VZCZCXRO2543
PP RUEHCHI RUEHDT RUEHHM
DE RUEHJA #0347/01 0400014
ZNR UUUUU ZZH
P 090014Z FEB 07
FM AMEMBASSY JAKARTA
TO RUEHC/SECSTATE WASHDC PRIORITY 3214
RUEATRS/DEPT OF TREASURY WASHINGTON DC PRIORITY
INFO RUCPDOC/DEPT OF COMMERCE WASHDC
RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS
RUEHKO/AMEMBASSY TOKYO 0219
RUEHBJ/AMEMBASSY BEIJING 3814
RUEHBY/AMEMBASSY CANBERRA 0414
RUEHUL/AMEMBASSY SEOUL 3861
ZEN/AMCONSUL SURABAYA

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