Public Financial Management in a Decentralized Context

1. Public Financial Management in a Decentralized Context Materials at : http://www-wbweb.worldbank.org/prem/premcompass/know_learn/psgo.htm

2. Public Financial Management in a Decentralized Context Common themes faced by local governments in Indonesia and Peru

3. Overview • Key features of decentralization in Indonesia and Peru • What’s wrong with local financial management ? • Cleaning up procurement ? • Concerns on Transparency and Accountability • Falling into bad habits-local level debt in Peru.. • How has the Bank responded—some challenges and opportunities

4. Indonesia Facts & Figures • Big Bang 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)

5. Indonesia Facts & Figures • 32% of overall budget is SN expenditures • 440 local governments, average budget of $32.8 million, population of 470,000, on average spend 34% of budget on development expenditures • IG system of fiscal transfers is based on equalizing grant (DAU), shared revenues and taxes and capital grant • 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

6. Indonesia Sub-nationals at a glance 1999-2002 Majority of spending goes to staff Dependency on IG transfer Poor budget forecasting No incentives to pay back

7. Peru Facts & Figures • Elected regional governments, 2002 • Two guiding principles in the Basic Law of Decentralization 2002: Fiscal Neutrality and Phased-In Decentralization • Safeguards to protect fiscal responsibility and hard budget constraints • Major weaknesses: labor, procurement, accounting, budgeting, M&E and financial management.

8. Peru Facts & Figures • 14 % (2002); 25 % (2003); 23% (2004) of overall budget is SN expenditures • 1800 highly unequal local governments • 25 regional governments with no tax revenues of their own • Peru has no horizontal equalization or compensation policy • Domestic borrowing limited according to standard indicators of borrowing capacity.

9. Peru Sub-nationals at a glance 1999-2004 Municipalities: Transfers/Income Ratio Regional: Transfers/Income Ratio, 2003-2004 Regional Revenues, 1999-2002

10. What’s wrong with local financial management (LFM)?Indonesia FM diagnostic survey of selected local governments show some common problems.

11. LFM Issues- Indonesia • 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 80-95%, budgets amended at least once a year, own revenues exceed targets • Some districts use different expenditure classifications not consistent with GFS classification - difficult to account for costs • Districts use multiple bank accounts for different sources of revenue • Districts starting to use performance based budgeting – can’t distinguish salaries versus goods and services

12. LFM Issues- Indonesia • Institutional and Legal • Few districts have appropriate and comprehensive local legislation or institutional arrangements in place for FM • Budget Execution and Monitoring • Lengthy bureaucratic process—many steps for disbursement of funds • Do not make monthly or quarterly cash forecasts—resulting in delays in payments • No verification of revenues collected • Because of multiple accounts - don’t know their cash position

13. LFM Issues-Indonesia Revenue and Asset Management • Lots of random and nuisance taxes-limited transparency • Revenue forecasts based on previous year with % increase • No analysis of revenue potential • No consolidated information on regional assets, lack national guidelines and legislation • Not all revenues reported Debt and Contingent Liabilities • Few formal records on debt -usually for local water company • No procedures for monitoring contingent liabilities

14. LFM issues-Indonesia Internal and External Audit • Internal auditor limited capacity and skills-only reports to executive, covers 5% of budget at most • Confusion over institutional roles in internal and external audits: five agencies involved (district, province and 2 national agencies as internal auditors plus a national external auditor) Accounting and Reporting • Accounting all cash based and on single entry basis • Confusion over accounting standards because of Home Affairs guidelines not entirely consistent with Govt. Account Standards. • Accounting classification inconsistent with central guidelines. • Weaknesses in internal controls over regional treasury operations.

15. LFM Issues - Indonesia Legislative Oversight • Legislature limited capacity to review draft budget or review performance Human Resources and Capacity • Lack of adequate staff—limited analytical ability • No requirement for certification

16. LFM Issues - Peru Institutional and legal • All levels of Government required to follow standard accounting and reporting practices on the basis of Integrated Financial Management System (SIAF). • By now all regional governments and more than 900 municipalities have basic SIAF modules installed.

17. LFM Issues -Peru Planning and Budgeting • Though communities participate in planning and budgeting activities—disconnect between plans and budgets or between budgets and available resources • Budgets often ignore prior liabilities • Budgets follow “functional-institutional” classification, with specification of projects that are funded through earmarked transfers.

18. LFM Issues- Peru Budget Execution and Monitoring • High level of discretion for treasury (disbursement) decisions at regional and local levels • Delays in payments are frequent • Floating debt accumulates from year to year • Local governments often resort to banking system for tax revenue payments and short term (liquidity) borrowing

19. LFM Issues - Peru Revenue and Asset Management • High level of discretion for treasury (disbursement) decisions at regional and local levels • Proliferation of random and nuisance fees at local level • Revenue forecasts based on previous year with % increase • No analysis of revenue potential • Inventory of public assets is being completed.

20. LFM Issues - Peru Debt and Contingent Liabilities • High level of discretion for treasury (disbursement) decisions at regional and local levels • Few formal records on debt • Unregistered/unprovisioned debt are common practices • No procedures for monitoring floating or contingent liabilities • Lack of standardized accounting practices weakens debt indicators contained in Fiscal Responsibility and Fiscal Decentralization Laws

21. LFM Issues - Peru • Internal and External Audit • Weak internal controls. Local council is subservient to the mayor. City managers are in weak position; • External auditor (Contraloría) limited capacity, low (and late) coverage of subnational governments; • Accounting and Reporting • Accounting is generally cash based; • Advances with standardized rules and reporting to the Contaduría (Gen. Accounting Office); • Weaknesses in internal controls over regional treasury operations.

22. LFM Issues - Peru • Legislative or Central Executive Oversight • No oversight by Legislature • M&E system being established at Ministry of Finance. Will take 2-3 years before it applies to SN • Human Resources and Capacity • Lack of adequate staff—limited analytical ability • Labor laws over-protect stability, thereby forcing subnational governments to duplicate payroll • Certification requirements will be applied shortly.

23. Cleaning Up Procurement! Common Problems in Indonesia Institutions weak not familiar with national procurement laws and processes: • Don’t use standard bidding documents • No mechanism to handle procurement complaints • Disclosure limited • Limited staff capacity and not certified in procurement Commonly seen deficiencies: • Pre-qualification of contractors (have to belong to a local business association-leads to bid fixing and collusion) • Lack of public disclosure on the process • Use of restricted bidders (based on locality) • Delays and lack of timeliness in contracting • Direct contracting-limited tendering, often use local district agencies rather than third-party

24. Cleaning Up Procurement! Common Problems in Peru Institutions weak not familiar with national procurement laws and processes: • Don’t use standard bidding documents • No mechanism to handle procurement complaints • Disclosure limited • Limited staff capacity and not certified in procurement Main deficiencies in implementing procurement law appear to be due to: • Lack of public disclosure on the process • Use of restricted bidders (based on locality) • Weak linkages between procurement commitments, liabilities, budget provisions, actual disbursements and medium term fiscal planning • Poor enforcement and sanctioning mechanisms • Providers and contractors protect themselves from arrears and non-payments through over-pricing and multiple contracting with one administration • Direct contracting-limited tendering, often use local district agencies.

25. Transparency and Accountability Concerns - Indonesia • Local Budget allocation decisions not transparency—though in theory have bottom-up planning process • Budget documents difficult to read and usually not accessible • Limited public consultation on draft local laws or budget process-though required by law • Limited information on how local government expenditures or performance rates with others i.e. benchmarking of service • Limited transparency on procurement and audit findings • District heads prepare annual accountability speech for parliament—needs to be accepted for budget to be approved • Villages receive limited funds for small infrastructure projects—though increasingly LGs decentralizing % of budget to village and sub-district for local planning and execution of infra projects

26. Transparency and Accountability Concerns - Peru • Budget documents difficult to read and usually not accessible • Frustration with participatory planning and budgeting • Limited use of naming and blaming. Central Government Fiscal M&E system is just being introduced • Limited transparency on procurement and audit findings • Contaduría Pública gives clearance for budget execution, yet it is just now in the process of strengthening accounting and control mechanisms • New legal requirements for medium term fiscal targets are just being regulated

27. Falling into bad habits: local level debt in Peru ! • Debt stock figures show a significant increase during the last 5 years. • Preliminary research suggests that unregistered debt is significant. • Debt is highly concentrated. (40% of total debt is explained by 20 municipalities out of 1829). • The debt/income ratios suggest that most of these municipalities may have structural problems. • A significant number of municipalities do not comply with Fiscal Responsibility and Transparency Law numeric rules. • A high share of liabilities is related to labor debt, however the netwage bill is always disbursed. • The structure of the liabilities in the balance reflects a great increase in long term debt. • 67.3% of the debt is under current liabilities. • Contingent and floating debt represent 13% of total registered debt.

28. Local level debt in Peru - DIAGNOSIS • Growing and highly concentrated municipal debt. Negative externalities affect service delivery. • High portion of liabilities associated with labor debt. Link with management – lack of liquidity difficult reforms. • Government needs to redesign fiscal rules. A more extensive set of indicators are needed to fully identify the sustainability of municipalities. • Debt recording has to be strengthen. The introduction of SIAF-GL is going to solve only part of the problem. • Field visits show evidence of links between debt problems, management, legal framework, civil service regime, transparency issues, political cycle, weak capacity to enforce laws, low capacity to generate revenues.

29. Local level debt in Peru

30. Local level debt in Peru-Recommendations • Differentiated treatment • Separate the stock from the flows • Joint plan of administrative controls, institutional reinforcement, revenue goals, primary results and repayment schedule. • Voluntary adjustment – Incentives. • Pilot plan – Set a good example.

31. How the Bank has responded in Indonesia: challenges and opportunities Challenge How to reorganize and work with 400 plus SNGs with weak capacity, unfamiliar with the Bank, poor fiduciary environment and incomplete decentralization policy framework Strategic organization • Indonesia CAS FY2004-2007, cross-cutting focus on SNGs through “multi-sector” local government platform group-estimated lending $400-600 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)

32. Indonesia: Responses and Opportunities Sub-national Lens on Country Diagnostic Work • Country Diagnostic • PER, CFAA, CPAR include 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 • Series of sectoral projects which build in governance reform at local level

33. How the Bank has responded in Peru: challenges Challenges (i) to put in place legal and regulatory framework that sends effective signals to SNGs in terms of fiscal discipline and expenditure efficiency, and (ii) to support an institutional-focused fiscal adjustment package for over-indebted municipalities.

34. How the Bank has responded in Peru: responses and opportunities Internal organization q   Peru CAS update (Board presentation – Dec. 2004), cross-sector focus on Decentralization Processes, including strengthening of the three levels of government q    Coordinated policy advice dialogue and analysis Cross-sectoral reform loans q    Series of decentralization-focused Programmatic SALs and TALs focused on fiscal (DECSAL), social and competitiveness. TA focused on accounting, FM, budget transparency and accountability, M&E, asset management and improving local investment climate  Strategy on Capacity Building qCoordination with donor community, CAF and the IADB Sub-national lens on Country Diagnostic Work q    Country Diagnostic work PER, ESW (Municipal Debt situation), other also has sub- national component