Hundred and Twenty-fifth Session
Rome, 26 – 28 November 2003
INFORMATION ON THE SPLIT ASSESSMENT METHODOLOGY AND PRACTICAL ASPECTS
Following a request by the Hundred and fourth Session of the Finance Committee in September 2003, this document is submitted for the information of the Council. To facilitate the understanding of the subject of Split Assessment and its impact on the calculation and collection of Member Nations contributions, the Secretariat has prepared a list of “frequently asked questions”. Following each question a brief explanatory note is provided. The document comprises four sections focussing on the budgetary, Member Nations contributions and practical application aspects, plus a glossary. The sections are covered under annexes A, B, C and D as follows.
Annex A - Budgetary Implications.
Annex B - Implications for Member Nations Contributions.
Annex C - Examples of Practical Application for Member Nations Contributions.
Annex D – Glossary.
What is split assessment?
1. Split assessment is a dual currency system of assessment whereby Members’ liability (assessed contributions to be paid) to the Organization is stated as two amounts – one each of the two selected currencies. Currently, FAO’s budget is developed and approved in US dollars, and Members’ contributions are assessed and paid in US dollars. Under the proposed split assessment system, the budget would still be developed in US dollars but the approved amount would be split between US dollars and euros.
How does split assessment help the Organization?
2. FAO spends a high proportion of its budget in euros (e.g. 44 percent in 2002). Because it receives all of its assessed contributions in US dollars, it has to buy euros to meet those euro expenditures. Any such purchase presents the possibility of an exchange variance (i.e. either a loss or a gain) between the estimated rate budgeted and the rate actually achieved when the euros are purchased. Split assessment would allow the Organization to match income to expenditure in its two major operational currencies (US dollars and euros) and largely avoid the need to purchase euros, thus eliminating the risk of exchange rate variances.
How was the risk of exchange rate fluctuations dealt with in the past?
3. There was little risk during the period from FAO’s inception up to the early 1990s because, the day that the Conference adopted the programme budget, it also revised the budget rate of exchange to the spot rate current on that day and accepted the consequences that this may have had for the budget level. In other words, if assessed contributions increased because of a fluctuation in the exchange rate, Members were obliged to accept the increase – and the same was true if the assessed contributions decreased.
4. In the early 1990s the era of zero nominal growth (ZNG) budgets began. Under the ZNG strategy, the budget is pre-established as an absolute amount during the negotiation process and no adjustment to compensate for changes in the US dollar exchange rate is made on the day the budget is adopted. In effect, this strategy has transferred the risk of a loss or gain caused by exchange rate variances between biennia from the Membership to the Programme of Work. This represents a potentially massive risk to the Organization’s Programme of Work.
Why propose split assessment now?
5. The proposal of a split assessment system has been under discussion by the Finance Committee for the last three years. Initially, the urgency was eased by the fact that the US dollar was strengthening through this period. However, the persistent weakening of the US dollar (since mid 2002) has now resulted in the Programme of Work facing a massive loss in purchasing power caused by the shift from the budget rate for 2002–03, which was approved at €1 = US$0.880, to the rate that needs to be approved for 2004–05. For example, if the current exchange rate of €1 = US$1.15 were to be approved as the budget rate, the figure for cost increases under a zero real growth (ZRG) budget would have to be raised by approximately US$100 million. As it is the expressed view of the Council that the approved Programme of Work and Budget should be protected to the extent possible from the effects of fluctuating exchange rates, the issue has now become urgent.
Who carries the risk of losses or the benefit of gains between the two currencies?
6. Under split assessment, the risk of exchange losses and the benefit of gains arising from the fluctuation of exchange rates between biennia returns to the Membership. Prior to the introduction of the zero nominal growth (ZNG) strategy, all Members, including those with US dollar-based currencies, shared the burden of the loss or the benefit of the gain by virtue of the fact that the Appropriation was always adjusted to reflect the spot exchange rate set on the day the Conference approved the budget.
Won’t split assessment double Members’ risk to exchange rate fluctuations, given that their contributions are assessed in two currencies?
7. No - split assessment generally reduces the risk for most Members. Under the traditional methodology of assessment in US dollars, all Members, whose national currency is not the US dollar (or US dollar-linked), are exposed to an exchange risk. Being assessed in two currencies does not double that exchange rate risk but rather diversifies the risk, and in some cases even offsets the risk. a
Does the split assessment methodology take budgetary decision-making power away from Members?
8. Split assessment does not remove budgetary decision-making power; rather, the methodology complies with the Membership’s stated objective to protect the approved Programme of Work and Budget to the maximum extent possible from the effects of fluctuating exchange rates. Thus, while the Membership would not be deciding how to handle exchange rate variances, it would have to decide on the extent of programme increases or decreases. For example, a ZNG budget under split assessment would be stated in two pre-established absolute amounts (a US dollar amount and a euro amount), at a level where the programme decrease would equal estimated cost increases, implying the total absorption of those increases. Clearly the extent of programme change (i.e. increase or decrease) is at the discretion of the Membership.
Does the exchange rate adopted for the budget affect how much a country is assessed in each currency?
9. No. The absolute euro amount and US dollar amount of the split assessment remain the same independent of the budget rate adopted. The Finance Committee has agreed to recommend that the budget rate should be established in advance of the Programme of Work and Budget based on the average forward rate for two years on 1 July of the FAO Conference year. However, as under split assessments the Organization’s euro requirements are paid by members in euros, the exchange rate effect does not come into play. In effect, the overall US dollar figure for the assessed contributions (which does depend on the exchange rate adopted) becomes a nominal figure. The actual cost to each Member in terms of their own currency will, as it always has in the past, depend upon the rate of exchange between the Member’s currency and the assessed currency or currencies.
What do other UN agencies do and why does FAO need to find a different solution?
10. Most agencies assess their Membership in a single currency, which is usually the functional currency of the Organization (e.g. US dollars for the New York-based agencies and Swiss francs for the Geneva-based agencies). They then handle the remaining risk by hedging. Almost without exception, these agencies face a much lower currency risk than FAO because their second most significant currency tends to account for a very low proportion of their total budget (e.g. less than 15 percent). Where this is not the case (i.e. UNESCO in Paris and IAEA in Vienna), a split assessment system has been employed. FAO is unique for the high proportion of its budget that is incurred in a single currency that is NOT its currency of assessment (i.e. 44 percent of budget expenditures in 2002 were in euros) – even more than is the case for those agencies that already use split assessment.
Has FAO taken expert advice on the best way to protect the Programme of Work from exchange rate fluctuations?
11. Yes. In its advice to the 99th session of the Finance Committee, the Cour des Comptes (FAO’s External Auditor at the time) indicated “the importance of reviewing the functional currency of the Organization and the means of protecting the Programme of Work from exchange rate fluctuations, noting, in particular the potential use of split assessments in this regard”. In the subsequent report, the internationally recognized accounting firm KPMG advised explicitly that “This option (split assessment) has the strong advantage of providing protection to FAO’s programme of work in the long run, so we believe the split assessment is the single most effective hedging strategy in FAO”. No alternative strategy has been found that meets the Council’s concern that the approved Programme of Work and Budget should be protected to the extent possible from the effects of the fluctuating exchange rates.
Doesn’t forward purchase solve the problem instead?
12. In theory, forward purchase can provide protection for the budget within a biennium. Given FAO’s biennial Appropriation, it is viable to enter into a contract and buy forward the Organization’s euro needs for the entire biennium. For example, this step was taken for 2002–03 and hence the Organization is still buying its euros month by month at a rate of €1 = US$0.880 – thus effectively protecting the Programme of Work throughout the current biennium and even generating gains. However, the forward purchase contract does not provide full protection within a biennium when the forward rate is different from the budget rate and market rates move against the forward rate. This was the case in 2000-01 when the Organization sustained some US$20 million in exchange losses. In addition, the current forward contract runs out on 31 December 2003, at which point FAO will have to start paying 30 percent more in dollars for the same quantity of euros. This is the nub of the problem – forward purchase cannot be applied across several biennia within the existing Financial Regulations; even if it could, there is a limit on how far forward the market would be prepared to contract. In other words, forward purchase can be a solution within a biennium but cannot function between biennia.
Why don’t we simply rely on the Special Reserve Account (SRA) to handle the gains and losses as they arise?
13. The SRA is not a suitable vehicle for protecting the Programme of Work between biennia. Firstly, the SRA was NOT established to assist in protecting the Programme of Work against exchange rate fluctuations between biennia. Rather, its function is to collect the losses and gains on specified transactions, thus enabling them to be collected in a separate account instead of impinging on the Programme of Work during the biennium.
In theoretical terms, the SRA ceiling is 5 percent of the effective working budget (i.e. US$32.6 million); this would not be sufficient to cover the envisaged loss in purchasing power currently estimated to be US$ 100 million. The actual situation is somewhat worse, in that the SRA as at 30 June 2003 has a balance of only US$15 million.
Is split assessment worth the change – what will it cost?
14. Undoubtedly, it is worth it. Total one-time development costs have been estimated at between US$ 150,000 and US$ 250,000 covering the programming work required to adapt the data warehouse environment and to create the revised reports for budget holders and corporate management. The cost of administering a split assessment system should be minor, with some temporary assistance possibly required to handle the extra calls for funds and manage the reconciliation of assessments received. When set against a an estimated real loss of US$100 million to the Programme of Work in the event of a ZNG budget being adopted for 2004-05, the answer is – “Yes – it is worth it”.
What are the advantages and disadvantages of split assessment for the Organization and its Members?
15. This entire proposal is about protecting the Programme of Work to the extent possible from the effects of the fluctuating exchange rates. If it is successful in this regard, all Members will benefit from the introduction of split assessment because of the stability it will bring back to the Organization’s work. Most Members will experience reduced currency exchange variations owing to the diversification of risk between two currencies. Finally, although a small group of Members whose currency is the US dollar or is linked to the US dollar will face exchange rate variations for the first time since the introduction of the ZNG strategy, even they will face both gains and losses over time. Hence, there should be no long-term disadvantages either for the Organization or its Members.
Will split assessments change the way in which the Scale of Contributions is calculated and the individual rates attributed to Member Nations?
1. No, there will be no change in the way the Scale of Contributions is calculated. The assessment rate for each Member Nation will continue to be calculated, as in the past, based on the United Nations Scale of Assessments in effect at the time of the FAO Conference as adjusted for differences in membership. For each Member Nation, the assessment rate will then be applied to both the US Dollar and the Euro total assessments as per the applicable Budget Resolution document approved by the Conference. (See Annex C)
How will the amounts payable in US Dollars and Euro be calculated?
2. Two separate assessment amounts will be calculated by applying the assessment rate of each individual country to the total appropriations amounts (as per the Budget Resolution) in US Dollars and Euro of each year. (See Annex C)
Will split assessments change the way in which contributions are called?
3. Circular State Letters to Member Nations will be issued in accordance with standard practice, specifying amounts payable in both currencies. Any arrears of contributions due will be called in the same communication in US Dollars only. Letters will include explanations on Split Assessments as well full banking instructions for the payment of both currencies.
What happens if the contribution is paid only in part?
4. In accordance with Financial Regulation (F.R.) 5.6 (revised), credit for any partial payment shall be given against contributions due in proportion to the amounts assessed in both currencies.
What happens when a payment covering the total of both assessments (US Dollars and Euro) is made using one of the two currencies?
5. In accordance with F.R. 5.6 (revised), credit will be given against contributions due in proportion to the amounts assessed in both currencies.
What happens if contributions are paid in a third currency?
6. In accordance with F.R. 5.6 (revised), credit will be given against contributions due in proportion to the amounts assessed in both currencies. It will be the responsibility of the member nations to ensure the convertibility of the currency of payment into USD and Euro. The Organization will continue to convert such payments into USD and Euro using the market rates of the USD and Euro to the currency of payment on the first business day in January of the calendar year in which the contribution is due, or the exchange rate in effect on the day the payment is made, whichever is more favourable to the Organization.
What will happen to unpaid contributions at year end?
7. As at the end of 2004, Arrears of Contributions denominated in Euro will be converted into USD at the rate, out of the three indicated in F.R. 5.7 (revised), which will be more favourable to the Organization. Converted Arrears will be henceforth called in US dollars until their full settlement.
Will split assessment impact existing or future instalment plans and how?
8. No, instalment plans are applicable to arrears which will be carried forward in USD only.
Will split assessment impact discount schemes and how?
9. Provided that contributions due are paid in accordance with the requirements of the “Incentive Scheme for the Prompt Payment of Contributions”, discounts will continue to be granted in the same way as in past years.
Appropriation – The appropriation is the amount voted by the Conference to cover the Regular Programme of Work and Budget for a given two-year period.
Budget level – real growth (RG) – A real growth budget level always shows an increase beyond ZRG, being that amount which is provided to increase the programme activities of the Organization. Consequently a RG budget will always show a positive programme change.
Budget level – zero nominal growth (ZNG) – A budget level wherein the assessed contributions as stated in US dollars and euro, remain at the same nominal level as in the budget for the previous period. This implies negative programme change of an amount equal to cost increases.
Budget level–zero real growth (ZRG) – A budget level which maintains purchasing power at the same level as the previous budget and hence is adjusted in nominal terms for cost increases and the effect on them of any change in the budget exchange rate from one period to the next. Consequently, a ZRG budget should show no programme change.
Contributions, Assessed – Amounts to be paid by Members towards the expenditure of the Organization for a given period in accordance with the scale determined by the Conference.
Discount Scheme – The Conference Approved Scheme, (officially called the “Incentive Scheme for the Prompt Payment of Contributions”) under which a Member Nation may be entitled to a discount on its following year’s assessed contribution if it pays its current assessment in accordance with the terms and conditions of the Scheme.
Effective working budget – The effective working budget refers to the total net appropriation line of the appropriation resolution as approved by the Conference.
Forward purchase – A transaction for delivery of currencies at a later date. Such transactions are concluded at forward rates. Forward rates reflect the time for which the agreement runs. Theoretically forward rates for a currency can be identical to the spot rate, but in practice it is almost always higher (premium) or lower (discount), depending on the interest rates for the period. Forward transactions are commonly used to hedge trading risks and the risk arising from financial transactions.
Hedging – Covering an open position against possible losses as a result of price movements by entering into a counter-transaction (e.g. forward contracts).
Instalment Plans – Rescheduling of a Member Nation’s accumulated arrears of assessed contributions in annual instalments payable over a period of several years in accordance with a Conference Resolution
a This was confirmed by an analysis of 74 world currencies comparing US Dollar exchange rates since 1996 to simulated split assessment exchange rates. Results showed that, when paying annual assessments in split currencies (the euro and the US dollar), currency exchange variations decreased for 80 percent of the currencies analyzed, thus decreasing their exchange rate risk. For one currency (the Japanese yen) the variation increased slightly (6 percent). The remaining group (18 percent of the currencies analyzed) had either US dollar or US dollar-linked currencies and moved from a zero exchange risk to some risk exposure in one currency (the euro).