A review of the method for setting interest rates on foreign-funded sub-loans to the regions : building capacity for the development of sub-national government capital market for municipal bonds

 68437 A Review of the Method for Setting Interest Rates on Foreign-Funded Sub-Loans to the Regions 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 sub- loan 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 FOREX Risk Interest Rate Total Country Borne by Based on 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. Final Report (April 2011) i  A Review of the Method for Setting Interest Rates on Foreign-Funded Sub-Loans to the Regions 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 sub- loan 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 Sovereign Loan Sub-Loan (foreign currency) (foreign currency or Rupiah) Foreign Government Regional 3% 3%+SC Lender Lender A (MoF) Govt A Government (MoF) Foreign Regional 1% 1%+SC Lender Lender B Govt B PROPOSED Ministry of Finance Foreign Government Regional 3% 2%+SC Lender Lender A (MoF) Govt A Municipal Development Fund (MDF) Foreign Regional 1% 2%+SC Lender Lender B Govt B * SC= surcharge Final Report (April 2011) 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 long- term borrowing for public infrastructure by regional governments, the Government of Indonesia (GOI) has recently revised Government Regulation 1 54 of 2005 on regional borrowing (PP54/2005). 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