DEBT REDUCTION FACILITY FOR IDA-ONLY COUNTRIES: PROGRESS UPDATE AND REQUEST FOR EXTENSION

Table of Contents I. INTRODUCTION .................................................................................................................................... 1 II. PROGRESS WITH IMPLEMENTATION ............................................................................................. 1

A. Overall Progress ............................................................................................................................. 1 B. Progress report since the last DRF Progress Update ...................................................................... 4 C. Requests received for DRF-support ............................................................................................... 7

III. CURRENT FINANCIAL POSITION OF THE DRF ............................................................................ 9 IV. AUDITS OF DRF ACCOUNTS AND OPERATIONS ...................................................................... 10 V. CHALLENGES .................................................................................................................................... 10

Challenge 1: DRF-supported operations for the next three-to-five years will need closer monitoring of buyback costs and financing needs than in the past. .................................................. 12 Challenge 2: Size matters: future buyback operations could rapidly exhaust available resources or prove cost-ineffective, while new financing will remain uncertain. ............................. 19 Challenge 3: Achieving the best repurchase price with the highest participation rate in future buyback operations may require innovations to strengthen current DRF policies and practices. ..... 20 A Way Out: Further analytical work is needed to make the DRF more responsive to emerging characteristics of future DRF-supported buyback operations. .......................................................... 22

VI. RECOMMENDATION ....................................................................................................................... 24

BOXES Box 1: Extended Timing for DRF Operations…………………………………………………... 14 Box 2: Availability of Self-Financing from Client Countries………………………………….. . 18 CHARTS Chart 1: Financing of DRF - Supported Buyback Operations…………………………………................... 2 Chart 2: On Average, Buyback Prices on DRF-Supported Operations Have Declined, and Creditor

Participation Rates Have Increased…………………………………………………………….... .3 Chart 3: Creditor Participation Rates Have Been High for Large Operations …………………………….. 4 Chart 4: The Average Price Paid for DRF Supported Operations Has Been Lower for Large Operations………………………………………………………………………………..... 4

Chart 5: Total Extinguished and Estimated External Commercial Debt, Potentially DRF-Eligible………………………………………………………………………... 12

Chart 6: Comparative Repurchase Prices: Past Actual and Potential Estimated......................................... 21

TABLES Table 1: Liberia – Financial Terms for the Buyback Operations………………………………..........5 Table 2: Resources Available to the DRF End-December 2011……………………………………...9 Table 3: Financing Scenarios for Groups A and B……………………………………………………15 Table 4: Large and Small Stocks of External Commercial Debt Have Polar Effects on Costs of Buyback Operations...............................................................................................................19 ANNEX ANNEX 1. BACKGROUND ON THE DRF ............................................................................................ 25 Annex Table 1: Summary of Completed DRF Operations ........................................................................ 29 Annex Table 2: Non-IBRD Grant Support in DRF-Supported Operations ............................................... 30 Annex Table 3: External Commercial Debt as of end 2010 ...................................................................... 31 Annex Table 4: Stock of Commercial Debt and Reserves, 2010-2015 ..................................................... 32

ACKNOWLEDGEMENTS

This report was produced under the guidance of Jeffrey Lewis (PRMED Director), Sudarshan Gooptu (PRMED Sector Manager), and members of the DRF Oversight Committee chaired by Otaviano Canuto (PRMVP) and composed of Merli Baroudi (CFRCR Director), Ximena Talero (LEGCF Chief Counsel), and Antonella Bassani (CFPIR Director). The task team was composed of Paul Moreno-Lopez (TTL), Luca Bandiera, Signe Zeikate, and Mirela Catuneanu (PRMED). Maria Lourdes Pardo and Thibaut Happel (LEGCF); and Veronique Kessler and Angelique DePlaa (CFRCR) provided substantial contributions. Comments and further contributions were received from Errol George Graham (AFTP4), Steven R. Dimitriyev (AFTFW), Cyrus P. Talati (AFTP4), Monthe Bienvenu Biyoudi (AFCCD), and Boris Gamarra (CFPIR). Devi Prasad Ayyannamahanty (CTRTN) provided information on DRF finances. Debbie L. Sturgess and Detre Dyson (PRMED) provided precious logistic and processing support.

ABBREVIATONS AND ACRONYMS

BBC British Broadcasting Corporation CPA Country Programmable Aid CRF Common Reduction Factor DAC Development Assistance Committee DRC Democratic Republic of Congo DRF Debt Reduction Facility DRFOC Debt Reduction Facility Oversight Committee ECD External Commercial Debt EU European Union FLIRBs Front Loaded Interest Reduction Bonds FOREX Foreign Exchange GNI Gross National Income G7 Group of Seven Industrialized Nations HIPC Heavily Indebted Poor Country IaDB Inter-American Development Bank IBRD International Bank for Reconstruction and Development IDA International Development Association IMF International Monetary Fund LICs Low-Income Countries MDRI Multilateral Debt Relief Initiative MICs Middle-Income Countries NGOs Non-Government Organizations OECD Organization for Economic Cooperation and Development PDIs Past Due Interest Bonds SDC Swiss Agency for Development and Cooperation SOE State Owned Enterprise

I. INTRODUCTION 1. The Debt Reduction Facility (DRF) for IDA-only Countries was established by the Executive Directors of the International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA) in July 1989. Its objective is to help reforming heavily indebted poor countries (HIPCs) reduce their commercial external debt as part of a comprehensive debt resolution program. The DRF provides support to eligible countries through grants to finance the preparation and implementation of external commercial debt buyback operations. Preparation grants help beneficiary countries retain the services needed to prepare the buyback strategy (the “Preparation Grant(s)”), and implementation grants finance the actual debt buybacks (the “Implementation Grant(s))” (for a detailed background on the DRF, see Annex 1). The increased activity of the DRF in recent years has played a key role in promoting greater creditor participation under the HIPC Initiative.1

In doing so, the DRF has promoted an equitable burden sharing among creditors of the delivery of HIPC Initiative debt relief. Moreover, the settlement of commercial creditors’ claims has helped reduce the threat of litigation against HIPCs.

2. This report reviews the progress, resources, and challenges under the Debt Reduction Facility for IDA-only countries since the last progress update to the Board in March 2010.2

II. PROGRESS WITH IMPLEMENTATION

The report is structured as follows: Section II reports on the implementation of DRF-supported operations; Section III presents the current financial position of the DRF; Section IV reports on the external audits of the DRF accounts and operations; Section V discusses the challenges the DRF will face, in the context of the impending termination date and financing needs; and Section VI recommends the extension of the DRF until July 31, 2017.

A. Overall Progress 3. Since its establishment in 1989, the DRF has helped IDA-only countries to reduce considerably their external commercial debt. Since then, the DRF has supported 25 external commercial debt reduction operations in 21 IDA-only countries.3 In 2004 the DRF was explicitly linked to the HIPC Initiative and has since supported external commercial debt relief consistent with the HIPC Initiative.4

1 The role of the DRF in promoting creditor participation under the HIPC Initiative has been highlighted in the 2007, 2008, 2009 and 2011 HIPC Initiative and MDRI Status of Implementation Reports (IDA/SecM2007-0540, September 6, 2007; IDA/SecM2008-0561, August 29, 2008, IDA/SecM2009-0508, September 16, 2009, and IDA/R2011-0310/1, November 8, 2011.)

The DRF has helped extinguish an estimated US$10.27 billion of

2 “Debt Reduction Facility for IDA-only Countries: Progress Update” IDA/R2010-0078, March 17, 2010. 3 Past DRF Progress Updates reported 22 countries benefited from DRF support. This number included Vietnam, which received a DRF Preparation Grant and not a DRF Implementation Grant. Subsequently, Vietnam completed an external commercial buyback operation outside the scope of the DRF, with support from an IDA Debt and Debt Service Reduction credit of US$ 35 million. As the DRF did not finance the buyback operation, in this Progress Report Vietnam has been excluded from the list of beneficiary countries. 4 In effect, the July 2004 DRF paper (“Debt Reduction Facility for IDA-only Countries Progress Review, Support to the HIPC Initiative and Proposed Enhancements,” IDA/R2004-0184, July 12, 2004) establishes that the debt reduction provided by creditors under any operation supported by the DRF should be “no less than the combined reduction applied through the provision of traditional and HIPC debt relief.”

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external commercial debt obligations in the beneficiary countries, of which US$5.05 billion was external commercial debt principal outstanding and US$5.22 billion was accrued interest, arrears and penalties (see Annex Table 1). 4. DRF-supported buyback operations have been financed with contributions from IBRD net income, grants from donors, and beneficiary governments’ own resources. The total amount of funds paid to extinguish US$10.27 billion through DRF-supported buyback operations is US$753 million.5 The IBRD provided 35 percent of this amount, equivalent to US$266.4 million out of its net income, while bilateral donors contributed with 33 percent of the cost, equivalent to US$246.9 million. The largest contributors were Switzerland (US$51.1 million), Norway (US$37 million), the Netherlands (US$31.2 million), and Sweden (US$25.2 million), making up to around 60 percent of the total donor resources (see Chart 1 and Annex Table 2). Beneficiary Governments’ own contributions matched the rest of the financing (32 percent, or about US$239.7 million).6

Chart 1: Financing of DRF - Supported Buyback Operations (total up to December 2011) Overall contributions (in US$ millions and %) Total donor contributions and direct funding-- US$ 247 million (in %

of total donor contributions)

Source: World Bank staff estimates. 5. Key hallmarks of DRF support are the high (and increasing) discount rates and very high participation rates by external commercial creditors7

5 DRF-supported external commercial debt buyback operations have at times been combined with debt restructuring and debt swaps, as part of a comprehensive resolution of the debt distress situation in the country, as in the case of Côte d’Ivoire in 1998.

(see Chart 2). The DRF has

6 Non-grant financing includes beneficiary countries’ own contributions towards the cost of the buybacks (e.g., Nicaragua’s contribution by up to US$3.4 million (source: Grant Agreement Implementation) and Liberia’s contribution of US$175,701.15 (source: Advisor’s Closing Report, 2nd closing) to their respective buybacks costs), and loan/credit financing towards the buyback (e.g., the SDR36 million IDA credit to Côte d’Ivoire, which the authorities contributed to the cost of its 1998 buyback operation). 7 In this report, the ‘discount rate’ is defined as the percentage of the value of the external commercial debt obligation negotiated between debtors and creditors to seal the buyback deal. For instance, a 95 percent discount rate is the agreed rate at which debtor countries buy back the external commercial obligations held by creditors. The remaining 5 percent represents the ‘recovery rate’ applied to the external commercial debt obligations held by the creditors. And since the unit of reference is the US dollar, a 95 percent discount rate is equivalent to a price of 5 cents to the US dollar face-value paid for the obligation bought back. Therefore, a high discount rate is equivalent to a low price paid for the buyback, and to a low recovery rate for the creditors. The ‘participation rate’ is the value of external commercial obligations (face value, interests, arrears, and penalties when applicable) sold back to the debtor in the DRF-supported buyback operation, as a percentage of the total value of all external commercial debt obligations that have been reconciled and have been assessed as eligible for DRF- supported buyback operations. A participation rate of 90 percent, for instance, indicates that 90 percent of the assessed and eligible value of the stock of external commercial debt obligations has been bought back, or extinguished, through the DRF-supported operation.

Governments contributions ($239.7 mill.,

32%)

IBRD ($266.4

mill., 35%)

Donor grants and direct

contributions ($246.9 mill.,

33%)

Switzerland21%Norway

15%

Netherlands13%

Sweden10%

EU10%

UK8%

Germany8%

France7%

USA5%

Canada0.16%Finland

1% Japan0.24%Russia

2%

Other8%

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provided an institutional framework through which the external commercial creditors have participated in debt relief efforts, particularly the HIPC Initiative, on an equitable basis to multilateral and bilateral donors, while progressively ensuring higher discounts on the face value of the external commercial debt obligations. This is partly by design: since 2004, the DRF requires that (i) commercial debt buyback operations take place at a discount at least comparable to that offered by bilateral creditors under the HIPC Initiative; and (ii) that at least 90 percent of eligible debt is tendered in the operation.8 The reporting in HIPC annual Status of Implementation Reports of cases in which external commercial creditors opted for litigation, instead of participating in the DRF-supported buyback operations may have also influenced high participation rates.9 Since 2007, Paris Club creditors have committed not to sell their claims on HIPC countries to other creditors who do not intend to provide debt relief under the HIPC initiative.10

Media documentaries on so called ’vulture funds’, and social pressure channeled by NGOs that condemn their practices on poor nations may also have contributed to the high participation rates.

Chart 2: On Average, Buyback Prices on DRF-Supported Operations Have Declined, and Creditor Participation Rates Remained High.

Source: World Bank staff estimates.

6. Past DRF-supported buyback operations show a correspondence between the amount of debt extinguished and the discount and participation rates. DRF-supported buyback operations that extinguished amounts above US$500 million have achieved discount rates of around 95 percent or higher (i.e., prices around 5 cents to the US$ or lower) and average participation rates of 92 percent (see Charts 3 and 4, and Annex Table 1). Conversely, operations that helped extinguish amounts lower than US$500 million, had discount rates lower than 95 percent (or its price equivalent in the range of 5 to 12 cents to the US$ in most operations) and average participation rates of 87 percent.11

8 Creditors are now required to provide a discount under the operation of at least the combined effect of the provision of traditional and HIPC Initiative debt relief.

This relationship may have implications for future

9 Despite this success, the ability of IDA and the IMF to encourage the participation of commercial creditors in the HIPC Initiative remains limited. The HIPC Initiative is not legally binding on other creditors. Moreover, in accordance with their respective Articles of Agreement and policies, both institutions are required to operate with neutrality and impartiality in disputes among members. See IDA and IMF “Enhanced HIPC Initiative–Creditor Participation Issues”, April 8 2003. 10 See Press release of the Paris Club on the threats posed by some litigating creditors to heavily indebted poor countries, May 22, 2007. 11 These stylized facts remain, regardless of marginal changes in the thresholds for the extinguished debts, the discount rates, and the participation rates, and despite the small number of outlier observations. The thresholds are chosen for the sake of convenience in presenting the stylized facts and showing supply and demand effects affecting buyback operations.

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DRF-supported buyback operations: established precedents regarding discount and participation rates will weigh heavily in negotiations in future buyback operations. Chart 3: Creditor Participation Rates Have Been High for Large Operations

Chart 4: The Average Price Paid for DRF Supported Operations Has Been Lower for Large Operations

Source: World Bank staff estimates. B. Progress report since the last DRF Progress Update 7. Progress over the last two years has been mixed. On the one hand, Liberia successfully concluded its second buyback operation and extinguished all its eligible commercial debt. On the other hand, the Democratic Republic of Congo (DRC) and Sierra Leone received grants for the preparation of their buyback operation, but were unable to use them in full before their respective closing dates. Liberia 8. With the second closing of the buyback operation Liberia fully extinguished its external commercial debt. The second closing, completed in November 2010, enabled the Liberian authorities to repurchase and cancel the last hold-out external commercial claim valued at US$43.9 million. This claim had not been resolved in the first DRF-supported buyback operation in April 2009, which extinguished US$1,213 million (see summary of both buyback operations in Table 1).12 The Liberian authorities successfully negotiated the first buyback operation and its second closing; with support from their legal and financial advisors,13

12 For more details on the first DRF-supported buyback operation for Liberia see “Debt Reduction Facility for IDA–Only Countries: Progress Update”, IDA/R2010-0078, March 17, 2010.

at a 96.87 discount rate on all claims, equivalent to a unitary repurchase price of 3.135 cents to the US dollar, one of the lowest repurchase prices achieved through the DRF. With this second

13 The Liberian authorities contracted legal and financial advisory services from internationally reputable firms to prepare both buyback operations, with financial support from a DRF Preparation Grant of US$1,300,000 approved by the Board on April 15, 2008 (“Proposed Grant of US$1,300,000 from the Debt Reduction Facility for IDA-only Countries to the Republic of Liberia for the Preparation of a Commercial Debt Reduction Operation”, IDA/R 2008-0085, April 15, 2008).

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closing, Liberia has successfully extinguished all known and traced external commercial debt claims, amounting to US$1.26 billion.14

Table 1: Liberia – Financial Terms for the Buyback Operations

Source: World Bank Staff calculations based on Authorities’ Memoranda – First and Second Closing (May 19, 2009 and July 27,

2010). 9. The DRF-supported second closing resolved Liberia’s most aggressively litigated claim. The holders of the claim withdrew from the negotiations in the April 2009 buyback operation and opted to continue litigation against Liberia in international courts. The debt underlying the claim had a legally enforceable “Currency Guarantee” from the Central Bank of Liberia, and Liberia was in default on this debt since August 1983. The holders of the claim sued Liberia in the U.S. Federal District Court in New York and, in June 2002, the Court awarded them a default judgment with a claim value of about US$18.4 million to which interest and penalties were to be attached. Following their withdrawal from the first buyback negotiations, the creditors continued the litigation in London and Hong Kong SAR, China, where, in December 2009 and June 2010 respectively, they obtained confirmation of the New York judgment.15 Eventually, the terms agreed upon for the second closing were the same as in the first closing of the DRF-financed buyback operation prior to the creditors’ withdrawal. 16

14 Almost at the same time, Liberia also won the approval of Paris Club creditors to cancel a total of $1.26 billion of bilateral debt. In the Government’s Press Release to announce the conclusion of these operations, the Minister of Finance declared that "(t)he savings resulting from Liberia's debt reduction operations with both commercial and bilateral creditors will allow us to devote our resources to critically-needed infrastructure projects and poverty alleviation programs" (Press Release 10/19/10). 15 The creditors claimed a payment of US$350,000 over the price of the repurchase, as litigation costs incurred in London and Hong Kong SAR, China. The Liberian authorities successfully negotiated to entirely exclude these litigation fees from the claim repurchase. 16 Both the authorities and the creditors were placed under pressure to expeditiously reach an agreement. The judgments, in the jurisdictions mentioned, entitled the creditors to seize Liberia’s assets and financial flows passing through those jurisdictions. At risk were financial flows linked to various concessions Liberia had extended to external partners, thereby causing delays in the implementation of Liberia’s reconstruction and poverty reduction programs. At the same time, however, the litigating creditors had been exposed to negative media publicity prompted by a BBC documentary broadcast in March 2010, revealing the damaging effects of the litigation pursued by them. “Vultures prey on Liberia’s debt”: http://news.bbc.co.uk/2/hi/programmes/world_news_america/8546628.stm

Value, costs and financingFIRST

BUYBACKSECOND CLOSING TOTAL

Total value of claims extinguished (as of HIPC cut-off date June 30, 2007) (in US$) 1,213,262,649 43,889,330 1,257,151,979 Discount rate (= cents to the US Dollar) 3.135 3.135 3.135 Total cost of repurchase of claims (in US$) 37,791,196 1,384,505 39,175,701 Total financing (in US$) 37,791,196 1,384,505 39,175,701 o/w Liberia DRF Trust Fund (in US$) 37,791,196 1,208,804 39,000,000 Government of Liberia's own resources (in US$) 175,701 175,701

Contributions to the Liberia DRF Trust Fund In (%) of total In US$ IBRD net income 44.2 17,246,613 Germany 16.7 6,515,000 Norway 13.4 5,238,387 United Kingdom 12.8 5,000,000 United States 12.8 5,000,000 Total 100.0 39,000,000

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10. Liberia joined contributions from bilateral donors and IBRD to finance the buyback operation. The total cost of the operation was US$39.2 million (US$37.8 million in April 2009 buyback and US$1.4 million in the November 2010 second closing; see Table 1). Bilateral donors contributed US$21.7 million (Germany, Norway, the United Kingdom, and the United States), IBRD net income resources through the DRF Trust Fund contributed US$17.3 million17

, and the Government contributed about US$0.2 million.

Democratic Republic of Congo 11. After two extensions, the DRF Preparation Grant for the DRC reached its closing date in June 2010 without finalizing the external commercial debt buyback strategy. The Board of Executive Directors initially approved a DRF Preparation Grant for the DRC in September 2005 for US$900,000, which was extended first on May 4, 2007, and again on June 30, 2009 with a closing date of June 30, 2010.18 The buyback strategy could not be concluded due to the inability to establish the legally acceptable value of the Belgolaise Bank (Belgolaise for short) claim, the largest among the obligations eligible for DRF support (see below).19

The DRF has communicated to the DRC authorities its willingness to review a request for a second DRF Preparation Grant (instead of a third extension of the first grant). Such request would be considered, once the authorities and the creditors resolve all issues involved in the Belgolaise claim.

12. The lack of resolution of the largest claim blocked the preparation of the buyback strategy.20 The DRC’s legal and financial advisors, based on un-reconciled figures, estimated the Belgolaise claim at over US$850 million, including principal, interest and penalties.21

17 “Proposed Grant of US$39 million from the Debt Reduction Facility for IDA-only Countries to the Republic of Liberia for a Commercial Debt Reduction Operation”, IDA/R2008-0328, December 24, 2008.

The total estimated amount of debt the buyback operation could treat was about US$1.2 billion, most of which is owed to London Club creditors, including Belgolaise. Belgolaise communicated to the DRC authorities in 2007 and 2008 that it irrevocably renounced then and in the future any intent to pursue the recovery of the claim. However, the DRC‘s legal and financial advisors established that these communications did not legally extinguish the obligation, as there remained some risk that the obligation could re-emerge in the hands of third parties, which could potentially derail the buyback operation under preparation at that time. The impossibility to

18 Grant No. TF055758 - DRC Preparation of Commercial Debt Reduction Program for US$ 900,000, September 2005. The grant proceeds financed the legal and financial advisory services from two highly reputable international firms, hired by the DRC authorities. 19 The name of the company is in the public domain. See Box 2 p. 25 in: http://siteresources.worldbank.org/INTDEBTDEPT/CompletionPointDocuments/22784041/DRCCompletionPoint.pdf 20 The Board was informed on the issues around the Belgolaise claim during the discussion of the “DEMOCRATIC REPUBLIC OF CONGO - Enhanced Heavily Indebted Poor Countries (HIPC) Initiative Completion Point Document and Multilateral Debt Relief Initiative (MDRI)”, IDA/R2010-0230, June 11, 2010. This document was categorized as confidential in the context of the Bank’s Disclosure Policy, and only a redacted version of it was publicly disclosed. 21 The Belgolaise claim dates back to March 31, 1980. It was part of the block of claims belonging to the London Club documented in the Rescheduling Agreement of above-said date. Union Bank of California, the Servicing Bank for London Club creditors with claims on the DRC, informed the DRC’s legal and financial advisors that at end-2009 interest in arrears to London Club creditors totaled $546.3 million, implying total claims of US$897.3 million, 91 percent of which (US$816.5 million) was held by Belgolaise. The advisors estimated the Belgolaise figure at US$850 million, to take into account the time it would take to negotiate a buyback deal.

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establish a legally acceptable extinction of the claim led to a deadlock in the communications among the parties, and the five-year old DRF Preparation Grant closed.22

Sierra Leone 13. The DRF Preparation Grant for Sierra Leone reached its closing date at the end of December 2011. Sierra Leone benefited from a DRF Preparation Grant of US$950,000, approved by the Board on January 9, 2009, with a closing date of December 31, 2011.23 The aim of the Preparation Grant was to help the Government of Sierra Leone to establish the buyback strategy through provision of expert legal and financial advisory services. By the closing date, the legal and financial advisory services had not been contracted, and the grant funds were returned to the DRF Trust Fund. The potentially DRF-eligible external commercial claims were estimated to be between US$144 million and US$254 million. The buyback was expected to resolve the holdouts from the first DRF-supported buyback operation in 1995.24

C. Requests received for DRF-support 14. Since the last DRF progress update, the DRF has received requests for support from the Republic of Congo and Côte d’Ivoire. The Republic of Congo requested support for a DRF Preparation Grant in 2010, to prepare an external commercial debt buyback operation covering mostly claims from suppliers. Côte d’Ivoire requested support for a DRF Implementation Grant in 2009, to finance the buyback operation the authorities had already prepared earlier with their own resources.25

The Republic of Congo 15. In April 2010, the Republic of Congo requested DRF support to prepare an external commercial debt buyback operation. The DRF Oversight Committee recommended the DRF team to conduct an assessment together with the authorities of the available information on the external commercial debt, in light of DRF eligibility criteria. A stock of about US$1.05 billion of external commercial debt obligations could be eligible for a DRF-supported buyback operation, one of the largest remaining among all HIPC countries (see Annex Table 3). The Republic of Congo meets the DRF country-eligibility criteria: (i) it has reached the HIPC Completion Point 22 Bank’s principle of neutrality and impartiality prevents the DRF from directly intervening in the resolution of this claim between the DRC government and Belgolaise Bank. Operational Policy 7.40 on “Disputes over Defaults on External Debt, Expropriation and Breach of Contract.” OP 7.40 provides that in cases of disputes not involving a Bank-financed project, the Bank seeks to avoid any involvement in the issue, although the Bank may urge both parties to promptly resolve the dispute. Furthermore, OP 7.40 establishes that in cases of disputes over defaults, its role is limited to improving communications between the parties to the dispute and impressing on them the desirability of a settlement, without passing judgment on the merits of the disputes. See also “Enhanced HIPC Initiative -- Creditor Participation Issues”, April 11, 2003; IDA/R2003-0058. 23 “Proposed grant of US$950,000 from the debt reduction facility for IDA-only countries to Republic of Sierra Leone for the preparation of a second commercial debt reduction operation (IDA/R2008-0325)”. 24 A DRF-supported buyback operation in September 1995 helped Sierra Leone extinguish US$329.5 million of its commercial external debt, with US$234.7 million of principal and US$94.8 million of interest and penalties. The average price was 13 cents per dollar of principal, with a 73 percent participation rate. 25 Typically, the DRF provides a Preparation Grant to prepare a buyback strategy and an Implementation Grant to effect the repurchase of the claims at a deep discount. According to DRF policies and practices, client countries can directly request an Implementation Grant, as Côte d’Ivoire did, provided the request is based on a sound external commercial debt buyback strategy. In case the client directly requests an Implementation Grant, the client will establish the buyback strategy with the help from international legal and financial advisors without financial support from the DRF.

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(January 2010); (ii) it is able to formulate a comprehensive debt reduction strategy covering its external commercial debt; and (iii) it has successfully completed the Fifth and Sixth Review of the ECF program with the IMF on July 27, 2011. Presently, no new IMF program is under preparation for the Republic of Congo. The DRF-eligibility of the individual claims would need to be determined by the authorities with help from legal and financial advisors during the preparation of the buyback operation. 16. The authorities, subsequently, proposed to self-finance the preparation and implementation of the buyback operation, but requested Bank support to ensure the success of the operation. The DRF team and the authorities are currently exploring options compatible with the DRF framework to respond to the request. Côte d’Ivoire 17. The DRF Oversight Committee reviewed Côte d’Ivoire’s February 2009 request for a second DRF Implementation Grant to support arrears clearance and restructuring of the outstanding principal on the commercial debt owed to the London Club. The arrears to be cleared were linked to the bonds issued in the 1998 commercial debt restructuring operation, supported by the first DRF Implementation Grant.26

The total amount proposed to be treated was US$2.89 billion, out of which US$1.02 billion were arrears to be bought back with DRF support, and the balance of US$1.87 billion corresponding to the outstanding principal would have been restructured through an exchange offer, in consultation with the London Club creditors. The strategy proposed involved a discount rate of 90 percent for the part to be bought back, and the discussions on the restructuring were relatively advanced. However, although Côte d’Ivoire was eligible for a second DRF operation, the proposed buyback strategy included a large portion of collateralized and guaranteed claims, which made them ineligible for DRF support - namely the principal on the Discount Bonds was guaranteed at maturity, and the interest on the Front Loaded Interest Reduction Bonds (FLIRB) was partially guaranteed for 13 years (i.e., up to 2011). Furthermore, DRF policies and practices require second operations to result in a comprehensive resolution of the commercial debt, which the proposal did not meet on two grounds. First, it excluded the debt owed to non-London Club commercial creditors (about US$175 million); and, second, the operation proposed included a large portion that would be restructured, not extinguished, thereby creating the possibility of re-emergence of arrears at a later stage.

18. In July 2009 the DRF communicated to the authorities its willingness to reconsider its support as long as it was in accordance with a comprehensive strategy to resolve all of Côte d’Ivoire’s external commercial debt. A fully comprehensive strategy would include debt obligations to all commercial creditors, with the ultimate objective to fully extinguish the commercial debt. The DRF could support the resolution of all non-guaranteed and non-collateralized commercial debt, provided the claims satisfied the DRF policies and practices and, subject to the availability of funds to finance the buyback operation. Subsequently, the

26 Côte d’Ivoire received a first DRF Implementation Grant in March 1998 in support of a comprehensive debt restructuring operation (Report No. P-7151-IVC). This was a Debt and Debt Service Reduction Operation that restructured $6.7 billion of commercial debt. The bonds conversion component amounted to US$2.6 billion divided in three categories: Discount Bonds, Front Loaded Interest Reduction Bonds (FLIRBs) and Past Due Interest Bonds (PDIs), all eventually held by London Club creditors. Each type of bond had specific payment terms and conditions, including a differentiated structure of guarantees for the Discount Bonds and the FLIRBs. The bonds in all three categories fell into default in September 2000.

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authorities did not avail themselves of DRF support, and proceeded with their initially proposed external commercial debt restructuring strategy in direct negotiations with London Club creditors.

III. CURRENT FINANCIAL POSITION OF THE DRF 19. As of December 2011, the balance available in the DRF Trust Fund was US$133.23 million (see Table 2). The total amount available is not earmarked and is available for future allocations.

Table 2: Resources Available to the DRF

End-December 2011

1/ The Fund balance as of end-December, 2011 represents only the balance of the DRF Trust Fund resources from IBRD net income contributions and net investment income. The contributions from donors reported in the table were made to specific past buyback operations directly. Donors do not contribute to the DRF Trust Fund itself, but to specific buyback operations donors decide to support. a) Prior to February 1, 2007, undisbursed fund balances were refunded to IBRD although they remained available to the DRF for future operations. For the period from inception through January 31, 2007, $75,114,688 was refunded to IBRD. Effective February 2007, amounts remaining undisbursed upon completion of activities, including the net investment income, are retained in the DRF Trust Fund for future operations. Additionally, all amounts previously refunded to IBRD were returned to the DRF Trust Fund in March 2007. (Note 8, Independent Auditors' Report, FY11). b) Investment income accumulated between June 30, 2011 – December 31, 2011. Source: Debt Reduction Facility for International Development Association - Only Countries Financial Statement,

Supplemental Schedules and Independent Auditors' Report as of June 30, 2011.

Total in US$In (%) of

total receipts

ContributionsInternational Bank for Reconstruction and Development (IBRD) 350,000,000 47%Donors, of which 1/ 255,096,046 34%

Cameroon 20,245,611 2.7% Canada 339,271 0.0% Finland 2,010,000 0.3% France 8,284,547 1.1% Germany 20,407,300 2.7% Netherlands 39,008,863 5.2% Norway 37,959,386 5.1% Russian Federation 5,000,000 0.7% Sweden 30,171,136 4.0% Switzerland - for approved Operations 56,365,761 7.5% Switzerland - not identified with an Operation 10,628,171 1.4% United Kingdom 19,676,000 2.6% United States 5,000,000 0.7%

Transfer from IBRD 75,114,867 a) 10%Net investment income 67,415,117 9%Total receipts 747,626,030 100%

Project disbursements 479,812,347Refunds to IBRD 75,114,688 a)Refunds to donors 31,342,552Transfer to DRTF 28,420,767Total disbursements 614,690,354

Fund balance before FX adjustment $132,935,676Foreign currency (FX) adjustment 63,371Investment Income 233,953 b)Fund balance as of end-December, 2011 1/ $133,233,000

Receipts, disbursements and DRF fund balances

10

IV. AUDITS OF DRF ACCOUNTS AND OPERATIONS 20. Independent auditors (KPMG) have audited the DRF financial reports for FY2011. The auditors' report states that the DRF financial statements present fairly the fund balance of the DRF and its cash receipts and disbursements for the period ending on June 30, 2011. 21. On May 4, 2011, the DRC authorities submitted the audit report for the DRF Preparation Grant, performed by ‘Strong NKV’. The auditor's report indicates that the trust fund financial statements present fairly the fund balance and the cash receipts and disbursements for the period ending on June 30, 2010. 22. The Government of Liberia has submitted the audit report for the Preparation Grant, which is satisfactory to the Bank. Although the audit report for the Implementation Grant has been delayed, the Government has already contracted the General Auditing Commission (GAC) and provided the Terms of Reference to undertake the audit expeditiously. The Government expects to submit the audit report to the World Bank by end-March 2012. Management is closely following up the matter with the authorities. In addition, Management confirms that it will closely follow up on the audit findings.

V. CHALLENGES 23. Notwithstanding the progress achieved so far, there remain significant challenges ahead. 27

Three key challenges emerge in the context of the impending termination date for the DRF, and the large stock of external commercial debt, potentially eligible for DRF support that remains to be extinguished. First, the DRF needs a sound financing plan to respond to anticipated requests for support in the next three-to-fi0ve years, based on a realistic assessment of resources available, financing shortfalls, and options to fill in the shortfalls. Second, DRF-supported buyback operations for client countries with large stocks of external commercial debt could rapidly exhaust available funds, whereas buyback operations for countries with small stocks could encounter cost-effectiveness issues. Third, achieving the most beneficial combination between the best repurchase price and the highest participation rate in future buyback operations may require innovations to current DRF policies and practices. To engage in a way out of these challenges, the DRF team proposed an agenda for further analytical work to make the DRF more responsive to emerging characteristics of future DRF-supported buyback operations.

24. The DRF will require an extension of its termination date to continue providing support to client countries. The DRF is currently due to terminate on July 31, 2012, as established in the most recent five-year extension approved by the Board in April 2007.28

27 These challenges are consistent with those identified earlier in the previous Debt Reduction Facility for IDA-Only Countries: Progress Update; IDA/R2010-0078, March 17, 2010.

As previously indicated, the DRF Trust Fund currently has a balance of US$133.23 million.

28 The DRF, administered by IDA as trustee, was established initially for a period of three years in July 1989 (“Operational Guidelines and Procedures for the Use of Resources of the Debt Reduction Facility for IDA-only Countries, (R89-156, IDAR89-103, July 13, 1989”). Since then it has been extended 7 times, usually for periods of between one and three years: (i) R92-33 IDA/R92-26: Review of Progress under the Debt Reduction Facility for IDA-Only Countries extended the DRF by 2 years (to

11

25. The case for continuation of the DRF is strong, as the stock of unresolved HIPC external commercial debt remains high. The total estimated stock of external commercial debt for 24 remaining HIPCs, which could be eligible for DRF support, is about US$11.2 billion, compared to about US$10.3 billion for 21 countries that was extinguished with the DRF support in the last 22 years (see Chart 5 and Annex Table 3).29

The actual DRF-eligible amounts could vary upwards or downwards around this estimate, according to a variety of factors outlined below.

26. Stocks of external commercial debt that could potentially be extinguished may differ from current estimates. Country-specific stocks of external commercial debt eligible for DRF support could be higher or lower than those reported by the authorities. Discrepancies are typically identified and resolved during the preparation phase, as the authorities and their legal and financial advisors proceed with the claim-by-claim reconciliation to assess if each of them is DRF-eligible.30

Key discrepancies could arise from the following:

• Arrears and related penalties, along with litigation and financial penalties would push up the value of the claims at the time of the buyback, proportional to the financial sanctions anticipated in the default clauses in the initial debt contract and/or the penalties determined by the judge in cases under litigation.31

• Claims that are collateralized and/or guaranteed (and therefore not eligible under the DRF), untraceable, and/or exposed to statute of limitations would push down the stock of claims that can be extinguished in DRF-supported buyback operations.

July 31, 1994); (ii) R93-132/ IDA/R93-114: Review of Progress under the Debt Reduction Facility for IDA-Only Countries extended the DRF by 1 year (to July 31, 1995); (iii) R95-122/ IDA/R95-100: Review of Progress under the Debt Reduction Facility for IDA-Only Countries extended the DRF by 3 years (to July 31, 1998); (iv) IDA/R98-107: Review of Progress under the Debt Reduction Facility for IDA-Only Countries extended the DRF by 3 years (to July 31, 2001); (v) IDA/R2001-0133: Progress Review: The Debt Reduction Facility for IDA-Only Countries extended the DRF by 3 years (to July 31, 2004); (vi) IDA/R2004-0184: Debt Reduction Facility for IDA-Only Countries Progress Report, Support to the HIPC Initiative and Proposed Enhancements extended the DRF by 3 years (to July 31, 2007); (vii) IDA/R2007-0064: Debt Reduction Facility for IDA-Only Countries Progress Update and Proposed Extension extended the DRF by 5 years (to July 31, 2012). 29 The estimated stock results from aggregating data for 24 out of 39 HIPCs that report having external commercial debt outstanding contracted prior to their respective HIPC cut-off date - 15 countries report not having external commercial debt claims. Of the 24 countries, four countries – Sudan, Côte d’Ivoire, Republic of Congo, and Ghana- hold 90 percent of eligible debt outstanding and the remaining 20 hold the balance. This estimate is based mostly on data provided by country authorities, as of end December 2010. Missing data was estimated based on the latest available HIPC documents. Note that this is un-reconciled data, which replicates the type of data available at the DRF Preparation Grant phase. During the preparation phase, the legal and financial advisors conduct a thorough due-diligence reconciliation of all external commercial debt claims, and determine the actual eligibility of claims for DRF support. See also footnote 42. 30 In the past, among 11 comparable cases of buyback operations, the discrepancy between initially estimated stocks and stocks extinguished was markedly dispersed. For instance, for Tanzania the extinguished stock was over 3,000 percent higher than the initially estimated stock, whereas that for Bolivia was 35 percent lower. On average for the 11 cases, the amounts extinguished exceeded by 34 percent the amounts initially estimated. 31 Negotiations in DRF-supported operations include arrears, penalties, and litigated claims. Related to the latter, in case of favorable judgments, the judge will typically impose interest rates and penalties en-vigueur within the jurisdiction the judge presides, which may be disconnected from the clauses in the initial contract. Although DRF-supported buyback negotiations would include litigated claims and claims that carry favorable judgments, the entirety of the cost of litigation incurred and claimed by the creditor is absolutely excluded.

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Chart 5: Total Extinguished and Estimated External Commercial Debt, Potentially DRF-Eligible

Source: World Bank staff estimates based on authorities’ data.

Challenge 1: DRF-supported operations for the next three-to-five years will need closer monitoring of buyback costs and financing needs than in the past. 27. Overall, estimated costs and financing needs for future DRF-supported buyback operations could be large. Based on DRF policies and practices, about US$1.84 billion could be needed to finance the buyback of the estimated US$11.2 billion total stock of external commercial debt obligations remaining in eligible HIPCs, pending a thorough analysis of DRF-eligibility for each claim.32 These estimates assume that all eligible countries will eventually benefit from DRF support. To finance the full extinction of the estimated stock of external commercial debt obligations for the 24 HIPCs, which could be eligible for DRF support, IBRD would need to potentially mobilize between US$607 and US$920 million, with the balance expected to be financed by bilateral donors and beneficiary countries. The latter amount is estimated based on a DRF policy established in 2008, which requires that the IBRD contribution will not normally exceed 50 percent of the cost of the buybacks.33

32 The estimates result from applying DRF and HIPC policies and practices to each client country, and are based on: (i) the total estimated amount of DRF-eligible debt; (ii) traditional debt relief applied to eligible amounts; and (iii) country-specific Common Reduction Factor (CRF) established at HIPC Decision Point (or, in some cases, estimated at pre-Decision Point) applied to the amounts after traditional debt relief. Actual costs, however, should be expected to be affected by factors including: the reconciled eligible debt and, for claims under litigation, the impact of arrears and penalties; the final discount rate negotiated; and the participation rates.

The former amount represents about one third of the total estimated cost, in line with the share of the IBRD contribution to the

33 The policy establishes that contributions from IBRD net income “should not normally exceed 50 percent of the costs of any given implementation grant”. See paras 92 and 100.v in “Debt Reduction Facility for IDA-Only Countries: Progress Update and Proposed Amendments to Policies and Practices”, IDA/R2008-0066, April 8, 2008.

Nicaragua, $3,193 mill.

Liberia, $1,257 mill.

Clients with large

stocks, $10,047

mill.

Others, $4,716 mill.

Others, $1,122 mill.

0

2,000

4,000

6,000

8,000

10,000

12,000

Total ECD extinguished Estimated total ECD outstanding as of end 2010

Cote d' Ivoire, $1,110 mill.

13

total cost of the buybacks in all past operations (see Chart 1). Country specific contributions from IBRD net income, however, could vary significantly from one case to another.34

28. However, these financing needs are not immediate because buyback operations take a long time to be prepared and completed. While the financing needs from IBRD appear large, the actual financing needs to complete all buyback operations are contingent on the actual sequence and timing of the buyback operations themselves. Based on how long past operations took to be completed, extinguishing all remaining DRF-eligible claims could take a long time (see Box 1). 29. More immediately, in the next three-to-five years, the DRF may be requested to handle up to three requests for support. Requests for DRF support are voluntary, and therefore eligible client countries reserve all discretion in terms of their actual willingness, timing, and readiness to request DRF support. Sierra Leone, the Republic of Congo, and Côte d’Ivoire or Sudan could request DRF support for buyback operations in the next three-to-five years. These requests would combine requests from countries with large and with small stocks of external commercial debt potentially eligible for DRF support. 30. In the three-to-five year horizon, three potential scenarios on financing needs for DRF-supported buyback operations can be anticipated. For the purpose of estimating financing needs, two groups of countries are considered: Group A includes Sierra Leone, Republic of Congo, and Côte d’Ivoire; and Group B includes Sierra Leone, Republic of Congo and Sudan. Sierra Leone and the Republic of Congo are recent cases that the DRF will continue handling, subject to the Board approval of the DRF extension date. Côte d’Ivoire is engaged in reaching the HIPC Completion Point, and may undertake efforts to deal with its external debt in a comprehensive manner, including its external commercial debt obligations. Sudan is currently being supported by an inter-institutional Sudan Working Group, and is engaging efforts to benefit from debt relief in the near-term. The financing scenarios below: (i) are related to estimated buyback costs for each country in the two groups, applying DRF policies and practices and under country-specific assumptions; (ii) refer exclusively to the estimated contribution likely to be needed from the IBRD net income (i.e., the scenarios do not include estimated contributions from donors and/or beneficiary countries) to finance the buyback operations; and (iii) assume that there would not be replenishment of the DRF Trust Fund from IBRD net income in the next three-to-five year period.

34 In practice, individual contributions from IBRD net income through the DRF were as small as 5 percent and as large as 100 percent.

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Box 1: Extended Timing for DRF Operations Since the establishment of the DRF in 1989, 25 operations have been completed in 21 countries. Most countries benefitted from one DRF operation, split between the Preparation phase and the Implementation phase, and with the actual buyback accomplished in only one closing. Exceptions did occur, with five countries having accomplished buybacks with more than one closing (Liberia –two closings; Nicaragua II – four closings; Sierra Leone – two closings; Tanzania – two closings; and Zambia – two closings) and three countries (Guyana, Mozambique and Nicaragua) benefitting from two separate buyback operations each (see Annex Table 1). A typical DRF operation has so far taken, on average, three years to complete, with the first two years dedicated to the preparation of the operation and the last year to the implementation. During the first phase of work, the legal and financial advisors hired by the recipient of a DRF Preparation Grant carry out the reconciliation work underlying the actual buyback. Claim eligibility is analyzed, the debt buyback strategy is established, and pre-negotiations with the creditors take place, including pre-negotiation of the buyback purchase price. The second phase is dedicated to lining up the necessary co-financing, performing the actual buyback, and closing the accounts in conformity with the requirements of the respective administrative and grant agreements. Exceptions to this timetable do occur, as case of Tanzania, where the operation took ten years to complete. The pace at which the operations to date have been completed varied with the level and complexity of constraints characterizing each of the countries involved, which, in general, fall into five categories: (a) incompleteness and scarcity of relevant records; (b) creditor participation; (c) legal issues related to the claims; (d) funding considerations; and (e) weak procurement capacity in the client-country. Low-income countries in general, and post-conflict countries in particular, either have only very basic record tracking, keeping, storing, and backing-up systems, or have lost their record-archives altogether, or both. This is the reality faced by the legal and financial advisors (the “Advisors”) in most DRF-recipient countries. The most striking example is Liberia where the only document available to the Advisors when they started the reconciliation work was a manual ledger, with incomplete information. Once the Advisors finish “book” reconciliation, they approach the creditors and start discussions aimed at getting the latter to accept the accountancy value of their eligible claims as well as the buyback price. Negotiations take a considerable amount of time to complete and in some cases some of the creditors never participate in the buyback or decide to participate later on, which results in several closings for the same operation, as mentioned above. Potential eligible claims are assessed from both a financial and a legal perspective with the latter sometimes requiring extended periods of time to clarify. In some cases, DRF-eligible claims are under litigation; in other cases, they are subject to the statute of limitations; and in yet other cases, the claims have “switched hands” and the Legal Advisors are faced with the task of establishing their actual legal ownership. These are lengthy processes which lead to increases in the amount of time necessary to prepare the respective DRF operation. Lack of complete records also makes the debt buyback co-financing needs hard to anticipate at an early stage. In addition, in most DRF operations, donor co-financing can only be requested at the end of the Preparation phase when the size of eligible debt has been determined, consequently delaying the implementation of the buyback itself. For instance, in Ethiopia, Tanzania and Liberia, the size of total eligible debt was much larger than initially estimated which involved mobilizing co-financing at a level much higher than initially planned; and Nicaragua I was delayed due to the difficulty of attracting, in a short period of time, roughly US$75 million needed for co-financing. Procurement implementation challenges in some of the DRF-recipient countries led to significant delays in completing the operation. For instance, in Mozambique I it took five years to hire the Advisors while in Sierra Leone II the grant agreement reached its closing date before the government was able to recruit the Advisors. Albania also faced difficulties in hiring the Advisors.

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Table 3: Financing Scenarios for Groups A and B (in US$ millions)

Source: World Bank Staff estimates.

• High-case scenario: (i) Financing needs: The estimated contributions for Groups A (US$278.3 million) and

B (US$433.1 million): (a) represent the upper limit of 50 percent financing from IBRD net income, through the DRF Trust Fund, to the cost of the buyback operations for each country; (b) are based on buyback operations that would cover only the country-specific eligible debt claims (i.e., excluding for instance collateralized and guaranteed claims). Actual costs may vary from estimated costs, depending on the results from a full reconciliation of the claims for each country, and the specific negotiations with the creditors.

(ii) Funds available in the DRF Trust Fund: The amount of US$123.2 million

corresponds to the total balance in the DRF Trust Fund, less US$10 million reserved to respond to potential and unforeseen requests for DRF Preparation Grants.

(iii) Financing gap: The financing shortfalls of US$155.1 million for Group A and of

US$309.8 million for Group B are high, although their timing is impossible to predict at this point. Options to mitigate the shortfall would need to be explored, including alternative sources of financing other than IBRD net income.

• Base-case scenario:

(i) Financing needs: The estimated contributions for Groups A (US$158.8 million) and

B (US$313.6 million) result from the same assumptions as in the High-case Scenario, except that the Base-case Scenario excludes the estimated costs of a buyback operation for the Republic of Congo under the assumption that the Government would self-finance the buyback operation.

(ii) Funds available in the DRF Trust Fund: As before, the amount of US$123.2

million corresponds to the total balance in the DRF Trust Fund, less US$10 million reserved to respond to potential and unforeseen requests for DRF Preparation Grants.

(iii) Financing gap: The financing shortfalls of US$35.6 million for Group A and of

US$190.3 million for Group B, although lower than in the High-case scenario, will require mitigating options, especially for Group B.

Total Group A 278.3 123.2 155.1 158.8 123.2 35.6 111.2 123.2 -12.1Total Group B 433.1 123.2 309.8 313.6 123.2 190.3 219.5 123.2 96.31/ Financing needs related to IBRD net income contributions, corresponding to 50 percent of the estimated buyback cost. 2/ Financing needs related to IBRD net income contributions, corresponding to 35 percent of the estimated buyback cost.

Base-case scenario

Financing needs 1/

Funds available in

DRF TF

Financing gap

Low-case scenario

Financing needs 2/

Funds available in

DRF TF

Financing gap

High-case scenarioFunds

available in DRF TF

Financing gap

Financing needs 1/

16

• Low-case scenario: (i) Financing needs: The estimated contributions for Groups A (US$111.2 million) and

B (US$219.5 million) result from the same assumptions as in the Base-case Scenario, except that in the Low-case Scenario a contribution of 35 percent financing from IBRD net income is assumed – consistent with the overall share of the contribution from IBRD net income to past operations.

(ii) Funds available in the DRF Trust Fund: As before, the amount of US$123.2

million corresponds to the total balance in the DRF Trust Fund, less US$10 million reserved to respond to potential and unforeseen requests for DRF Preparation Grants.

(iii) Financing gap: There would be a financing surplus of US$12.1 million for Group A

and a financing shortfall of US$96.3 million for Group B. Although the shortfall for Group B is even lower than in the Base-case scenario, options to mitigate it would need to be explored.

31. The anticipated financing gaps in almost all scenarios in the next three-to-five years call for a more proactive monitoring of sources of financing and for exploring options to minimize costs of DRF-supported buyback operations. Actual financing gaps in the next three-to-five years may fall within the Low-case and Base-case scenarios, contingent on the full reconciliation and eligibility analysis of each claim, and on the negotiation of the repurchase price. The exceptional surplus of US$12.1 million in the Low-case scenario for Group A may also swiftly turn into a financing gap if the reconciliation, eligibility, and repurchase price turn towards more costly buyback operations than estimated here for this group. A gap emerges between financing availability and rising costs of DRF-supported buyback operations. On the financing side, constraints affecting IBRD net income allocations, donors and Governments alike increase the difficulty in securing the continued financing of DRF-supported buyback operations. On the costs side, the DRF needs to continue being responsive to requests for support from client countries, in an environment where the anticipated costs of the buybacks may be high (for broader and country-specific analysis on costs, see the next two sections). This dilemma shall be resolved on a country-by-country basis, based on country-specific progress in the preparation of the buyback operations, for which the DRF must develop its capacity for on-time country-specific responsiveness, in parallel with the preparation of the buyback operations by the client countries. This responsiveness will require more proactive monitoring than in the past, diversification of the sources of financing (traditionally limited to IBRD allocable net income, donors, and Governments’ own resources) and exploring and developing effective cost reducing options for future buyback operations.

• Monitoring financing sources. In terms of IBRD net income, while the near term income position of IBRD remains relatively robust, the current low interest rate environment is dampening IBRD's income-generating prospects and therefore the availability of IBRD allocable net income for transfers to the DRF. If interest rates follow implied forward market rates, and at current levels of pricing on its loans, IBRD will find it increasingly difficult to maintain the level of its transfers to IDA, fund administrative expenses and retain sufficient income in reserves to grow capital in line

17

with lending. This longer-term fragility creates the need for caution in current spending plans as income diverted to other uses now will directly reduce resources available in future years.35

Over the next three-to-five years, the DRF will prepare a periodic update on overall financing needs, including estimated financing from donors and/or client countries and estimated potential financing requests from IBRD that will be reviewed in accordance with its financial outlook at the time. The periodic update will be based on on-time country-specific needs as they arise and will be reviewed by the DRF Oversight Committee, which will make specific recommendations related to the overall financing needs at issue.

Donor financing will need to be approached more proactively than in the past. According to the OECD, official development assistance reached its highest level ever in 201036

and is projected to continue increasing, albeit at a slower pace. It is however unclear how much donors would allocate to finance DRF-supported buyback operations. As with the IBRD net income resources, early knowledge on anticipated country-specific financing needs will help donors better plan their potential contributions. These needs will be identified in parallel with the preparation of the buyback operations. As a result, following the DRF Oversight Committee review of financing needs, the DRF team will endeavor to inform potential donor champions on the status of these financing needs. The authorities from the beneficiary country will continue to be responsible for obtaining actual financial support for DRF-supported buyback operations, as per standard practice. Management will determine the optimal venue and channel for the information sharing, in coordination with donors.

In terms of Government’s own financing, as of end-2010 most DRF-eligible HIPCs held foreign currency reserves larger than their aggregate stock of external commercial debt (see Box 2 and Annex Table 4). The feasibility and opportunity cost of using those reserves to contribute to the financing of DRF-supported buyback operations will need to be evaluated on a case-by-case basis. This issue will be especially important for the set of countries that could potentially request support in the next three-to-five years.

35 The Board will be discussing IBRD's longer-term income and capital outlook in April with context provided by the Medium Term Business Planning and Finance Paper. 36 According to OECD Development Assistance Committee, in 2010 aid flows from donor countries to developing countries totaled US$129 billion, the highest level ever, an increase of 6.5% over 2009. In 2011, the OECD has completed the fourth comprehensive survey of donors’ future spending plans, which provides an indication of the collective forward programming of bilateral and multilateral donors through 2013. Preliminary findings suggest slower aid growth ahead. Global country programmable aid is planned to grow at a real rate of 2% per year from 2011 to 2013, compared to 8% per year on average over the past three years. See http://www.oecd.org/document/35/0,3746,en_2649_34447_47515235_1_1_1_1,00.html.

18

• Exploring options to minimize costs of future buyback operations. The key factors affecting buyback costs are the discount rate and the participation rate.37

37 The interaction between discount and participation rates in DRF-supported buyback operations, although well structured, is not simple. During preparation, the client and the legal and financial advisors estimate an initial discount rate, prior to engaging in pre-negotiations with the creditors. Based on initial contacts with creditors during the claims reconciliation work, the legal and financial advisors estimate the potential participation rate. Negotiations ensue, with a view to ensure the highest discount and participation rates possible. Pursuing the maximum creditor participation presents opportunities and risks: on the one hand, a higher participation rate may provide more leverage to the authorities to negotiate higher discount rates, but on the other hand negotiations could become more complicated and protracted, especially if many creditors are involved and/or several are litigious, both potentially yielding detrimental effects on the discount rate.

Country-specific options to minimize costs should be explored taking into account three factors: (i) the good precedents of high discount and participation rates achieved since 2004 – the year DRF operations were aligned with the HIPC initiative- which should weigh heavily on future buyback operations; (ii) lessons learned from past DRF-supported buyback operations and the specific factors that led to high discount and participation rates, which could be applicable, on a selective basis, to future DRF-supported buyback operations; and (iii) lessons learned on how similar operations to those supported by the DRF in

Box 2: Availability of Self-Financing from Client Countries1 The availability of foreign exchange reserves beyond an optimal precautionary level could help assess whether DRF-eligible countries have adequate resources to finance commercial debt buyback operations, without an undue increase in risk of macroeconomic instability in the event of shocks. Reserves are held by countries for both precautionary reasons (so that liquid reserves are available for potential balance of payments needs) and for non-precautionary reasons (to support exchange rate policy, or for intergenerational savings). A recent IMF analysis suggests that in low-income countries (LICs) optimal reserve coverage, measured in months of imports, depends on the probability of occurrence of shocks, the magnitude of those shocks - measured as a reduction in absorption- and the opportunity-cost of holding reserves, correcting for country specific characteristics. Optimal reserves levels are found to be higher in countries with fixed exchange rate regimes, compared to flexible regimes; and in fragile states and commodity exporters, compared to the average for all LICs.2 Indicative results for LICs are as follows:

Calibrated Optimal Reserves in LICs: An Illustrative Example (In months of imports)

Exchange rate regime Country Groups

LICs AFR COM NCOM FRG

Fixed 5.5 5.3 5.9 5.2 7.6

Flexible 2.1 2.4 2.9 1.8 2.9 Source: “Assessing Reserve Adequacy”, IMF, February 2011. Notes: It assumes a unit cost of reserves of 4 percent. LICs=All LICs, AFR=Sub-Saharan African countries, COM=commodity exporters; FRG=fragile states.

The estimated level of excess reserves for DRF-eligible countries as a whole - defined as the foreign exchange reserves above the optimal level of reserves- surpasses the outstanding stock of external debt at end-2010. However, country-specific projections reflect a dispersed picture. Among four countries that are potentially DRF-eligible which hold large stocks of commercial debt, only two are expected to accumulate sizable excess reserves, owing to revenues that would arise from recent oil discoveries. For most of the 20 countries with smaller stocks of commercial debt, their levels of reserves are several multiples of their outstanding commercial debt stocks, but, as of end-2010, only six had excess reserves above their optimal precautionary level. 1 This box draws on “Assessing Reserve Adequacy”, and “Assessing Reserve Adequacy—Supplementary Information”, IMF, February 2011.

19

countries other than DRF clients – buybacks and/or restructuring in LICs and possibly MICs- which could be applied to future DRF-supported buyback operations. An analytical review of these three factors will enable the DRF to help client countries enhance the options during the preparation of the buyback operations to minimize costs.

Challenge 2: Size matters: future buyback operations could rapidly exhaust available resources or prove cost-ineffective, while new financing will remain uncertain. 32. Beyond the three-to-five year horizon, the size of future buybacks could have distinctive impacts on DRF funds. Table 4 summarizes the distribution of stocks of external commercial debt obligations, and the country-specific estimates of the total cost of buyback operations, for the 24 HIPCs that still hold external commercial debt obligations potentially eligible for DRF support (see also Annex Table 3). Countries are regrouped to distinguish those with large stocks from those with small stocks of external commercial debt, as reported by the authorities. The size of the buybacks raises particular challenges:

Table 4: Large and Small Stocks of External Commercial Debt Have Polar Effects on Costs of Buyback Operations

(in US$ millions, or otherwise indicated).

Source: World Bank Staff calculations and estimates.

• Buybacks to support client countries holding large stocks of external commercial

debt could rapidly deplete available DRF funds and leave a large financing shortfall. Four countries hold 90 percent of the total HIPCs external commercial debt obligations potentially eligible for DRF-support. This represents around US$10 billion to be extinguished at an overall estimated cost of about US$1.72 billion, based on DRF policies and practices.38

If two of these countries pursued buybacks at the same time, available DRF funds would be immediately exhausted.

• Buybacks to support numerous client countries holding small stocks of external commercial debt would not strain DRF resources, but could be particularly cost-ineffective. A total of 20 HIPCs hold external commercial debt obligations amounting to US$1.1 billion - only 10 percent of the total external commercial debt held by potentially DRF-eligible countries. The corresponding estimated buyback cost of US$124 can be met through the present DRF Trust Fund balance. However, for most of these countries, the relative cost to prepare the buyback strategy with respect to the costs of the buyback

38 The methodology to estimate the country specific amounts for potential future DRF-supported operations in Table 4 is exactly the same as in the cost and financing scenarios before. The specific figures for each country remain confidential, to avoid potentially influencing future buyback negotiations between DRF client countries and their creditors.

Estimated external commercial debt (ECD) from potentially DRF-

eligible countries

In % of total ECDEstimated cost of DRF-supported

buyback operations

Countries with large stocks of ECD 10,047 90% 1,718Countries with small stocks of ECD 1,122 10% 124GRAND TOTAL 11,170 100% 1,842

20

itself is likely to be significantly higher than in past operations. Moreover, for 7 out of the 20 countries, the absolute preparation cost would be larger than the estimated DRF contribution to the buyback itself.

33. As before, financing of future buyback operations will require close monitoring, along with exploring country-specific options for cost minimization. The issues with respect to financing discussed in the previous challenge also apply here. Options for financing and reducing costs will need to be explored further and continuously over the long run.

Challenge 3: Achieving the best repurchase price with the highest participation rate in future buyback operations may require innovations to strengthen current DRF policies and practices. 34. The prospects for repurchase prices and participation rates reveal a need for a more proactive approach to achieve the best price-maximum participation combination in future DRF-supported buyback operations. DRF policies and practices approved by the Board emphasize that DRF-supported buyback operations should seek the best price, i.e., the highest discount rate, that is consistent with full or near-full participation rates.39

In the past, as shown earlier, high and increasing discount and participation rates were key hallmarks of DRF-supported buyback operations. The prospects for future DRF-supported buyback operations may be affected by the following issues, and as a result increase the importance of more pro-active efforts to achieve the best price - maximum participation possible:

• Rough estimates of discount rates for future buyback operations based solely on traditional debt relief plus the HIPC related Common Reduction Factor (CRF) - as established in DRF policies and practices- are in the range of 73 – 97 percent for individual cases, compared to an average of 94.4 percent for the most recent DRF-supported buyback operations. 40

These roughly estimated discount rates could imply more variable and higher repurchase prices for many future buyback operations (see Chart 6 below).

• The effects of these prospective discount rates on participation rates will ultimately depend on how creditors perceive the impact of future discount rates on their expected recovery, which will remain uncertain.41

39 “Debt Reduction Facility for IDA-Only Countries: Progress Update and Proposed Amendments to Policies and Practices”, IDA/R2008-0066, April 8, 2008. Along with seeking the best price consistent with maximum participation rates, however, the DRF policies and practices also establish that “best price” is not always the “best deal” if it is at the expense of participation rates.

40 Since the DRF was aligned with the HIPC initiative in 2004, only a few client countries that completed buyback operations have been able to obtain marginally higher discount rates than those determined by the application of their respective CRF, thanks to assertive negotiations by the authorities with help from their legal and financial advisors. 41 Ambiguous and unpredictable effects on participation rates would result from contrasting perceptions of the price signal (i.e., the discount rate) by external commercial creditors, other things being equal. In a simplistic context, low discount rates could be perceived as high recovery rates by creditors, which would push participation rates upwards. In a less simplistic view, creditors could identify low discount rates with weaker leverage by debtor countries to negotiate buyback transactions, and then press for even lower discount rates, short of which coercing legal and financial actions could be taken. In this case, participation rates would be pushed downwards. Arguably, small amounts to be negotiated add sources of ambiguity and unpredictability. For instance, creditors without liquidity constraints may value benefits higher than costs of not participating in the buyback operations if they assess that countries can indeed pay back the full face-value of the claims since they involve small amounts,

21

• Discount and participation rates in future DRF-supported buyback operations may need

to integrate specific options to prevent the size of the DRF-eligible stock of external commercial debt from influencing negotiations on discount rates and on participation. Countries with smaller stocks of DRF-eligible external debt may be more vulnerable in this area. Past DRF-supported operations suggest that smaller external commercial debt volumes extinguished do not necessarily command the best price and near-full participation.

Chart 6: Comparative Repurchase Prices: Past Actual and Potential Estimated

Source: World Bank Staff calculations and estimates.

35. Such a proactive approach will require identifying options and tools, additional to current DRF policies and practices. Identifying complementary options and tools and making them operational will require a proactive learning-by-doing during the anticipated DRF-supported operations in the near - term, and turning lessons into formal policies and practices at some point in the future. Through the complementary options and tools to strengthen the best price - maximum participation combination, the DRF expects to continue and also strengthen its support to debt relief that is at least comparable to or even better than overall debt relief provided to client countries consistent with the HIPC Initiative. In this context, a non-exhaustive set of options to explore include: (i) integration of net present value (NPV) in the initial estimates of discount rates, prior to negotiations; and (ii) ring-fencing options on repurchase price, participation rates, time-bound negotiations, resource-bound negotiations, eligibility of debt claims, etc. Some of these options will be explored in the anticipated operations in the next three-to-five years, on a case-by-case basis. These and other options will be explored in the analytical work proposed below.

especially if coercing legal actions are threatened. Conversely, creditors with liquidity constraints may opt to participate despite the low recovery rate, as the alternative recovery could be zero. Assessing empirically the final effect is beyond the scope of this report.

8.2

12.8

3.9 4.1

11.0

17.1

0

2

4

6

8

10

12

14

16

18

1991-1995 1996-1999 2000-2004 2005 -2010

Repurchase price (cents to

US$)

Average prices - samples of potential future buyback operations.Weighted averages past buyback operations.

22

A Way Out: Further analytical work is needed to make the DRF more responsive to emerging characteristics of future DRF-supported buyback operations. 36. Aligning DRF support to the issues client countries will face in future buyback operations requires a better assessment and understanding of the challenges above. The aim of exploring innovative alternatives for the DRF to provide support to future buyback operations is to increase the range of support options, without substituting the services provided by legal and financial advisors during the preparation of the buyback operations. The key issues where the DRF intends to undertake analytical work are:

(i) The specific characteristics of client countries’ stocks of external commercial debt and their DRF-eligibility. The estimated figures in this report are based on unfiltered data from country authorities, and it is difficult at present to verify their accuracy and eligibility for DRF support.42

A better knowledge of potential stocks and eligibility of debt claims will help narrow the discrepancy between initial estimates and actual stocks of external commercial debt to be extinguished, and improve the assessment of potential costs and terms of future buyback operations. This assessment cannot be undertaken at once for all countries, but can be done progressively for those countries that might request DRF support, starting with those countries that could request support in the next three-to-five years. This analytical work would not substitute the extended legal and financial debt reconciliation work to be undertaken by the authorities with support from legal and financial advisors, during the preparation of the buyback strategy.

(ii) The evolving characteristics of market operators. Gaining a better understanding of the market interactions in DRF-supported buyback operations – particularly in terms of creditors’ incentives, constraints, and their strategies – could help client countries achieve more favorable debt buyback negotiations and mitigate costs and uncertainties in future buyback operations.43

42 Some issues with the estimated data include: (i) non-eligible claims such as collateralized and guaranteed are not systematically identified and excluded; (ii) a share of the external commercial debt may be contracted after the country-specific cut-off dates; (iii) classification of claims as external commercial debt may not be accurate; and (iv) data may not include external commercial debt contracted by public enterprises and para-statals.

On the creditor side, signaling-effects from past repurchase transactions and market expectations, for instance, are not well known, and yet could have a substantial impact on future negotiations to increase the discount rates. A similar line of reasoning can be applied to debtor countries. The primary source to build better knowledge on these issues is the market itself. An analysis of the outcomes may improve the understanding of debtor and creditor strategies, with potential benefits for HIPCs

43 Two illustrations related to creditor’s moral hazard, about which knowledge is limited, can be advanced. First, creditors with relaxed time preferences (arguably thanks to a favorable liquidity situation), which hold external commercial debt obligations from a resource rich country, could rationally choose to claim the title value later, to maximize their expected profits. The assumption would be that the resource-rich country will be in a position to pay the face value of the title plus interests and arrears/penalties, once the usufruct of the resource improves its financial solvency. Second, conversely, creditors with tight time preferences (presumably pressed by liquidity or profit constraints), may increase pressure to claim the obligations now, especially if the originating country is resource rich. This could involve more intense litigation, if it is perceived that the expected returns from litigation will be superior to the incurred costs. Arguably these creditors would be aware that the debtor countries have accumulated foreign exchange resources, and, at the same time, do not have the expertise to sustain litigation against them in international courts. Furthermore, to press their case even more, these creditors’ may count on the fact that the marginal cost of litigation in international courts drops substantially after obtaining a first favorable judgment; and that they have more informational, financial and technical leverage to seize assets and financial flows if favorable judgments in international courts enable them to come to the point of seizing assets and financial flows in exchange of payments default by the debtor.

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which could be involved in future negotiations. Furthermore, market dynamics and outcomes in secondary markets for external commercial debt obligations are not well understood.44

The effect on DRF-supported operations can be significant. For instance, creditors holding titles traded at prices higher than a DRF-supported repurchase price would, in principle, not have incentives to participate in a DRF-supported buyback operation. The characteristics of prices, volumes, market operators, institutional holders of obligations in secondary markets need to be better identified.

(iii) Options to minimize costs and preserve reasonable cost-effectiveness in future buyback operations. The challenges identified above could require efforts to strengthen DRF support to future buyback operations.45 The analytical work just outlined could lead to exploring operational options additional to the current options under DRF policies and practices. These operational options would need to take into account their potential impact on all issues raised before. For instance, operational options that would have detrimental impacts on cost-effectiveness of future DRF supported buyback operations would not necessarily be adopted. However, ultimately these detrimental impacts would also need to be assessed against the non-cost benefits that such operations option could imply.46

Operational options to be explored include, for instance:

a. For countries with large stocks of debt, operational options could include: (i) combinations of debt repurchase with debt restructuring transactions within a framework allowing for ring-fencing options (i.e., to avoid debt restructuring terms that would provide incentives or propose weaker penalties for debtors to fall back into default); and (ii) flexible financing arrangements, including expanding the sources of financing to reduce the average contributions, and reconsidering the notional rules guiding historical contributions to buyback costs.

b. For countries with small stocks of debt, options could include: (i) syndication of

client countries – i.e., regrouping some countries into a single DRF-supported buyback operation; (ii) negotiating buyback operations with creditors common to more than one country client (e.g., London Club creditors holding debt obligations from several HIPCs in Africa); and (iii) client countries’ self-

44 Past attempts by DRF staff and financial advisors to collect information on trading prices in the secondary markets have succeeded only rarely. In many cases, the titles exchanged owners, without official records. 45 One additional source of pressure is the following: for 17 DRF-eligible countries that have graduated from the HIPC initiative and that could engage in an external commercial debt buyback operation, the requirement to seek comparable treatment from all external creditors could weaken its leverage, because these countries have already received full irrevocable debt relief from most Paris Club bilateral creditors. Commercial creditors could be “free-riding” by default in these countries. The comparable treatment clause is a standard clause under Paris Club debt relief agreements, which compels debtor countries to negotiate with all creditors debt relief terms comparable to those agreed with the Paris Club. A breach of the clause could result in the suspension of the implementation of debt relief agreements. 46 Arguably, for instance, syndication of some debtors with small stocks of potentially DRF-eligible debts may well increase the preparation costs of future buyback DRF-supported operations because of possible cross-country coordination externalities that such syndication would generate. However, such high-cost of preparing a syndicated DRF-supported operation would need to be evaluated against the sum of the individual preparation costs for country-specific DRF-supported buyback operations for the countries syndicated; and against other non-cost related benefit such as a 100 percent participation rate or full extinction of the debts. The analytical work would need to consider cases like this, by casting a net over feasible operational options, including those listed in this section of the report.

24

financing of buyback operations, with some assistance from the DRF, yet to be determined.

c. In addition, there is a need to identify the characteristics of buyback and/or

restructuring operations undertaken by LICs and MICs, without support from the Bank, and analyze if there could be any transferability to DRF-supported buyback operations.

(iv) Prospects on availability and diversification of sources of financing for DRF-

supported operations. Closer monitoring of traditional financing sources (IBRD net income, donors, and Governments’ own contributions) needs to be accompanied by further efforts to explore non-traditional financing sources. The latter could include regional multilateral development institutions and other potential bilateral donors that have so far not contributed to DRF-supported buyback operations.

37. In light of the challenges above, Management anticipates that it would report on DRF business to the Board as follows:

• By year two of the extension, on: (i) progress in DRF operations; (ii) developments on the status of the financing needs; and (iii) progress on the analytical work the DRF will engage upon.

• By year three of the extension, on: (i) progress in DRF operations; (ii) Management

discussions on financing needs to support DRF operations over the next three-to-five years; and (iii) the final results from the analytical work and the potential implications on DRF policies and practices, if any.

• By year five of the extension, on: (i) the overall status of DRF operations; and (ii)

Management discussions on the anticipated financing needs for future DRF-supported buyback operations.

VI. RECOMMENDATION 38. Management recommends that the termination date of the DRF be extended for an additional five years, from July 31, 2012 to July 31, 2017.

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ANNEX 1. BACKGROUND ON THE DRF 1. The Executive Directors of IBRD and IDA established the DRF in July 1989.1 Administered by IDA as trustee, the DRF was established initially for a period of three years but has so far been extended a number of times. Following the five year extension approved by the Board in April 2007,2 the current mandate expires on July 31, 2012. Management provides periodic updates to the Board on progress under the DRF.3

2. The objective of the DRF is to help reforming, heavily indebted, IDA-only countries reduce their sovereign commercial external debt as part of a broader debt resolution program, and thereby to contribute to growth, poverty reduction and debt sustainability. 3. The DRF provides support on a grant basis and all such grants require approval of the IDA Board. The DRF provides grants for both the preparation and the implementation of commercial debt reduction operations.

• The Preparation Grants provided by the DRF support eligible governments in retaining the professional services necessary for preparing commercial debt reduction operations. Financial and legal advisers are hired by eligible governments in accordance with the Bank’s procurement guidelines using grants provided by the DRF. Such advisers assist with the debt reconciliation process to determine the eligible amount; make informal contacts with creditors to determine market expectations; prepare a commercial debt reduction strategy with the Government, in consultation with IDA (as trustee of the DRF); provide advice and opinions on legal issues associated with executing the strategy and, where appropriate, extinguishing the claims; draft the invitation memorandum to creditors and other legal documents; and act as closing agents for the operation.

• The Implementation Grants provided by the DRF help eligible governments in

financing the costs of debt repurchase as part of the implementation of commercial debt reduction operations. DRF-supported commercial debt reduction operations typically involve a government buying back its public and publicly guaranteed debts from external commercial creditors for cash at a deep discount, thereby extinguishing such

1 Operational Guidelines and Procedures for the Use of Resources of the Debt Reduction Facility for IDA-only Countries (R89-156, IDA/R89-103, July 13, 1989). 2 Debt Reduction Facility for IDA-Only Countries: Progress Review and Proposed Extension (IDA/R2007-0064, April 3, 2007). 3 Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R92-26, March 9, 1992); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R93-114, July 20, 1993); Debt Reduction Facilities for IDA-Only Countries Progress Report (IDA/SecM94-29, September 14, 1994); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R95-100, June 12, 1995); Review of Progress Under the Debt Reduction Facility for IDA-Only Countries (IDA/R98-107, July 10, 1998); Progress Review: the Debt Reduction Facility for IDA-Only Countries (IDA/R2001-0133, July 25, 2001); Debt Reduction Facilities for IDA-Only Countries Progress Review, Support to the HIPC Initiative and Proposed Enhancements (IDA/R2004-0184, July 12, 2004); and Debt Reduction Facility for IDA-Only Countries: Progress Review and Proposed Extension (IDA/R2007-0064, April 3, 2007).

26

debts from the books of the public sector. However, other modalities have occasionally also been used including debt swaps (which have been part of operations in Niger, Bolivia, Zambia, Albania, Senegal and Tanzania); and debt restructurings (used in the case of Vietnam and for a substantial part of the debt reduction in Côte d’Ivoire).

4. Since its inception, the DRF has played a significant role in extinguishing commercial external debt for low-income countries where high debt burdens have constrained economic growth and poverty reduction. The DRF promotes creditor participation under the Heavily Indebted Poor Countries (HIPC) Initiative – an issue on which the Boards of both the Bank and the Fund have repeatedly expressed concern. As such, it helps reduce the risk of non-concessional creditors taking advantage of debt relief provided by IDA and other Multilateral Development Banks under the Multilateral Debt Relief Initiative (MDRI). Settlement of commercial claims, which are generally in arrears, may also help to improve the climate for foreign direct investment and trade. Moreover, the settlement of arrears with commercial creditors enables countries to manage their debts and reserves in a more cost effective way by reducing the incentives for creditors to sell such debts to aggressive distressed debt funds,4

by avoiding expensive litigation and by avoiding the consequent court judgments, the high statutory interest rates on such judgments and attempted attachment of assets. In some cases, the DRF can help HIPCs extinguish court judgments where litigation has already occurred and such judgments have been awarded.

5. The DRF is financed from transfers from IBRD net income and grant contributions from other donors, as well as investment income earned on such contributions. At its inception, the DRF was funded with a US$100 million transfer from IBRD’s FY89 net income. This was subsequently replenished by US$100 million from IBRD’s FY93 net income; US$100 million from IBRD’s FY95 net income; and US$50 million from IBRD’s FY04 net income. In addition, bilateral donors, including Canada, Finland, France, Germany, Norway, Netherlands, the Russian Federation, Sweden, Switzerland, the United Kingdom, and the United States have contributed grants to the DRF for support of commercial debt reduction operations; and the European Commission, France, Germany, Japan, Switzerland and the United States have made grants directly to debtor governments in support of DRF-sponsored operations. Governments’ own financing resources have also contributed to DRF-supported operations. 6. In 2006, changes were made to the management of the DRF. In March 2006, responsibility for managing the DRF was transferred from the Infrastructure Economics and Finance Department in the Infrastructure Vice-Presidency to the Economic Policy and Debt Department in the PREM Vice-Presidency. In July 2006, a new Debt Reduction Facility Oversight Committee (DRFOC) was established, chaired by the Vice President of PREM and reporting to the Managing Director responsible for PREM, the Chief Financial Officer and, on country-specific matters, the Managing Director for the relevant region. 4 Distressed debt funds, sometimes referred to as “vulture funds”, are specialized asset management funds which buy the sovereign debts of low income countries from other creditors at deep discounts and then attempt to obtain a settlement with the debtor on substantially better terms than those that they paid. They frequently engage in litigation to obtain judgments against the debtor, often at a full contractual valuation of the principal, interest and penalties. They then exert pressure on the debtor by attempting to obtain attachment of the Government's assets abroad. Through such strategies, such funds attempt to maximize their returns in any ultimate settlement.

27

7. Decisions regarding the implementation of DRF-supported operations are reviewed and endorsed by the DRFOC. Following the endorsement by the DRFOC, the operations are sent to the Board for approval. The objectives of the DRFOC are, among others, to review DRF activities and provide guidance to staff on:

• the goals, principles, policies, and operating procedures governing the implementation of the DRF and their application to individual debt reduction operations;

• proposed grants from the DRF to support the preparation and implementation of

commercial debt reduction operations; and

• the review and strengthening of the DRF, including extensions and replenishments of the Facility.

8. In April 2008, IDA’s Executive Directors approved changes to the DRF’s policies and practices. The modifications aimed at making the DRF even more effective in helping reforming, heavily indebted IDA-only countries to reduce their sovereign commercial external debt as part of a broader debt resolution program. These modifications incorporate past experience from DRF negotiations and feedback from stakeholders including the Paris Club, the G7 debt experts group, recent DRF-beneficiary governments, and their financial and legal advisers. The approved modifications include:

• Eligibility for DRF Preparation Grants was extended, on a case-by-case basis, to pre-decision point HIPCs. In 2004, the Executive Directors had decided to limit eligibility of the DRF to post-decision-point HIPCs only. This modification gives reforming pre-decision-point HIPCs access to Preparation Grants to enable them to move faster to decision point. However, eligibility for Implementation Grants remains at decision point.

• Formerly bilateral debts that were sold to commercial creditors after the HIPC decision

point reference date will normally no longer be considered eligible for buyback. This modification aims to prevent distressed debt funds from making a profit by buying bilateral claims at a deep discount and tendering them for a buyback under the DRF. It is also aimed to discourage the sale of debt from official to commercial creditors.

• For the same reason, formerly domestic debts sold to external creditors after the HIPC

reference date will normally be considered ineligible for buyback.

• Participation thresholds stipulated for buybacks, including second buybacks, will normally not be below 90 percent. Participation rates in earlier operations were below 80 percent in six cases and below 65 percent in two cases. The increase to 90 percent aims to help resolve the commercial debt problem more comprehensively as well as avoid second buybacks and increase in the value of holdout claims.

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• IBRD contributions to DRF will normally not exceed 50 percent of the costs of any given Implementation Grant. Exceptions were made to the earlier limit of US$10 million in seven of the 22 DRF operations. Hence, the limit was modified to reflect financing needs better.

• More flexibility on budgeting advisory fees – particularly in larger and more complex

cases. Preparation Grants had been capped at US$0.8-0.9 million, regardless of the size or complexity of the operation and without inflation adjustments. This modification, coupled with a Quality-Based Selection as the preferred procurement method, was expected to enhance the ability of participating countries to hire the best qualified financial and legal advisors.

Annex Table 1: Summary of Completed DRF Operations

As of end 2011 in US$ millions

Year of a Buyback Operation Country

Principal extinguished - cash buy back

Principal extinguished -

debt swapTotal Principal

extinguished

Estimated interest

extinguished 1/

Estimated total debt

extinguished

Official price

(cents/$ of eligible debt) 2/

Estimated price in cents/$ of

estimated total debt

extinguished 14/

Participation as percent of eligible debt

IBRD resources utilized

Non-IBRD grant

resources untilized

Other resources

utilized

Total resources utilized 3/

Mar-91 Niger - 107.0 107.0 10.0 117.0 18.0 16.5 99.0 8.4 11.0 0.0 19.4Dec-91 Mozambique I 123.8 0.0 123.8 80.3 204.1 10.0 6.1 64.0 5.9 7.5 0.0 13.4Nov-92 Guyana I 69.2 0.0 69.2 23.5 92.7 14.5 10.8 100.0 10.0 0.2 0.0 10.2Feb-93 Uganda 153.0 0.0 153.0 27.9 180.9 12.0 10.1 89.0 10.2 12.4 0.0 22.6May-93 Bolivia 4/ 77.0 93.0 170.0 151.0 321.0 16.0 8.5 94.0 9.8 17.5 0.0 27.3Aug-94 Sao Tome & Principe 10.1 0.0 10.1 1.0 11.1 10.0 9.1 87.0 1.3 0.0 1.3Sep-94 Zambia 5/ 107.2 92.5 199.7 186.9 386.6 11.0 5.7 79.0 11.8 13.2 0.0 25.0Jul-95 Albania 6/ 146.3 225.0 371.3 112.0 483.3 26.0 20.0 99.0 26.0 23.3 48.1 97.4Sep-95 Sierra Leone 7/ 234.7 0.0 234.7 94.8 329.5 13.0 9.3 73.0 21.0 7.9 2.6 31.5Dec-95 Nicaragua I 1,099.4 0.0 1,099.4 722.2 1,821.6 8.0 4.8 81.0 40.8 24.5 23.9 89.2Jan-96 Ethiopia 226.0 0.0 226.0 40.5 266.5 8.0 6.8 80.0 6.2 12.7 0.0 18.9Aug-96 Mauritania 52.8 0.0 52.8 35.5 88.3 10.0 6.0 98.0 3.2 2.6 0.0 5.8Dec-96 Senegal 8/ 1.5 69.5 71.0 40.7 111.7 20.0 12.7 96.0 7.5 5.2 2.3 15.0Dec-97 Togo 44.9 0.0 44.9 29.4 74.3 12.5 7.6 99.0 5.1 1.0 0.0 6.1Mar-98 Cote d' Ivoire 9/ 724.5 0.0 724.5 385.5 1,110.0 24.0 15.7 100.0 20.0 15.5 138.5 174.0Aug-99 Guyana II 34.4 0.0 34.4 38.2 72.6 9.0 4.3 62.0 1.2 2.2 0.0 3.4Apr-00 Guinea 62.2 0.0 62.2 30.0 92.2 13.0 8.8 75.0 4.8 4.3 0.0 9.1Feb-01 Yemen 10/ 362.4 0.0 362.4 334.2 696.6 2.9 1.5 91.0 8.0 3.5 0.0 11.5Aug-01 Honduras 13.0 0.0 13.0 22.0 35.0 18.0 6.7 90.0 0.6 2.0 0.0 2.6Aug-03 Cameroon 266.2 0.0 266.2 530.0 796.2 14.5 4.8 79.0 10.2 9.2 20.8 40.2Apr-04 Tanzania 11/ 98.1 0.2 98.3 105.0 203.3 12.0 5.8 88.0 4.9 7.3 0.0 12.2Oct-07 Mozambique II 120.0 0.0 120.0 33.2 153.2 9.0 9.0 100.0 0.7 13.8 0.0 14.5Nov-08 Nicaragua II 12 /13/ 219.5 0.0 219.5 1,151.4 1,370.9 4.5 4.5 97.4 31.6 28.5 3.4 63.5Nov-10 Liberia 15/ 216.6 - 216.6 1,040.5 1,257.1 6.2 3.1 100.0 17.2 21.6 0.2 39.0

4,462.8 587.2 5,050.0 5,225.7 10,275.7 8.3 88.4 266.4 246.9 239.7 753.0

1/ Interest estimates have been revised on the basis of available records, with estimated figures used for Uganda, Bolivia, Sao Tome & Principe, Zambia, Sierra leone, Nicaragua I, Ethiopia, Mauritania, Senegal, Togo, and Guyana II.2/ Of original face value of principal, except for Mozambique II and Nicaragua II where the eligible debt is principal plus interest.3/ Represents resources from IBRD, donors and contributions from certain recipient countries. The figures also include technical assistance grants, closing costs and expenses.4/ The cash buyback was at 16 cents while the debt swap was between 16-18 cents for a dollar of principal.5/ Both the cash buyback and the debt swap were priced at 11 cents to a dollar.6/ Average price for both options was 26 cents. (Cash buyback was priced at 20 cents to a dollar).7/ Commercial debt was bought at 15 cents and pipeline debt at 8 cents per dollar of principal.8/ The cash buyback was at 16 cents while the debt swap was at 20 cents to a dollar.9/ Cash buyback only. The operation also included a debt exchange.10/ The buyback was at 10 cents of eligible principal debt. The implicit price reflects a previous debt reduction of 80% of Russian suppliers' debt.11/ Includes both closings ( of June 2001 and of April 2004).12/ All four closings are reflected.13/ Average price. Creditors were offered either 8 cents per dollar of principal or 4.5 cents per dollar of principal and interest, with the vast majority accepting the latter.14/ Total includes simple average. Calculated weigted average is 7.1 cents to US$.15/ Liberia reflects two closings (of April 2009 and November 2010) under one operation; Liberia contributed USD 175,701.15 for the second closing out of its own resources. *Table does not report the Preparation Grant amounts.

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Annex Table 2: Non-IBRD Grant Support in DRF- Supported Operations As of end 2011 in US$ millions 1/

Canada Finland France Germany Japan Norway Netherlands Russia Sweden Switzerland EU UK USA TotalNiger 8.4 2/ 2.5 11.0Mozambique I 1.1 1.1 2.4 2.9 7.5Guyana I 0.2 0.2Uganda 5.0 2/ 2.7 0.7 4.0 2/ 12.4Bolivia 2.7 4.9 3.0 6.9 2/ 17.5Zambia 3.6 2/ 2.2 3.6 3.9 13.2Albania 5.0 2/ 18.3 2/ 23.3Sierra Leone I 3.1 2/ 4.8 7.9NicaraguaI 6.2 8.2 10.0 24.5Ethiopia 6.3 6.4 12.7Mauritania 1.0 2/ 1.7 2.6Senegal 1.6 1.8 1.8 5.2Togo 1.0 2/ 1.0Cote d'Ivoire 5.1 10.4 15.5Guyana II 0.2 2.0 2.2Guinea 1.1 2/ 0.6 2/ 0.9 1.7 4.3Yemen 3/ 1.8 1.7 3.5Honduras 1.0 1.0 2.0Cameroon 4.7 4.4 9.2Tanzania 3.4 3.9 7.3Mozambique II 4/ 13.8 13.8Nicaragua II 2.0 9.9 3.0 5.0 5.1 3.5 28.5Liberia 6.5 5.2 5.0 5.0 21.7Total 0.4 2.0 17.9 12.9 0.6 37.0 31.2 5.0 25.2 51.1 25.4 19.7 11.9 247.0

1/ Actual disbursements except where stated2/ Contributions directly to debitor country governments as grants3/ Excludes US$ 4.0 million of the Netherlands contribution allocated to buy back US$ 40.7 million of Yemen's debt to bilateral creditors, initially included in the DRF buyback.4/ Excludes US$ 0.9 milion of Norway contribution that was not drawn.

30

31

Annex Table 3: External Commercial Debt as of end 2010

Note: The estimated stocks in this table are based mostly on data provided by country authorities, as of end December 2010. Missing data was estimated based on the latest available HIPC documents. These figures are not reconciled, and the DRF eligibility of the external commercial claims has not been determined. As a result, the estimated stocks in this table are only indicative of the volumes of external commercial debt owed by potentially DRF-eligible countries. Some issues with the data in the table include: (i) non-eligible claims such as collateralized and guaranteed are not systematically identified and excluded; (ii) a share of the external commercial debt may have been contracted after the country-specific HIPC cut-off dates; (iii) classification of claims as external commercial debt may not be accurate; and (iv) data may not include external commercial debt contracted by public enterprises and para-statals.

External commercial debt as

of end 2010

in million US$3,394

Afghanistan 0Benin 0Bolivia 0Burkina Faso 30Burundi 6Cameroon 1Central African Republic 50Congo, Rep. of 1,050 Congo, Dem. Rep. of the 176Ethiopia 30Gambia, The 0Ghana 1,378 Guinea-Bissau 0Guyana 19Haiti 0Honduras 6Liberia 0Madagascar 17Malawi 0Mali 5Mauritania 24Mozambique 18Nicaragua 0Niger 0Rwanda 0São Tomé and Príncipe 28Senegal 6Sierra Leone 243Tanzania 0Togo 32Uganda 0Zambia 274

2,686 Chad 40Comoros 0Côte d'Ivoire 2,646 Guinea 0

5,089 Eritrea 49Somalia 66Sudan 4,974

11,170

Country

Post-completion point

Interim Period Countries

Pre-decision point countries

Total

Annex Table 4: Stock of Commercial Debt and Reserves, 2010-2015

Stock of reserves at year-end Excess reserves 1/ Reserves2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015

(At end-2010) Actual Projections Estimates Actual Projections

(In millions of U.S. dollars) (In months of imports, simple averages)

Countries with commercial debt above US$500 million 10,047.2 13,591.0 19,050.3 24,802.4 31,158.5 37,110.2 42,272.2 754.2 4,707.2 9,546.3 15,098.0 19,026.9 24,283.8 5.1 3.9 5.5 7.0 8.7 9.6 10.8

Countries with commercial debt below US$500 million 1,122.4 22,937.7 26,285.4 28,983.6 32,044.4 35,860.8 40,123.6 1,219.4 1,446.7 2,143.5 2,982.6 4,314.1 6,141.5 5.3 3.5 3.6 3.8 4.0 4.3 4.7

Gand total 11,169.6 36,528.7 45,335.7 53,786.0 63,202.9 72,970.9 82,395.8 1,973.6 6,154.0 11,689.8 18,080.7 23,341.1 30,425.3 5.3 3.5 3.9 4.3 4.8 5.2 5.8

Source: Country authorities, Staff estimates; and World Economic Outlook , IMF, November 2011.1/ Defined as stock of reserves exceeding the estimated optimal level of reserves.2/ As estimated in “Assessing Reserve Adequacy”, IMF, February 2011, assuming a unit cost of holding reserves at 4 percent.

Eligible commercial debt

Optimal Reserves 2/

DRF-eligible countries

32