Bilateral creditors and IFIs created the HIPC Initiative in 1996 to address concerns that certain poor countries had accumulated unsustainable debt burdens, despite receiving debt relief from bilateral creditors. In response to concerns over the continuing vulnerability of poor countries, the World Bank and IMF enhanced the initiative in 1999 by reducing the qualifying thresholds and increasing the number of potentially eligible countries. Countries must meet numerous criteria in order to qualify for HIPC Initiative debt relief, such as establishing a track record of reform and sound policies. To fully benefit from HIPC debt relief, countries must progress through different phases of the initiative (see fig. 1). At a country’s “decision point,” IDA and IMF use certain criteria to determine whether a country qualifies to receive HIPC Initiative debt relief. If a country is determined to qualify, it can begin to receive interim HIPC debt relief. Subsequently, at the “completion point,” IDA and IMF determine whether the country meets additional criteria and can receive full and irrevocable HIPC debt relief. As of November 2008, of the 41 countries that may benefit from debt relief efforts, 23 had reached the completion point and 11 more had reached the decision point. An additional seven countries are considered “pre-decision point” countries and have not yet qualified for debt relief. MDRI expands upon the HIPC Initiative and represents the most recent effort to provide debt relief to heavily indebted poor countries. To receive MDRI debt relief, countries must first complete the HIPC Initiative. In addition, IMF has determined that it will provide MDRI debt relief to member countries with debt outstanding to IMF and a per capita income at or below $380 at end-2004 that do not otherwise qualify for debt relief. While the HIPC Initiative provides for a reduction in the debt levels of eligible countries, the process associated with MDRI debt relief requires IDA and ADF to take additional actions that provide resources to poor countries beyond those countries benefiting from debt relief. We estimate that IDA, IMF, ADF, and IaDB will provide, in present value dollars, about $58 billion in debt relief (in end-2008 present value dollars) under the HIPC and MDRI Initiatives to 41 countries over the next several decades. The amount of total debt relief provided under each initiative will be about equal, with over $28 billion provided under the HIPC Initiative and about $30 billion provided under MDRI. IDA is to provide the greatest level of debt relief at $34 billion (almost 60 percent of the total). IMF is to provide $10.6 billion, while ADF and IaDB are to provide $9.1 billion and $4.1 billion, respectively. Table 1 provides data on the amount of funding each institution will provide for each program. For the 33 countries currently receiving debt relief under both programs, IDA has secured about $8.6 billion for the HIPC Initiative and $4.4 billion for MDRI (for more detailed information, see app. III). This total of $13.1 billion represents 47 percent of the total required IDA financing of almost $27.8 billion for these countries under both debt relief initiatives. ADF will provide about $7.5 billion in HIPC Initiative and MDRI debt relief and has secured about $5.7 billion, about 76 percent of this amount. IMF and IaDB have fully financed their $8 billion and $3.8 billion of HIPC Initiative and MDRI debt relief for the countries currently receiving such relief, respectively, using internal resources and donor-provided funds. Because these two institutions have fully funded their HIPC Initiative and MDRI debt relief, almost 65 percent of total debt relief costs for all four IFIs has been secured. Based on our projections, the United States has committed to provide a total of about $8.4 billion to the four IFIs to finance the total costs of their HIPC Initiative and MDRI debt relief (see table 2). We estimate that the U.S. government is to provide $6.2 billion, or 74 percent, of its debt relief financing to IDA and $1.3 billion, or 16 percent, to ADF. The U.S. government has already provided $0.5 billion to IDA and $0.9 billion to ADF, leaving the majority of these costs ($5.7 billion for IDA and $0.4 billion for ADF) to be paid in the future. The U.S. government has provided $0.8 billion to IMF and $0.1 billion to IaDB. Of the $2.3 billion that the United States has already provided, $2.0 billion was for the HIPC Initiative and $0.3 billion was for MDRI. (App. IV provides information on bilateral debt relief that the United States has provided to countries under the HIPC Initiative.) Treasury, IDA, and ADF have agreed to a financing approach for MDRI called early encashment, under which the U.S. government earns income for early replenishment payments to IDA and ADF. Since the U.S. government is currently in arrears on its replenishment payments to IDA14, early encashment does not fully fund the current U.S. MDRI commitment. We also estimate that U.S. early encashment income will be insufficient to fully finance future MDRI debt relief. Furthermore, the U.S. financing approach is more costly than other options. The U.S. government currently uses an early encashment approach to fund U.S. MDRI obligations at both IDA and ADF. Early encashment income is earned by IDA and ADF when the United States allows the IFI to draw funds on, or encash, its replenishment commitment early, rather than according to a standard encashment schedule that spans 9 years for IDA and 10 years for ADF. The standard encashment schedule represents the IFI’s expected disbursement pattern of the funds committed during the 3- year replenishment period. Treasury has agreed to allow IDA and ADF to encash the U.S. replenishment commitment over an accelerated 4-year period. Since the early encashments exceed amounts required during the first 4 years under the regular 9-year or 10-year encashment schedule, IDA and ADF can invest these funds and earn income (see app. V). IDA and ADF guarantee fixed discount rates that determine the amount of income countries using the early encashment approach will receive for full and timely encashments according to the accelerated schedule, regardless of IDA’s and ADF’s actual earnings on early encashments over the period. These amounts are then credited to the U.S. government and can be used toward paying the U.S. MDRI commitment. Treasury has separate agreements with IDA and ADF regarding the methodology used to estimate the amount of early encashment income that the United States will earn. The World Bank requires that the U.S. IDA14 replenishment be paid in full before early encashment income can be earned and used to fund MDRI; however, the United States is currently in arrears on its replenishment commitment. In recent years, Congress has withheld a portion of the U.S. replenishment contribution to encourage the World Bank to undertake specified reforms such as strengthened efforts to enhance transparency and combat corruption. In fiscal year 2006, Congress required that 20 percent of the funds appropriated to IDA be withheld from disbursement until the Secretary of the Treasury reported to Congress that the World Bank had undertaken certain anticorruption reforms. In fiscal year 2006, most of these funds were eventually disbursed pursuant to the requirements in the law; however, there was a shortfall in fiscal year 2006 of approximately $41 million due to both the anti-corruption withholding provision and an across-the-board rescission. In fiscal year 2007 there was an additional rescission of about $9.5 million. In fiscal year 2008, Congress rescinded $7.7 million and required that 10 percent, or $94 million, of IDA funds be withheld until Treasury reported that the World Bank had undertaken anticorruption reforms, and that another 10 percent be withheld until Treasury reported that the World Bank had enacted certain transparency reforms. As of July 2008, Treasury had reported to Congress that the World Bank had enacted anti-corruption reforms called for in the fiscal year 2008 appropriations law and had disbursed the corresponding funds. However, Treasury still had not reported to Congress that the World Bank had accomplished all of the 2008 transparency reforms and continued to withhold funds. Treasury has complied with its legal obligation to withhold these funds that have created arrears. When funds are rescinded or withheld from IDA, the shortfall amounts become arrears of the United States that remain until the appropriated funds are released from Treasury. We estimate that the U.S. government has arrears to the IDA14 replenishment of about $152 million, since the U.S. nominal contribution of $2,698 million is less than the U.S. commitment of $2,850 million. Because the United States is currently in arrears on its IDA14 replenishment commitment, the early encashment income the United States earns does not fully finance the current U.S. MDRI commitment. Under the early encashment process, the World Bank first uses early encashment income to fund the present value of the shortfall in the U.S. IDA replenishment before applying early encashment income to the U.S. MDRI commitment. As such, the present value of the U.S. replenishment to IDA14 will be fully funded before the MDRI obligation begins to be paid. As shown in figure 2, based on current U.S. payments, we estimate that the United States will generate sufficient early encashment income to fully fund the U.S. IDA14 replenishment commitment in present value dollars, with $83 million in encashment income applied toward the $232 million U.S. MDRI commitment. After applying its earned encashment income of $83 million, the United States will have a shortfall of $149 million in its MDRI commitment. Treasury officials noted that if the United States ultimately pays its arrears to the IDA14 replenishment, early encashment income will then fund the U.S. MDRI commitment. However, to fully fund the U.S. MDRI commitment, (1) Treasury will need to release a withholding of $94 million from the IDA14 replenishment, by reporting to Congress that the World Bank has accomplished transparency reforms required under U.S. law, and (2) Congress will need to appropriate approximately $49 million in funds to compensate for the rescissions. Both actions will need to be completed by June 30, 2009. We estimate that the additional encashment income generated from releasing the $94 million will amount to $97 million and the shortfall in the U.S. MDRI commitment will decrease from $149 million to $52 million. A congressional appropriation of approximately $49 million by June 30, 2009 would generate enough early encashment income to finance the remaining $52 million U.S. MDRI commitment. Although it is unknown whether there will be any future shortfalls in U.S. replenishment payments, we assessed the impact of a shortfall on U.S. financing of MDRI similar to those that have occurred in recent years. The U.S. replenishment obligation for IDA for 2009 through 2011 is $3.7 billion, which includes $375 million for IDA’s HIPC Initiative costs. In addition, the United States has agreed to pay $356 million for its MDRI commitment, which Treasury plans to finance using early encashment. We assumed a 5 percent across-the-board shortfall, slightly less than the current 5.3 percent shortfall during the 2006 through 2008 period. (See app. V for further information on this simulation.) Under this scenario, the U.S. government would make payments of $3.52 billion, leaving a shortfall of $185 million. U.S. early payments would generate investment income of $308 million. After first financing the replenishment shortfall, the remaining early encashment income of $146 million would be used to pay the U.S. MDRI commitment of $356 million, leaving a MDRI shortfall of $210 million. ADF and Treasury have agreed to a different approach to calculate early encashment income that does not prioritize paying replenishment shortfalls before funding MDRI. All encashment income is solely used to pay the U.S. MDRI commitment. Excess encashment income is used to pay future U.S. MDRI commitments when needed. Any arrears or shortfalls in U.S. replenishment payments reduce encashment income proportionately. None of the early encashment income is used to offset regular replenishment shortfalls. The approach of funding the U.S. share of MDRI through early encashment income will not generate sufficient funding to meet the future U.S. commitment under the projected growth rate for future IDA replenishments. As we reported in our July 2008 correspondence, even if the United States pays its replenishments on time and in full, early encashment credits will be insufficient to finance U.S. MDRI obligations by 2014 for IDA and ADF. Table 3 shows the relationship between the U.S. replenishments and the use of early encashment to finance U.S. obligations to MDRI under the World Bank’s projected average 7 percent growth rate for IDA replenishments. The first row in table 3 shows the U.S. MDRI commitment from 2006 through 2023 in nominal dollars. Under this scenario, even if the U.S. government pays the replenishments on time and in full, there will be funding shortfalls for each replenishment period that will increase over time. We found that the U.S. government would need to increase its future replenishments to IDA by an average of 31 percent over the next 15 years, in order to fully fund its MDRI obligation using early encashment. Treasury’s use of an early encashment approach to finance the U.S. share of MDRI debt relief has been more costly than paying U.S. MDRI costs directly because U.S. costs to borrow funds have been greater than the agreed-upon encashment interest rate for IDA and ADF. We estimate that during the replenishment period from 2009 through 2011, early encashment will cost the United States an additional $39 million, $41 million more for IDA and $2 million less for ADF. (See app. VI for more information on this cost differential.) In September 2008, the Congressional Budget Office (CBO) forecasted Treasury note borrowing interest rates. For the 4-year period from fiscal year 2009 through fiscal year 2012, CBO projected the average borrowing cost to the U.S. government to be 5 percent. This interest rate is greater than the 4 percent interest rate used by IDA and the 4.69 percent used by ADF to calculate early encashment credits. We estimate that 41 countries are to receive nearly $44 billion in additional MDRI and HIPC resources from the four IFIs, but the degree to which the countries target these resources at poverty-reducing activities is unknown. The $44 billion consists of freed-up resources resulting from HIPC Initiative and MDRI debt relief, as well as a MDRI-related reduction and subsequent reallocation of IDA and ADF assistance. The estimated amount by which IFI assistance will increase or decrease as a result of MDRI resource reallocation varies by country. The World Bank and IMF encourage countries to spend debt relief resources on activities to reduce poverty and make progress toward the UN Millennium Development Goals (MDG). Although the World Bank and IMF have suggested an association between reduced debt service payments and increased poverty-reducing expenditures, the extent to which countries spend debt relief resources on poverty-reducing activities is unknown. It is difficult to establish that debt relief has led directly to increased poverty-reducing expenditures for two reasons: (1) debt relief resources are difficult to track and (2) country spending data are not comparable and also may not be reliable. Overall, we project that the 41 countries receiving debt relief are to receive $43.8 billion in additional resources from the four IFIs between 2000 and 2054. As shown in figure 3, this estimate is based on three projected amounts: $21.4 billion in HIPC debt relief, $28.3 billion in MDRI debt relief (IFIs will provide about 95 percent of MDRI debt relief by 2034), and $5.9 billion in reduced new IDA and ADF assistance resulting from MDRI’s two-step process. Under this process, IDA and ADF reduce their new assistance to MDRI debt relief recipients by the amount of debt relief provided, $18.9 billion, and reallocate $13.0 billion of this reduction to MDRI recipients. IDA and ADF then reallocate the remaining approximately $5.9 billion to all low-income countries eligible to receive only concessional resources from IDA or ADF that did not receive debt relief. IDA and ADF determine the amount of funding each country is to receive primarily on the basis of country performance. Based on our projections, individual countries will have different results from MDRI as they realize increases, decreases, or both in their annual IDA and ADF assistance due to the resource reallocation process. For example, while the overall net change in resources available due to MDRI is positive for each of the five countries we analyzed (Ethiopia, Ghana, Tanzania, Nicaragua, and Rwanda), the countries are projected to receive different amounts of new IDA and ADF assistance. Table 4 illustrates the overall projected impact of MDRI, including the net change in IDA and ADF assistance, for our five case study countries. We project that, even as MDRI debt relief frees up fiscal resources, Ghana and Nicaragua may experience a decrease in IFI assistance over the life of MDRI due to the MDRI netting out and reallocation process. In contrast, for Tanzania and Ethiopia, we project that this MDRI process may result in an increase in assistance from IDA and ADF. For Rwanda, MDRI may provide a mixture of increases and reductions in IDA and ADF’s annual assistance over the MDRI period. (See app. VII for additional information on the impact of MDRI for our five case study countries, and app. VIII for additional information regarding the mechanics of the MDRI process.) While IFI and U.S. government documents state that countries should spend savings from debt relief on activities to reduce poverty and make progress toward the MDGs, the extent to which countries do so is unknown. In 2008, the World Bank and IMF suggested an association between reduced debt service payments and increased poverty-reducing expenditures, while acknowledging that it is difficult to show causation. Specifically, these IFIs reported that since the late 1990s, the debt service payments of countries that received debt relief have declined by about 2 percent of GDP, while poverty-reducing expenditures have increased by about the same amount. However, it is difficult to establish that debt relief has led directly to increased poverty-reducing expenditures for two reasons: (1) debt relief resources are difficult to track, and (2) country spending data are not comparable and also may not be reliable. The IFIs have suggested an association between debt relief and increased poverty-reducing expenditures. However, IMF and World Bank officials told us that they are unable to link debt relief resources directly to poverty-reducing expenditures because it is difficult to separate debt relief resources from other types of financial flows, such as international assistance and fiscal revenue. Based on the five case study countries, we found that these other resources often represent a much larger percentage of country budgets than savings from debt relief. For example, in the 2007 budgets of Ethiopia and Ghana, tax revenue and grant assistance represented at least 67 percent of government revenue combined, while HIPC Initiative and MDRI debt relief resources represented less than 8 percent (see fig. 4). Although IMF and the World Bank publish aggregated poverty-reducing expenditures for all countries that received debt relief, individual countries can define and report such expenditures differently, resulting in data that are not comparable. We found that definitions of poverty- reducing expenditures vary. For most countries that receive debt relief, reported poverty-reducing expenditures include spending on primary education, basic health care, and rural development; however, countries can also choose to include additional categories. For example, as shown in figure 5, some countries consider expenditures in areas such as energy development, transport, or judicial systems as poverty reducing, while other countries do not. Country definitions of poverty-reducing expenditures can also change over time to include or exclude categories. For example, in 2005, Rwanda expanded its definition of poverty-reducing expenditures to include energy development, while Nicaragua no longer included institutional strengthening. Such differences in definitions between countries, as well as changing definitions for particular countries, complicate comparability across countries and over time. In addition, we found that three of our five case study countries report aggregate spending in broad areas such as education, health and rural development rather than providing a detailed breakdown of poverty- reducing expenditures in these areas. For example, as shown above, while two countries (Ghana and Rwanda) reported specific spending in primary education and public health in their country budget documents, three countries (Ethiopia, Nicaragua, and Tanzania) reported only on aggregate spending in these two areas. Aggregate spending data can include activities that do not directly affect the poor and may overestimate actual poverty-reducing expenditures. For example, a 2003 IMF and World Bank Poverty and Social Impact Analysis for Nicaragua found that almost no public spending on university education affects the extremely poor, who generally do not participate at that level of the educational system. Furthermore, country capacity to collect and report on poverty-reducing expenditures is questionable. According to several IFI assessments, countries receiving debt relief have numerous weaknesses in collecting and reporting information on poverty-reducing expenditures that raise doubts about the data’s reliability. For example, a 2005 IMF assessment of country capacity to track poverty-reducing expenditures found that 19 out of 26 countries needed substantial upgrades to their data management systems and had weaknesses in tracking budgetary expenditures in areas such as budget formulation, execution and reporting. IMF and the World Bank do not independently track poverty-reducing expenditures, and instead rely on country governments to provide such data even though the accuracy of these data and country capacity to provide such information are uncertain. Additionally, the 2005 IMF assessment found that while 20 countries define poverty-reducing spending in their PRSPs, not all countries could identify these areas of expenditures in their budgets or report on such spending. Limitations in country capacity to report on poverty-reducing spending raise further concerns about the reliability of the combined data published by IMF and the World Bank. Moreover, while it is difficult to establish that debt relief has led directly to increased poverty-reducing expenditures, it is even more difficult to determine if debt relief has improved progress toward the MDGs. We found that for all five of our case study countries, progress data on the MDG targets were often either lacking or incomplete. In 2008, IMF and the World Bank reported that it is difficult to quantify the impact of debt relief on the MDGs and that they have instead focused their analysis on linking debt relief and poverty-reducing expenditures. The World Bank and IMF have improved their country debt sustainability analyses (DSA) since 2005, including by addressing weaknesses that GAO and others have previously identified. If countries do not realize the objectives outlined in the new DSAs, they once again may experience unsustainable debt levels. These objectives are ambitious and could prove difficult for these poor countries to achieve over the course of the 20-year projection period. The World Bank and IMF introduced the Debt Sustainability Framework (DSF) in 2005 to provide a new and improved approach to assessing debt sustainability in low-income countries. The DSF is intended to help guide financing for low-income countries’ development needs, while also reducing the chances of another excessive build-up of debt in the future; help detect potential problems early so that preventative action can be improve World Bank and IMF assessments and policy advice; and provide guidance for country borrowing and creditor lending decisions. Under the DSF, IMF and World Bank staff prepare DSAs, which project debt sustainability indicators over a 20-year period and are conducted roughly every 12 to 18 months for low-income countries. These DSAs include elements that were lacking in the past and address weaknesses that had previously been identified by GAO, such as overly-optimistic economic assumptions. Furthermore, DSAs now result in a linkage between debt sustainability and the composition of future IFI assistance (grants and concessional loans), thus addressing a previous GAO assessment that IFIs should provide grants as a way of addressing future debt concerns. In a departure from prior DSAs, the new DSAs consider the strength of a country’s policies and institutions in assessing risk and determining sustainable debt loads; countries with strong policies and institutions are considered capable of successfully carrying greater levels of debt. The DSF uses the World Bank’s CPIA index to sort countries into three policy performance categories (strong, medium, or poor). Countries with strong policies and institutions have a higher CPIA rating. An acceptable risk of debt distress for current strong performers, such as Tanzania, allows for higher levels of debt compared to countries with currently low CPIA ratings, such as Sierra Leone. Furthermore, performance categories are updated annually according to the latest CPIA ratings and, therefore, certain countries’ annual performance categories have varied since the new process was introduced in 2005. For example, Burkina Faso’s 2007 DSA noted that the country was a strong performer, but the country’s CPIA rating was subsequently lowered and the 2008 DSA identified Burkina Faso as a medium performer. As a result, DSAs for Burkina Faso now require lower levels of debt in order to be categorized as debt sustainable. The new process provides flexibility to assess every country’s risk differently based on individual performance, as well as an ability to adjust risk assessments within a specific country’s DSA over time as CPIA ratings shift. Currently, of the 23 countries receiving HIPC Initiative and MDRI debt relief, a majority (14) have been identified as medium performers, 5 as poor performers, and 4 as strong performers. DSAs conducted under the DSF now consider debt burden “threshold” indicators when assessing a country’s debt sustainability position. Five thresholds have been established that provide key insights into a country’s debt situation and that vary according to a country’s CPIA-based performance category (see table 5). Other DSAs, on the other hand, assess primarily only one variable. Strong performers have higher thresholds, indicating an ability to carry higher debt levels while maintaining debt sustainability. In order to project a country’s risk of future debt distress, these threshold indicators are compared against a country’s performance under a “baseline” scenario based on assumptions of macroeconomic performance expected for the future in areas such as national income, inflation, exports, imports, and government revenues and expenditures. Various sensitivity scenarios are also used to test the robustness of the indicators to changes in key assumptions. These scenarios include the following: (1) numerous temporary standardized “stress” or “shock” scenarios that consider possibilities such as lower growth in national income or exports than experienced in the past; and (2) two additional scenarios: (a) a scenario that assumes a level of public loans on terms that are less concessional, and (b) a historical scenario that uses macroeconomic assumptions based on past performance (which has often, but not always, been less optimistic than the baseline scenario in the past). IMF and World Bank staff explained that baseline assumptions will diverge from the historical scenario if the institutions agree that the economic outlook of a country has changed. Such changes must be explained in the DSA. For example, in the case of Tanzania’s 2007 DSA, a baseline GDP growth rate of 7.6 percent was used, rather than the historical 5.3 percent growth rate. According to the DSA, this change reflected “strong overall ratings of Tanzania’s macroeconomic policies, as well as ongoing structural reforms in key areas.” A country’s risk of future debt distress is then categorized as follows: Low risk – All scenario debt burden indicators are well below the thresholds throughout the 20-year projection period, and sensitivity testing does not result in significant breaches of thresholds; Moderate risk – Debt burden indicators are below the thresholds under the baseline scenario, but sensitivity testing causes them to exceed thresholds; High risk – Debt burden indicators exceed thresholds under the baseline scenario, and sensitivity testing further exacerbates the situation; or In debt distress – Debt burden indicators are currently in significant or sustained breach of thresholds, and the country is already experiencing repayment difficulties. As shown in table 6, for the 23 countries receiving HIPC Initiative and MDRI debt relief, 9 are classified at “moderate” risk of future debt distress, 4 at “high” risk, and 10 at “low” risk. IFI officials have considered refinements to the “moderate” risk classification that would provide greater distinctions within risk assessments, but have determined that there is currently no need to revise the category. New DSA assessments of country debt sustainability under multiple scenarios address past concerns that DSAs only used one scenario, which may have contained overly-optimistic economic assumptions. For example, we reported in 1998, 2000, and 2004 that expected debt sustainability for debt relief countries was calculated based on one scenario that assumed high economic growth, including strong and sustained export growth. We noted that such growth could be unrealistic given that many countries had very narrow export diversity (i.e., a limited number of exported goods), and these exports tended to be concentrated in the area of commodities that are highly vulnerable to events outside a country’s control, such as drought or price fluctuations. IMF officials told us that current DSAs use assumptions that have been lowered to more realistic levels. They also stated that DSAs, which include descriptions of macroeconomic assumptions, are now transparent because they are publicly available and subject to scrutiny by outside parties. In addition, IMF officials noted that because DSAs are conducted on an annual basis, DSAs can now begin to incorporate events such as increases in food or fuel prices in a timelier manner. However, IMF officials also noted that the current approach for determining future macroeconomic performance assumptions is “not a perfect science,” particularly when it makes projections over a 20-year period, and cannot be executed without potential forecast errors. In addition, a debt management capacity building group concluded that the sensitivity analyses contained in DSAs do not alter all relevant variables and exclude additional or secondary effects. It also reported that DSAs do not necessarily reflect all the risks that a country may think are likely in its own economic or borrowing prospects. IDA and ADF have adopted a revised system for providing future assistance based on DSA results. According to IDA officials, countries with a high risk of debt distress, or countries that are already in debt distress, receive 100 percent grant assistance, countries with a moderate risk of debt distress receive 50 percent grants and 50 percent concessional loans, and countries with a low risk of debt distress receive only concessional loans. ADF officials told us that ADF has adopted a similar system. According to World Bank officials, when a country’s risk of future debt distress changes, the change is reflected in IDA allocations annually. This approach directly aligns IDA and ADF assistance with a country’s assessed ability to repay debt, and is relevant to our past reporting that the increased use of grant assistance would have a positive impact on future debt sustainability. However, IDA and ADF reduce the volume of grant assistance provided under this system. Specifically, IDA and ADF reduce grant assistance by 20 percent for countries classified at a high or moderate risk of debt distress, thereby reducing resources available for poverty reduction. The 20 percent volume reduction is divided into an “incentives”-related portion and a “charges”-related portion. The incentives-related portion is reallocated to IDA-only countries based on performance, and the charges-related portion is provided to creditworthy blend countries. According to IDA, this grant reduction was instated to maintain IDA’s performance incentive. Other IFIs, such as IaDB and the Asian Development Bank, are also utilizing the new DSAs as part of their lending decision-making process, according to IMF and World Bank officials. In addition, OECD export credit agencies adopted a set of lending principles that adhere to IDA and IMF concessionality in January 2008. Conversely, regarding borrowing decisions, IDA, ADF, and IMF officials stated that they work with country governments to improve their understanding and use of DSAs in future borrowing decisions. For example, IMF officials noted that DSAs are discussed as part of regular economic consultations with countries. Furthermore, according to an IMF and World Bank report, since 2005 eight training workshops have been organized in Africa, Asia, and Latin America and attended by officials from all 23 countries receiving HIPC Initiative and MDRI debt relief. However, IMF officials pointed out that countries currently range widely in terms of their ability to use the DSA process to conduct their own analyses, and some country officials have said that they find the DSA process to be overly complicated. The new DSAs have cited many actions that countries receiving HIPC Initiative and MDRI debt relief should take in order to avoid unsustainable debt burdens in the future. Of the 23 countries receiving HIPC Initiative and MDRI debt relief, 13 (over 50 percent) have been found to have a moderate or high risk of future debt distress. These countries maintain this level of risk despite substantial HIPC Initiative and MDRI debt relief. DSAs have stressed numerous policies or growth scenarios that countries should achieve in order to avoid further eroding their debt sustainability. For example, DSAs note that projected debt sustainability could be eroded if countries do not realize broad objectives that affect their overall economy, such as the following: continued concessional borrowing, implementation of sound macroeconomic policies, strengthened debt management capacity, sustained national income or export growth, and increased export diversity. Such broad and ambitious objectives could prove difficult for countries to achieve over the course of the 20-year DSA period for various reasons. A country’s debt position may be at risk even after it receives significant debt relief if, for example, its economy remains overly dependent on one export. For instance, Burkina Faso still held a moderate debt risk in 2007 despite World Bank and IMF reports that the HIPC Initiative and MDRI had substantially reduced its debt burden, because its economy is highly dependent on cotton exports (60 percent of total export value in 2006) which are vulnerable to large price fluctuations and weather shocks such as drought. In 2008, Burkina Faso’s debt risk was elevated to high due to deteriorating country performance. Other unexpected factors beyond a country’s control, such as oil and food import prices, may also affect economic position and debt sustainability. IMF and the World Bank have projected that countries may eventually return to pre-MDRI debt positions as they accumulate new debt over time. Continued concessional borrowing is cited frequently as an action countries must take to maintain debt sustainability. IFIs have taken actions to address the issue of excessive nonconcessional borrowing. While IFIs aim to lower the risk of debt distress in low-income countries by providing new financial assistance on appropriately concessional terms, other creditors and borrowing governments may gain from nonconcessional lending that is made possible following large-scale debt relief or in conjunction with IFI grant assistance. According to the World Bank, rating agencies may upgrade commercial risk ratings for countries that have received MDRI debt relief, improving the countries’ ability to secure nonconcessional loans. The risk of realizing an unsustainable nonconcessional debt burden is particularly high in resource-rich countries that can more easily obtain nonconcessional borrowing by using expected future export earnings as collateral to back such loans. In addition, IDA has noted that countries are experiencing significant risks associated with their weak debt management capacity. Debt management offices in low-income countries lack adequate capacity to monitor and accurately record debt data and new resource flows, let alone effectively manage them. IDA established a nonconcessional borrowing policy in 2006 to prevent the rapid reaccumulation of unsustainable debt. This policy states that IDA has two instruments at its disposal to confront excessive nonconcessional borrowing— reducing its assistance volumes (primarily used in countries where debt sustainability is a major concern) and “hardening” its lending terms in countries with stronger debt sustainability and greater financial market access. According to IDA staff, hardened lending terms could include an increased interest rate, a shorter grace period, or a reduced repayment period. IDA has also reported that these options come with trade-offs as volume cuts reduce resources available to pursue poverty reduction, and hardened terms may exacerbate debt sustainability problems. As of June 2008, IDA reported that there had been two cases of hardened lending terms (Angola and Ghana) and, as allowed, one exception (Mali) granted under its nonconcessional borrowing policy. IMF can impose limits on nonconcessional loans for countries that have a current arrangement with the institution. For countries that do not have a loan arrangement with IMF, there is nothing IMF officials can do when countries borrow on a nonconcessional basis beyond consulting with borrowing country officials. While HIPC Initiative and MDRI debt relief are projected to provide countries with additional resources, it is unknown how much of these additional resources countries will spend on poverty-reducing expenditures or pursuit of the MDGs. Furthermore, some countries may have difficulty maintaining debt sustainability, which requires demonstrating strong and sustained performance in numerous critical areas such as national income and export growth over the next several decades. The current U.S. approach for financing MDRI has several limitations. First, if the U.S. government does not fully pay its regular contributions to IDA on time, which is currently the case primarily due to withholdings, early encashment funding will be used to cover shortfalls in U.S. funding to IDA, rather than to solely fund debt relief. Second, according to our estimates, the U.S. financing approach will likely result in future shortfalls for funding MDRI for both IDA and ADF as early as 2014, even if the U.S. government provides full funding in a timely manner. Given these limitations, reassessing the options for funding U.S. MDRI commitments for IDA and ADF is critical. To address limitations in the U.S. approach for financing MDRI, we recommend that the Secretary of the Treasury consider the use of different funding options that clarify the priority between paying U.S. arrears owed to IDA and paying MDRI obligations, such as requesting separate appropriations from Congress. The Department of the Treasury, the World Bank, and IMF provided written comments on a draft of this report, which are reprinted in appendixes IX, X, and XI. Treasury stated that it is open to our recommendation that alternative U.S. funding approaches for MDRI be considered in the future. Treasury emphasized its objective to fully meet its current IDA and MDRI funding commitments while also noting that a lack of full funding would jeopardize this objective. In addition, Treasury expressed a view that World Bank and IMF analyses produced under the Debt Sustainability Framework represent an improved ability to assess the debt sustainability outlook in low-income countries. Treasury explained that while debt relief can be a valuable tool, merely canceling debt is not sufficient to ensure long-term debt sustainability if underlying economic vulnerabilities remain. The World Bank stressed the importance of full funding for IDA and a sustainable U.S. funding approach to cover debt relief costs. The World Bank also noted that our report could more explicitly state that it will not be possible for the United States to fund future MDRI costs through early encashment of the regular IDA contributions. The World Bank reported that the annual MDRI costs of IDA will more than triple over the next two decades, reaching an estimated $1.8 billion per year by 2025. Continuing the current practice would presuppose a commensurate increase in regular IDA contributions from the United States. The World Bank further noted that funds from debt cancellation are small, relative to domestic revenues and external aid flows in countries benefiting from the debt relief, but represent a source of predictable financing for poverty-reducing expenditures. IMF stated that poverty-reducing spending has increased in countries that have benefitted from debt relief - a point also made by Treasury. IMF further noted its disagreement with our position that the impact of debt relief on poverty-reducing spending is unknown. We maintain that our position is accurate since, while data compiled by IMF report that poverty- reducing spending has increased in countries receiving debt relief, it is not possible to link such increases to debt relief. Multiple factors, including challenges in tracking how debt relief resources are used and data reliability concerns, make it difficult to establish a linkage. Treasury, the World Bank, IMF, and the African Development Bank provided technical comments on a draft of this report, which we have incorporated as appropriate. The World Bank’s technical comments are included as part of its formal comment letter and suggested, as did IMF technical comments, that we better distinguish between recent debt sustainability analyses conducted under the Debt Sustainability Framework and other analyses conducted to establish the amount of debt relief needed to lower external public debt to agreed HIPC Initiative thresholds. We have altered our report to address this point. The African Development Bank provided comments on the U.S. costs for funding MDRI. We requested comments from IaDB, but none were provided. We are sending copies of this report to other congressional offices and the Department of the Treasury, as well as the World Bank, IMF, AfDB, and IaDB. The report also is available at no charge on the GAO Web site at http://www.gao.gov. If you or your staff have any questions about this report, please contact me at (202) 512-9601 or at melitot@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last past of this report. Other contacts and major contributors are listed in appendix XII. Our objectives were to (1) analyze the U.S. financing approach for debt relief efforts, (2) review the extent to which the Multilateral Debt Relief Initiative (MDRI) might affect resources available to countries for poverty- reducing activities, and (3) assess revisions to the analyses conducted by the World Bank and IMF to review and promote future debt sustainability. To analyze U.S. financing for debt relief, we compiled data from Treasury and IFI staff and reviewed the U.S. contribution with these staff. To evaluate whether the U.S. approach to funding its IDA and ADF MDRI costs was adequate to fully pay U.S. commitments, we estimated total U.S. commitments in each IDA and ADF replenishment period and then used this amount in a simulation model of the U.S. payment schedule in order to estimate the amount of early payment credits that would be earned annually if Treasury continued to use the early encashment approach. To evaluate the early encashment approach the United States is using to finance its IDA and ADF MDRI costs during 2006-2011, we analyzed the statistical models that IDA and ADF are using to calculate U.S. encashment income. We performed simulations of shortfalls in U.S. replenishment payments and discussed our results with officials from Treasury and these IFIs. We developed a model to compare the costs to the United States of paying the MDRI obligation using the current early encashment approach rather than paying annual MDRI costs directly when due. Appendixes V and VI provide additional information regarding the costs associated with use of early encashment. We calculated and have presented all figures in this report in end-2008 present value dollars unless otherwise noted. We assessed the reliability of the data analyzed and found the data to be sufficiently reliable for the purpose of this report. To estimate the impact of MDRI debt relief on countries’ resources, we calculated the aggregate net change in resources for MDRI recipient countries using an approach that considers the value of money over time. Our methodology reflects the three elements of MDRI’s structure: MDRI debt relief, IDA and ADF reductions of annual assistance to the countries by the amount of debt relief provided in that year, and the reallocation of a portion of the cancelled debt service to countries based on their performance. IDA, ADF, and IaDB provided aggregate, annual debt relief and country-specific annual MDRI debt relief data for all current and expected future MDRI recipient countries, including our five case-study countries. To calculate the aggregate reduction of annual assistance from IDA and ADF, we applied each IFI’s encashment schedule to the disbursement of the annual MDRI debt relief that both IDA and ADF provided. While 1 year’s debt relief is matched by a reduction in 1 year’s IDA or ADF assistance, the reduction in assistance takes place over a 9- year disbursement cycle for IDA and a 10-year disbursement cycle for ADF. This annual MDRI debt relief reduction, aggregated over all MDRI recipients, is the amount to be reallocated to IDA-only recipients—a larger subset of IDA recipients than those that receive MDRI debt relief—on the basis of performance. We refer to this as the performance-based reallocation, or PBA reallocation. We discussed our methodology with IMF and World Bank officials. The staff of both IFIs concurred that our approach was a valid way to analyze MDRI. To determine the portion of the MDRI debt relief to be reallocated to recipients as additional HIPC countries reach their completion point, we created a weighted allocation index based on data provided by the World Bank. The World Bank told us that the group of 23 completion point countries is currently receiving 50 percent of the reallocated cancelled debt relief funds, and that this would rise to 60 percent as the interim (decision point) countries reach their completion points, which is assumed to occur during 2009 and 2010. To determine the portion of the additional 10 percentage points that would go to each of the 10 interim countries, we created a weighted allocation index by dividing each country’s projected percentage of IDA14 assistance flows by the portion of IDA14 assistance going to this group of 10 countries. To compute each country’s share of the IDA PBA reallocation, we multiplied their weighted allocation index by the 10 additional percentage points to calculate the portion of the 10 percent that each would receive. Finally, to calculate the changing PBA allocation over the period as the individual countries reach their completion point, we added each country’s respective share of the 10 percentage points on to the 50 percent base, arriving at 60 percent in 2010. We used the same methodology to determine the additional portion of the MDRI pool of debt relief that would go to 8 pre-decision point countries, based on their projected completion point dates that the Bank provided. We assume that the pre-decision point countries will account for a proportional percentage of the 10 percentage points, reflecting their projected portion of IDA14 assistance flows. Based on this methodology, we estimate that, adding on the 8 pre-decision point countries, 41 HIPCs would receive about 67 percent of the reallocated MDRI debt relief and the remainder would go to all other low-income countries eligible to receive only concessional loans from IDA or ADF. ADF provided us with the amount of MDRI debt relief reallocated to all of its member countries, as well as the projected completion point dates for the HIPCs. To determine the portion of ADF’s MDRI debt relief to be reallocated to recipients as additional HIPC countries reach their completion point, we added each country’s percentage of total MDRI debt relief to the current reallocation percentage as countries successively reach their completion point. For ADF countries, by 2016, 33 HIPC countries would account for nearly 90 percent of ADF’s reallocated MDRI debt relief. For all efforts to review the impact of MDRI on country resources, we assessed the reliability of the data analyzed and found the data to be sufficiently reliable for the purposes of this report. We also included Enhanced HIPC Initiative debt relief in our analysis to present a more complete picture of the IFIs’ contribution to debt relief. IDA, ADF, IaDB, and IMF provided annual data for Enhanced HIPC, by country. We included these data in our reported estimate of overall debt relief resources. To calculate the impact of MDRI debt relief on individual countries, we selected five countries (Ethiopia, Ghana, Nicaragua, Rwanda, and Tanzania) as case studies based on several criteria, including dispersion of country ranking in terms of the percentage of total HIPC and MDRI debt relief they received from the four institutions, geographic diversity, and debt sustainability risk classification. In terms of percentage of debt relief received, we selected countries at or near the top, middle, and bottom of the ranking to use as examples of how the program works. Our choice of countries is meant to be illustrative, not representative. We used the same methodology to estimate the three components of MDRI debt relief for individual countries as we used in the aggregate. To determine whether countries receiving debt relief are using the savings toward poverty reduction and achieving the MDGs, we reviewed documents provided by Treasury, the World Bank, IMF, ADF and IaDB, and spoke with officials at Treasury and these four institutions. We also examined publicly-available online data sources for poverty-reducing expenditures in areas such as education and health. To illustrate the impact of debt relief on individual nations, we examined the spending data for the five countries cited above. We reviewed the most recent Poverty Reduction Strategy Papers (PRSP) of the five countries in order to examine their poverty-reducing goals and objectives. In addition, we reviewed the most recent (2007) online country budgets and IMF Article IV consultation documents for our five case study countries to examine how countries were reporting their poverty-reducing expenditures. In order to assess revisions to IMF and World Bank debt sustainability analyses (DSA) since 2005, we first reviewed prior GAO reports issued between 1998 and 2004 that identified weaknesses in past DSAs. We then examined IMF and World Bank documentation explaining the Debt Sustainability Framework (DSF) and the related DSAs and other relevant issues, the following in particular: Staff Guidance Note on the Application of the Joint Fund-Bank Debt Sustainability Framework for Low-Income Countries, October 6, 2008; Heavily Indebted Poor Countries (HIPC) Initiative and Multilateral Debt Relief Initiative (MDRI) – Status of Implementation, September 12, 2008; IDA’s Nonconcessional Borrowing Policy: Review and Update, June 2008; Applying the Debt Sustainability Framework for Low-Income Countries Post Debt Relief, November 6, 2006; How to Do a Debt Sustainability Analysis for Low-Income Countries, IDA Countries and Nonconcessional Debt: Dealing with the “Free Rider” Problem in IDA14 Grant-Recipient and Post-MDRI Countries, June 19, 2006; Review of Low-Income Country Debt Sustainability Framework and Implications of the MDRI, March 27, 2006; and Operational Framework for Debt Sustainability Assessments in Low- Income Countries – Further Considerations, March 28, 2005. We then collected and reviewed all DSAs performed for 23 completion point countries since the DSF was implemented in 2005 as part of IMF Article IV consultations, IMF Poverty Reduction Growth Facility (PRGF) arrangement requests or reviews, or other events. We identified the assumptions and scenarios used, and compiled the most recent risk determinations for each country. We did not independently assess the accuracy or comprehensiveness of the assumptions and data included in the DSAs. We discussed the DSA process with IMF and World Bank officials and found the DSA information sufficiently reliable for descriptive purposes. We compared the current process against the weaknesses we had previously identified to determine whether the new process addressed these limitations. Furthermore, we identified additional alterations to the process and interviewed IMF, World Bank, IaDB, and AfDB officials to obtain their views on the new DSA process and results. Finally, we compiled the results of DSAs to determine the debt distress risk of countries currently receiving HIPC Initiative and MDRI debt relief, as well as DSA recommendations for actions such countries should take in order to avoid future downgrading of their debt risk classification and deterioration of their debt sustainability. Our work focused on analyses related to external debt and not domestic public debt. We conducted this performance audit from December 2007 through January 2009 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. Lawsuits by commercial creditors to collect on outstanding HIPC country debt can erode gains made through debt relief. International courts and U.S. federal courts have allowed commercial creditors to pursue legal action in order to recover funds owed to them, but these creditors are sometimes viewed as creating difficult circumstances for countries that have received debt relief from other creditors. As of the end of 2007, based on survey data provided by country governments, 47 litigating creditors had filed suits against 11 countries receiving HIPC Initiative and MDRI debt relief (see table 7). Over $1 billion has been awarded by courts and is due to commercial creditors. About one-third of this total, or over $440 million, has been awarded against the Republic of Congo, followed by over $350 million against Liberia, and $100 million against the Democratic Republic of the Congo. Treasury officials told us that while a court can award claims in favor of commercial creditors, actually enforcing the judgments and receiving payment is a separate, potentially more difficult exercise. The international community has taken numerous actions to address such cases: The World Bank’s Debt Reduction Facility (DRF) allows governments to buy back—at a deep discount—country debts owed to external, commercial creditors. Through grants, the DRF supports heavily indebted IDA-only countries that undertake reforms to retain professional services necessary in preparing these commercial debt reduction operations and assists the countries in funding the cost of these operations. For example, court judgments against Nicaragua were settled through the DRF-supported buyback. All four litigating creditors participated in the buyback operation and accepted a significant cut in the value of their legal claims. The Nicaragua buyback extinguished about $1.3 billion in commercial debt. Another buyback operation has been concluded for Mozambique. Furthermore, according to Treasury officials, a DRF operation is currently being prepared for Liberia, and the United States intends to contribute $5 million to help fund the cost of this buyback. Paris Club creditors have committed as a group not to sell claims on HIPC countries to creditors who do not intend to provide debt relief. In April 2008, AfDB approved a proposal to establish the African Legal Support Facility (ALSF), which would provide (1) technical legal advice to members of the facility in creditor litigation, and (2) technical legal assistance to members of the facility to strengthen their legal expertise and negotiating capacity in matters related to debt management and other issues. The U.S. government was the only participating state to vote against establishment of the ALSF, and Treasury officials have noted that countries that have been the target of recent litigation have had very able legal representation to date, calling into question the need for ALSF assistance. In addition, Treasury staff expressed a position that some of the proposed activities for the ALSF are not an appropriate use of AfDB funds and noted concerns over the substantial administrative costs associated with ALSF. Furthermore, Treasury staff have emphasized that the DRF—an option already in operation that is achieving results in reducing country debt burdens to commercial creditors—is a preferred alternative. IDA and ADF have not secured all financing that will be required to meet their HIPC Initiative and MDRI debt relief commitments for countries currently receiving such relief, though IaDB and IMF have secured all necessary funding. Overall, about 65 percent of the $47 billion in funding required to cover debt relief over the next several decades has been secured. Countries have currently received about $14 billion in debt relief. Overall, we project that the U.S. government is committed to provide about $8.4 billion in funding for the HIPC Initiative and MDRI. Of the $27.8 billion required to finance IDA’s HIPC Initiative and MDRI debt relief for the 33 countries currently receiving such relief, IDA has secured about $8.6 billion for the HIPC Initiative and $4.4 billion for MDRI (see fig. 6). This total of $13.1 billion represents 47 percent of the total required financing for both debt relief initiatives. IDA previously financed the HIPC Initiative primarily through transfers from the World Bank’s International Bank for Reconstruction and Development. Beginning in July 2006, this financing process changed and became part of the regular 3-year replenishment process. Donors have agreed to finance MDRI costs on a “dollar for dollar” basis (i.e., total MDRI costs will be covered) in conjunction with, and in addition to, replenishment contributions through 2044. According to our projections, ADF is to provide about $7.5 billion in HIPC Initiative and MDRI debt relief and has secured about $5.7 billion, or more than 75 percent, of this amount. ADF has secured $4.6 billion for the HIPC Initiative and $1.1 billion for MDRI. ADF is financing the HIPC Initiative from internal African Development Bank resources and donor contributions, all of which are channeled through the HIPC Trust Fund administered by the World Bank. As with IDA, donors have agreed to finance ADF’s MDRI costs on a “dollar for dollar” basis in conjunction with, and in addition to, replenishment contributions through 2054. IMF and IaDB have fully financed their $8 billion and $3.8 billion of HIPC Initiative and MDRI debt relief for the countries currently receiving such relief, respectively, using internal resources and donor-provided funds. Because these two institutions have fully funded their HIPC Initiative and MDRI debt relief for the countries currently receiving debt relief, almost 65 percent of total debt relief costs for all four IFIs have been secured. To fund HIPC Initiative and MDRI debt relief, IMF uses internal resources, including proceeds from its 1999 and 2000 off-market gold sales, and donor contributions. IMF has also secured some of the funds to cover its future debt relief costs for the countries not yet receiving debt relief. IaDB has fully financed its HIPC Initiative debt relief from internal resources and donor funding through the HIPC Trust Fund. With the advent of its MDRI-like program in 2007, IaDB created a blended loan product made up of concessional and nonconcessional funds, according to Treasury officials. The process of creating this blended product freed up resources to be used for debt relief while allowing IaDB to continue to provide concessional lending. Furthermore, Treasury officials noted that IaDB took other measures to obtain additional resources, such as canceling undisbursed portions of nonperforming concessional loans, to gain access to additional funding. IaDB freed up sufficient internal resources to provide debt relief for its four member countries receiving HIPC Initiative and MDRI debt relief as well as reserves of about $0.4 billion for Haiti when it completes both programs. Countries currently receiving debt relief have thus far realized less than a third of expected assistance. Countries realize the benefits of debt relief as annual debt service payments to IFIs that would have come due are no longer required to be paid. Debt relief provides the countries with additional available resources that they can spend on other activities, such as poverty-reduction programs. Table 8 shows the amount of debt relief assistance that each IFI has delivered compared to the required amount of assistance that has been approved. The IFIs have delivered a total of $14.3 billion in debt relief, which is 30 percent of the approved $47.1 billion for the 33 countries. IDA has delivered the largest amount, $6.2 billion, representing 22 percent of its approved $27.8 billion in debt relief assistance. IMF has delivered $4.8 billion, or 60 percent, of its approved $8 billion in debt relief. The HIPC Initiative has delivered nearly 80 percent, or $11.4 billion, of the debt relief delivered to date. Countries began receiving HIPC Initiative debt relief benefits in 1998, whereas MDRI debt relief began in 2006. Table 9 shows the budget cost and the amount of bilateral debt relief the U.S. government has provided or is projected to provide to 30 countries under the HIPC Initiative. We calculated the outcome of the early encashment approach to funding the U.S. MDRI commitment under a scenario (1) where the U.S. government makes its payments in full and on time, and (2) where the U.S. contribution is 5 percent less than required. Our analysis demonstrates the significant impact on early encashment income and actual U.S. funding levels for MDRI when funding reductions, similar to those experienced in recent years, are realized. The following is our explanation of the early encashment process. We use the same assumptions that are being used by Treasury and IDA, but describe the process in nominal dollars. The U.S. government plans to pay its share of IDA’s debt relief costs for MDRI from the encashment income generated by paying its regular IDA replenishment commitment over a 4- year period, rather than over the standard 9-year period. Table 10 describes this process. The U.S. replenishment obligation for IDA15, which covers the period 2009 through 2011, is $3.7 billion. Column (a) describes the annual standard encashment or payment schedule over the 9-year period from 2009 through 2017. Column (b) is the annual U.S. payment over a 4-year period. Column (c) is the annual outstanding excess payment. In 2009, this amount consists of the difference between what the U.S. government pays, $1.1 billion, and the required amount of $252 million. In subsequent years, it consists of the annual excess in payment plus the outstanding excess payment balance. Beginning in the fifth year, no new payment is made. The excess payment balance is used to cover the required payment. In the ninth year, the excess payment balance is just sufficient to pay the last year’s required payment. Column (d) is the annual encashment investment income. This amount is the estimated earned income calculated by multiplying the excess payment balance by the agreed-upon interest rate, which is 4 percent for the IDA15 replenishment. The line “Total (nominal)” shows that the total payments under the standard encashment schedule is equal to the total under the early encashment schedule. The total nominal dollar earned income is $359 million. Treasury and IDA use a different method to compute early encashment income. Under their method, Treasury and IDA first calculate the present value sum of the payment schedules. The present value is a statistical method that takes into consideration the amount of annual payments, the time during which these payments are made, and the interest rate when computing the sum. Although the nominal sums of the two schedules are the same, the present value of the early encashment schedule, $3,414 million, is larger than that of the standard schedule, $3,114 million. Treasury and IDA compute the percent face value as the difference between these present values divided by the present value of the standard schedule. The percent face value, 9.63 percent in this example, is multiplied by the nominal sum of early encashment payments, $3,705 million, to calculate the early encashment income of $357 million. This is the agreed-upon methodology and $357 million will be used toward paying the U.S. IDA MDRI commitment of $356 million. The surplus $1 million can be used to pay future MDRI obligations. In the previous example, the U.S. government pays its replenishment in full and all the early encashment income is used to pay its MDRI obligation. In the next example, we assume that the U.S. government does not pay its replenishment in full, either due to a rescission or a decision to withhold payment until certain reforms are made by the World Bank. Under the agreed-upon methodology, early encashment income is first used to pay off the replenishment shortfall. Any remaining encashment income is then used to pay the U.S. IDA MDRI commitment. Table 11 describes the calculation of early encashment income when there is a replenishment shortfall. We assume an across-the-board shortfall in U.S. annual payments of 5 percent, resulting in a shortfall of $185 million. Thus, the total nominal early encashment payments are $3,520 million. Since the annual U.S. payments are less, the earned income in column (d) is less: $308 million or a 14-percent reduction. The calculated early encashment income to pay for the U.S. MDRI commitment is $146 million, a 59 percent reduction. Most of the earned encashment income is used to pay the replenishment shortfall. If the across-the-board shortfall were 8.8 percent or more of the replenishment, all of the earned encashment income would be used to pay the shortage and nothing would be used to pay the U.S. MDRI commitment. Treasury and ADF have agreed to use a different methodology to compute early encashment income. We applied this ADF approach to the IDA15 replenishment. If there is no funding shortfall, the results are identical between the two approaches. When there is a shortfall, the ADF approach implicitly reduces the standard encashment schedule payments by the average across-the-board percentage shortfall. Thus, the nominal total of the standard encashment schedule is the same as the total early encashment schedule payments. In the previous example with a 5 percent shortfall, the computed early encashment income would total $339 million and all of this amount would be used to pay the MDRI obligation. None of the earned encashment income would be used to pay the shortfall to IDA. Under some conditions the early encashment approach to pay the U.S. MDRI commitment may be more costly than paying the annual MDRI obligations directly when they are due. If the cost for the U.S. government to borrow the funds exceeds the agreed upon interest rate used to compute early encashment income, then the early encashment approach is more costly than paying the U.S. replenishment and MDRI obligations annually as they come due. Conversely, if the borrowing cost to the U.S. government is less than the agreed-upon interest rate used to compute early encashment income, then the early encashment approach is less expensive. According to the Congressional Budget Office, the average medium-term cost to borrow funds during fiscal year 2009 through fiscal year 2012 is projected to be 5.0 percent. This amount is greater than the 4.0 percent agreed-upon interest rate used to compute early IDA encashment income. Under these conditions, the early encashment approach to finance the U.S. IDA MDRI commitment is more costly than paying the U.S. commitment directly. Assuming that the full replenishment and IDA MDRI commitments are paid, we estimate that the cost to the U.S. government for early encashment payments, including financing costs for IDA15, will be $3,347.2 million in end-2008 present value dollars. This is about $38 million more than the cost of paying IDA15 replenishment and MDRI obligations annually as they come due, a total of $3,309.6 million. In nominal dollars, we estimate the additional cost is $42 million. Since early encashment income earned is $1 million more than MDRI obligations, the net additional cost is $41 million. A similar cost analysis for ADF-11 in end-2008 present value terms shows that the early encashment cost, including financing costs, is $416.8 million, about $12.2 million more than the cost of paying ADF-11 replenishment and MDRI obligations annually as they come due, a total cost of $404.6 million. This reflects the higher government cost of borrowing, 5 percent, than the 4.69 percent used by ADF to calculate early encashment income. Again we have assumed that the United States pays its full replenishment and ADF MDRI commitment. In nominal dollars, we estimate the additional cost is $14 million. Since early encashment income earned is $16 million more than MDRI obligations, for ADF-11 early encashment results in a net benefit of $2 million as compared to paying replenishment and MDRI obligations annually as they come due. Based on CBO’s projections for the cost of U.S. borrowing, we estimate that during the replenishment period from 2009 through 2011, early encashment will cost the United States an additional $39 million, $41 million more for IDA and $2 million less for ADF. Based on our projections, while the overall net change in resources available due to MDRI is positive for each of the five countries we analyzed (Ethiopia, Ghana, Tanzania, Nicaragua, and Rwanda), individual countries may experience increases or decreases in their IFI assistance. The following graphs illustrate the projected overall impact of MDRI for these five countries. The shaded area indicates the negative (below the axis) or positive (above the axis) change in IDA and ADF assistance. Ghana and Nicaragua are projected to experience a decrease in IFI assistance due to reduced IDA and ADF assistance over the life of MDRI, even as MDRI debt relief provides freed-up resources. (See shaded area in figs. 7 and 8.) In contrast, for Ethiopia and Tanzania, MDRI is projected to result in an increase in assistance from IDA and ADF. (See shaded area in figs. 9 and 10.) As shown in figure 11, for Rwanda, MDRI is projected to provide a mixture of increases and reductions in IDA’s and ADF’s annual assistance over the MDRI period. We found that countries receiving MDRI debt relief are projected to receive about $3 billion more than suggested in World Bank/International Development Association (IDA) documents describing MDRI. IDA documents state that, in a particular year, IDA is to reduce its commitments of financial assistance to countries receiving MDRI debt relief by the amount of debt relief provided, netting each other out. Donor governments have agreed to compensate IDA for the foregone debt service payments. IDA is to reallocate these funds to all countries eligible to borrow only from IDA, which includes countries that receive MDRI debt relief as well as those that do not. Thus, when IDA reallocates the donor funds, all IDA-only countries would be at the same starting point—with no net additional funds. We compared the projected amount of debt relief to the projected amount of reduced assistance under two scenarios, each incorporating the time value of money. In the first scenario, we assumed that IDA reduces its assistance by the amount of debt relief provided in the same year, as described in World Bank documents. In the second scenario, we considered the disbursement pattern that IDA actually uses to distribute the reduction in allocations for MDRI recipients as well as the reallocation of those funds. Under the second scenario, because the disbursement pattern takes place over a 9-year period, the dollar value of MDRI debt relief is greater than the actual reduction in IDA disbursements. In the first scenario, IDA is projected to provide $18.9 billion in debt relief and reduce its assistance commitments to MDRI recipients by the same amount. IDA is then projected to reallocate—on the basis of performance—a portion of this $18.9 billion of reduced assistance commitments to recipients of debt relief, $12.3 billion, and the remainder, $6.6 billion, to IDA-only countries that do not receive debt relief. (See fig. 12.) Under the second scenario, the overall annual amount of debt relief is greater than the overall annual reduction in assistance. When considering the disbursement pattern of IDA funds, the projected net present value of MDRI debt relief, $18.9 billion, is greater than the net present value of IDA’s reduction in assistance, $15.8 billion, by $3.1 billion. Countries that receive debt relief are projected to receive this $3.1 billion in addition to about $10.2 billion in reallocated assistance, for total MDRI benefits of $13.3 billion. (See fig. 13.) The additional $3.1 billion places debt relief recipients in a more advantageous position at the outset of the reallocation process than their non-debt relief counterparts. While IDA documents indicate that donor funding provided to compensate for MDRI debt relief is to be reallocated to IDA-only countries, IDA is using donor finances to provide the $3.1 billion in net debt relief benefits to debt relief recipients, in addition to their performance-based reallocation of donor funds. Thus, the $18.9 billion in donor financing for MDRI is allocated as follows: $3.1 billion to net debt relief benefits, $10.2 billion in IDA reallocations to debt relief recipients, and $5.5 billion in reallocations to non-debt relief recipients. The following is GAO’s comment on the Department of the Treasury’s letter dated January 9, 2009. 1. GAO could not identify sufficient empirical evidence to suggest that increases in spending for the poor are directly related to savings from debt relief. It is difficult to establish that debt relief has led directly to increased poverty-reducing expenditures for two reasons: (1) debt relief resources are difficult to track, and (2) country spending data are not comparable and also may not be reliable. Because of these limitations, it is difficult to establish if debt relief has caused these countries to increase or decrease their spending toward the poor. The following is GAO’s comment on the World Bank’s letter dated January 12, 2009. 1. We have revised our report language to clarify this distinction between DSAs. The following is GAO’s comment on the International Monetary Fund’s letter dated January 8, 2009. 1. Based on our evidence, we found that the impact of debt relief on poverty-reducing expenditures is unknown. Our report shows that additional resources have been created by debt relief, but it is difficult to establish that debt relief has led directly to increased poverty- reducing expenditures for two reasons: (1) it is not possible to track how debt relief resources are used, and (2) country spending data are not comparable and also may not be reliable. In addition, based on our review of five MDRI case study countries, we found that debt relief resources are often much less than other types of resources such as tax revenue and grants. Therefore, while we agree that associations between debt relief and poverty-reducing expenditures may exist, the impact is unknown. In addition to the person named above, Cheryl Goodman, Assistant Director; Leslie Holen; Bruce Kutnick; RG Steinman; Farahnaaz Khakoo; Ashley Alley; and Debbie Chung made key contributions to this report. Developing Countries: U.S. Financing for Multilateral Debt Relief Initiative Currently Experiencing a Shortfall. GAO-08-888R. Washington, D.C.: July 24, 2008. Developing Countries: Challenges in Financing Poor Countries’ Economic Growth and Debt Relief Targets. GAO-04-688T. Washington, D.C.: April 20, 2004. Developing Countries: Achieving Poor Countries’ Economic Growth and Debt Relief Targets Faces Significant Financing Challenges. GAO-04-405. Washington, D.C.: April 14, 2004. Developing Countries: Switching Some Multilateral Loans to Grants Lessens Poor Country Debt Burdens. GAO-02-593. Washington, D.C.: April 19, 2002. Developing Countries: Challenges Confronting Debt Relief and IMF Lending to Poor Countries. GAO-01-745T. Washington, D.C.: May 15, 2001. Developing Countries: Debt Relief Initiative for Poor Countries Faces Challenges. GAO/NSIAD-00-161. Washington, D.C.: June 29, 2000. Developing Countries: Status of the Heavily Indebted Poor Countries Debt Relief Initiative. GAO/NSIAD-98-229. Washington, D.C.: September 30, 1998.

Summary: In 1996, the Heavily Indebted Poor Countries (HIPC) Initiative was created to provide debt relief to poor countries that had reached unsustainable levels of debt. In 2005, the Multilateral Debt Relief Initiative (MDRI) expanded upon the HIPC Initiative by eliminating additional debt owed to four international financial institutions (IFI): the International Monetary Fund (IMF), World Bank's International Development Association (IDA), African Development Fund (ADF), and Inter-American Development Bank (IaDB). These four IFIs are projected to provide $58 billion in total debt relief to 41 countries. GAO (1) analyzed the U.S. financing approach for debt relief efforts; (2) reviewed the extent to which MDRI might affect resources available to countries for poverty-reducing activities; and (3) assessed revisions to the analyses conducted by the World Bank and IMF to review and promote future debt sustainability. GAO analyzed Treasury, IFI, and country documents and data, and interviewed officials at Treasury and the four IFIs. Treasury's approach to financing MDRI, known as early encashment, does not fully fund current and future U.S. commitments. The approach does not fully fund the current U.S. MDRI commitment because the United States is in arrears on its IDA replenishment. These arrears are due to requirements under U.S. law for withholdings and across-the-board rescissions. Under early encashment, the World Bank requires that the U.S. commitment to the IDA replenishment be paid in full before early encashment income can be used to fund MDRI. The World Bank deducts the U.S. arrears to IDA from any early encashment income before applying this income toward the U.S. MDRI commitment, resulting in a current MDRI shortfall of $149 million. Treasury officials said that if the United States ultimately pays its arrears to the IDA replenishment, early encashment income will then fully fund the U.S. MDRI commitment. However, to fully fund the U.S. MDRI commitment, (1) Treasury will need to release a withholding of $94 million by reporting to Congress that the World Bank has accomplished transparency reforms required under U.S. law, and (2) Congress will need to appropriate approximately $49 million to compensate for the rescissions. Moreover, GAO estimates that the early encashment approach will be insufficient to fully finance future U.S. MDRI commitments even if U.S. payments are made on time and in full because these commitments exceed projected early encashment income. GAO estimates that the HIPC Initiative and MDRI debt relief from the four IFIs combined may provide countries for which data are available with nearly $44 billion in additional resources over the next 50 years, but the extent to which countries spend these resources on activities to reduce poverty is unknown. In addition to providing debt relief, the MDRI program for IDA and ADF provides for a reallocation of assistance, based in part on a consideration of the strength of country policies and institutions. The estimated amount of this MDRI assistance individual countries receive will vary. Although IFIs and the U.S. government encourage recipient countries to spend resources generated from debt relief on efforts to reduce poverty, the extent to which such spending occurs is unknown for two reasons. First, debt relief resources are difficult to track, because these resources cannot easily be separated from other types of financial flows such as international assistance and fiscal revenues. Second, country data on poverty-reducing expenditures are not comparable across countries and also may not be reliable. The World Bank and IMF have improved their country debt sustainability analyses (DSA) since 2005, including by addressing weaknesses GAO previously reported. DSAs now consider the strength of a country's policies and institutions in determining sustainable debt loads and assess future debt sustainability under multiple scenarios that adjust economic assumptions. Furthermore, IDA and ADF now structure their assistance based on a country's risk of debt distress. While the new DSAs have identified numerous ambitious actions countries should take to avoid eroding their debt sustainability, implementing these actions could prove difficult.