OM Section D4/BP Issued on 8 August 2016 Page 1 of 14 · OM Section D4/BP Issued on 8 August 2016 Page 3 of 14 OPERATIONS MANUAL BANK POLICIES (BP) nonstandard lending terms, and

OM Section D4/BP Issued on 8 August 2016

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OPERATIONS MANUAL BANK POLICIES (BP)

These policies were prepared for use by ADB staff and are not necessarily a complete treatment of the subject.

POLICY-BASED LENDING

A. Introduction 1. The Asian Development Bank (ADB) provides policy-based lending in the form of budget support in conjunction with structural reforms and development expenditure programs of a developing member country (DMC). It is also used to provide balance-of-payments (BOP) assistance. ADB makes policy-based loans only to DMC governments. 2. Policy-based lending may be either from ADB’s ordinary capital resources (OCR) or the Asian Development Fund (ADF). For financing from the ADB’s concessional resources, policies regarding concessional lending to DMCs apply.1 3. Policy changes that improve growth prospects based on consideration of the economy and efficiency are the basis for policy-based lending to a DMC. Such policy reform 2 along with the development expenditure program is set forth in a policy statement by the DMC government concerned in the form of a letter to the President of ADB. The program outlined in that development policy letter (DPL) is the focus of ADB’s support. B. Definitions 4. The term “sector” in the context of policy-based lending is to be understood in the broad sense of the word. In addition to the traditional concept of a sector characterized by production of particular goods or services (such as the agriculture, industry, and service sectors), the term may also cover subsectors of more limited scope, or relate to a cross-cutting sector addressing economy-wide themes, ownership, or the specific area of policy coverage (such as the private, public or external sectors) with possible macroeconomic implications. 5. In general, policy-based loans (i) are linked to the implementation of policy reforms, and are disbursed quickly, and (ii) have sector-wide and economy-wide impact. 6. A negative import list specifies imports that are excluded from financing under the loan, either by item or by specification of the Standard International Trade

1The terms “lending” and “loan(s)” include ADF grant(s), except that ADB’s special policy-based lending (SPBL) and Countercyclical Support Facility (CSF) lending are financed only from OCR. See OM Section D2 (Lending and Grant Policies [Asian Development Fund]).

2 The term “policy reform” covers: (i) structural reform required under stand-alone policy-based lending, the programmatic approach and special policy-based lending (SPBL); and (ii) resort to fiscal policy under the CSF.

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Classification. All items not listed may be financed under the loan. In contrast, a positive import list specifies eligible imports for financing under the loan. C. The Policy

7. Policy-based lending supports sectoral and intersectoral development programs in a DMC. It involves adjustments to policies and investment plans, and capacity building of institutions. The program addresses underlying constraints that are sector-wide or intersectoral, or have a bearing on links between sectors and the macroeconomy. 8. Policy-based loans, as well as sector development programs (SDPs),3 must be targeted at sectors in which the government is firmly committed to reform. Strong government ownership of the reform program is essential. Policy-based lending should also be limited to areas where ADB has or can readily acquire the requisite experience to provide well-founded advice on the formulation and implementation of reform programs. 9. A DMC’s experience in implementing policy conditions attached to project and sector loans in the same sector, and implementation experience with past policy-based loans, are important factors for planning further policy-based lending. This should cover not only the status of tranche release of ongoing policy-based loans in the DMC, but also post-evaluation results of completed policy-based and project or sector loans. Where serious problems were experienced with other policy-based loans in the same DMC, processing of further policy-based loans or SDPs needs to be particularly well justified, and will be contingent on substantial front-loading of the relevant conditionality. D. Scope of the Policy

10. ADB has four policy-based lending products, each catering to a different situation in a DMC. Stand-alone policy-based lending provides budget support and is typically packaged as a multitranche loan to support structural reforms in a particular sector. The program is short- to medium-term, and formal links to other programs are not usually envisaged. The second policy-based lending product, the programmatic approach, is ADB’s primary mode of policy-based lending that is provided in conjunction with structural reforms over a medium-term time frame. Programmatic budget support finances a series of subprograms, each of which should be designated as a fully front-loaded single-tranche intervention. The programmatic approach can take the form of chronologically sequenced packaging (over time), vertical packaging (across levels of government), and horizontal packaging (intersectoral). The third policy-based lending product, special policy-based lending (SPBL), is used for emergency BOP support to a DMC in times of payments crisis. It is short-term, large, and quick disbursing with

3 See OM Section D5 (Sector Development Programs).


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nonstandard lending terms, and it focuses on actions to reduce the severity of the crisis.4 The fourth policy-based lending product is a loan from the Countercyclical Support Facility (CSF), which provides budget support to facilitate a DMC’s fiscal stimulus at the time of the economic crisis. It has the pricing and terms scheme equivalent to the SPBL. Stand-alone policy-based lending and the programmatic approach form part of the assistance package contained in a country partnership strategy (CPS) or indicative rolling country operations business plan for a DMC. However, because a crisis is often hard to anticipate, SPBL and CSF lending are not planned in advance.5 An SPBL and a CSF loan can lead to subsequent planned stand-alone policy-based lending and/or programmatic approach operations during the recovery phase following a crisis. Technical assistance (TA)6 may also be attached to all policy-based lending products to study major policy issues and to strengthen key sector institutions. 11. Stand-alone policy-based lending and the programmatic approach, as well as SPBL where applicable, are based on comprehensive sector analyses that identify structural constraints to sector development, and on policy dialogue with the government to determine the means to address these constraints. The program resulting from the sector studies and policy dialogue must have the full commitment of the government, be consistent with ADB’s CPS for the DMC concerned, coincide with the DMC’s development plans and priorities, and be closely coordinated with other major development agencies. Macroeconomic policy dialogue and assessment are essential for CSF operations.

1. Stand-Alone Policy-Based Lending 12. Stand-alone policy-based lending for budget support is normally used to improve the policy and institutional environment for enhanced sector efficiency and for higher returns on investment. Structural reforms seek to improve the efficiency and amount of investment in a sector by (i) enhancing resource mobilization through increasing cost recovery, reducing or eliminating subsidies, and rationalizing interest rates; (ii) improving the allocation of resources by lowering barriers; and (iii) promoting efficient resource use by increasing competition and private sector involvement. Where policy adjustments are required in a particular sector over an extended period, a succession of stand-alone budget support loans may be considered to sustain the process.

2. Programmatic Approach 13. The programmatic approach is designed to provide more effective and flexible ways of translating complex objectives of structural reforms into implementable policy

4 Exceptional assistance under SPBL would typically be provided in a crisis situation where a large

international rescue package led by International Monetary Fund is being mounted in one or more of ADB’s DMCs to help restore stability.

5 Incremental resource mobilization for SPBL and CSF lending should be permitted exceptionally during a crisis and only to the extent that it does not hinder ADB’s risk-bearing capacity.

6 OM Section D12 (Technical Assistance).



actions. The programmatic approach recognizes imperfections in information and its availability, and allows for flexibility in designing policy packages. The logical links between the packages are captured in a programmatic approach concept paper. Sound policy and institutional settings that help improve the economic welfare within a country-specific context are prerequisites for making financing commitments under the programmatic approach. 14. The first type of programmatic approach, the chronologically sequenced packaging of policy reforms, allows for phasing in reforms over an adequate period in a coherent yet flexible framework. The programmatic approach enables (i) the capacity to deliver policy reform to be matched with the intended policy change; (ii) changes to be made in nontraditional areas of policy where solutions are not obvious; (iii) solutions to policy issues to be reframed in response to changes in the external environment; and (iv) incentives to be balanced sequentially throughout the program cycle to sustain commitment and ownership to change. 15. Chronologically sequenced packaging is characterized by (i) a coherent reform strategy with discrete subprograms linked as a program; (ii) a link between satisfactory performance under the current subprogram and the decision to proceed with a successive subprogram ; and (iii) the provision of flexibility, which enables experience and changes in the external environment to be incorporated in downstream subprograms. 16. The second type of programmatic approach, the vertical packaging of policy reforms, is a variant of the chronologically sequenced package. It is based on the understanding that the implementation of certain types of policy objectives will involve several levels of government and that follow-through will be required at each level over an adequate time frame. Vertical packaging of policy reforms allows for concurrent implementation of logically linked subprograms across several levels of government and provides the means of managing the complexity and dynamics of multilevel policy change. Concurrent implementation in this type of programmatic budget support should be structured to avoid a top-down approach in implementing policy change, and to ensure that a constraint at a particular level of government does not impede implementation of the other subprograms of reform while the constraint is addressed at the source. Each of the subprograms should be designed to link the policy instruments, actions, and institutional arrangements at a particular level of government. While implementation of some of the subprograms may occur concurrently, others may be implemented subsequently based on the experience gained with the initial subprograms. 17. The third type of programmatic approach, the horizontal packaging of policy reforms, is another variant of the chronologically sequenced packaging, involving cross-sectoral policy goals. In horizontal packaging, policy change would be undertaken simultaneously and followed through in a number of sectors to achieve a common goal. This approach may be used to address thematic policy change where solutions to


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problems are multifaceted and have substantive policy and investment requirements that are mutually reinforcing.

3. Special Policy-Based Lending 18. Extraordinary financial crisis situations, principally as a feature of globalized capital markets, can reoccur and be unexpected. Large reversals of capital flows and marked unexpected swings in relative prices require very sizable resources to restore stability. A protracted recovery phase is likely to ensue after stability has been restored, during which period the structural weaknesses that precipitated the crisis are addressed. 19. Typically, these crises are likely to affect DMCs at a more advanced stage of development: emerging market economies that are regular OCR eligible or those that have graduated. The special characteristics of crisis-related lending, particularly its unanticipated character and exceptional scale, and the associated credit risk require adequate risk-bearing capacity at the side of ADB to back up such lending. The SPBL is used to address external and internal payments crisis by providing large-scale support as part of an international rescue effort, including the International Monetary Fund (IMF) and the World Bank.7 Another dimension that would justify ADB intervention is when the crisis has significant structural dimensions8 and is likely to have significant negative social impact. To avail itself of assistance under an SPBL, a DMC must be regular OCR eligible.9 Countries that have graduated from regular ADB assistance are also eligible for SPBLs.

4. Countercyclical Support Facility Lending 20. The CSF provides budget support to DMCs undertaking fiscal stimulus for growth in the form of countercyclical development expenditures.10 CSF lending has features similar to those of SPBL, such as accessibility to regular OCR-eligible or graduate countries only and the requirement to secure adequate risk-bearing capacity at ADB. However, given its purpose to provide budget support for fiscal stimulus, rather than BOP support to DMCs with payment difficulties, the CSF requires a DMC to have a countercyclical development expenditure/policy program, rather than the international rescue package. Countries that have graduated from regular ADB assistance are eligible for CSF lending.

7 In this context, a crisis would be defined as a situation in which a DMC is facing unanticipated difficulties in meeting its payments obligations, both external and internal. In practice, involvement of IMF signifies existence of BOP difficulty, and SPBL is not expected to be mobilized in the case of domestic payments difficulty alone.

8 However, not all structural reforms that are beneficial in the long run should be undertaken in the midst of the crisis addressed by SPBL.

9 SPBL and CSF lending are not proposed for concessional assistance-only countries.

10 A loan from the CSF is aimed at making up for lost aggregate demand at the time of economic crisis and containing its adverse impacts on growth.



21. While the CSF lending takes the form of a single-tranche operation, disbursement may be immediate or deferred under certain conditions, such as a deterioration of market conditions. The precautionary financing option (PFO) may be exercised when it is highly likely that the impacts of the exogenous shock will reach the recipient country but have not fully materialized at the time of ADB’s financing commitment. PFO enables a borrower to postpone drawing down the funds once the loan agreement has been declared effective until such time that the prescribed drawdown conditions have been satisfied. The conditions for drawing down should be articulated in the report and recommendation of the President (RRP) of individual CSF operations.

5. Identification 22. Identification of stand-alone policy based lending and programmatic approach is made in the context of ADB’s CPS for the DMC concerned to achieve medium-term objectives in a particular sector or across sectors. SPBL and CSF lending can be identified only when a crisis arises. The decision to initiate preparation of policy-based loans requires a comprehensive assessment of sector or cross-sectoral issues and their analyses. Full commitment by the government to institute a reform program is a prerequisite for a policy-based loan, as are the ability and political will to implement the needed reforms. In addition, the reform program must merit ADB support on account of its scope and strength, and the policy-based lending must facilitate and accelerate implementation of the reform program. 6. Sector Analysis 23. Comprehensive sector or intersectoral studies are a prerequisite for considering stand-alone policy-based lending and the programmatic approach.11 A problem analysis should be conducted as part of the summary sector assessment linked to the report and RRP. The analysis is expected to help clients identify the most binding constraints to development and hence streamline the conditionality attached to policy-based lending. The RRP should briefly explain how ADB contributed to the design and implementation of the government-owned reform package, including TA support (if applicable), and present a summary of the envisaged reform impacts. In addition to policy issues, the sector or intersectoral studies are to address social and environmental issues,12 the relative roles of the public and private sectors, and institutional development needs. TA may be processed with the policy-based loan to study unresolved policy issues or to strengthen the capacity of key sector institutions. For CSF operations, the assessment

11

This does not mean that a formal sector study must necessarily be carried out by ADB. Where the necessary information is already available, for example through ongoing sector work by ADB or studies carried out by other institutions, these may serve as a foundation for policy-based loan formulation.

12 For environmental and social safeguards, the Safeguard Policy Statement’s provisions on program lending should apply. Strategic environmental assessment may be usefully applied where appropriate. See OM Section F1 (Safeguard Policy Statement).


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should cover the appropriateness of the countercyclical development expenditures and present ADB’s value addition. 24. An assessment must be carried out of the impact of the proposed sector reforms on the poor and other vulnerable groups. Where a reform program entails adverse short-term impacts on the poor or other vulnerable groups, the policy-based loan must seek to include mitigating or offsetting measures to the extent feasible. When applicable, counterpart funds generated by the foreign currency disbursed under the loan may be used for this purpose. 7. Fiduciary Safeguard 25. Since general budget support under stand-alone policy-based lending and programmatic approach are absorbed into a DMC’s public expenditures in the form of counterpart funds of loan proceeds, fiduciary arrangements need to be in place to ensure efficient utilization of overall resources through sound public financial management. Hence, knowledge of the public financial management environment in the country should be supported by up-to-date diagnostic work. Risk assessments, as mandated by the Second Governance and Anticorruption Action Plan,13 are to be carried out at the country, priority sector, and program levels to evaluate public financial management, procurement, and corruption issues. The country-level assessments can serve as an important evaluation of country systems, and the CPS needs to describe the extent of fiduciary risks to budget support. 14 When the available analysis identifies weaknesses in the borrower’s budget management system, ADB should identify the additional steps needed to secure sound fiduciary arrangements for policy-based lending. In such a case, the policy matrix should designate prior actions as conditionality to improve budget performance, such as allocative or expenditure efficiency.

8. Macroeconomic Link and Aid Coordination 26. A policy-based loan must take into account the link between the loan and the macroeconomic conditions in the DMC. The direction of macroeconomic policies must be deemed satisfactory before a policy-based loan can be considered. Also, the effects of untied capital inflows on the money supply and exchange rate must be considered. ADB is to systematically consult and closely coordinate with the IMF, the World Bank, and, where applicable, other multilateral development banks, and major bilateral funding agencies in formulating and implementing policy-based loans. Aid coordination must in particular address the interface of the ADB-supported program with macroeconomic aspects, including the adequacy of the macroeconomic framework for successful

13

See OM Section C4 (Governance). 14

To this end, the public expenditure and financial accountability assessment could be a good point of reference where available. The public expenditure and financial accountability program was founded in December 2001 as a multi-donor partnership to strengthen recipient and donor ability to (i) assess the condition of country public expenditure, procurement, and financial accountability systems; and (ii) develop a practical sequence of reform and capacity building actions.



implementation of the program, and the potential impact of the latter on the above-mentioned macroeconomic variables. At the same time, there should be efforts to mobilize cofinancing. 27. CSF is an exceptional instrument reserved for addressing severe crises at the macroeconomic level.15 A DMC will be eligible to receive CSF assistance only when the following access criteria are met:

(i) Adverse impact of exogenous shocks.16 The DMC has experienced, or is likely to experience, a severe decline in growth.17 While it is difficult to specify a strict threshold for this decline, the experience of those earlier crises may be referenced as a guide to determine eligibility for CSF operations. Whereas a severe decline in growth would be the main criterion for the CSF lending, the following additional indicators tailored to specific country contexts could also be part of the justification: (a) the DMC may be facing, or is likely to face, substantial fiscal stress, such as actual or projected fiscal deficit and lower revenue collections; (b) for DMCs relying on international capital markets to finance public expenditures, a rise in the spread on government bonds could disrupt their access at favorable terms;18 (c) for DMCs relying on exports and/or remittances, exogenous factors can cause a sharp decline in those inflows.

(ii) Countercyclical development expenditures. The government has an

effective countercyclical development expenditure/policy program to be supported by the CSF, and is committed to its implementation. The program includes social safety nets targeting the poor or vulnerable groups.

(iii) Pre-shock record of generally sound macroeconomic management. Monetary policy addresses price stability as one of its core objectives, and inflation is controlled. Public finances are sound, as shown by recent fiscal balances in relation to the economy’s cyclical position, the quality of any adjustment measures being planned, and an overall sound institutional budgetary framework.

(iv) Structural reforms. Where structural weaknesses substantially increase

vulnerability to exogenous shocks, there need to be assurances that the country is taking credible steps to address the underlying structural issues. To

15

In most cases, the use of stand-alone policy based lending and programmatic approach should be considered as a default form of ADB budge support.

16 Because these broader exogenous shocks can disrupt growth, mitigating such adverse impacts is in line with ADB’s institutional mandate. If such shocks lead to a serious BOP crisis requiring IMF’ intervention, ADB should mobilize special PBL under IMF’s leadership. However, when such impacts are limited primarily to slower growth, the CSF would be the right instrument.

17 In addition to data from relevant national authorities and ADB data and publications, such as the Asian Development Outlook, its Update, and Supplement, macroeconomic analysis should be sourced from IMF’s staff report on Article IV consultation and other IMF reports.

18 Alternatively, the credit default swap spread could be referenced.


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enhance the effectiveness of such reforms, the country may engage with ADB to negotiate stand-alone policy based lending or policy-based lending under a programmatic approach to address these weaknesses.

(v) Debt sustainability. The borrower’s debt sustainability, including potential impacts of the prospective CSF assistance, is confirmed. International reserves are determined to be adequate, taking into account the imports coverage ratio and the short-term external debt financing requirement. Relevant indicators may be based on the debt sustainability analysis by the IMF and the World Bank, or a similar assessment when such a joint analysis is not conducted.

(vi) Coordination with the International Monetary Fund. If the IMF is not involved

in crisis response, ADB will ensure that the country has had constructive dialogue with the IMF, such as recently completed or ongoing Article IV consultations. ADB should secure an assessment letter from the IMF confirming the soundness of the government’s macroeconomic management and other policies before the Board of Directors considers the proposed assistance. ADB should work closely with its counterparts at the IMF to determine that the CSF and the related conventional policy-based lending would be appropriate, despite the absence of an IMF program.19

28. An assessment of the access criteria may involve a degree of judgment, and flexibility might be needed. The assessment should take into account the diversity in DMCs' circumstances and the uncertainties underpinning economic projections.

9. State- or Provincial-Level Policy-Based or Subprogram Loans

29. Policy-based lending (including subprogram loans) at the state or provincial levels may be considered selectively in DMCs where sufficient policy autonomy exists at these levels of government, and where there are no legal or administrative impediments to such loans. The ability of these levels of government to address all relevant sector issues, and the full concurrence of the national government and the state or provincial level government, are required for this approach. 10. Tranching 30. A policy-based loan is divided into multiple tranches if major elements of the structural reforms are to be introduced after the loan agreement becomes effective. Multiple tranches enable ADB to monitor and expedite phased program implementation. The program period and number of tranches are determined case by case. Single-

19

Consultation with the IMF and other international financial institutions is important for the CSF, beyond securing the IMF assessment letter, especially when the IMF is not involved in the crisis response. ADB should involve IMF staff through regular and active policy dialogue during preparation of the CSF operation. ADB should routinely attend the Article IV consultations or other IMF missions. Similar engagement with other international financial institutions should also be adopted as needed.



tranche loans may be considered if the most important reforms can be implemented before effectiveness. 31. Considerable importance in policy-based lending is attached to the proper timing and sequencing of reforms. Structural reform conditionality for tranche release must be formulated with a view to optimizing the sequencing of reform steps, as well as minimizing short-term costs of adjustment. The policy matrix should be used as a flexible implementation guide for assessing whether intended objectives were substantively achieved, and conditionality should be streamlined. Staff should adopt a flexible approach to conditionality in policy-based loans, and apply the following good practice principles in its design and implementation: (i) conditionality should reinforce country ownership, (ii) it should be agreed with the government and linked closely to national development strategies, (iii) only a minimum number of actions critical for removing or mitigating binding constraints should be selected, and (iv) transparent progress reviews that contribute to predictable and performance-based financial support should be conducted regularly. 32. In principle, CSF operations should focus on short-term fiscal responses at the macroeconomic level; and the policy matrix listing structural reform conditionality at the microeconomic level is not required. 20 Where structural weaknesses substantially increase vulnerability to an external shock, however, CSF operations might be accompanied by, and integrated with, complementary conventional policy-based lending operations addressing the underlying structural issues connected with the crisis.21

33. In view of the dislocations often caused by drastic policy changes and the sometimes adverse short-term impact of reform on specific groups, ADB can, where justified, support an incremental pace of reform. This may be accomplished through a succession of policy-based loans in a sector, or through the adoption of a longer time frame together with multiple tranches.

20

The CSF does not require structural reform conditionality. Only where structural weaknesses substantially increased vulnerability to exogenous shocks, there need to be assurances that the country is taking credible steps toward addressing them in the near future, if not earlier. For instance, DMCs suffering from a collapse of international commodity prices may wish to advance reforms for diversification of the economy to reduce dependency on commodity exports, provided that such measures also enhance economic efficiency and welfare. However, these do not necessarily have to take the form of negotiating stand-alone policy based lending or policy-based lending under a programmatic approach with ADB. The DMC concerned may request such conventional policy=based lending from ADB only if it wishes to do so at its discretion, either in parallel or subsequent to the CSF operation.

21 In such cases of structural weaknesses, during loan negotiations, the requesting country must commit to a robust structural reform program to be defined within a short-time frame. The RRP seeking the Board approval of CSF support should include the mechanism for monitoring and reporting of such a reform program.


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11. Loan Amount 34. The overall loan size for stand-alone policy-based lending and programmatic budget support should be determined by the development financing needs of the country at the broad macroeconomic level. 22 Additional reference should be made to more specific elements of the development expenditure programs23 (within the entire public finance) supported by counterpart funds24 of ADB’s policy-based loan proceeds and, where relevant, other supports provided by development partners. A clear basis for determining the loan amount based on the overall and sector-specific requirement of the DMC should be presented. Total lending to each country under the CSF is capped at $500 million per exogenous shock or crisis episode. 25 12. Loan Terms 35. Stand-alone policy-based loans and subprogram loans under the programmatic approach from regular OCR have a 15-year maturity including a 3-year grace period. ADB’s London interbank offered rate (LIBOR)-based loan lending terms 26 apply. Standard policy-based loans and subprogram loans under the programmatic approach financed by ADB’s concessional resources follow the applicable policy-based loan terms.27 The pricing and terms of SPBL and CSF lending comprise interest rates set at a minimum spread of 200 basis points over LIBOR, a rebate or surcharge reflecting the cost of funds, maturity of 5–8 years including a grace period of up to 3 years, and a commitment charge at 75 basis points per year on the undisbursed loan balance. The terms of SPBL and CSF lending should be determined by the crisis situation (including

22

The loan amount should be determined individually to accommodate country-specific circumstances, including overall projected budgetary (or BOP-related) financing requirements, the availability of alternative financing, and debt sustainability at the macroeconomic level. As appropriate, development financing needs as reflected in the key macroeconomic indicators, such as the budget deficit (or current account deficit), should be referenced.

23 The development expenditure program supported by the CSF is primarily aimed at stimulating the aggregate demand to restore growth. ADB support through the CSF is expected to ensure that pro-poor fiscal measures are preserved—and possibly expanded—in spite of the crisis. The development expenditure program supported by other forms of budget support (stand-alone policy-based lending or programmatic budget support) has broader objectives of contributing to the acceleration of the economic development.

24 No specific rules are possible for use of counterpart funds generated from conventional policy-based loans. Each policy-based loan RRP should take into account country-specific circumstances, particularly the budget mechanism and accounting environment. Where relevant, the cost of adjustment can still be counted in a development expenditure program financed by the counterpart fund of policy-based lending, but does not have to be regarded as a prime determinant of loan size.

25 The Strategy and Policy Department confirms resource availability for SPBL and CSF operations in consultation with the Treasury Department The Office of Risk Management should be consulted for assessment on ADB’s risk-bearing capacity. .

26 See OM Section D1 (Lending Policies for Sovereign and Sovereign-Guaranteed Borrowers [Ordinary Capital Resources]).

27 See OM Section D2 (Lending and Grant Policies [Asian Development Fund])



its severity and market conditions), country-specific considerations (including the borrower’s debt repayment capacity), and ADB’s risk-bearing capacity.28 13. Ceilings 36. There are no individual country ceilings for policy-based lending. Total annual stand-alone policy-based loans, subprogram loans under the programmatic approach, the policy-based component of SDP loans, and policy-based guarantees are not to exceed 20% of total public sector lending on a 3-year moving average basis under normal circumstances.29 Similar lending from ADB’s concessional resources is subject to a ceiling of 22.5% of total concessional lending. Loans under SPBL and the CSF are exempted from counting towards the ceiling on regular policy-based lending, but should be managed within ADB’s risk-bearing capacity.

14. Technical Assistance

37. TA projects attached to policy components of a policy-based loan must be carefully targeted to meet key capacity building needs in the sector and/or address major policy issues having a bearing on future strategy decisions. The number and design of attached TA projects must be geared to the absorptive capacity of the executing agencies involved. Close supervision of TA execution by ADB, and incorporation of TA findings in ongoing policy dialogue, are an essential part of policy-based loan administration.

15. Counterpart Funds 38. Policy-based lending must include a broad review of budgetary allocations to and within the sector, with a view to ensuring that essential expenditures are met. Where shortfalls in the allocation of development or operating expenditures to the sector are identified, the policy-based loan must seek to correct these, to the extent feasible, by

28

As a preliminary benchmark, a spread of 200 basis points above LIBOR should be regarded as an initial default pricing basis for loans up to $500,000,000 with the 5-year maturity (including the 3-year grace period), while case-by-case adjustments in the spread and maturity may be made within the permissible range prescribed herein. Repayment terms of equal installments or the annuity method with the general practice of 10% discount rate are applicable. A complete analysis of the impact on ADB’s relevant financial indicators and discussion on the measures to ensure consistency with ADB’s financial policy should be undertaken.

29 The first such 3-year period following the adoption of the ceiling covering 2000–2002. Under the current practice stated in the 1999 policy R-paper on program lending, the 3-year moving average is computed with the current year regarded as the middle year. This approach has two problems: (i) the estimates of the most recent year are tentative since the policy-based lending pipeline for future years is usually indicative, and (ii) departure from the policy ceiling limit can be identified only after 1 year. In case that the current year is proposed to be treated instead as the third year in computation of the 3-year moving average, for both ordinary capital resources and ADF, the Board should be duly informed of the applied method of 3-year average calculation with the relevant documents (such as the R-paper seeking waiver of the concessional policy-based lending ceiling).


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obtaining matching expenditure commitments from the borrowing government in exchange for the counterpart funds generated. Such matching expenditure commitments may, where applicable, take the form of policy covenants, and may be documented in the loan agreement and indicated in the policy matrix.

16. Procurement and Disbursement 39. The approach to procurement and disbursement under policy-based lending is different from that under project loans. There is considerable flexibility in the use of policy-based loan proceeds to meet a DMC’s development needs. The loan proceeds will be disbursed against economy-wide import requirements on the basis of a negative import list, or, where necessary and appropriate, sector-specific import requirements on the basis of a positive import list. For CSF operations, the RRP should specify the likely loan disbursement date.

40. Where the foreign exchange provided by ADB is used for procurement by public sector entities rather than private, commercial importers, ADB must review the standard public sector procurement procedures used in the DMC with regard to their economy and efficiency. Where exchange controls are in effect, ADB will review the general foreign exchange allocation mechanism in the DMC with regard to its efficiency and transparency; where these cannot be guaranteed, remedial steps should be adopted as an integral part of program design. Also, ADB must always ensure that the standard exclusion negative list applies in the case of economy-wide imports. Basis: This OM section is based on:

ADB. 2016. Review of ADB’s Lending Instruments for Crisis Response. Manila. ADB. 2015. Enhancing Operational Efficiency of the Asian Development Bank. Manila. ADB. 2011. Review of ADB’s Policy-Based Lending. Manila.

ADB. 2009. Safeguard Policy Statement. Manila. ADB. 2009. Enhancing ADB’s Response to the Global Economic Crisis ─ Establishing the Countercyclical Support Facility. Manila.

ADB. 1998. Simplification of Disbursement Procedures and Related Requirements for Program Loans. Manila.

ADB. 1996. Review of Bank’s Program-Lending Policies. Manila.



For other background information and references, see:

ADB. 2009. Program Lending Policy: Clarification. Manila. ADB. 2006. Second Governance and Anticorruption Action Plan. Manila. ADB. 2004. Disaster and Emergency Assistance Policy. Manila. This OM section is to be read with OM Section D4/OP.

Compliance: This OM section is subject to compliance review. For inquiries: Questions may be directed to the Director, Strategy, Policy, and Interagency Relations Division, Strategy and Policy Department.

8 August 2016 This supersedes OM Section D4/BP issued on 1 April 2013.

Prepared and issued by the Strategy and Policy Department

with the approval of the President.

OM Section D4/OP Issued on 8 August 2016

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OPERATIONS MANUAL OPERATIONAL PROCEDURES (OP)

These procedures were prepared for use by ADB staff and are not necessarily a complete treatment of the subject.

POLICY-BASED LENDING

A. Introduction 1. Although the objectives of policy-based lending are different from project or sector lending, operational procedures for processing policy-based loans are generally same,1 except that (i) the emphasis is on understanding the existing policy framework in the sector (or sectors) and on assessing the need and scope for reform and development; (ii) the Management-cleared concept paper should be circulated to the Board for information and comments, if any, within 10 working days;2 (iii) an informal Board seminar should be conducted for complex policy-based lending and countercyclical support facility (CSF) operations;3 and (iv) fast-track business processes and documentation requirements similar to those applicable to emergency assistance loans should be adopted for crisis response with CSF loans. 4 Sector work on the relevant policy and institutional issues generally precedes formulation and due diligence of a policy-based loan. B. Application of the Policy

1. Identification

2. A policy-based loan 5 supports a government program for sector reform and development. The decision to start preparing a policy-based loan must be made in the context of the Asian Development Bank (ADB) strategy for the developing member

1 See OM Section D11 (Processing Sovereign and Sovereign-Guaranteed Loan Proposals).

2 This concept clearance should not be confused with the programmatic approach concept paper to be

presented to the Board for its approval together with the first subprogram loan proposal as an integral part of the report and recommendation of the President (RRP). For the first subprogram loan under a programmatic approach, a single-tranche stand-alone policy-based loan, and a multi-tranche stand-alone policy-based loan, including those packaged in a sector development program, the Board should be informed of the preliminary program design through circulation of a loan concept paper upon Management’s clearance. The concept papers that are circulated to the Board for information should be edited by the Office of the Secretary before approval by the operations vice president concerned. Concept clearance for subsequent subprogram loans under the programmatic approach is not required.

3 Early information will be provided to Management and the Board when a DMC has requested CSF lending.

An informal Board seminar should be conducted as soon as Management receives sufficient information. The rationale for mobilizing the CSF, especially the existence of economic stress, should be clearly presented in the informal Board seminar.

4 See OM Section D7 (Disaster and Emergency Assistance). For CSF loans, an economic assessment is

conducted in lieu of the damage and needs assessment. Unless the Management advises otherwise, concept clearance should not be required. Special abbreviated Board consideration will be done within 1 week after RRP circulation.

5 Unless it specifically includes a special policy-based loan (SPBL) or a CSF loan or otherwise stated, a

policy-based loan in this section generally refers to a stand-alone policy-based lending or a subprogram loan under the programmatic approach.

OM Section D4/OP Issued on 8 August 2016 Page 2 of 8


country (DMC) concerned, with a view to achieving certain medium-term sector, multisector or subsector objectives. The initiating department must be convinced that the DMC authorities are willing and able to institute an acceptable reform program and to maintain close and continual policy dialogue with ADB. This also includes an assessment that the program proposed merits ADB support on account of its scope and strength, and that policy-based lending by ADB will facilitate and accelerate program implementation. The decision to initiate preparation of a policy-based loan also requires careful assessment of available sector analysis and the demand on ADB staff for sector work and policy dialogue.

2. Development Policy Letter 3. During policy-based loan processing, ADB will need to determine whether the existing and envisaged policy framework and institutional development plan form an appropriate basis for ADB support. This also includes an assessment of public investment plans in the sector, and of the envisaged distribution of roles between the public and private sectors. Hence, a major objective in policy-based loan processing is to reach an understanding with the government on the medium-term development framework in the sector and on the schedule of policy steps to be undertaken during the program period which will be formalized as the government's policy statement in the form of a letter from an appropriate government official to the President of ADB. This development policy letter (DPL) is a key document throughout policy-based loan processing. The letter must spell out in appropriate detail medium-term sector objectives, the measures already taken and those to be taken to achieve them, and various indicators to be used in monitoring program implementation and sector performance. 4. The focus of the policy-based loan process is to reach an understanding with the government, and to develop and review the draft DPL with the government. In the early stages of processing, an initial draft of the DPL is produced and discussed with the authorities for reference purposes only, that would also be subject to subsequent Management approval at various stages of the policy-based loan process. The draft DPL is included in full in the successive stages of the draft report and recommendation of the President (RRP) on the policy-based loan. The RRP also includes a policy matrix, i.e., a table setting out the overall objectives of the program, measures already taken, specific actions to be taken under the program and their timing, and further actions needed over the medium term.6 The DPL remains a draft until ADB and the DMC authorities reach an understanding on its finalization. 7 However, agreement must have been reached regarding the essential features of the DPL prior to loan negotiations. The signed DPL is an integral part of the documentation sent to the Board when seeking its approval of the policy-based loan.

6 Staff should use the policy matrix as a flexible implementation guide rather than as way to monitor and

control conditionality fulfillment. Staff should ensure that the link between the policy matrix and the design and monitoring framework is enhanced.

7 The mission must inform the government accordingly.


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5. For stand-alone policy-based lending and the programmatic approach, specific elements of a DMC’s development expenditure program to be supported need to be indicated in the DPL. For CSF lending, the DPL should indicate the government‘s countercyclical development expenditure program for fiscal stimulus and its commitment to implementation.

3. Programmatic Approach Concept Paper 6. For programmatic budget support, the programmatic approach concept paper is a key design element.8 The broad objectives and scope of the various subprograms will be set forth in the programmatic approach concept paper, with particular attention paid to articulating the logical link among the subprograms. The programmatic approach concept paper covers (i) initial conditions and issues to be addressed under the policy-based loan, (ii) the desired end state, (iii) the logical link among the issues, (iv) the rationale for adopting the programmatic approach, (v) an outline of the intended objectives and scope of each subprogram, (vi) an approximate cost estimate of the cluster, and (vii) an indicative implementation time frame of the cluster. The programmatic approach concept paper forms the basis for a memorandum of understanding with the borrower on the broad design and the implementation approach of the programmatic budget support.9 The first subprogram under the programmatic approach is presented to the Board of Directors for approval along with the programmatic approach concept paper, which indicates the total amount that ADB is willing to provide over the entire program period. The programmatic approach should emanate from the country partnership strategy and should be grounded in a sector study. As in stand-alone policy-based loans, each subprogram will include a policy matrix. The multiyear programmatic approach concept paper will include a design and monitoring framework that will serve as a route map to reach the target/outcome. All subprograms under a programmatic approach operation will be placed within an indicative rolling schedule that would be reviewed and amended as needed. Subject to satisfactory performance on the subprogram and after consultation with the DMC, further subprograms are presented for Board approval. Disbursements are made against each subprogram's policy matrix.10

8 Customarily, the programmatic approach concept paper forms an integral part of the RRP presenting the

first subprogram proposal. 9 A policy-based loan under the programmatic approach also has a DPL, which reflects the understanding

reached in this memorandum. 10

The programmatic approach comprises a series of single-tranche loans, whose processing is initiated by broadly identified triggers. Prior actions are a set of mutually agreed policy and institutional actions that are deemed critical to achieving the objectives of the program supported by a policy-based loan and that a country agrees to take before the Board approves the loan. Triggers are expected prior actions of the next subprogram in a programmatic series. Lending is committed based on prior actions completed by the client country before Board approval. Expected prior actions for subsequent subprograms will be indicative and such actions will not be conditionality for disbursement, and the actions may be amended as subsequent subprograms are developed jointly with the DMC. However, if during subsequent subprogram processing there are deviations from the original indicative actions, staff should make these clear when the subsequent subprogram is presented to the Board for its approval. Staff should also explain the impact such changes are likely to have on development results.



7. Performance monitoring at each stage of implementing the programmatic approach is of critical importance for ADB to (i) determine whether to proceed with the next subprogram, and (ii) incorporate the lessons learned into the design of subsequent subprograms. Performance indicators should comprise three main categories: (i) policy indicators that monitor the policy and institutional actions, (ii) ownership and capacity indicators, and (iii) outcome indicators. Some policy indicators will be unique to a subprogram; others could be common to two or more subprograms. Ownership and capacity indicators, although difficult to develop ex ante, are particularly important for the programmatic approach. Identifying such indicators at the outset and tracking them will help in the design of later subprograms and in the evaluation of the impact of the programmatic approach as a whole. Ownership indicators will normally be common across all the subprograms whereas capacity indicators could be distinct or overlapping. Outcome indicators will be based on the desired end state and should be specified in the overall programmatic approach framework. The contribution of individual subprograms to the desired outcomes should also be kept under review.

4. Fact-Finding 8. Preparation of a policy-based loan involves ADB conducting detailed sector analysis; reviewing with the government its plans and needs for policy and institutional change; firming up details on specific policy measures to be taken; evaluating—and if necessary modifying—the sectoral investment program 11 and institutional support provided; coordinating with the International Monetary Fund (IMF),12 the World Bank, and important bilateral agencies; and determining the criteria for measuring progress in program implementation and sector performance. Continual dialogue between ADB and key policy makers in the DMC is essential to assess the degree of the government's commitment to concrete policy actions and to determine when the policy-based loan is ready to be appraised. 9. The RRP for policy-based loans should address the following issues: (i) diagnostics—assessing the extent to which a particular policy distortion leads to a particular binding constraints; (ii) the policy matrix—selecting policy actions for inclusion in the matrix based on the extent to which they address problems identified in the diagnostics; (iii) the link with the sector strategy—ensuring that the program formulation is consistent with the government’s plan for the sector and ADB’s sector strategy; (iv) tranches—apportioning policy actions into tranches to ensure proper sequencing and implementation of required policy actions; (v) policy-focused institution building— providing complementary assistance to enhance policy delivery capacity; (vi) indicative costs of specific elements of a DMC’s development expenditure program to be

11

Especially with regard to the adequacy of capital and recurrent spending and the appropriate split between public and private sector activities.

12 When processing a policy-based loan, ADB staff is required to request an assessment letter from the IMF. If ADB staff and Management decide to proceed with submission to the Board for approval of the proposed policy-based loan, the concerned regional department is required to post the IMF assessment letter as a linked document to the RRP and indicate if the information may be disclosed to the public.


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supported13 and, where relevant, support provided by development partners other than ADB; (vi) performance indicators—specifying monitorable indicators in the design and monitoring framework that can subsequently be used to assess the development impact of the program; (vii) ADB’s contribution to the design and implementation of the reform package, including technical assistance support (if applicable); and (viii) a summary of the envisaged reform impacts. Policy-based loan designs are complex exercises in economic and institutional reform.14 Their successful implementation depends not only on the technical design but also the manner in which the political economy of the reforms is factored into the design.

5. Due Diligence 10. As part of due diligence, it is important that an understanding is reached on detailed program objectives and content, conditions of loan effectiveness, tranches and conditionality for tranche release, use of counterpart funds, procurement and disbursement, how key elements of the program will be monitored, and all other issues listed in the draft RRP and the minutes of the management review meeting or the staff review meeting.

6. Legal Documents 11. As the government’s DPL is the basis on which a policy-based loan is granted, the letter must be referred to in the loan agreement and must serve as the basis for any major conditions for effectiveness and conditionality for tranche release that are reflected in the policy matrix attached to the DPL. The interpretation of DPL-related covenants or tranche release conditionality and their compliance question must be considered in the context of the program framework laid out in the DPL. The loan agreement will also contain appropriate arrangements for procurement and disbursement.

7. Negotiations 12. ADB and the government must agree on the essential features of the DPL prior to loan negotiations. Although the final wording of the DPL may still change during negotiations, these changes should be relatively minor and be cleared quickly with the negotiators’ capital. A final agreed version of the DPL and of the policy matrix is normally confirmed on the last day of negotiations, which is normally the date of the DPL. The

13

In all cases, agreement on the appropriate development expenditures out of the additional budgetary resources generated by the policy-based loan must be reached during loan negotiations, and specified as counterpart funds and explained in the RRP.

14 While the RRP for a CSF loan is expected to be concise on account of the time-pressing crisis situation, it should be written in a manner to allow assessment of the DMC’s compliance with the access criteria stated in OM Section D4/BP (Policy-Based Lending). As appropriate, the standard RRP format may be adjusted to accommodate CSF’s characteristics as a crisis response instrument. The development policy letter should be included as an appendix. Linked documents include: (i) debt sustainability analysis; (reflecting potential impacts of CSF borrowing); (ii) IMF assessment letter; (iii) summary poverty reduction and social strategy; (iv) list of ineligible items; and (v) development coordination matrix.



final step of the negotiation process is furnishing to the President the DPL, duly signed by an appropriate government official.

8. Loan Agreement Signing and Effectiveness 13. Following Board approval of a policy-based loan, standard rules and regulations for loan agreement signing and effectiveness must be followed, and in addition, staff should generally try to arrange for signing almost immediately after Board approval. Conditions for effectiveness will thus generally be kept to a minimum, with all substantial program-related matters having been resolved as a precondition for Board consideration. This also means making advance arrangements with the borrower to have a draft legal opinion furnished to ADB at the time of negotiations or as soon as possible thereafter so that the final legal opinion may be ready as soon as the loan agreement is signed. 9. Release of Tranches15 14. Tranche release will be conditional on the introduction of the agreed upon program elements. The policy matrix should be used as a flexible implementation guide for assessing whether intended objectives were substantively achieved. Before the release of the second and subsequent tranches, a progress review should be undertaken. If the conditionality for a tranche release has been met, tranche release is authorized by the President. A progress report reviewing and assessing program implementation and compliance with conditionality would be submitted to the Board for information thereafter. However, if the Board at the time of approving a policy-based loan believes it merits additional Board scrutiny before the release of the second (or subsequent) tranche, then Management circulates the progress report to the Board and waits for 10 days before releasing that tranche. 15. If a tranche release is proposed even though compliance with conditionality has been incomplete, Board approval will be sought through a progress report on a no-objection basis. The progress report will be similar to that under para. 14, but will also explain the factors justifying the proposed release despite the incomplete compliance. Board approval should be sought for an appropriate waiver of or amendment to the relevant loan covenant.16 The advice of the Office of the General Counsel should be sought in cases of doubt whether particular loan covenants require waiver or amendment.

15

Tranche release (or its equivalent) under the single-tranche loans whose conditionality has not been met within 6 months of Board approval of the loan will require a progress report. In this case, the progress report should be prepared following the same procedure as that for release of the second and any subsequent tranches presented in paras.14-15. If conditionality for the tranche release (or its equivalent) under the single-tranche loans is met within 6 months of Board approval, then a progress report will not be required.

16 It is generally expected that the DMC concerned has formally requested or concurred with the proposed waiver or amendment prior to consideration by the Board.


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10. Procurement and Disbursement 16. There is considerable flexibility in the use of policy-based loan (including special policy-based and CSF lending) proceeds to meet a DMC’s developmental needs. The loan proceeds may be utilized to finance economy-wide import requirements on the basis of a negative import list, or sector-specific import requirements on the basis of a positive import list. Normally, negative import lists will be appropriate, although positive lists may also be applied, for example when foreign exchange is scarce and ADB wishes to ensure that sector import requirements are met. 17. The proceeds of a policy-based loan for which there is only a negative list of ineligible items may be disbursed without supporting import documentation. Documentation in respect of specific imports will continue to be required for policy-based loans for which a positive list of eligible items is utilized. 18. ADB’s international competitive bidding procedures are not required for contracts financed under policy-based loans. For goods commonly traded in international commodity markets (e.g., petroleum products and fertilizers), normal commercial procedures appropriate to the trade are regarded as acceptable for ADB financing. Financing of specific commodities may be limited to an agreed upon maximum percentage (say 60% of the total loan amount). The specific procurement procedures proposed for each policy-based loan are based on ADB’s assessment of the procedures in the borrowing DMC and are set out in the loan documentation. The borrower and, where appropriate, concerned agencies are required to keep accurate records of the accounts under the policy-based loan. 19. Disbursement under policy-based loans normally takes the form of reimbursement to the central bank of the DMC acting as a depository. The central bank is generally responsible for administering policy-based loans17 in close consultation with the government and sector-specific entities responsible for implementing the sector program. Where appropriate, the central bank may disburse the loan through commercial banks or development finance institutions or both.

17

Occasionally, this role can be played by the ministry of finance.



Basis: This OM section is based on OM Section D4/BP and the documents cited therein.

Compliance: This OM section is subject to compliance review

For inquiries: Questions may be directed to the Director, Strategy, Policy, and Interagency Relations Division, Strategy and Policy Department.

8 August 2016 This supersedes OM Section D4/OP issued on 1 April 2013.

Prepared and issued by the Strategy and Policy Department

with the approval of the President.