A Review of the Method for Setting Interest Rates on Foreign-Funded Sub-Loans to the Regions Final Report

Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized 68437 A Review of the Method for Setting Interest Rates Final Report Building Capacity for the Development of Sub-National Government Capital Market for Municipal Bonds April 2011

Executive Summary The Minister of Finance plans to revise PMK83/2005, a decree that stipulates the interest rate to be charged on sub-loans to regional governments that are financed from foreign sources, such as the World Bank or the ADB. This report contains a review of the existing rate setting method, and presents recommendations for improvement. Key Findings #1 There is no theoretical basis for the surcharge of 5.02%. PMK 83/2005 states that the interest rate on a Rupiah-denominated sub-loan is the sum of: (i) the interest rate on the foreign loan from the sub-loan is financed, and (ii) a surcharge to cover foreign exchange rate (FOREX) risks. The surcharge that applies to the interest rate on a foreign-financed regional government sub-loan has been 5.02% for all (of the few) sub-loans proposed to regional governments since the PMK was issued. The surcharge largely consists of a provision of 4.42% to compensate MoF for bearing FOREX risks. This amount is higher than the FOREX risk cover MoF used for the pricing of subloan interest rates before the krismon. It is also higher than the surcharge imposed by other countries with comparable on-lending systems (see table below). It is important to know to what extent the surcharge correctly prices FOREX risks borne by MoF, in order to (i) ensure that the surcharge is not unnecessarily high, thereby artificially depressing demand for sub-loans, and (ii) provide regional government with a justification for the surcharge. KEY FEATURES OF ON-LENDING SYSTEMS IN SELECTED COUNTRIES Country FOREX Risk Borne by Interest Rate Based on Total Surcharge Indonesia, pre-krismon Central government Foreign lender rate 3.5% Indonesia, current Central government Foreign lender rate 5.02% Brazil State government Foreign lender rate 1.7-3.5% China End borrower Foreign lender rate - India (Tamil Nadu) Central government Foreign lender rate 2.5-3.0% Philippines Central government 91-day T-bills 2% #2 The existing rate setting method ignores interest rate risk. To date, most sub-loans to regional governments have been financed from the proceeds of sovereign World Bank and ADB loans. Most of these loans carry a variable interest rate, usually based on the 6-month LIBOR. However, MoF charges a fixed interest rate on sub-loans to regional governments. This means that the central government is running interest rate risk in addition to FOREX risk. The surcharge defined in PMK83/2005 does not cover this type of risk. #3 Sub-loan interest rates are determined by the underlying sovereign loan, which may result in inequitable treatment of regional governments. The interest rate of sub-loan to a regional government is the sum of the interest rate on the underlying sovereign foreign loan and the applicable surcharge. At present, there is considerable variation in interest rates charged by foreign lenders. For example, interest rates on JBIC loans tend to be lower than rates on ADB or World Bank loans. As a result, regional governments may pay different interest rates on sub-loans used for identical purposes. i

Recommendations to Improve PMK83/2005 #1 Reduce the FOREX risk cover included in the surcharge from 4.42% to 1.4%. To provide an objective estimate of MoF s actual cost of covering FOREX risks, two approaches were considered. The historical approach suggests a FOREX risk cover ranging from 0.6% to at most 3.0%, assuming that MoF would not want to include the risk of a monetary crisis in the subloan interest rate. The market-based approach suggests a FOREX risk cover of about 2.2%. The average of the two approaches is (0.6 + 2.2 =) 1.4%. These estimates are both substantial lower than the 4.42% included in the surcharge regulated by PMK83/2005. #2 Include a cover for interest rate risk in the surcharge. The websites of ADB, the World Bank and other foreign lenders present regularly updated quotes for variable and fixed interest rates on sovereign loans. The interest rate differential should be added to the surcharge. #3 Apply the surcharge to the average interest rate on sovereign foreign loans, not to the interest rate of an individual loan. This recommendation is made to prevent potentially large differences between sub-loan interest rates charged to regional governments. The figure below illustrates how this recommendation may be put into practice. Foreign sovereign loans would be pooled into a Municipal Development Fund (MDF), to be established in MoF. The fund will re-lend the proceeds at uniform sub-loan conditions to eligible regional governments. The conditions will be updated periodically to reflect changes in the average financing costs of the Fund. CURRENT AND PROPOSED LOAN CHANNELING ARRANGEMENTS* CURRENT Foreign Lender A Foreign Lender B Sovereign Loan (foreign currency) Sub-Loan (foreign currency or Rupiah) Government 3% 3%+SC (MoF) Government (MoF) 1% 1%+SC Regional Govt A Regional Govt B PROPOSED Ministry of Finance Foreign Lender A Foreign Lender B 3% 1% Government (MoF) Municipal Development Fund (MDF) 2%+SC 2%+SC Regional Govt A Regional Govt B * SC= surcharge ii

A Review of the Method for Setting Interest Rates on Foreign-Funded Sub-Loans Background. As part of an ongoing program of activities to encourage longterm borrowing for public infrastructure by regional governments, the Government of Indonesia (GOI) has recently revised Government Regulation 54 of 2005 on regional borrowing (PP54/2005). 1 Unlike PP54/2005, the new regulation allows regional governments to borrow long-term for public infrastructure projects that are indirectly revenue-generating, such as roads and flood control systems. Until the late 1990s, a major portion of long-term loans to regional governments was financed by multilateral lenders, mainly ADB and the World Bank. GOI is currently considering re-opening this mechanism, which would be managed as a Municipal Development Fund (MDF) in the Ministry of Finance. To operationalize this mechanism, it is necessary to revise PMK83/2005, a Minister of Finance Decree that stipulates the interest rate to be charged on sub-loans to regional governments that are financed from foreign sources. Against this background, the Directorate-General of Fiscal Balancing in the Ministry of Finance (MoF) has requested the Decentralization Support Facility (DSF) to recruit a consultant to assist the Directorate-General with a review PMK83/2005, and recommend on improvements. Objective and Contents of this Report Objective. The objective of this report is to identify options for improving the method that is currently used by the Ministry of Finance to set interest rates on sub-loans to regional governments that are financed from foreign loans to the Government of Indonesia. This method is hereinafter also referred to as the rate setting method. Structure of this report. The first part of this report first gives an overview of the current rate setting method, as defined in PMK83/2005, and concludes that the existing method suffers from several methodological weaknesses. The second part presents recommendations aimed at improving the existing method. Disclaimer. This report has been reviewed by the Directorate for Regional Investment and Capacity in the Directorate-General of Fiscal Balancing, which found it satisfactory. It should be emphasized that the contents of this report do not necessarily reflect the views of the DSF or the Government of Indonesia. 1 Peraturan Pemerintah 54 Tahun 2005 tentang Pinjaman Daerah 1

1 Review of the Existing Rate Setting Method Background On-lending to regional governments. Historically, the Government of Indonesia (GOI) has financed a major portion of its investments in public infrastructure from the proceeds of sovereign foreign loans. Since the mid- 1970s, the Ministry of Finance has on-lent part of these proceeds of these loans to regional governments (provinces, kabupaten and kota). On-lending to regional governments can be described as a two-step process: Step 1. The Government, represented by the Minister of Finance, signs a sovereign loan agreement with a foreign lender (such as the World Bank or the ADB). Without exception, sovereign loan agreements are denominated in a currency other than Rupiah (usually US Dollar). Step 2. The Minister of Finance re-lends part of the proceeds of the sovereign foreign loan to a regional government, and signs a sub-loan agreement with the head of that regional government. To date, almost all sub-loans have been denominated in Rupiah. Figure 1 OVERVIEW OF LOAN CHANNELING ARRANGEMENTS Foreign Lender Sovereign Loan (foreign currency) Government 1 2 (MoF) Sub-Loan (foreign currency or Rupiah) Regional Government Source: Consultant PMK53/2006. In July 2006, the Minister of Finance issued a decree concerning the mechanism for the on-lending of sovereign foreign loan proceeds to regional governments. 2 This decree, better known as PMK53/2006, was issued as an implementing guideline to PP54/2005. According to PMK53/2006, the Government may on-lend sovereign foreign loan proceeds to a regional government in the currency of the sovereign loan itself, or in Rupiah. To date, the Government has almost exclusively on-lent in Rupiah (indeed, MoF no longer wishes to re-lend in a currency other than Rupiah, given that regional governments do not receive revenue in foreign currency). 3 Article 12(2) of the PMK states that the interest rate on a Rupiah-denominated sub-loan consists of two elements: the interest rate on the foreign loan from the sub-loan is financed (as mentioned in the sovereign loan agreement), plus a surcharge, set by the Minister of Finance, to cover foreign exchange rate (FOREX) risks. 2 Peraturan Menteri Keuangan 53/PMK.010/2006 tentang Tata Cara Pemberian Pinjaman Daerah dari Pemerintah yang Dananya Bersumber dari Pinjaman Luar Negeri 3 From 1975 to 2004, fewer than 10 of 838 sub-loans to regional governments were denominated in a foreign currency. 2

Definition of the surcharge PMK83/2005. The calculation of the surcharge to the interest rate on a sovereign foreign loan, as mentioned in Article 12 of PMK53/2006, is regulated by Minister of Finance decree 83/PMK.06/2005. 4 This decree (hereinafter also referred to as PMK83/2005) defines three surcharges, the application of which depends on the currencies in which the sovereign loan and sub-loan are denominated. The following surcharges can be distinguished: Sub-loans denominated in the currency of the sovereign loan: 0.5% Rupiah-denominated sub-loans, financed from a sovereign loan denominated in US Dollar: 5.02% Rupiah-denominated sub-loans, financed from a sovereign loan denominated in a foreign currency other than US Dollar: a figure based on an adjustment of the 5.02% for the six-month forward rate (but not lower than 0.35%) Table 1 APPLICABLE SURCHARGES TO THE SOVEREIGN LOAN INTEREST RATE CURRENCY OF SOVEREIGN LOAN CURRENCY OF SUB-LOAN Same as Sovereign Loan Rupiah US Dollar 0.5% 5.02% Other foreign currency 0.5% Source: Consultant, based on PMK83/2005 5.02% adjusted for sixmonth forward rate (but not lower than 0.35%) Surcharge on Rupiah-denominated sub-loans, financed from sovereign loans not denominated in US Dollar. To date, most foreign-funded subloans to regional governments have been financed from the proceeds of IBRD and ADB loans, which are all denominated in US Dollar. Nonetheless, most of PMK83/2005 is devoted to the adjustment of the surcharge of 5.02% in the event the underlying sovereign loan would be denominated in a foreign currency other than the US Dollar. The adjustment procedure consists of two steps, which can be summarized as follows: Step 1: determine the expected change of the sovereign loan currency to the US Dollar. This change is measured by the increase or decrease of the six-month forward rate vis-à-vis the spot rate as reported by Reuters, on the day closest to (but not earlier than five days before) the signing of the sub-loan agreement to which the surcharge applies. Step 2: adjust the US Dollar surcharge for the expected change. If the sovereign loan currency is expected to appreciate against the US Dollar, the adjustment will be positive, and the total surcharge higher than 5.02%. If the sovereign loan currency is expected to depreciate against the US Dollar, the surcharge will drop below 5.02%. 4 Peraturan Menteri Keuangan Republik Indonesia Nomor 83/PMK.06/2005 tentang Tambahan Tingkat Suku Bunga Penerusan Pinjaman Luar Negeri Pemerintah yang Diteruskan Kepada Daerah. This decree was issued before PMK53/2006, because it was initially used as an implementing guideline to KMK35/2003, the regulatory predecessor of PMK53/2006 3

Box 1 CALCULATING THE INTEREST RATE OF A RUPIAH DENOMINATED SUB-LOAN FINANCED FROM A SOVEREIGN EURO LOAN (EXAMPLE) Sovereign loan. In 2010, the Government of Indonesia signs a sovereign loan agreement with KfW. The loan is denominated in Euro and carries a variable interest rate of 2.5% p.a. Sub-loan. In 2011, the Minister of Finance decides to on-lend part of the proceeds of the KfW loan to Kabupaten ABC. On 15 March 2011, the Mayor of Kabupaten ADB signs a sub-loan agreement with the Minister of Finance. The currency of the sub-loan is Rupiah. Calculation of interest rate on sub-loan. On 14 March 2011, the EUR/ USD spot rate was 1.40. On the same day, the 6-month forward rate was 1.35. This means that the EUR is expected to depreciate against the US Dollar. The rate of change is ([1.35-1.40]/1.40 =) minus 3.57%. The applicable surcharge to the interest rate is therefore (5.02 3.57=) 1.45%. Because the interest rate on the sovereign loan is 2.5%, the interest rate of the sub-loan of Kabupaten ABC is (2.5% + 1.45% =) 3.95% p.a. Source: Consultant Composition of the surcharge. The surcharge defined in PMK83/2005 covers: Bank fees. These are fees charged by channeling banks that MoF employs to disburse sub-loan funds and collect debt service payments (According to Article 7 of PMK83/2005, the fees are 0.25% p.a. for Rupiah-denominated sub-loans, and 0.15% for sub-loans denominated in a foreign currency.) Service charge. This is an administrative fee charged by the Ministry of Finance itself (0.35%). This charge is not explicitly mentioned in PMK83/ 2005, but can be derived from the surcharge on sub-loans denominated in a foreign currency (the surcharge of 0.5% includes a channeling bank fee of 0.15% but not a provision to cover FOREX risks, so that the remainder is available to cover administration costs). FOREX risk cover. The cost of foreign exchange rate risks arising from uncertainties in the exchange rate between the Rupiah and the currency of the sovereign loan. For a Rupiah sub-loan that is financed from a sovereign loan denominated in US Dollar, the implied FOREX risk cover is (5.02 -/- 0.35 -/- 0.25=) 4.42%. Table 2 COMPOSITION OF THE SURCHARGE BY TYPE OF SUB-LOAN Sub-Loan Type Sub-loan in same currency as sovereign loan Sub-loan in Rupiah, financed from US$ sovereign loan Sub-loan in Rupiah, financed from non-us$ sovereign loan Bank Fees Source: Consultant, based on PMK83/2005 Service Charge FOREX Risk Cover Total Surcharge 0.15% 0.35% 0.50% 0.25% 0.35% 4.42% 5.02% 0.25% 0.35% > -0.25% > 0.35% 4

Key issues Key issue #1: there is no known theoretical basis for the surcharge of 5.02%. Historically, most sovereign foreign loans to the Government have been denominated in US Dollar. In addition, it has been a long-standing policy of the Ministry of Finance to on-lend sovereign foreign loan proceeds in Rupiah only. For these reasons, the surcharge that applies to the interest rate on a foreign-financed regional government sub-loan has been 5.02% for all (of the few) sub-loans proposed to regional governments since PMK83/ 2005 was issued. The 5.02% surcharge largely consists of a provision of 4.42% to compensate MoF for bearing the risk of unfavorable changes in the exchange rate of the Rupiah vis-à-vis the US Dollar. This amount is higher than the FOREX risk cover that MoF used for the pricing of sub-loan interest rates before the krismon (3% per year, at that time the estimated annual rate of depreciation of the Rupiah against the US Dollar), It is also higher than the surcharge, which mainly covers FOREX risk, imposed by other countries with comparable on-lending systems (Table 3). For two reasons, it is important to review to what extent the surcharge correctly prices FOREX risks borne by MoF: (i) to ensure that the surcharge is not unnecessarily high, thereby artificially depressing demand for sub-loans, and (ii) to provide regional government with a justification for the surcharge. Table 3 KEY FEATURES OF ON-LENDING SYSTEMS IN SELECTED COUNTRIES Country FOREX Risk Borne by Interest Rate Based on Total Surcharge Indonesia, pre-krismon Central government Foreign lender rate 3.5% Indonesia, current Central government Foreign lender rate 5.02% Brazil State government Foreign lender rate 1.7-3.5% China End borrower Foreign lender rate - India (Tamil Nadu) Central government Foreign lender rate 2.5-3.0% Philippines Central government 91-day T-bills 2% Source: Consultant Key issue #2: the method for adjusting the surcharge of 5.02% is flawed. If the underlying foreign sovereign loan is not denominated in Rupiah, then PMK83/2005 requires an adjustment to the surcharge of 5.02%. The adjustment is equal to the six-month forward rate vis-à-vis the spot rate of the sovereign loan currency. This method is flawed for two reasons. Firstly, the six-month forward rate is not a reliable indicator for the changes in the exchange rate of the sovereign loan currency vis-à-vis the US Dollar during the remainder of the sub-loan repayment time (which typically ranges from 15 to 20 years). Secondly, the surcharge is highly sensitive to changes in the forward rate. For example, if the six-month forward rate of the sovereign loan currency is 5% higher than the spot rate (so that the currency is at a swap premium), the surcharge to the interest rate is (5.02+5=) 10.02%. Conversely, if the forward rate is 5% lower than the spot rate (so that the currency is at a swap discount), the surcharge drops to the minimum threshold of 0.35% (Figure 2). In summary, the existing method produces a surcharge on a long-term fixed Rupiah interest rate that is highly dependent on short-term developments in foreign currency markets. 5

Figure 2 SURCHARGE FOR SELECTED CHANGES TO SPOT RATES 16% 12% Swap discount < > Swap premium 8% 4% 0% -10% -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% Six-month forward rate / Spot rate Source: Consultant Key issue #3: the existing surcharge does not provide cover for interest rate risk. To date, most sub-loans to regional governments have been financed from the proceeds of sovereign World Bank and ADB loans. Most of these loans carry a variable interest rate, usually based on the 6-month LIBOR. In contrast, the Ministry of Finance charges a fixed interest rate on sub-loans to regional governments. This means that the central government is running interest rate risk in addition to FOREX risk. The surcharge defined in PMK83/2005 does not provide for coverage of this type of risk. At present, interest rate risk is particularly high because 6-month LIBOR rates are at a historical low (Figure 3). This means that it is highly likely that interest charges payable by GOI will increase, whereas interest charges payable by regional governments will remain unchanged because sub-loan interest rates are fixed. Figure 3 6-MONTH LIBOR RATES, 2000-2010 (END OF YEAR) Percent 6% 5% 4% 3% 2% 1% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: British Banking Association (2011) 6

Key issue #4: sub-loan interest rates are determined by the underlying sovereign loan, which may result in inequitable treatment of regional governments. The interest rate of sub-loan to a regional government is the sum of the interest rate on the underlying sovereign foreign loan and the applicable surcharge. At present, there is considerable variation in interest rates charged by foreign lenders. For example, interest rates on JBIC loans tend to be substantially lower than rates on ADB or World Bank loans. As a result, two regional governments may pay different interest rates on subloans used for identical purposes (see Box 2 for an example). Box 2 DIFFERENTIAL INTEREST RATES (EXAMPLE) Kota ABC and Kota XYZ each want to borrow Rp 10 billion to build a Class A bus terminal. The Ministry of Finance approves both sub-loan proposals. The bus terminal of Kota ABC will be financed from an almost fully disbursed Yen loan with a fixed interest rate of 1% per year. The Yen is expected to depreciate by 2% against the US$ during the six-month period following the signing of the sub-loan agreement. The terminal of Kota XYZ will be financed from a newly signed US$ loan with a variable LIBOR-based interest rate that is currently 3% per year. The interest rates on the two sub-loans are calculated as follows: Kota ABC: 1% + 5.02% - 2% = 4.02%. Kota XYZ: 3% + 5.02% = 8.02%. In this scenario, the sub-loan interest rate of Kota XYZ is almost twice as high as the interest rate payable on the sub-loan of Kota ABC. If the Ministry of Finance would have allocated the Yen loan proceeds to Kota XYZ instead, the situation would have been reversed. Source: Consultant 2 Recommended Improvements to the Existing Rate Setting Method Starting points. This section presents recommendations aimed at improving the method for setting interest rates on foreign-funded sub-loans to regional governments. All recommendations are based on two key assumptions: Rupiah sub-loans only. The Ministry of Finance will continue to disallow sub-loan agreements denominated in a currency other than Rupiah, not only because regional governments do not receive income in foreign currency, but also because regions do not have any experience with managing foreign exchange rate risks. (For the sake of clarity, it is recommended that revision to PMK83/2005 will explicitly prohibit on-lending to regional governments in a currency other than Rupiah, instead of allowing both options.) Fixed interest rate sub-loans only. Regional governments have a strong preference for loans with a fixed (as opposed to variable) interest rate, mainly because such loans do not carry interest rate risk, but also because fixed interest rates do not require revisions to budgeted interest payments. For administrative reasons, the Ministry of Finance also prefers to on-lend against fixed interest rates (among other things, this avoids the need to send updated interest payment schedules to regional governments). 7

Concept for improving the existing rate setting method. Provide a sound theoretical basis for the FOREX risk cover charge. At present, MoF imposes a relatively high surcharge on the interest rate on Rupiah sub-loans to regional governments to cover foreign exchange risk, without providing a justification of the surcharge. Redefine the composition of the surcharge. This is necessary to ensure that the rate setting method provides MoF with cover for interest rate risk. Adjust the base interest rate. It is proposed that the surcharge will apply to an average interest rate (instead of the interest rate of a specific foreign loan agreement) to eliminate interest rate differences among regional government borrowers. Theoretical basis for estimating FOREX risk cover Basis for estimating FOREX risk. As was shown in Table 3, MoF imposes a higher surcharge to the interest rate of (US$-denominated) sovereign loans than countries with comparable on-lending systems. By itself, this does not mean that the current surcharge, as defined in PMK83/2005, is unjustifiably high. It may well be that FOREX risk of the Rupiah vis-à-vis the currencies of GOI s sovereign foreign loans is inherently higher than the FOREX risks that are borne by borrowers in other countries. 5 To provide an objective estimate of MoF s actual cost of covering FOREX risks, the following two approaches were used: Historical approach. This approach assumes that the historical depreciation of the Rupiah against the major currencies of GOI s sovereign foreign loans is a good approximation of the cost of MoF s FOREX risk cover. Market-based approach. The approach seeks to identify the cost of FOREX risk cover by comparing the yields on marketable securities that are traded both in Rupiah and in a foreign currency, but are otherwise identical. Historical approach. From 1975 to 2004, the Government of Indonesia onlent about Rp 5.7 trillion to regional government borrowers (including municipal enterprises owned by regional governments). Of this amount, about Rp 3.8 trillion was financed from the proceeds of sovereign foreign loans, 63% of which from US$-denominated World Bank and ADB loans, and most of the remainder from Yen-denominated OECF loans and loans denominated in Euro or predecessor currencies (such as the German mark). 6 From to 2000 to 2010, the Rupiah has strengthened against the US Dollar (which means that MoF would have made a net exchange rate gain on Rupiah sub-loans during this period, even if it had not included a FOREX risk cover in the surcharge). However, from 2000 to 2010, the Rupiah depreciated against the Yen and the Euro (Figure 4). The weighted average depreciation of the Rupiah against the three major currencies (with weights taken from the 5 Because loan administration costs normally do not require an surcharge to the interest rate of more than 0.5% p.a., it is assumed that the of the surcharge imposed by countries other than Indonesia also mainly consists of FOREX risk cover. 6 B. Lewis, On-Lending in Indonesia: Past Performance and Future Prospects, Bulletin of Indonesian Economic Studies, 2007, vol. 43, issue 1, pages 35-58. 8

historical share in sovereign loans on-lent to regional governments) was 0.3% during the five-year period 2005-2010, and 0.6% during the ten-year period 2000-2010 (Table 4). These figures are relatively low because of the appreciation of the Rupiah against the US Dollar. However, also during 2000-2010 the average depreciation of the Rupiah against Yen and the Euro did not exceed 3% per year, which is substantially lower than the current FOREX risk cover of 4.42%. Only during the fifteen-year period of 1995-2010 was the average depreciation of the US Dollar higher than the FOREX risk cover (9.5%), but this outlier was entirely caused by the monetary crisis of 1997/98. Figure 4 EXCHANGE RATE OF RUPIAH VS. US DOLLAR, YEN AND EURO, 2000-2010 (2000 = 100) 120 100 80 60 40 20 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Consultant, based on IMF (2011) Table 4 Rp/US$ Rp/Yen Rp/Euro DEPRECIATION OF RUPIAH VS. US DOLLAR, YEN AND EURO, 1995-2010 Percent per year Currency 1995-2010 2000-2010 2005-2010 US Dollar 9.5-0.6-1.7 Yen NA 2.9 5.9 Euro NA 3.0 0.7 Weighted average* NA 0.6 0.3 Source: Consultant, based on IMF (2011) * Assumed weights: US$ 63%, Yen 27%, Euro 10% Market-based approach. In recent years, the Government of Indonesia has issued several US Dollar-denominated bonds on the international capital market. In March 2011, the yield on Rupiah-denominated Government bonds with a term of 20 years (the most common term of Rupiah sub-loans) was about 10.1%. In that month, the yield on US$-denominated Government bonds with the same term was about 6.2% (Table 5). At first sight, this implies an exchange rate risk premium of about (9.8 -/- 6.2 =) 3.6%. However, this risk premium should be seen as a maximum estimate of the FOREX risks associated to the Rupiah vis-à-vis the US Dollar, because inter- 9

national bond holders would also incorporate default risk in the yield. (From the point of view of GOI, non-repayment risk of regional governments is zero, because MoF has the right to withhold DAU and DBH transfers in case a regional government would default on its debt to the Government.) In March 2011, the rate on five-year GOI credit default swaps a proxy for the price of default risk was about 1.4%. This suggests a FOREX risk accounts for about (3.6 -/- 1.4=) 2.2% of the yield differential on 20-year GOI bonds. Table 5 YIELDS ON RUPIAH AND US$-DENOMINATED BONDS ISSUED BY THE GOVERNMENT OF INDONESIA Percent per year Term (years) Yield on Rupiah Bonds Yield on US$ Bonds Yield Differential 5 7.953 3.045 4.908 10 8.535 NA NA 15 9.437 NA NA 20 9.780 6.162 3.618 30 10.135 6.217 3.918 Source: Bloomberg (7 March 2011) Summary of basis for estimating FOREX risk. The historical approach suggests a FOREX risk cover ranging from 0.6% to at most 3.0%, assuming that MoF would not want to include the risk of a monetary crisis in the subloan interest rate. The market-based approach suggests a FOREX risk cover of about 2.2%. The average of the two approaches is (0.6 + 2.2 =) 1.4%. These estimates are both substantial lower than the 4.42% included in the surcharge regulated by PMK83/2005. It should be noted, however, that the surcharge does not provide for interest rate risk. Interest rate risk cover Description of interest rate risk. In February 2011, the six-month LIBOR rate, which is the basis for setting the interest rate on most of GOI s sovereign foreign loans, was 0.45% p.a. Five years earlier, in February 2006, the rate was 4.99% p.a. (see also Table 3). If six-month LIBOR rates will increase, as is widely expected, MoF s interest payments on sovereign foreign loans will increase, while its receipts of interest payments from regional government borrowers will remain unchanged, thereby reducing the spread on sub-loans in the MoF portfolio. This (to MoF) unfavorable development is entirely caused by the fact that the Ministry of Finance borrows at a variable interest and on-lends at a fixed rate. It is important to note that interest rate risk is unrelated to FOREX risk. MoF is also exposed to this type of risk if it would on-lend sovereign foreign loan proceeds in US Dollar. Pricing of interest rate risk. Foreign lenders usually offer loan products at variable or fixed rates. The difference between the two rates is, in effect, the price that a prospective borrower has to pay to eliminate interest rate risk. In March 2011, the World Bank charged a variable LIBOR-based interest rate on its sovereign loans of 0.87% p.a. The fixed interest rate of an otherwise identical loan with a term of 15 years would be 3.87% p.a. which implies an interest rate risk cover of (3.87 -/- 0.87=) 3.0%. Interest rate differentials on 10

sovereign ADB loans with a term of 15 years range from 1.5% on Yen loan to 3.6% on US$ loans (Table 6). MoF may consider using this publicly available information to add cover for interest rate risk to the surcharge. Table 6 VARIABLE AND FIXED RATES ON 15-YEAR SOVEREIGN ADB LOANS Percent per year ADB Loan Currency Fixed Interest Rate Variable Interest Rate Interest Rate Differential US$ 4.430 0.862 3.569 Yen 2.230 0.748 1.483 Euro 4.220 1.891 2.329 Source: ADB (11 March 2011) Application of surcharge to an average interest rate Towards the establishment of a Municipal Development Fund (MDF). As described before, as long as the surcharge is linked to the interest rate of the sovereign foreign loan from which a sub-loan is funded, regional governments will be charged different interest rates on sub-loans that are used for similar purposes. This problem can be resolved by pooling sovereign foreign loans that the Government intends to on-lend to regional governments, and use the average interest rate on these loans as the basis for setting sub-loan interest rates. This process is illustrated in Figure 5 below. Foreign sovereign loans would be pooled into a Municipal Development Fund (MDF), to be established in MoF. The fund will re-lend the proceeds at uniform sub-loan conditions to eligible regional governments. The conditions will be updated periodically to reflect changes in the average financing costs of the Fund. Figure 5 CURRENT AND PROPOSED LOAN CHANNELING ARRANGEMENTS* CURRENT Foreign Lender A Foreign Lender B Sovereign Loan (foreign currency) Sub-Loan (foreign currency or Rupiah) Government 3% 3%+SC (MoF) Government (MoF) 1% 1%+SC Regional Govt A Regional Govt B PROPOSED Ministry of Finance Foreign Lender A Foreign Lender B 3% 1% Government (MoF) Municipal Development Fund (MDF) 2%+SC 2%+SC Regional Govt A Regional Govt B Source: Consultant * SC= surcharge 11

Recommendations for improving the existing rate setting method #1 Reduce the FOREX risk cover included in the surcharge from 4.42% to 1.4%. This estimate is the unweighted average of the average depreciation of the Rupiah against a basket of three major currencies (0.6%) and the yield differential, corrected for default risk, on 20-year Government bonds denominated in US Dollar and Rupiah (2.2%). The same surcharge will apply to all sub-loans, irrespective of the currency in which the underlying sovereign loan is denominated. #2 Include a cover for interest rate risk in the surcharge. The websites of ADB, the World Bank and other foreign lenders present regularly updated quotes for variable and fixed interest rates on sovereign loans. The interest rate differential should be added to the surcharge. #3 Apply the surcharge to the average interest rate on sovereign foreign loans, not to the interest rate of an individual loan. This recommendation is made to prevent potentially large differences between sub-loan interest rates charged to regional governments. Box 3 PROPOSED RATE SETTING METHOD (EXAMPLE) Kota ABC and Kota XYZ each want to borrow Rp 10 billion to build a Class A bus terminal. The Ministry of Finance approves both sub-loan proposals. Both terminals will be financed by the Municipal Development Fund in MoF, which currently charges an interest rate of 2% per year, plus a standard surcharge. The surcharge covers bank fees and administration costs (0.6%), a FOREX risk cover (1.4%), and an interest rate risk cover (currently estimated at 3%). The interest rates on the two sub-loans are calculated as follows: Kota ABC: 2.0% + 0.6% + 1.4% + 3.0% = 7.0%. Kota XYZ: 2.0% + 0.6% + 1.4% + 3.0% = 7.0%. Source: Consultant 12

APPENDIX Powerpoint Presentation PMK 83/2005 tentang Tambahan Tingkat Suku Bunga Review and Recommendations 13

Agenda 1. Overview of PMK83/2005 2. Review of PMK83/2005 3. Recommendations for Improvement 14

1. Overview of PMK83/2005 On-Lending of Foreign Loans to the Regions Sovereign Loan (foreign currency) Sub-Loan (foreign currency OR Rupiah) Foreign Lender Government of Indonesia (MoF) Regional Government Interest rate: X% Interest rate: X% + SURCHARGE 15

1. Overview of PMK83/2005 Surcharges CURRENCY OF SOVEREIGN LOAN CURRENCY OF SUB-LOAN Same as Sovereign Loan Rupiah US Dollar 0.5% 5.02% Other foreign currency 0.5% 5.02% adjusted for six-month forward rate (but > 0.35%) Surcharge of 5.02% = FOREX Cover (4.42%) + Charges (0.60%) 16

2. Review of PMK83/2005 Key Issues 1. No theoretical basis for surcharge of 5.02% 2. No correct adjustment of 5.02% (adjustment needed if foreign loan not in US$) 3. No cover for interest rate risk 4. No equal treatment of regional govt borrowers 17

2. Review of PMK83/2005 Issue #1: No Theoretical Basis for 5.02% Why is theoretical basis necessary? - To know if MoF has sufficient risk cover - To explain rate to regional govt borrowers Comparison with surcharges of other countries: - Indonesia now: 5.02% - Indonesia before krismon: 3.0% - Selected other countries: 1.7%-3.5% 18

2. Review of PMK83/2005 Issue #2: No Correct Adjustment of 5.02% Inconsistency between - Sub-loan term: 15-20 years - Swap-premium or discount: based on 6-month forward rate 19

2. Review of PMK83/2005 Issue #3: No Cover for Interest Rate Risk Sovereign Loan (foreign currency) Sub-Loan (foreign currency OR Rupiah) Foreign Lender Government of Indonesia (MoF) Regional Government VARIABLE interest rate (based on LIBOR, will change) FIXED interest rate (will NOT change) 20

2. Review of PMK83/2005 Issue #3: No Cover for Interest Rate Risk (cont'd) LIBOR rates will increase, sub-loan rates won't 6% 5% 4% 3% 2% 1% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 21

2. Review of PMK83/2005 Issue #4: No Equal Treatment of RG Borrower Kota A Kota B Project Funds needed Financed by Terminal Rp 10M ADB Terminal Rp 10M JBIC Interest on Foreign Loan 3.00% Base surcharge 5.02% Swap discount - 1.00% 5.02% -1.00% Interest rate 8.02% 4.02% 22

3. Recommendations Starting Points Key assumptions 1. On-lending in Rupiah only 2. On-lending at fixed interest rates only Because - Regional government have no revenue in FOREX - Regional governments prefer fixed rates - Fixed rate sub-loans easier to administer by MoF 23

3. Recommendations #1: Reduce FOREX Cover from 4.42% to 1.4% Proposed cover is unweighted average of: 1. Historical depreciation of Rupiah vis-a-vis USD/Euro/Yen from 2000-2010 (0.6%) AND 2. Yield differential between Rp and USD, corrected for default risk (2.2%) 24

3. Recommendations #1: Reduce FOREX Cover from 4.42% to 1.4% (31 December 2000 = 100) 25

3. Recommendations #2: Include cover for interest rate risk in surcharge Example: rate differential for 15-year ADB loans ADB Loan Currency Fixed Interest Rate Variable Interest Rate Interest Rate Differential US Dollar 4.430 0.862 3.569 Yen 2.230 0.748 1.483 Euro 4.220 1.891 2.329 - Cover depends on currency, easily available from websites of major foreign lenders 26

3. Recommendations #3: Apply the same average rate to all borrowers Towards a Municipal Development Fund (MDF) CURRENT Sovereign Loan (foreign currency) Sub-Loan (foreign currency or Rupiah) Foreign Lender A Foreign Lender B Government 3% 3%+SC (MoF) Government (MoF) 1% 1%+SC Regional Govt A Regional Govt B PROPOSED Ministry of Finance Foreign Lender A Foreign Lender B 3% 1% Government (MoF) Municipal Development Fund (MDF) 2%+SC 2%+SC Regional Govt A Regional Govt B 27

Terima Kasih! 28

PMK 83/2005 Tentang Tambahan Tingkat Suku Bunga Kajian dan Rekomendasi

Agenda 1. Sekilas PMK83/2005 2. Kajian Mengenai PMK83/2005 3. Rekomendasi untuk Penyempurnaan

1. Sekilas PMK83/2005 On-Lending Pinjaman Luar Negeri yang Diteruskan ke Daerah Sovereign Loan (mata uang asing) Pinjaman yang Diteruskan (mata uang asing atau Rupiah) Pemberi Pinjaman Luar Negeri Pemerintah RI (Kemenkeu) Pemerintah Daerah Tingkat Suku Bunga: X% Tingkat Suku Bunga: X% + Tambahan (Surcharge)

1. Sekilas PMK83/2005 Tambahan (Surcharges) KURS SOVEREIGN LOAN Kurs Pinjaman yang Diteruskan Sama dengan Sovereign Loan Rupiah US Dollar 0,5% 5,02% Mata uang asing lainnya 0,5% 5,02% disesuaikan untuk tingkat suku bunga 6 bulan kedepan (tapi > 0,35%) Tambahan 5,02% = FOREX Cover (4,42%) + Biaya lain (0,60%)

2. Kajian Mengenai PMK83/2005 Isu-isu Utama 1. Tidak ada landasan teoritis untuk pengenaan tambahan 5,02% 2. Tidak ada penyesuaian yang benar dari 5,02% (perlu dilakukan penyesuaian jika pinjaman luar negeri tidak dalam US$) 3. Risiko tingkat suku bunga tidak di cover 4. Tidak diberikan perlakuan yang sama bagi peminjam dari kalangan pemerintah daerah

2. Kajian Mengenai PMK83/2005 Isu #1: Tidak ada landasan teoritis untuk pengenaan tambahan 5,02% Mengapa diperlukan landasan teoritis? - Untuk mengetahui apakah Kemenkeu sudah mempersiapkan risk cover yang cukup - Untuk menjelaskan tingkat suku bunga ke pemerintah daerah Perbandingan tambahan negara lain: - Indonesia saat ini: 5,02% - Indonesia sebelum krismon : 3,0% - Negara-negara lain: 1,7%-3,5%

2. Kajian Mengenai PMK83/2005 Isu #2: Tidak ada penyesuaian yang benar dari 5,02% Inkonsistensi antara - Periode pinjaman yang diteruskan: 15-20 tahun - Premium-Swap atau diskon: berdasarkan tingkat suku bunga 6-bulan kedepan

2. Kajian Mengenai PMK83/2005 Isu #3: Risiko tingkat suku bunga tidak di cover Sovereign Loan (mata uang asing) Pinjaman yang Diteruskan (mata uang asing atau Rupiah) Pemberi Pinjaman Luar Negeri Pemerintah RI (Kemenkeu) Pemerintah Daerah Tingkat Suku Bunga VARIABEL (berdasarkan LIBOR, akan berubah) Tingkat Suku Bunga FIXED (TIDAK akan berubah)

2. Kajian Mengenai PMK83/2005 Isu #3: Risiko tingkat suku bunga tidak di cover (lanjutan) Tingkat LIBOR akan meningkat, sementara tingkat pinjaman yang diteruskan tidak 6% 5% 4% 3% 2% 1% 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2. Kajian mengenai PMK83/2005 Isu #4: Tidak diberikan perlakuan yang sama bagi peminjam dari kalangan pemerintah daerah Proyek Kebutuhan Dana Dibiayai oleh Kota A Terminal Rp 10M ADB Kota B Terminal Rp 10M JBIC Suku bunga pinjaman luar negeri 3,00% 1,00% Tambahan dasar 5,02% Discount Swap - Tingkat Suku Bunga 8,02% 5,02% -1,00% 4,02%

3. Rekomendasi Titik Awal Asumsi-asumsi Utama 1. On-lending dalam mata uang Rupiah saja 2. On-lending pada tingkat suku bunga fixed saja Karena - Pemerintah daerah tidak memiliki pendapatan dalam bentuk mata uang asing - Pemerintah daerah lebih memilih tingkat suku bunga fixed - Pinjaman yang diteruskan dengan tingkat suku bunga fixed lebih mudah untuk dikelola oleh Kemenkeu

3. Rekomendasi #1: Kurangi FOREX Cover dari 4,42% menjadi 1,4% Cover yang diusulkan adalah rata-rata tak tertimbang dari: 1. Depresasi historis Rupiah vis-à-vis USD/Euro/Yen tahun 2000-2010 (0,6%) 2. Yield differential antara Rp dan USD, dikoreksi untuk default risk (2,2%) DAN

3. Rekomendasi #1: Kurangi FOREX Cover dari 4,42% menjadi 1,4% (31 Desember 2000 = 100)

3. Rekomendasi #2: Tambahkan risk cover untuk risiko tingkat suku bunga kedalam tambahan nilai Contoh: Selisih tingkat suku bunga untuk pinjaman 15-tahun dari ADB Mata uang pinjaman ADB Tingkat Suku Bunga Fixed Tingkat Suku Bunga Variabel Selisih Tingkat Suku Bunga US Dollar 4,430 0,862 3,569 Yen 2,230 0,748 1,483 Euro 4,220 1,891 2,329 - Besarnya cover tergantung pada mata uang, informasi tersebut tersedia di situs-situs pemberi pinjaman luar negeri utama

3. Rekomendasi #3: Kenakan tingkat suku bunga rata-rata yang sama kepada semua peminjam Menuju Municipal Development Fund (MDF) CURRENT Foreign Lender A Foreign Lender B Sovereign Loan (foreign currency) Sub-Loan (foreign currency or Rupiah) Government 3% 3%+SC (MoF) Government (MoF) 1% 1%+SC Regional Govt A Regional Govt B PROPOSED Ministry of Finance Foreign Lender A Foreign Lender B 3% 1% Government (MoF) Municipal Development Fund (MDF) 2%+SC 2%+SC Regional Govt A Regional Govt B

Terima Kasih!