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Review of Cost-Sharing Limits for Projects Financing as an Element of ADB's 1998 Graduation Policy

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II. Review of ADB's Policies on cost-Sharing Limit

A. Cost-Sharing Limits under the 1998 Graduation Policy

3. According to ADB’s 1998 graduation policy, the maximum proportion of project costs that ADB may normally finance is determined by a DMC’s country grouping. ADB’s cost-sharing is the ratio of ADB’s financing to total project cost inclusive of taxes and duties. The 1998 paper stated that “these limits are not to be applied mechanically, but are to be based on a DMC's performance in domestic resource mobilization, the balance-of-payments situation, and any special circumstances that may prevail. These criteria relate to the economic strength of a DMC, the same principle on which assessment of debt repayment capacity is based.” Therefore, the 1998 graduation policy proposed that, in general, country classification should be used when applying cost-sharing limits. The 1998 graduation policy proposed that the existing cost-sharing limits 80% for Group A (ADF [Asian Development Fund]-only), 60% for Group B (ADF-OCR [ordinary capital resources] blend), and 40% for Group C (OCR-only) be retained with modification that a ceiling of 70% be applied to Group B1 (ADF with limited OCR), i.e., if a country graduates from Group A to Group B1, it will also graduate from an 80% cost-sharing limit to a 70% limit.² The 60% cost-sharing limit will apply to Group B2 (OCR with limited ADF). The lower ceilings for countries that are reclassified will be effected in a phased manner, with 5 percentage points reduction per year. Under exceptional circumstances and where justified on country and project considerations, ADB financing may exceed the normal cost-sharing limit. With the approval of the 1998 graduation policy, project cost-sharing limits were well established as an integral part of the graduation framework.

B. DMCs’ Graduation Process and Corresponding Changes of Cost-Sharing Limits

4. The 1998 paper introduced a systematic approach for applying the two criteria, i.e., per capita GNP and debt repayment capacity, for the purpose of country classification. The 1998 paper observed that, prior to the introduction of this system, countries had remained in the groups to which they were originally assigned since 1977.³ The 1998 paper set up a graduation process that generally would allow graduation to take place from Group A to Group B1, Group B1 to Group B2, Group B2 to Group C, and graduation from regular ADB assistance. The 1998 paper noted that there would be changes in project cost-sharing limits for the following graduating DMCs: (i) for Bangladesh, Cook Islands, Marshall Islands, the Federated States of Micronesia (FSM), Pakistan, Sri Lanka, Tonga, and Viet Nam, the limit will fall from 80% to 70%; (ii) for the People’s Republic of China (PRC) and India, the limit will fall from 80% to 60%; (iii) for Philippines, Thailand, and Uzbekistan, the limit will fall from 60% to 40%; and (iv) for Kazakhstan from 80% to 40%. The prevailing cost-sharing limits prior to the 1998 paper were introduced in 1983.4 Under the 1998 graduation framework, four DMCs, Hong Kong, China; the Republic of Korea; Singapore; and Taipei,China; graduated from regular ADB assistance.

C. Changes in the Cost-Sharing Limits: Impact on ADB’s Operations

5. It is noted that the 1998 paper brought ADB’s country classification system largely in line with that of the World Bank. However, the cost-sharing limits particularly for Group B2 and Group C countries have fallen significantly below that of the World Bank (see Table 2). ADB’s stringent cost-sharing limits constrains ADB’s country programming and project processing, as well as project implementation (for example, a government under current and midium-term budgetary constraints naturally has an incentive to process or implement a project that requires less counterpart financing). This puts ADB’s operations at a disadvantage in serving the needs of its DMCs. It is observed that since 1999, there has been a large number of projects that sought the Board’s approval on an exception basis to exceed the cost-sharing limits.⁵

6. The current Group C countries include Fiji Islands; Kazakhstan; Malaysia; Philippines; Thailand; and Uzbekistan. The per capita GNPs of these countries were in 1998 and continue to be much lower than the graduation trigger level of $5,445 at 1997 prices. Their general economic development level and debt repayment capacity were weaker than those of the four graduating DMCs when the 40% limit was applied to them prior to 1998. Malaysia, Philippines, and Thailand were hard hit by the Asian financial crisis; Kazakhstan and Uzbekistan were hit by the Russian financial crisis. These countries are still recovering from the crises or constrained by strict fiscal positions even for financing national development. The Asian Development Outlook 2002 Update noted that “over the last several years, particularly in East Asia and Southeast Asia, there has been a general tendency toward deteriorating fiscal balances. Rising public debt obligations have accompanied the increased tendency toward deficits.”⁶ Consequently, for development financing, the 40% cost-sharing limit puts an undue fiscal burden on these DMCs. Indonesia was a blend borrower prior to the 1998 graduation policy. However, it is well known that the country was severely affected by the Asian financial crisis, with its per capita GNP reduced from $1,110 in 1998 (at 1997 prices) to $680 in 2002 (at 2001 prices) and its debt repayment capacity drastically weakened. Similarly, the 60% cost-sharing limit also puts an undue fiscal burden on this country.

D. Evolving Development Agenda and ADB’s Portfolio

7. Poverty reduction was declared the overarching goal of ADB in 1999, and ADB’s Board approved the poverty reduction strategy later that year.⁷ In March 2001, the ADB Board endorsed the long-term strategic framework (LTSF) of the Asian Development Bank (2001–2015), Moving the Poverty Reduction Agenda Forward in Asia and the Pacific.⁸ The LTSF is intended to realize a new vision and mission of ADB.⁹ ADB’s operations have been gradually moving from concentration in traditional project financing such as physical in frastructure projects, to a more diversified portfolio with strong emphasis on poverty reduction and social development. These areas of investment often have lower financial rates of returns and higher levels of local currency expenditures, which taken together can put undue pressure on governments’ short- and medium-term fiscal positions. In this context, ADB needs to be ready to provide a higher share of financing for poverty reduction and social development projects.

E. Refinement Needed to the 1998 Graduation Policy

8. Against this varied background, it is considered necessary and relevant to review the cost-sharing limits under the 1998 graduation policy, taking into consideration similar policies and practices of other MDBs that provide a useful benchmark for determining appropriate costsharing limits for ADB.¹⁰

9. It is worth noting that this paper is concerned only with proposed changes to costsharing limits for project financing (i.e., only changes in the percentage points for Group B1, Group B2, and Group C countries). All other elements of the existing graduation policy framework are retained. In this context and as per current policy, under exceptional circumstances and where justified on country and project grounds, ADB financing may also exceed the normal cost-sharing limit. A revision of the cost-sharing limits under the graduation framework is to bring ADB’s cost-sharing limits in alignment with the level of development in DMCs and with practices of other MDBs.¹¹

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