## _081606

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### Annex I — History and Purpose of the Sunset Clause
- A sunset clause was introduced in the 1996 Program of Action at the start of the HIPC Initiative to restrict access to countries that had started IMF- and IDA-supported reform programs within a two-year period, after which the Initiative would be reviewed.
- Objectives of the sunset clause:
  - (i) prevent the Initiative from becoming permanent;
  - (ii) minimize moral hazard;
  - (iii) encourage early adoption of reforms.
- The Boards of IDA and the IMF extended the sunset clause four times; it is scheduled to take effect on December 31, 2006.
- September 2004 decision: extend sunset clause through December 31, 2006 and close Initiative to new entrants by ring-fencing application to countries meeting income and indebtedness criteria based on end-2004 data.
- April 2006: Boards endorsed and closed the list of countries assessed to have met the two criteria using end-2004 data; only countries on that list (and others subsequently assessed using end-2004 data) could be considered for future HIPC Initiative debt relief.
- Risk: letting the sunset clause take effect as scheduled could leave several identified countries with debt burdens in excess of the Initiative’s thresholds and/or without the policy eligibility criterion (having started a qualifying IDA- and IMF-supported program by the specified date).

### Countries meeting ring-fenced criteria (based on end-2004 data) — status as of end-July 2006
- Countries that Meet the Policy Eligibility Criterion (ratio refers to the NPV of debt-to-revenue):
  - Central African Republic — 562
  - Côte d'Ivoire 3/ — 361
  - Haiti — 189
  - Kyrgyz Republic 3/ — 376
  - Nepal — 198
  - Togo 3/ — 409
  - Note: 3/ Qualifies under the fiscal window.
- Countries that do not Meet the Policy Eligibility Criterion:
  - Eritrea — 522
  - Comoros — 378
  - Liberia — 1,433
  - Somalia — 1,091
  - Sudan — 561
- Table note clarifications:
  - Exports refer to the last three-year average of exports of goods and non-factor services. Revenue refers to the current year revenue of the central government, excluding grants.
  - For IDA, both the income and indebtedness criteria are bound by the end-2004 deadline; the IMF Board decided that only the indebtedness eligibility criterion be applied to end-2004 data.

### Key issues — A. Moral Hazard and Free Riding
- Maintaining access for identified countries prolongs moral hazard concerns: countries might borrow expecting eventual debt relief.
- Staffs consider establishing a cutoff date for debt subject to relief undesirable because:
  - It would create incentives for some creditors to increase lending after the cutoff, free riding on fiscal and balance-of-payments space created by debt relief;
  - Arrears clearance may result in new loans after the cutoff date, which would not be subject to debt relief;
  - HIPC Initiative debt relief could be insufficient to bring debt ratios to the Initiative’s thresholds at the decision point.
- Applying the cutoff date only to debt owed to IFIs would:
  - Violate equitable burden sharing and could discourage participation by other creditors;
  - Undermine the Initiative’s objective of ensuring sufficient overall debt relief.
- Existing and proposed measures to address moral hazard/free riding:
  - Decision-point track record requires stringent limits on non-concessional borrowing.
  - IDA two-pronged package: enhance creditor coordination and provide disincentives on new borrowing by reducing volumes and/or hardening terms of assistance for IDA grant-recipients and post-MDRI countries.
  - IDA and the IMF will monitor debt accumulation through the debt sustainability framework for low-income countries (DSF).
  - IMF minimum financing assurances: 70 and 80 percent after the decision and completion point, respectively; consideration could be given to raising thresholds or additional assurances, though staffs do not recommend these options due to risk of cutting off countries with significant shares of debt to non-Paris Club and commercial creditors.

### Key issues — B. Perceived Permanence and Incentives
- The sunset clause may no longer be needed because:
  - Repeated extensions have reduced its credibility.
  - Even if it takes effect, Initiative would not be closed: eligible pre-decision point and remaining interim countries face no deadline to reach decision or completion points.
  - Ring-fencing based on end-2004 data has narrowed the Initiative’s scope.
  - Some countries not meeting the policy-eligibility criterion face deeper problems (internal conflict, protracted arrears) that reduce responsiveness to sunset-clause incentives.
- Staffs do not recommend establishing a deadline for all pre-decision point countries to reach decision point because:
  - It would significantly change Initiative architecture by imposing additional deadlines;
  - Setting a realistic deadline is difficult;
  - MDRI design already provides time-sensitive incentives (debt eligible for MDRI relief is bound by fixed cutoff dates and countries must service eligible debt until completion point);
  - Imposing another deadline could be perceived as unfair to countries facing greater challenges.

### Options presented to deal with the sunset clause (as of July 2006)
- Option 1: let the sunset clause take effect at end-2006.
- Option 2: let the sunset clause take effect at end-2006, but allow identified HIPCs that do not meet the policy eligibility requirement to earn an extension of one year to meet it (via starting an SMP prior to end-December 2006).
- Option 3: extend the sunset clause for another two years to end-2008.
- Option 4: let the sunset clause take effect at end-2006 and grandfather all countries assessed to have met the income and indebtedness criteria based on end-2004 data.
- Option 5: let the sunset clause take effect at end-2006 and grandfather all countries assessed to have met the income and indebtedness criteria based on end-2004 data, but limit the debt subject to debt relief as of a given cutoff date (end-2006).

### Board and Directors' informal views (summary)
- Majority of Directors were not in favor of Option 1 and did not favor extending the sunset clause (Options 2 and 3) because several HIPCs could be left without HIPC/MDRI debt relief.
- Directors broadly supported Option 4 (let sunset clause take effect and grandfather countries meeting income and indebtedness criteria based on end-2004 data).
- Most Directors did not support Option 5 (limiting debt subject to relief as of a cutoff date), mainly due to free riding concerns.

### Eligibility, intent, and ring-fencing (April 2006 developments)
- In April 2006, three of the 14 countries assessed to have met income and indebtedness criteria based on end-2004 data indicated they did not wish to avail themselves of the Initiative.
- Under current rules these countries remain eligible and can change intent and request debt relief later if otherwise eligible and qualified.
- Fund perspective:
  - A current indication of intent not to avail of HIPC relief cannot serve as a basis for making a country ineligible.
  - Any criterion for limiting eligibility must be relevant to the Fund’s Articles and related Executive Board policy; current intent is not considered relevant.
- Bank perspective:
  - The Board could revise Initiative terms to allow countries otherwise eligible to permanently exit the Initiative.
- Staff recommendation on exit strategy:
  - Postpone consideration of an exit strategy. Mitigating factors:
    - Eligible countries not wanting debt relief would not receive it unless they request it.
    - Receipt of HIPC relief requires meeting conditions for decision and completion points.
    - Directors could choose new ring-fencing exercises later; staffs could make suggestions in annual HIPC Initiative-MDRI reports.

### Costs of providing debt relief — estimates and uncertainties
- Grandfathering countries assessed to have met income and indebtedness criteria based on end-2004 data would add about US$21.9 billion in end-2005 NPV terms to costs of HIPC Initiative debt relief already committed to post-decision point countries.
  - Of the additional costs for grandfathered countries:
    - IDA’s share amounts to US$3.1 billion.
    - IMF’s share amounts to US$2.5 billion.
- If MDRI costs are also taken into account, total cost would increase by an additional US$2.7 billion in end-2005 NPV terms.
  - Of the additional MDRI debt relief costs:
    - US$1.9 billion would be borne by IDA.
    - US$0.4 billion would be borne by the IMF.
- The IMF has made no provision for financing HIPC Initiative and MDRI assistance for protracted arrears cases or newly identified potentially eligible countries; additional financial resources will be needed prior to those countries reaching HIPC decision points.
- Potential further cost increases if new countries are added (e.g., Afghanistan and Myanmar) or if countries change intent.
- Sources of cost uncertainty:
  - HIPCs’ debt levels at the date of the decision point.
  - Discount and exchange rates.
  - Exports and revenues at the decision point.
  - Timing of decision and completion points and, where applicable, of arrears clearance.
  - Type and size of IMF-supported arrangements.
  - Results of updated DSA.
  - Future interest rate path.
  - Modalities of IMF MDRI relief to protracted arrears cases (current MDRI and traditional arrears clearance frameworks may render post-clearance debt non-eligible, requiring a modified approach).
- Measures that could reduce but not eliminate uncertainty:
  - Allowing permanent exit from the Initiative.
  - Setting a cutoff date for debt subject to debt relief (staffs note serious drawbacks).

### Table 2 — Estimated Costs of Debt Relief under the Grandfathering Option (end-December 2005 NPV terms)
- Country groupings (as presented): (11 countries) (29 countries) (40 countries)
- Numeric sequence extracted from source (preserving presentation):
  - 21.9 41.3 63.2
  - 8.6 20.7 29.4
  - 3.1 9.8 12.9
  - 2.5 3.1 5.6
  - 13.3 20.5 33.8
- Memorandum item Estimated cost of MDRI debt relief:
  - 2.3 22.2
  - 24.5
  - 1.5 15.3
  - 16.8
  - 0.4 3.6
  - 4.0
- Total HIPC Initiative and MDRI cost:
  - 24.2 63.5
  - 87.6
- Notes accompanying Table 2 (verbatim):
  - 2/ Refers to the 11 countries that have been assessed to meet the Initiative's income and indebtedness criteria based on end-2004 data and that might wish to be considered for HIPC Initiative debt relief.
  - 3/ Cost estimates are very preliminary and subject to a number of assumptions, including on: (i) timing HIPC decision and completion points, and, where applicable, of arrears clearance; (ii) type and size of IMF-supported arrangements, (iii) results of updated DSA; (iv) future interest rate path; and (v) modalities of IMF MDRI relief to the protracted arrears cases (after arrears clearance, their debt would not be MDRI-eligible under the current MDRI and traditional arrears clearance frameworks, requiring a modified approach).
  - Sources: Country authorities, multilateral creditors, Paris Club Secretariat, Global Development Finance, and IMF and IDA staff estimates.
  - 1/ Based on the estimates presented in the documents "Heavily Indebted Poor Countries (HIPC) Initiative - Statistical Update," March 27, 2006 and “Heavily Indebted Poor Countries (HIPC Initiative)—List of Ring-Fenced Countries that Meet the Income and Indebtedness Criteria at end-2004,” April 12, 2006.

### Recommendations and follow-up actions (staffs' proposal)
- Staffs propose:
  - Allow the sunset clause to take effect at end-2006.
  - Grandfather countries assessed to have met the income and indebtedness criteria based on end-2004 data (including any countries subsequently assessed and added to the ring-fencing list).
    - Rationale: grandfathering is comprehensive in coverage of both countries and their debt, treats countries equitably, and ensures all potentially eligible HIPCs continue to have the possibility to benefit from maximum debt relief under existing initiatives rather than leaving a few with unsustainable debt burdens.
    - Grandfathering allows countries time to go through the HIPC process at their own pace without undue pressure.
- Staffs will continue to:
  - Work on limiting moral-hazard behavior and closely monitor and report on free riding.
  - Provide Boards with updates on efforts and refined costing estimates in annual HIPC Initiative and MDRI implementation reports.
- Practical recommendation:
  - Discontinue semi-annual statistical updates on HIPC Initiative implementation to streamline documentation; continue informing Boards through annual progress reports on HIPC Initiative and MDRI progress and potential policy issues.

### Annex I — History highlights (chronology)
- 1996: Program of Action established a two-year limit with comprehensive review.
- 1998: Proposed two-year extension; countries not meeting entry requirements included Angola, Burundi, Democratic Republic of the Congo, Equatorial Guinea, Liberia, Myanmar, Saõ Tomé and Príncipe, Somalia and Sudan.
- 2000: Sunset clause extended to end-2000; remaining countries included Angola (later dropped), Burundi, Democratic Republic of Congo, Liberia, Myanmar, Somalia, and Sudan.
- 2002: Extended to end-2004; HIPCs yet to be considered expanded to 12 countries: Côte d’Ivoire, Burundi, Central African Republic, Comoros, Republic of Congo, Democratic Republic of the Congo, Lao P.D.R., Liberia, Myanmar, Somalia, Sudan, and Togo.
- 2004: Fourth extension; Directors ring-fenced application to countries meeting income and indebtedness criteria based on end-2004 data.
- April 2006: Boards endorsed and closed list of countries meeting the two criteria based on end-2004 data:
  - 11 countries that might wish to be considered: Central African Republic, Comoros, Côte d’Ivoire, Eritrea, Haiti, the Kyrgyz Republic, Liberia, Nepal, Somalia, Sudan, and Togo.
  - Three additional countries met the criteria but indicated they do not intend to avail themselves of the Initiative.
  - Directors decided list could be amended to include other countries whose data verify meeting the criteria based on end-2004 data (possible candidates include Afghanistan and Myanmar).

### Annex II — Selected country summaries (political developments and reform program status, as of end-July 2006)
- Comoros:
  - Inter-island cooperation fragile; Ahmed Abdallah Sambi sworn in as president on May 26, 2006.
  - No IMF-supported arrangement since 1994. 2005 staff-monitored program (SMP) performance mixed; SMP extended through end-June 2006 and may be extended to end-2006. Satisfactory performance could lead to PRGF-supported arrangement, contingent on arrears-clearance understandings with official creditors.
- Eritrea:
  - Remains in military mobilization due to border conflict with Ethiopia.
  - Never had an IMF arrangement; discussions on a 2006 staff-monitored program ongoing; could pave way for an EPCA or PRGF-supported program.
- Liberia:
  - New President inaugurated January 16, 2006; strong desire to work with international community and endorsed assistance program agreed in September 2005.
  - Staff-monitored program covering February-September 2006 presented in April 2006; successful completion could pave way for a RAP and eventual PRGF-supported arrangement. Nearly all of Liberia's debt is in arrears.
- Somalia:
  - Transitional Parliament inaugurated August 2004; cabinet appointed January 2005; TGF lacks sufficient international recognition; security situation turbulent in south-central Somalia; Puntland and Somaliland relatively stable.
  - No Fund-supported arrangement since 1987; arrears substantial; declared ineligible to use general resources of the Fund in 1988. World Bank engaged under LICUS approach.
- Sudan:
  - Interim National Constitution passed July 2005; Government of National Unity and Government of Southern Sudan established fall 2005; situation in Darfur remains critical.
  - Good cooperation with IMF over past 7 years; broadly satisfactory performance under 2005 SMP; new SMP for 2006 began in May 2006. Resolution of Darfur could pave way for RAP and subsequent PRGF-supported arrangement. External debt is large and mostly in arrears.

### Annex III — Possible Options Regarding the Sunset Clause (overview and Option details)
- Options apply to identified countries (Comoros, Eritrea, Liberia, Somalia, and Sudan) and to others subsequently found to meet income and indebtedness criteria using end-2004 data.

Option 1: Let the sunset clause take effect at end-2006
- Core implication:
  - Countries assessed as meeting income and indebtedness criteria but that have not started a qualifying IMF- and IDA-supported program by end-2006 (Comoros, Eritrea, Liberia, Somalia, and Sudan) would be ineligible for HIPC Initiative assistance and for MDRI relief.
  - Also excluded would be countries subsequently found to meet the two criteria using end-2004 data and that have not started a qualifying program by end-2006 (Myanmar could be such a case).
- Advantages:
  - Ends repeated extensions and could reduce moral hazard; provides incentive to start qualifying program before year-end.
- Disadvantages:
  - International support unlikely to be mobilized in time to clear arrears for all arrears countries (Liberia, Somalia, Sudan), preventing them from meeting policy-eligibility requirement.
  - Five countries—and possibly more—could be left with unsustainable debt burdens.
- Comments:
  - Debt sustainability of excluded countries could be addressed through alternative channels or a new comprehensive debt-relief initiative, but both have challenges including free riding.

Option 2: Sunset clause takes effect at end-2006, but allow a one-year earned extension via SMP
- Core implication:
  - Executive Directors could allow identified HIPCs to earn a one-year extension by starting an SMP before end-December 2006.
  - Comoros, Liberia, and Sudan would have already earned this extension because they have SMPs in place; they would still need to start a qualifying IMF- and IDA-supported program by end-2007. Eritrea and Somalia would risk ineligibility unless they start an SMP before year-end.
- Advantages:
  - Gives additional chance to HIPCs recently emerging from conflict; signals that extension is earned by commitment to reforms; incentivizes engagement and arrears resolution.
- Disadvantages:
  - One-year extension may be insufficient to clear arrears and start qualifying programs; may raise uniformity of treatment concerns as SMPs lack uniform standards and Board endorsement.

Option 3: Extend the sunset clause to end-2008 (two-year extension)
- Core implication:
  - Applies to identified countries and others subsequently assessed using end-2004 data.
  - Staffs consider Comoros, Sudan, Liberia, and Eritrea may meet the policy criterion by end-2008; Somalia may require more time.
- Advantages:
  - Allows most remaining countries sufficient time to start qualifying programs; provides incentive to adopt required programs.
- Disadvantages:
  - Could give impression Initiative becoming permanent; two-year extension may not suffice for Somalia; risk of further extensions and prolonged moral hazard.
- Comments:
  - A longer extension (five years) could be considered for Somalia though uncertainty remains.

Option 4: Let the sunset clause take effect but grandfather countries meeting income and indebtedness criteria (end-2004)
- Core implication:
  - Permit countries assessed to have met the income and indebtedness criteria based on end-2004 data to qualify for HIPC Initiative debt relief at their own pace; list is closed but could be amended to include other verified countries whose end-2004 data meet criteria.
  - MDRI cutoff dates (end-2003 for IDA and end-2004 for IMF and AfDB) provide incentives to adopt reform programs quickly for maximum MDRI relief, though limited relevance for countries with substantial arrears.
- Advantages:
  - Deals with all identified countries; avoids undue pressure; eliminates repeated extensions.
- Disadvantages:
  - May weaken incentives to move quickly through HIPC process and may prolong moral hazard concerns; could be perceived as keeping Initiative open indefinitely.

Option 5: Grandfather countries meeting end-2004 criteria but limit debt eligible for relief to debt outstanding as of end-2006
- Core implication:
  - Only debt outstanding and disbursed as of end-2006 would be eligible for debt relief under the Initiative; applicable to all countries not yet at decision points.
- Advantages:
  - Eliminates moral hazard issue; deals with all countries and removes need for further sunset clause extension.
- Disadvantages:
  - May leave debt relief insufficient to reach HIPC thresholds at decision point; arrears clearance may create post-cutoff obligations; would require reconsideration of topping-up policy at completion point; departs from past practice and treats countries differently; could incentivize creditors to lend after cutoff, exacerbating free riding and violating equitable burden-sharing.
- Note: Implementation could vary depending on parameters chosen to calculate debt relief at the decision point.

### Annex Table — Estimated Costs of HIPC Initiative Debt Relief under Different Options (end-December 2005 NPV terms)
- Header country counts shown in source: (6 countries) (9 countries) (10 countries) (11 countries) (29 countries)
- Cost rows and values (sequence preserved exactly as in source):
  - 5.5 19.9 20.2 21.9 41.3
  - 2.2 10.6 10.7 11.5 19.0
  - Paris Club: 1.9 6.5 6.5 7.1 15.2
  - Other official bilateral: 0.3 4.1 4.2 4.4 3.8
  - 0.8 1.8 1.8 1.8 1.5
  - 2.6 7.4 7.6 8.6 20.7
  - World Bank: 1.3 2.6 2.8 3.1 9.8
  - IMF 3/: 0.2 2.2 2.2 2.5 3.1
  - AfDB Group: 0.4 0.9 0.9 1.0 3.5
  - AsDB: 0.4 0.4 0.4 0.4 0.0
  - Other: 0.3 1.3 1.3 1.6 4.3
- Notes and sources (verbatim from table):
  - Sources: Country authorities, multilateral creditors, Paris Club Secretariat, Global Development Finance, and IMF and IDA staff estimates.
  - Footnotes:
    - 1/ Based on the estimates presented in the documents "Heavily Indebted Poor Countries (HIPC) Initiative - Statistical Update," March 27, 2006 and “Heavily Indebted Poor Countries (HIPC Initiative)—List of Ring-Fenced Countries that Meet the Income and Indebtedness Criteria at end-2004,” April 12, 2006.
    - 2/ Refers to the estimated cost for the 11 countries that have been assessed to meet the Initiative's income and indebtedness criteria based on end-2004 data and that might wish to be considered for HIPC Initiative debt relief.
    - 3/ Additional financing for the Fund is needed for Haiti, Kyrgyz Republic, Liberia, Nepal, Somalia, Sudan, and possibly Eritrea.
    - 4/ Includes the Central African Republic, Cote d'Ivoire, Haiti, the Kyrgyz Republic, Nepal, and Togo.
    - 5/ Includes all countries under Option 1, plus Comoros, Liberia, and Sudan.
    - 6/ Includes all countries under Option 2, plus Eritrea.
    - 7/ Includes all countries under Option 3, plus Somalia.

*Source: IMF/World Bank staff paper (Annex I, Annex II, Annex III: History of the Sunset Clause, eligibility, cost estimates, options, and recommendations, as contained in the supplied content).*

### Annex I: History of the Sunset Clause...................................................................................

### Annex I: History of the Sunset Clause

### Background and purpose of the sunset clause
- A sunset clause was introduced in the 1996 Program of Action at the start of the HIPC Initiative. The Program of Action stated that “the Initiative would be open to all HIPCs that pursue or adopt programs of adjustment and reform supported by the IMF and IDA in the next two years, after which the Initiative would be reviewed and a decision made whether it should be continued.”
- The sunset clause restricted access to countries that had started IMF- and IDA-supported reform programs within a two-year time period to: (i) prevent the Initiative from becoming permanent; (ii) minimize moral hazard; and (iii) encourage early adoption of reforms.
- The Boards of IDA and the IMF extended the sunset clause four times; it is scheduled to take effect on December 31, 2006.
- In September 2004, the Boards decided to extend the sunset clause through December 31, 2006 and to close the Initiative to new entrants by ring fencing its application to those countries meeting the Initiative’s income and indebtedness criteria based on end-2004 data.
- In April 2006, the Boards endorsed and closed the list of countries assessed to have met these two criteria. Only countries in that list, and others subsequently assessed to have met the relevant criteria using end-2004 data, could be considered for future HIPC Initiative debt relief.
- Letting the sunset clause take effect as scheduled could leave several identified countries with debt burdens in excess of the Initiative’s thresholds and/or without the policy eligibility criterion (i.e., having started a qualifying IDA- and IMF-supported program by the specified date).

### Options presented to deal with the sunset clause (as of July 2006)
- Option 1: let the sunset clause take effect at end-2006;
- Option 2: let the sunset clause take effect at end-2006, but allow the identified HIPCs that do not meet the HIPC Initiative policy eligibility requirement to earn an extension of one year to meet it;
- Option 3: extend the sunset clause for another two years to end-2008;
- Option 4: let the sunset clause take effect at end-2006 and grandfather all countries that are assessed to have met the income and indebtedness criteria based on end-2004 data;
- Option 5: let the sunset clause take effect at end-2006 and grandfather all countries that are assessed to have met the income and indebtedness criteria based on end-2004 data, but limit the debt subject to debt relief as of a given cutoff date (end-2006).

### Board and Directors' views (informal discussions)
- Majority of Directors were not in favor of letting the sunset clause take effect with no mitigating action (Option 1) and did not favor extending it (Options 2 and 3), due to concerns that several HIPCs would be left without the possibility of HIPC/MDRI debt relief.
- Directors broadly supported letting the sunset clause take effect and grandfathering all countries that are assessed to have met the income and indebtedness criteria based on end-2004 data (Option 4).
- Most Directors did not generally support limiting the debt subject to debt relief as of a given cutoff date (Option 5), mainly on account of free riding concerns.

### Countries that might wish to be considered for HIPC Initiative debt relief (As of end-July 2006)
- These countries satisfy the Initiative's income and indebtedness criteria based on end-2004 data (ring-fenced list). They exclude countries that satisfied the two criteria but indicated they would not avail themselves of the Initiative (Bhutan, Lao PDR, and Sri Lanka) and countries with insufficient data (Afghanistan and Myanmar).
- Countries that Meet the Policy Eligibility Criterion:
  - Central African Republic — 562
  - Côte d'Ivoire 3/ — 361
  - Haiti — 189
  - Kyrgyz Republic 3/ — 376
  - Nepal — 198
  - Togo 3/ — 409
  - (Note: 3/ Qualifies under the fiscal window. The ratio refers to the NPV of debt-to-revenue.)
- Countries that do not Meet the Policy Eligibility Criterion:
  - Eritrea — 522
  - Comoros — 378
  - Liberia — 1,433
  - Somalia — 1,091
  - Sudan — 561
- Table note clarifications:
  - Exports refer to the last three-year average of exports of goods and non-factor services. Revenue refers to the current year revenue of the central government, excluding grants.
  - For IDA, both the income and indebtedness criteria are bound by the end-2004 deadline; the IMF Board decided that only the indebtedness eligibility criterion be applied to end-2004 data.

### Key issues for consideration — A. Moral Hazard and Free Riding
- Maintaining access to the HIPC Initiative for identified countries prolongs moral hazard concerns: countries might be tempted to borrow in anticipation of eventual debt relief.
- Establishing a cutoff date for debt subject to debt relief could provide a disincentive for debt accumulation, but staffs consider this undesirable for three reasons:
  - First, having a portion of debt not subject to debt relief would create incentives for some creditors to increase lending after the cutoff, thereby free riding on the fiscal and balance-of-payments space created by debt relief;
  - Second, arrears clearance may result in new loans after the cutoff date, which would not be subject to debt relief;
  - Third, HIPC Initiative debt relief could be insufficient to bring the debt ratios to the HIPC Initiative’s thresholds at the decision point, thus undermining the primary objective of the Initiative.
- Applying the cutoff date only to debt owed to the international financial institutions (IFIs) would violate two fundamental principles:
  - It would violate equitable burden sharing and could discourage participation by other creditors, perpetuating free riding;
  - It would undermine the Initiative’s primary objective of ensuring sufficient overall debt relief to reach the Initiative’s thresholds at the decision point.
- Existing mechanisms and proposed measures to address moral hazard and free riding:
  - The decision-point track record requires countries to abide by stringent limits on non-concessional borrowing.
  - IDA approved a two-pronged package to address free riding on future borrowing by IDA grant-recipients and post-MDRI countries: enhancing creditor coordination and providing disincentives on new borrowing by reducing volumes and/or hardening terms of assistance.
  - IDA and the IMF will continue monitoring debt accumulation, including non-concessional borrowing, through the debt sustainability framework for low-income countries (DSF).
  - The IMF requires minimum financing assurances (70 and 80 percent after the decision and completion point, respectively) from other creditors prior to disbursing its own debt relief; consideration could be given to raising these thresholds or establishing additional financing assurances for debt contracted after a cutoff date, though staffs do not recommend these options because countries with significant shares of debt to non-Paris Club and commercial creditors could be cut off from debt relief.

### Key issues for consideration — B. Perceived Permanence of the Initiative and Incentives
- The sunset clause may no longer be needed:
  - Repeated extensions have reduced its credibility.
  - Even if the sunset clause takes effect, the Initiative would still not be closed: eligible pre-decision point and remaining interim countries face no deadline to reach either the decision or completion point.
  - Ring fencing of the list of countries assessed to have met the income and indebtedness criteria based on end-2004 data has narrowed the Initiative’s scope.
  - Some countries that do not meet the policy-eligibility criterion face deeper problems (internal conflict, protracted arrears) that make them less responsive to incentives provided by the sunset clause.
- Establishing a deadline for all pre-decision point countries to reach their decision point is not recommended by staffs because:
  - It would significantly change the Initiative’s architecture by placing an additional deadline on countries that already meet eligibility requirements.
  - Setting an effective and realistic deadline is difficult; too early would require extension, too late would be redundant.
  - Countries already have incentives to obtain HIPC Initiative debt relief quickly because MDRI debt relief amounts decline with the passage of time: debt eligible for MDRI debt relief is bound by fixed cutoff dates and countries must service eligible debt until reaching their HIPC Initiative completion point.
  - Imposing another deadline could be perceived as unfair to countries facing greater challenges.

*Source: IMF/World Bank staff paper (Annex I: History of the Sunset Clause, as contained in the supplied content).*

### 14. In April 2006, three of the 14 countries that were assessed to have met the

### _081606 - 14. In April 2006, three of the 14 countries that were assessed to have met the

### Eligibility, intent, and ring-fencing
- In April 2006, three of the 14 countries assessed to have met the HIPC Initiative’s income and indebtedness criteria based on end-2004 data indicated that they did not wish to avail themselves of the Initiative.
- Under current rules, these countries remain eligible or potentially eligible for the Initiative and can change their intent at any point in the future and decide to apply for debt relief if otherwise eligible and qualified.
- From the Fund’s perspective:
  - A country’s current indication of its intention not to avail itself of HIPC relief cannot serve as a basis for making the country ineligible under the HIPC Initiative.
  - Any criterion relied upon for limiting eligibility must be relevant to the objectives of the provision of the Fund’s Articles (and any related Executive Board policy).
  - Current intent is not considered relevant for denying debt relief if a country later requests such relief; a strategy to exclude countries would need to be based on criteria relevant and applied to all similarly situated countries (for example, a future eligibility criterion related to debt levels at a future point in time — a second ring-fencing exercise).
- From the Bank’s perspective:
  - The Board could revise Initiative terms to allow countries otherwise eligible to permanently exit the Initiative (e.g., formal permanent exit through amendment of eligibility criteria or a future ring-fencing exercise).
- Staff recommendation on exit strategy:
  - Staffs suggest postponing consideration of an exit strategy. Factors mitigating concerns about the three countries that indicated they would not avail themselves:
    - Eligible countries not wanting debt relief would never be provided with it unless they request it.
    - Receipt of HIPC relief requires meeting the requisite conditions for decision and completion points.
    - Directors could choose new ring-fencing exercises later; staffs could make suggestions in annual HIPC Initiative-MDRI progress reports.

### Costs of providing debt relief (estimates and uncertainties)
- Grandfathering countries assessed to have met the income and indebtedness criteria based on end-2004 data would add about US$21.9 billion in end-2005 NPV terms to the costs of HIPC Initiative debt relief already committed to post-decision point countries.
- Of the additional costs for grandfathered countries:
  - IDA’s share amounts to US$3.1 billion.
  - IMF’s share amounts to US$2.5 billion.
- If MDRI costs are also taken into account, total cost would increase by an additional US$2.7 billion in end-2005 NPV terms.
  - Of the additional MDRI debt relief costs:
    - US$1.9 billion would be borne by IDA.
    - US$0.4 billion would be borne by the IMF.
- The IMF has made no provision for financing HIPC Initiative and MDRI assistance for either the protracted arrears cases or those countries newly identified as potentially eligible; it will need to secure additional financial resources prior to these countries reaching their respective HIPC decision points.
- The possibility of adding new countries to the HIPC Initiative list (such as Afghanistan and Myanmar, as well as others that could change their minds) would further increase costs.
- Cost uncertainty sources:
  - HIPCs’ debt levels at the date of the decision point.
  - Discount and exchange rates.
  - Exports and revenues at the decision point.
  - Timing of decision and completion points and, where applicable, of arrears clearance.
  - Type and size of IMF-supported arrangements.
  - Results of updated DSA.
  - Future interest rate path.
  - Modalities of IMF MDRI relief to protracted arrears cases (after arrears clearance, their debt would not be MDRI-eligible under the current MDRI and traditional arrears clearance frameworks, requiring a modified approach).
- Measures that could reduce but not eliminate uncertainty:
  - Allowing permanent exit from the Initiative.
  - Setting a cutoff date for debt subject to debt relief (but this has serious drawbacks).

### Table 2 (Estimated Costs of Debt Relief under the Grandfathering Option) — as presented (end-December 2005 NPV terms)
- (11 countries) (29 countries) (40 countries)
- 21.941.363.2
- 8.620.729.4
- 3.19.812.9
- 2.53.15.6
- 13.320.533.8
- Memorandum item Estimated cost of MDRI debt relief2.322.2
- 24.5
- 1.515.3
- 16.8
- 0.43.6
- 4.0
- Total HIPC Initiative and MDRI cost24.263.5
- 87.6
- Notes accompanying Table 2 (verbatim points included in source):
  - 2/ Refers to the 11 countries that have been assessed to meet the Initiative's income and indebtedness criteria based on end-2004 data and that might wish to be considered for HIPC Initiative debt relief.
  - 3/ Cost estimates are very preliminary and subject to a number of assumptions, including on: (i) timing HIPC decision and completion points, and, where applicable, of arrears clearance; (ii) type and size of IMF-supported arrangements, (iii) results of updated DSA; (iv) future interest rate path; and (v) modalities of IMF MDRI relief to the protracted arrears cases (after arrears clearance, their debt would not be MDRI-eligible under the current MDRI and traditional arrears clearance frameworks, requiring a modified approach).
  - Sources: Country authorities, multilateral creditors, Paris Club Secretariat, Global Development Finance, and IMF and IDA staff estimates.
  - 1/ Based on the estimates presented in the documents "Heavily Indebted Poor Countries (HIPC) Initiative - Statistical Update," March 27, 2006 and “Heavily Indebted Poor Countries (HIPC Initiative)—List of Ring-Fenced Countries that Meet the Income and Indebtedness Criteria at end-2004,” April 12, 2006.

### Recommendations and follow-up actions
- Staffs propose:
  - Allow the sunset clause of the Initiative to take effect at end-2006.
  - Grandfather countries that are assessed to have met the income and indebtedness criteria based on end-2004 data (including countries that in the future are assessed to have met these criteria and added to the ring-fencing list).
    - Grandfathering is comprehensive in coverage of both countries and their debt, treats countries equitably, and ensures all potentially eligible HIPCs continue to have the possibility to benefit from maximum debt relief under existing initiatives rather than leaving a few with unsustainable debt burdens.
    - Grandfathering allows countries time to go through the HIPC Initiative process at their own pace without undue pressure.
- Staffs will continue to:
  - Work on limiting moral-hazard behavior and closely monitor and report on free riding.
  - Provide Boards with updates on results of these efforts and refined costing estimates of debt relief in annual HIPC Initiative and MDRI implementation reports.
- Practical recommendation:
  - Discontinue semi-annual statistical updates on implementation of the HIPC Initiative to streamline documentation; continue informing Boards through annual progress reports on HIPC Initiative and MDRI progress and potential policy issues.

### Annex I — history of the sunset clause (highlights)
- 1996 Program of Action established a two-year limit to HIPC Initiative with a comprehensive review after two years.
- 1998 review: proposed a two-year extension; countries not meeting entry requirements then included Angola, Burundi, Democratic Republic of the Congo, Equatorial Guinea, Liberia, Myanmar, Saõ Tomé and Príncipe, Somalia and Sudan.
- 2000: sunset clause extended to end-2000; countries still not meeting entry requirement included Angola (later dropped), Burundi, Democratic Republic of Congo, Liberia, Myanmar, Somalia, and Sudan.
- 2002: sunset clause extended to end-2004; list of HIPCs yet to be considered expanded to 12 countries: Côte d’Ivoire, Burundi, Central African Republic, Comoros, Republic of Congo, Democratic Republic of the Congo, Lao P.D.R., Liberia, Myanmar, Somalia, Sudan, and Togo.
- 2004: sunset clause extended for the fourth time; Directors ring-fenced Initiative’s application to countries meeting income and indebtedness criteria based on end-2004 data.
- April 2006: Boards endorsed and closed list of countries assessed by staffs as meeting the two criteria based on end-2004 data:
  - 11 countries that might wish to be considered for HIPC Initiative debt relief: Central African Republic, Comoros, Côte d’Ivoire, Eritrea, Haiti, the Kyrgyz Republic, Liberia, Nepal, Somalia, Sudan, and Togo.
  - Three additional countries met the criteria based on end-2004 data but indicated they do not intend to avail themselves of the Initiative.
  - Directors decided list could be amended to include other countries whose data are verified to meet the relevant criteria based on end-2004 data (possible candidates include Afghanistan and Myanmar).

### Annex II — political developments and reform program status and prospects (as of end-July 2006) — selected country summaries
- Comoros:
  - Progress on inter-island cooperation fragile; Ahmed Abdallah Sambi sworn in as president on May 26, 2006.
  - No IMF-supported arrangement since 1994. 2005 staff-monitored program (SMP) performance mixed; SMP extended through end-June 2006 and may be extended to end-2006. Satisfactory performance could lead to PRGF-supported arrangement, contingent on arrears-clearance understandings with official creditors.
- Eritrea:
  - Remains in military mobilization due to border conflict with Ethiopia.
  - Never had an IMF arrangement; discussions on a 2006 staff-monitored program ongoing; could pave way for an EPCA or PRGF-supported program.
- Liberia:
  - New President inaugurated January 16, 2006; strong desire to work with international community and endorsed assistance program agreed in September 2005.
  - Staff-monitored program covering February-September 2006 presented in April 2006; successful completion could pave way for a RAP and eventual PRGF-supported arrangement. Nearly all of Liberia's debt is in arrears.
- Somalia:
  - Transitional Parliament inaugurated August 2004; cabinet appointed January 2005; TGF lacks sufficient international recognition; security situation turbulent in south-central Somalia; Puntland and Somaliland relatively stable.
  - No Fund-supported arrangement since 1987; arrears substantial; declared ineligible to use general resources of the Fund in 1988. World Bank engaged under LICUS approach.
- Sudan:
  - Interim National Constitution passed July 2005; Government of National Unity and Government of Southern Sudan established fall 2005; situation in Darfur remains critical.
  - Good cooperation with IMF over past 7 years; broadly satisfactory performance under 2005 SMP; new SMP for 2006 began in May 2006. Resolution of Darfur could pave way for RAP and subsequent PRGF-supported arrangement. External debt is large and mostly in arrears.

*Source: IMF staff paper (text provided).*

### ANNEX III: POSSIBLE OPTIONS REGARDING THE SUNSET CLAUSE

### ANNEX III: POSSIBLE OPTIONS REGARDING THE SUNSET CLAUSE

### Overview
- Presents five options to deal with the imminent expiry of eligibility of five identified HIPCs at end-2006 owing to the sunset clause.
- All options apply to the identified countries (Comoros, Eritrea, Liberia, Somalia, and Sudan) and to others subsequently found to meet the HIPC Initiative income and indebtedness criteria using end-2004 data.

### Option 1: Let the sunset clause take effect at end-2006
- Core implication:
  - Countries assessed as meeting the HIPC Initiative income and indebtedness criteria but that have not started a qualifying IMF- and IDA-supported program (Comoros, Eritrea, Liberia, Somalia, and Sudan) by end-2006 would neither be eligible for HIPC Initiative assistance nor for MDRI relief.
  - Also excluded would be countries subsequently found to meet the two criteria using end-2004 data and that have not started a qualifying IMF- and IDA-supported program by end-2006 (Myanmar could be such a case).
- Advantages:
  - This option would end the repeated extensions of the sunset clause that have made the Initiative appear permanent.
  - It could also reduce moral hazard concerns, as the five countries bound by the sunset clause would no longer be guaranteed debt relief on their borrowing, and provide an incentive for these countries to start a qualifying program before the end of the year.
- Disadvantages:
  - International support is unlikely to be mobilized in time to clear the arrears of all the countries with arrears (Liberia, Somalia, and Sudan), thus preventing these countries from meeting the policy-eligibility requirement independently of any of their own efforts to do so.
  - Five countries—and possibly more—could be left with unsustainable debt burdens.
- Comments:
  - Debt sustainability problems of the excluded countries could be addressed through alternative channels, e.g., on a case-by-case basis, or through a new comprehensive debt-relief initiative.
  - The former would require a decision by the Executive Boards specifying general criteria for dealing with the debt of these countries to IDA and the IMF, which would need to be applied uniformly to similarly situated countries.
  - The latter could prove time-consuming and challenging, as it would involve addressing issues similar to those encountered in the design of the HIPC Initiative, including free riding concerns.

### Option 2: Sunset clause takes effect at end-2006, but allow a one-year earned extension via SMP
- Core implication:
  - Executive Directors could allow the five identified HIPCs that would otherwise become ineligible to earn a one-year extension by starting an IMF staff-monitored program (SMP) prior to end-December 2006.
  - Comoros, Liberia, and Sudan would have already earned this extension because they currently have SMPs in place; they would still need to start a qualifying IMF- and IDA-supported program by end-2007 to become eligible. Eritrea and Somalia would run the risk of being ineligible unless they start an SMP before the end of the year.
- Advantages:
  - Gives another chance to HIPCs recently emerging from conflict to meet the Initiative’s policy eligibility criterion.
  - The “earned” extension signals that only HIPCs committed to reforms would eventually become eligible for HIPC Initiative debt relief.
  - Provides an incentive to countries to engage in reforms, mobilize international support, and raise funds to resolve arrears quickly.
- Disadvantages:
  - A one-year extension may not be sufficient for all identified countries to clear their arrears and start an IMF- and IDA-supported program.
  - Two countries, or more, may become ineligible for HIPC Initiative relief and be left with debt burdens significantly in excess of the Initiative’s thresholds.
  - May raise uniformity of treatment concerns, as SMPs do not have uniform standards and are not endorsed by the Fund’s Board.

### Option 3: Extend the sunset clause to end-2008 (two-year extension)
- Core implication:
  - Extension would apply to the identified countries and to others subsequently assessed to have met the income and indebtedness criteria using end-2004 data.
  - Staffs consider Comoros, Sudan, Liberia, and Eritrea may be able to meet the policy criterion by end-2008, but Somalia may require more time.
- Advantages:
  - Allows most remaining countries sufficient time to start qualifying IMF- and IDA-supported programs.
  - Given the new deadline (end-2008), provides an incentive to countries to move quickly to adopt the required program.
- Disadvantages:
  - Could give the impression that the Initiative is becoming a permanent facility.
  - A two-year extension may not be sufficient for all identified countries (in particular Somalia) to start an IMF- and IDA-supported program; the issue of extending the sunset clause could arise again.
  - A fifth extension (and the risk of further extensions) could prolong moral hazard concerns (such as further accumulation of debt in anticipation of eventual debt relief).
- Comments:
  - A longer extension (five instead of two years) could be considered to give more time to Somalia, although this would not eliminate the high degree of uncertainty associated with a two-year extension.

### Option 4: Let the sunset clause take effect but grandfather countries meeting income and indebtedness criteria (end-2004)
- Core implication:
  - Permit countries assessed to have met the income and indebtedness criteria based on end-2004 data to qualify for HIPC Initiative debt relief at their own pace.
  - The list of countries assessed to meet the Initiative’s income and indebtedness criteria based on end-2004 data is closed (though it could subsequently be amended to include other countries whose data are verified to have met the income and indebtedness criteria at end-2004).
  - The MDRI cutoff dates (end-2003 for IDA and end-2004 for the IMF and the AfDB) provide incentives for countries to adopt reform programs quickly to obtain maximum relief under MDRI, though this may be of limited relevance for countries with substantial arrears.
- Advantages:
  - Deals with all identified countries.
  - Does not create undue pressure to start an IMF- and IDA-supported program at any cost; allows countries to move at their own pace given the enormous challenges they face.
  - Eliminates the possibility of repeated extensions of the sunset clause.
- Disadvantages:
  - May weaken incentives for countries to move quickly through the HIPC process and may prolong moral hazard concerns.
  - Could be perceived as keeping the Initiative open indefinitely.

### Option 5: Grandfather countries meeting end-2004 income and indebtedness criteria but limit debt eligible for relief to debt outstanding as of end-2006
- Core implication:
  - Only debt outstanding and disbursed as of end-2006 would be eligible for debt relief under the Initiative.
  - Applicable to all countries that have not yet reached their decision points, including those that already met the policy eligibility criterion.
- Advantages:
  - Eliminates the moral hazard issue (a shared concern across other options).
  - Similar to Option 3, deals with all countries and eliminates the need for a further sunset clause extension.
- Disadvantages:
  - May result in debt relief insufficient to bring debt ratios to the HIPC Initiative’s thresholds at the decision point, undermining a main principle of the Initiative.
  - Would not deal effectively with countries with substantial arrears, where arrears clearance may result in new obligations after the cutoff date.
  - Would require reconsideration of the policy regarding possible topping-up assistance at the completion point.
  - Constitutes a departure from past practice, treating differently countries that reached decision points before and after end-2006.
  - May create incentives for creditors to lend to HIPCs after the cutoff, exacerbating free riding concerns and violating the Initiative’s equitable burden-sharing principle.
- Note:
  - This option could be implemented in various ways, depending on parameters chosen to calculate debt relief at the decision point.

### Annex Table — Estimated Costs of HIPC Initiative Debt Relief under the Different Options (end-December 2005 NPV terms)
- Caption: Annex Table. Estimated Costs of HIPC Initiative Debt Relief under the Different Options 1/ (In billions of U.S. dollars, in end-December 2005 NPV terms)
- Header labels shown in source (country counts): (6 countries) (9 countries) (10 countries) (11 countries) (29 countries)
- Cost rows and values as presented in the source (preserving sequence and numeric values exactly):
  - 5.5 19.9 20.2 21.9 41.3
  - 2.2 10.6 10.7 11.5 19.0
  - Paris Club: 1.9 6.5 6.5 7.1 15.2
  - Other official bilateral: 0.3 4.1 4.2 4.4 3.8
  - 0.8 1.8 1.8 1.8 1.5
  - 2.6 7.4 7.6 8.6 20.7
  - World Bank: 1.3 2.6 2.8 3.1 9.8
  - IMF 3/: 0.2 2.2 2.2 2.5 3.1
  - AfDB Group: 0.4 0.9 0.9 1.0 3.5
  - AsDB: 0.4 0.4 0.4 0.4 0.0
  - Other: 0.3 1.3 1.3 1.6 4.3
- Notes and source lines included in the table text (preserved wording):
  - Sources: Country authorities, multilateral creditors, Paris Club Secretariat, Global Development Finance, and IMF and IDA staff estimates.
  - Footnotes (as in source):
    - 1/ Based on the estimates presented in the documents "Heavily Indebted Poor Countries (HIPC) Initiative - Statistical Update," March 27, 2006 and “Heavily Indebted Poor Countries (HIPC Initiative)—List of Ring-Fenced Countries that Meet the Income and Indebtedness Criteria at end-2004,” April 12, 2006.
    - 2/ Refers to the estimated cost for the 11 countries that have been assessed to meet the Initiative's income and indebtedness criteria based on end-2004 data and that might wish to be considered for HIPC Initiative debt relief.
    - 3/ Additional financing for the Fund is needed for Haiti, Kyrgyz Republic, Liberia, Nepal, Somalia, Sudan, and possibly Eritrea.
    - 4/ Includes the Central African Republic, Cote d'Ivoire, Haiti, the Kyrgyz Republic, Nepal, and Togo.
    - 5/ Includes all countries under Option 1, plus Comoros, Liberia, and Sudan.
    - 6/ Includes all countries under Option 2, plus Eritrea.
    - 7/ Includes all countries under Option 3, plus Somalia.

*Annex III: Possible Options Regarding the Sunset Clause (source text).*

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