Challenges of Development Financing

May 30, 2017

By M Ikhsan Modjo, UNDP Indonesia Technical Advisor for Innovative Financing

One of the main challenges in development in Indonesia today is finding a source of relatively cheap and sustainable development financing. This challenge is not easy given the large amount of financing required and the increasingly high level of competition between countries in obtaining low-cost investment funds.

The amount needed for development funding is significant, for example, financing need for infrastructure development during 2015-2019 amounted to Rp 5,519.4 trillion, or no less than Rp 1,103.9 trillion per year. In addition to infrastructure, Indonesia also needs other funding, both routine for public administration and to improve people's welfare, such as social spending and subsidies.

In the 2017 state budget, the amount of funds allocated for infrastructure is Rp 194.3 trillion. The allocation for public administration, both for employee expenditure and purchases of goods is Rp 639 trillion. While the allocation of social spending and subsidies is the lowest, around Rp 170 trillion, which means less than half of the Rp 400 trillion allocated in 2014.

Infrastructure funding

Based on the above estimates, three important aspects may be observed. First, the amount that the state can afford to allocate for infrastructure is much lower than the needs. The government is only able to provide 17.6 percent of the needs.  Second, there is an increase in funding needs for routine state administration. Third, there is a lower allocation for social spending and subsidies in the state budget.

The implications of the above observations are clear in that significant additional funding is needed to meet the funding needs of infrastructure development. These funds can theoretically be obtained either by increasing financing through budget deficit, or from other sources of financing originating from private sector, both domestic and overseas.

The problem is, in practice this is not easy because there are several obstacles.

First, development financing by increasing the budget deficit will add destabilization effect to the state budget which has not been completely free from pressure. In 2016, Indonesia recorded a 2.46 percent budget deficit on gross domestic product (GDP). This figure, though lower than the realization of the 2015 budget deficit of 2.80 percent of GDP, is still slightly higher than the target deficit of 2.35 percent  .

The greater deficit realization indicates that the full state revenue target has not been fully met, especially from the taxation sector. The tax amnesty policy that is expected to bridge the gap of tax revenue in 2016 only generates state revenues from a tax penalty of Rp 135 trillion, short of the target of Rp 165 trillion.

Furthermore, this policy has also been unsuccessful in increasing the number of tax bases, as it only generates about 48,000 new taxpayers, or an additional 0.49 percent of the previous tax base of 9.7 million.

It is certain that this policy will not be sustainable to increase state revenues in the years ahead, which will in turn push for a higher budget deficit.

Second, financing through the state budget also risks raising Indonesia's debt ratio with all its consequences. Indonesia has indeed just received an investment grade from Standard & Poor's, which will lower the interest cost of bonds to be issued. On the other hand, Indonesia has also experienced a relatively sharp increase of debt to GDP ratio in recent years.

In 2012, the debt to GDP ratio was only 22.9 percent. In 2017, it increased sharply to 27.9 percent, or increased by 0.5 percent with total accumulated debt reaching Rp 3.589 trillion. This ratio is still below the 60 percent figure that is considered safe both theoretically and according to the law.

But there is an accelerated increase in debt that will affect domestic liquidity. This amount of debt does not include indirect debt of state owned enterprises (SOEs), which has also increased in the past two or three years.

Third, the acceleration of debt growth will tighten domestic liquidity, which will also directly add pressure to the domestic money market. Currently Indonesia's financial sector stability is being tested by increasing market volatility and weakening banking asset quality.

The tight liquidity and weakening banking asset quality can be observed, for example, from the continued decline of third party funds in banks whose growth has fallen from a range above 20 percent per year to only 5-6 percent, as well as from non-performing loans (NPL), which steadily climbs from an average range of 1 percent to above 3 percent.

Additional pressure on the financial markets will further impact the stability of the financial sector, which through its transmission effects will drive up inflation and interest rates. Thus not only financial stability will be disrupted, but the decrease in interest rates that is generated by the investment grade will be neutralized.

Fourth, in relation to the above, financing through the deficit increase will also lead to "Ricardian effect" in the form of substitution of the current level of consumption with savings. This substitution is done by consumers who anticipate the need to increase state revenues in the future to cover the current increase of debt. Unless the government can ensure that the use of debt issued will be very effective, intertemporal substitution on consumption will suppress the rate of economic growth.

Social finance mobilization

Therefore, development financing by increasing the budget deficit is not a smart way to cover the existing funding needs. Another way that is more plausible is to intensify cooperation with the private sector, both domestic and abroad.

Unfortunately, from existing investment data, the rate of capital formation and investment in Indonesia has not been very encouraging, despite various improvements through policy packages and deregulation by the government. By the end of 2016, the growth rate of fixed capital formation was still below the 5 percent range, or only about half of the growth rate before 2011.

It could be because it takes time before the effect shows, which is usually 3-4 years following policy adoption. However, it could also be due to the lack of private sector investment and inadequate platform that can bring together those who have capital with those who need capital.

One potential increase in private sector investment is through the social finance platform, which has not  been optimally developed in Indonesia. Social finance is an approach to mobilize private capital that delivers not only economic, but also social and environmental benefits.

Mobilizing private capital through social finance creates an opportunity for investors to access new sources of funding for projects that generate profits and social impact. The potential of social financial investment can be seen from the accumulation of mobilized funds in the last two years totaling no less than Rp 105 trillion (UNDP 2016, Overview of Social Finance in Indonesia).

Several institutions, such as UNDP Indonesia, are currently promoting social finance in collaboration with the Financial Services Authority and several investors under Angel Investor Indonesia. The government can accelerate this sector by providing flexibility in regulation and regulatory incentives.

In addition to social finance, the government can also utilize several other funds that are available, especially if there are common goals, especially in the social and humanitarian field.

At this point, efforts to channel zakat funds for sustainable humanitarian development programs pursued by the National Zakat Agency (Baznas) in collaboration with UNDP deserve more support and encouragement. Of course, there are challenges in using religious funds like zakat for sustainable development purposes. However, they can be bridged through proper understanding and harmonization with the existing religious rules (sharia), as well as transparency and oversight.

As published on Kompas newspaper, 27 May 2017