Fourteenth Replenishment of the African Development Fund (ADF-14)

Fourteenth Replenishment of the African Development Fund (ADF-14) Clarification note on questions raised by several Donors on the proposed parameters for the ADF s Innovative Financial Instruments 29 September 2016 Abidjan, Côte d Ivoire 1

AFRICAN DEVELOPMENT FUND Table of Contents 1. INTRODUCTION... 3 2. UNDERLYING ISSUE: WHETHER LOANS PROVIDED AT THE SAME INTEREST RATE, IN DIFFERENT CURRENCIES, SHOULD RECEIVE THE SAME LEVEL OF GRANT ELEMENT.... 3 3. COMPARISON BETWEEN THE PROPOSED GRANT ELEMENT COMPUTATION METHODOLOGIES FOR IDA-18 AND ADF-14... 5 4. MANAGEMENT S RESPONSES TO THE CONCERNS RAISED BY DONORS... 6 5. CONCLUSION... 7 2

CLARIFICATION NOTE ON QUESTIONS RAISED BY SEVERAL DONORS ON THE PROPOSED PARAMETERS FOR THE ADF S INNOVATIVE FINANCIAL INSTRUMENTS 1. Introduction 1.1. The purpose of this note is threefold: First, the note seeks to clarify several questions that have been raised by some potential Donors on the proposed framework for concessional loans to African Development Fund (ADF). Second, the note aims to remove any information asymmetries among any other potential Donors regarding the parameters of the proposed framework. And third, the note provides information on additional flexibility Management has built into the framework so as to improve the concessionality of any donors concessional loans, and in turn, their grant element, without breaching the principles of fairness to all donors and protecting the financial capacity of the Fund. 1.2. It is important, at the outset, to recall the underlying principle guiding the clarifications in this note, which is in fact, unchanged from what it has been since Management and Deputies began considering financial innovations for the Fund: preservation of the long-term financial viability of the Fund. Thus, for example, both Deputies and Management have agreed that any proposal for innovation should ensure that grants remain the main source of financing for the Fund even as measures are introduced to increase the overall concessional resources for the Fund s beneficiary countries. Likewise, Deputies and Management have agreed that any proposal should ensure fairness to all donors, especially with regard to the grant element, computation of burden sharing and voting powers. 1.3. Following this introduction, the rest of the note is organized in five parts: Part II summarizes the underlying issue on the grant element around which some misunderstanding have arisen. Part III briefly presents a comparison of the approaches taken by the International Development Association (IDA) and the ADF. Part IV addresses several specific concerns raised by several potential loan Donors, including additional flexibility Management has built into the proposed framework in order to improve the level of the grant element for any loan providers to the Fund. Finally, Part V concludes. 2. Underlying Issue: Whether loans provided at the same interest rate, in different currencies, should receive the same level of Grant Element. 2.1. First, it is important to recall that Section 2.13 of the paper entitled Innovative Financial Instruments, presented to Deputies by Management during the second ADF-14 replenishment meeting, provided the following information about the computation of the grant element: Following consultations with several Donors, and with the objective of making CDLs attractive during ADF-14, Management proposes a discount rate of 2.65%. This will ensure that donors providing CDLs are recognised in a similar way as in IDA. However, given that ADF and IDA do not have the same concessionality embedded in their lending terms, the proposed discount rate will not reflect the actual value contribution of CDLs to the Fund. Table 1 provides the grant-element for CDLs for various levels of interest rates and for discount rates of 1.75% and 2.65%. 2.2. The same paper also included the table below, indicating various changes to the grant-element under different discount rate conditions. 3

Average Maturity 5-35 20.25 5-40 22.75 Table 1: Grant-element increases with discount rate Duration Discount Rate Interest rate on the Concessional Donor Loan (cost of borrowing) 0.00% 0.25% 0.50% 0.75% 1.00% 1.75% 26.6% 22.8% 19.0% 15.2% 11.4% 2.65% 36.8% 33.3% 29.8% 26.3% 22.8% 1.75% 29.5% 25.2% 21.0% 16.8% 12.6% 2.65% 40.2% 36.4% 32.6% 28.8% 25.0% 2.3. Regrettably, the table above did not clearly specify the currency in which the grant element should be computed, which may have wrongly suggested that the coupon rates (cost of borrowing) in the table applied uniformly to all currencies. For the avoidance of doubt, the rates in the table above are SDR rates, which are to be translated to currency equivalents. This ensures consistency not only with market reality, but also with the approach used at IDA. 2.4. Furthermore, it is also important to recall that during the technical session, as well as in the Coordinator's Summary following the June ADF meeting, Management emphasized that it would confirm, in writing, all the rules agreed during the meeting. It was also agreed that Management would also provide additional information on the proposed parameters for concessional loans responding to specific queries from Deputies. In addition, it was agreed that the final maximum borrowing rates and grant elements will be communicated as early as possible, and preferably before the November 2016 pledging session. 2.5. Several donors have since expressed concerns on Management s proposed framework and methodology for determining the grant element of concessional loans and indicated that changes have been introduced since the June replenishment meeting. These changes are perceived as unfavorable, and in turn, reducing the attractiveness of the proposed loans in certain currencies. 2.6. In order to properly address this issue, we should simply respond to the question of whether the Fund should provide the same grant element to two Donors providing loans in different currencies at the same interest rate. An illustrative response is provided in the box below. Should two Donors providing loans in different currencies at the same rate they receive the same level of grant element? Suppose, as indicated in Table 1 there are two donors providing loans in EUR and GBP at the same coupon rate. Knowing that the yield curve in GBP is higher than it is in EUR (reflecting the fact that liquidity invested in GBP currently provides a higher return than it does in EUR). Should the two donors receive the same grant element? The Donor providing resources in GBP makes a higher effort given that alternative sources of investment would provide that donor a higher return in GBP. This is reflected in swaps rates which indicate that a coupon of approximately 0.5% in GBP can currently be swapped approximately at 0% in EUR. Consequently, it is fairer to provide a higher grant element to Donors who contribute concessional loans in GBP rather than in EUR. Table 2: Grant element when computed uniformly for all countries Maturity EUR Loan Amount Coupon in equiv. Donor currency in Currency UA equivalent Currency Coupon France EUR 10/40 110 0% 0% 100 UK GBP 98 0% 0.5%* * Cross currency swap rate from an interest rate of 0% in GBP into EUR. Grant Element 1 % 40.20% 4

2.7. Undoubtedly, the approach of computing the grant element uniformly for all currencies for the SDR basket breaches the key principle of equity and fairness across all Donors. Indeed, based on such an approach, Donors providing a UA equivalent amount of loans and at the same rate, would receive the same level of grant element and burden share, irrespective of the currency in which their loan is provided. At the same time, different levels of concessionality are achieved when swapping the loan proceeds from the currency in which it is received into the currency in which the loan is disbursed. Therefore, each currency enables the ADF to achieve a certain level of concessionality which should be the fair basis for the allocation of a grant element. 3. Comparison between the proposed grant element computation methodologies for IDA-18 and ADF-14 3.1. In order to reflect the various level of concessionality, vis-à- vis the SDR reference rate for each currency of the SDR basket, both IDA and the Fund provide a conversion table which is specified in their respective documents. Table 3 presents IDA s conversion table which is available in the document on Updated IDA 18 Operational and Financial Framework dated September 2016 (See Table 3 in Annex 13 of this document). Table 4 presents AfDB conversion table which is available in the document on ADF-14 Updated parameters on Innovative Instruments (see Table 8 of this document). 3.2. The figures highlighted in Tables 3 and 4 below demonstrate that the methodology proposed for ADF- 14 is well aligned with that of IDA. Not only would the ADF-14 methodology produce similar results to that of IDA-18, it would likewise translate into recognition by the same order of magnitude as in IDA-18 of the effort of all concessional loan providers to the ADF. Table 3: Illustrative Grant Elements from Concessional Partner Loans at Different Coupon Rates 40-year CPL with 3-year disbursement schedule Source: Annex 13: IDA18 Concessional Partner Loan Framework (Using June 2016 market rates) Table 4: Conversion of local currency interest rate into an SDR equivalent rate for a 10/40 Concessional Donor Loan / Bridge Loan (Indicative figures subject to changes based on prevailing swap rates and a discount rate of 2.65%) SDR borrowing rate for 10/40 BL 0.00% 0.25% 0.50% 0.75% 1.00% 1.75% Grant element 44.5% 40.3% 36.1% 31.8% 27.6% 14.9% Equivalent rate in single currency: USD +0.65% +0.92% +1.17% +1.42% +1.67% +2.42% JPY -1.08% -0.88% -0.63% -0.38% -0.13% +0.63% EUR -0.63% -0.41% -0.16% +0.09% +0.34% +1.09% GBP -0.28% -0.05% +0.20% +0.45% +0.70% +1.45% CNY +1.03% +1.33% +1.58% +1.83% +2.08% +2.83% Source: ADF Updated parameters on Innovative Instruments (Using September 2016 market rates) 5

4. Management s responses to the concerns raised by donors 4.1. Several Donors have requested Management to consider that additional flexibility be built into the concessional loan framework so as to enable them to improve the grant element of their loans to expected levels based on their understanding of the framework. To respond to this request, Management investigated several options, and has provided options that take into account the various guiding principles specified earlier in this note. 4.2. The section below presents the various suggestions considered and Management s recommendations: 4.3. SUGGESTION 1: Increase of the discount rate beyond the agreed 2.65% level. 4.4. Response: It is important to recall that the current discount rate has been negotiated and agreed among all donors. Management thus recommends that no increase in the discount rate is considered beyond the compromise rate of 2.65%. 4.5. SUGGESTION 2: Consider offering loans in USD, whose rates are currently much more attractive than other currencies. 4.6. Response: Management does not have any objection with Donors providing loans in different currencies from their Grant contribution. For instance, the USD which provides a higher grant element may be selected by any Donor country. Such an approach is in line with the various guiding principles as it both does not generate negative impacts for the Fund s financial sustainability and, is a fair approach vis-à-vis other Donors. 4.7. SUGGESTION 3: Improving the concessionality of the loans by either extending maturities beyond 40 years or extending the grace period. 4.8. Response: Management has no objections with Donors improving the concessionality of their loans by extending maturities or the grace period so as to increase the grant element of their contributions. Such an approach will in fact benefit the Fund given that additional concessionality facilitates the debt management framework. 4.9. For example, a 40-year EURO denominated CDL with a 10-year grace period would have a grant element of 33.35% compared to 29.46% for a 5-year grace period. 4.10. SUGGESTION 4: Applying a 0% floor to the highest negative national currency interest rate (when converting SDR coupon rates into national currency equivalents), as made by IDA during IDA 17. 4.11. Response: IDA-17 provided the possibility of applying a 0% floor for the highest negative interest rate per currency. Considering the data summarized in Table 5 (page 8) of Management s Updated parameters on innovative instruments paper previously shared with Deputies, applying such a condition to a 5/40-year CDL at 0% interest rate (in national currency) would have the following financial impact on the Fund: Without Interest rate floor With Interest rate floor SDR equiv. Grant SDR equiv. Grant Loss to the Fund Currency coupon Element (A) coupon Element (B) (B A) EUR 0.71% 29.46% 0.5% 32.6% -3.14% JPY 1.18% 22.24% 1% 25% -2.76% GBP 0.27% 36.08% 0.25% 36.4% -0.32% 4.12. Management has two main concerns with such approach. First, that approach would result in a loss for the Fund which would, in turn, negatively impact its financial. Second, there is no justification for higher benefits as a result of the zero floor in certain currencies. Therefore the methodology is unfair to all Donors. 4.13. It should also be pointed out that IDA has discontinued offering that option under IDA-18. 1 1 The grant element of the loan will be calculated based on the SDR equivalent rate without the floor. 6

4.14. Management does not recommend the implementation of this approach for ADF-14. 5. Conclusion 5.1. This note has sought to clarify several questions that have been raised by some potential Donors on the proposed framework for concessional loans to African Development Fund (ADF). The note has also aimed at keeping all parties with the same amount of information on the parameters of the proposed framework. Lastly, the note has provided information on additional flexibility Management has built into the framework so as to improve the concessionality of any donors concessional loans, and in turn, their grant element, as follows: (i) provide grants in one currency while also providing their concessional loans in a different currency; and (ii) increase the concessionality of their loans by increasing the maturity or the grace period of these loans beyond the standard levels indicated in the document previously shared with Deputies. 5.2. This note reaffirms Management s position that the grant element of concessional loans should be similarly recognized as is the case at IDA. This will ensure that Donors providing similar concessional loans receive a comparable grant element and burden share. 5.3. Deputies are requested to take note of these clarifications on the parameters of the concessional loans based on the discussions Management has had with several Donors. 7