Special Report No 5/2001

on counterpart funds from structural adjustment support earmarked for budget aid (seventh and eighth EDFs), together with the Commission's replies

(pursuant to Article 248(4), second subparagraph, EC)

(2001/C 257/01)

CONTENTS

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ABBREVIATIONS USED

ACP African, Caribbean and Pacific States signatory to the Lomé Convention

EDF European Development Fund

ESAF Enhanced structural adjustment facility

FCFA CFA franc

HIPC Heavily indebted poor countries

IMF International Monetary Fund

PRGF Poverty-reduction and growth facility

PRSP Poverty-reduction strategy paper

SCR Common Service for External Relations

Stabex System for the stabilisation of export earnings, provided for by the Lomé Convention

Sysmin System of aid for mining products

TOFE Table of government financial transactions

WAEMU West African economic and monetary union

References used

COM(2000) 58 final Communication from the Commission to the Council and to the European Parliament of 4 February 2000 on Community support for economic reform programmes and structural adjustment - Review and prospects

SUMMARY

I. The Court examined the Commission's monitoring of the use of the counterpart funds from EDF support for structural adjustment in ACP States, but did not examine the structural adjustment programmes per se. The audit mainly considered 23 Financing Agreements concluded with eight ACP States between 1994 and 1999. Most of the support took the form of direct aid to beneficiary countries' budgets and was subject to the national implementing and control procedures applicable to public expenditure in the ACP States, not the EDF procedures.

II. The observations concerning the Commission's management are about the extent of budget expenditure targeting, the provision of funds, the use of technical assistance and auditing and the administrative organisation of the Commission departments. Some of the weaknesses that were noted in these different areas confirm the importance for the Commission of monitoring more closely the quality of public finance management in beneficiary countries, the volume and regularity of the social sector expenditure and the refocusing of programmes, in coordination with all the parties concerned, in order to achieve effective poverty reduction in the beneficiary countries.

III. Control of the expenditure targeted by EDF support was affected by the Commission's wishing to support balances of payments and priority sectors, and social sectors in particular, at one and the same time by refinancing expenditure. The controls were not always effective, because the data on the actual implementation of budgets were, in some cases, non-existent or inaccurate. Technical assistance was underused. Monitoring the quality and regularity of expenditure is the key to improving social services, but it was slow. From 1998 onwards the Commission's programme audit organisation improved. The irregularities that were uncovered did not result in funds being repaid to the EDF, but in several cases further aid was suspended pending corrective action.

IV. Given the weaknesses in the national implementation and control procedures for public expenditure, it is unrealistic to think that in the priority sectors the beneficiary States' expenditure will always be effected regularly and will have a real impact on the level and quality of social services. The reforms that have been undertaken by these countries in the area of public finance management are recent and will only be fully effective in the longer term. The reality of this was confirmed by the audits that have been undertaken by the Commission from 1998 onwards. The budgetary authority must be aware of the inherent risks of the approach that has been adopted, must insist that the risks be evaluated through audits of public expenditure and should endeavour to reduce the extent of them gradually by encouraging effective implementation of reforms in the ACP States and, in particular, by means of concerted action by all the donors together.

V. In order to improve control over the implementation of support and ensure that it develops in line with the new guidelines from the budgetary authority, the Commission should:

(a) base its programmes on a strategy and a plan for the reform of public finance management and on intensive coordination between all the parties concerned;

(b) draw up clear guidelines so that its departments are better able to assess progress in the management of public finance in each of the countries concerned and to carry out a qualitative appraisal of the expenditure, otherwise there is a risk that programme objectives might not be achieved;

(c) lay down procedures for monitoring and control of each programme, before the Financing Agreements are concluded;

(d) effect a better distribution between its own departments of responsibility for monitoring general macroeconomic and institutional support, on the one hand, and, on the other, responsibility for appraising the operation of the social sectors;

(e) in coordination with the IMF, improve the predictability of annual budget support, irrespective of the source of the funding;

(f) within the framework of multilateral approaches integrate its sectoral support into the budgets of the beneficiary countries wherever possible.

INTRODUCTION

Counterpart funds from structural adjustment support

1. At the beginning of the 1980s many ACP States had substantial balance of payments and budget deficits, which they financed by recourse to external debts on a scale that was often excessive compared with their growth and revenue prospects. In order to counteract these difficulties the countries in question, under the aegis of the Bretton Woods institutions(1), embarked on structural adjustment programmes consisting of a set of macroeconomic measures that aimed to restore economic equilibrium and reduce their financial deficits, both domestic (budget) and external (balance of payments). The European Community joined this process, with the Fourth Lomé Convention(2), Articles 243 to 250 of which introduced a structural adjustment support facility. In consequence the Commission had, by the end of 2000, disbursed 2320 million euro to 42 ACP States by way of this new Instrument, in order to support the reforms agreed between the beneficiary countries and the Bretton Woods institutions. These payments represented 22 % of the total payments from the seventh and eighth EDFs (see Annex I).

2. The EDF contributions are paid, in euro, into an account opened by the beneficiary government, usually with its central bank. The counterpart of these contributions is a deposit for the equivalent amount in national currency in a bank account, with two signatories(3), with the same bank. The national currency amounts improve the government's financial position with the issuing institution by that amount and can be used to finance the beneficiary country's public-sector spending (see Table 1). The funds provided by means of EDF structural adjustment support have taken the form of:

(a) balance-of-payments support, contributing to the economic and financial equilibrium of each country within the framework coordinated by the IMF;

(b) support for the budgets of the beneficiary countries, giving priority to the social sectors. In actual fact, structural adjustment programmes usually entail a rescaling of public expenditure, which may be reflected in a reduction in social services for the poorest segments of the population.

Table 1

Mechanism for mobilising EDF structural adjustment support

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3. The EDF aid arrangements are subject to a joint management system put in place under the Lomé Conventions. Each structural adjustment support programme is the subject of a financing agreement between the Commission and the national authorising officer for the ACP State in question. In most of the beneficiary countries the financing agreements are supplemented by protocols of agreement which lay down conditions and procedures for using the counterpart funds.

4. The Commission neither authorises nor accounts for the use of the counterpart funds and they do not appear in its accounts. However, by insisting that the funds are deposited in a joint-signature account and that the financing agreements and protocols specify the conditions under which they may be used, the Commission has tried to ensure that the counterpart funds contribute to the development and good governance objectives pursued by the European Union.

5. Since the beginning of the seventh EDF the Commission has actively participated in consultations between fund providers and has adapted its support to the changing constraints in ACP States. In so doing it has switched from import aid to more general budget aid, placing the emphasis on the results of administrative reforms and on evaluation of the actual poverty situation. The terms "import programme" and "counterpart funds" ought to have been abandoned, since they have helped to sustain a certain amount of confusion about the reality of budget aid operations. In 1999, the main fund providers decided that, in return for aid, beneficiary countries should draw up and introduce poverty-reduction strategy papers (PRSP). This applies to IMF and World Bank loans, debt relief under the heavily indebted poor countries (HIPC) initiative, and European Community budget aid subsidies. When it replaced the enhanced structural adjustment facility (ESAF) with the poverty-reduction and growth facility (PRGF), the IMF made poverty reduction an objective and a criterion for evaluating the success of its programmes. The main guidelines presented by the Commission and the Council over this period are shown in Annex II.

The Court audit

6. The audit was a follow-up to the European Parliament discharge resolution for the financial year 1998(4), with the objective of assessing the Commission's supervision, not of the structural adjustment programmes as such, but of the use of the counterpart funds resulting from EDF structural adjustment support to ACP States. The appraisal was mainly based on examination of a sample of 23 Financing Agreements concluded with eight beneficiary countries between 1994 and 1999 for an amount which, at the end of 2000, represented 23 % of the structural adjustment support from the seventh and eighth EDFs (see Annex III). For these programmes, the audits at Commission headquarters were supplemented by site visits to the Delegations and to the national authorities responsible for the use of the funds.

7. This report shows that many of the observations that were published on the subject of counterpart funds between 1990 and 1996 in various annual reports and special reports of the Court (see Annex IV) are still relevant, despite the advances that have been made by the Commission in organising the follow-up to them.

8. This report is concerned only with the counterpart funds generated by EDF structural adjustment support. Other EDF financial instruments may also work towards the same objectives and take the form of budget aid(5). The Stabex(6) and Sysmin Instruments, in particular, gave rise under the seventh and eighth EDFs to payments that amounted to 2043 million euro as of the end of 2000. Food aid(7) and the dues paid through the Community budget under fisheries agreements are also sources of funds for the budgets of some ACP States.

PROGRAMME DESIGN

Scope of expenditure targeting

9. The aim of targeting was to encourage satisfactory execution of the public expenditure that was considered to be a priority area for the ACP States, the most important being budget expenditure for social sectors(8). In some cases it was also possible for the disbursement conditions contained in the Financing Agreements to make a contribution to the satisfactory execution of public expenditure. In Benin, for all the programmes examined, the conditions in question referred to the real level of budget implementation rather than budget allocation forecasts. On the other hand, in two of the countries reviewed (Senegal and Zambia) the Financing Agreements did not contain any quantified objectives for budget implementation.

10. In half the countries examined the Financing Agreements and Protocols of Agreement concluded between the national authorising officer and the Commission Delegate detailed the support targets by means of a list of specific expenditure items selected from the social sector expenditure. In practice this targeting of specific expenditure items allowed the Commission to check how far the expenditure had been effected in the priority sectors and to see how expenditure was handled by the beneficiary country, but it also enabled it to confine its examination of supporting documents and the execution of selected expenditure items to an amount equivalent to the Community financing.

11. In all the countries where the EDF provides structural adjustment support, the IMF exercises surveillance over public finance in general. In 1996 the World Bank(9) observed that, given the fungibility of all government funds, it was more important for the Bank, in the context of structural adjustment loans, to look at the foreign exchange reserves and budget management as a whole, rather than concerning itself with the detailed application of its aid. At the time of the seventh EDF, fund providers in general were still only moderately interested in the qualitative aspects of public expenditure, which was why, starting with the audits of counterpart funds undertaken from 1995 onwards, the Commission gradually began to seek assurance as to the regularity and relevance of public expenditure by beneficiary countries in the sectors targeted by counterpart funds. However, it often confined itself to identifying expenditure to the amount of the Community finance, despite the fungibility of the budget support provided. In 2000, the Commission recognised the limited effectiveness of targeting, as well as its perverse effects, in certain cases, on the procedures and deadlines for budget implementation(10), but it has still to define its approach to controlling expenditure, by seeking joint action with other donors.

Choice of target expenditure

12. The choice of target expenditure was not just dictated by the desire to achieve a particular impact on social sectors: it is possible to achieve an impact by means other than disbursement conditions in financing agreements. In some cases it was the will to provide a rapid input of resources to the budget that prevailed, whilst in other cases the priority was to make it easier subsequently to provide administrative and accounting justification for the use of funds (see Box 1).

Box 1 Expenditure targeted

1. In Malawi, the programmes financed 98 % of the Ministry of Health's administrative expenditure (excluding salaries). Without this support the level of expenditure would have remained low.

2. In Benin, the effect of refinancing past expenditure, in the health sector especially, was to encourage the authorities to effect expenditure, at the same time providing a rapid input of additional resources to the national budget.

3. In Burkina Faso, the ease with which expenditure could be identified was one of the criteria that determined the choice of target, especially in the case of centrally administered expenditure, whilst in the health sector the budget headings that were targeted were not always directly linked to the priority accorded to the decentralised structures that were providing health services for the population.

4. In Senegal, it was mainly the expenditure with a strong chance of being executed regularly that was selected as targets in the health sector. On the other hand, the support for decentralised expenditure proved difficult to monitor.

13. In many countries the IMF considers that the question of domestic arrears is crucial, because of its repercussions on the country's financial situation, as well as that of the private sector, and the banking sector in particular. Funding the arrears helps to redress the financial situation. It also makes it possible to free up resources quickly and can be equated with general budget support. There is, however, a risk that by taking over the residual results of past bad management or unauthorised expenditure, donors will take the responsibility away from the authorities and endorse the practices that gave rise to the arrears. Moreover, providing the finance to clear arrears constitutes action to improve public finance only if it is part of effective reforms that will prevent their resurgence. Whereas measures were being adopted in Benin, this condition was not satisfied when the Commission took over the responsibility for arrears in Tanzania and Zambia.

14. In Ghana, Zambia and Côte d'Ivoire, treasury bonds, or simply the financial costs which they generate, were redeemed(11). This type of use, too, can be equated with rapid, general budget assistance, but does not have any direct impact on sectoral reforms and protecting the operation of social sectors.

15. The Lomé Convention provides that the counterpart funds may also be used as part of EDF project financing. Since it is difficult to reconcile these provisions with budgetary discipline when projects are implemented out of public funds but are not entered in the national budget, the Commission has gradually stopped targeting extra-budgetary projects. Until 1998, however, such allocations were being adopted in three of the countries reviewed (Ghana, Malawi and Tanzania). In Tanzania, there was no provision for these allocations in the Financing Agreement, but they were justified by the risks inherent in the poor quality of the public expenditure management.

16. The Commission communication of February 2000 gives very few figures concerning the nature of the target expenditure(12). In particular, there is no mention of the fact that, according to the Commission's estimates, taking over the arrears absorbed about 7 % of the support from the seventh EDF.

CONTROLLING PROGRAMME EXECUTION

Support timetable

17. The Commission divided the structural adjustment support among the eligible countries for two-year periods. As the Commission did not think it possible to obtain reliable budget deficit statistics for the various countries(13), the link between these allocations and real financial needs is tenuous and is only one of the criteria for allocating resources. In the case of Senegal in 1998, whereas the Commission had provided the EDF Committee with justification for the Community support on the grounds of immediate financial need, at the end of 2000, FCFA 7000 Mio (10,7 million euro) remained unutilised in the counterpart funds account and the authorities appeared to be in no hurry to use it(14).

18. Table 2 shows that the calendar followed by the Commission in making support available to the beneficiary countries differed markedly from the intentions expressed in the financing proposals submitted to the EDF Committee. The time differences can be explained by the inherent delays of the EDF decisional procedures and the time required for ACP States to meet the disbursement conditions imposed by the Financing Agreements, with a total suspension of support if those conditions were not met. Under the prevailing system beneficiary countries could not be certain of financial support until just before it was actually disbursed by the Commission staff, often at the end of the financial year and after the countries in question had drawn up the budget for the financial year for which the support was programmed.

Table 2

Differences between actual and expected payments for budget years 1995 to 2000 for the 23 programmes examined

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Source:

Commission decisions and accounts.

19. After the foreign exchange had actually been disbursed by the Commission, in three of the eight countries examined (Malawi, Mozambique and Zambia), there were delays in the creation of the counterpart funds by the central bank. After that the transfer of funds to the general treasury accounts took place at varying rates. Due to these variations in the timetabling, the already tenuous relationship between the support granted and the treasury needs for particular budget years was stretched still further. This situation does not make it any easier for beneficiary countries to meet their foreign and domestic payment deadlines, nor does it help them avoid a build-up of payment arrears (see Box 2).

Box 2 Shifts in the support timetable

1. In Malawi, a payment of 16 million euro scheduled for July 2000 was disbursed by the Commission at the end of December 2000, after several reminders from the Delegation to Commission headquarters. For its part, the central bank was late in paying funds into the counterpart funds account for the previous payment. The World Bank has estimated that the financial cost to Malawi of payment delays by all fund providers is around 11 million US dollars per year(15).

2. In Zambia, the counterpart funds were paid into the joint-signature account six months after a payment of 20,6 million euro under the fourth structural adjustment programme.

3. In Ghana, it was not possible to establish a correlation between the annual volume of counterpart funds released from the joint-signature account and the amounts in foreign exchange decided by the Commission as support for the budget years in question.

20. There is no generally agreed practice among the IMF and the beneficiary countries as regards the procedures and timetable for incorporating Community financial support into the national accounts. Depending on the country or period, the support is (or is not) included in the calculation of the government's net position with its central bank. Similarly, it may be taken into account before the budget deficit estimates are established or, conversely, as a source of funding for the deficit. Such accounting procedures and delays do not make it easier to incorporate the support in the estimated budget revenue(16), nor do they facilitate compliance with public accounting standards(17) and the coordination of assistance, that the Commission wishes.

Controls on the constitution of counterpart funds

21. In several of the Commission Delegations checks on bank statements and the conversion rates applied were insufficient. None of the 23 Financing Agreements examined contained detailed information about determining the exchange rates to be used to calculate the national currency equivalents of payments made in European currency by the Commission. The Protocols of Agreement subsequently dealt with this point, but did not apply uniform rules (see Box 3).

Box 3 Controls on the constitution of counterpart funds

1. In four countries (Malawi, Mozambique, Tanzania and Zambia), the central banks used unfavourable rates, thereby reducing the amount transferred to the exchequer.

2. In Mozambique, the exchange rate applied by the central bank in order to constitute the counterpart funds was 3 % below the most favourable rate. Furthermore an additional 1 % was levied by way of handling charges. According to the Court's estimates, the margin thus obtained by the central bank was four million euro.

3. In Mozambique and Senegal, the Delegations did not have any bank statements that could be used to check that the counterpart funds had been set up correctly. In Mozambique, in addition, the counterpart funds were not set up as a joint-signature account and the constitution of the counterpart funds corresponding to the 8 million euro paid under the first import programme (1992) could not be confirmed(18).

Use of technical assistance

22. Technical assistance is one of the three forms of structural adjustment support provided for in Article 247 of the Fourth Lomé Convention. Article 20(e) of the Internal Agreement for the seventh and eighth EDFs defined its role only in relation to the monitoring of import programmes. This was the Commission's main concern in 1990, but it should have been adapted for the eighth EDF in 1995, in view of the emphasis placed on budget support. The Commission's operations manual, which was updated in July 1998, states that technical assistance may be employed to supervise and direct the operational side of programme implementation and to monitor budget implementation (programming, execution, control), but it does not contain any details about the timetabling or substance of these activities. The Financing Agreements rarely provided more detail and left the definition of needs and activities for the Protocols of Agreement concluded on the spot and for the remits technical assistants.

23. Table 3 gives an overview of the budgets allocated for technical assistance and their implementation for the programmes examined. These budgets were underutilised and often late in terms of the timetable for releasing the counterpart funds, to such an extent that only 31 % of the total finance provided had been subject to payments as of the end of 2000. With the exception of Benin, it was not possible to cite local conditions as the explanation for the limited use of technical assistance and an objective reason for dispensing with it. The cumbersome nature of the Commission's centralised procedures for recruiting technical assistance and, in some cases, the reluctance of the national authorities, slowed down the release of the resources earmarked for these essential support functions.

Table 3

Implementation of the technical assistance provided for in the financing agreements examined

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Source:

Financing agreements and EDF accounts at 31 December 2000, according to the breakdown in Annex III.

24. In the eight countries examined the technical assistance personnel following the progress of operations in the target sectors were sometimes already working in place on other social-sector programmes, or even in budgetary and financial areas. This indirect monitoring did little for the transparency of the objectives pursued or the work carried out, which focused more on quantitative analysis of budgets than on the regularity and impact of the expenditure. Some technical assistance did make it possible for the Commission to monitor programme execution, but it was only indirectly that it had any operational advantages for the beneficiary administrations (Senegal). The division between expatriate assistance and local assistance was not based on any generalised policy. Amidst all this diversity some measures did have an impact (Burkina Faso, Tanzania), but the cases where tasks were badly defined and resources inappropriately mobilised were not always resolved and, on balance, there were very marked variations in the use of technical assistance.

25. In Benin, Ghana and Malawi, the finance for technical assistance was taken from the counterpart funds up until 1999(19), especially as regards the audits and evaluations provided for in the programmes. In such cases the activities are not recorded in the Commission's management systems, which have no provision for analytically monitoring the technical assistance employed. As with EDF direct-financing, mission statements and contracts are negotiated on the beneficiary country's initiative. Commission control over these activities is much weaker than for the contracts concluded at central services level from other resources, especially as regards the actual content of the works, the harmonisation of methods and the time required to put them in place.

Auditing

26. The Financing Agreements make provision for financial audits to be carried out at the instigation of the Commission or the national authorities. Table 4 provides an overview, for the programmes under consideration, of the audits carried out and the follow-up to them. In half the countries concerned the audits covered all the programmes. In Zambia there were no audits, but the reasons for this exception were not clear. In only two countries (Benin and Burkina Faso) were the audits annual audits that covered all the support for one budget year, rather than a number of financial years receiving support from one, or even several, programmes. It was found that annual audits made a more timely contribution to programme-monitoring. They intermesh with the budgetary arrangements and reinforce the national public finance control systems.

Table 4

Position at 31 December 2000 as regards audits of use of counterpart funds for the programmes examined

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Source:

Commission files.

27. Even where the controls on which the audits focused were similar, their terms of reference and the resources devoted to them varied significantly from one country to another. The disparity of the situations is not mirrored by any pragmatic policy of performing audits according to a reasoned evaluation of the conditions prevailing in each of the countries concerned. As in the case of technical assistance, a general framework outlining the objectives, defining the checks to be carried out and the scope of them and describing the auditing strategy would have facilitated the programming of resources by serving as a benchmark for all the countries.

28. Until 1998 the audits financed by the programmes were mainly concerned with the constitution of the counterpart funds, the eligibility of expenditure and the level of budget implementation. In some cases, however, the auditors devoted most of their work to understanding ill-defined expenditure systems, reconstructing accounts and producing quantitative overviews, without being able subsequently to examine the reliability of the accounts or the execution and regularity of the transactions, so that the reports proved to be inconclusive.

29. Following the irregularities established in Côte d'Ivoire in 1998(20), the Commission had a better idea of the risks associated with its approach. As of 1999, the financial audits in several countries were reinforced with checks that focused more on the nature of expenditure, the reliability of the accounts and the soundness of the management and control systems (see Box 4).

Box 4 Results of audits financed by the EDF

1. In Benin, the audit of health expenditure for 1998 revealed anticipations of the service rendered, poor inventory control and shortcomings in connection with tendering. In addition to verifying the reality of the arrears, the audit of arrears that was performed in 2000 also considered the plan of action proposed by the Government for preventing a recurrence of the situation.

2. In Burkina Faso, the auditors noted a number of irregularities in 1998 then, in 1999, stated that the accounts did not give a true view of the level of expenditure. In April 2000, an extended audit confirmed the weaknesses affecting the accounting systems and procurement procedures, highlighted fresh anomalies, questioned the administration and financial management of a public-sector institution and evaluated the impact of the various anomalies found in the financial years 1997 to 1999.

3. In Ghana, an extended financial audit of budget years 1996 to 1999 was carried out by SCR in February 2000. Apart from establishing the ineligibility of around 25 % of the expenditure, the final report in April 2000 gave numerous accounts of the weaknesses of the operational side of public finance, and of the control systems and tendering procedures as well.

4. In Tanzania, an audit was carried out by SCR in 2000 in order to check the 1999 support for the plan to clear internal indebtedness. Apart from the absence of supporting documents for 4 % of payments, the report highlighted the inefficiency of the internal control systems and the unreliability of the accounts.

30. In 1999 and 2000, SCR organised several financial audits in countries(21) where independent audit of the use of counterpart funds was felt to be a matter of priority. With a framework provided by a service specialising in financial audit, on the basis of carefully drafted terms of reference that were capable of yielding consistent, quantified results that would be comparable from one country to another, this initiative by SCR illustrates the advantages of a coordinated approach. Table 5 gives an overview of the main results of these audits. However, the initiative did not cover all the countries. As regards the countries reviewed in October 2000, there were no audits of this type in Malawi, Mozambique or Zambia, countries where the risks of public finance management are similar to those identified in other countries.

Table 5

Results of audits organised by SCR in 1999 and 2000

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Source:

SCR files.

31. The extent of the problems revealed by the financial audits from 1998 onwards persuaded the Commission to improve the follow-up to their results. In 2000, in three of the countries reviewed (Burkina Faso, Ghana and Tanzania), the implementation of programmes was suspended pending the signature of Protocols of Agreement on the treatment of the irregularities established. In Malawi and Mozambique the audits were not organised by Commission headquarters and were unsound, so that it was not possible to follow them up. In Benin the Commission simply took note of the Government's undertaking that it would in the future take steps to correct the weaknesses found during the audits.

32. The Protocols of Agreement that followed the audits provided for the counterpart funds to be reconstituted by the beneficiary country to the amount of the ineligible expenditure. In principle this reconstitution entails for the Commission a right to review the execution of new expenditure. The Protocols of Agreement set out the measures which the governments agree to undertake in order to reinforce their public finance management, using part of the reconstituted counterpart funds for the purpose. These arrangements are a significant advance in the Commission's attention to tangible reform of the mechanisms for sound management of budget execution in beneficiary countries.

33. The Protocols of Agreement that stem from the audits make no provision for resources to be returned to the EDF. The reconstitution of counterpart funds is a transfer of funds between two government accounts for the equivalent of the ineligible expenditure (see Table 6). The impact of this is greater where the joint-signature account is omitted from the government's net position. Payments already made in support of the balance of payments, and those for servicing external debt in particular, thus become final. In Ghana a link was, however, established between the implementation of corrective measures and the provision of new foreign exchange aid by the Commission. In addition, there were several cases where suspensions of payment in connection with the audits led to the cancellation of the final instalments for programmes that had exceeded the completion deadlines (Côte d'Ivoire and Ghana), or to cuts in potential new allocations of foreign currency (Cameroon, Côte d'Ivoire, Guinea and Tanzania).

Table 6

Mechanism for repaying ineligible expenditure

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34. The Commission has sometimes simply identified other eligible transactions to the amount of the Community finance as a way of correcting for ineligible expenditure that has been included in the accounts (see Box 5). This tendency first became apparent when the import programmes were being monitored and in the preliminary audit of budget expenditure in certain countries, which turned into a "hunt" for eligible invoices for amounts equivalent to the Community finance.

Box 5 Substitution of qualifying expenditure for ineligible expenditure

1. In Côte d'Ivoire, 18000 million CFA francs (approximately 27,4 million euro) was returned to the counterpart fund account in January 2000, following audits in 1998 and 1999, bringing the total counterpart funds available to 28800 million CFA francs(22). The audits having shown that the practices in question would have to be improved before the Commission could again provide budget support for the Ministry of Health(23), the funds were reallocated in June 2000 to refinancing treasury bonds that had already been redeemed (9500 million CFA francs), to payment of arrears (5000 million CFA francs), to support for the electoral process (6000 million CFA francs), to implementation of corrective measures (4300 million CFA francs), and to priority public health activities (3000 million CFA francs). The Commission, in fact, gave preference to the objective of releasing the counterpart funds quickly in order to help the country meet foreign deadlines and relegated the social sector measures to a lower level of priority.

2. In Gabon, in order to allow programmes to continue in spite of the severity of the conclusions of the 1996 financial audit (irregularities, inadequate documentation, poor accounting management) the Commission accepted the principle of a new audit that sought to demonstrate that there had also been other, regular expenditure equivalent to the amount of the Community contribution. By doing this a new "hunt" for invoices made it possible to turn a blind eye to the financing of ineligible transactions.

The Commission's administrative organisation

35. From 29 July 1989 to 18 June 2000, 40 internal notes on structural adjustment support were issued, most of them reviews or forecasts. Two precise sets of instructions on the procedures for monitoring counterpart funds date back to 14 March 1991. The instructions were not updated when the programme emphasis switched to budget aid and the quality of public finance management, so that they are still vague compared with the scope of the questions to be dealt with. It would have helped the Delegations to be consistent in their monitoring of different countries and managers had they been able to consult detailed information on the role of technical assistance, conditions for the release of counterpart funds to the general exchequer accounts, the line to be followed as regards arrears and the refinancing of past expenditure, respect for the annuality of the budget, and the nature and scope of the checks to be made by the various parties concerned. In most of the Financing Agreements this omission was remedied by a reference to subsequent Protocols of Agreement (see paragraph 10), which in many cases continued to be terse or irrelevant.

36. The Commission central services responsible for the design and monitoring of support for structural adjustment programmes were afflicted by the lack of organisation in their file management. Although a files and archives plan has existed since 1999, the application of it and the structure of files are left to the discretion of individual members of staff. This is not sound administrative practice and is particularly damaging to the continuity of programme management. Owing to the heavy workload, the amounts at stake, the small number of staff, and the high staff turnover, these departments should be able to rely on an information system that is rigorously maintained, complete and reliable.

37. The Delegations' minutes vary in form and quality and the only model document, which was drawn up in 1991, is limited in scope. Under these circumstances the headquarters services have not been able to monitor the situation as a whole, especially not by means of summary management information on programme implementation. In order to assess the results of seventh EDF support, the Commission had to call in a consultant to collect the basic information on programme implementation which it lacked.

38. Monitoring and appraising the use of the counterpart funds, interaction with aid from other fund providers and mastery of macroeconomic and sectoral policies are difficult and complex tasks which call for a variety of skills. Quality of public finance management and sectoral policies using performance indicators have widened and complicated the area to be monitored. The respective duties of the headquarters departments and the Delegations varied between countries and, at the level of individual countries, between periods, according to the capabilities and inclinations of the departments responsible. These contrasts are attributable to the lack of detail in the instructions (see paragraph 35), and also to the unstable ratio of resources to requirements. From 1999 onwards the Commission headquarters departments have produced breakdowns of their duties, activities and resource allocations(24). As of the end of 2000, however, the Commission, in the context of its reform of external aid, had still not defined the human resources and skills required at headquarters and in the Delegations to monitor the use of budget aid, particularly as regards the overall qualitative appraisal of public finance management.

39. It is important for the department specialising in macroeconomic questions, which is currently responsible for structural adjustment support programmes, to examine balance-of-payments aid in consultation with the IMF, the Member States and forums such as the Club of Paris, but taking into account as well the evaluation of the individual circumstances of EDF support. It is, however, inappropriate for this department to be involved in assessing the operation of social sectors as well. Monitoring and auditing the use of support in these sectors call for other skills, which are already available in other Commission departments (see paragraphs 30 and 50). Responsibilities for setting and monitoring the performance indicators in these sectors still have to be defined as part of the establishment of the external aid department (EuropeAid).

THE CHALLENGES OF BUDGET AID

Public finance management

40. EDF budget support is mobilised according to the beneficiary country's own public expenditure procedures. It is subject to the same internal controls, and the same risks, as the expenditure that is financed from national income and differs in this respect from project aid, which is implemented according to the procedures imposed by individual fund providers. Many financing proposals evaded the question of the quality of public finance management. Only the macroeconomic aspects and questions concerning the structure and drawing up of the budget were covered. More attention was paid to sectoral budget allocations than to their implementation (see paragraph 9). Although the Commission started to provide budget aid on a large scale with the seventh EDF, it was not until 1998 that it began to carry out qualitative appraisals of public expenditure management in ACP States.

41. In most of the countries examined the reform of public finance initially focused on the framework for drawing up budgets and was beginning to have an impact on the quality of the programming. The place of the public sector in social policies and government's capacity to collect and analyse sectoral statistics have still not received sufficient attention. These aspects are essential for appraisal of the sectoral effects of budget finance, especially as the NGOs and religious organisations often provide a substantial proportion of the social services available to the population.

42. Reforming the chain of expenditure and accounting was only tackled at the second stage. It was, however, in these areas that the various audits revealed the weaknesses that caused most concern as regards the proper use of budget aid. In general there were substantial delays in the forwarding of the accounts showing the implementation of the budget and they were insufficiently audited. The shortcomings in expenditure procedures were fairly similar from one country to another. Compliance with the national rules on budget annuality was jeopardised by disbursement delays and there was frequent use of exceptional procedures, so that payments were not always correctly authorised or accounted for and arrears began to accumulate. Imperfect mastery of procurement procedures led to excessive costs, because contracts were not put out to tender. Budget allocations were poorly mobilised as regards the more remote and less central levels. Administrative discipline (documentary evidence in support of expenditure, archives) was poor. The consolidation and the reliability of the accounts were affected by the lack of harmonised accounting procedures and by incomplete or late end-of-year adjustments.

43. In a number of the countries under review the recent reforms must be welcomed as a very positive advance. Nevertheless they were still far from ensuring that there was a sound institutional framework to limit the risk of anomalies in the management of public funds, and it was difficult to judge how long it would be before the reforms began to take effect (see Box 6).

Box 6 Public finance controls in beneficiary countries

1. In Benin, the rationalisation and computerisation of the expenditure chain was undertaken in 2000. Financial controls and internal audits have been introduced, but with insufficient resources. The first discharge bill (1998 budget) was tabled for debate by the National Assembly in 2000, but could not be discussed for procedural reasons. The national audit institution and the parliament still did not have the resources needed for them to play to a full part in the budgetary control process.

2. In Senegal, many of the reforms that have nevertheless been undertaken by other countries were still at the project stage (notably the modernisation and computerisation of the expenditure chain), to such an extent that the undertaking to implement the WAEMU guidelines by 2002 seemed rather unrealistic. As of October 2000 the discharge bills for financial years 1997 to 1999 had still not been adopted. The Cour des Comptes was set up at the beginning of 1999 but only 12 of the complement of 60 magistrates were in office.

3. In Burkina Faso, the expenditure flows have been computerised since 1996, but the end-of-year closure procedures were still unsatisfactory. The discharge bills for financial years 1995 to 1998 had been drafted. However, as of the end of October 2000, they had not been sent to the national audit institution nor tabled in the national assembly. The national audit institution was reformed in 2000, but the new institution was still not operational at the end of that year.

4. In Ghana, a major public finance reform project that was started in 1996 in partnership with, amongst others, the World Bank and the European Community and with United Kingdom and Canadian cooperation, has made little progress in the area of dealing with expenditure and drawing up accounts, so that the first results are not expected until 2002. In the meantime heavy decentralisation, combined with a sectoral approach that has been well coordinated among the fund providers, has made it possible for the Ministry of Health to improve the quality of its financial management alongside the more general reforms. A restructuring of the national audit institution (800 auditors) was undertaken in 2000. The consolidated national accounts for the 1998 financial year have been audited and the consolidated national accounts for 1999 have been prepared. In 2000 the Parliament reported on the implementation of the 1996 and 1997 budgets and severely criticised the handling of expenditure.

5. In Mozambique, a strategy for reforming the management of public expenditure was drawn up in 1997. In 2000 the first quarterly reports on the implementation of the budget were prepared by the Government, as were the annual accounts (the first since 1975) for the financial year 1998. The audit of these accounts was Delegated to the Administrative Court (which reported to Parliament in 2000 on the 1998 accounts). This court is also responsible forex ante financial control of expenditure, but the effectiveness of the latter was limited.

44. Not until 1999, as an aid to its examination of new loan applications, did the World Bank begin to evaluate beneficiary countries' ability to account for the implementation of their national budgets(25). The IMF, for its part, offered beneficiary countries a framework for evaluating budget transparency. Other bilateral donors have recently begun to audit public finances and the governments of the ACP States themselves are placing more importance on the reform of public finances. The Commission has begun to appraise the overall management of public finance in ACP States, but since the appraisal is derived from the Commission's own audit results, it does not cover all beneficiary countries. At the beginning of 2001, as a consequence of the recent awareness of the significance of this omission, reinforced by the results of audits carried out on the Commission's initiative, the latter, with the World Bank, began to consider introducing an enhanced form of cooperation, with joint objectives and pooled financial resources(26), and coordinating it with the work of all the parties concerned.

Volume of expenditure in social sectors

45. In three of the eight countries examined (Benin, Burkina Faso and Ghana), the impact of support on the social budgets situation was carefully monitored and documented by the Delegations. It is difficult to establish a chain of causality between increased expenditure in social sectors and EDF aid, but some examples illustrate the positive role of the Delegations in respecting budget implementation objectives in Benin and Ghana. In Burkina Faso the complexity of the monitoring machinery did not ensure that the funds were actually spent during the budget year (see Box 7). In the other countries the limitations of the monitoring that had been applied meant that it was not possible to discern any relationship between the support provided and the budget input to the social sectors.

Box 7 Quantitative monitoring of expenditure by the Delegations

1. In Benin, the Delegation drew up a comparison for each budget year between the rate of health sector expenditure and the objectives that appeared in the financing Agreements. The correspondence between the Delegation and the Ministry of Health showed that in 1999 the Commission's determination not to release the counterpart funds until the objectives had been achieved had a decisive effect on the Government's respect for its undertakings.

2. In Ghana, the Delegation intervened actively in 1999 in order to speed up the release of budget appropriations in favour of social ministries.

3. In Burkina Faso, despite an overall increase in the budgets allocated to social sectors, the complex system of adding amending clauses to the Protocols of Agreement masked the take-up problems, as well as the delays in implementing budgets. By failing to compel respect for the budget timetable the system helped to institutionalise an excessive number of derogations to the length of the budget year, in the social sectors in particular, contrary to the principles of sound public financial management. In order to mop up 2300 million CFA francs that remained in the accounts under the heading of support for the 1998 budget, the Delegation, in May 1999, proposed using an accounting device which would allocate the residue retrospectively to other 1998 budget headings where implementation had been satisfactory. The headquarters departments, quite rightly, opposed this and in November 1999 the residue was allocated to the 1999 budget.

46. The Delegations usually monitored the mobilisation of budget appropriations through the government's central accounts, but it was only in 1999 that the Commission began to pay attention to the question of whether these accounts were reliable, when ex post facto audits brought this issue to light in two of the countries examined (Burkina Faso and Mozambique), showing that the accounts overstated the real execution of expenditure in the target sectors.

Impact of expenditure on social sectors

47. Commission monitoring has recently taken account of the objectives of the Financing Agreements that aim to improve social services for the population. For example, out of the 23 Financing Agreements examined, only two, signed in 1999 (Benin and Burkina Faso), included conditions relating to the results obtained in the social sectors. Very few resources were devoted to on-site appraisals of the utility, effectiveness and impact of the expenditure. Under these circumstances the Commission cannot evaluate the impact of the budget support contributed under the seventh and eighth EDFs on the quality of social services.

48. Since 1996(27) the use of summary management information has been recommended as a way of including measured results in the mechanisms for assessing and controlling expenditure. The pilot experiment that was carried out in Burkina Faso made it possible to steer the political dialogue away from intentions and towards results. It also highlighted(28) the main difficulties that have to be overcome in order to permit credible use of summary management information: tight definition, preset levels of achievement, existence and reliability of systems for measuring results and, lastly, agreement between the partners as regards the choice of indicators within the framework of poverty reduction strategy papers (PRSP).

49. The problems of regularity and good governance(29) brought to light by the financial audits have a direct impact on the quality of expenditure and the situation of vulnerable and disadvantaged members of society. The public spending reviews that are carried out in many countries still have too little regard for the quality of expenditure and are usually only carried out intermittently, so that they cannot alleviate the shortcomings of the internal control mechanisms applicable to public finance in beneficiary countries.

50. Although the Commission's sectoral adjustment support encouraged sectoral reforms, the latter were sometimes undertaken without any direct link to the structural support, even when the expenditure targeting related to the sector or sectors concerned. The extent of these reforms was such that in several countries they were accompanied by coordinated multilateral initiatives, particularly as part of a global approach. The Commission's structural adjustment support programmes have so far not tackled the problem of integrating budget aid into these initiatives (see Box 8).

Box 8 Multilateral sectoral approaches

1. A multilateral sectoral approach was started in the education sector in Mozambique in 1998. Not until the financing proposal for the 2001 programme of structural adjustment support, however, did the Commission tackle the question of promoting improved access to social services in the areas of health, education and water as part of a sectoral approach. It would be better if the tasks associated with such participation were clearly defined, so that the number of sectors supported was compatible with the Delegation's resources.

2. In Ghana, alongside structural adjustment support, the EDF participated with other fund providers in a global sectoral approach in the area of health. Part of it concerned budget aid to a fund monitored and serviced jointly by several fund providers. The advantages and main features of this approach are very relevant in the context of redirected EDF budget support, especially as regards the management of public finance, result indicators and control procedures. In the delicate area of quality of expenditure it has had a real impact on the relevance of the investments.

Redirecting the monitoring and control of budget support

51. In the first half of 2000, on the basis of the review and perspectives drawn up by the Commission(30), the Council(31) advocated less-detailed allocation of funds (untargeted, direct budget aid) in the countries whose public finance management was satisfactory and recommended establishing a link between the effects of reforms and disbursements of aid in foreign exchange. The financing proposals submitted to the EDF Committee in the second half of 2000 for five of the countries examined (Benin, Burkina Faso, Mozambique, Senegal and Zambia) anticipate the progress made in the management of public finances. At the end of 2000 the Commission departments expected that, following an audit in Senegal, the implementing arrangements for that country would be modified, because of shortcomings that had been found in the execution of recent programmes.

52. These financing proposals gave as justification for abandoning targeted expenditure the absence of cash-flow problems and the sufficiency of the budget implementation (quantitative aspects), rather than the soundness of the public finance management. Some of the proposals include elements of management quality appraisal, but there is no explanation of what the consequences of the appraisal might be in terms of programme procedures and the release of funds.

53. It is difficult to assess whether the conditions for effective use of the performance indicators adopted in the financing proposals might be met in the future (see paragraph 48). In the area of sound public finance management, the performance indicators are still primarily quantitative and take too little account of the weaknesses identified by the audits carried out in 1999 and 2000. In the case of Senegal the choice of performance indicators was still under discussion when the Financing Agreement was signed in October 2000.

54. The new programmes drawn up in the second half of 2000 comprise several instalments. In every case the first payment is to be disbursed in the light of IMF macroeconomic evaluations. One instalment, which in the case of Benin represents half of the programme total (but only one third in the case of Burkina Faso, Senegal and Zambia), will be disbursed in varying proportions, depending on the level reached by the performance indicators. The systematic disbursement of a minimal sum is intended to ensure that the beneficiaries plan their use of resources better (see paragraph 18), but the procedures for releasing further instalments often require further definition, in order to ensure that poor performance is actually taken into account.

55. Although the system of targeting that has been established for selecting individual "eligible" expenditure items is to be abandoned because of its artificiality and low impact on the quality of public finance management in terms of reducing the administrative cost, the Commission cannot forgo the controls that are necessary for it to assess whether the Community finances entrusted to it are properly used (see paragraph 43). In addition to a general review (for which the outlines still have to be defined), the new programmes provide for audits of a volume of transactions equivalent to the volume of support provided. There is little sense in the link that has been established between the extent of the checks and the amount of support. With the retention of targeted checks there is the risk of a tendency to pick out eligible expenditure items to the amount of the Community finance in order to obtain assurance (see Box 9). A sample check in order to assess the regularity of the transactions as a whole, in one or more expenditure sectors, would be more appropriate.

Box 9 Justifying the eligibility of expenditure

1. In the latest programmes for Benin and Burkina Faso, the role of audit in justifying European aid by verifying amounts of priority budget expenditure equivalent to the support given and certifying the eligibility of the financed expenditure lacks clarity.

2. The financing proposal for Mozambique is the only one that reflects an overall audit approach. It is, however, far from clear whether the work of the external auditors is consistent with that of the national audit institution and under what conditions the Commission will rely on it in order to produce an independent appraisal.

56. The Commission Communication of February 2000 did not go into the question of expenditure controls(32). In the context of untargeted budget aid the necessary assurance can only be obtained by means of overall appraisal of public expenditure, but the most recent Financing Agreements (year 2000) do not give any indication of a general audit approach combining the work of national audit institutions, external auditors and technical assistance and, when possible, other budget aid providers. In the absence of a soundly based approach, the results of the 1999 and 2000 audits are still not sufficiently taken into account by the performance criteria for sound public finance management.

CONCLUSIONS AND RECOMMENDATIONS

General appraisal

57. In beneficiary countries counterpart funds are made available as part of the national public expenditure procedures and because of that and the inherent risks of those procedures it is unrealistic to think that the quantitative objectives being pursued in the priority sectors can be achieved without any hitches (see paragraphs 45 and 46), that expenditure will always be executed regularly (see paragraphs 26 to 34 and 40 to 43) and that it will always have a positive impact on the situation in the social sectors (see paragraphs 47 to 50).

58. The desire to provide balance of payments support and support for social sector budgets simultaneously has sometimes affected the decisional mechanisms (see paragraphs 11, 33, 39, 52 and 54). The controls on the counterpart funds have, in some cases, been reduced to formal administrative justification and ex post facto checks on expenditure (see paragraphs 10, 12, 34 and 55) with no direct relation to properly functioning, government-run, social services for the benefit of vulnerable and disadvantaged people (see paragraph 47).

59. The Commission's headquarters departments did not pay sufficient attention to certain aspects of overall supervision (see paragraphs 17 and 37) nor to the technical aspects of the use of programme funds (see paragraphs 21 and 22, 35 and 36, 40 and 46). The new guidelines, and especially the increased importance attached to strengthening the management and control of public finance (see paragraph 51), should improve the effectiveness of the mechanism, provided that the framework for monitoring reforms has been improved, by means of institutional support if necessary, and that the Commission deploys appropriate resources to ensure that implementation is consistent and coordinated with the main providers of funds (see paragraphs 22 to 25, 27, 30 and 35 to 39).

60. In-country monitoring of the EDF programmes is based on combined action by various parties: the Delegations, public administration in the beneficiary countries, national audit institutions, technical assistance, and external auditors. The roles of those concerned within the organisational structure have not been defined sufficiently. Monitoring, carried out by the Delegations chiefly at central administration level, is hampered by the unreliability of public accounts, particularly as regards decentralised expenditure (see paragraphs20, 38 and 46). Technical assistance was not sufficiently exploited as support for action by the Delegations (see paragraphs 22 to 25). The audits financed under the programmes rarely highlighted the internal control weaknesses that affected the use of the counterpart funds (see paragraph 28). The financial audits subsequently ordered by the Commission proved to be much more effective (see paragraph 30). It is important for these audits to be retained, but there is no guarantee that there will be provision for this under the current reorganisation. Any ineligibility discovered did not result in funds being repaid to the EDF (see paragraph 33), but in several cases new programmes were suspended pending corrective action.

61. With the support of fund providers, a number of countries have undertaken wide-ranging reforms that aim gradually to improve the management of their public finances. The process will, inevitably, be slow, because it is very complex and addresses a variety of situations and the beneficiary governments' resources are limited. As of the end of 2000 it is not possible to expect that budget aid will immediately be released in accordance with the principles of sound financial management and under conditions that are always regular (see paragraphs 41 to 43). The budgetary authority must be aware of the inherent risks of the approach adopted and must try gradually to reduce the extent of it by encouraging effective implementation of reforms in the ACP States, especially through concerted action by the donor community.

Recommendations on the organisation of monitoring

62. Recommendation 1 - In order to remove the ambiguities from programmes and ensure that support changes to follow the new direction being taken by poverty reduction, clear guidelines should be laid down for use by Commission managers and national authorising officers. The linkage of the remits of the main parties involved in the chain of monitoring and control must receive close attention. In particular:

(a) criteria for assessing the progress made in the management of public finances (see paragraph 52) should be laid down and should include monitoring the remedies applied to weaknesses and shortcomings highlighted by financial audits (see paragraphs 42 and 56);

(b) procedures for reviewing expenditure in a context of untargeted budget support should be defined and should give the budgetary authority an indication of the extent to which the funds are being soundly managed. Financial audits should be an integral part of this mechanism and could take the form of a set of sectoral appraisals where necessary (see paragraphs 55 and 56). They should preferably be carried out annually and aligned on the budget years of the beneficiary countries (see paragraph 26);

(c) the various possibilities for making use of reliable performance indicators in the social sectors, and their relation to budget expenditure (see paragraphs 41 and 48) should be defined;

(d) technical assistance for beneficiary administrations should be clearly distinguished from the technical assistance that helps EDF authorising officers and the Commission Delegations to fulfil their obligations (see paragraphs 24 and 25);

(e) the nature and level of the Delegations' own supervision of expenditure should be specified. Although they cannot be held responsible for the management errors of the national departments that execute national budgets (see paragraphs 40 and 42), the Delegations must be able to perform a qualitative appraisal of the expenditure in priority sectors (see paragraph 47), one of the ways being concerted action by fund providers.

63. Recommendation 2 - The principles and procedures for the monitoring and control of aid (see paragraph 62), which are defined in detail when the programmes are drawn up, should be included in the financing Agreements (see paragraph 35).

64. Recommendation 3 - As part of the reform of its external departments, the Commission should establish a clearer separation between the responsibilities of, on the one hand, the departments responsible for examining programmes, for the overall monitoring of macroeconomic support and for the reform of public finance in beneficiary countries and, on the other, the departments responsible for assessing the functioning of social sectors (see paragraph 39).

Recommendations on coordination

65. Recommendation 4 - The Commission should, each year, according to a timetable that is compatible with the drawing-up of the beneficiary budgets and coordinated with that of the IMF, decide the amounts of money that are to be disbursed for the following year, for each country, notify the beneficiaries of the amounts, then check that they are included in public accounts in accordance with a clearly agreed scheme (see paragraphs 18 and 20).

66. Recommendation 5 - Increased coordination between all the parties concerned with the improvement of public finance management in general, and within the PRSP framework in particular, would allow fund providers and beneficiary countries to define the tangible weaknesses in public finances (see paragraph 42) and would facilitate the piloting and periodic evaluation of the remedies applied and the progress achieved (see paragraph 62(a) and (b)).

67. Recommendation 6 - Wherever possible, the Commission, in association with other fund providers, should take care that its sectoral support is incorporated into the budgets of beneficiary countries. This type of approach would facilitate the desired cooperation with the bodies responsible for auditing public finance in the beneficiary countries(33), since concerted action is essential if the objectives of qualitative improvement of public expenditure are to be achieved (see paragraphs 50 and 56). Furthermore, participation in multilateral sectoral programmes would be a visible demonstration of the Commission's intention of concentrating its efforts on a smaller number of sectors and activities(34)

68. Recommendation 7 - In order to facilitate the introduction of the above recommendations, programmes should place increased reliance on:

(a) a strategy and an overall plan for reforming public finance management for each country, highlighting the progress achieved in public expenditure systems. This development should be assessed and documented as part of an ongoing process, in coordination with other fund providers, so that the direction followed in decisions and new measures is taken in full knowledge of what is involved;

(b) an overall approach in the social sectors, including mechanisms for qualitative control of expenditure (impact and management), here too, in intensive coordination with the main fund providers in the countries concerned, and with Member States in particular.

This report was adopted by the Court of Auditors in Luxembourg at the Court meeting of 27 and 28 June 2001.

For the Court of Auditors

Jan O. Karlsson

President

(1) International Monetary Fund (IMF) and World Bank.

(2) The Fourth Lomé Convention was signed on 15 December 1989 with a duration of 10 years (from March 1990 to March 2000), together with a five-year Financial Protocol corresponding to the seventh EDF; it was revised on 4 November 1995, together with a second five-year Financial Protocol corresponding to the eighth EDF.

(3) Joint signatures of the Commission Delegate and the national authorising officer.

(4) Resolution of the European Parliament containing its comments accompanying the European Parliament Decision giving discharge to the Commission in respect of the sixth, seventh and eighth EDFs for the financial year 1998 (OJ L 234, 16.9.2000). In recital D of the Resolution Parliament said that the use of counterpart funds suffered at times from inadequate management, poor supervision and insufficient evaluation.

(5) Article 226(c) of the Fourth Lomé Convention.

(6) See COM(2000) 58 final, section 2.1.1.

(7) See COM(2000) 58 final, section 2.1.4.1.

(8) See (COM)2000 58 final, section 2.1.3.2.

(9) World Bank Operation Memorandum "Simplifying disbursements under structural and sectoral adjustment loans", 8 February 1996.

(10) See COM(2000) 58 final, sections 2.1.3.2 and 2.3.4.3.

(11) See Box 5, paragraph 1.

(12) COM(2000) 58 final, section 2.1.3.2.

(13) Information note to the EDF Committee dated 22 June 2000.

(14) Similarly, at the end of 2000, 29 million euro paid under Stabex, mainly from 1996 to 1998, remained unused in bank accounts in Europe.

(15) Report "Administrative procedures for macroeconomic assistance to Malawi", table "Cost of delays in macroeconomic aid and inflows 1996 to 1998".

(16) Note to the Member States concerning convertibility and direct budget support, 3 February 1997.

(17) For example, the WAEMU guidelines for compiling the table of government financial transactions.

(18) As regards the difficulties experienced in connection with the central bank in Mozambique, see also paragraph 4.52 of Special Report No 2/94 on the import programmes carried out under the sixth EDF (OJ C 97, 6.4.1994).

(19) The Financing Agreements concluded in 1999 broke with this practice and provided for an audit and evaluation budget separate from that for budget aid.

(20) Ineligible expenditure amounting to 27,4 million euro.

(21) Including Ghana and Tanzania, see Table 4 and Box 4.

(22) Not including 7200 million CFA francs for Stabex 1993, also available for use since the end of 1997.

(23) Protocol of Agreement dated June 2000.

(24) "Mission statements" 2000 and 2001.

(25) Country financial accountability assessment.

(26) "Trust Fund for Public Expenditure".

(27) Commission working paper on the reformulation of conditions, December 1996.

(28) Commission internal note of 22 June 2000.

(29) Relevance of and justification for expenditure, reality of the service performed, fair price, absence of favouritism and distortions of competition.

(30) Commission communication on structural adjustment, COM(2000) 58 final of 4 February 2000.

(31) Resolution of 18 May 2000 on structural adjustment.

(32) COM(2000) 58 final, section 2.3.4.3.

(33) 1999 Annual Report, paragraphs 46 and 47 (OJ C 342, 1.12.2000).

(34) Declaration of the Council and of the Commission of 10 November 2000 on the European Community's development policy, section 12.

ANNEX I

AMOUNTS ALLOCATED AND DISBURSED FOR STRUCTURAL ADJUSTMENT SUPPORT UNDER THE SEVENTH AND EIGHTH EDFS AS AT 31 DECEMBER 2000

>TABLE>

Source:

EDF accounts as at 31 December 2000.

ANNEX II

MAIN GUIDELINE DOCUMENTS ISSUED BY THE COMMISSION AND THE COUNCIL

>TABLE>

ANNEX III

PROGRAMMES EXAMINED

>TABLE>

Source:

EDF accounts at 31 December 2000.

ANNEX IV

MAIN COMMENTS MADE BY THE COURT IN THE PAST ON THE MONITORING OF COUNTERPART FUNDS

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The commission's replies

SUMMARY

I. The study concerns one aspect of the assistance provided by the Commission for structural adjustment programmes: the monitoring of counterpart funds. The Court of Auditors did not look into the role of the Commission in such programmes, the use of conditionality, the impact of assistance on macroeconomic balances or on the structural and sectoral reforms central to such programmes.

Structural adjustment programmes, in which the Bretton Woods Institutions (BWI) play a major role under their international mandate, are complex. They are aimed at encouraging the beneficiary countries to carry out what are seen as essential reforms: macroeconomic reforms and structural reforms concerning public finances, privatisations, civil service reforms, etc. The support provided by the international community has always been conditional on adherence to a macroeconomic programme monitored primarily by the IMF and structural reforms guaranteed by the World Bank. Compliance with the programme's conditions enables the donors to provide balance-of-payments support with a direct impact on governments' budgets. The Commission has taken part in such programmes and sought to make sure that certain of its concerns were taken into account. In line with the Council's guidelines, these concerns include shielding priority sectors, especially the social sectors, and supporting reform in those sectors: the introduction of essential drugs policies, the re-targeting of budget spending on primary spending, the introduction of vaccination policies, etc. This concern has been reflected in Community support programmes by specific conditions and by the targeting of counterpart funds generated by assistance. These programmes have changed considerably in the past two years. These changes reflect both the lessons learned and the Lomé Convention's emphasis on a gradual approach that respects a country's efforts to implement difficult reforms that cannot be carried out all at once.

II. The Commission's approach has been consistent with the principles of the Lomé Convention: its concern has been to support reform programmes drawn up by governments (Article 244(a)) and backed by the donor community, and in particular the BWI. It has adhered to the principles laid down: respect for countries' priorities (244(e)), a realistic pace of reforms (244(g)), adaptation to needs (248(a)) and flexible implementation (247(4)).

Most of the programmes for which the Court of Auditors examined counterpart funds belong to what can be described as the first generation of economic reform programmes, which focused on priority reforms. The current trend in programmes owes much to the Commission's role in the international debate. The Commission has, in the past two years, applied an innovative approach based on indicators of budget performance and results, especially in the social sectors.

III. In these programmes the Commission's checks have focused mainly on compliance with the conditions determining the disbursement of aid.

While the other donors have confined themselves to providing aid for cash-flow, the Commission has sought, by targeting funds, to make sure that its aid promoted the execution of spending in priority sectors. The targeting of counterpart funds offers governments an incentive to execute priority spending and therefore to increase their volume, since the Community's money is paid to the treasury as it executes such spending. The government loses out if it fails to execute the targeted budget expenditure. Moreover, the supporting documents necessary for the disbursement of Community funds oblige the government to monitor budget execution.

As for technical assistance, it is provided to governments at their request, in accordance with the Lomé Convention. The support has fostered an approach whereby technical assistance can be rapidly provided to any government expressing the need. Changes have been made to make sure that unused sums are returned to the budget support.

IV. It is vital that the developing countries improve their management of public finances. This will obviously take time and will have to be done in stages: the donors will have to coordinate their activities and monitor the progress made by the beneficiary countries. Budget support allows this issue, which cannot be addressed by projects alone, to be raised.

Structural adjustment programmes have brought major reforms in the management of public finances. Audits by the Commission have shown that further developments are necessary. Of all the donors, only the Commission has monitored governments' budgets and insisted on corrective measures and repayments to the central bank accounts requiring the signature of the Commission and the beneficiary country. In order to promote a concerted approach by the donors in this matter, the Commission and the World Bank have decided to set up a trust fund for designing tools for assessing public finances and measuring progress.

V. The Commission endorses the recommendations of the Court of Auditors, which in many cases reflect the guidelines followed in the programmes implemented over the past two years: increased coordination under the Poverty Reduction Strategy Papers, pursuit with the Bretton Woods Institutions of common instruments for assessing the quality of the management of public finances, increased importance of issues related to public finances, development of budget performance indicators and performance indicators in the social sectors. It will maintain the current approach to non-targeted programmes recommended by the Court of Auditors in point 55. It will foster the planning of aid with three-year programmes under the Cotonou Agreement. Last but not least, it is developing, as a complement to macroeconomic aid, sectoral approaches within the budget framework, as authorised by the Cotonou Agreement. It will continue to pursue a consistent approach based on its delegations and capacities in both the economic sphere and specific sectors, especially the social sectors. New instructions based on these developments and the implementation of the Cotonou Agreement are now being finalised by the Commission.

It undertakes to specify the monitoring arrangements in the financing agreements rather than in the protocols for the use of counterpart funds. These will reflect the proposals of the Court of Auditors, namely that the overall quality of public finances be assessed, as far as possible, with other donors and indicators specified for measuring the progress made. In addition to the Court of Auditors's recommendations, the Commission proposes to check that a sum matching its aid has been used to fund basic spending in the priority sectors.

INTRODUCTION

Counterpart funds from structural adjustment support

2. The description of the use of structural adjustment funds is not wholly consistent with the objectives laid down by the Lomé Convention. Structural adjustment support has primarily focused on macroeconomic reforms, an area in which the IMF is the main player, and structural reforms, in which the World Bank takes the lead, in accordance with their international mandate. The Commission has backed such reform programmes by means of an approach geared to developing specific aspects. It has from the very outset drawn attention to the dangers of cutting public spending without protecting priority sectors, and in particular social sectors. It has endeavoured to make sure that structural reforms redirect budget spending towards the primary sectors (in particular basic health care and primary schools) or foster improvements in the policies pursued (e.g. essential drugs).

This support for sometimes difficult reforms is voiced in the conditions attached to the disbursement of tranches, an aspect outside the scope of the review of the Court of Auditors.

The report therefore concerns only one, Commission-specific aspect of structural adjustment support, namely the monitoring of the counterpart funds generated by the foreign exchange provided. The other donors, and in particular the Bretton Woods Institutions which offer soft loans, have simply transferred their aid to treasury departments or central banks with no particular monitoring.

4. The Commission's initial objective was to ensure that the support provided did actually help governments to protect priority spending.

5. Structural adjustment programmes have evolved in step with the progressive, realistically paced approach recommended by the Lomé Convention. The recent shift towards support for Poverty Reduction Strategy Papers (PRSPs) reflects the Commission's long-standing concerns: an increased emphasis on the results for the population, ownership of programmes by the countries concerned, increased attention to sound management of public finances.

This shift towards what can fairly be described as second-generation reforms reflects a change in priorities now that many of the most pressing cash-flow problems have been resolved and basic reforms carried out. Over the last two years the new approach has led the Commission gradually to review its support mechanisms. The Commission accepts the proposal of the Court of Auditors that the term "counterpart funds" be abandoned in the context of budget aid.

PROGRAMME DESIGN

Scope of expenditure targeting

9. The targeting of budget aid supplements the conditions attached to programmes, which were not reviewed by the Court of Auditors. Targeting is in itself an incentive to governments to execute the targeted spending, since the Community's money is paid to the joint-signature treasury account as such spending is executed. The government loses out if it fails to execute the budget. Moreover, the supporting documents required for disbursements oblige the government to monitor budget execution.

The conditions governing budget execution have therefore been invoked only where targeting itself has proved inadequate or where the Commission has switched to non-targeted aid.

11. The past two years in particular have seen the Commission switch to non-targeted aid while seeking to develop an overall approach to supervising spending with the other donors.

Choice of target expenditure

12. The choice of targeted expenditure has in most cases been dictated by an analysis of what were held to be the most vulnerable expenditure headings while seeking a rapid input of funds consistent with the instrument's purpose. Box 1 shows how the refinancing of expenditure in Benin sanctions past use of the budget. In very many cases this targeting has had beneficial effects: increasing the level of budget execution in social sectors in Benin (Box 7), increasing budget execution in Malawi (Box 1). Other effects include the implementation of essential drugs policies or the decentralisation of the supply of materials to Burkina Faso's schools. The impact on the social sectors is to a great extent achieved through conditionality.

13. The expenditure covered by Commission programmes is part of the stabilisation and economic reform programme; this is particularly the case of arrears. Targeting arrears is not general budget aid, it is very clearly targeted. There are many economic arguments (presented to the EDF Committee and forwarded to the Court of Auditors) for targeting such expenditure, which is audited before repayment. Adjustment support programmes are aimed at limiting arrears and are supervised by the IMF, an activity that the Commission does not intend to duplicate. The Commission considers the reform programmes steered by the IMF in the countries cited to be effective.

14. The financing of arrears or treasury bonds does not prevent the Commission from supervising sectoral reforms or making sure that social sectors are protected. This is done indirectly by relieving the financial burden on the government and through the conditions attached to the programme.

15. The Commission's position is to encourage the inclusion of all external aid in the budget (including project aid) and, it is true, to move away from project financing: in Ghana, for example, this aid has been decreasing, and other expenditure requested by the government but not included in the budget has been refused by the Commission.

16. February 2000's communication to the Council gives a sectoral breakdown of targeted expenditure showing, for example, that health, education and road maintenance (excluding arrears) have respectively accounted for 34 %, 27 % and 6 % of counterpart funds.

CONTROLLING PROGRAMME EXECUTION

Support timetable

17. There are no international standards for budget deficits. Indeed, they have only recently been established at European Union level. The criteria used for budget aid are therefore based primarily on balance-of-payments financing needs. "Need" is obviously a subjective concept, and we are still a long way off covering a country's needs. The concept of overfinancing does not exist: in the case of a very poor country like Senegal this would be tantamount to saying that it had too much money (something even the richest countries would deny).

19. There are several possible explanations for the differences between actual and expected payments, in particular difficulties in discussions between a country and the IMF ("off track" or suspended programmes). In the case of Ghana and Tanzania, for example, IMF programmes were suspended for about two years. It is no doubt possible to improve the predictability of budget support but this remains largely contingent on the outcome of the IMF's assessment. In other cases delays can be attributed to failure to comply with specific conditions. The shift to three-year programmes under the Cotonou Agreement will increase the predictability of aid for countries that perform well.

Box 2 Shifts in the support timetables

1. In Malawi payment was made at the end of 2000 after a review of compliance with conditions. The analysis of compliance presented by the Government via the Delegation had been considered inadequate by the headquarters departments responsible.

2. In Zambia the Commission paid for a consultant to examine the issue raised by the Court of Auditors and carried out an audit in the country.

3. In Ghana the two-year interruption in the macroeconomic programme accounts for the discrepancy between the year of disbursement and the year of use of funds.

20. The Commission regrets that there is no international IMF standard for the incorporation of external budget aid.

Controls on the constitution of counterpart funds

21. In a country with a convertible currency there is only one exchange rate for official transactions (the interbank rate) recognised by the country's financial and monetary rules (that rate being used for BWI aid to the central bank). However, the Commission will see that it specifies the exchange rate to be used in future financing agreements.

Box 3 Controls on the constitution of counterpart funds

1. The Commission believes it justified not to use preferential rates and to align itself on the formula used by the central bank for converting its foreign-exchange holdings (interbank rate).

2. In Mozambique the amount of the counterpart funds results from the formula applied by the central bank. The administrative costs highlighted by the Court of Auditors are no longer applied to direct budget aid to Mozambique.

Use of technical assistance

22. Under the Lomé Convention, technical assistance, including its terms of reference and the choice of consultants, is the responsibility of the national authorising officer: the Commission is therefore dependent on the government for the use made of it.

23. Recent programmes adopted by the Commission have tried to resolve the issue of technical assistance by according countries greater flexibility in the use of funds for capacity-building. In the event of such assistance not being used, these programmes provide for the resources concerned to be reincorporated into the budget support.

24. The Commission believes that it makes sense to use its various instruments in a coherent manner and to make use of any existing skills. Quite apart from the fact that it is not covered by the Lomé Convention, the breakdown between local and expatriate technical assistance depends on local skills and governments' choices.

25. In the case of technical assistance paid for using counterpart funds (Benin, Ghana, Malawi), contracts have always been closely supervised by the delegations, which have consulted headquarters whenever necessary.

Auditing

26. With regard to the audits carried out by the Commission, the Zambian audit began on 14 May this year. The delay was wholly due to a shortage of resources in the Commission's audit department.

29. It should be stressed that the Commission is the only donor to have conducted audits covering government budgets in the course of its budget support programmes. Box 4 confirms the impact and relevance of the Commission's audits.

30. The overall audit of budget support to Malawi took place in November last year; the audit of support for Zambia has just begun. Only Mozambique has yet to be audited. The implementation of these audits is constrained by the understaffing of the department concerned.

Response to table 5: The audit in Mauritania confirmed the ineligibility of certain expenditure already rejected by the Commission and therefore required neither a protocol of agreement nor the repayment of funds.

33. Where audits have revealed shortcomings in governments' budget management, the Commission has taken a number of measures: (1) repayment to the joint-signature account for counterpart funds. This repayment is, however, much more than a mere transfer between two government accounts, since the joint-signature account, which is generally held at the central bank, cannot be used by the government. These joint-signature accounts are not usually included by the IMF in the government's net position and automatically limit the government's cash-flow. Where they are taken into account, they enable the government to borrow either from the banking sectors or the central bank. As for possible repayments to the EDF, this does not apply because counterpart funds are not EDF resources (see point 4) but own resources of the beneficiary country; (2) the drafting of an action plan to limit the risks of new shortcomings; (3) the identification of institutional support needs; (4) in many cases, the reduction or cancellation of programmes.

34. The acceptance of invoices eligible for European financing is quite above board as long as it is accompanied by broader measures to improve the quality of budgets (see also response to points 55 and 56).

Box 5 Substitution of qualifying expenditure for ineligible expenditure

1. In Côte d'Ivoire, of the planned allocations of repaid funds, only election support, the refinancing of treasury bonds and certain emergency health spending have actually been implemented, primarily owing to the suspension of cooperation with the country on political grounds. As for the concern to release funds quickly, this can only be explained in the context of the quite exceptional financial and institutional situation prevailing in the country in the period April-September last year.

2. In Gabon the acceptance of eligible invoices for European financing is quite above board: a wide-ranging audit of public finances and the government's internal arrears permitted major reforms, in agreement with the IMF. The support programmes of the BWI and the Commission were suspended pending the conclusion of the audits and signing of a new agreement with the IMF (October last year).

The Commission's administrative organisation

35. The instructions concerning counterpart funds were updated by a Commission communication and a Council resolution in 1996 and by a new DG VIII manual of procedures in 1998. It is, however, clear, in view of this Court of Auditors report and the guidelines it lays down and the implementation of the Cotonou Agreement, that new instructions are being drafted, especially concerning the abandonment of the term "counterpart funds", the abandonment of targeting and the assessment of the quality of budget management.

36. The Commission reiterates the commitment it gave in the 1998 discharge to set up an effective archiving system, something on which it is actively working. Indeed, a filing and monitoring system has been set up by the unit responsible for macroeconomic support.

37. Supervision by headquarters services has normally focused on monitoring the overall programme and compliance with programmes' conditions. Supervision of disbursements of counterpart funds according to the rules agreed in the protocols of agreement has been exercised by the delegations under the supervision of headquarters. The consultant recruited carried out an in-depth study, including qualitative judgments (based on a questionnaire sent to all the delegations concerned), something that officials could not have done in good time.

38. The shortage of human resources means that the Commission is constantly having to prioritise its activities. In any case, the issue of the resources needed to supervise the quality of public finances can only be resolved by an overall approach and a division of responsibilities involving the other donors.

39. The macroeconomic unit is not alone in monitoring the sectoral impact of aid (this is monitored by the delegations and by the units responsible for the sectors concerned: roads, agriculture, social sectors). In order, however, to separate, in macroeconomic programmes, the assessment of purely macroeconomic aspects from that of the effectiveness of the policies carried out to reduce poverty, recent Commission programmes distinguish purely macroeconomic tranches from variable tranches linked to performance indicators in the social sectors (a proposal that came out of the test on the reform of conditionality).

THE CHALLENGES OF BUDGET AID

Public finance management

40. As the Court of Auditors notes in point 11, the IMF exercise supervision over the entirety of public finances. The Court of Auditors also noted the developments in the Commission's approach to audit (points 26 to 29). At present the shortcomings in the management of public finances, highlighted in particular by the Commission's audits, need to be assessed and monitored by means of a coordinated approach involving entire donor community, not just the Commission.

42. The description by the Court of Auditors of the challenges of budget management illustrates the scale of the problems encountered in the developing countries. The Commission's step-by-step approach is warranted and consistent with the Lomé Convention/Cotonou Agreement.

46. The computerised system set up by Burkina Faso to track expenditure is one of the best in Africa. As in many other countries, it requires further development to track devolved expenditure.

Impact of expenditure on social sectors

47. The Commission led the way in addressing the question of the assessment of the quality of public services, introducing performance indicators in its structural adjustment programmes in 1999.

48. Until the Commission involved all donors in a review of conditionality in the SPA context, donors operated on the assumption that the sectoral and budget reforms required of countries would automatically increase provision of public services. The test carried out in Burkina Faso, in which the Commission coordinated the activities of 12 donors, showed that this was not the case and was followed by proposals for a radical change in methods with a greater emphasis on performance indicators. This complex shift, which the Commission alone has made so far, is beginning to bear fruit. It took two years of discussions in the SPA for this mandate to be conferred on the Commission.

50. The unit responsible for structural adjustment is involved in the sectoral approach both at the level of the SPA (analysis and monitoring of sectoral programmes) and within the Commission, where it jointly chairs a working party producing guidelines in the matter. Implementation has remained in the hands of sectoral units as recommended by the court, with an effort to ensure a coherent approach.

Redirecting the monitoring and control of budget support

52. The absence of cash-flow problems (the result of countries' efforts and external aid) is the main argument for ending targeting of budget aid and making funds totally fungible. With or without targeting, the donors must pay more attention to the sound management of public finances.

53. Along with the use of performance indicators, the Commission monitors the application of measures negotiated with governments in the wake of audits. These measures are far more numerous and detailed, including in qualitative terms, than the indicators chosen as conditions for budget aid. The Court of Auditors is undoubtedly aware of the difficulty of finding universally relevant and usable indicators, but the Commission has tried to do so in recent programmes.

Wherever possible - financing proposal following the negotiation of an action plan - account has been taken of this in new aid (Cameroon).

In the case of Senegal, the list of indicators was confirmed in December last year.

54. The new programmes consist of a tranche directly linked to economic performance and another, variable tranche linked to performance indicators. The relative size of these tranches varies according to the countries concerned, their financial situation and the level at which indicators are set. This innovative approach is currently the object of an outside study aimed at optimising the approaches used. It is an established principle that poor performance will le