37870 IDA14 ASSESSINGIMPLEMENTATIONOF THE IDA14 GRANTS FRAMEWORK International Development Association Resource Mobilization (FRM) October 2006 Selected Abbreviations and Acronyms AfDF African Development Fund AsDF Asian Development Fund CAS Country Assistance Strategy CPIA Country Policy and Institutional Assessment DEC Development Economics Vice Presidency DSA Debt Sustainability Assessment DSF Debt Sustainability Framework FRM Resource Mobilization Department FY Fiscal year GDF Global Development Finance GDP Gross Domestic Product GNI Gross National Income HIPC Heavily IndebtedPoor Countries IBRD InternationalBank for Reconstruction andDevelopment IDA InternationalDevelopment Association IMF InternationalMonetary Fund MDB Multilateral Development Bank MDG MillenniumDevelopment Goals MDRI Multilateral DebtReliefInitiative MTR Mid-TermReview MVA Modified Volume Approach NPV N e t Present Value PAYG Pay-as-you-go PBA Performance-Based Allocation PRMED Economic Policy and Debt Department TABLE OF CONTENTS Executive Summary........................................................................................................................... i I. Introduction .............................................................................................................................. 1 I1. The IDA14 Grant Eligibility andAllocation Framework..........................................................2 A. An Overview ofthe IDA14 Grants System......................................................................... 2 B. Implementingthe IDA14 Grants System: HowDoes ItCompare with IDA13?.................4 111. Operational Outcomes andOperational Policy Issues............................................................... 6 A. Operational Outcomes.......................................................................................................... 6 B. Operational Policy Issues..................................................................................................... 9 C. Comparison with IDAl3 Outcomes................................................................................... 14 IV. Financial Outcomes andFinancial Policy Issues..................................................................... 17 A. Financial Outcomes............................................................................................................ 18 B. Financial PolicyIssues....................................................................................................... 19 V. Conclusions and Issues for Discussion.................................................................................... 23 Tables Table 1: IndicativePolicy-Dependent Debt andDebt-Service Thresholds ........................................ 2 8 Table 4: Grants for SelectedCategories as aPercentageo f Total Grants: IDA13 vs.IDA14 .........14 Table 3:FY07 Grant Allocations ........................................................................................................ Table 2: FY06 Outcomes (SDR million) ............................................................................................ 9 Table 5: CompensationMechanisms for IDA14 Grants................................................................... 18 Table 6: Forgone Credit Reflows due to IDA13 & IDA14 Grants (SDR billion)............................ 18 Table 7: IDA13 and IDA14 Grants: Forgone PrincipalReflows (SDR million) ............................. 19 Table 8: FY06: Usage o fthe Hard-TermEnvelope......................................................... 21 Charts 4 Chart 2: Resource Transfers andPerformance: FY06 ...................................................................... Chart 1:IDAAllocations: Performance. Needs and Debt Sustainability........................................... 10 Chart 3: Resource Transfers andPerformance: FY07 ...................................................................... 11 Chart 5: Sectoral Composition o f IDA Commitments. Credits and Grants IDA12-14 ................16 Chart 4: Sectoral Composition o fIDA Grant Commitments. IDAl3-14............................... 17 Chart 6: RequiredLevel o f Donor Contributions ............................................................................. 20 Chart 7: Compensating Forgone Charge Income Due to IDA14 grants (SDR million) ...................23 Text Boxes Box 1: Delivering Concessional Flows inthe Form o fDebt Relief........................................ 12 Annexes Policy-Dependent Debt Distress Classifications: FY06 .......................................................... 26 I1. I. Policy-Dependent Debt Distress Classifications: FY07 .......................................................... 28 I11. Changes in"Traffic Light" Assignments over Time............................................................... 30 EXECUTIVE SUMMARY 1. This paper respondsto a request by IDA Deputiesto conductan assessment o f the newframeworkfor IDA grantsintroducedas part of the IDA14 Replenishmentagreement. Inthisnewframework, there is only one grant eligibility criterion, based on economic analysis: countries' risk o f debt distress. This risk is assessedon the basis o f the methodology proposed inthejoint IMF-WorldBank debt sustainability framework (DSF) for low-income countries.' The riskratings ("traffic lights") are thentranslated into grant allocations: highrisk("red") is associatedwith 100 percent grants, medium ("yellow") with 50 percent grants, and low ("green") with zero grants. This is unlikeIDA13, where grants were allocated according to multiplecriteria for grant eligibility. 2. Inthis new framework, the aggregateamount ofIDA grantsandthe overall share of grantsintotalIDA allocationsare endogenousvariables. This is also in contrast with the IDA13 grants system, where a target grant percentage range (18 to 21 percent) was determined upfront. The total amount of grants to beprovided inIDA14 will dependnot only onthe number o f grant-eligible countries (of 63 IDA-only countries, 44 countries were eligible for grants inFY06 and 41 inFY07), but onthe total amount of IDA resources committed to each one o f them over the same period. The actual grant share inFY06 was 19.2 percent. For the first two years of IDA14 (FY06- 07), the average annual grant share is estimated at about 22 percent of the total IDA envelope. This share rises to about 31percent o fthe total IDA envelope excludingblend and "gap" (hardened-term) countries. 3. Most recipientsofIDA grants are amongthe poorestcountriesinthe world and are locatedin Sub-SaharanAfrica. Poorest countries as perthe IDA13 definition -thosewithpercapitaincomelessthanUS$360-continuetobeamongthemajor beneficiaries of IDA14 grants. Infact, inFY06, poorest countries accounted for 73 percent o f all grant-financed operations approved duringthe period. Furthermore, more than 70 percent o ftotal IDA grant commitments inFY06-07 are expected to directly benefitthe Africa Region. 4. The IDA14 grant allocationsystemhas a direct relationshipwith the Performance-BasedAllocation (PBA) system, termed "modifiedvolume approach" (MVA). It involves a 20 percent volume discount on grant allocations, and a reallocation ofthe resources from such volume discount. The volume discount i s dividedinto two components: (i) "incentives-related" discount, which aims to an preserve the integrityof the incentive systemembeddedinthe PBA (equivalent to an 11 percent volume discount); and (ii) a "charges-related" volume discount, which represents the present value of forgone charge income on grants (equivalent to a 9 percent volume discount). The reallocationprocess has two tracks: (i) resources generated by the incentives-related discount are allocated to IDA-only countries (excluding post-conflict and "gap" countries) according to the PBA; and (ii) resources generated by the charges- ' IMFand IDA (2004). "Debt Sustainability inLow-Income Countries -Proposal for anOperational Framework and Policy Implications." February. - - ~. 11 related discount are earmarked for a "hard-term" credit window for creditworthy blend countries with per-capita income below the IDA operational cutoff ($1,025 infiscal year 2007). These elements interact with the PBA by ultimately affecting allocationvolumes as well. 5. The IDA14 grants system was complementedby IDA'Spolicy on non- concessional borrowingby grant-recipient and MDRI-eligible countries, adopted by the Board on July 6, 2006.2 A key motivation for this new policy i s the risk that IDAgrants (and debt relief, inthe case ofMDRI)cross-subsidize non-concessional loans by other creditors. Indeed,the introduction o fthis new systemincreased the need for coordination with other creditors around financing terms. Some progress has been made inincreasing such coordination, and the adoption o fthe DSF as the basis for the African Development Fund's grants framework i s an important milestone. 6. The new grants framework has also increased the need for accelerated learning on the part of all those affected by the change. New training needs - on the part of Bank staff, client countries, and other MDBs implementinga similar, DSF-based framework -brought about by the new grants system are beingaddressedthrough the provisiono f regulartraining carried out by PRMED, with assistancefrom FRMand DEC. 7. Inorder to be sustainable, the new IDA grants framework needsto be appropriately financed. The financing arrangements for IDA14 grants agreed comprise two elements: (i) forgone principalreflows due to IDA14 grants will be financed through additional donor contributions infuture replenishments, on a pay-as- you-go (PAYG) basis; and(ii) forgone charge income on IDA14 grants will be financed through part o fthe 20 percent "tax" on grants -more specifically, by a charges-related volume discount on grants equivalent to 9 percent o f individual country grant allocations, representingthe present value o f forgone charges. The resources from the 9 percent discount have beenmade available to creditworthy IBRD/IDA blendcountries with income below the IDA operational cutoffunder a new hard-term creditwindow in IDA. InFY06, Azerbaijan, India, andPakistanbenefitedfrom resourcesfrom the newly-created hard-termwindow. InFY06, only India andPakistan are eligible for hard- term credits. 8. The primary financial risk from IDA14 grant financing relates to future donor compensation of forgone principal reflows. A particularly important concern i s to ensure additionality of such financing over regular donor contributions infuture IDA replenishments. This is ariskthat needs to be collectively addressedbythe donor community. One option would be for donors to commit to usingthe "baseline" for compensation under the MDRIalso for purposes o f IDA grant financing. That baseline hasbeen set at the level o fregular IDA14donor contributions, inreal SDR terms. See IDA (2006b). IDA Countries andNon-Concessional Debt: Dealing with the `Free-Rider' Problem in IDA14 Grant-Recipient andPost-MDRI Countries.IDAlR2.006-0137, July. ASSESSING IMPLEMENTATION OF THE IDA14 GRANTS FRAMEWORK I.INTRODUCTION 1. The IDA14 Replenishmentintroduced a new grant eligibility and allocation framework for IDA. Interms of grant eligibility, unlike IDA13, where the overall grant percentagewas negotiated and then allocated according to multiplecriteria for grant eligibility, IDA14has only one criterion, based on economic analysis: countries' risk ofdebtdistress. This risk is assessedonthe basis ofthe methodology proposed in thejoint IMF-World Bank debt sustainability framework (DSF) for low-income co~ntries.~ The riskratings ("traffic lights") are then translated into grant allocations: high risk("red") i s associatedwith 100percent grants, medium("yellow") with 50 percent grants, and low ("green") with zero grants. 2. Thispaper aimsto carry out a key mandatefor the Mid-Term Review (MTR) ofIDA14:to "assess implementationofthe grant framework, closely monitor the grant level and devise action plan a~cordingly".~ This paper concentrates on issues related to the actual "roll out" o f the new system. 3. Thepaper assessestwo dimensionsof the new grant framework: operational and financial. For eachdimension, the paper provides data describing the key operational and financial outcomes, andpoints to the main operational and financial policy issues involved inthe implementationofthe new framework. As such, this paper deals mostly with issues related to the grant allocationprocess as well as to the compensation of IDA for grant-related forgone credit reflows. The discussion o f financing issues i s limitedto credit repayments forgone due to the making o f IDA grants inlieuofprovidingIDAcredits. Thus itdoes not addressthe more immediateissue of IDAproviding debt relief(under the HIPC Initiativeandthe MultilateralDebtRelief Initiative) andthe forgone credit repayments associatedwith the debt relief. Inturn, grant eligibility issues are addressedindepth inthe companion paper for the IDA14 Mid-TermReviewon the operationalization ofthe forward-looking aspects o fthe DSF.' 4. The paper is organizedas follows. SectionI1provides abriefdescriptionofthe IDA14 grant eligibility and allocationframework andcompareswith the grants system under IDA13. Section I11discussesthe operational outcomes and operational policy issues associatedwith the new grants framework. Section IV focuses on the grants framework's financial outcomes and financial policy issues. Concludingremarks are presented in Section V. Annexes Iand I1show country-by-country debt-distressrisk IMFandIDA (2004). "Debt Sustainability inLow-Income Countries -Proposal for an Operational Framework and Policy Implications. February. IDA (2005a). Additions to IDAResources: FourteenthReplenishment. WorkingTogether toAchieve theMillennium Development Goals.March. IDA (2006a). "Debt Dynamics and FinancingTerms: A Forward-Looking Approachto Determining Grant Eligibility inIDA". October. - 2 - ratings and grant eligibility categories for FY06 and FY07, respectively. Annex 111 summarizes changes over time in"traffic light" assignments. 11. THEIDA14GRANTELIGIBILITY ANDALLOCATIONFRAMEWORK A. An Overview of the IDA14 Grants System 5. The operational arrangements for implementing the IDA14 grants framework comprise the following elements: (i) a grant eligibility systembasedon countries' risk o f debt distress; and (ii) a grant allocationsystemthat determines countries' terms o f assistancebutthat also affects the total amounts they receive. GrantEligibility 6. The new grant eligibility systemis based on countries' risk of debt distress, determined inaccordance with the DSFmethodology. The eligibility system apriori excludes IBRD/IDAblendcountries and hardened-term (or "gap") countries from the scope of grant eligibility, irrespectively o ftheir external debt situation. 7. Untilthe IDA14 MTR, determination of debtdistress risk and, consequently, grant eligibility has rested on the "first pillar" of the DSF. More specifically, countries current external debt ratios are compared with the DSF's indicative policy-dependent external debt thresholds (Table 1). As noted, a separate paper6will discuss ways to operationalize the "second pillar" o f the DSF-namely, forecasts about future behavior o f external debt ratios- into an operational systemto determine grant eligibility. Performance Category N P V of debt-to-GDP NPV ofdebt-to-exports Debt service-to-exports Weak (CPIA13.25) 30 100 15 Medium (3.25