ID- East Java Regional Development and Reform Program This note highlights the key reasons which support the decision of the Bank management to drop the project. It has been cleared by the Sector Manager.  The note also describes the project preparation process and the lessons learned regarding the East Java Regional Development and Reform Project (EJRDRP). The documents cited are included in project files. 1.   Project Concept: The EJRDRP was conceptualized in 2004 as the first major project to help define the role of regional governments in financing infrastructure and support the emerging decentralization regime in Indonesia. The project was designed to help the Government of Indonesia (GOI) implement its new policy on on-lending ODA to regional governments. In East Java, the project was supposed to be the first borrowing under the Strategic Infrastructure Development and Reform Program (SIDRP) of the East Java Provincial Government (EJPG). The Governor and other leadership of East Java had established SIDRP to address the infrastructure challenges in East Java through a regional, long-term and strategic approach. The EJRDRP concept was based on decisions reached in high-level meetings between senior Bank management, Governor Utomo and leadership in the relevant GOI ministries. The Bank team commenced project preparation in 2004 following the GOI decision to include the EJRDRP in the Bank project pipeline. The EJPG assigned the leadership role to the department of planning (Bappeda). In Bappenas, the project was assigned to the Department of Housing and Human Settlements, which helped to process the Japanese PHRD grant for project preparation. Several donors also financed studies to support SIDRP. The PHRD funded consultant team was launched, and CIDA grant was obtained to help the EJPG prepare a regional infrastructure development strategy. 2.   Project Design: The EJPG and Bank teams designed the EJRDRP with a view to demonstrate the implementation of government policy on ODA on-lending to regional governments which was being prepared under the Bank's Development Policy Loan in 2005. The Project Concept Note (PCN) Review conducted in December 2005 highlighted the need to simplify project design and focus on investments which could be packaged in a loan in FY'06 in order to demonstrate results on the ground and maintain the momentum surrounding SIDRP. The Bank team and Bappenas representatives visited Surabaya in March 2005 to consult with the EJPG on project design.  The Bank team and Bappenas agreed with the EJPG request that the project investments should focus on provincial road infrastructure to stimulate growth and an anti-poverty program involving similar investment structures to the Bank's UPP and KDP programs. The EJPG made a clear commitment that they were willing to borrow under the project.  The decisions reached are described in the Aide Memoire, and in the Status Report, dated May 12, 2005, which coincided with the change of Bank Task Team Leader for the project. 3.   Project Preparation: Over the next ten months the Bank team conducted five full missions and several brief visits to ensure delivery of the project in FY'06. The EJPG team - including the PHRD consultants - worked diligently and prepared project components with high technical quality. The EJ Provincial Parliament approved approximately $500,000 addition funds for project preparation to assist the EJPG team. Bappensas project officers also joined the Bank team during several missions to participate in mission wrap-ups. Again, the EJPG maintained a clear commitment that the East Java was prepared to borrow under the project, which was being prepared as an "on-lending" project. The Bank team - often joined by EJPG representatives - conducted an extensive dialogue with the relevant GOI agencies to clarify the new rules which were expected to govern the project's on-lending structure. Indeed, extensive discussions involving GOI agencies focused on the need for GOI agencies to allow the EJPG to make decisions regarding project design since the project involved on-lending as oppose to on-granting, i.e., if the EJPG was going to pay for the project, it must also have the right to design the project according to its regional development priorities. The EJPG and the Bank team conducted an extensive analysis of the EJPG finances and determined, based on the MoF rules, that the EJPG had no debt, no defaults and more than enough borrowing capacity to borrow for the project. 4.   On-lending Arrangement: In January 2006 the Bank team conducted a successful Project Pre-Appraisal. The team concluded that the technical quality of the project, including the safeguards and engineering designs, was very good. The on-lending structure - the funds flow structure, assignment of execution agency and implementation agency, etc., which were permissible under the new policy - was the only remaining project element which was not finalized. The Department of Housing and Human Settlements in Bappenas was finding it difficult to coordinate the project because it involved sectors, such as roads, which were outside its mandate. The high quality of project preparation meant that the Pre-Appraisal could be converted to Appraisal following the finalization of the on-lending structure. 5.   EJPG Decision: At the conclusion of the Pre-Appraisal mission, the EJPG leadership surprised the Bank team by declaring that the EJPG was willing to borrow for a portion of the project (the anti-poverty program), but would request GOI grants for the transportation component. The decision appears to have been based on the calculation of the political leadership that the Provincial Parliament was not ready to accept East Java borrowing the full cost of the project when almost all other similar ODA-funded projects in Indonesia were arranged on the basis of 100% GOI grant. Hence, in the absence of the appropriate incentive structure and a strategic, gradual implementation plan for the on-lending arrangements, East Java decided that it could not proceed with 100% borrowing, and offered to discuss a combination of grants and borrowing with the GOI. The GOI agencies (Bappenas and MoF) informed the Bank team that they were not interested in funding the EJRDRP with any GOI grants. Subsequently, the Governor of East Java wrote letters to the Minister of Finance, the Minister of Bappensas, and the WB Country Director, proposing an on-lending/on-granting arrangement for the project. The EJPG and the GOI have not managed to reach agreement on the project financing arrangement to date. In late 2006, a Bank mission visited Jakarta and Surabaya to determine the status of the project.  The mission concluded that there was a very limited chance that the project can move forward in the near future. Indeed, it is likely that any ODA-funded project focusing on development infrastructure which is based on an on-lending arrangement will face significant delays and possible cost over-runs as the government has not yet concluded its work on establishing the rules, procedures and incentive structure for on-lending arrangements. 6.   Conclusion: The concept of EJRDRP remains very valid and important for Indonesia as the country attempts to decentralize the responsibility of financing and managing infrastructure to the regional governments. The high level of involvement of the EJPG in project design and preparation, and the high quality of project preparation suggest that regional governments can prepare good projects. However, the timing of the project was unfortunate in that a project like the EJRDRP cannot be easily processed until the new framework for ODA on-lending and on-granting and its accompanying procedures and systems are fully implemented. Importantly, the GOI will probably need to implement concepts such as matching grants and other mechanisms for the gradually implementing the new policy. Indeed, once the appropriate incentive structure and rules for on-lending arrangements have been implemented, the project can be reinstated in the future as a viable regional development initiative in East Java. Decentralization to regional governments also creates GOI coordination problems for multi-sector ODA projects because they cannot be coordinated by one GOI agency or department with sector-specific responsibilities (e.g. Public Works/Transportation Department cannot coordinate a multi-sector regional project which address transportation but also water supply or micro-finance). This lack of "ownership" for regional projects in the central government makes it difficult for the regional governments and the GOI to appropriately communicate and resolve problems. The lack of ownership in the GOI ultimately puts the Bank in a difficult position of coordinating project activities between the two clients, which increases the risk that GOI might get the impression that a project is "Bank-driven." Finally, in traditional ODA projects the agencies of the regional government can play the role of an implementing agency, but the GOI coordinating department retains the executing agency designation. The successful implementation of the on-lending policy will require that executing agency functions and associated accountabilities be taken up by the regional governments. The key lessons for the Bank vis-Ã -vis project preparation are as follows: -   The Bank proceeded to prepare the project under the on-lending" arrangement scheme based on the strong commitments from the EJPG - at the very beginning of the process as well as during the project preparation stage. However, in retrospect, the Bank should have not commenced project preparation before obtaining a formal, written  commitment from the EJPG and the GOI on the project cost sharing arrangements. . -   Operational programs should follow policy reforms conducted with AAA or other policy-based instruments. The sequence and timing of the Bank's instruments is importa nt. -   There was a very long Pre-PCN stage and it was extremely expensive for the Bank. This was because the EJPG took a long time to identify the investment/sub-projects for the loan. This could have been avoided, for example, if the EJPG had prepared the regional infrastructure strategy before the commencement of project preparation activities. -   At the national level, the project would have had a better chance of moving forward if matching grants and other concepts for the gradual implementation of the on-lending/on-granting policies had already been established with the help of AAA. -   The key project bottleneck - on-lending arrangement - was not a project-specific problem, i.e., it applies to all on-lending projects in Indonesia. This issue therefore could have been best handled with non-project resources (by CMU or other corporate staff) if the EJRDRP had been processed after the government had fully implemented its on-lending policy and the accompanying rules and procedures. -   Note that the actual project preparation took only 10 months (March 2005 - January 2006). List of Relevant Documentation in Project Files -   Project Concept Note, December 2004 -   Minutes of the Project Concept Note, March 2005 -   Project Status Report, May 2005 -   Aide Memoires -   March 2005 (Revised May 2005) -   August 2005 -   October 2005 -   December 2005 -   January 2006 (Pre-appraisal) -   Letter from Governor of EJ to Minister of Finance, March 2006 -   Letter from the Governor of EJ to WB CD, May 2006