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p. 3 of 6 BACK | NEXT Introduction New Approach for Cost Sharing and Expenditure Eligibility Proposed Cost Sharing and Expenditure Eligibility Rules Fiduciary Oversight Implementation Arrangements and Resource Implications Recommendations

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

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Proposed Cost Sharing and Expenditure Eligibility Rules

A. Cost Sharing and Local Cost Financing

17. ADB’s policy on cost sharing and local cost financing is in OM section H3/BP, issued on 23 December 2004. This section outlines the maximum percentages of project costs that can be financed in countries falling in the four DMC groups. These percentages range from 65% in the most-developed DMC group to 80% in the least-developed. ADB financing can—and routinely does—cover the full amount of direct and indirect foreign exchange costs in a given project’s investment plan, even if this exceeds the DMC’s total cost sharing limit. This implies that the policy effectively limits only the financing of local currency costs. ADB can finance a share of these local costs, if ADB deems the amount to be reasonable and not doing so would strain a DMC’s balance-of-payments situation.

18. In addition, the four DMC country groups do not reflect accurately the diversity of DMC needs for development financing at different times. Quite often, the limit on local currency financing only for individual projects (given that the local currency content of development projects can vary significantly) leads to widely differing financing obligations for borrowers. Moreover, problems with counterpart financing of local costs often have affected the timing and quality of implementation, particularly in less-developed DMCs. Counterpart financing difficulties are not necessarily the result of poor commitment and ownership of the investment program. Rather, they can be a function of temporary budget constraints, and in some cases of significant differences between the budgetary and project planning cycles. The problem can be compounded by periodic budgetary crises, even in more advanced DMCs, and the reality that externally funded projects are often outside the regular budgetary process.

19. A change to this ADB policy regime is not inconsistent with its core operating principle of DMC commitment and ownership of investment projects and programs. This principle will continue with the new framework. It is important to note that ADB financing in most DMCs represents at most 1% of their annual public sector investment program while total development assistance covers on average about 4% of public investments. Hence, borrowers effectively are funding (directly or indirectly) more than 95% of their own public sector investments. ADB financial assistance, whether targeting a stand-alone project or a sector investment program, is part of this public investment program. Borrower commitment, ownership, and cost sharing makes more sense when judged against the aggregate portfolio rather than against an individual project.

20. ADB policy on cost sharing should be modified to replace the existing ceilings applicable to the four DMC country groups with an overall financing ceiling in each DMC. This ceiling would be established for the aggregate ADB portfolio in a DMC, rather than for individual projects. It would take into consideration, inter alia, the DMC’s balance of payments situation and other macroeconomic factors (see below). The ceilings would be established in principle during the preparation of the country strategy and program (CSP). For DMCs where the CSP was completed recently, the ceiling could be established as a stand-alone exercise. This would be an interim measure until the next CSP cycle.

21. The macroeconomic and fiduciary-related variables to be assessed would be detailed in the OM section and staff instructions. Consistent with the variables agreed upon by other development partners, the establishment of an aggregate portfolio ceiling would be based on detailed macroeconomic assessments covering, but not limited to, the following:

1. Past, present, and projected fiscal policy stance in the country (including revenue collection system, and the level and quality of the public expenditure program and its financing plan);
2. Public financial management system (including the institutions, policies, and approaches); and the quality of the mechanisms for budget preparation, implementation, and control (including the financial management information system, specific tax regime, and associated governance/fiduciary arrangements);
3. The degree to which the ADB portfolio agreed upon with the DMC is integrated into the latter’s budget process;
4. Debt sustainability, involving matching the fiscal capacity and sustainability with the short-, medium-, and long-term structure of the public sector debt stock; and distinguishing between commercial, official, and multilateral debt; and
5. The nature and characteristics of the foreign exchange regime, the balance of payments situation, and general trade and financial policies.

22. Once ADB has established a DMC’s financing parameters, these would apply to all loan and TA operations prepared thereafter.¹³ In line with sound banking principles, the specific cost sharing arrangements for each individual project would depend on the specific sector, client, and project characteristics. In some cases, the ceiling may be exceeded; in other cases, it may not. Such variations are permissible so long as the financing parameters established for each DMC are observed within the applicable period.

23. Under the current policy, ADB can finance local currency costs above the direct and indirect foreign exchange costs outlined in an investment plan. However, such local cost financing is based on two main conditions: (i) the DMC is making a reasonable effort to develop and mobilize the required domestic savings; and (ii) despite these efforts, the financing requirements of the development project or program exceed the DMC’s financing capabilities at that time. Under the revised policy, these conditions—and the financing limitations derived from them—would be expressed in terms of ADB’s aggregate investment and TA portfolio. In accordance with its Charter, ADB would not finance 100% of project costs.¹⁴ Variations could occur between projects, depending on their specific nature and characteristics, as well as on sector and client considerations. so long as ADB ensures that its financing envelope falls within the ceiling during the ceiling applicability period.

24. A legal analysis established that the proposed cost sharing arrangements are consistent with the Charter, particularly Article 13. As described above, the ceiling for an individual DMC is determined generally on the basis of its balance of payments and other macroeconomic factors. ADB financing will always be less than 100% of the project costs, and will be based on what is reasonable in light of specific sector, client, and project characteristics.

25. ADB structures individual investment plan components and subcomponents separately into foreign exchange (direct and indirect) and local cost equivalent. However, under current international best practice for project financing, investment plan components are not normally structured in this manner. In many instances, local and foreign exchange costs are impossible to separate out with any degree of accuracy. Further complicating this situation, final project design often is undertaken only after ADB Board approval. This means that the exact procurement packages (and the corresponding disbursement plans) for some projects can be finalized only during project implementation. Moreover, splitting foreign exchange and local costs in the investment plan is not a sound means to estimate and mitigate currency risks in projects. The latter can be evaluated only through other means, such as economic and financial modeling, which implies reviewing assumptions governing the quality of the income stream and the exchange rate regime. While the split between foreign and local costs in the investment plan might have been appropriate 40 years ago when ADB was established, it no longer is.

26. The project cost or investment plan should no longer distinguish between local and foreign exchange cost categories. The financing plan instead should differentiate the sources of finance—including finance to be provided by ADB, the government, and other cofinanciers. The financing plan can distinguish further between lending in different currencies, as well as between short-, medium-, and longer-term maturities. Therefore, the financing plan no longer would be determined based on an artificial split between foreign or local expenditures worked out for each subproject component in the investment plan. The amount of financing that ADB proposes for a project would be based on specific sector, client, and project considerations. For revenue- and nonrevenue-earning projects, debt finance should adhere to sound banking principles. This means, among other things, taking into account a project’s cost recovery profile (i.e., ability to pay), sustainability configurations (i.e., adequate budget support), and currency mismatch risks.

27. A similar approach is proposed for cost sharing in TA operations, irrespective of whether the TA is financed as a grant, loan, or a combination. At present, the share of TAs to be financed by ADB is specified for each DMC group. In addition, the DMC’s contribution is limited to local cost financing, measured in a rather artificial and restricted way.¹⁵ Under the proposed policy, the share of TA operations to be financed by ADB would be agreed for the aggregate ADB portfolio in the DMC. Thereafter, the funding proposed for each TA could vary from the cost sharing ceiling, reflecting the sector focus and the nature and purposes of the TA.

B. Taxes and Duties

28. Indirect taxes (including import duties, value-added taxes, and sales taxes) levied on specific goods, works, and services are ineligible for ADB financing, as specified in OM section H3/BP, issued on 23 December 2004. ADB has treated taxes and duties as ineligible expenditures on the grounds that they (i) represent, potentially, transfer payments to borrowers; (ii) are denominated in local currency; and (iii) can be distorted by high tax rate regimes. ADB’s development partners used these same grounds in the past.

29. In practice, however, ADB has treated taxes and duties inconsistently, which at times has complicated the financing plan of projects and even created temporary budgetary distortions in DMCs. One example of such an inconsistency concerns taxes paid inside the territory of the borrower and taxes paid outside. The former are ineligible for ADB financing; the latter are often financed. Inconsistencies and distortions of this type at the project level have an impact on the financing plan, especially with value-added taxes. The ineligibility of taxes and duties for ADB financing increases counterpart financing requirements. Such financing might not be available when needed, potentially leading to implementation delays and even project viability problems. Increasing counterpart financing this way does not automatically increase DMC commitment or ownership. Finally, tax exemptions on projects funded by development agencies can put undue pressures on the DMC’s budget.

30. The cost of taxes and duties related to project expenditures should be eligible for ADB financing. However, ADB financing of such taxes and duties should be limited to a reasonable amount. The definition of “reasonable” would be based on an assessment of the specific fiscal/tax regime in the country. This would be followed by an evaluation of whether the overall tax and duties “line” is pitched at an excessive and material level, or whether this falls generally within what is regarded as a normal threshold. The inclusion of taxes and duties would be based on an assessment of transparency, competitive neutrality, and fiscal sustainability of the arrangements proposed. Country teams also might produce and assess regional and international emerging market benchmarks for this purpose. At the project level, this evaluation would focus on the share of the investment plan accounted for by this item. The value should not represent an excessive share of the investment plan. Further, it should be applicable strictly to ADB-financed projects, activities, and expenditures. Taxes and duties also would be judged as to whether they are material and relevant to the success of the project. For operations involving parallel cofinancing with bilateral development partners, the eligibility of taxes and duties for a cofinanced portion of the financing plan would adhere to the rules of these partners. Some might have restrictions in this area. The Asian Development Fund IX arrangements do not prevent the adoption of this reform.

C. Land Acquisition and Payments for Rights-of-Way

31. Land acquisition and payments for rights-of-way are currently ineligible for ADB financing. This is captured in OM section H3/BP, issued on 23 December 2004. However, land is a standard component of an investment project, like working capital, civil works, and plant and equipment. ADB has excluded land acquisition from its list of eligible financing items because land (i) does not meet traditional development tests associated with public sector investments; and (ii) represents a local cost component with complex legal issues, such as tenure and community rights.

32. The argument that financing land does not measure up to traditional development impact tests is flawed. First, land plays a significant role in economic activity, in most cases like labor and capital do. Second, land acquisition is often a necessary expenditure that helps make projects happen. This applies to infrastructure and utility finance transactions, as well as to social development projects, including schools and hospitals.

33. Financing land acquisition and payments for rights-of-way (often costly components) can make a major difference to clients. Funding this component also could lower the risk of project implementation delays, as well as cost escalations resulting from inadequate and/or late government budgetary allocations.¹⁶ The importance of government commitment to cofinancing projects and meeting specific loan covenants is not questioned. The ability of governments to provide financing on time to acquire land and pay for rights-of-way is another matter. The distinction between land treated as a component of an investment plan and land acquisition as a project by itself is significant. The latter normally is associated with community-based investments. In the first instance, the cost tends to represent a relatively small share of the investment plan (perhaps 10% or less). In the second, it would account for the bulk of the project itself. Irrespective of these differences, the existing policy framework prevents ADB from financing land effectively, consistently, and efficiently.

34. To address these constraints, the present policy framework should be revised to allow ADB to finance land acquisition and rights-of-way. Like other development partners, ADB should pursue a cautious approach in financing land acquisitions. The guidelines on how to handle this item would be provided in the OM section and associated staff instructions. Specifically, project teams would be required to undertake assessments focusing on, among others, (i) confirmation of the productive nature of the acquisition; (ii) suitability of land market conditions, including the definition of strategies to deal with any foreseen distortions; (iii) adequacy of the administrative arrangements, essentially to ensure that the channeling of funding is done transparently and efficiently; (iv) definition of the risk profile of the transaction, and the type of risk mitigation measures required; and (v) soundness of the monitoring and evaluation arrangements for the purchase and payments for rights-of-way. Only bona fide values would be taken into account. As required, external independent professional valuation experts would undertake these valuations. Earlier reviews and screenings should be carried out at the time of concept paper clearance before incorporating this item into the investment and financing plan.

D. Other Expenditures

35. The current ADB policy regime excludes several other project expenditures from the eligibility list. While some of these are more important than others, their exclusion is generally inconsistent with international project finance best practice. Further, their exclusion works against the principles of responsiveness and relevance. These expenditures include (i) local transport and insurance, (ii) late payment penalties, (iii) food expenditures, (iv) resettlement assistance charges, (v) interest during construction on non-ADB loans, (vi) bank charges, (vii) retroactive financing, (viii) secondhand goods, and (ix) leased assets. This section also explains ADB’s current policy and exit strategy in relation to financing recurrent expenditures. These eligibility items, of course, must be assessed, documented, and justified in the Report and Recommendation of the President to the Board (RRP).

36. Transport, Insurance, Late Payment Charges, Bank Charges, Food Expenditures, Resettlement Expenses, and Interest During Construction on Non-ADB Loans. These expenditure items, which are not eligible for ADB financing, can make a material difference to the viability of investment projects, as well as to DMCs. As such, the policy framework should be changed to allow these expenditures to qualify for ADB financing. In all cases, they would be evaluated for being bona fide during the due diligence process. The OM section and the staff instructions would provide guidance on the type of assessments and controls needed.

37. Retroactive Financing. The policy on retroactive financing (OM H4) should be changed to allow financing for up to 20% of the total ADB loan amount, and for eligible expenditures incurred 12 months before the signing of the ADB Loan Agreement. In addition, the policy framework should allow flexibility to the 12-month time limit on a case-by-case basis. ADB recognizes that some projects might require a number of advance actions (and thus expenditures) much earlier than 12 months before ADB approval and loan signing. Land acquisition is one such example. In some instances, land has to be purchased up to 3 years in advance. Selected project support facilities (e.g., access roads, water, gas, electricity, and telecommunication connections) also might have to be put in place for the purposes of the project (or an investment program involving the project) before the approval of the investment project. ADB should be able to support such expenditures when they are shown (i) to be genuine, reasonable, and material to getting the operation off the ground; and (ii) to have been incurred for proper reasons and in a transparent manner over a reasonable period of time. Any deviations from the proposed 12-month period always should be documented properly and justified in the RRP.

38. Secondhand Goods. The proposed policy framework revision also calls for ADB to be able to finance secondhand goods. Key criteria to be followed by staff in evaluating such a project component would focus on economy, efficiency, and appropriateness. The inclusion of this item in the eligibility list would be based on two further considerations: (i) confirmation of a surplus of goods from enough sources to ensure competitive bidding; and (ii) confirmation of limited economies of scale for the procurement of new goods, implying excessive costs to the client.

39. Leasing. In view of the increasing relevance of leasing in DMCs, ADB should allow lease financing. Leasing is fast becoming an alternative to purchasing in project and asset finance, and can offer financial and economic advantages to the lessee. This advantage can be manifested in lower financing costs, special tax breaks, and temporary asset utilization (cutting down the risk of obsolescence). Under a lease, the asset owner (”lessor”) transfers to a user (“lessee”) the right to use equipment under payment over time. Leases can be classified as capital or operating, depending on length and ownership at the end of the contract. Capital leases (financial leasing) cover the cost of an asset for most of its useful economic life. Although ownership remains with the lessor, the main benefits and risks (because of the longer length of the lease) fall on the lessee. The lessee is expected to take over the asset title at the end of the lease period. Operating leases, on the other hand, are more akin to a renting agreement. The lease period is shorter than for capital leases, and the title remains with the lessor during and at the end of the contract. In principle, leased assets can be subjected to the same procurement rules as purchased goods. However, leases do require special accounting and financing reporting, which must be in line with the financial management arrangements made under the transaction.

40. Staff instructions would provide guidance on how to evaluate leasing transactions. The evaluation should assess (i) the alternatives in the context of the project, driven largely by the value of the assets and by a comparison of the net present value of this arrangement with purchasing; (ii) the most appropriate lease options (capital or operating), the bidding arrangements, and sustainability issues (e.g., the ability of the client to buy out the leased asset at the end of the contract); and (iii) financial management, including appropriate accounting and financial reporting.

41. Recurrent Costs. This paper does not propose specific changes to the policy framework on recurrent costs, which are already eligible for ADB financing—in revenue- and nonrevenue-earning projects. However, ADB should reexamine some practices in the context of individual projects. The inclusion of these expenditures in ADB financing plans would continue to be subject to existing limitations, most of which follow from the Charter. First, the coverage is confined to outlays estimated strictly during physical implementation. Second, sound banking principles require an effective limitation and exit strategy. This implies that, even if the expenditure eligibility list is increased and made more flexible by the proposed framework, the amount that ADB and others can finance will be limited to what a project structure can absorb. It is also limited by cost recovery and sustainability considerations (the latter applicable especially, but not exclusively, to nonrevenue-earning operations). Project finance typically covers capital outlays and working capital requirements. However, once implementation is over, most public sector transactions require a commitment from the authorities to provide the required budget resources to maintain the quality, sustainability, and life span of the assets or activities. Since most of these operations are cofinanced with the authorities, this commitment also effectively extends to the implementation phase. In private sector-led transactions, this commitment normally is (or should be) reflected in the equivalent of a project completion and funding guarantee. The independent Credit Risk Management Unit will screen and evaluate the risk profile and cost recovery capabilities of private and public sector projects.

E. Imprest Accounts

42. ADB requires the currency of an imprest account to be indicated in the Loan Agreement. In the future, DMCs with freely convertible currencies should be given the option to maintain imprest accounts in a convertible currency or in their own currency.

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