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Cost Sharing and Eligibility of Expenditures for Asian Development Bank Financing: A New Approach

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New Approach for Cost Sharing and Expenditure Eligibility

A. Origin of Current Rules, Evolving Practices, and Increasing Distortions

7. ADB rules on cost sharing and expenditure eligibility are outdated. They were developed in the 1970s when ADB financed development projects in an environment where the integrity of each project required it to be “ring-fenced” with its own regulatory framework. At the time, fiscal, monetary, and external regulations often distorted the investment climate. Except in a few isolated cases, such policy distortions and regulations are no longer in place. Many DMCs have removed many of the restrictions on the internal and external movement of goods and capital.¹⁰ More conservative fiscal and monetary policies also have extended the planning horizon, while supporting the mobilization of domestic savings for investments required for poverty reduction, growth, and development. In the meantime, project finance practices have evolved, as have the range of project structures, financial instruments, and financing modalities.

8. In this new environment, the role and significance of ADB-financed projects within the overall development process and public sector investment programs have declined. ADB has responded by diversifying its range and type of interventions, adding program lending and various forms of technical assistance (TA) to the list.

9. Despite these changes in internal and external conditions, ADB’s cost sharing limits and expenditure eligibility criteria for project financing have remained largely the same. Over the years, this situation has created a considerable disconnect with best practices in the market, and has prevented ADB from keeping up with the changing market reality and the actual needs of DMCs. The application of outdated cost sharing and expenditure eligibility rules, focusing primarily on the project level and individual contract and loan withdrawal applications, has also constrained ADB’s ability to mobilize cofinancing.

10. Policy application also is distorted and inconsistent across different ADB financial instruments. For example, despite its commitment to support human development in projects, ADB has difficulty financing the cost of salaries of teachers and health workers, except in exceptional circumstances. In contrast, under sector reform program loans, ADB has financed severance payments for employees who cannot work productively anymore. In addition, while ADB can finance the construction of physical assets, it generally cannot finance those same assets through alternative—and in some cases more financially efficient—modalities, such as leasing.

11. Inconsistency in cost sharing and expenditure eligibility rules across ADB instruments can affect DMC costs and choices. For instance, while project financing cannot finance taxes and duties, program loans can be used to fill financing gaps arising from fiscal constraints. Because of these inconsistencies, some borrowers might seek program rather than project lending, even when the latter might be more appropriate.

12. Overall, ADB’s cost sharing and expenditure eligibility rules make it difficult to deliver procedural consistency across instruments and investments. This impacts ADB’s ability to be responsive and client-driven, and limits harmonization with other funding agencies. An update of these rules is long overdue—not only to put ADB on a “level playing field” with other financiers, but also to respond better to client needs and reduce transaction costs.¹¹

B. New Principles

13. A revised ADB policy framework on cost sharing and expenditure eligibility should adhere to three basic principles: (i) expenditures covered under the loan proceeds should promote development, and thus underpin the poverty reduction agenda; (ii) operations funded in the new and more flexible manner should not unduly burden the country’s fiscal, debt, and macroeconomic sustainability; and (iii) effective fiduciary and other oversight arrangements should be in place at all stages of the business cycle—at the country, executing agency, and project level. These principles must be reinforced with the governments’ commitment to, and ownership of, the programs and projects financed by ADB. These principles are consistent with the Charter and coincide broadly with those of other development partners.¹²

14. The revised policy framework calls for revisions to the section in ADB’s Operations Manual (OM) on the subject. The OM section and staff instructions would not show expenditure eligibility in terms of a series of limitations and/or prohibitions. Instead, expenditure eligibility would be presented as a positive policy framework that lays out what ADB financing can cover, and how the associated risks would be managed. This change from prohibition, with provisions for exceptions, to a positive framework would allow full harmonization with a DMC’s development program, as well as with the “rules of engagement” of other funding agencies.

15. The new OM section and associated staff instructions would incorporate all the provisions contained in this paper to ensure full adherence to the principles and the new eligibility criteria. The assessments and methodologies to be followed are consistent with those of ADB’s partners. This is to avoid duplication and inconsistencies at the DMC level, and to promote close coordination and collaboration between ADB and its development partners.

16. ADB will maintain its approach on the financing of military expenditures, nuclear reactors, environmentally hazardous substances, and other nondevelopment expenditures. The proposed changes in ADB policies are described in Section III. Appendix 1 provides a summary matrix of these (as well as an account of the World Bank’s old and new policies). Appendix 2 summarizes the IEI mandate and shows a results framework.

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