Financial Management Issues in Development Policy Lending

1. Financial Management Issues inDevelopment Policy Lending Financial Management Anchor October 21, 2004

2. FM in Development Policy lending • Development policy lending provides both balance of payment and budget support • Two main FM issues: • Appropriate management of the country’s budget resources through its public financial management (PFM) system • Funds flow arrangements – reasonable assurance that Bank loan proceeds reach the country’s foreign exchange reserves and the budget • Bank reviews of above inform decisions on loan amounts, tranching, program content, conditionality and risk mitigation measures

3. Development Policy lending trends • DPLs account for around 30% of Bank lending

4. Development Policy lending trends • On average there are 30-40 DPL operations annually

5. Development Policy lending trends • The preparation time for DPL operations is half that for IL.

6. Development Policy lending trends • Around 30% of DPL is to IDA countries.

7. Development Policy lending trends • The average size of IDA DPL operations is around 30% of IBRD DPL operations.

8. Knowledge of PFM System • Bank’s own principal instruments are CFAA, CPAR and PER (or integrated analytic work) • Analytic work may also be done by IMF or other donors or country institutions • “Mandate” for diagnostic work replaced with justification based upon business needs of the Bank. • Pre-requisite – analytic work on the country’s PFM system. Covers aspects such as: • Comprehensiveness and transparency of budget • Reliable information on fiscal position and performance • Systems to monitor implementation and monitoring of budget • Financial accountability for use of public resources

9. Design of Program Content, Conditionality, Tranching, Risk Mitigation (1) • No established minimum PFM standard as precondition for Bank support – e.g. in post conflict countries • Main issue is Government’s commitment to PFM improvement/reform, and reasonable evidence that improvements are occurring in a timely manner • Improved PFM performance may be an outcome, rather than a precondition • Sometimes PFM improvements may be supported by other donors, rather than through the Bank-supported operation

10. Design of Program Content, Conditionality, Tranching, Risk Mitigation (2) • Link PFM conditions and triggers to analytic work • Sequence PFM benchmarks, conditions and triggers and ensure continuity of actions • As far as practicable, make PFM conditions specific, time bound and result-based. • Provide realistic assessment of PFM environment in the PAD. • Ensure that appropriate implementation arrangements are in place

11. Funds Flow : Normal arrangements • Bank loans are disbursed into an account that forms part of the country’s official FX reserves (normally held with the central bank) • Equivalent amount is credited to an account of the government that is available to finance budgeted expenditures (e.g., Single Treasury Account, Consolidated Fund). • This is an accounting transaction; in some cases money may also be transferred from the FX bank account to the local currency bank account. • These are mandatory, and covered in the legal agreement. • Bank has due diligence role to ensure that these are done. The simplest and therefore recommended approach is to obtain a confirmation (or “representation”) from the borrower with details.

12. Funds Flow (2): Due diligence responsibilities • Understand the control environment within which foreign exchange is managed by the borrower (i.e., the central bank control environment) • Principal tool is the IMF’s Safeguards Assessment of Central Banks. • Audit reports of the central bank may also be reviewed. • Control weaknesses are addressed through IMF-monitored improvement plan. • Understand the control environment for budget management i.e., borrower’s PFM system. • as discussed earlier

13. Funds Flow (3): Negative list • Ultimate use of Bank funds (FX and local currency) are not tracked • Borrower’s undertaking that proceeds will not be used for “negative list” is a self-implementing “code of conduct”, which if breached would trigger Bank remedies • “Negative list” includes items such as military expenditures, environmentally hazardous goods, jewelry, tobacco, alcoholic beverages • Local currency expenditures is no longer on the “negative list”

14. Additional Fiduciary Arrangements • When? • Inadequate knowledge of central bank’s FX control environment, and audit reports of the central bank indicate weaknesses • Inadequate knowledge of the country’s PFM system • Acceptable plan to deal with identified weaknesses is not in place • Bank management considers significant possibility of ‘reputational risk’ that Bank loan proceeds could be identified as being used for ineligible expenditures (the “negative” list) • How? • Deposit of Bank loan proceeds into a dedicated account(s). Dedicated account may be established for FX or local currency or both. Dedicated accounts are also part of the country’s FX reserves and budget resources. • Agree on purposes for which loan proceeds may not be or may be used • Audit of the dedicated account(s). • Principally protects against reputational risk and provides some (but not full) assurance

15. Documentation in the Program Document • PFM system • Status of analytic work and summary results • Summary of PFM improvement plans and actions taken/committed • Conditions, triggers, benchmarks, indicators • Funds flow arrangements • Central bank control environment drawing from IMF’s Safeguards Assessment. Bank reports should only record information contained in the summaries of safeguards assessments that are submitted to the Fund’s Board • Brief description of funds flow arrangements • Any additional fiduciary arrangements

16. Supervision • Agreed fund flow arrangements have been complied with • Bank loan proceeds have reached country’s FX reserves and budget • Any additional fiduciary arrangements were complied with • Agreed PFM improvement actions are being implemented