Sub-National Financial Management and Accountability Reforms Experience from Indonesia Asmeen Khan & Rajiv Sondhi

Presentation Roadmap Key features of decentralization in Indonesia –Regulatory Developments and Framework –Country Profile Defining the Country ’ s FM Reform Agenda Moving from National to Sub-national levels Some Outstanding Issues at Sub National level The Challenges of Transition The Bank ’ s approach and response

Key Features of Decentralization Fundamental and simultaneous transitions – political, economic, fiscal, administrative. Far reaching impact. ‘ Big Bang ’ Fiscal Decentralization 2001: Laws 22 and 25 in 1999 on Decentralization and Fiscal relations and Law 34 on Regional Taxes in 2000 Expenditure responsibilities for public service delivery decentralized to localities Laws revised 2004: Some political claw-back. E.g. Ministry of Home Affairs must approve provincial budgets (ex-ante) Raises some very fundamental issues on administrative capacity, fiduciary management and accountability.

Country Profile The Story so far …. 32% of overall country ’ s total budget is SN expenditures. There has been a substantial decline in overall development spending, despite fiscal consolidation at the centre. Development budgets remain scattered between the Centre (about half), provinces (14%) and Local Govts. 440 local governments *, average budget of $32.8 million each, population of 470,000, on average spend 34% of budget on development expenditures. Local Govts. remain highly dependent on fiscal transfers from centre. IG system of fiscal transfers is based on equalizing grant (DAU), shared revenues and taxes and capital grant. Degree of inequality between regions and provinces is staggering. Domestic borrowing limited, foreign borrowing needs approval by Ministry of Finance (borrowing less than one half of one percent of GDP) Own source revenues limited but have doubled in past 4 years ! Data show trend of budget surplus in local governments. * Kabupaten, Kota

High Dependency on IG transfers Structure of Local Govt. Revenues

Large increase in level of expenditure Majority of spending goes to staff

Poor budget forecasting Significant increase in surplus and reserves as percentage of total expenditure— 16 percent for all sub-national governments (1.2 percent of GDP);

The Country’s PFM Reform Journey Bank diagnostic work ( PER 2000, CFAA & CPAR 2001-SN FM assessment 2003); on-going policy dialogue. The National Reform Agenda gets set –White Paper issued by Govt –New Laws on State Finance, Treasury and Audit (2003, 2004). Implementing regulations being issued in stages. –Budgeting reforms – performance budgeting, GFS, Accounting Standards. –Modernization of Ministry of Finance –GFMRAP Project to lock in reforms, treasury automation –Audit sector reform recently commenced. Changing practices may be a bigger challenge, as law enforcement is endemically weak.

Moving Reforms to the Districts The challenge is local, as districts move centre-stage Political Issues Evidence of elite capture Limited local information Some participation in local decision making Administrative Issues Inconsistent legal framework Proliferation of regional governments Limited authority over local civil service PFM systems improving, gradually. Weak local capacity Institutional Issues Pressing need for institutional reforms to support increased responsibilities: –To improve investment climate –To strengthen governance –To improve service delivery Huge variation in regional needs, capacity and performance Fiscal Transfers Formula-based DAU, though limited equalization Shared taxes fluctuate and create inequality Development Impact

The Financial Management and Accountability Beehive Some Outstanding Issues at Local Level Budget Execution Planning & Budgeting Accounting Reporting External Audit Oversight Public Debt and Asset Management Regulatory Framework

Some Outstanding Issues - Regulatory Framework Budget Execution Planning & Budgeting Accounting Reporting External Audit Oversight Regulatory Framework Regulatory Framework Legal architecture - Inter Government fiscal relations Public Debt and Asset Management Key National Laws on PFM passed - but many implementing regulations are yet to come out. Implementation handicapped. Central Regulations are PFM Regulations; links between sectors and between plans and fiscal budgets not well laid out. Regulatory authorities unclear – between MOF and Home Affairs; Conflicts in some regulations. Regions not always clear on what their legislative authority is. Few districts have appropriate and comprehensive local legislation or institutional arrangements in place for FM Although modernized Procurement decree issued (2003), there is no procurement law. Law enforcement continues to be a major concern. Limited public consultation on draft local laws or budget process-though required by law

Some Outstanding Issues – Planning and Budgeting Five year plan lacks targets, priorities or hard budget constraint Many bank accounts for technical departments, not all revenue reported Though communities participate in planning activities — disconnect between plans and budgets Budget realization varies from %, budgets amended at least once a year, Region ’ s own revenues exceed targets Some districts use different expenditure classifications not consistent with GFS classification - difficult to account for costs. Districts starting to use performance based budgeting – can ’ t distinguish salaries versus goods and services Budget Execution Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting External Audit Oversight Regulatory Framework Legal architecture - Inter Government fiscal relations Public Debt and Asset Management

Some Outstanding Issues – Budget Execution Weak cash management – inefficiency from idle funds and pilferage risks;no cash forecasting; Local revenues collection – arbitrary basis for setting levies, fees, resulting in random and nuisance taxes; no analysis of revenue potential;poor revenue forecasting. Procurement – weak capacity;collusive practices endemic.No transparency. Outdated administrative procedures weaken internal controls. Internal audit agencies at regional and provincial levels cover about 5% of budget, not professionally staffed, seen as punishment posting. Weaknesses in internal controls over local cash collections Multiple bank accounts, frequently not reconciled to accounting records. Budget Execution Procurement Treasury Mgmt Internal Controls Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting External Audit Oversight Regulatory Framework Legal architecture - Inter Government fiscal relations Public Debt and Asset Management

Some Outstanding Issues – Accounting, Reporting Cash basis and single entry accounting. Confusion over accounting standards due to inconsistency between MOF and Home Affairs guidelines Very weak capacity that do not allow move to improved accounting practices and accrual accounting Reporting restricted to Budget realization reports. Timeliness of reporting improving, now legally required within 4 months of year end. But reliability? Budget Execution Procurement Treasury Mgmt Internal Controls Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting Standards Timeliness Reliability External Audit Oversight Regulatory Framework - Legal architecture - Inter Government fiscal relations Public Debt and Asset Management

Some Outstanding Issues – External Audit Supreme Audit Institution (BPK) is able to cover only 50% of sub-national governments. Audit Reports not yet publicly disclosed. Audit mandate primarily to certify Budget Realization Reports of governments. Performance audits not yet developed. Budget Execution Procurement Treasury Mgmt Internal Controls Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting Standards Timeliness Reliability Regulatory Framework - Legal architecture - Inter Government fiscal relations External Audit Oversight Public Debt and Asset Management

Some Outstanding Issues – Oversight Limited capacity of Local Legislatures to review budgets or review performance Public disclosure of financial and procurement virtually non-existent. Budget documents difficult to read and accessible. Civil Society and slow slowly flexing their power Oversight Budget Execution Procurement Treasury Mgmt Internal Controls Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting Standards Timeliness Reliability External Audit Regulatory Framework - Legal architecture - Inter Government fiscal relations Public Debt and Asset Management

Some Outstanding Issues – Public Debt and Asset Management No consolidated information on regional public assets; Local Public debt requires central (MOF) approval. Municipal debt market very nascent Few formal records on local public debt Oversight Budget Execution Procurement Treasury Mgmt Internal Controls Planning & Budgeting Comprehensiveness Classification Projection Accounting Reporting Standards Timeliness Reliability External Audit Regulatory Framework - Legal architecture - Inter Government fiscal relations Public Debt and Asset Management

PFM Reforms Critical Success Factors (i) Commitment to reform; Supply side vs Demand side - Stimulating the demand for reforms. Role of civil society, media and donors. Change champions. (ii) Identification of functional reform priorities; thinking small. Which end of cycle to start? Synchronizing with central reforms. (iii) Adequacy of the roll-out plan and the sequencing of reforms; clearly defining benchmarks and milestones;modular approach. Should reform of budget preparation precede or follow budget execution reforms? (iv) Adequacy of technical solution; use of technology, aligned with institutional reforms. But change in business processes bigger challenge. (v) Adequacy of capacity building activities; capacity to absorb and then sustain reforms. (vi) Realism of short, medium, and long-term cost estimates.

How the Bank has responded in Indonesia: challenges and opportunities Challenge: How to reorganize and work with 400 plus SNGs with weak capacity, and unfamiliar with the Bank, poor fiduciary environment and incomplete decentralization policy framework Strategic organization Indonesia CAS FY , cross-cutting focus on SNGs through “multi-sector” local government platform group-estimated lending $ million over current CAS Coordinated policy advice dialogue and analysis through dedicated decentralization team Capacity Building Coordinated capacity building program through WBI and partnership with other donors (DFID, Dutch)

Approach and Response Continue to consolidate National reform. GFMRAP – APL to lock in reforms at National Level Sub-national Lens on Country Diagnostic Work Regional PER to provide sub-national component Cross-sectoral Reform Loans Series of sub-national local governance reform projects with “reform minded” districts and cities targeting capacity building, TA in procurement, FM, budget transparency and accountability, and improving local investment climate Sectoral projects which build in governance reform at local institutions (e.g. Water Utilities, Higher Education Institutes) PFM Measurement Toolkit under development

Sub National Measurement Framework for Good Financial Governance Measurement framework and toolkit under development Toolkit measure integrity of processes at each stage of PFM spectrum Design will provide ‘Snapshot’ and ‘Trajectory’ Scorecard PFM Toolkit will embed PFM outcomes in a wider sectoral context Key Outcomes Public Service Delivery Reduced Corruption Effective Governance Structures and Processes Good Financial Governance Budget Formulation External Audit Oversight Budget Execution Accounting Reporting

Thank you!