Document of

The World Bank

FOR OFMICIAL USE ONLY

Report No. P-4502-IND

MEMORANDUM AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION ANID DEVELOPMENT

TO THE EXECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN AN AMOUNT EQUIVALENT TO US$101.S MILLION

TO THE

REPUBLIC OF INDONESIA

FOR THE

BRI/KUPEDES SMALL CREDIT PROJECT

APRIL 7, 1987

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without Wortd Bank authorization.

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CURRENCY EQUIVALENT

Currency unit = Indonesian rupiah(as of February 1987)

US$1.0 - Rp 1,630

FISCAL YEAR

Government of Indonesia - April 1-March 31Bank Rakyat Indonesia - January 1-December 31

PRINCIPAL ABBREVIATIONS AND ACRONYMS USED

BI - Bank IndonesiaBINAS - Bimbingan Massal (an integrated program for crop

intensification)BRI - Bank Rakyat IndonesiaGOI - Government of IndonesiaKUPEDES - Kredit Umum Pedesan (General Village Credit Program)PPAR - Project Performance Audit ReportSEDP - Small Enterprise Development ProjectSOE - Statements of ExpenditureUSAID - United States Agency for Internationdl Development

FOR OICUAL W ONLY

INDONESIA

BRI/RUPEDES SMALL CREDIT PROJECT

Loan and Project Summary

Borrower: Republic of Indonesia

Beneficiary: Bank Rakyat Indonesia (BRI)

Amount: US$101.5 million

Terms: Twenty years, including five years of grace, at thestandard variable interest rate.

Onlending Terms: Onlent to BRI for 20 years, including five years of grace,at an interest rate equal to the average cost of BRI'scustomer deposits.

Financing Plan:IBRD Loan (first generation funds) US$ 101.5 millionIncremental Unit Desa savingsmobilization US$ 69.0 million

USAID Technical Assistance Loan US$ 10.0 millionGOI/BRI US$ 19.7 millionRepayments of Previous KUPEDESLoans US$ 925.7 million

Total US$1,125.9 million

Economic Rate of Return: Not applicable

Staff Appraisal Report: No. 6579-IND

This document has a rtficted distribution and may be used by reipients onb in th p4rfweof their official duties. Its contents may not otherwise be disclosed without World Bank authofiztion.

MEMORANDUM AND RECOMMENDATION OF THE PRESIDENTOF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOANTO THE REPUBLIC OF INDONESIA FOR THE BRI/KUPEDES SMALL CREDIT PROJECT

1. The following report on a proposed loan to Indonesia for US$101.5million is submitted for approval. The proposed loan would have a term of20 years, including five years of grace, at the standard variable interestrate and would help finance a BRI/UPEDES small credit project. The proceedsof the loan would be made available by the Government of Indonesia (GOI) toBank Rakyat Indonesia (BRI) for a term of 20 years, including five years ofgrace, at a variable interest rate which reflects the ongoing cost of 8RI'srupiah customers deposits. GOI would carry the foreign exchange risk.

2. Background. Compared to its neighbors', the financial system ofIndonesia is still in an early stage of development. It has improvedsubstantially, however, since Government took major liberalization measures inJune 1983. Interest rates were then freed on deposits and nongovernment-supported loans; credit ceilings were removed; and the volume of Government-financed programs was reduced. These reforms had a substantial effect on thebanking system. Deposit and lending rates of State Banks increased sharply.There was a rapid rise in deposits, particularly time deposits, but with aAhort maturity, limiting the availability of term loans. Private banks alsoincreased their share of bank credit and an active money market emerged.Financial services outside the main metropolitan areas, and particularly thosefor small credit and small savings, are provided by a large variety of formal,semiformal and informal intermediaries. The largest single nationwide programat the lowest Level of loan size is the KUPEDES program of BRI which is thesecond largest bank and the most important source of credit for the rural andsmall-scale enterprise sectors in Indonesia. The KUPEDES program wasinitiated in 1984 as part of the thrust (brought about by the financial sectorreforms of 1983) to reduce credit subsidies. It operates exclusively throughthe subdistrict-based Unit Desas (village sub-branches) of BRI which had beenoriginally established in 1970/71 to administer credit related to the ricecrop intensification program (BrIMAS - now abolished). Until the introductionof KUPEDES, the Unit Desas had relied on a Goverment subsidy to cover theiroperating costs and most of the loan losses. The objectives of BRI in intro-ducing the KUPEDES credit program were to enable the Unit Desas to providecredit and mobilize savings at market rates, and make a profit. KUPEDES loansare available to all small creditworthy borrowers and 81 also activelypromotes savings mobilixation by the Unit Desas. At present, about 10Z ofKUPEDES loans are funded through liquidity credits from Bank Indonesia (BI).The remaining 301 comes from the Unit Desas' savings mobilization efforts.The interest rate to BRI on BI liquidity credits to fund KUPEDES loans is121. BRI passes these funds on to the Unit Desas at an internal transfer rateof 17? for working capital loans and 5Z for investment loans compared to the9-15X rate paid by Unit Desas on customer deposits. Effective rates to finalborrowers (whose current use of KUPEDES loans is heavily for working capital)range from 21.51 on investment loans (up to three years) to 31.71 on workingcapital loans (up to two years). These are highly positive in real terms(inflation in Indonesia in 1986 was about 9Z). The resulting spread is needed

I - 2 -

to enable SRI to cover all the costs of delivering a large number of verysmall loans in rural areas across Indonesia and still make a profit. Loanamounts are between US$60 and US$1,200. The market for KUPEDES loans isclearly defined and does not overlap with that of other Government supportedschemes.

3. Project Objectives. The project has the objectives of: (a) promot-ing BRI's efforts to develop the Unit Desa system into a financially viablesub-branch network that is able to provide credit on a nonsubsidized basis toall creditworthy small borrowers, to mobilize savings, and to provide otherbanking services; (b) encouraging BRI to improve its resource mobAli:ationefforts so that it could eventually fund KUPEDES loans out of the deposits itraises; (c) providing long-term credit to BRI for KUPEDES lending so as toreduce its reliance on SI liquidity credits; and (d) improving the overallinstitutional capability of BRI, as it relates to the KUPEDES program, withtechnical assistance complementing a USAID technical assistance package (US$10million) recently approved for that purpose.

4. Project Description. The project would comprise the following twocomponents:

(a) A credit component for general purpose financing in all sectors. Atotal of US$100.0 million of the proposed Bank loan is expected tomeet all BRI's projected external funding requirements for at leastthe next three years of the KUPEDES program. Funds out of thiscomponent would be disbursed on the basis of 10% of new KUPEDES loanapprovals (up to 65Z of the total increment in the KUPEDES loanportfolio outstanding during the first year of the project and 60Xin subsequent years), or alternatively, 50% of the increment in theKUPEDES loan portfolio outstanding, whichever is higher. Disburse-ments would be on the basis of SOEs from BRU on the level ofapprovals or outstandings, whichever is applicable.

(b) A technical assistance component, in which US$1.5 million of theproposed Bank loan would complement an ongoing USAID financedtechnical assistance program and would enable BRI to: (i) developits capacity to design, implement and analyze studies for monitoringand evaluating the lending and savings activities of the Unit Desas;and (ii) improve the capability of BRI's field auditors andsupervisory staff for Unit Desa operations.

5. Based on current rates, the on-lending arrangements referred to inpara. 1 above would result in an onlending rate of about 11, or about 3%above the current Bank rate. The project would be carried out over fiveyears. A breakdown of costs and the financing plan are shown in Schedule A.Amounts and methods of procurement and disbursements, and the disbursementschedule are shown in Schedule B. Retroactive financing (up to US$10 million)would be allowed for expenditures in the quarter in which the loan agreementis signed. A timetable of key project processing events and the status ofBank Group operations in Indonesia are given in Schedules C and D, respec-tively. A map, No. 11038R1, is also attached. The Staff Appraisal Report,No. 6579-IND dated April 7, 1987, is also being distributed.

- 3 -

6. Rationale for Bank Involvement. The KUPEDES program represents adramatic departure from the heavily subsidized credit programs that havecharacterized much of the directed lending in Indonesia. Its success wouldhave a strong demonstration effect vis-a-vis existing priority credit schemesand could lead to changes, long advocated by the Bank, aimed at reducing thesubsidy cost of these schemes. Also, for the first time in such a project,resource mobilization is a specific and important objective. The numerouscredit Pthemes currently available in the rural and semi-urban areas inIndonesia are being studied under a rural credit sector study in order todetermine how best these can be rationalized and made more effective. In theinterim, the project would allow the Bank to express its strong support for asmall credit scheme oriented towards the lower economic level of society,within the context of a financially viable operation.

7. Previous Bank Group Lenjing to the Sector. To date, the Bank Grouphas provided a total of US$837.6 million through thirteen operations withfinancial intermediaries. The success in meeting the objectives of the Bank'slending operations in the sector have been mixed. As shown in the two PPARs(Nos. 2563-ID and 6403-1ND) dealing with the first five operations withBAPINDO (the Development Bank of Indonesia), there has been considerableimprovement in some areas of its operations but it remains a weak institutionthat continues to face serious problems. These are now being addressed withsubstantial Bank assistance. The first two Small Enterprise DevelopmentProjects (SEDP I and II - Cr. 785-IND and Ln. 2011-IND) have been completedand a project completion report on their achievements is being compiled. SEDPIII (Ln. 2430-IND) will be completed by year-end 1987. These projects appearto have had a positive impact on employment and income distribution. Theircosts have been very high, however, largely due to a substantial subsidyelement. The lessons learned from these operations will be helpful to theBank's future involvement in the sector including the proposed project. Thus,under the proposed project, funds would be onlent at market rates. Inaddition, measures to improve organization and management, as well as tomaintain sound portfolio quality, would put the intermediary in a position toearn a profit. Also, there is no targetting of borrowers which could distortthe basis for credit decisions.

8. Agreed Actions. In order to achieve project objectives, it wasconfirmed at negotiations that: (a) modification of the interest rate struc-ture for KUPEDES loans to final borrowers would only be done after consul-tation with the Bank; (b) BRI would furnish to the Bank by March 31, 1988, astudy relating to the identification of measures that may be needed to inducegreater demand for KUPEDES loans for investment purposes, and by June 30,1988, a time-bound plan of action based on the study. BEI would thereafterimplement this plan; (c) no further liquidity credits from BI would be madeavailable as long as there remained undisbursed funds under the credit compo-nent of the proposed Bank loan and any drawdowns of additional BI liquiditycredit between March 1, 1987, and loan effectiveness would be repaid over aperiod of one year or less; (d) the agreement between BRI and BI concerningthe repayment by BRI of liquidity credits outstanding as of March 1, 1987,would not be changed without the Bank's agreement; (e) BRI would allocate tothe Unit Desa Development Fund at least 5OZ of the margin between the cost toitself of the Bank loan proceeds and the onlending rate to the Unit Desas; (f)

-4-

BRI would employ by October 31, 1987, an advisor in surveying techniques andmethodology for strengthening its Research and Planning Division; (g) shouldarrears of one day or more exceed 8Z of the KUPEDES loan portfolio over a six-month period, BRI would, within three months, submit to the Bank informationrelating to actions taken and its action plan to reduce such arrears; and(h) BRI would incorporate into its Unit Desa Strategy Statement a clausestating that maintaining a sound portfolio quality would receive management'shighest priority and that arrears of three months or more past final install-ment due date of 62 or more would be considered unsatisfactory performance.Should this level be reached, BRI management would evaluate the overall pro-grams and organization of the Unit Desas with a view to redesigning ongoingprograms, organization and procedures to ensure the continued financialviability of the Unit Desa system on an autonomous basis.

9. The following would be conditions of loan effectiveness: (a) adop-tion of the agreed Unit Desa Policy Statement and Unit Desa Strategy Statementby BRI's Board of Managing Directors (these statements would not be amendedwithout prior agreement of the Bank); and (b) the signing of a subsidiary loanagreement, satisfactory to the Bank, between GOI and BRI.

10. Project Justification and Risks. The KUPEDES program is a majorsource of financial services for small-scale activities in mostly rural areaswhere access to financial institutions, and especially credit, is still inade-quate. Funds, lent at highly positive interest rates, would be used for acLi-vities with acceptable economic returns and would promote rural development.The risks are two-fold: (a) portfolio deterioration, particularly as the pro-gram expands, and (b) bureaucratization of the credit process if it moves fromsimple procedures that do not target specific borrowers to more intricateapplication procedures and specific lending targets. This could distort thebasis of lending decisions and stifle the program. Recognizing both risks,BRI's management is developing a progrem for training staff, improvinginternal controls and incentives, and monitoring program performance. Theproject provides support to BRI's policy to operate the Onit Desas as auto-nomous profit oriented sub-branches that no longer participate in highly sub-sidized administered credit schemes. The project's design also takes accountof the above risks. Given these efforts and GOIts commitment to developing amore open financial system, the potential benefits of this project outweighthe risks.

11. Recommendation. I am satisfied that the proposed loan would complywith the Articles of Agreement of the Bank and I recommend that the ExecutiveDirectors approve the proposed loan.

Barber B. ConablePresident

Attachments

Washington, D.C.April 7, 1987

- 5 - Schedule A

INDONESIA

BRI/KUPEDES SMALL CREDIT PROJECT

Estimated Costs and Financing Plan

(US$ million)

Local Foreign Total

Estimated Costs:

Total KUPEDES loan disbursements 1,006.2 100.0 1,106.2Total technical assistance and training 8.2 11.5 19.7

Total Project Costs 1,014.4 111.5 1t125.9

Financing Plan:

IBRD Loan (first generation funds) - 101.5 101.5Incremental Unit Desa savingsmobilisation 69.0 - 69.0

USAID Technical Assistance Loan - 10.0 10.0GOI/BRI 19.7 - 19.7Repayments of previous KUPEDES loans 925.7 - 925.7

Total Financing 1,014.4 111.5 1,125.9

i

- 6 - Schedule B

INDONESIA

BRI/KUPEDES SMALL CREDIT PROJECT

Procurement Method and Disbursements(Us$ million)

Procurement Metv-od /aTotal

Project Element ICB LCB Other N.A. Cost

Credit - 1,106.2 1,106.2(100.0) (160.0)

Technical assistance - - - 19.7 19.7(1.5) (1.5)

Total - - - 1,125.9 1,125.9-101.5) (10.i5i)

DisbursementsCategory X

Credit: 101 of new KUPEDES loan approvals,/bor 501 of the increase in KUPEDES loan

9 portfolio outstanding, whiche.ver isgreater

Technical assistance:Consultants and Overseas Training 10O1 of total expendituresLocal Training 70% of total expenditures

Estimated IBRD Disbursements

Bank FY 1988 1989 1990 1991 1992

Annual 15.3 25.7 35.5 18.0 7.0Cumulative 15.3 41.0 76.5 94.5 101.5

/a Figures in parentheses are the respective mounts financed by the Bank.7i In the case of disbursements based on 10 of KUPEDES new loan approvals,

Bank disbursements cannot exceed 65X of the total increase in KUPEDES loanportfolio outstanding during the first year after loan effectiveness and601 in subsequent years.

-7- Schedule C

INDONESIA

BRI/KUPEDES SMALL CREDIT PROJECT

Timetable for Key Project Processing Events

Time taken to prepare 7 months

Prepared by BRI with Bank assistance

First Bank mission June 1986

Appraisal mission departure October 1986

Negotiations March 1987

Planned date of effectiveness July 1987

List of relevant PCRs and PPARs BAPINDO I through V Projects(PPARs No. 2563 datedJune 29, 1979, and No. 6403dated September 10, 1986)

-8 - Schedule DPage 1 of 4 pages

THE STATUS OF BANK GROUP OPERATIONS IN INDONESIA

A. STATEAENT OF BANK LOANS AND IDA CREDITS (as of September 30, 1986) /a

Loani Amount (US$ million)Credit Fiscai (less cancellations)number year Purpose Bank IDA Undisbursed

Forty-one Loans and forty-five Credits fully disbursed 1,950.45 819.70 -

1578 1978 Tenth Irrigation 107.00 - 16.341604 1978 Nucleus Estate and Smallholders II 50.50 - 4.711653 1979 Third Urban Development 53.60 - 5.341707 1979 Transmigration II 54.00 - 28.141708 1979 Eighth Power 169.00 - 25.461709 1979 Second Water Supply 35.49 - 3.56946 1980 Yogyakarta Rural Development - 12.00 5.351751 1980 Nucleus Estate and Smallholders III 92.00 - 15.67995 1980 Fifteenth Irrigation - 37.40 3.77996 1980 National Agriculture Extension II - 39.00 14.491811 1980 Fourteenth Irrigation 116.00 - 28 .21835 1980 Nucleus Estate and Smallholders IV 30.00 - 14.421840 1980 National Agricultural Research 35.00 - 31.321872 1980 Ninth Power 235.00 - 39.821898 1981 Smallholder Coconut Development 25.00 - 1.791904 1981 University Development 45.00 20.801950 1981 Tenth Power 250.00 - 7.161958 1981 Swamp Reclamation 22.00 - 9.891972 1981 Foui'th Urban Development 43.00 - 17.332007 1981 Nucleus Estate and Smallholders V 134.00 - 75.072049 1982 Jakarta-Cikampek Highway 85.00 - 60.762056 1982 Eleventh Power 170.00 - 30.472066 1982 Second Seeds 15.00 - 8.92

/a The status of the projects listed in Part A is described in a separate report onall Bank/IDA financial projects in execution, which is updated twice yearly andcirculated to the Executive Directors on April 30 and October 31.

- 9 - Schedule DPage Z ot 4 pages

Loan/ Amount (USs million)Credit Fiscal (less cancellations)number year Purpose Bank IDA Undisbursed

2079 1982 Bukit Asam Coal Mining Development andTransport 183.70 - 48.49

2083 1982 Rural Roads Development 85.00 - 31.022101 1982 Second Teacher Training 79.59 - 54.112102 1982 Second Textbook 25.00 - 18.652118 1982 Sixteenth Irrigation 37.00 - 13.632119 1982 Seventeenth Irrigation (East Java 70.00 - 30.10

Province)2120 1982 National Fertilizer Distribution 40.09 - 3.462126 1982 Nucleus Estate and Smallholders VI 55.50 - 41.232153 1982 Coal Exploration Engineering 25.00 - 11.922214 1983 Twelfth Power 300.00 - 203.852232 1983 Nucleus Estate and Smallholders VII 138.90 - 130.352235 1983 Provincial Health 27.00 - 20.152236 1983 Jakarta Sewerage and Sanitation 22.40 - 18.442248 1983 Transmigration III 101.00 - 40.352258 1983 Public Works Manpower Development 30.00 - 22.352275 1983 East Java Water Supply 30.60 - 12.362277 1983 Fifth BAPINDO 208.90 - 117.412288 1983 Transmigration IV 63.50 - 58.162290 1983 Second Polytechnic 107.40 - 103.062300 1983 Thirteenth Power 279.00 - 144.312341 1984 Third Agricultural Training 63.30 - 42.392344 1984 Nucleus Estate and Smallholder Sugar 79.20 - 43.322355 1984 Second Non-Formal Education 43.00 - 30.412375 1984 Second Provincial Irrigation Dev. 89.00 - 44.762404 1984 Highway Betterment 240.00 - 138.162408 1984 Fifth Urban Development 39.25 - 30.872430 1984 Third Small Enterprise Development 204.65 - 27.202431 1984 Second Swamp Reclamation 65.00 - 60.332443 1984 Fourteenth Power 210.00 - 184.231950-1 1985 Supplemental Loan for Tenth Power

(1950-IND) 50.00 - 8.382472 1985 Secondary Education and Management

Training 78.00 - 72.87

- 10 - Schedule DPage 3 of 4 pages

Loan/ Amount (US$ million)Credit Fiscal (tess cancellations)number year Purpose Bank IDA Undisbursed

2474 1985 Upland Agriculture and Conservation 11.30 - 11.272494 1985 Smallholder Rubber Development II 131.00 - 130.982529 1985 Fourth Population 46.00 - 45.312542 1985 Second Health (Manpower Development) 39.00 - 38.662543 1985 Kedung Ombo Multipurpose Dam and

Irrigation 156.00 - 150.632547 1985 Second University Development 147.00 - 147.002560 1985 West Tarum Canal Improvement 43.40 - 43.012577 1985 National Ports Development 111.00 - 109.732578 1985 Transmigration V 160.00 - 159.562599 1986 Science and Technology Training 93.00 - 88.902628 1986 Smallholder Cattle Development 32.00 - 31.742632 1986 Second East Java Water Supply 43.30 - 43.302636 1986 Second Nutrition and Community Health 33.40 - 31.972638 1986 Nusa Tenggara Agriculture Support 33.00 - 33.002649 1986 Central and West Java Irrigation 166.00 - 166.002690 1986 Gas Distribution /a 34.00 - 34.002702 1986 Export Development /a 64.50 - 64.502705 1986 Manpower Development and Training 58.10 - 58.102717 1986 Highway Maintenance and Betterment 300.00 - 300.002725 1986 Housing Sector Loan /a 275.00 - 275.002748 1987 Third National Agricultural Extension 70.00 - 70.00

Total Bank loans and IDA credits 8,835.19 908.10

Of which has been repaid -671.36 -26.22

Total now outstanding 8,163.83 881.88

Amount sold to third party -57.56 -

Total now held by Bank and IDA /b 8,106.27 881.88

Total undisbursed /c 4,317.20

/a Not yet effective.7L Prior to exchange ad ustment.Jc Includes loans not yet effective.

11 - Schedule DPage 4 of 4 pages

B. STATEMENT OF IFC INVESTMENTS (as of September 30, 1986)

Fiscal Loan Equity Totalyear Obligor Type of business -- (US$ million) --

1971 P.T. Semen Cibinong Cement 10.6 2.5 13.11971 P.T. Unitex Textiles 2.5 0.8 3.31971 P.T. Primatexco Indonesia Textiles 2.0 0.5 2.51971 P.T. Kabel Indonesia Cable 2.8 0.4 3.21972 P.T. Daralon Textile Mfg. Corp. Textiles 4.5 1.5 6.01973 P.T. Jakarta Int. Hotel Tourism 9.8 1.6 11.41973 P.T. Semen Cibinong Cement 5.4 0.7 6.11974 P.T. Primatexco Indonesia Textiles 2.0 0.3 2.31974 P.T. Monsanto Pan Electronics 0.9 - 0.91974 P.T. PDFCI Dev. fin. co. - 0.5 0.51974 P.T. Kamaltex Textiles 2.4 0.6 3.01976 P.T. Semen Cibinong Cement 5.0 1.5 6.51976 P.T. Semen Cibinong Cement - 1.1 1.11977 P.T. Daralon Textile Mfg. Corp. Textiles 0.4 - 0.41977 P.T. Kamaltex Textiles 1.3 0.2 1.51979 P.T. Daralon Textiles 0.9 - 0.91980 P.T. Papan Sejahtera Capital market 4.0 1.2 5.21980 P.T. Indo American Industries Glass dinnerware 11.1 0.9 12.01980 P.T. Semen Andalas Indonesia Cement and construc-

tion material 48.0 5.0 53.01982/5 P.T. Saseka Gelora Leasing Capitai market 5.0 0.3 5.31984 P.T. Semen Cibinong Cement 25.0 - 25.0

Total gross commitments 143.6 19.6 163.2

Less: sold oi repaid and cancelled 116.7 8.1 124.8

Total held by IFC 26.9 11.5 38.4

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