67853 DEVELOPMENT POLICY LENDING TO POLITICAL SUBDIVISIONS POLICY PAPER OPERATIONS POLICY AND COUNTRY SERVICES FEBRUARY 11, 2011 ABBREVIATIONS AND ACRONYMS BP Bank Procedure (statement) CAS Country Assistance Strategy DPO Development Policy Operations IBRD International Bank for Reconstruction and Development ICR Implementation Completion Report IDA International Development Association IDB Inter-American Development Bank IEG Independent Evaluation Group OD Operational Directive OP Operational Policy (statement) DEVELOPMENT POLICY LENDING TO POLITICAL SUBDIVISIONS CONTENTS Executive Summary ........................................................................................................... i I. Introduction ............................................................................................................... 1 II. Legal and Policy Framework for Lending to Subnational Units .......................... 2 III. Evolution of Policy and Practice .............................................................................. 4 IV. The Case for Development Policy Lending to Municipalities ................................ 9 V. Implications ................................................................................................................ 13 VI. Conclusions and Next Steps .................................................................................... 14 Annex A. Possible Modification of OP 8.60, Development Policy Lending ................ 17 Annex B. List of Subnational Development Policy Operations (Approved through August 31, 2010) .......................................................... 19 DEVELOPMENT POLICY LENDING TO POLITICAL SUBDIVISIONS EXECUTIVE SUMMARY 1. The Bank uses development policy operations to help a member achieve sustainable reductions in poverty through a program of policy and institutional actions that promote growth, enhance well-being, and increase the incomes of poor people.1 In countries with a decentralized structure of government political subdivisions often have independent budgetary authority and legislative competence in areas of importance for the country’s growth and poverty reduction, notably in business regulations and service delivery. The Bank can provide investment lending to any political subdivision that has the legal ability to borrow from the Bank or enter into a contractual relationship with the Bank. The operational policy governing development policy operations, set out in OP 8.60, states that the Bank may lend to a member country or to a subnational division of a member country, but it limits eligible subnational divisions to states and provinces. However, depending on a country’s structure of government other political subdivisions (e.g., federal districts, national territories, cities, and municipalities) can have responsibilities that are equally relevant for growth, poverty reduction, and service delivery as those of some states or provinces. Supporting the reform program of such an entity can be consistent with the objective and spirit of the Bank’s development policy operations. 2. Purpose of the Paper. Responding to a country’s demand for a development policy loan2 to a political subdivision other than a state or province requires the Board to grant a policy waiver. This paper examines the case for a policy change extending eligibility for development policy operations to political subdivisions that in accordance with the country’s constitutional and legislative framework have independent budget authority, legislative competence for the actions to be supported by the operation, and the requisite legal ability to borrow from, or enter into a contractual relationship with, the Bank. The paper presents, for the Board’s approval, Management’s specific proposals for modifying the policy. 3. Main Messages. The paper highlights the following points:  General case. The general case for providing development policy lending to a political subdivision rests on the relevance of such an entity’s policy and institutional actions for attaining the country’s development objectives. A subdivision’s eligibility therefore should reflect its policy and institutional domain within the country’s structure of government rather than its specific status as a state or province. Depending on the country’s constitution or applicable law, such a subdivision may have a direct fiscal relationship with the central government, another political subdivision such as a state, or with 1 See OP 8.60 (Development Policy Lending). 2 “Loan� includes credit and IDA grant. ii both. The case for development policy operations does not extend to state economic enterprises and other sub-sovereign entities that are not political subdivisions. Lending to such entities would earmark resources for particular sub-sectors rather than providing general budget support.  Macroeconomic framework. All development policy operations (DPOs) require that the country’s macroeconomic policy framework is appropriate. For a DPO to a political subdivision it is also necessary that the subdivision has an appropriate expenditure program, sustainable debt, and appropriate fiscal arrangements with the central government and/or with the applicable political subdivisions in accordance with the country’s constitutional and legislative framework.  Selectivity. Selection between eligible subdivisions should be guided by criteria that are relevant to the country’s development, such as potential development impact, fiscal and debt sustainability, impact on poverty reduction, or demonstration effect on other political subdivisions. The criteria should be country-specific and be agreed with the member country. 4. Borrower. The Bank’s policy governing IBRD’s and IDA’s choice of borrower apply to DPOs for political subdivisions.3 IBRD may lend directly to a political subdivision with a sovereign guarantee or may lend to the country with arrangements for onlending to the subdivision. IDA may lend or provide an IDA grant to the country with arrangements to transfer the proceeds to the subdivision. 5. Proposals. Management proposes, for the Board’s approval, the following modifications to the operational policy:  The Bank may provide development policy operations to a member country or to a political subdivision of a member country. For the purpose of the policy, the term political subdivision refers to entities that in accordance with the country’s constitutional and legislative framework have budget authority and legislative competence for the policy and institutional actions supported by the development policy operation. In addition, they must have the requisit legal ability to borrow from, or enter a contractual relationship with, the Bank.  For development policy lending to a political subdivision, the subdivision must have an appropriate expenditure program, sustainable debt, and appropriate fiscal arrangements with the central government and/or with the applicable political subdivisions in accordance with the country’s constitutional and legislative framework.  For a development policy operation to a political subdivision, the Bank reviews the financial management and procurement arrangements of the country, of the political subdivision, and of the applicable subdivisions in accordance with the country’s constitutional and legislative framework. 3 See OP 7.00 (Lending Operations: Choice of Borrower and Contractual Agreements). iii 6. Next Steps. If Executive Directors approve Management’s proposals, Management will make appropriate revisions to OP 8.60. Annex A provides for information a comparison of the existing and the proposed policy provisions in OP 8.60, paragraphs 1 (including footnotes), 5, and 19. Management would update its guidance to staff on the application of OP 8.60 to subnational development policy operations. DEVELOPMENT POLICY LENDING TO POLITICAL SUBDIVISIONS 1. INTRODUCTION 1. The Bank uses development policy operations to support a borrower’s program of policy and institutional actions that promote growth, enhance well-being, and increase the incomes of poor people.4 In countries with a decentralized structure of government, the responsibility for such actions—notably in business regulations and service delivery— rests, to varying degrees, with political subdivisions.5 The performance of political subdivisions with legislative and budgetary authority in delivering public infrastructure and social services, managing the public sector, regulating private sector activities, and conducting fiscal affairs can matter greatly for the country’s growth and poverty reduction and, if budget constraints are weak, also for its fiscal stability. In recognition of this circumstance, the Bank’s operational policy governing development policy operations (reflected in OP 8.60) states that the Bank may lend to a member country or to a subnational division of a member country, though it limits eligible subnational divisions to states and provinces.6 The distribution of policy domains among subnational divisions, however, differs between countries. Political subdivisions such as federal districts, national territories, cities, and municipalities can have policy responsibilities that are relevant for growth, poverty reduction, and service delivery. Also, a single city, like a single state, may not itself drive country growth and poverty reduction, but may illustrate the benefits of better management with a demonstration effect on other political subdivisions. 2. Background. Approving a development policy operation to a political subdivision other than a state or province currently requires the Board to grant a policy waiver, as recently occurred in the approval of a loan to the Municipality of Rio de Janeiro.7 There is country demand for financial support for improvements in the policy and institutional frameworks for service delivery of subnational governments, which the Bank can only provide through development policy operations (DPOs). As part of a Review of Instruments, which the Executive Directors discussed at an informal Board meeting on January 28, 2010, Management indicated that a possible approach to enabling the Bank to respond to such demand would be to modify OP 8.60 to allow for municipal DPOs. In the discussion, several Executive Directors supported such an approach and one Executive Director stated that policy-based lending to municipalities should be left to the regional development banks. During the Board discussion of the loan to Rio de Janeiro Management indicated that it was preparing a review of the policy provision that limits 4 See OP 8.60, Development Policy Lending. 5 The term political subdivision is used in the Bank’s Articles, the terms subnational division and subnational entity in OP 8.60, and the term subnational unit in the 1998 Guidelines on subnational adjustment lending. Except as the context may otherwise require, this paper uses the term political subdivision. 6 OP 8.60, para. 1 and footnote 1. 7 See Brazil – Fiscal Consolidation for Efficiency and Growth Development Policy Loan (R2010- 0162/1), June 8, 2010. 2 subnational development policy lending to states and provinces. Also underpinning the need for reconsidering this provision is the Bank’s Urban and Local Government Strategy,8 which indicates growing demand for policy-based financing in several Regions. This paper reviews the issue and concludes that modifying OP 8.60 to allow for lending to political subdivisions (including not only states and provinces but also other entities such as federal districts, national territories, cities, and municipalities) under certain conditions would be consistent with the objectives of the policy. The paper provides, for the Board’s approval, specific Management proposals to that end. 3. Structure of the Paper. This paper is structured as follows: Section II summarizes the Bank’s legal and policy framework for lending to subnational units; Section III describes the evolution of policy-based operations for political subdivisions and examines why it has been limited to states and provinces; Section IV presents the case for removing the limitation and introducing appropriate conditions for development policy lending to political subdivisions; Section V considers implications for the results framework, for analytic work, and for risk management; and Section V concludes and sets out next steps. I. LEGAL AND POLICY FRAMEWORK FOR LENDING TO SUBNATIONAL UNITS 4. Lending to political subdivisions of member countries is grounded in the Bank’s Articles. IBRD Article III, section 4, states in part that the Bank may make loans to any political subdivision of any member and lists among the conditions that the member, or an agency of the member acceptable to the Bank, fully guarantees the repayment of the principal and the payment of interest and other charges of the loan. IDA Article V, section 2, states in part that the Association may provide financing to a political subdivision of any member and may, at its discretion, require a suitable governmental or other guarantee. 5. Direct and Indirect Lending. The Bank’s policies on choice of borrower and contractual agreements (which are codified in OP 7.00, Lending Operations: Choice of Borrower and Contractual Agreements) govern the legal arrangements between the Bank and a political subdivision regarding a DPO. According to OP 7.00, IBRD generally prefers to lend directly to the subdivision responsible for the implementation of the program for which the loan is made. In such case, the Bank may enter into a loan agreement directly with the political subdivision (with the member country’s guarantee), if the political subdivision is capable of entering into such an agreement. Where direct lending is not possible or practical, IBRD may lend to the member country, which is expected to on-lend the loan proceeds to the political subdivision. In these cases, the Bank normally enters into a “program agreement� with the political subdivision concerning its program of policy and institutional actions supported by the DPO. As a policy matter, IDA’s financing is only available to member countries to ensure that IDA members receive the full benefits of IDA’s resource concessionality. Consequently, in the 8 See Systems of Cities: Harnessing Urbanization for Growth and Poverty Alleviation, World Bank 2009. 3 case of a DPO to a political subdivision of an IDA country, IDA enters into a financing agreement with the member country with arrangements to transfer the credit or grant proceeds to the political subdivision, and normally enters into a “program agreement� with the political subdivision concerning the program supported by the DPO. In the following, we use the term indirect lending for IBRD and IDA lending to member countries with arrangements for the transfer of loan, credit, or grant proceeds to a political subdivision. 6. Use of Lending Instruments. The use of the Bank’s lending instruments and their options are governed by policies that are summarized in Management’s Operational Policy statements (OPs): OP 8.60, Development Policy Lending; OP 10.00, Investment Lending and the OPs for several investment lending options; and OP 14.25, Guarantees. The policies are consistent with, though in parts more restrictive than, the Bank’s Articles and OP 7.00. 7. Investment Lending. The operational policy governing investment operations (OP 10.00) allows financial support to states and provinces as well as any other sub- sovereign entity meeting the requirements of OP 7.00. In fact, the Bank has provided investment loans and credits to municipalities and to municipal public enterprises throughout its history and in all Regions. The number of such operations has increased over time: 4 operations in the 1950s, 5 in the 1960s, 12 in the 1970s, 37 in the 1980s, 54 in the 1990s, and 48 in the 2000s. Of these 160 operations 73 used direct lending (including 29 loans/credits to municipalities and 44 to enterprises wholly or partly owned by a municipality) and 87 used indirect lending (including 84 loans/credits onlent to municipalities and 3 onlent to municipal enterprises). IBRD committed a total of US$ 11,459 million and IDA a total of US$ 1,218 million equivalent. 7. Guarantees. The Bank can also use its guarantee instrument at the subnational level. A partial risk guarantee (with a sovereign counter-guarantee) can cover a sub- sovereign entity’s commitments (including the commitments of a political subdivision and a state-owned enterprise) to a private sector project. In IBRD-eligible countries, the Bank may also provide a partial credit guarantee for a private sector loan to the project of a sub-sovereign entity, subject to a sovereign guarantee. Policy-based guarantees are subject to the limitations that also apply to development policy lending. 8. Development Policy Lending. The operational policy governing development policy operations (OP 8.60), however, limits subnational development policy operations (DPOs) to states and provinces.9 This excludes DPOs to other political subdivisions such as federal districts, national territories, cities, and municipalities. Like all DPOs, those provided to states or provinces must meet the “special circumstances� provision of the Bank’s Articles. They also must comply with the other provisions of operational policy including the provision that the Bank must have determined that the country’s macroeconomic policy framework is appropriate. In addition, the state or province must have an appropriate expenditure program and appropriate fiscal arrangements with the 9 OP 8.60, footnote 1. 4 central government.10 Since August 2004, when this policy was adopted, it has governed a total of 18 subnational DPOs: 8 in Pakistan, 5 in Brazil, and 5 in India11 (see Annex B). Of these, seven were IBRD operations, six were IDA operations, and five were combined IBRD/IDA operations. The operations in Brazil involved lending directly to the subnational divisions—four states and one municipality—with a sovereign guarantee, and those in Pakistan and India involved lending to the member country with onlending arrangements to the provinces and states. II. EVOLUTION OF POLICY AND PRACTICE 9. Before adopting OP 8.60, the Bank provided adjustment lending to political subdivisions governed by policies summarized in the Operational Directive (OD) 8.60. 12 Adjustment lending was introduced by the Bank in 1980, in the aftermath of the oil price shock, as an instrument for providing quick-disbursing support to assist members coping with structural changes to their economy.13 It was originally intended to provide financing for the balance of payments and to support policy changes that helped stabilize the economy and minimize the adverse effects of economic shocks in a sustainable manner, including changes in fiscal, exchange rate, and trade policies. But it soon became apparent that countries had problems requiring changes beyond fiscal and other macroeconomic policies, so structural adjustment lending was used to support reforms also in other areas of economywide policy—such as state-owned enterprises restructuring, financial sector policies, and resource mobilization and expenditure policies of the public sector—and also to support sector policy reforms that complement the reform of economywide policies. OD 8.60 neither explicitly included nor excluded adjustment lending to subnational divisions. By the mid-1990s, the Bank began to use adjustment lending to help members address problems arising from subnational issues, notably the adverse impact of weak subnational finances on fiscal stability, growth, and poverty reduction. 10. Provincial and State Reform Loans. Between 1995 and 1998 the Bank provided a series of adjustment loans to support provincial reforms in Argentina14 and investment loans with policy conditionality to support state reforms in Brazil15—weak subnational finances were adversely affecting these countries’ fiscal balance. The operations focused on underlying structural problems, notably loss-making state/provincial public sector enterprises and state/provincial health and pension systems. The Bank also began 10 OP 8.60, para. 5. 11 As discussed below, an operation in the Russian Federation, which the Board approved in February 2005, was governed by the Bank’s adjustment lending policy (OD 8.60). 12 OD 8.60, Adjustment Lending Policy. 13 See Issues in Adjustment Lending (R96-55), April 4, 1996. 14 Including Provincial Bank Privatization Loan (P-6570), April 20, 1995; Provincial Health Sector Development Project (P-6607), July5, 1995; Provincial Pension Reform Adjustment Loan (P-6967), November 6, 1996; and Four Second Provincial Reform Adjustment Loan Projects – Rio Negro, Salta, San Juan, and Tucuman (P-7136), July 30, 1997. 15 Including Rio Grande do Sul State Reform Loan Project (15943), January 24, 1997; Mato Grosso State Privatization Project (16515), May 22, 1997; Rio de Janeiro State Reform Privatization Project (15869), June 6, 1997; and Minas Gerais State Privatization Project (16466), April 9, 1998. 5 supporting reforms in the incentive structure of fiscal federalism (e.g., the assignment of expenditure responsibilities and revenue sources between the tiers of government, intergovernmental transfers, and rules for subnational borrowing) with adjustment lending to several countries—Brazil, Bolivia, Russian Federation, and Ukraine—but these operations involved neither direct nor indirect lending to subnational units. In Argentina, the first provincial reform loans were “wholesale� loans in which the national government onlent loan proceeds to any province willing to implement a set of reforms designed by the center, and the second provincial reform loans were “retail� loans onlent by the member to specific provinces implementing their own reform programs. In Brazil, direct investment loans to the states (with a sovereign guarantee) were used to support state reform programs. These operations were structured with significant retroactive financing to facilitate disbursements against the policy and institutional actions on which the loans were conditioned. During the Board discussion of the Rio Grande do Sul operation, Executive Directors voiced concerns—about the high transaction costs associated with the disbursement mechanism, the large amount of retroactive financing, and the lack of clarity about macroeconomic considerations—and requested Management to organize a seminar on Bank lending to states and provinces. 11. Guidelines on Adjustment Lending to Subnational Units. Management responded to the request with an approach paper16 and followed up with a paper that was discussed by Executive Directors at an informal meeting on February 24, 1998, with a final text circulated on May 14, 1998.17 This document stated that the Bank’s adjustment lending policy applies to subnational adjustment lending, and no changes to the policy were proposed. The final text was issued as Guidelines for Staff on June 1, 1998. The key guidance to staff was that subnational adjustment lending: (i) was provided only to states or provinces—defined as political subdivisions at the level immediately below the national level—that have independent budgetary authority from the central government and the requisite legal authority to undertake the proposed reforms; (ii) had the two objectives of stable economywide fiscal and external balances and efficient public expenditure; (iii) required the country’s macroeconomic policy framework, its framework for center-subnational government finances, and the state or province’s program of subnational expenditures and specific action program of reforms to be satisfactory to the Bank; and (iv) was used selectively to ensure the greatest contribution of Bank resources to the attainment of national development objectives, with selection criteria emphasizing the state or province’s relative significance to the national economy, high poverty rates, and the severity of its distortions and associated adverse impact on growth. 12. Consistency with Structural Adjustment Lending. The guidance on subnational adjustment lending was consistent with the objectives of the Bank’s structural adjustment lending policy at the time (OD 8.60), and it also reflected the Bank’s role as a major source of external finance for most of its borrowers.18 The Bank used structural adjustment lending largely to help countries achieve macroeconomic stabilization and adjustment by supporting reforms in public finances (improving the efficiency of public 16 World Bank Lending to States and Provinces: An Approach Paper (SecM97-478), June 11, 1997. 17 Adjustment Lending to Subnational Units: Final Text (SecM 98-96 [Rev.]), May 14, 1998. 18 See Issues in Adjustment Lending, op.cit. 6 expenditures, taxation, and financing) and in economywide and sector policies and also by strengthening the government’s capacity to implement policies. These were first- generation reforms that focused on removing distortions—for example, by liberalizing the trade regime, deregulating domestic goods and factor markets, and lifting obstacles to private sector investment. By allowing the provision of adjustment lending to states and provinces, the Bank considered that the actions of these units could adversely affect macroeconomic stability and that reforms of subnational finances and expenditure policies could be important for macroeconomic stabilization and adjustment. This is reflected in the guidance on the objectives of subnational adjustment lending, i.e., stable economywide fiscal and external balances and efficient public expenditure. It also is consistent with the guidance to limit lending to states or provinces—as the actions of lower level entities were considered less relevant for country-level macroeconomic stability, which was a key objective of structural adjustment lending. 19. This is further reflected in selection criteria that emphasize the state or province’s relative significance (in terms of size, concentration of poverty, or severity of distortions) to national development. 13. Movement to Development Policy Lending. In the years following the issuance of the 1998 Guidelines on adjustment lending to subnational units, the objectives of structural adjustment lending evolved leading, in August 2004, to the replacement of the Bank’s Adjustment Lending Policy (OD 8.60) with the operational policy on Development Policy Lending (OP 8.60). Countries increasingly moved beyond stabilization and structural adjustment toward fostering sustained growth and poverty reduction through more complex second-generation policy and institutional reforms. Such reforms focus more on supporting institutions and microeconomic incentives, calling attention also to the actions of entities below the level of states or provinces. Furthermore, members increasingly gained access to alternative sources of financing— such as financial markets, regional development banks, and bilateral donors—for their projects and programs of policy and institutional actions and also for supporting the actions of subnational governments. One implication is that the contribution of Bank support for subnational reforms began to depend less on the relative size of the political subdivision and more on other criteria, such as the development outcomes of Bank- supported service delivery reforms, or the demonstration effect of improved management on other political subdivisions. These developments are illustrated in the subnational adjustment loan the Bank provided to the Russian Federation through the Tatarstan Republic in support of the reform program of the city of Kazan.20 19 The Guidelines remained silent on the reasons for limiting eligibility, even though the preceding approach paper had indicated that adjustment lending to municipalities would also be considered. 20 Before OP 8.60 was issued in August 2004, the Bank began processing and appraising a programmatic structural adjustment loan to the Russian Federation with onlending arrangements through the Tatarstan Republic for the city of Kazan. The loan, which was ultimately approved by the Board in February 2005, supported a municipal program of actions to improve the Kazan’s fiscal situation, improve municipal budget and asset management, and provide more efficient delivery of housing, utility, and social services. It was anticipated that this loan would have a strong demonstration effect for other subnational divisions. The operation received a satisfactory outcome rating from IEG. 7 14. Subnational Development Policy Lending under OP 8.60. While moving from adjustment lending to development policy lending in 2004, the Bank brought lending to subnational divisions explicitly into the Board-approved policy. OP 8.60 states, “The Bank may provide development policy lending to a member country or to a subnational division of a member country�21 and specifies in a footnote that “subnational divisions refer to states and provinces.�22 Thus lending to a subnational division that is not a state or province—such as a federal district, national territory, city, or municipality—is not covered under the policy and thus would require a waiver from the Board. The OP also articulates two specific requirements for subnational DPOs: “For development policy lending to a subnational entity, the state or region must have an appropriate expenditure program, as well as appropriate fiscal arrangements with the central government.� 23 All other requirements for development policy lending set out in the OP also apply to subnational DPOs. 15. Management Guidance. Management provided guidance to staff on how to meet the requirements set out in OP 8.60. Lending programs, including financing of subnational units through investment and development policy operations, is expected to be discussed in the context of the CAS and CAS Progress Report. The discussion would be informed by country demand and development priorities, and by Bank assessments of the country’s structure of government, its decentralized fiscal framework, and its policy and institutional framework, underpinned by the necessary analytic work. The decision to provide development policy financing to a subnational entity is based on assessments of the central government’s policy and support for subnational development, the strength and sustainability of the subnational program to be supported by the operation, and the ownership of the program by both the subnational unit and the member country. In addition, Management also provided guidance on the choice of lending instruments (investment lending, development policy lending, and guarantees), the operation’s design, the establishment of results indicators, baselines and targets for monitoring and evaluation, fiduciary issues, and risk mitigation. 16. Evolution of Countries’ Objectives. The reform programs supported by the 18 subnational DPOs approved to date indicate that the objectives of countries seeking Bank support for the reform programs of political subdivisions differ in emphasis from objectives envisaged in the Guidelines on adjustment lending to subnational units. The borrowers of subnational development policy loans have focused more on improving service delivery than on ensuring economywide macroeconomic stability. The shift in emphasis reflects, on the one hand, progress in strengthening center-subnational fiscal arrangements through measures such as Brazil’s fiscal responsibility law and, on the other hand, the devolution of responsibilities to lower tiers of government in a number of countries—both changes that the Bank supports with financing and analytic and technical assistance. Many subnational DPOs, like national DPOs, support enhancements in service delivery and the investment climate, but virtually all include measures to improve fiscal and/or debt management: 21 OP 8.60, para 1. 22 OP 8.60, footnote 1. 23 OP 8.60, para. 5. 8  Fiscal adjustment has been a prominent objective in all DPOs to subnational entities. But the focus of fiscal policy actions supported by the operations has been on achieving and maintaining fiscal sustainability in the state or province to ensure that an adequate level of public spending can be maintained in a sustainable manner and to lessen the risk of a reversal of sector policy and institutional reforms. The program documents for DPOs to Indian states, for example, include measures to address unsustainable debt dynamics, which can occur even with appropriate federal-state fiscal arrangements.24  All operations support sector policy and institutional actions, often in the education and health sectors, that are aimed at improving service delivery and the quality of public spending. Strengthening of sector governance and accountability is highlighted in the DPOs to Indian states and Pakistani provinces, and public sector management reforms in the DPOs to Brazilian states. Beyond education and health, support for sector policy reforms is widening into other areas such as agriculture (Orissa and Bihar, India), basic infrastructure (Bihar, India), irrigation (Punjab, Pakistan), and hydropower and tourism (Himachal Pradesh, India).  The DPOs to states in India and Brazil prominently support policy and institutional actions aimed at strengthening private sector development including improving the investment climate and reforming business regulations. 17. Development Outcomes. Subnational DPOs generally have been effective in supporting borrowers’ development objectives. Among the 14 operations for which an Implementation Completion Report (ICR) is available, one operation (Brazil: Minas Gerais Partnership for Development) received an outcome rating of highly satisfactory, nine operations in Pakistan25 and two operations in India received a satisfactory outcome rating, and one operation in India was rated moderately satisfactory. None was rated unsatisfactory. ICRs are self-assessments by management and are validated by IEG. IEG has to date rated the Brazil operation and the Punjab Education Sector series, confirming the highly satisfactory outcome rating for the Brazil operation and the satisfactory outcome rating for the Punjab Education Sector series. A recent IEG study on Bank engagement at the state level,26 which covers lending (investment lending and development policy lending), knowledge transfer, and technical assistance, notes that the Minas Gerais operation helped the state lay the foundations for improved public sector management, complete a fiscal turnaround and regain its investment capacity, introduce a culture of results-based management, and strengthen coordination within the state 24 While DPOs serve as general budget financing and are not conditioned on a specific use of loan proceeds, program documents typically reflect the intended use of the equivalent amount (e.g., retiring high-cost debt) in medium-term fiscal projections and in debt sustainability analysis. 25 The Pakistan operations include four operations in the Punjab Education Sector series. The first of these operations pre-dates the approval of OP 8.60 and is not listed in Annex B. 26 IEG. 2010. World Bank Engagement at the State Level. The Cases of Brazil, India, Nigeria, and Russia. Washington, DC: World Bank. 9 government. The Punjab Education Sector operations provide an example of the development outcomes subnational DPOs can achieve. Over the three-year period of the first three operations: the education sector budget increased by 50 percent, primary girls’ net enrollment in government schools increased from 35 percent to 52 percent; girls’ enrollment was increased through a stipend program targeted at low literacy districts; 20 million free textbooks were distributed to 9.7 million students; standard Grade V examinations were conducted universally; and some 6,500 teachers from low cost private schools received training. These outcomes had a strong demonstration effect on other provinces, notably Sindh and the North West Frontier Province adopted programs similar to the Bank-supported program of Punjab. IV. THE CASE FOR DEVELOPMENT POLICY LENDING TO MUNICIPALITIES 18. Municipal development has long been mainstreamed in the development thinking and in the operations of the Bank. Every World Development Report (WDR) since 1990 has referred to the role of municipalities in addressing development issues. The 2009 WDR Reshaping Economic Geography cited them as engines of growth and poverty reduction. A recent study by IEG27 found that nearly 3000 municipalities benefitted from Bank support to municipal development through lending, technical assistance, or training in the 1998-2008 period. Some 85 percent of municipal development projects completed in the second half of the period achieved satisfactory outcomes, above the Bank-wide average for completed projects. The focus of Bank support was on strengthening the planning, finance, and service provision dimensions of municipal management. Subsequent to the IEG study, the Bank’s Urban and Local Government Strategy28 highlighted the growing demand for development policy lending in support of municipalities’ policy and institutional reforms. Against this background, the following considers the case for extending eligibility for development policy lending to municipalities and other political subdivisions. 19. Extending Eligibility. The general case for development policy lending to political subdivisions in countries with a decentralized structure of government rests on the importance of the role these entities play in designing and implementing policies and institutions relevant for achieving the growth and poverty reduction objectives. Which entities should be eligible for development policy lending, therefore, is foremost a matter of the distribution of policy and institutional domains according to a country’s constitutional and legislative framework, not of their specific designation as a state or province. This section discusses eligibility in the light of differences between countries’ decentralized structures. Extending eligibility beyond states and provinces calls for extending policy provisions on the macroeconomic framework and fiduciary arrangements to political subdivisions other than states or provinces. In addition, this section discusses criteria for the selection between eligible political subdivisions, and the potential value added of the Bank in policy-based financing at this level. 27 IEG. 2009. Improving Municipal Management for Cities to Succeed. Washington, DC: World Bank. 28 See: Systems of Cities: Harnessing Urbanization for Growth and Poverty Alleviation. Op.cit. 10 20. Political Subdivisons. A number of countries have political subdivisions that are on the same level in terms of political and institutional domain as states, provinces, or regions (in the case of the Russian Federation). Examples include federal districts (e.g., the capital cities of Argentina and Brazil), capital territories (e.g., the capital cities of India and Nigeria), union territories (India), and subjects of the Federation (e.g. St. Petersburg in the Russian Federation). There appears to be no rationale for excluding such entities from consideration for development policy lending. Indeed, given their relative size in the economy and in the population of poor people, reforms in these entities may be as relevant for national development as some states or provinces. In some countries, notably Brazil, municipalities have a direct relationship with the federal government and are also a part of the state in which they are located. They have independent budget authority and legislative competence in important areas. In Rio de Janeiro state and municipality, for example, the responsibility for education services is divided between pre-school and fundamental grades (municipality) and secondary grades (state), for health services between primary services (municipality) and medium- and high-complexity services (state), and for business regulation between the issuance of operating licenses (municipality) and business registration (state). Development policy lending to municipalities can help improve fiscal sustainability, public sector management, and service delivery, and can also help strengthen policy coordination in sectors where responsibilities are divided between the state and the municipality. In other countries, municipalities and other entities such as cities, towns, or counties have relationships only with the state or province in which they are located. But in accordance with the country’s constitutional and legislative framework they can have budgets and policy responsibilities independent of the state, i.e., they are not simply administrative units implementing the actions of the state. 21. Management is of the view that development policy financing should be possible to support the reform programs of such political subdivisions in important areas such as public sector management, service delivery, and business regulations. This is consistent with the findings of the 2009 World Development Report on Reshaping Economic Geography and the Bank’s Urban Strategy,29 which recognize the crucial role of the development of cities for growth and poverty reduction. However, administrative units without legislative competence should not be eligible for development policy lending, nor should sub-sovereigns that are not political units (e.g., public enterprises or special bodies such as a metropolitan transport or water authority). While such sub-sovereigns tend to have some regulatory authority, a DPO in support of their actions would earmark resources rather than provide general budget support. 22. Eligibility Criteria. The wide variation between countries’ decentralized structures of government argues against linking the eligibility of a political subdivision to any particular designation such as state, federal district, or municipality. Instead, a political subdivision should be eligible if, in accordance with the country’s constitution or applicable law, it has the ability to conduct its own program of policy and institutional reforms in important areas such as public sector management and delivery of public services, i.e., has the necessary legislative competence and budget authority. For the 29 Systems of Cities: Harnessing Urbanization for Growth and Poverty Alleviation, op. cit. 11 Bank to provide policy-based financing, the political subdivision also must have the legal ability to borrow from the Bank and/or enter into a contractual relationship with the Bank, normally a program agreement covering the reform program to be supported by the DPO. 23. Macroeconomic Framework and Intergovernmental Fiscal Arrangements. An appropriate macroeconomic policy framework of the country is crucial for the effectiveness of any DPO, including for operations that support the reform program of a political subdivision. This requirement would be maintained for all DPOs, including for subnational DPOs to political subdivisions, as is already the case for DPOs to states or provinces. For DPOs supporting political subdivisions, and as is already the case for DPOs to states or provinces, it is important that the subdivision have an appropriate expenditure framework, sustainable debt, and appropriate fiscal arrangements with the relevant jurisdictions. For subnational DPOs to municipalities, this may require assessing fiscal arrangements with more than one level of government. Depending on the country’s constitutional and legislative framework, these could be fiscal arrangements with the central government and/or with applicable political subdivisions (e.g., with the state in which the borrower is located). 24. Fiduciary Arrangements. For DPOs, the Bank reviews the country’s public financial management and procurement arrangements to determine whether the operation should include measures to address identified weaknesses and inform decisions on risk mitigation measures. For DPOs supporting a political subdivision the Bank will also review the financial management and procurement arrangements of the subdivision and of other applicable subdivisions—as is the case for DPOs to states or provinces. 25. Selectivity. Selection of subnational divisions to which the Bank would provide financing—through investment, development policy, or guarantee operations—is generally made as part of the Country Assistance Strategy process. Selection criteria for subnational divisions to receive Bank support through development policy lending could include: country demand and development priorities, potential development and poverty impact, and demonstration effect for other political subdivisions. The recent IEG study World Bank Engagement at the State Level 30 highlighted a selection bias in favor of high- performing states that tend to be the wealthier states, but also noted that Bank engagement with states and provinces through DPOs was valuable—even for better- performing states or provinces. Better-performing states may also have severe poverty and exclusion issues, and these may be targeted in the program supported by a state-level DPO, as they have for instance in the Pakistan Punjab Education Sector series, which supported a stipend program for girls’ education targeted at low literacy districts. Given the importance of country ownership and the need for trade-offs in the use of Bank resources, selection criteria must be country-specific and have country buy in. Countries that guarantee—or borrow and onlend—Bank financing have a strong interest that the reforms supported by the operation have merit in their own right and serve the country’s development objectives. Management believes that the logic of the selection criteria 30 Op. cit. 12 employed is best articulated as part of the CAS process and with the agreement of the member country. 26. Capacity Issues. Some subnational governments may have comparatively low capacity to design and implement a policy and institutional reform program. Support for improving the capacity of the subnational government—through development policy lending, investment lending, technical assistance, and/or training, or through support by other development partners—may be part of DPO financing. This is the approach already followed by the Bank in low-income countries and fragile and conflict-affected states, where capacity building is critical for achieving development results in a sustained manner. Such issues would be reflected in the CAS. 27. Bank Value Added. The issues the Bank helps countries address through development policy lending to political subdivisions are shared by a number of countries with a decentralized structure of government. They are not regional in nature. The Bank’s global experience in both investment lending and development policy lending, and also in technical assistance and knowledge transfer, to subnational entities is likely to be an advantage in providing support to reforms in political subdivisions that are not states or provinces. Likewise, the Bank has international experience and technical competence in many areas of subnational fiscal reform, public sector and governance reform, service delivery, and private sector development that are of relevance to political subdivisions below the level of states or provinces. Among the regional development banks, the Asian Development Bank currently limits subnational program lending to states and provinces. The Inter-American Development Bank can provide direct policy-based lending (with a sovereign guarantee) to subnational units, including states, provinces, and municipalities, but has provided only one loan (to the State of Bahia, Brazil) since 2001. The African Development Bank currently does not provide policy-based loans or grants (including structural adjustment loans/grants, sector adjustment loans/grants, budget support loans/grants, and policy-based loans/grants for governance) to subnational units. The Bank has long provided investment lending support, technical assistance, and knowledge transfer to third-tier entities. 31 It has both the competence and the knowledge and lending relationship also to help such entities improve policy and institutional frameworks, which development policy lending has been successful in doing at national and state/provincial levels. 28. Conclusion. The considerations set out in this section show that development policy lending to political subdivisions (including not only states or provinces but also entities such as federal districts, national territories, cities, and municipalities) would be consistent with the spirit and objectives of the operational policy for DPOs, summarized in OP 8.60. Management believes that the Bank is well positioned to support the reforms of political subdivisions and that selection criteria agreed with the country can be effective in ensuring the best use of Bank resources for supporting the country’s growth and poverty reduction. Management proposes that OP 8.60 be modified accordingly. It will then update the Management guidance to staff on supporting the reform programs of 28 See: IEG. 2009. Improving Municipal Management for Cities to Succeed. Op cit. 13 political subdivisions, including providing advice on appropriate selection criteria and on the choice between investment lending, development policy lending, and guarantees. V. IMPLICATIONS 29. Extending eligibility for development policy lending from states and provinces to other political subdivisions (e.g., federal districts, national territories, cities, and municipalities) would have some implications for the Bank’s analytical work and risk management.  Analytic work. The decision to provide development policy operations to a country’s political subdivisions would be informed by analysis of their policy domains and their fiscal arrangements under the country’s constitution and applicable laws. Assessments underpinning development policy operations— such as the country’s economic situation, governance and fiduciary arrangements, debt sustainability, environmental/natural resource management, poverty and social aspects, and ownership of and institutional capacity to implement the program--would need to include the relevant levels of political subdivisions. In addition, such financing would need to consider the country’s (and if applicable the state’s) policy toward local government issues. Such assessments would draw upon research and analytical work done within the Bank and also on work within the country or other agencies. A new Bank product would not be needed, but the content of existing products and possibly the analytic work supporting the CAS would need to be broadened. In some cases, required analytic work could have resource implications— however the trade-offs required would be managed within existing budget constraints and as part of the Bank’s dialogue with country authorities on the CAS and CAS implementation.  Risk management. Development policy financing to political subdivisions potentially involves risks additional to those associated with development policy financing of countries. There could be a higher risk of disbursing into a deteriorating fiscal situation, which could be, and in most subnational DPOs has been, mitigated by incorporating prior actions on fiscal policy and debt management in the operation’s design. Policy inconsistencies between the center (and possibly the state or province) and a political subdivision could undermine the effectiveness of the program supported by the DPO. Such inconsistencies would need to be identified in the assessments preceding the operation, reducing the risk that the Bank lends into an unsustainable policy and institutional environment. Disputes between the center and relevant subdivisions could put the support of the central (and possibly state or provincial) government for the political subdision’s reform program at risk. This is not different from the risk faced by any other form of Bank financing of sub- sovereign entities. The risk is mitigated by the requirement that the central government (and possibly state or provincial government) must endorse the program to be supported through the loan. To maintain adequate support, such 14 government(s) would normally be involved in monitoring the program. Political support for the political subdivision’s program at the center (and possibly the state or province) may not be sustained over successive political cycles, particularly if different political parties gain power at these levels. To mitigate this risk, it is important to ensure during preparation of the DPO that at each level the ownership of the reforms to be supported is broad-based. Another possible risk could be created by relatively weak fiduciary arrangement at the level of the subdivision. This risk tends to be mitigated by the typical focus of such subdivision’s reform program on public financial management. In highly risky fiduciary environments, the Bank could also require additional measures such as dedicated accounts for loan proceeds.  Results Framework. Each subnational DPO would have its own results framework, with monitorable indicators, baselines and targets—like those of national DPOs and state or provincial DPOs. The focus on results is one of the characteristics distinguishing development policy lending from adjustment lending. As is already the case for state and provincial DPOs, the program document for a DPO supporting the reform program of a political subdivision, like that for a DPO supporting a country’s program, would set out the program being supported and the specific results expected from the operation, and it would include measurable indicators for monitoring progress during implementation and evaluating outcomes on completion. The link between expected results influenced by the operation and expected CAS results or more often CAS outcomes would be made explicit. Such results would be primarily on the level of the subnational entity. Characteristic indicators established in DPOs—such as service standards, debt ratios, indicators of budget transparency, and financial management measures—would be entirely applicable also to a DPO supporting the reform program of a political subdivision. VI. CONCLUSIONS AND NEXT STEPS 30. This paper has examined the evolution of the policy and practice of the Bank’s adjustment lending and development policy lending to political subdivisions. Such lending has been effective in supporting reforms that contribute to attaining important country development objectives, notably in Brazil, India, Pakistan, and the Russian Federation. On that basis, the paper has presented a strong case for extending eligibility from states and provinces to other political subdivisions such as federal districts, national territories, cities, and municipalities. 31. Recommendations. Management recommends that Executive Directors approve the following proposals for modifications to provisions of the operational policy governing the use of development policy lending:  The Bank may provide development policy lending to a member country or to a political subdivision of a member country. For the purpose of this policy, the term political subdivision refers to entities that in accordance with the country’s constitutional and legislative framework have budgetary authority 15 and legislative authority for the actions supported by the development policy operation. In addition, they must have the requisite legal ability to borrow from, or enter a contractual relationship with, the Bank.  For development policy lending to a political subdivision, the subdivision must have an appropriate expenditure program, sustainable debt, as well as appropriate fiscal arrangements with the central government and/or with the applicable political subdivisions in accordance with the country’s constitutional and legislative framework. For a development policy operation to a political subdivision, the Bank reviews the financial management and procurement arrangements of the country, of the political subdivision, and of the applicable subdivisions in accordance with the country’s constitutional and legislative framework. 32. Next Steps. If Executive Directors approve Management’s proposals, Management will make appropriate revisions to OP 8.60. Annex A provides for information a comparison of the existing and the proposed revised policy provisions in OP 8.60, paragraphs 1 (including footnotes) and 5. Upon approval of this change, Management will update its guidance to staff on the application of OP 8.60 to development policy lending to political subdivisions. Annex A POSSIBLE MODIFICATION OF OP 8.60, DEVELOPMENT POLICY LENDING Current text Possible new text Paragraph 1 Paragraph 1 Development policy lending is rapidly disbursing Development policy lending is rapidly disbursing policy-based financing, which the Bank1 provides in policy-based financing, which the Bank1 provides in the form of loans or grants to help a borrower address the form of loans or grants to help a borrower address actual or anticipated development financing actual or anticipated development financing requirements that have domestic or external origins. requirements that have domestic or external origins. The Bank may provide development policy lending to The Bank may provide development policy lending to a member country or to a subnational division of a a member country or to a political subdivision of a member country.2 member country. 2 1 “Bank� includes IBRD and IDA, “loans� includes credits 1 “Bank� includes IBRD and IDA, “loans� includes credits and IDA grants, “borrower� includes borrower and IDA and IDA grants, “borrower� includes borrower and IDA grant recipient, and “subnational divisions� refers to states grant recipient, and “political subdivision� refers to or provinces. political entities that have budget authority and legislative competence for the actions supported by the development 2 See OP 7.00, Lending Operations: Choice of Borrower policy operation; it does not refer to public enterprises. and Contractual Agreements. Except as the context may otherwise require, “borrower� includes a “political subdivision� where the loan is provided to, or for the benefit of, a political subdivision. 2 The Bank may lend to a political subdivision with a member guarantee or to the member country with arrangements for onlending to the subdivision. The political subdivision must have the requisite legal power to borrow directly from the Bank and/or to enter a contractual relationship with the Bank: see OP 7.00, Lending Operations: Choice of Borrower and Contractual Agreements. Paragraph 5 Paragraph 5 Macroeconomic Framework. The Bank undertakes Macroeconomic Framework. The Bank undertakes development policy lending in a country only when it development policy lending in a country only when it has determined that the country’s macroeconomic has determined that the country’s macroeconomic policy framework is appropriate. The release of each policy framework is appropriate. The release of each tranche requires the maintenance of an appropriate tranche requires the maintenance of an appropriate macroeconomic policy framework. For development macroeconomic policy framework. For development policy lending to a subnational entity, the state or policy lending to a political sub division, the entity region must have an appropriate expenditure program, must have an appropriate expenditure program, as well as appropriate fiscal arrangements with the sustainable debt, as well as appropriate fiscal central government. arrangements with the central government and/or with the applicable political subdivisions in accordance with the country’s constitutional and legislative framework. Paragraph 19 (b) Paragraph 19 (b) Budget resources. The Bank reviews the country’s Budget resources. The Bank reviews the country’s public financial management and procurement public financial management and procurement arrangements through diagnostic work and through arrangements through diagnostic work and through 18 reports prepared by the borrower and others, including reports prepared by the borrower and others, including published annual audit reports of the central bank and published annual audit reports of the central bank and of the government. of the government.1 1 For a development policy operation to a political subdivision, the Bank reviews the financial management and procurement arrangements of the country, of the subdivision, and of the applicable subdivisions in accordance with the country’s constitutional and legislative framework. ANNEX B LIST OF SUBNATIONAL DEVELOPMENT POLICY OPERATIONS (APPROVED THROUGH DECEMBER 31, 2010) Country Project Name Approval Amount in ID Date US$ million IBRD IDA India P081882 Orissa Socio-Development Program 11/02/04 85 40 Loan/Credit1 Pakistan P090346 Punjab Education Sector DPC2 07/01/05 100 Brazil P088543 Minas Gerais Partnership for 4/11/2006 170 Development Pakistan P090689 North-West Frontier Province DPC 6/1/2006 90 1 Pakistan P096962 Punjab Irrigation Sector DPL 1 6/1/2006 100 Pakistan P097636 Punjab Education Sector DPC 3 6/1/2006 100 India P097036 Orissa Socio-Economic 8/1/2006 150 75 Development Program Loan/Credit 2 India P075174 Andhra Pradesh Economic Reform 1/11/2007 150 75 Loan/Credit 3 Pakistan P097471 North-West Frontier Province DPC 6/7/2007 130 2 Pakistan P100846 Sindh Education sector DPC 1 6/7/2007 100 Pakistan P101243 Punjab Education Sector DPC 4 6/7/2007 100 Pakistan P102333 Punjab Irrigation Sector DPL 2 6/7/2007 100 India P105124 Himachal Pradesh DPL/DPC 1 9/25/2007 135 65 India P102737 Bihar DPL/DPC 12/20/2007 150 75 Brazil P106767 Rio Grande do Sul Fiscal 7/31/2008 1100 Sustainability for Growth DPL Brazil P103770 Alagoas Fiscal and Public 12/17/2009 195 Management Reform DPL Brazil P117244 Rio de Janeiro State DPL 2/2/2010 485 Brazil P111665 Rio de Janeiro Municipal Fiscal 7/1/2010 1045 Consolidation DPL