a portion of their time deposits to sub-sovereign debt. "Though the East Java government perceives that issuing municipal bonds is risky and involves complicated procedures and requirements, it needs a way to bring the abundant existing capital in the province sitting in banks back into the local economy", stated Pasaribu. SSX is planning an awareness campaign to inform local investors about municipal bonds; what they are and how they could benefit their portfolios. Pasaribu also mentioned that Indonesian institutional investors have expressed interest in purchasing investment grade municipal bonds. Pasaribu thinks there would be strong demand for well-structured municipal bonds and a liquid secondary market. ¶4. (SBU) SSX sees great potential demand for Indonesian sub-sovereign debt securities however contacts at major rating agencies provide a more sober outlook. Standard and Poor's and Fitch Ratings see some potential for municipal bonds in Indonesia for the right credit and project but predict the secondary market would be thin. Pricing would also likely be several grades below Indonesian sovereign debt, thus well below investment grade. By law, Indonesian sub-sovereign debt must be approved by, but may not be guaranteed by the GOI, forcing local governments to obtain a credit rating on their own. This would be difficult given the lack JAKARTA 00000347 002 OF 004 of transparency in accounting systems and poor histories of prior debt repayment. Indonesian local governments have a 48% default rate on loans from the central government, according to a recent World Bank report. Obstacles to Issuing Municipal Bonds Still Large -------------- --- ¶5. (SBU) The regulatory environment for the issuance of municipal bonds is still in flux. The October 2004 revision of the local autonomy law improved opportunities for local governments to issue municipal bonds. These complex and restrictive regulations gave local governments the authority to issue municipal bonds, enabling them to repay debt instruments. The legal revision was again clarified by the central government regulations on regional loans (PP No. 54/2005). According to the regulations, debt may be used to finance new or ongoing projects of any size, where the project can be used as collateral. A feasibility study must be performed to demonstrate need for the project prior to local government approval. Any municipal bond issuance requires prior approval by the Minister of Finance and the local parliament. Bonds must be denominated in rupiah, issued in the domestic market, and proceeds invested in revenue-generating projects. All municipal bond issuances conform to capital market regulations, and must be rated by an approved rating agency in advance. ¶6. (SBU) Even though local governments are now permitted to issue municipal bonds, there are no technical regulations or procedures on exactly how this can be done. According to Pasaribu, a team from local governments and SSX is discussing a regulatory structure with the Indonesian Capital Markets Supervisory Agency (BAPPEPAM-LK) to establish the mechanisms and procedures to be implemented. Pasaribu hopes that technical regulations will be agreed upon this year, detailing the process local governments will follow to issue municipal bonds. Strict Underwriting Standards Limit Usability -------------- ¶7. (SBU) Our contacts in the East Java provincial government criticize the revised municipal bond regulations, arguing they are inflexible and overly complicated. They complain that municipal bonds are treated in Indonesia as both a revenue bond, secured by the project as collateral, and a general obligation of the local government. In addition, municipal bonds may only be used to finance public infrastructure which generates income and may not be used for public schools or public road development, for example, which generate no fee-based income. The bonds must also be guaranteed by the local government, making them general obligation bonds. They require a budgetary "set aside" of funds from annual discretionary budgets to fully pay principle and interest due for the year, even though the project should generate enough income to repay the bonds. This provision creates a "double underwriting" standard, making municipal bonds onerous for local governments to issue while trying to provide non-revenue generating services. ¶8. (SBU) Municipal bonds are also included in the national debt ceiling and have other underwriting restrictions in the form of a local debt coverage ratios (DCR) calculated as follows: - Local tax revenues, - Plus net GOI local-source revenue sharing (e.g. from natural resources or income taxes generated in the locality paid directly to the GOI), - Plus GOI block grants for discretionary spending, - Divided by the annual bond debt service. This must equal 2.5 or greater, and cannot fall below 2.5 in any one year. Under this criterion, East Java could issue $1.5 billion of municipal bonds. Two additional constraints apply. First, total JAKARTA 00000347 003 OF 004 outstanding local government debt (including proposed borrowing) may not exceed 75% of the prior year's income. Second, local governments bonds may not increase the cumulative outstanding debt (central and local combined) to greater than 60% of national GDP. The Ministry of Finance (MOF) determines if the new bonds are allowable under this restriction. Some Local Governments Averse to Transparency -------------- ¶9. (SBU) When Pasaribu discusses the possibility of municipal bond issuance with local governments, he notes that many have no interest in subjecting themselves to the increased transparency and accounting requirements that a municipal bond issue would bring. They claim a lack of skilled accountants inhibits them from implementing the accounting systems necessary to issue municipal bonds. Business Indonesia Daily reported as of August 2006, that only 6.3% of Indonesian local governments have applied Standard Financial Accounting Practices as required by the Government Accountancy Standards Board (SAP). According to the A.B Triharta, a member of SAP, only 30 out of 470 provincial, regency and city governments have applied the Indonesian equivalent of Generally Agreed Accounting Principles (GAAP). Pasaribu argued that local governments could hire professionals for implementation and training. In his opinion, local governments have limited interest in transforming their accounting systems which currently thrive on non-transparency. "If we could get any of our local governments to issue municipal bonds, the market would force greater levels of transparency in their financial dealings", said Pasaribu. SOEs the Infrastructure Answer? -------------- ¶10. (SBU) Pasaribu and the SSX recommend a regulatory arbitrage scheme for local governments to form state-owned enterprises (SOEs) to develop infrastructure projects and procure bond financing. SOEs are not subject to the restrictions or "double underwriting" standards that local governments face when considering municipal bond issuance. While admitting Indonesian SOEs are notorious for poor management and corruption, Pasaribu feels that the local governments can set up a new SOE that conforms to SAP standards and acquire bond financing based on the feasibility of the project alone, without obligating limited discretionary funds. This solution has the "advantage" of avoiding MOF and local government approval, both potential sources of corruption that could require diversion of funds from the project. While Pasaribu acknowledges that the SOE alternative moves the local infrastructure financing process from regulated underwriting and oversight to a lack thereof, he sees few alternatives to deliver much needed infrastructure projects in a ti(mely manner. "The market will determine which projects are feasible and transparent and award them bond financing", stated Pasaribu. GOI Fears Local Funds Misuse -------------- ¶11. (SBU) Decentralization is still a work in progress. According to MOF contacts, the GOI set up the strict underwriting standards and accounting requirements to limit local government's ability to develop infrastructure, fearing local government corruption. By including municipal bond issues in the national debt, the GOI assumes that it may have to bailout failed "provincial" bond issues in order to maintain the national credit rating. However, contacts tell us this is not only a local government problem: Indonesia has never had a transparent infrastructure project. Municipal bonds are one example of the central government devolving the responsibility to local governments for services, such as electricity, transportation, water and sanitation, while maintaining tight control over the funds needed to improve, expand or even maintain their systems. Virtually all local governments are dependent on central government for block grants of funds for infrastructure, which are generally insufficient to maintain existing systems. Our contacts call this forced dependence "soft nationalization" and regularly express their frustration at the inability to determine their economic futures apart from Jakarta. JAKARTA 00000347 004 OF 004 Rewards for Performance and Benchmarks -------------- ¶12. (SBU) GOI fears of local misappropriations of bond funds, however well-founded, hinder their stated decentralization and national infrastructure development goals. A possible solution may be to allow local governments, which adhere to SAP accounting standards and operate transparently, to more easily issue municipal bonds to finance their infrastructure needs. Benchmarks could be established to determine transparency. Local governments exceeding those standards could be offered a graduated reduction of the "double underwriting" standard allowing reduced "set asides" as the bonds develop a performance history. Given that there are specific, revenue-generating projects backing the bond issues, it should not take too long to assess financial performance backing the bonds, freeing discretionary funds for other purposes. PASCOE