1992 Report of the Auditor General of Canada
Chapter 11—Canadian International Development Agency and the Regional Development Banks
There is a need to assess the full cost of maintaining the regional banks' preferred creditor status
Parliament may want to consider the need to approve the unpaid subscriptions to the capital of the regional banks
Accounting for the legal obligation to make future cash payments to the Funds needs to be reconsidered
CIDA needs to involve its Finance and Corporate Information Branch and its Audit and Evaluation Division
Assistant Auditor General: Paul Ward
Responsible Auditor: Vinod Sahgal
11.2 Canada's cumulative financial assistance to the banks has risen from $2.6 billion in 1983 to $6.2 billion in 1991. Per capita, Canada contributes more than any other G-7 country.
11.3 Canada's purpose for participating in the regional development banks has been articulated in the International Development (Financial Institutions) Assistance Act.
11.4 CIDA, and Parliament, need better information to know how effective Canada's participation in the regional development banks has been in promoting the social and economic advancement of developing countries. CIDA is working with each bank to improve effectiveness evaluations. So far the results have been mixed. A study on the effectiveness of the banks is under way in Canada by the North-South Institute. CIDA, along with six other funders, is actively participating in this study.
11.5 The matters for which the Minister is accountable to Parliament need to be clarified. It is reasonable to expect that the Minister be able to: provide an account to Parliament of the overall results achieved through the regional development banks; justify, based on these results, the extent of Canada's participation in each bank; and account for the specific means employed to achieve Canadian objectives in these international institutions.
11.6 Certain aspects of Canada's management, accounting, control and reporting procedures need to be re-examined. We have four concerns:
- There is a need for CIDA to enhance its analysis of the quality of the banks' loan portfolios.
- The accounting treatment of the $391 million Canada has paid as capital to the banks needs to be reconsidered. There is, for example, no expectation of financial return on this "asset".
- Canada has committed $3.7 billion to the banks as unpaid subscribed capital - in essence, guarantees that support the banks' borrowings. There is no explicit approval by Parliament of these guarantees.
- The Public Accounts do not show as liabilities the $1.1 billion in notes payable for moneys committed to the regional development banks, despite Canada's legal obligation to pay. This accounting treatment needs to be reconsidered.
11.8 The three main development banks referred to in this Chapter are the African Development Bank (AfDB) based in Abidjan, Côte d'Ivoire; the Asian Development Bank (AsDB), based in Manila, Philippines; and the Inter-American Development Bank (IDB), based in Washington, D.C.
11.9 Membership in the regional development banks is generally made up of developing countries in a particular region and industrialized countries of the world.
11.11 The regional development banks obtain the funds for their "hard window" from three main sources: interest and fees on loans and investments, the money member countries pay to the banks in return for shares (the paid-in capital), and the money the banks borrow in the international capital markets. Member countries guarantee that borrowing through an unpaid subscription to the banks' capital, known as the "callable capital". The loans from the "soft window" are financed mainly through grants made by member countries (see Exhibit 11.1 ).
11.12 Assistance to developing countries by the African Development Bank, the Asian Development Bank and the Inter-American Development Bank has been growing. Loans outstanding totalled approximately US $53 billion at 31 December 1991 compared to approximately US $22 billion in 1985. In addition, undisbursed loans increased from US $22 billion in 1985 to US $32 billion at the end of 1991 (see Exhibit 11.2 ). An undisbursed loan is a loan that has been approved but not all disbursements have been made.
11.13 The regional development banks make the bulk of their loans for social and physical infrastructure projects in sectors like transportation, energy or agriculture. However, since the peak of the debt crisis in the mid-1980s, they have also been making policy-based loans - which can be disbursed more quickly than the traditional project-based loans - co-financed, in many cases, with the World Bank. Through this policy-based lending, they finance a borrower's "structural adjustment" - the term used for packages of economic assistance linked to policy reform in developing countries, designed to put a country on a path of sustainable growth and thereby help it meet its international financial obligations. The regional development banks also advise member governments on sectoral policy reform, and make "sectoral" or "policy" loans for that purpose.
11.14 Most of the money for both traditional project loans and policy-based loans goes to governments and state undertakings in the public sector, although assistance is also provided to the private sector.
11.15 Each bank is headed by a Board of Governors. Operating authority and responsibility for policy development is delegated by the Board of Governors to a full-time Board of Executive Directors. The Executive Directors meet regularly and normally make their decisions by consensus. If a vote is needed, voting power is weighted according to the size of a member country's contribution. As a member of the regional development banks, Canada accepts the principle of collective control by member states.
Canada's participation in the regional development banks is significant and growing11.16 Like other members of the Group of Seven (G-7) largest industrialized countries, Canada is a member of all three regional development banks. Only the United States and Canada permanently have Executive Directors in all three banks. Per capita, Canada contributes more to the banks than any other G-7 country and its absolute share is often greater than that of the U.K., France, Germany or Italy. This seems to reflect the importance Canada attaches to multilateral co-operation.
11.17 The percentage of Canada's available budget that is allocated to international development assistance is a Government of Canada decision, as is the allocation of those funds between bilateral programs and multilateral programs. The government also decides the relative extent of Canada's participation in the World Bank Group and the regional development banks.
11.18 Canada's contribution to each regional development bank is influenced by a variety of economic, financial and foreign policy objectives, including development. Canada has adopted the practice of allocating enough money to each of the three banks mentioned in this chapter to ensure that it permanently retains a seat on the Boards of Executive Directors. Influence in an international organization is enhanced by having a seat on the Board.
11.19 The banks do not borrow more than the total value of the callable portion of the capital provided by the industrialized countries. This is important to credit-rating agencies because the creditworthiness of the guarantor countries is the main support for the banks' bondholders. Over the past 10 years, we estimate that approximately 11 percent of Canada's development assistance has been provided to the regional development banks in the form of payments for shares (paid-in capital), grants (the "fund component") and financial guarantees to back the borrowing of the banks in the world's capital markets (callable capital). It is important to note that this callable capital component is not considered part of Canada's official development assistance. During 1990-91 alone, Canada's assistance to the regional development banks amounted to approximately $640 million (see Exhibit 11.3 ).
11.20 Canada's cumulative financial participation in the three major regional development banks has risen from $2.6 billion as at 31 March 1983 to $6.2 billion as at 31 March 1991. This $6.2 billion consists of three elements (see Exhibit 11.4 ).
The Secretary of State for External Affairs is accountable for Canada's participation11.21 Canada participates in the regional development banks under the authority of the International Development (Financial Institutions) Assistance Act (the IFI Act). This Act states that "the Secretary of State for External Affairs may, for the purpose of promoting the social and economic development of developing countries, provide financial assistance" to these institutions. The Secretary of State for External Affairs represents Canada on the Boards of Governors of the regional development banks.
11.22 The Department of External Affairs Act makes the Secretary of State for External Affairs the Minister responsible for CIDA, thereby bringing the Agency under that Act's broad authority.
11.23 In this chapter, accountability means the obligation of the Minister to account to Parliament for the means chosen to pursue the requirements of the Act and for the results Canada has achieved through the regional development banks.
11.24 As the Agency to which Parliament votes the funds, CIDA manages the payments to the three regional development banks and the guarantees of their borrowings. CIDA is the lead agency, but the departments of External Affairs and Finance also play a role. Finance acts as an advisor, at CIDA's request, on the financial matters pertaining to the banks. External Affairs is responsible for the conduct of Canada's foreign policy.
Development assistance is part of Canada's foreign policy11.25 Canada's foreign policy provides the context for its development assistance policy. Canada's foreign policy framework stresses that many issues can be pursued only multilaterally and that current opportunities for multilateral co-operation provide the best potential for new forms of North-South co-operation, and for avoidance of further marginalization of the poor. In "Foreign Policy Themes and Priorities, 1991-92 Update", published by External Affairs in December 1991, the section entitled "Managing Interdependence" sets out as one of the government's overall objectives for development assistance to "improve the effectiveness of IFIs (International Financial Institutions) in reducing world poverty and in improving the environment".
11.26 External Affairs states that the regional development banks serve Canada's regional and global foreign policy objectives. They also allow the pursuit of Canada's objectives of "good governance", which include respect for human rights, commitment to democratic processes and institutions, sound economic management, appropriate levels of military expenditures, probity and transparency of public accounts, and priority for basic social programs. External Affairs also regards the projects funded by the development banks as sources of contracts for Canadian companies.
11.27 There is no specific enabling legislation that sets out CIDA's mandate and accountability for official development assistance. The 1987 document entitled "Sharing Our Future" outlines Canada's official policy on assistance to developing countries. The policy is based on four principles:
- The primary purpose of Canadian official development assistance is to help the poorest countries and peoples of the world.
- The aim is to strengthen the ability of people and institutions in developing countries to solve their own problems in harmony with the natural environment.
- Development priorities must prevail in setting objectives for the aid program. (The six priorities are poverty alleviation, structural adjustment, increased participation of women, environmentally sound development, food security and energy availability. These priorities are detailed in the document "Sharing Our Future".)
- Partnership is the key to fostering and strengthening the links between Canada's people and institutions and those of the developing world.
11.29 CIDA points out that the statements of goals, objectives and purposes of Canada's official development assistance need to be taken together from all the policy documents that set them out. These include "Foreign Policy Themes and Priorities, 1991-92 Update", "Sharing Our Future" and "To Benefit a Better World". There is no single document where one can find all the specific objectives that the Minister has decided to pursue at the regional development banks. CIDA also points out that the government determines the policy direction pursued by the Minister.
11.30 CIDA informed us that the purpose of Canada's membership, shared by all members, is to support the institutions so that they can collectively play a stronger role in bringing about sustainable social and economic development in the borrowing member countries, and thereby solidify the international economic and financial system. In addition, Canada's role in the regional development banks is to ensure their integrity as prudent financial institutions and to promote their effectiveness as risk-taking, innovative development institutions.
Audit Objective, Scope and Approach11.31 Objective. We conducted this audit with a view to helping Parliament scrutinize the activities, financial resources and results associated with the development assistance Canada provides through the regional development banks.
11.32 Scope. We focussed on how CIDA manages Canada's participation in the regional development banks to achieve the requirements of the IFI Act. The scope of our audit included both headquarters management at CIDA and management at the offices of Canadian Executive Directors at the three main regional development banks. We examined CIDA's stewardship of Canada's participation in the banks, in the context of current financial restraint and Canada's international commitments overall.
11.33 We did not examine management practices of the departments of Finance and External Affairs related to the objectives they too may be pursuing through Canada's participation in regional development banks.
11.34 Approach. We examined how CIDA assesses the development results of participating in the regional development banks. We also looked at whether the Agency communicates these and other results to Parliament in a way that permits public scrutiny and debate on the extent of Canada's participation in the banks and on their effectiveness as a channel for development assistance.
11.35 We reviewed official documents made available by the banks on financial and operational matters, and examined reports published by the banks and other organizations. We also looked at official and public documents on CIDA's activities, as well as studies in the field of international development. We visited the headquarters of the three regional development banks. We interviewed officials of CIDA, other departments and the banks, including the Canadian Executive Directors. Finally, we reviewed two of the main reports CIDA uses to account to Parliament for its activities and spending: Part III of the Main Estimates and the Public Accounts of Canada.
11.36 CIDA's Audit and Evaluation Division had not carried out any recent internal audit of Canada's participation in the regional development banks, nor evaluated how effectively the Agency manages that participation. Accordingly, we could not review the work done by the Division.
11.37 Unlike the external auditors of some other international organizations, like the United Nations, the external auditors of the regional development banks do not have the mandate to do performance audits on behalf of the banks' shareholders and, consequently, have not carried out such audits. Their mandate is limited to an annual examination of the banks' financial statements. Consequently, in developing our observations we could not review the work of these external auditors.
Observations and Recommendations
How Effective Are the Regional Development Banks?11.38 The IFI Act states that "the Secretary of State for External Affairs may, for the purpose of promoting the social and economic development of developing countries, provide financial assistance" to the regional development banks.
11.39 It is important that parliamentarians have available clearly articulated objectives for Canada's participation in the regional development banks. These should be presented in a readily understandable format, preferably in one document. Parliament can then hold CIDA to account for its stewardship of Canada's participation in the banks. The IFI Act provides CIDA with a basis for developing these objectives and for measuring and reporting on effectiveness.
11.40 There are two related considerations in assessing the effectiveness of the regional development banks: the extent to which they promote development in borrowing countries and the degree to which they operate as viable financial institutions.
11.41 We examined how CIDA monitors the following three related matters: first, how well Canadian objectives have been achieved through CIDA's participation in the regional development banks; second, to what extent Canada's desire to promote sound management practices, including financial viability, is being pursued; and third, what information on effectiveness is provided to Parliament.
Effectiveness measurement is under way11.42 There is high inherent risk in implementing most development projects. Regular monitoring and periodic assessment of projects, programs and organizational performance can provide important lessons for decisions about policy, future programs and projects. The Secor Report, an internal study on CIDA's management, notes that evaluation "can also play a critical strategic role in ensuring the credibility of aid agencies and in legitimizing development assistance vis-à-vis various constituencies. This is because evaluation can provide evidence that aid is really effective in achieving practical solutions to development problems." The methodology for evaluating development results is evolving rapidly.
11.43 The extent to which regional development banks give CIDA systematic evaluations of continuing benefits, on either a sector or project level, has been uneven. CIDA is working with each bank to improve the quality of evaluations. So far, the results have been mixed.
11.44 An overall study on the effectiveness of the regional development banks is under way by the North-South Institute. CIDA is actively participating in this study along with six other external funders, whose objectives include assessing how well the banks have diagnosed the problems of developing countries, how effectively they have tackled them and how successful the banks are as "development agencies". The Institute notes that the World Bank and the three main regional development banks "emerged during the 1980s at the forefront of new trends in thinking about development and in assisting developing countries. Yet, astonishingly little research has been done on these agencies, particularly the regional development banks. The purpose of this project is to make a contribution to understanding about their role and effectiveness as agencies of development in the increasingly turbulent and uncertain decade of the 1990s." The Institute will also examine why Canada participates in these institutions and what results are achieved. The study began in 1991 and the report is scheduled to be published in mid-1993.
CIDA is promoting sound management practices11.45 In 1989, CIDA identified significant management issues affecting Canada's participation in the regional development banks. In 1990, it developed recommendations to deal with these issues and took action on each. Canada's concerns about the banks' management practices and policies have been brought to the attention of bank management.
11.46 Canada and other member countries have made progress in promoting sound management practices at the banks and enhancing their financial viability. This helps protect the banks and their shareholders against a call on capital. Regional development banks have been encouraged to maintain adequate levels of liquidity; two of the three banks have increased their provisions for loan losses (the highest now being at 3 percent of its total loan portfolio) and the third reportedly has undertaken to do so. CIDA has developed a framework to monitor the financial viability of the banks. We are encouraged to see that CIDA is now taking the next step and using a framework to systematically assess the on-going financial viability of these institutions. CIDA informed us that it is establishing a process to periodically carry out such assessments. However, we have two remaining concerns. They are covered in paragraphs 11.65 to 11.85.
Reporting is needed on effectiveness11.47 It is important that policy makers and legislators be made aware from time to time of the development results that are being achieved. If the results are significantly different from those originally anticipated, this fact and its implications need to be determined and reported clearly to Parliament. At the World Bank there is ongoing review of projects in difficulty. That bank recently conducted a systematic study of some 1,015 development projects, which among other things assessed the extent of bias toward overestimating the expected rate of return during project appraisal. At issue is whether and how the regional development banks are addressing these kinds of questions.
11.48 CIDA could extend the information it provides to Parliament to include how effective it thinks the regional development banks have been in meeting Canada's objectives and priorities for its membership, and how Canadian managers assure themselves of the integrity of the regional development banks as prudent financial institutions. A demonstration of what Canada has achieved at the regional development banks and has learned from the past, as well as an explanation of the specific management improvements under way, would be helpful for parliamentarians. CIDA should also disclose any difficulties or constraints that it believes limit its ability to provide this information. That type of disclosure would make clear the limits, if any, of effectiveness measurement and of a single member's influence at the institutions.
11.49 CIDA should periodically assess and report on how Canada's objective of promoting social and economic development in developing countries has been achieved through the regional development banks.
CIDA's response: CIDA agrees that the objectives and results of Canada's participation in the regional development banks need to be clearly stated and the Agency has been working to improve its performance in this regard. The Agency will continue to improve its current reporting through existing documents such as the Part III of the Main Estimates and through testimony in parliamentary committees. The current North-South Institute evaluation of the regional development banks, which is sponsored and funded by CIDA, will assist CIDA in this improvement.
The matters for which the Minister is accountable to Parliament need to be clarified11.50 Canada is only one of many members of the regional development banks; in these international organizations, decisions are taken on a collegial basis. CIDA accepts the responsibility for providing, with other countries, the means - money, personnel and policy advice - for these institutions to help poorer countries achieve social and economic development. CIDA also states that it is responsible for assessing the effectiveness and efficiency of funded institutions through appropriate evaluation activities.
11.51 Accountability for results of individual programs or projects rests with the Boards of the institutions. The extent of accountability for overall results, and the related reporting responsibility, are not articulated in the IFI Act. Consequently, nor is the extent to which the Minister could reasonably be expected to account for the overall results of Canada's participation in the banks. Accountability for two other matters also needs clarification: for justifying the extent of Canada's participation and for the means employed to achieve Canadian objectives in these international institutions.
11.52 Clarifying accountability would also help define what should be reported periodically to Parliament. CIDA has recently taken an initial step to more clearly define its accountability framework by preparing a document entitled "CIDA Accountability" and by holding related discussions with central agencies. We believe CIDA should take the next step to obtain parliamentary approval of the accountability framework it believes is appropriate for the Agency.
11.53 CIDA should seek a clarification from the appropriate authority, possibly through legislation, of what the Minister can reasonably be asked to account for in terms of the means and the results associated with Canada's participation in the regional development banks.
CIDA's response: The Agency is currently in conformity with the IFI Act and provides information to parliamentarians through Part III of the Main Estimates, the Public Accounts of Canada, parliamentary committees and responses to direct inquiries. It is not for CIDA to determine if amendments to existing legislation should be sought.
Certain Management, Accounting and Control Procedures Need Re-examination11.54 In recent years, there has been a significant shift in the composition of the total debt owed by developing countries; official creditors (sovereign states and international financial institutions) have taken over from private creditors (commercial banks and other private sources) as the main source of new lending for the developing world. Financial exposure in the regional banks is growing. Over the last ten years, many developing countries have experienced difficulties in servicing their external debt. It may take a long while for the creditworthiness of many borrowing countries, especially in Africa, to improve in a sustainable way. Uncertainty about the creditworthiness of many developing countries remains evident. In such an uncertain environment, prudence is generally recommended.
11.55 In our opinion, prudence would suggest that certain aspects of Canada's management, accounting and control procedures need to be re-examined. First, the regional development banks should be encouraged to conduct periodic assessments of the quality of their loan portfolios. Further, CIDA could strengthen its assessment as to whether Canada's practice of not recognizing any cost associated with maintaining the preferred creditor status of the banks is, indeed, appropriate. Second, the accounting for Canada's financial participation in the banks needs to be reconsidered. Finally, there is a need for better control over Canada's subscriptions to the unpaid capital of the banks; a mechanism should be established for Parliament to approve these contingent liabilities before they are made.
Financial exposure in the regional banks is growing11.56 Sovereign debt of the developing countries has been rising. The total debt the developing countries owe to industrialized countries is now 13 times what it was 20 years ago: it rose from about US $100 billion in 1970 to about US $575 billion in 1980 and to US $1,280 billion in 1990, before adjusting for inflation. Arrears on this sovereign debt have also been rising, increasing from US $40 billion in 1986 to US $111 billion in 1990. In the past ten years, official creditors have taken over from private creditors as the main source of new lending for the developing world. The World Debt Tables indicate that the proportion of the total long-term debt that developing countries owe to official creditors has increased significantly - from 37 percent in 1980 to slightly over 50 percent a decade later. Projections indicate that this shift could continue.
11.57 More and more of the new debt is owed to multilateral institutions. In 1980 the multilateral development banks held 11.5 percent of the long-term debt owed by developing countries. Ten years later this stood at 20 percent.
11.58 Among the multilateral lending institutions, the regional development banks are taking a larger share of the net disbursements. They accounted for 15 percent of the net multilateral disbursements in 1982. By 1990, their share had risen to 22 percent.
11.59 Canada's financial exposure in the regional banks is also growing. As indicated in paragraph 11.20, Canada's cumulative participation in the three regional banks has increased from $2.6 billion in 1983 to $6.2 billion in 1991.
Uncertainty about the creditworthiness of some countries remains evident11.60 The regional development banks are often lenders of last resort, making loans almost exclusively to governments and state undertakings of developing countries. The international capital markets view this area as highly risky, a view reflected in their interest rates. Risk is inherent in the lending operations of the development banks. Developing countries borrow from these banks at lower interest rates than those charged in the international capital markets. The difference between the two interest rates represents the market's evaluation of the risk in lending to certain sovereign states.
11.61 The creditworthiness of many sovereign states remains a matter of concern. A substantial portion of the loan portfolios of two of the regional banks is made to countries that have rescheduled some of their debts. The ability and willingness of these countries to service outstanding external debt has not consistently improved in a timely and sustainable way, despite debt relief and, in some cases, stringent reform packages initiated by the International Monetary Fund (IMF). Implementing structural adjustment - economic assistance in exchange for policy reform - takes time. This is particularly true of many borrowing countries in Africa and, to a lesser extent, of certain countries in Latin America and Asia. Although the economic performance of a growing number of developing countries has been improving, some experts believe that the structural adjustment programs of the World Bank and the IMF are not in themselves sufficient. Additional debt relief, more trade and "good governance" are just as important, as are further investments in health, education and population control.
11.62 The long-term cost of some infrastructure projects is now likely to be higher than expected because certain costs, such as those of protecting the environment, were underestimated when the project loans were approved. More important, a significant proportion of recent loans made by the regional development banks are structural adjustment loans, intended to put a country on a path of sustainable growth, thereby helping it meet its international financial obligations.
11.63 The IMF has recently pointed out that "The developing world would appear to be at a critical juncture: if the reforms take hold, and the external environment is favourable, the rest of the decade could see sustainable growth in per capital GDP; on the other hand, if reforms are not sustained, and if stabilization policies are relaxed prematurely, growth is likely to remain elusive" (emphasis ours).
11.64 How is CIDA adapting its management, accounting and control procedures to the uncertainty in its environment?
The quality of loan portfolios needs monitoring11.65 The regional development banks are not immune to the global debt problem. Although it is true that the regional banks are acknowledged as preferred creditors, and that the risk of default by borrowing countries is therefore relatively low, there have been cases of prolonged arrears. The preferred creditor status of the regional development banks is not based on a formal or legal subordination of the debts owed other creditors to the debts owed to the banks. It is based on informal factors, like the willingness of the development banks to maintain a positive cash flow to their borrowing countries. One must ask whether these flows can be maintained indefinitely.
11.66 Maintaining the preferred creditor status of the regional development banks is not cost free to countries like Canada. The costs show up indirectly when debt relief becomes necessary, normally through the Paris Club (see Chapter 10). Moreover, pressure to provide fast-disbursing loans and loan guarantees to relieve balance-of-payment difficulties, linked with the reform packages initiated by the IMF, has been mounting - even in Asia, which is otherwise considered a relatively good credit risk area. Not surprisingly, the outstanding external debt in most developing countries has risen significantly in the last ten years.
11.67 CIDA points out that the preferred creditor status accorded to the regional development banks by borrowers is in the borrowers' interest. Unlike commercial banks, the regional development banks are willing to lend to borrowing members in good standing provided that loan conditions are met and upon approval by their Boards. In other words, in their capacity as development institutions, the regional development banks do not impose credit rationing on strictly commercial grounds, as commercial banks do. This willingness to lend (under stringent performance conditionality), even to borrowers whose creditworthiness has been impaired, is certainly a factor in the banks being accorded preferred creditor status. At the same time, maintaining status as a member in good standing with the banks (which means they are following sound economic and financial policies carefully assessed by professional staff of the banks) arguably is even more valuable to the borrowers for preserving their credit standing in the international financial community as a whole. It is the value attached to this standing that is important in assessing why borrowers accord preferential creditor status to the regional development banks.
11.68 CIDA also points out that creditworthiness of many borrowers - that is, their capacity to service their debt - has recently improved. However, the creditworthiness of some heavily indebted countries in Africa is not likely to improve dramatically in the near future.
11.69 In view of the significant financial exposure at the regional development banks and uncertainty about the creditworthiness of many developing countries, we expected CIDA and the Canadian Executive Directors, as stewards of Canadian participation, to have available an analysis of the credit risk associated with the banks' loan portfolios as a basis for judging the quality of the portfolios.
11.70 The changing environment makes it vital that member countries like Canada urge the regional development banks to continually monitor the quality of their loan portfolios. This is just as important as the need for rigorous, unbiased systematic evaluations of funded projects.
11.71 A periodic analysis of sovereign risk (the credit risk of lending to sovereign states) helps identify the risk of financial loss inherent in the current loan portfolio. The results of this analysis could be incorporated into the loan appraisal process.
11.72 The World Bank conducts such analysis of the quality of its loan portfolio. It recently concluded that one third of the portfolio was in countries that are viewed as high risk, where severe financial pressures may cause them to fall into arrears to the bank. Further, it reported that the quality of the portfolio has deteriorated since 1980 and that this deterioration may continue. Trends like these must be watched, assessed for their causes and, where possible, corrected. This is an important responsibility of this bank's Board of Executive Directors.
11.73 The Executive Directors told us that the regional development banks had not yet undertaken systematic risk analyses of borrowing countries. CIDA, in conjunction with the Canadian Executive Directors, needs to enhance its analysis of the quality of the banks' loan portfolios. CIDA officials cautioned us against drawing conclusions based on country risk analyses done by independent sources such as export credit agencies, which may also lend to these same developing countries, because each institution's loan portfolio has different characteristics.
11.74 We agree with CIDA that there is no substitute for country-risk analysis by each institution. The financial viability of the banks cannot be systematically assessed without such analysis. We encourage CIDA to insist that the regional development banks carry out periodic country-risk analyses; there is a need to continually watch for unfavourable trends in changes to the quality of their loan portfolios.
11.75 CIDA, in concert with other countries, should urge the regional development banks to carry out systematic analyses of their loan portfolios based on the sovereign risk of individual borrowers.
CIDA's response: CIDA believes that the financial integrity of the regional development banks is critical if those institutions are to remain effective development institutions, and if Canada's investments are to be safeguarded. Levels of reserves and loan loss provisions are fundamental to this objective and are factored into account in the financial viability framework developed by CIDA to monitor each institution and to facilitate Canadian interventions in regular bank discussions of financial policies.
The Agency, in consultation with the Department of Finance and the Department of External Affairs, will urge, through its Executive Directors, the regional development banks to make improvements in the area of comprehensive analyses of the quality of the banks' loan portfolios. The Agency has been urging, along with other donors, that the banks review the quality of the loan portfolios. The banks have responded and recently have started to perform these analyses.
There is a need to assess the full cost of maintaining the regional banks' preferred creditor status11.76 Together with a bank's other reserves, loan loss provisions are a first line of defence for member countries should any of the bank's larger borrowers default. Such prudent financial management and accounting practices reduce the likelihood that a bank would experience significant financial losses that would necessitate additional financial support from member countries.
11.77 As we have noted, a periodic analysis of sovereign risk helps identify the risk of financial loss inherent in a bank's current loan portfolio. The results of this analysis could also be used in determining the level of provisioning for losses on loans that is necessary for fair presentation in financial statements.
11.78 The lending environment in which the regional banks operate and the creditworthiness of their borrowing countries are now acknowledged by the banks in their financial statements. As pointed out in paragraph 11.46, two of the regional banks have increased their loan loss provisions. The other bank included in this audit, which has never before made a provision for loan losses, is reportedly considering incorporating such provision in its financial statements.
11.79 In determining the size of the loan loss provision it considers necessary to reflect the collectability of its sovereign loan portfolios, the World Bank takes into consideration the amount of future financial support its shareholders would likely accord to countries the Bank considers to be high risk. This support takes the form of bilateral debt relief, additional financial support - including bridge financing - toward clearing the arrears to multilateral development banks, and cash transfers linked to the International Monetary Fund and the World Banks's structural adjustment programs. Additional financial assistance from multilateral sources through similar support programs is also taken into account.
11.80 The regional development banks have implicitly recognized the importance of such future shareholder financial support by adopting a similar approach. Canada, though, has not recognized any amount of this future support in its own books of account. An important question for Canada and other member countries is, what would the banks' level of provisioning be without such additional support from their shareholders? The answer to this question would allow member countries to assess the cost, if any, of maintaining the preferred creditor status of these institutions.
11.81 An assessment of the loan loss provisions, from a member country's perspective, would provide CIDA with greater assurance that Canada's practice of not building up a provision for the cost associated with maintaining the regional banks' preferred creditor status is, indeed, appropriate.
11.82 We expected CIDA to be fully aware of the methodology for making loan loss provisions at each bank.
11.83 We asked CIDA, as the lead Agency accountable to Parliament for monitoring the financial viability of the banks, to describe to us how it assures itself that the loan loss provisions at the regional development banks are adequate from a member country's perspective - in other words, whether and to what extent the methodology for loan loss provisions takes into account additional financial support from member countries.
11.84 At the time of our audit, CIDA could not demonstrate the link between the inherent risk in the banks' loan portfolios and the appropriateness of Canada's practice of not building up a provision for the cost of maintaining the preferred creditor status of the banks.
11.85 We believe CIDA could strengthen its knowledge and assessment of the loan loss provisioning methodology used by the regional development banks. CIDA would then be in a better position to advise the Department of Finance on the continuing appropriateness of not building up a provision for the cost of maintaining the banks' preferred creditor status.
Accounting and control procedures need to evolve11.86 The government's accounting policies require that liabilities be recorded when incurred and assets recorded when acquired. In addition, assets such as loans, advances and investments must be re-examined periodically to ensure that they are fairly presented in the financial statements. Normally, this kind of check is conducted by each department or agency at least once a year. As the Agency most knowledgeable about the workings of the regional banks, CIDA is in the best position to identify any need for accounting changes and has a duty to point them out. If the President of the Treasury Board and the Minister of Finance agree, the changes are implemented and appear in the Estimates and the Public Accounts of Canada.
11.87 The accounting policies also require that all contingent liabilities, such as the subscriptions to the callable capital of the banks, be noted annually in the Public Accounts.
11.88 The Canadian Institute of Chartered Accountants (CICA) guidelines for the accounting of government transactions pay specific attention to transfer payments like those made to the "fund component" of the regional banks.
11.89 These guidelines cover how and when transactions should be recorded in the books of an entity such as Canada, and how they should be presented in the government's financial statements.
11.90 We took the above factors into consideration in examining the accounting and control procedures as they apply to Canada's financial exposure at the regional banks.
11.91 Structural adjustment loans represent a significant proportion of recent loans made by the regional development banks. This is evidence of a fundamental shift in the nature of the regional development banks themselves, from a more traditional role as banks to an increasing role as development policy agencies. In view of this shift, and given Canada's growing financial exposure, the highly uncertain environment, and the lack of adequate information on the quality of each institution's loan portfolio, prudence is recommended in choosing the control procedures and the financial accounting conventions that Canada should now use to record its involvement in the regional development banks. In this context we have three concerns about the existing accounting and control procedures.
Accounting for Canada's paid-in capital to the regional development banks needs to be reconsidered11.92 The accounting treatment of Canada's paid-in capital to the regional banks needs to be reconsidered. Canada treats as an asset, without any impairment in its value, the $391 million it has paid as capital to the banks. This is despite the increasing recognition that sovereign lending is not risk free. CIDA states that the paid-in capital reflects a claim on the assets of the banks, and that it is a sound investment on which member countries earn income that is retained by the banks in the form of reserves. We note that there is no financial return expected by Canada from this "asset", and that Canada's paid-in capital will likely remain in the banks for many years to come. The regional development banks were never intended to be self-sustaining financial institutions. They depend on member countries like Canada for ongoing financial assistance. A similar situation exists with respect to the $330 million Canada has paid as capital to the World Bank. In both cases, the rationale for carrying these as assets at full value needs to be reconsidered.
11.93 CIDA, in consultation with the Department of Finance and the Office of the Comptroller General, should reconsider the accounting treatment of the paid-in capital of the regional development banks.
CIDA's response: CIDA has reviewed this issue with the Office of the Comptroller General and we are in agreement that the current accounting treatment is appropriate. Paid-in capital is used by the development banks to make loans to developing countries. As these investments are essentially a flow-through mechanism for Canada and other countries to make loans to sovereign states, it is our position that the government's valuation policy for sovereign loans also applies to these subscriptions. They are viewed as collectable unless formally repudiated by the debtor countries.
Parliament may want to consider the need to approve the unpaid subscriptions to the capital of the regional banks11.94 The IFI Act gives the Secretary of State for External Affairs unlimited authority to commit Canada to purchase shares in the regional development banks without going first to Parliament for approval. In 1989, for instance, the authority of section 3 of the Act was used to commit Canada to subscribing to unpaid shares in the Inter-American Development Bank worth more than $1 billion. This commitment was not specifically approved by Parliament, although Parliament has been informed of the extent of this contingent liability through the Public Accounts of Canada.
11.95 When section 3 of the IFI Act was drafted, Canada's involvement in the regional development banks was not as significant as it is today. However, the scale of Canada's participation and the attendant sovereign risk - current and potential - have grown dramatically since 1983. Canada has committed a total of $3.7 billion in unpaid subscribed capital to the regional banks. These unpaid subscriptions (shown as contingent liabilities in the Public Accounts of Canada) may have financial implications for Canadian taxpayers in the future, because they are guarantees that support the borrowings of the banks. We are concerned that there is no mechanism for Parliament to approve these financial commitments. In our opinion, the appropriateness of making financial commitments of such magnitude without explicit parliamentary approval needs to be reconsidered, with a view to improving parliamentary control.
11.96 CIDA should seek amendments to the International Development (Financial Institutions) Assistance Act that would require the Minister to obtain the approval of Parliament before financial commitments are made to the unpaid capital subscription of the regional development banks.
CIDA's response: The Agency proposes to disclose through vote wording the financial commitments for the unpaid capital subscriptions of the regional development banks made pursuant to the IFI Act. It is not for CIDA to determine if amendments to existing legislation should be sought.
Accounting for the legal obligation to make future cash payments to the Funds needs to be reconsidered11.97 Demand notes to the regional development banks - notes payable of $1.1 billion at 31 March 1991 - are shown on the government's statement of assets and liabilities as a reduction in the government's investment in the banks rather than as liabilities. Since 1 April 1986, note encashments ($159 million in 1990-91) are made under budgetary authority, whereas notes issued to the banks ($229 million in 1990-91) continue to be made under non-budgetary authority. The net investment in the regional development banks - the investment, reduced by budgetary expenditures since 1986 and by notes payable - is included in the government's allowance for valuation of assets.
11.98 The deposit by Canada of the demand notes to the Funds signifies an acknowledgement of Canada's obligation to pay. At the time of issuance the notes represent resources of the Funds. They are immediately available for conversion to the Funds' loans receivable. The issuance of the notes by Canada establishes Canada's liability and in turn allows the Funds to immediately make further loans and grants to developing countries. Accordingly, we hold the view that a significant economic event occurs when Parliament approves the issuance of the demand notes, and at that point Canada has met all the terms of the commitment previously made by the Minister. To not recognize the issuance of the notes as a reduction of the resource base of Canada would appear to be inappropriate. These resources cannot belong to both Canada and the Funds at the same time. We therefore believe that notes payable to the regional development banks should be shown as liabilities on the government's balance sheet rather than being netted against the investment in the banks. Further, the related expenditures should be recognized, in an appropriate manner, at the time they are incurred. One view is that it would be appropriate to recognize the expense and the increase in the deficit when the notes are issued rather than waiting until they are encashed.
11.99 CIDA has a different view of this matter. CIDA believes that including the notes in the deficit when they are encashed matches the cost to Canada more closely with the development benefits received. For example, the agreement for replenishing the Inter-American Development Bank's Fund for Special Operations explicitly states that the notes will be encashed according to a ten-year schedule to be established by the Board of Executive Directors. This schedule will match anticipated disbursements of loans approved. Although they are labelled "notes payable", CIDA argues that these notes actually represent only a commitment by Canada over a long period of time and, consequently, they should not be included in the deficit when issued.
11.100 On this matter, the CICA's pronouncement on "Accounting for Government Transfers" states that "government transfers should be recognized in a government's financial statements as expenditures or revenues in the period that the events giving rise to the transfer occurred, as long as: (a) the transfer is authorized; (b) eligibility criteria, if any, have been met by the recipient; and (c) a reasonable estimate of the amount can be made." Judgment is required to account for transfers in a manner that represents the substance of the underlying events rather than the form or funding pattern. The Treasury Board's technical requirements for identifying, quantifying, recording and reporting liabilities are consistent with this pronouncement.
11.101 Subscriptions to the "fund component" of the regional banks appear to meet these criteria at the time the demand notes are issued.
11.102 CIDA, in consultation with the Department of Finance and the Office of the Comptroller General, should reconsider, and revise as appropriate, its accounting for and reporting of notes payable to the regional development banks.
CIDA's response: CIDA has reviewed this issue with the Office of the Comptroller General and we are in agreement that the current accounting treatment is appropriate. These notes payable are commitments to the development banks and not liabilities. They are an agreement to make payments over a scheduled future period, which in turn is used to establish project schedules. Consequently, the matching of costs with benefits, or outputs, should occur when the notes are encashed and not when they are issued.
A Need for Checks and Balances
CIDA needs to involve its Finance and Corporate Information Branch and its Audit and Evaluation Division11.103 Despite Canada's significant and growing financial exposure at the regional development banks, CIDA told us it does not expect its Finance and Corporate Information Branch or its Audit and Evaluation Division to help in managing Canada's participation in the banks.
11.104 We believe that at least one of these units could be monitoring, independently of program management, the way the risks and benefits associated with Canada's participation in the regional development banks are periodically assessed, and could periodically look into the appropriateness of the accounting for that participation. This would strengthen the checks and balances in the management process.
Parliament Needs to Know the Risks and Benefits
CIDA should provide better information11.105 CIDA could enhance its reporting to Parliament on its stewardship of Canada's participation in the regional development banks. What is needed is better, more relevant information. The information submitted to Parliament should be of a "strategic" nature. This might include such items as the development returns for the banks' main borrowers; the value to Canada of permanently retaining a seat on the Board of every regional development bank; and the value of using these institutions to the extent Canada does, instead of using other channels for multilateral or bilateral development assistance. Any significant change in Canada's financial exposure and risk could also be reported.
11.106 Three main published documents tabled each year disclose information on the regional development banks: Part III of the Estimates, the Public Accounts of Canada and CIDA's annual report. Members of Parliament can also obtain information on regional development banks in several other ways: directly from CIDA; through the hearings and special reports of parliamentary committees; from visits to the institutions; and, in some cases, by participating as representatives of Canada at the annual meetings of the banks.
11.107 Our audit concentrated on the formal, publicly accessible documents and the IFI Act. We reviewed these documents to assess whether each meets its main purpose with respect to the information it reports on Canada's participation in the regional development banks.
11.108 Parliament's ability to scrutinize effectively the value obtained from Canada's participation in the regional development banks can be enhanced. Many items need better disclosure. These include the specific objectives for Canada's participation in the banks, the extent of its financial exposure and the net benefits derived. We believe that periodic assessment and disclosure of results could lead to a more discernible portrayal of the net benefits. We recognize that such assessments cannot be done in a purely quantitative or precise terms.
11.109 Three areas need improvement: CIDA's Part III of the Main Estimates, CIDA's input in the Public Accounts, and the IFI Act.
Reporting to Parliament: improving CIDA's Part III of the Estimates11.110 Part III of the Main Estimates is intended to indicate, for each program activity, the results expected for the money spent. CIDA does not report the results expected from the grants, payments and guarantees Canada provides to the regional development banks. For instance, no linkage is made between the resources requested and the results the regional development banks achieve in promoting social and economic development as set out in the IFI Act.
11.111 CIDA should try to link the results expected from its participation in the regional development banks with the money spent. If CIDA finds that this link cannot be made, it should disclose the basis for this finding to Parliament in its Part IIIs.
CIDA's response: As noted in the response to recommendation 11.49, CIDA agrees to the periodic assessment and reporting of how Canada's objectives as set out in the IFI Act are being achieved through the regional development banks. Indeed, the Agency attempts to make such assessments on an ongoing basis and in particular in the context of decisions on fund replenishment or capital increase negotiations. The Agency will try to improve the link between funds disbursed by Canada to the banks and the results expected from our memberships. The Agency would note, however, that assessing the benefits of participation against Canada's objectives in unequivocal and quantifiable terms is difficult. The regional development banks engage in a range of activities that provide benefits for Canada and the international community that are not readily subject to precise measurement.
Improving CIDA's input to the Public Accounts of Canada11.112 The Financial Administration Act, which prescribes the Public Accounts of Canada, demands a statement of assets and liabilities that shows Canada's financial position at the end of a fiscal year, together with a statement of revenue and expenditure for the fiscal year. As previously stated, we have two concerns about the way Canada's contribution to the regional development banks is treated in the Public Accounts: first, the $391 million paid-in capital is recorded as an asset whereas, in our view, the carrying value of this asset needs to be reconsidered; second, notes payable of $1.1 billion are not presented as liabilities. In our view, the accounting treatment for the legal obligation to make future cash payments to the Funds needs to be reconsidered. We have noted in paragraphs 11.103 and 11.104 our concern about lack of adequate involvement of CIDA's Finance and Corporate Information Branch. We have made related recommendations in paragraphs 11.93 and 11.102.
Improving the IFI Act11.113 Competition for development assistance funds is on the rise with recent demands from eastern Europe and the countries of the former Soviet Union. At the same time, it is increasingly clear that development problems are more intractable than they once were believed to be. Policy lending linked with structural adjustment programs of the World Bank and the IMF may take a long time to achieve anticipated results in some developing countries. It is time, perhaps, for Parliament to consider monitoring Canada's role and performance at the regional development banks more closely.
11.114 For example, there is no "sunset clause" in the IFI Act that would require the government to renew its mandate to participate in the regional development banks based on the results of a performance evaluation. Knowing what results have been achieved in the past few years and what is planned for the future could be useful to Parliament when it approves Canada's payments to each of the regional development banks, or when it engages in policy debates on the subject.
11.115 In Chapter 12 of our 1991 Report, "Membership Payments to International Organizations", we suggested that the Department of External Affairs report periodically - but not necessarily every year - on the costs, activities and results associated with Canada's participation in the field of multilateral co-operation. We think CIDA should do the same for Canada's participation in the regional development banks, perhaps submitting a thorough report when negotiations are under way to either replenish a "fund component" or increase a capital subscription to a "bank component". To draw Parliament into the process in a meaningful way, Parliament may want to consider building into the legislation the requirement for CIDA to submit a periodic report.
11.116 The accountability chain that links these institutions to Parliament also needs attention. For instance, there is no requirement in the IFI Act for the Minister to report periodically on Canada's participation in these banks. Nor is it the practice of the Minister to encourage the Canadian Executive Directors, who reside at the banks and are very knowledgeable about what is happening there, to appear before parliamentary committees to account for the results achieved by these institutions.
11.117 CIDA should seek, possibly through amendments to the International Development (Financial Institutions) Assistance Act, a requirement for conducting a periodic assessment and report to Parliament on the developmental and other returns from Canada's participation in the regional development banks.
CIDA's response: The Agency is currently in conformity with the IFI Act. CIDA currently reports to Parliament through Part III of the Estimates as well as frequent appearances before parliamentary committees, including the recently established sub-committee on the international financial institutions. It is not for CIDA to determine if amendments to existing legislation should be sought.