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p. 3 of 10 BACK | NEXT Executive Summary I. The Context II. Present Bank Policies and Practices III. Graduation Policies of Other Multilateral Development Banks IV. Rationalizing the Bank's Classification and Graduation System V. Other Operational Implications VI.Conclusions VII. Recommendation

A Graduation Policy for the Bank's DMC's

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II. Present Bank Policies and Practices

A. Policies

7. The Bank's Charter states that:

1. in financing development of its DMCs, the Bank should have special regard for the needs of smaller and less developed countries;
2. due account should be taken of the borrower's capacity to service Bank loans; and
3. Bank funding should not preempt resources that would otherwise have been made available to the borrower on reasonable terms.

These guiding principles form the basis for using country criteria to determine the eligibility of DMCs for Bank assistance. The first principle requires indicators that capture the dimensions of country size and development. The second principle requires indicators that capture a country's debt-repayment capacity. The third principle requires that indicators be taken into account of alternative sources of financing, including (i) a country's access to international capital markets and domestic resources, and (ii) the capacity of a sector/project within a country to attract capital on reasonable terms on a sustained basis.

1. Country Criteria for Bank Assistance

8. Consistent with the principle that Bank assistance should be based primarily on country criteria, the Bank has at present a three-tier country classification system, viz., Groups A, B, and C.⁶ This three-tier classification allows for a differentiation among groups in regard to ADF eligibility. Group A DMCs are "fully eligible," Group B DMCs are eligible for "limited amounts in particular circumstances," and Group C DMCs are ineligible for ADF resources. The policy implies the progression (although no country has been formally reclassified or graduated since the adoption of the policy in 1977) of a DMC from Group A through Group B to Group C. The policy does not envisage a stage beyond Group C when a DMC would cease to be eligible for Bank assistance.
9. The basic rationale for providing concessional assistance to Groups A and B is their economic situation as reflected in two main criteria: per capita gross national product (GNP) and debt repayment capacity. The ADF Regulations state that the goal of ADF is “to enable the Bank more effectively to carry out its purpose and functions by providing resources on concessional terms for the economic and social development of the developing member countries of the Bank, having due regard to the economic situation of such countries and to the needs of the less developed members.” The benefits of concessionality are meant to accrue to a member government⁷ and, through its policies, to the economy as a whole. In fact, in its ADF operations, the Bank provides loans only to DMC governments.
10. The existing policy does not explicitly prohibit Group A DMC governments from borrowing from OCR beyond the amount available from ADF. At the same time, however, the policy does suggest that the possible adverse effects on capital markets of the Bank’s lending from OCR to countries of low creditworthiness should be carefully considered. For this reason, and to minimize strain on their debt repayment capacities, OCR lending to Group A countries that have been identified as having low creditworthiness has normally⁸ not been encouraged. They have therefore come to be characterized as "ADF-only" countries. Group B countries with ADF access⁹ are characterized as "ADF-OCR blend" countries, while Group C countries are "OCR-only" countries.
11. In addition to ADF eligibility, the existing classification system has been used to differentiate between groups with regard to (i) loan terms,¹⁰ (ii) scale of concessional assistance, (iii) sector coverage, and (iv) applicable limits for Bank financing of project costs. In regard to new loans, the most concessional terms are for the "ADF-only" countries. Assistance to ADF-OCR blend countries is less concessional than that for "ADF-only" countries due to (i) blending of concessional and nonconcessional assistance, and (ii) the “harder” ADF loan terms for blend DMCs. Assistance to the OCR-only countries is the least concessional.¹¹
12. The classification system also signifies a scaling back in the volume of concessional assistance: compared with Group A, Group B DMCs have limited access to ADF and Group C DMCs no access at all. After a country's per capita GNP and debt repayment capacity improve sufficiently to warrant graduation from ADF-only to ADF-OCR blend, OCR resources are expected to increasingly replace concessional ADF funding. Eventually, the country would graduate from concessional funding altogether and become an OCR-only DMC.
13. Also associated with the classification system is a differentiation between Group A and Group B DMCs in terms of sector coverage. For Group A DMCs, there are no sector restrictions for ADF funding. For four Group B DMCs (Indonesia, Kazakhstan, Philippines, and Uzbekistan) during the ADF VI period, ADF funding has been restricted to a few specified sectors.¹²
14. The classification system has to strike a balance between (i) avoiding frequent movements of DMCs back and forth between categories, and (ii) having country groupings that are reasonably homogenous internally in terms of the main criteria (otherwise the purpose of the classification system would be defeated). Whether a balance is struck between these considerations depends on how the guidelines for applying the country criteria are framed.

2. Guidelines for Applying Country Criteria

15. Under the existing system, the two country criteria (per capita GNP and debt repayment capacity) are to be applied such that Group A includes countries with low per capita GNP and limited debt repayment capacity; Group B includes lower-middle income countries at intermediate levels of economic development and with increasing capacity to service their debt; and Group C includes upper-middle income and high-income countries with relatively high debt repayment capacity.
16. The present Bank policy allows considerable latitude in the application of the country criteria. In regard to the per capita GNP criterion, the approach is that rigid cutoff points should not be used for classifying countries. This has allowed country groups to be characterized¹³ in terms of certain per capita GNP limits that do not form a continuous scale (see Appendix 1). There is also an operational cutoff for ADF access, originally set at $300 (1972 prices) which when updated using the United States (US) gross domestic product (GDP) deflator¹⁴ is $1,017 in 1997 prices.
17. For the debt repayment capacity criterion, Bank policy¹⁵ is that this capacity is to be judged by the overall strength of an economy, indicated by factors such as its development performance and prospects, levels of saving and investment, ability to generate export earnings, levels of international reserves, outstanding external debt, and debt-servicing burden. The criterion has been applied in a qualitative way.

B. Practices

18. The structure and composition of the Bank's classification system is meant to reflect the relative levels of development of its DMCs and the dynamics of development in the region over time. In a sense, the country classification system is an evolving taxonomy of DMCs, reflecting changing development realities in the region.
19. The composition of DMCs under the various categories when the three-tier classification system was first set up in 1977¹⁶ compared to the current situation shows that the system has remained essentially static, i.e., countries have remained in the groups to which they were originally assigned. The only change is that, from time to time, new members have been added to the list.
20. At the time it was originally conceived, the classification system reflected the differing levels of development in the region. For Group A and to a lesser extent Group B countries, most of the external financing came from official sources, both bilateral and multilateral. Foreign direct investment other than for the exploitation of natural resources was low. Commercial bank lending and portfolio investment were also low. Inward orientation and modest rates of export growth limited the capacity of these DMCs to generate foreign exchange earnings. Due to these and other factors, low levels of per capita GNP went hand-in-hand with low debt repayment capacity.¹⁷ Since then, however, the region has seen fundamental economic changes. These changes are reflected in a shift in the interrelationship between per capita GNP and debt repayment capacities within and across country groupings.
21. A growing number of low- and lower-middle income DMCs no longer conform to the expected pattern of development finance.¹⁸ Asian economies have heterogeneous economic management records and growth performances. Yet the region as a whole shows changing trends in DMCs' creditworthiness, access to international capital markets, and sources of external financing. There are also changing trends in the capacity of DMCs to generate foreign exchange earnings and high rates of growth. The larger countries (People’s Republic of China [PRC], India, Indonesia, Philippines, and Thailand) in the region have built up the capacity to service debt on non-concessional terms, including OCR terms. They have gained access to international capital markets¹⁹ and have demonstrable capacity to attract foreign direct investment.
22. The current financial crisis in Southeast and East Asian economies has led some observers to take a pessimistic view of the region’s prospects. In this vein, doubt has also been cast on the usefulness of a proposed policy that assumes that countries will make development progress over the medium term. In this connection, it is worth noting that the crisis has not engulfed the entire Asian region, but only some economies. Even for these economies, recent events cannot erase their past achievements in accumulating savings, promoting investment, and developing human capital. Moreover, in historical perspective, growth in the region has never been a linear progression. Rather, it has been characterized by episodic recessions and recovery. The historical record also suggests that financial crises by themselves do not irretrievably destroy the potential for long-term growth. Economies have recovered from contraction in output to regain their previous course over time. The crisis-affected Southeast and East Asian economies should, given the requisite commitment to financial sector reform and improved public and corporate governance, not only recover but emerge from the crisis stronger than before.
23. Returning to the longer term, Asia-wide perspective, the changing trends in the region make a strong case for redesigning the classification system to better meet the changing realities. The system should provide a formal framework in which countries graduate through a sequence of stages in Bank financing, culminating in graduation from regular Bank assistance. This would ensure that the classification system reflects the development progress of borrowing DMCs. Before discussing the proposed approach, the graduation policies of other MDBs will be outlined.

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