Asian Development Fund Currency Management Proposal October 2005

Asian Development Bank

ABBREVIATIONS

ADB – Asian Development Bank ADF – Asian Development Fund ALM – asset liability management DMC – developing member country

EACA – expanded advance commitment authority IDA – International Development Association

MDB – multilateral development bank SDR – Special Drawing Right

US – United States

GLOSSARY

Special Drawing Right (SDR)

A unit of account used by the International Monetary Fund and some other international organizations. Its value is based on a basket of key international currencies that currently consists of the euro, Japanese yen, pound sterling, and US dollar. The most recent review of the currency basket covered the period 2001-2005.

SDR currencies The currencies that the SDR valuation is based on, currently the euro, the Japanese yen, the pound sterling, and the US dollar.

Disbursement currency The currency requested by a borrower in which the cost of goods and services will be financed.

Cost currency From the perspective of ADB, either the currency in the ADF liquidity pool used directly for disbursement, or the currency in the ADF liquidity pool selected by ADB to be converted into the borrower's required disbursement currency.

Liability currency From the perspective of the borrower, the currency ADB records as the liability of the borrower, in which the principal is repaid and interest and service charges are paid. According to current practice, the liability currency is the same as the cost currency.

Repayment currency

The currency used for loan service payments, including payments for both principal and interest and service charges. According to current practice, the repayment currency is the same as the cost currency and the liability currency.

Functional currency For statutory accounting purposes, the currency of the primary economic environment in which an entity primarily operates. Changes in exchange rates of this currency against the reporting currency are not recorded in the income statement.

Reporting currency The currency in which the financial statements are prepared and presented. The reporting currency for ADB since its inception in 1966 has been the US dollar.

CONTENTS

I. INTRODUCTION 1 II. CURRENT CURRENCY PRACTICE 2

A. ADF Product 2 B. Currency Preservation Principle 2 C. Current Practice Overview 3 D. Impact of Current Practice on Borrowers 5 E. Impact of Current Practice on the ADF 6 F. Comparison with IDA 6

III. HISTORY OF CURRENCY DISCUSSIONS 8 IV. THE CURRENCY PROPOSAL 9 V. RATIONALE OF THE CURRENCY PROPOSAL 12

A. Why SDR? 12 B. Benefits To Borrowers 12 C. Managerial Benefits 13

VI. IMPLEMENTATION CONSIDERATIONS 13 VII. LEGAL REQUIREMENTS 14 VIII. SUMMARY AND RECOMMENDATIONS 15

APPENDIXES: 1. Illustration of Loan Disbursement and Repayment Under Current Practice 16 2. Inconsistent Product Across Borrowers: An Illustration 17 3. Illustration of Proportional Recalling of the Loan Service Payment 18 4. ADF Currency Rebalancing Model 19 5. Questions and Answers 20 6. (Draft) Report of the Board of Directors 22 7. (Draft) Resolution of the Board of Governors 24

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I. INTRODUCTION

1. In this paper, Management is proposing to improve the currency practice of the Asian Development Fund (ADF) in order to benefit its borrowers. Essentially, the current practice of managing ADF resources in as many as 15 currencies will be discontinued. While ADF donor contributions will still be made in national currencies, United States (US) dollars or in Special Drawing Rights (SDR), the Asian Development Bank (ADB) will convert donor contributions and ADF loan reflows1 from various currencies into the currencies which constitute the SDR. The borrower’s obligations regarding repayment of the loan principal and payment of interest and service charges will be determined in SDR, rather than in national currencies. 2. Under the existing legal framework governing the administration of ADF resources, ADB has to preserve the currencies contributed by donors. Governed by this “currency preservation principle”,2 ADF currently has a complex currency structure with planning in US dollars; the size of ADF replenishments in SDR; contributions in national currencies, SDR or US dollars; loan denominations in SDR; and disbursement and repayment in various currencies. There are significant and widespread mismatches between (i) the stated replenishment size and aggregate amount of donors’ contributions, (ii) the operational planning level and available ADF resources, and (iii) loan commitments made in SDR and the currency or currencies of the developing member country (DMC) borrowers’ actual payment obligations. These mismatches increase the commitment risk and disbursement risk of the ADF. 3. More importantly, because of the uneven distribution of foreign exchange risks associated with the various liability currencies chosen at ADB’s discretion, the current practice treats borrowers unequally with an inconsistent loan product. It significantly hampers borrowers’ debt management and planning capability. Borrowers have repeatedly expressed their concerns over these clear disadvantages of the present currency practice.

4. Over the past few years, suggestions have been made on various occasions to improve ADF currency management. However, no consensus on the introduction of a full-fledged SDR system has been reached by donor countries. 5. In response to the President’s call for ADB to be more responsive, relevant and result- oriented, Management reengaged ADF donors in 2005 to discuss possible solutions. ADF currency practices have been reviewed in depth. A holistic approach was followed and a working group composed of staff from various departments was formed to develop a practical proposal to simplify the ADF currency system by adopting a full-fledged SDR approach. 6. By streamlining the SDR approach in key aspects of ADF resource management, the proposal will:

(i) benefit borrowers with a simplified and predictable currency practice; (ii) offer a consistent loan product to DMCs; (iii) harmonize ADB’s practices with those of other multilateral development banks

(MDBs), especially with International Development Association (IDA); (iv) manage and mitigate exchange risk exposures for both borrowers and ADB; and (v) enhance ADF resource management and financial planning capabilities.

1 Loan reflows refers to repayments of loan principal and payments of interest and service charges. 2 The “currency preservation principle” of ADF contributions is part of the “agreement” relating to the ADF between

contributors and ADB referred to in Article 19.3 of the Agreement Establishing the Asian Development Bank (the Charter). Under this agreement, no systematic currency conversion is allowed and the ADF is required to retain the donor-contributed currencies, which are composed of national currencies, US dollars, and SDR.

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7. The proposal was well received by board members at an informal board seminar held on 22 August 2005. Borrowers are also expected to respond favorably to the proposal. The tentative target implementation date is 1 January 2006. 8. This paper is organized into eight sections. Section II reviews the current ADF currency practice, explaining its implications for borrowers and for ADF resource management. A comparison with IDA is drawn. Section III summarizes the history of currency discussions. Section IV outlines the currency proposal, while Section V explains the rationale of the proposal. Section VI describes the implementation considerations. The legal requirements of the proposal are highlighted in Section VII. A summary and recommendations are provided in the last section. The appendixes include detailed analysis and illustrations, a list of questions and answers, and draft legal documents.

II. CURRENT CURRENCY PRACTICE

A. ADF Product

9. ADF loans have been approved and denominated in SDR since 1982.3 In 1999, ADF loan terms and conditions were hardened. Project loans approved since 1999 have a maturity of 32 years with an 8-year grace period. Program loans approved since 1999 have a maturity of 24 years with an 8-year grace period. Both types of loan carry an interest charge of 1.0% during the grace period and 1.5% for the remaining life of the loans.4 Emergency assistance loans have a maturity of 40 years with a 10-year grace period and 1.0% interest charge. No commitment fee is charged for any ADF loan. 10. Under the eighth replenishment of the ADF (ADF IX) covering 2005–2008, ADB is authorized for the first time to provide ADF grant financing for projects and programs of high developmental priority.5 The grants are committed and disbursed in US dollars while ADF resources can be converted to US dollars for grants.6 In addition, disbursement can be arranged in currencies other than US dollars by ADB if requested by the beneficiaries, who would in that case be responsible for any shortfall in the grant amount caused by exchange rate fluctuations of the disbursed currency. Therefore, there is no real currency mismatch or inconsistency with grants. The focus of this proposal is on ADF loan currency management only. B. Currency Preservation Principle

11. Resolutions Nos. 67 and 68 of the Board of Governors regarding initial resource mobilization for the ADF expressly provide that contributions of members have to be made in the “national currency” of the member. This approach was adopted, in the absence of a general maintenance of value requirement in the ADF, to help keep the overall value of the resources of the ADF at a reasonably constant level. While ADF contributors were subsequently given the opportunity to denominate their contributions in national currencies, SDR, or US dollars, it is still one of the basic principles governing administration of ADF resources that ADB is required to

3 ADB.1982. Denomination of ADF Loans in SDR. Manila 4 ADB. 1998. Review of the Loan Terms of the Asian Development Fund. Manila. In December 1998, the Board

approved a proposal that the service charge (for loans before 1999) would be redesignated as an interest charge and that this would apply to new loans with formal loan negotiations completed on or after 1 January 1999.

5 ADB. 2004. ADF IX Donors’ Report: Development Effectiveness for Poverty Reduction. Manila 6 Per ADF IX Grants Program: Staff Instructions dated 16 November 2004 issued by SPD. ADB is authorized to

convert ADF resources into US dollars after an effective grant commitment in US dollars has been made by ADB.

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preserve donors’ contributions in the originally denominated currencies drawn down by ADB (currently in 15 currencies). 12. The currency preservation of ADF contributions is part of the arrangements agreed between ADF contributors and ADB relating to the administration of ADF resources. In accordance with Article 19.3 of the Agreement Establishing the Asian Development Bank (the Charter), any conversion of ADF resources over time into a basket of SDR currencies requires for that reason the agreement of ADF donors, or, alternatively, donors must be given the opportunity to opt against conversion of their currencies by filing a statement to that effect. Moreover, ADB is only authorized in accordance with Article 24.4 (i) of the Charter to convert currencies at the spot rate to finance expenditures under ADF loans. C. Current Practice Overview

12. Under the current system governed by the currency preservation principle, the borrower is obliged to repay the principal of the loan and to pay interest and service charges in the currency or currencies withdrawn from the loan account, unless ADF resources were converted to provide the borrower with a particular currency or currencies. In the latter case, repayment of the principal and payment of interest and service charges is in the currency or currencies which had to be converted for that purpose.7 This has resulted in a complex ADF currency system, with (i) planning in US dollars; (ii) replenishments in SDR; (iii) contributions in national currencies, US dollars, or SDR; (iv) loans in SDR; and (v) disbursement and repayment under ADF loans in as many as 15 currencies. 13. Table 1 illustrates the skewed currency composition of ADF financial assets. Because of the requirement to retain the currency composition of ADF resources, Management has adopted a currency prioritization working principle to maximize investment income. Maximized investment income directly contributes to the expanded advanced commitment authority (EACA), which ultimately increases ADF lending capacity in the future. 14. Based on the currency prioritization working principle, low-yield currencies (such as the yen in the current market environment) are disbursed first and recalled last, while high-yield currencies (such as the Australian dollar in the current market environment) are disbursed last and recalled first. This is evident from Table 1, as the ADF liquidity pool currently holds a small percentage of low-yield currencies and a large percentage of high-yield currencies. On the other hand, the receivables on loans outstanding show the reverse pattern, with a large percentage of low-yield currencies and a small percentage of high-yield currencies. For reference, at the end of June 2005, total ADF liquidity was $5.8 billion, while ADF loans outstanding amounted to $20.4 billion.

7 Article III, Section 3.8 (b), of the Regulations of the Asian Development Fund and Article IV of the Special

Operations Loan Regulations.

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Table 1: ADF Currency Weights (%)

Currency

SDR Basket1

2 September 2005 FX

Cumulative ADF Contribution2

Board Resolution FX

ADF Liquidity 30 June 2005

FX

Receivable on Loan

Outstanding 30 June 2005 FX

US dollar 38.9 17.8 7.0 15.9 Euro 36.0 18.1 37.1 14.7 Japanese yen 12.9 37.0 1.1 58.9 Pound sterling 12.2 4.5 16.7 0.8 Subtotal 100.0 77.4 61.9 90.3 Canadian dollar 6.7 14.5 3.9 Australian dollar 6.6 18.5 1.3 Others3 9.3 5.1 4.5 Total 100.0 100.0 100.0

ADF = Asian Development Fund, FX = foreign exchange, SDR = Special Drawing Right, US = United States. 1 All currency weights calculated in US dollar equivalent. Currency weights of SDR from 2001–2005 are fixed by the

IMF at 45% of US dollar, 29% of euro, 15% of Japanese yen, and 11% of pound sterling. The fixed amount of each currency in the SDR basket during 2001-2005 is determined by the average exchange rates over the last 3 months of year 2000. As foreign exchange rates fluctuate, the SDR currency composition in terms of the US dollar also changes.

2 Includes all contributed and pledged resources: for European countries that contributed in euros since ADF VII, the US dollar equivalent amount of their pre-euro contribution is included in the euro amount.

3 Other currencies include Danish krone, Swedish krone, Korean won, Malaysian ringgit, New Zealand dollar, Norwegian krone, Singapore dollar, Swiss franc and Thai baht.

Source: Treasury Department.

15. While ADF loan commitments are denominated in SDR, disbursement and payment of loan principal and interest and service charges are made in any of the currencies contributed by ADF donors. Example A of Appendix 1 illustrates the procedure of a single loan disbursement and repayment. If the currency requested by the borrower to finance the cost of goods and services (defined as the disbursement currency) is unavailable within the ADF liquidity pool, ADB usually sells a low-yield currency on hand (defined as the cost currency) to buy the disbursement currency in the market. The cost currency determines the actual liability amount to the borrower for this disbursement (defined as the liability currency). At present, the cost currency, in any of the national currencies, is always the same as the liability currency for each disbursement. The borrower, therefore, needs to repay the principal and pay the interest and service charges based on the cost currency or the liability currency amount. Furthermore, for reporting purposes, the US dollar equivalent of the cost currency is recorded. The maximum availability of the aggregate disbursements is controlled in SDR amount using ADB’s official foreign exchange rates. 16. An ADF loan generally incurs multiple disbursements, as illustrated in example B of Appendix 1. Each disbursement may be made in a different cost currency, according to the low-yield currency priority at the time. Similarly, the currency to be billed for each installment payment is selected by ADB based on the high-yield currency priority. As indicated in Appendix 1, because of fluctuations in the exchange rates of the cost currencies, the SDR equivalent of aggregate disbursements, calculated using historical exchange rates at the time of disbursements, does not equal the SDR equivalent of the total payment obligation of the borrower at the time of payments. The inherent mismatch between the loan commitment expressed in SDR and the SDR equivalent of the borrower’s actual payment obligation is the result of determining the borrower’s liability in the cost currencies rather than in SDR.

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17. Table 2 shows the US dollar equivalent of disbursement and repayment of ADF loans by cost currency in 2004. This further demonstrates the currency priority working principle. The yen was the main currency disbursed in 2004, followed by the US dollar, because these were low-yield currencies. Similarly, high-yield currencies such as the euro and the Australian dollar were the main currencies recalled in 2004.

Table 2: Actual Loan Disbursement and Repayment Amount by Cost Currency

Currency

2004 Disbursement (US$ million)

% of Total

2004 Repayment

(US$ million)

% of Total

Japanese yen US dollar Norwegian krone Euro Korean won Swiss franc Canadian dollar Australian dollar Swedish krone Pound sterling Danish krone Others

496.6 248.9 188.5 72.9 22.9 22.3 0.2 0.2 0.1 0.0 0.0 2.5

47.1% 23.6% 17.9% 6.9% 2.2% 2.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.2%

64.6 23.9 4.1 97.8 1.7 6.2 67.5 68.7 12.7 31.6 9.9 1.6

16.6% 6.1% 1.1%

25.1% 0.4% 1.6%

17.3% 17.6% 3.2% 8.1% 2.5% 0.4%

Total 1,055.1 100.0% 390.2 100.0% US = United States. Notes: Calculated based on exchange rate at the time of disbursement; converted at prevailing exchange rates at the time of receipt; other currencies include Malaysian ringgit, New Zealand dollar, Singapore dollar, and Thai baht. Source: Controller’s Department. 18. In summary, ADB Management and ADF borrowers currently have to manage as many as 15 currencies because ADF is not permitted to systematically convert contributed currencies. The currency prioritization working principle is followed to maximize ADF investment income and to ultimately increase ADF’s future lending capacity. The borrower’s liability is locked in the cost currency instead of SDR, creating a mismatch between the SDR amount in the loan commitment and the SDR equivalent of the borrowers’ actual repayment obligation. D. Impact of Current Practice on Borrowers

19. Current ADF currency practice brings apparent challenges to the borrowers’ debt management and planning.

(i) DMCs are not given the option of selecting the liability currencies. Any of the 15 currencies contributed by donors can be used as the cost currency or liability currency at ADB’s discretion.

(ii) It is difficult for DMCs to anticipate the sequence of currencies that will be recalled by ADB over the repayment period.

(iii) Without knowing exactly what liability currencies will be disbursed or recalled, borrowers are unable to manage the foreign exchange risks of their debt portfolio effectively. Moreover, coping with as many as 15 currencies adds to the borrowers’ debt administration.

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(iv) The difference between ADF’s currency practice and that of the IDA further complicates borrowers’ debt management.

20. More importantly, the mismatch between the SDR amount in the loan commitment and the borrower’s actual obligations leads to an inconsistent and volatile ADF loan product. The ADF is in effect treating borrowers unequally because of the different foreign exchange risks associated with different cost currencies. A simple illustration in Appendix 2 underscores the inconsistency of ADF loans to the borrowers. Given the same loan terms, depending on the movement of foreign exchange rates, the nominally identical loan terms lead to different profit or loss position for the borrowers. E. Impact of Current Practice on the ADF

21. While ADF donors generally contribute in a variety of national currencies and in US dollars,8 ADF loan commitments are denominated in SDR. Foreign exchange rate fluctuations create imbalances between ADF resources and commitments, leading to commitment risk and disbursement risk. Commitment risk occurs when exchange rate fluctuations cause a reduction in the commitment authority, which imposes ADF lending program adjustments. Disbursement risk occurs when adverse exchange rate movement causes a resource shortfall in meeting the disbursement requirement of loans already committed. To mitigate disbursement risk, a 6.5% cushion is built into the commitment authority calculation. 22. Present currency practice complicates the situation and leads to additional currency mismatches. The mismatch between the ADF resource pool (made up of ADF replenishments and EACA converted into either US dollars or SDR) and the ADF operational planning level (in US dollars) complicates ADF resource management. ADF is exposed to foreign exchange risks because of the misalignment between the SDR amount of loan commitment and subsequent payments. 23. From the perspective of internal financial management, handling 15 currencies entails substantial transaction and administration costs for borrowers and ADB over the life of the loans. F. Comparison with IDA

24. SDR and/or US dollars are commonly used by other MDBs, including IDA, for financial management and operational planning of concessional financing. The ADF and IDA share many features in terms of the replenishment framework of the fund, the modality of loans, loan currency denominations, allocation methods, and performance measures. Most ADF borrowing countries also participate in the IDA programs. 25. However, ADF currency practice differs significantly from that of IDA. Table 3 compares the currency practices of IDA and ADF in various aspects of fund administration. Although both IDA and ADF loans are denominated in SDR and donors’ contributions in national currencies,9 IDA has adopted a full-fledged SDR approach as the loan liability is determined on the SDR value of disbursements. Operational planning and commitment authority are also SDR-driven. The IDA liquidity pool is rebalanced periodically to reach SDR composition using a forward-looking currency rebalancing model. Unlike IDA, the ADF has a mixed currency model.

8 Donors’ contribution can also be denominated in SDR. 9 Donors’ contribution can also be denominated in US dollar or SDR.

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Table 3: Currency Practices of the International Development Association (IDA) and the Asian Development Fund (ADF)

IDA ADF

Replenishment Size

SDR

SDR or US$

Donor Contributions1 National currencies National currenciesLoan Denomination SDR SDRCommitment Authority SDR/US$ US$ Disbursement Currency Per borrower Per borrowerCost Currency (to Bank) SDR currencies, mostly in US$ At ADB’s discretion; any currency

within the liquidity poolLiability Currency (to borrowers) SDR Same as cost currencyRepayment Currency One of SDR currencies

(determined during negotiation)At ADB’s discretion; tie with liability

currencyOperational Planning SDR and US$ US$Advanced Commitment Authority SDR (US$ testing) US$ (convert to SDR)Currency Alignment Quarterly or as needed Not allowedContribution Currency Conversion

Immediately converted into SDR currencies

Not allowed. Currency preservation

Reporting Currency US$ US$Functional Currency SDR and US$ National currencies Liquidity Currency Composition Tranche1:cash immunization

Tranche2: residual liquidity; exact SDR weights

Currency yield prioritization

ADF = Asian Development Fund, IDA = International Development Association, SDR = special drawing right 1 Contributions to ADF can also be denominated in US dollars or SDR. Contributions to IDA can be denominated in

national currencies, SDR, or freely convertible currencies of another member country with the agreement of IDA. Source: Treasury Department. 26. Figure 1 compares IDA’s currency model with that of the ADF. The aim of IDA’s model is to achieve immunized asset liability management10 (ALM) through a foreign exchange risk mitigation mechanism. In this way, non-SDR-denominated resources are fully aligned with SDR-denominated obligations. However, ADF loans have a pseudo-SDR nature in that the real liability currency is determined at the discretion of ADB and can be any of the currencies within the ADF resource envelope.

10 See Appendix 5 for an explanation of immunized asset liability management.

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Figure 1: International Development Association (IDA) and Asian Development Fund (ADF)

Currency Model Comparison

IDA Model

IDA RESOURCES IDA OBLIGATIONS SDR

SDR Non-SDR

[Immunized ALM and Rebalancing]

************************************************************************************************************

ADF Model ADF RESOURCES ADF OBLIGATIONS US$ Planning Non-SDR Reflows Non-SDR Disbursement

_____________________________________________________________________________________________ ADF = Asian Development Fund, ALM = asset liability management, FX = foreign exchange, IBRD = International Bank for Reconstruction and Development, IDA = International Development Association, OCR = ordinary capital resources, SDR = special drawing right, US$ = United States dollars. Source: Treasury Department.

III. HISTORY OF CURRENCY DISCUSSIONS

27. ADF currency issues have been raised several times in the last few years. Borrowers have repeatedly expressed concern about the unpredictability and complexity of ADF debt management. During the negotiations on the seventh replenishment of the Asian Development Fund (ADF VIII) in 1999–2000, Management proposed five general options to donors to manage the currency risk of the ADF. Except for the recommendation on operational planning

SDR-Denominated Assets • Reflows

Non-SDR-denominated assets • Donor Contributions • Investment Income • IBRD Transfer • Other Flows

IDA’s FX Risk Mitigation Mechanism

SDR-Denominated Obligations

(Real)

SDR/US$ Planning

Non-SDR-Denominated Resources • Reflows • Donor Contributions • Investment Income • OCR Income Transfers • Other Flows

SDR-Denominated Obligations

(Pseudo)

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in SDR, the other options were not pursued because of a lack of consensus among donors in allowing currency conversion.

(i) 13–14 October 1999 (ADF VIII Donors’ Meeting in Brisbane). ADB proposed five options for managing currency risk. Two were considered not feasible by donors: (i) to denominate future donor contributions in SDR, and (ii) to create an ADF unit of account.

(ii) 14–15 June 2000 (ADF VIII Donors’ Meeting in Rome). Two of the three remaining options—(i) to correct currency imbalances in received and committed resources, and (ii) to introduce a full-fledged SDR denomination—were dropped because of a lack of a donors’ consensus on currency conversion. The surviving proposal—(iii) to conduct operational planning in SDR rather than in US dollars—was recommended by the donors.11

(iii) 2003–2004 (ADF IX Negotiations). A series of informal currency discussions was held to clarify questions on (i) the currency preservation principle, (ii) hypothetical liquidation or withdrawal from the ADF, and (iii) other required regulatory changes for a full-fledged SDR denomination of ADF loans. However, no further development on the currency issues materialized.

28. In response to the President’s call for ADB to be more responsive, relevant and result- oriented, an interdepartmental working group was formed in 2005 to thoroughly review ADF currency management practices and to formulate a feasible currency proposal.

IV. THE CURRENCY PROPOSAL

29. To streamline the SDR approach in key aspects of ADF financial management and operational planning, ADB Management proposes to improve ADF currency management within the existing loan framework in order to (i) to benefit the borrowers, and (ii) to harmonize with IDA practice. The essence of this proposal is that ADB will be authorized to convert ADF resources currently held in various currencies into SDR currencies and to establish SDR as the liability currency of the ADF borrowers. ADF resources will be systematically converted to SDR currencies over time. Borrowers’ obligations on repayment of the principal and payment of interest charge will be determined in SDR, rather than in various national currencies.

30. Table 4 outlines the proposal. It is proposed that the full-fledged SDR mechanism be applied to new loans for which invitations to loan negotiations are issued on or after 1 January 2006. Loans will remain denominated in SDR in loan agreements. Under the proposed scheme, for each disbursement of new loans, one of the four SDR currencies will be used by ADB as the cost currency, based on transaction and administrative efficiency. Disbursements will be calculated as the SDR equivalent of the cost currencies based on applicable exchange rates at the time of disbursements. The liability currency for repayment of loan principal and payment of interest charge will be SDR. In this way, the loan disbursement and collection cycle will be fully controlled in SDR. To further benefit DMCs, borrowers will be able to determine the repayment currency out of the SDR currencies during loan negotiations. They will also be offered the flexibility to change the repayment currency, provided they give sufficient advance notice to ADB.

11 ADB. 2000. ADF VIII Donors’ Report: Fighting Poverty in Asia. Manila.

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Table 4: Asian Development Fund (ADF) Currency Proposal Matrix

A. ADF Loans For Existing Loans For New Loans Undisbursed Portion Already Disbursed Potion 1. Loan Denomination SDR SDR SDR 2. Cost Currency SDR currencies SDR currencies National currencies 3. Liability Currency SDR Same as cost currency Same as cost currency 4. Repayment Currency SDR currencies, pre-

predetermined at negotiations; changeable upon advance notice

(i) Same as cost currency (ii) Proportional recalling of multicurrency disbursement (iii) Option to pay in SDR currencies

B. ADF Management 1. Principles (i) Currency preservation principle to be modified to allow currency conversion.

(ii) Currency prioritization strategy to be changed to a rebalancing scheme, aimed at SDR realignment and immunized ALM.

2. Currency Rebalancing (i) Liquidity management through tranching approach.

(ii) Currency rebalancing by foreign exchange transactions.

3. Accounting (i) Reporting currency remains US dollars while functional currencies will be based on the economic environment of ADF operations which may change over time as it becomes evident.

(ii) Maintain two different ADF loan products (“new” and “existing”) for loan accounting and billing purposes until the old ADF loans are fully repaid.

(iii) Gains or losses associated with foreign exchange movements between non-functional currencies (including SDR-denominated loans) and functional currencies to be recorded in the income statement. Foreign exchange gains or losses between functional currencies and reporting currency to continue to be recorded in the balance sheet.

4. Operational Planning Determined and controlled in SDR (planning at country and regional level remains

in US dollars) 5. Commitment Authority Determined and controlled in SDR (planning at country and regional level remains

in US dollars) 6. Contribution Currency Will be mapped and converted to SDR currencies upon receipt.

ADF = Asian Development Fund, ALM = asset liability management, SDR = special drawing right, US = United States. Source: Asian Development Bank.

31. The proposal will also improve the currency practice of existing loans, as highlighted in Table 4. These changes will make the future repayment of loan principal and payment of interest and service charges more predictable for borrowers, reduce the foreign exchange transaction cost for the loan service payments, and distribute foreign exchange risk to the borrowers in line with the SDR currency composition.

(i) For all existing loans, ADB plans to revise the amortization mechanism to proportionally recall the outstanding currencies. The option of making the repayment of loan principal and payment of interest and service charges in one of the SDR currencies (converted by ADB) will be also offered to borrowers. These changes will be implemented once the accounting system has been enhanced, possibly starting from billings to be generated after 1 July 2006. Appendix 3 demonstrates the proportional recalling approach.

(ii) For partially disbursed loans or yet-to-be disbursed existing loans, cost currencies of the new disbursements will be made in one of the four SDR

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currencies, starting from 1 January 2006. For disbursement of program loans, ADB will disburse the four SDR currencies as per SDR currency weights from 1 January 2006. For the remaining disbursements of existing loans, business rules will be established to approximate the SDR approach with a target starting date on 1 January 2006. For example, SDR currencies can be disbursed as cost currencies in rotation during the disbursement period. For collection, borrowers will be given the option to pay with SDR currencies (converted by ADB) once the accounting system is in place, possibly by 1 July 2006.

32. Recognizing the significant technical and administrative challenges of converting existing loans to the proposed SDR regime, Management intends to apply the full-fledged SDR mechanism only to new loans. The option of converting existing loans to the new SDR framework may be offered to borrowers at a later phase of the project implementation, subject to borrowers’ in-depth review of their existing ADF loan portfolios and ADB’s administrative readiness. 33. This proposal will affect many key aspects of ADF’s internal financial management, including policies, accounting, operational planning, commitment authority, and currency rebalancing.

(i) The proposal will authorize ADB to convert ADF resources into the four SDR currencies. It will entail a change from the currency prioritization strategy to an SDR rebalancing scheme.

(ii) The ADF liquidity position will be comprehensively reviewed so that a new ADF liquidity policy and investment authority can facilitate currency rebalancing with foreign exchange transactions.

(iii) Internal operational planning and commitment authority will be determined and controlled in SDR, although the operational planning at country and regional level will remain in US dollars to facilitate dialogue with DMCs.

(iv) For accounting purposes SDR cannot be considered as a functional currency according to the outside auditor. Therefore, any fluctuation in the exchange rate movements between functional currencies and non-functional currencies, including exchange rate movements in SDR against functional currencies, will impact ADF income statement. This may potentially result in volatility in the income statement. As an illustration, historically, the annual SDR/US dollar exchange rate fluctuations have ranged from 2% to 10% in the last 10 years. However, this accounting procedure will not affect the real financial soundness of the ADF. Meanwhile, Management will take measures to monitor such accounting gains or losses prudently.

34. Another important implication of this proposal is the requirement to strengthen the ADF’s ALM. An integrated ADF financial projection model needs to be developed to provide currency rebalancing instructions aimed at achieving immunized ALM, both in terms of currency composition and in terms of cash flow and duration. Appendix 4 explains the general structure of the forward-looking currency rebalancing model from the cash flow perspective of ALM. 35. The proposed currency management practice will not change the manner in which the ADF replenishment negotiations are conducted, the method of determining donors’ burden shares, their units of obligation, or the modalities of concessional financing offered by ADB.

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V. RATIONALE OF THE CURRENCY PROPOSAL

A. Why SDR?

36. Since 1982, ADF loans have been denominated in SDR.12 In general, SDR has less foreign exchange rate volatility than any single currency. In addition, a consensus among ADF donors to endorse any single currency denominated lending product is unlikely. 37. To demonstrate SDR’s low volatility, Figure 2 shows the percentage fluctuation of each ADF replenishment size in US dollars and in SDR between time of the adoption of Board resolutions and the end of each replenishment cycle. The volatility of SDR-denominated resources has been significantly lower than that of US dollar-denominated resources in all ADF replenishments.

Figure 2: Fluctuations in ADF Donors' Contributions Between the Board Resolution and the End of Each Replenishment

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

ADF I ADF II ADF III ADF IV ADF V ADF VI ADF VII ADF VIII ADF IX

Contribution Resource % Increase (Decrease) in SDR

Contribution Resource % Increase (Decrease) in USD

ADF = Asian Development Fund. Notes: ADF IX contribution value is updated based on 30 April 2005 foreign exchange rates; contribution

includes income from accelerated notes encashment, financing of foregone interest of grants, and supplementary contribution but excludes the Technical Assistance Special Fund portion.

Source: Treasury Department.

B. Benefits To Borrowers

38. The proposal is intended to strengthen ADF currency management with an overarching goal of benefiting borrowers. The following benefits will arise: 12 ADB. 1982. Denomination of ADF Loans in SDR. Manila.

13

(i) By specifying SDR as the liability currency, all DMC borrowers will be treated equally in terms of foreign exchange risk and in the determination of the payment obligation. A consistent ADF product will be created that is fair to all borrowers.

(ii) DMCs will benefit from predictable currency planning and debt portfolio management, because the liability currency will be known.

(iii) DMC borrowers will be able to select the repayment currency at the time of the loan negotiations. They will also have the flexibility to change the repayment currency provided they give sufficient advance notice to ADB.

(iv) DMCs’ financial management of their concessional borrowing portfolios will be simplified and streamlined.

(v) DMC borrowers will have a more stable liability currency, since the SDR is generally less volatile than any of the single currencies.

C. Managerial Benefits

39. The proposal will also improve long-term solution to improve ADF product and financial management with the following managerial benefits to ADB:

(i) The proposal will harmonize concessional financing practices across MDBs. The ADF and IDA often lend to the same borrowers in Asia. The proposal will enable the ADF to streamline its currency practice with IDA’s full-fledged SDR mechanism.

(ii) ADF operational planning currency will be aligned with the loan commitment currency. Currently, ADF planning is driven by US dollars which are then converted to SDR. Under the proposal, although operations will still be predominately planned in US dollars at country and regional level, ADF internal planning and commitment authority will be managed in SDR.

(iii) The proposal would reduce 15 currencies to 4 currencies in the financial management framework, which will significantly simplify ADF currency transactions and loan administration in the long term.

VI. IMPLEMENTATION CONSIDERATIONS

40. Implementation of the proposal will require staff resources and system enhancements. Costs will be incurred in rearranging the loan accounting system. The different accounting treatment for the new loans and existing loans will require additional resources. Specifically, one of the prerequisites for implementing the proposal will be the adoption of daily foreign exchange rates as ADB’s book exchange rates to ensure the outstanding loan balances are determined more accurately. At present, the ADB-wide book rates are updated on a semi-monthly basis. A separate Board document has been circulated proposing adoption of a daily exchange rate system. The proposed practice requires enhancement of the existing Comprehensive Loan Administration and Servicing System (CLASS) with respect to (i) change of the amortization and billing mechanism of existing loans, and (ii) recording of the new SDR loans in the functional currency or currencies to reflect exchange gain or loss to the income statement. The cost of the services for the enhancements to CLASS is estimated to be US$270,000, and the entire cost can be accommodated within the administrative budget envelope for 2005. In addition, for existing loans, approximating the SDR value-based disbursements will take additional staff time and effort on cash management.

14

41. Staff resources are critical for the development of a projection model with a currency rebalancing capability. Once the model is established, further resources will be required to maintain and update the model. This multi-currency projection model will have the capacity to run sensitivity and scenario analysis. With several modules incorporated, the model will generate projected financial statements, cash flow projections, EACA, currency rebalancing, and other reports for more detailed analysis. 42. As an integral part of currency rebalancing, ADF’s liquidity and investment practices should be reviewed and a new policy established. The change from the currency prioritization principle may reduce ADF’s investment income from the ADF liquidity pool by about 20%. However, the potential loss in investment income can be mitigated by enhanced duration management under the new ALM framework. An effective liquidity policy and investment authority will be needed to achieve an optimal currency rebalancing scheme and to compensate for the investment income loss. 43. Given the long maturity structure of ADF loans, an extended transition period should be expected to fully benefit the borrowers. To ensure the full understanding and successful implementation of the proposal, training arrangements will be made to DMC borrowers and ADB staff. 44. For the anticipated resource requirement, Management plans to mobilize internal and temporary staff resources. Management does not currently foresee any increase in the regular staff workforce. 45. Finally, within the new full-fledged SDR framework, functional currency may change over time. Foreign exchange gains or losses of nonfunctional currencies, including SDR, as against functional currencies will affect the income statement as a separate line item. However, this accounting treatment will not change the economic position of the ADF.

VII. LEGAL REQUIREMENTS

46. An opinion regarding “Legal Implications Concerning a Conversion of Asian Development Fund Resources into other Currencies” was prepared by the Office of the General Counsel (OGC) for the ADF VIII Donors’ meeting in Brisbane in October 1999. As set out in that opinion, any systematic conversion of ADF resources into other currencies for the purpose mentioned above requires a decision by the Board of Directors pursuant to Article 24.4(ii) of the Charter, taken by a vote of the Directors representing not less than two thirds of the total voting power of the members, and substantial changes to the legal framework of ADF resources currently in force. 47. The various resolutions of the Board of Governors regarding the initial mobilization of ADF resources and the ADF replenishments are predicated on the assumption that donors’ contributions are to be held in the currencies in which they were contributed. This understanding was confirmed by ADF donors in the ADF VIII Donors’ Report,13 which was referenced by the Board of Directors in its Report to the Board of Governors and accepted as such by Resolution No. 276 of the Board of Governors. Therefore, the adoption of a SDR-based approach to the financial management of ADF resources requires express authorization of the Board of Governors. A letter to the Board of Directors is attached as Appendix 6, seeking confirmation from individual donor countries to convert the contributed currencies into SDR currencies. A

13 ADB. 2000. Seventh Replenishment of the Asian Development Fund, Attachment 1. Manila.

15

proposed draft Resolution of the Board of Governors, which provides such authorization, is contained in Appendix 7. 48. The introduction of an SDR-based approach requires amendments to Article III, Section 3.08(b), of the ADF Regulations and to the “Currency Provisions” set forth in Article IV of the Loan Regulations, which authorize ADB to value disbursements, repayments and charges under loans from ADF resources in terms of SDR. In addition, amendments to Article V of the ADF Regulations would be necessary regarding the valuation of donors’ contributions and other ADF resources (including set-aside resources and OCR net income and surplus transferred to the ADF) in terms of SDR, in the case of withdrawal of a contributor or the termination of the ADF. The amendments to Article V of the ADF Regulations will provide inter alia that the value of a paid-in contribution will be the equivalent in terms of SDR of the amount paid in by a contributor, determined in accordance with the exchange rates set forth in the relevant authorizing Resolution of the Board of Governors, except that for contributions made pursuant to Resolutions Nos. 67, 68, 92 and 121 of the Board of Governors and the amendments thereto, the value of the contributor’s contribution will be determined with reference to the SDR equivalent of the US dollar of the weight and fineness in effect on 31 January 1966, as used by ADB for the valuation of its capital, in accordance with Article 4, paragraph 1, of the Charter. 49. The proposed amendments to Article V of the ADF Regulations will not imply a fundamental change, as the methodology for determining the proportionate share of contributors in case of withdrawal of an ADF contributor or the termination of the ADF, essentially will remain unchanged. While under the proposed new framework, SDR would be used as the basis in determining the donor’s share, such determination would generally be based, as under the current framework, on applying historical exchange rates set forth in the Resolution of Board of Governors regarding the initial resource mobilization to the ADF and ADF replenishments. 50. Appropriate amendments to the ADF Regulations and the Loan Regulations will be submitted to the Board of Director for approval following adoption of the proposed resolution by the Board of Governors. Adoption of the amendments to the ADF Regulations will require a special resolution of the Board of Directors, approved by a majority of the Directors, representing not less than two thirds of the total voting power of the members.

VIII. SUMMARY AND RECOMMENDATIONS

51. The proposal will allow the ADF to adopt a full-fledged SDR approach to resource administration and operational planning to benefit borrowers and to bring the ADF in line with the currency practices of the soft lending facilities of other MDBs. Therefore, it is recommended that the Board of Directors:14

(i) agree to adopt the (draft) report to the Board of Governors and submit this report with the proposed resolution to the Board of Governors; and

(ii) submit this matter to the Board of Governors under the special procedure

provided under section 3 of the by-laws, with a request for a vote by telex, facsimile or e-mail within 30 days of the date of such request.

14 Please refer to Appendix 7, the draft resolution of the Board of Governors.

Appendix 1 16

ILLUSTRATIONS OF LOAN DISBURSEMENT AND REPAYMENT UNDER CURRENT PRACTICE

A. Single Disbursement

B. Multiple Disbursements

A$ = Australian dollar, JPY = Japanese yen, M = million, SDR = special drawing right, US$ = United States dollars. 1 Maximum availability of aggregate disbursement of a loan is controlled in SDR- denominated commitment. Source: Controller’s Department

Total Repayment

JPY 2000M

Liability Currency

A$ 26M

Euro 20M

SDR Equiv.

Amortization in SDR

=

=

=

SDR 12M

SDR 20M

SDR 16M

________ Total = SDR 48M =

32 Years Incl. 8 Year Grace

= 48 Semi-annual Installment or

SDR 1M/Installment

____________ SDR 48M

Principal Due (For First Installment)

If JPY is called, principal amount due will be: SDR 1M x (2000M/12M) = JPY167M or, If A$ is called: SDR 1M x (26M/20M) = A$1.3M or, If Euro is called: SDR 1M x (20M/16M) = Euro 1.25M

JPY 2000M

A$ 26M

Euro 20M

Rupee

Japanese yen

(US$)

SDR

Japanese yen

• The borrower requests rupee payment to its contractors.

• ADB sells yen from the ADF liquidity pool (because of its low yield) at spot rate to enable it to buy and disburse the rupee amount. Yen is the cost currency for this disbursement.

• For reporting purposes, ADB records the US dollar equivalent of the yen sold.

• The SDR equivalent of the disbursement (of yen) is recorded and debited to the loan account (to reduce the undisbursed loan balance).1

• The borrower will repay the principal and pay the service and interest charges based on the yen amount. Yen is the liability currency.

______________ ≠ SDR 48M

Appendix 2 17

INCONSISTENT PRODUCT ACROSS BORROWERS: AN ILLUSTRATION

Assumptions Loan Amount: SDR100 million Year Start Disbursement: 1981 Terms: 24 years with 8 years grace Repayment Terms: Equal repayment Disbursement Pattern:

Year Year 1 6.80% 6 12.80% 2 7.90% 7 11.30%

3 14.30% 8 9.70% 4 15.10% 9 4.80% 5 14.70% 10 2.60%

Item DMC 1 DMC 2 DMC 3

Original

Loan Liability

Currency Liability

Currency Liability Currency

in SDR

(million) ¥

(million) US$

(million) A$

(million) Total Disbursements

in Liability Currency 100

21,741

110 148 Total Repayments

in Liability Currency 100

21,741

110 148

in SDR Equivalent

134

79 73 Effect of Exchange Rate due to Current Practice in SDR % Gain (Loss) - (33.8%) 21.0% 26.9% A$ = Australia dollar, DMC = developing member country, SDR = special drawing right, US$ = United States dollar, ¥ = Japanese yen. Notes: 1. Exchange rates used per year end rates from 1981 to 2004. 2. Liability currency refers to the cost currency ADB uses to convert to disbursement currency per request of borrowers. 3. This example is for illustration purpose to show the extreme case. It does not represent the real loan case. In reality, the

disbursement of a loan takes place in a variety of currencies. Source: Treasury Department

Appendix 3 18

ILLUSTRATION OF PROPORTIONAL RECALLING OF LOAN SERVICE PAYMENT

A$ = Australian dollar, JPY = Japanese yen, M = million, SDR = special drawing right. Source: Controller’s Department

JPY 2000M

Liability Currency

A$ 26M

Euro 20M

SDR Equiv.

Amortization in SDR

=

=

=

SDR 12M

SDR 20M

SDR 16M

________ Total Disb.= SDR 48M =

32 Years Incl. 8 Year Grace

= 48 Semiannual Installment or

SDR 1M/ Installment

_____________SDR 48M

Principal Due (For First

Installment)

JPY principal amount due will be: SDR 1M/48M x 2000M = JPY41.7M and A$ : SDR 1M/48M x 26M = A$0.54M and, Euro: SDR 1M/48M x 20M = Euro 0.42M

Total Repayment for First Installment

Pay each of the three currency: JPY41.7M + A$0.54M + Euro 0.42M

Or, option to pay in SDR Currencies as follows:

USD (or any of the SDR basket currencies) equivalent to the amounts of the 3 currencies. Any surplus/shortage due to foreign exchange fluctuation between billing cut-off date and date of actual payment will be carried forward to the next due date.

Proportional recalling

Appendix 4 19

ADF CURRENCY REBALANCING MODEL

ADF = Asian Development Fund, SDR = special drawing right. Source: Treasury Department

SDR Commitments

SDR Quarterly

Rebalancing

SDR Future SDR loan Reflows

Non-SDR Liquidity

Non-SDR PV of contracted flows:

Donor Funds

Repayments on existing ADF loans

ADB net income transfers

Less Admin. E

Assets (Receivables and Liquidity)

Liabilities (Commitments)

Appendix 5 20

QUESTIONS AND ANSWERS

A. What is immunized asset liability management (ALM)? Asset liability management (ALM) is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints. In general, immunization is a strategy used to minimize interest rate risk. The primary risk source is interest rate risk in the ALM framework. As interest rate changes, the value of a bank's assets (i.e., loans and liquid assets) will fluctuate in the opposite way to its liabilities (i.e., funding). An immunized ALM can be employed to hedge the interest rate risk of the balance sheet to achieve a better financial position. In the context of financial management of a concessional fund, an immunized ALM reflects a cash-flow-based strategy with matching size, duration and currency of cash inflows (assets) and outflows (liabilities). This immunized ALM approach has been adopted by the International Development Association (IDA) to manage its financial resources. It aims to ensure that funds will be sufficient to finance future net cash outflows due to disbursement requirements. The most straightforward way to fund a single-period liability is through a held-to-maturity strategy, for example, by purchasing a zero-coupon bond maturing at the date of the future cash outflow. The face of the bond will be set to the value of the liability to be funded. However, this method is impractical because ADF’s future cash flows are inherently uncertain. The uncertainty can result from change of donors’ decision on contribution, unexpected demands for ADF assistance, volatility in commitments and disbursements, and unpredictability for ADB’s support through net income transfer. A practical approach to immunization would be to match the size and duration of ADF’s liquid assets to the present value and duration of its future net cash outflows. This would allow active portfolio management within an immunization framework and existing active risk limits so as to add value to the overall portfolio. B. What is Special Drawing Right (SDR)? Why was it created and what it is used for

today? What is the valuation of the SDR?

The special drawing right (SDR) is an international reserve asset, created by the International Monetary Fund (IMF) in 1969 to supplement the existing official reserves of its member countries. Today, the SDR has only limited use as a reserve asset and its main function is to serve as the unit of account of the IMF and some other international organizations. Its value is based on a basket of key international currencies, which currently consists of the euro, the Japanese yen, the pound sterling, and the US dollar. The basket’s composition is reviewed every 5 years to ensure that it reflects the relative importance of currencies in the world’s trading and financial systems. SDR currency weights from 2001-2005 have been fixed by IMF at 45% of US dollar, 29% of euro, 15% of Japanese yen, and 11% of pound sterling. C. When did the Asian Development Fund (ADF) officially adopt the SDR?

Contributions to the ADF started to be denominated in SDR (as well as national

currencies) in 1983 during the third replenishment of the ADF (ADF IV). Before that, the US dollar equivalent was supplemented by the national currency amount specified in the Resolutions of the Board of Governors. Loan commitments started to be denominated in SDR in 1982. Currently, ADF loans are all denominated in SDR in the loan agreement.

Appendix 5

21

D. Can a donor opt out of the conversion of its currency into SDR currencies?

For the reasons explained in this paper, the proposed currency conversion scheme requires the agreement of donors. Donors will have the opportunity to opt out by filing a statement to that effect. Irrespective of the above, in addition, a decision by a qualified majority of the Board of Directors is required both to authorize a systematic conversion of ADF resources into other currencies under Article 24.4 (ii) of the Charter and to adopt a special resolution authorizing the amendment to the ADF Regulations.

The agreement of all donors to the conversion of ADF resources into SDR currencies

would be highly desirable if the proposal is to be fully effective. If donors decided to opt out, two different legal and financial regimes would be applicable to the administration of ADF resources, which would create substantial administrative and legal complications and might even endanger the viability of the proposed currency conversion scheme. Specifically, ADB would, after the adoption of the currency proposal, be constrained in making use for its lending operations contributions in the national currency of contributors that have opted out. Therefore, the support of all donors is highly desirable.

Appendix 6 22

(Draft) Report of the Board of Directors

CONVERSION OF ADF RESOURCES INTO OTHER CURRENCIES

1. Under the current legal framework governing resources of the Asian Development Fund (ADF), ADF resources are preserved by Asian Development Bank (ADB) in the currencies in which they were contributed by donors. This principle of currency preservation of ADF contributions is part of the arrangements relating to the administration of ADF resources agreed between contributors to the ADF and ADB. In view of the foregoing, ADF currently has a complex currency structure with planning in US dollars, the size of ADB replenishments being determined in Special Drawing Right (SDR), ADF contributions in national currencies, SDR or US dollars, loan denomination in SDR, and with disbursement and repayment under ADF loans in as many as 15 currencies. Significant mismatch is widespread between the (i) stated size of ADF replenishments and the aggregate amount of donors’ contributions, (ii) operational planning and available ADF resources, and (iii) loan commitments made in SDR and the currency or currencies of the borrower’s actual payment obligation under ADF loans. 2. The Board of Directors notes that at present borrowers are obliged to repay the principal of ADF loans and the interest charge in one or more national currencies, rather than in SDR. This leads to an inconsistent ADF loan product. ADF is in effect treating borrowers differently, due to different foreign exchange risks associated with varying liability currencies chosen at ADB’s discretion. Such a currency practice also entails substantial disadvantages to the borrowers’ debt management and planning capability, as borrowers do not know the currencies which will be disbursed by ADB, or in what sequence such currencies will be recalled by ADB over the amortization period. Moreover, the fact that ADB’s currency practice differs from that of International Development Association (IDA) further complicates borrowers’ debt management. 3. By streamlining the SDR approach in key aspects of ADF resource management, the proposed new currency management practice will address all the issues described above and bring significant benefits to borrowers including:

(i) predictable and simplified currency management practice, (ii) a consistent loan product that is fair to all borrowers, (iii) reduced exposure to foreign exchange risks, and (iv) harmonized currency practice with that of IDA.

4. In addition, the proposed new practice will benefit and enhance ADF resource management and financial planning. However, it will not change the manner in which the ADF replenishment negotiations are conducted, the method of determining donors' burden shares, the current practice of donors regarding determination of the unit of obligation of their contributions, or the modalities of concessional financing offered by ADB. 5. At an informal board seminar held on 22 August 2005, ADB Management made a preliminary proposal to improve ADF currency management practices, which was well received by Directors. Therefore, on 14 September 2005, ADB Management sought the consent of ADF donor countries for amendments to the current legal framework governing ADF resources, which will authorize ADB, as to be determined by the Board of Directors:

(i) to convert ADF resources held in various currencies into the currencies which constitute the SDR;

Appendix 6

23

(ii) to value disbursements, repayments and charges under loans from ADF resources in terms of SDR; and

(iii) to determine in case of withdrawal of a contributor or the termination of the ADF, as set forth in Article V of the ADF Regulations, the value of contributors’ paid-in contributions and other ADF resources in terms of SDR.

6. [This proposal met with the unanimous agreement of all ADF donors.] [This proposal met with the agreement of most ADF donors.] 7. The Board of Directors has reviewed the rationale of the proposed new currency management practice set out above, and recommends it for acceptance by the Board of Governors. Also attached is a proposed Resolution of the Board of Governors authorizing a conversion of ADF resources as mentioned above and changes to the current legal framework governing ADF resources. 8. The Board of Directors is of the view that the decision on this matter should be taken as soon as possible and that the Special Procedure set forth in Section 3 of the By-Laws of the Bank should be invoked. The Board of Directors accordingly has authorized the President to transmit to each Governor the text of the draft Resolution together with this Report and the Donors’ Report, with a request for a vote by telex, facsimile or e-mail message within thirty days of the date of such request.

Appendix 7 24

(Draft) Resolution of the Board of Governors

CONVERSION OF ADF RESOURCES INTO OTHER CURRENCIES

WHEREAS: (A) The Asian Development Bank (ADB) has accepted contributions to the Asian Development Fund (the Fund) pursuant to paragraph 1 (ii) of Article 19 of the Agreement Establishing the Asian Development Bank (the Agreement), consistent with the terms and conditions set forth in Resolution No. 62 of the Board of Governors, and as authorized by Resolutions Nos. 67, 68, 88, 92, 101, 103, 105, 107, 121, 136, 145, 154, 156, 182, 214, 247, 276, 288, and 300 of the Board of Governors, which Resolutions shall hereinafter be referred to collectively as ADF Resolutions. (B) The Board of Governors adopted on 26 April 1975 Resolution No. 85 authorizing the Board of Directors to arrange for a transfer from the Multi-Purpose Special Fund to the Fund of all resources set aside to Special Funds from the ordinary capital resources of ADB as of the date of that Resolution. (C) The Board of Governors allocated by Resolutions Nos. 251, 294, and 298 a total amount of US$480 million from ADB’s ordinary capital resources’ net income and surplus to the Fund. (D) Paragraph 3 of Article 19 of the Agreement provides that Special Funds accepted by ADB under paragraph 1 (ii) of Article 19 of the Agreement may be “used in any manner and on any terms and conditions not inconsistent with the purpose of the Bank and with the agreement relating to such Funds.” (E) It is part of the arrangements between Contributors and ADB regarding the administration of contributions to the Fund that such contributions shall be administered by ADB in the currency in which they were drawn down by ADB from Contributors, except as otherwise agreed by the Contributor.

(F) It is desirable to amend the ADF Resolutions by reference, as specified in this Resolution, to authorize ADB to convert ADF resources held in various currencies into the currencies which constitute Special Drawing Right (SDR). (G) It is desirable to value in case of the withdrawal of a Contributor or the termination of the Fund, paid-in contributions of Contributors, and all other resources of the Fund, including set-aside resources and net income and surplus from ADB’s ordinary capital resources transferred to the Fund, in terms of SDR. NOW, THEREFORE, the Board of Governors RESOLVES: 1. The Board of Governors accepts the Report of the Board of Directors.

Appendix 7

25

2. ADB is authorized to convert ADF resources held in various currencies into the currencies which constitute the SDR, in accordance with such determinations as may be made by the Board of Directors. 3. ADB is authorized to value disbursements, repayments and charges under loans from resources of the Fund in terms of SDR, in accordance with such determinations as may be made by the Board of Directors. 4. ADB is authorized to determine in case of withdrawal of a Contributor from the Fund or the termination of the Fund, as set forth in Article V of the Regulations of the Asian Development Fund, the value of Contributors’ paid-in contributions and the value of all other resources of the Fund, including set-aside resources and net income and surplus from ADB’s ordinary capital resources transferred to the Fund, in terms of SDR, in accordance with such determinations as may be made by the Board of Directors. [5. A Contributor may notify ADB within 30 days after the adoption of this Resolution that the authority provided to ADB by paragraphs 2, 3, and 4 of this Resolution shall not extend to a contribution or contributions made by that Contributor pursuant to any of the ADF Resolutions. The right of the Contributor shall be deemed waived if no written notice is received by ADB within the aforesaid period.]*

* To be included if there is no agreement of all ADF donors regarding the proposed new scheme.

I. IntroductionII. Current Currency PracticeIII. History of Currency DiscussionsIV. The Currency ProposalV. Rationale of the Currency ProposalVI. Implementation ConsiderationsVII. Legal RequirementsVIII. Summary and RecommendationsAppendices