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Allocate SDRs Directly to Multilateral Development Banks

MDBs need more firepower to help low- and middle-income countries weather the climate transition. Their proposal to use SDR-funded hybrid capital to increase loans has merit but is mired in conservative interpretations of its use and the inability to use mutually a class of reserves globally. Allocating SDRs directly to MDB hybrid capital bypasses the current inefficient and lengthy SDR recycling system.

It is widely recognized that the world is badly off track in mobilizing the financing needed to meet the Paris goals of reducing greenhouse gas emissions and dealing with the impact of climate change. Climate disasters, on the other hand, are stubbornly on track, increasing exponentially and demanding ever increasing resources to battle their impacts. Cutting carbon emissions will be costly—trillions of dollars a year for decades. And if we don't cut emissions, the resulting environmental damage and meteorological instability will cost us even more. Low- and middle-income countries’ (L/MICs) finances are already being hit hard by climate change, and countries will need significant financial assistance to adapt to its impacts and mitigate its causes. However, high-income countries are straining under their own fiscal burdens and are unlikely to increase aid to L/MICs soon.

The multilateral development banks (MDBs) are critical to mobilizing financing to help L/MICs face these global challenges. The MDBs have the expertise needed to partner with L/MICs to launch effective projects that make economic sense. They just need more financial firepower. The G20 has encouraged the MDBs to be bold and ambitious, and to think outside the box so that they can provide the grants and loans vital to LMICs' sustainable future.

The African Development Bank (AfDB) and the Inter-American Development Bank (IDB) have put forward a proposal to use high-income countries’ excess Special Drawing Rights (SDRs) to increase their lending capacity. SDRs are reserve assets issued by the IMF to all its 190 member countries. During the COVID pandemic, the IMF allocated $650 billion worth of SDRs, which helped many L/MICs in financial distress. But almost $400 billion in SDRs sit idle on high-income countries’ balance sheets. The AfDB and IDB propose that those idle SDRs be loaned to them and used as hybrid capital. For every $1 billion of SDRs lent as hybrid capital, MDBs can make $4 billion of loans to climate or development projects in L/MICs.

However, the AfDB/IDB proposal has yet to be implemented. No country has committed SDRs to the banks, and various high-income countries (including some that encouraged the MDBs to innovate) have held back their contributions in the guise of protecting the SDR's "reserve asset characteristic.” The irony is that the MDBs designed the proposal to do just that, by guaranteeing a means of liquidating any SDR loan if needed and paying an interest rate that remunerates lenders. Today, lending SDRs as hybrid capital has been added to the IMF’s list of “permitted transactions.”

The blockage is due to an unwillingness among central banks in high-income countries to see their reserves used for fiscal purposes. Central banks use their reserves to ensure the smooth flow of trade and support their currencies. They loathe using them to pay for current spending or investments in their own countries, much less others. Lending to MDBs is seen as chipping away at high-income countries' financial safety margins to help bail out developing countries that are a world away.

However, an MDB onlending scheme presents little risk to the global financial system. First, the SDRs would not be spent—they'd be held at the MDBs' SDR account at the IMF as capital, which MBDs would then leverage on capital markets. Only in the improbable case that the MDBs went belly-up would the SDR capital be called upon by the MDBs. Second, total global reserves amount to about $15 trillion. With an overall IMF-mandated cap of $15 billion for all MDBs, this does not pose substantial risk to the system. It is doubtful that putting aside 0.1 percent of global reserves as hybrid capital for the MDBs will destabilize the global financial system, even in the worst times. In fact, during the two recent financial crises—the Great Recession and the aftermath of COVID-19—global reserves rose as economic activity slowed and high-income country banks reinforced their balance sheets.

A second political blockage is that the decision to loan SDRs to the MDBs is made on a country-by-country basis. No high-income country wants to put its own reserves on the line when others are not doing so—"let others take the risk." But that means no one does, even though, collectively, advanced economies have plenty of extra reserves that MDBs could put to good use.

These two problems—central bank hesitancy and the need for collective action—could be solved by rethinking how SDRs are allocated. Currently, SDR allocations go to countries; if countries are willing, they can on-lend SDRs for funds at the IMF or MDBs. However, if the global community could reach a consensus that a part of any new SDR allocation should go directly to MDBs as capital to be held at the IMF, it would short-circuit the incentive-incompatible recycling process.

Including MDBs as direct recipients of the next SDR allocation would increase these institutions' capital and strengthen their lending power. Direct SDR allocation to MDBs would bypass the constraints put on countries to preserve the SDR's reserve asset status—no country would have to withdraw the SDRs because of its own difficulties. With the MDBs holding the SDRs as capital in their accounts at the IMF, they would not be at risk unless the banks encountered serious solvency problems that required capital liquidation. In that unlikely event, the burden of liquidating SDR capital could be shared by IMF members in proportion to their quota, thus spreading the liability across the globe in small amounts. In essence, allocating SDRs directly to MDBs allows each country to contribute to strengthening the MDBs' lending power.

Another advantage of this proposal is that MDBs can leverage the SDR-based capital, thus expanding their loanable funds by about four times the value of the SDRs. They can then target their interventions to the countries that are in most need of assistance, with loans terms appropriate to confronting the challenges countries face.

The climate crisis is afoot and we are losing the gains of the last decade; action is needed to change course. World leaders must start discussing how to best use the SDRs as a solution. There are many details to work out, including which MDBs, how much, and their status. Most importantly, such a change would entail rethinking the SDR allocation formula and require an 85 percent vote of the IMF executive board—no small feat in today's politically fractured world. However, allocating some SDRs directly to MDBs would allow the current system of quota-based allocation to countries to be maintained. Whether it would garner an 85 percent vote of the IMF board is an open question, but it seems more likely to do so than other country allocation proposals.

MDBs are crucial to financing efforts to tackle climate change and promote global development. We can unlock a powerful, cost-effective, and low-risk solution by boosting their capital through the strategic allocation of SDRs as hybrid capital. This approach equips MDBs with the financial strength to scale their impact, mobilizing the needed resources to address the world's most pressing challenges.

Disclaimer

CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.


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