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The rise of China as a major bilateral development partner and the emergence of new development agencies raises the question of whether the existing multilateral financing system is fit for purpose. In addition, nations face shared problems—such as climate change, the threat of pandemics, and unregulated cross-border movements of people—that can only be addressed through international cooperation.
With aid a declining share of development finance, CGD is asking what institutional changes are needed within the multilateral development banks and other international financial institutions to reflect new realities and rise to the challenge of funding the SDGs? And how can those changes be made most effectively?
Economic recovery in Latin America and the Caribbean (LAC) is gaining momentum, but more work is needed to ensure growth is both sustainable and inclusive. Looking ahead, activity is expected to gather further momentum—reflecting stronger demand at home and a supportive external environment. But there are still challenges ahead. Risks to the region’s outlook reflect internal factors as well as heightened external risks—notably, a shift towards more protectionist policies and a sudden tightening of global financial conditions. Additionally, longer-term growth prospects for Latin America and the Caribbean remain subdued.
When US Treasury Under Secretary David Malpass appeared before Congress just five months ago, he indicated that the World Bank “currently has the resources it needs to fulfill its mission” and went on to characterize the bank and other multilateral institutions as inefficient, “often corrupt in their lending practices,” and ultimately only benefitting their own employees who “fly in on first-class airplane tickets to give advice to government officials.”
From that standpoint, it would be hard to imagine US support for a significant injection of new capital into the World Bank’s main lending arm, the IBRD, as well as the bank’s private sector lender, the IFC.
And yet, that’s exactly the surprising outcome just announced at the World Bank’s spring meeting of governors. Not only is the Trump administration supporting a $7.5 billion capital increase for the IBRD (and at that, one that is 50 percent larger than the capital increase supported by the Obama administration in 2010), it has also signed on to a policy framework for the new money that makes a good deal of sense.
Here are the highlights:
The capital increase package will better enable the institution to deliver on its commitment to be a leader on climate finance and more broadly in support of global public goods, aligning with key recommendations from CGD’s 2016 High Level Panel on the Future of Multilateral Development Banking. Under the agreement, the climate-related share of the IBRD’s portfolio will rise from the current 21 percent to 30 percent. The IFC’s share will rise even higher to 35 percent. New ambition on the climate agenda also includes commitments to screen all bank projects for climate risks and incorporate a carbon shadow price into the economic analysis of projects in emissions-producing sectors. For global public goods more generally, the agreement newly commits a (very modest) share of IBRD annual income to global public goods.
The package introduces the principle of price differentiation based on country income status, with higher income countries paying more than the bank’s other borrowers. This proposal, which was also put forward by CGD’s High Level Panel in 2016, will generate additional revenues for the bank and asks more of countries that have less financing need. While the introduction of the principle marks an important step forward, the actual price differentiation is extremely modest—at most, the spread between high income borrowers will be just 45 basis points on IBRD lending rates of about 4 percent.
The package assigns new guidelines for the IBRD’s overall lending portfolio to channel 70 percent of the bank’s resources to countries with per capita incomes below $6,895 and 30 percent to countries above this so-called “graduation threshold.” These targets would not be binding when it comes to crisis lending. In practice, these new guidelines seem to align with the existing pattern of IBRD lending, as indicated in the figure. In this sense, the idea that these guidelines amount to cutting China's access to World Bank loans appears exaggerated, though over time, as more countries join the higher income category, the 30 percent share will be allocated across more borrowers.
The package also attempts to identify a new financial framework that requires greater discipline when it comes to tradeoffs between lending volumes, loan pricing, and the bank’s administrative budget. This framework, which reportedly was a priority for the US government, may not ensure that this will be the last ever capital increase for the World Bank (as an unnamed US official promises), but it does appear to introduce a greater level of coherence around financial/budgetary decisions that have historically proceeded in a disjointed fashion within the institution.
Finally, even as the agreement seeks greater differentiation among countries, it reaffirms the World Bank’s commitments to stay engaged with all its client countries, including China. In fact, given US rhetoric, it’s surprising that the agreement does not stake out any new ground on the subject of country graduation. In fact, it seems to go out of its way to reassure all current bank borrowers that they are still welcome and that the decision to graduate from assistance is theirs to make. In the end, as much as ending China’s borrowing from the bank would have been a political prize for the Trump administration, US officials appear to have taken a sensible policy path that favors good incentives over polarizing fiats.
Pascale Hélène Dubois will discuss the global impact of World Bank investigation and prevention activities and then join a panel with Kathrin Frauscher, Deputy and Program Director, Open Contracting Partnership and Hasan Tuluy, Partnership for Transparency Board Director, former World Bank Vice President, to dive deeper into what more can be done at the World Bank and other international institutions to combat corruption.
When the world’s finance ministers and central bank governors assemble in Washington later this month for their semi-annual IMF meeting, they will no doubt set aside time for yet another discussion of the lingering debt problems in the Eurozone or how impaired bank debt could impact financial stability in China. They would do well to also focus on another looming debt crisis that could hit some of the poorest countries in the world, many of whom are also struggling with problems of conflict and fragility and none of which has the institutional capacity to cope with a major debt crisis without lasting damage to their already-challenged development prospects.
Nearly two decades ago, an unprecedented international effort—the Heavily Indebted Poor Countries (HIPC) Debt initiative—resulted in writing off the unsustainable debt of poor countries to levels that they could manage without compromising their economic and social development. The hope was that a combination of responsible borrowing and lending practices and a more productive use of any new liabilities, all under the watchful eyes of the IMF and World Bank, would prevent a recurrence of excessive debt buildup.
Alas, as a just-released IMF paper points out, the situation has turned out to be much less favorable. Since the financial crisis and the more recent collapse in commodity prices, there has been a sharp buildup of debt by low-income countries, to the point that 40 percent of them (24 out of 60) are now either already in a debt crisis or highly vulnerable to one—twice as many as only five years ago. Moreover, the majority, mostly in Sub-Saharan Africa, have fallen into difficulties through relatively recent actions by themselves or their creditors. They include, predictably, commodity exporters like Chad, Congo, and Zambia who have run up debt as they adjusted (or not) to revenue loss from the collapse in oil and metals prices. But they also include a large number of diversified exporters (Ethiopia, Ghana, and the Gambia among others) where the run-up in debt is a reflection of larger-than-planned fiscal deficits, often financing overruns in current spending or, in a few cases, substantial fraud and corruption (the Gambia, Moldova, and Mozambique).
The increased appetite of sovereign borrowers has been facilitated by the willingness of commercial lenders looking for yield in a market awash with liquidity, and by credit from China and other bilateral lenders who are not part of the Paris Club. It is striking that between 2013-16, China’s share of the debt of poor countries increased by more than that held by the Paris Club, the World Bank and all the regional development banks put together.
Nor do traditional donors come out entirely blameless. Concessional funding for low-income countries from the (largely OECD) members of the DAC fell by 20 percent between 2013–16, precisely the period in which their other liabilities increased dramatically. As for the IMF and World Bank, while it may have been wishful thinking to hope they could prevent a recurrence of excessive debt, it was not unreasonable to expect that they would have been more aware as this buildup was taking place and sounded the alarm earlier for the international community. There is also a plausible argument that excessively rigid rules limiting the access of low-income countries to the non-concessional funding windows of the IMF and World Bank left no recourse but to go for more expensive commercial borrowing, with the consequences now visible.
How likely is it that these countries are heading for a debt crisis, and how difficult will it be to resolve one if it happens? The fact that there has been a near doubling in the past five years of the number of countries in debt distress or at high risk is itself not encouraging. And while debt ratios are still below the levels that led to HIPC, the risks are higher because much more of the debt is on commercial terms with higher interest rates, shorter maturities and more unpredictable lender behavior than the traditional multilaterals. More importantly, while the projections for all countries are based on improved policies for the future, the IMF itself acknowledges that this may turn out to be unrealistic. And finally, the debt numbers, worrying as they are, miss out some contingent liabilities that haven’t been recorded or disclosed as transparently as they should have been but which will need to be dealt with in any restructuring or write-off.
The changing composition of creditors also means that we can no longer rely on the traditional arrangements for dealing with low-income country debt problems. The Paris Club is now dwarfed by the six-times-larger holdings of debt by countries outside the Paris Club. Commodity traders have lent money that is collateralized by assets, making the overall resolution process more complicated. And a whole slew of new plurilateral lenders have claims that they believe need to be serviced before others, a position that has yet to be tested.
It is too late to prevent some low-income countries from falling into debt difficulties, but action now can prevent a crisis in many others. The principal responsibility lies with borrowing country governments, but their development partners and donors need to raise the profile of this issue in the conversations they will have in Washington. There is also an urgent need to work with China and other new lenders to create a fit-for-purpose framework for resolving low-income country debt problems when they occur. This is not about persuading these lenders to join the Paris Club but rather about evolution towards a new mechanism that recognizes the much larger role of the new lenders, and demonstrates why it is in their own interest to have such a mechanism for collective action.
Traditional donors also need to look at their allocation of ODA resources, which face the risk of further fragmentation under competing pressures, including for financing the costs in donor countries of hosting refugees. Finally, the assembled policymakers should urge the IMF to prioritize building a complete picture of debt and contingent liabilities as part of its country surveillance and lending programs, and to base its projections for future economic and debt outcomes on more realistic expectations. They should also commission a review to examine the scope for increased access to non-concessional IFI funding for (at least) the more creditworthy low-income borrowers.
It is the poor and vulnerable that pay the heaviest price in a national debt crisis. They have the right to demand action by global financial leaders to make such a crisis less likely.
The shareholders of the private finance operations or windows (PSWs) of the multilateral development banks (MDBs) expect them to pursue three objectives simultaneously: (1) market returns, (2) high mobilization rates (dollars of private finance raised per PSW dollar committed), and (3) high development impact. It is no surprise that in the real world there are often tradeoffs among these objectives. Yet shareholders send mixed messages about where their priorities lie. The actual PSW track records suggest more success on objective (1) than on (2) and (3).
This confused status quo becomes untenable in the context of the enormous challenges of financing the Sustainable Development Goals (SDGs), the disappointing data and trends for actual private finance flows for development, limited aid dollars, and tight fiscal constraints on developing country government capacity to fund infrastructure and other development spending. A 2018 report estimates that a total of $60 billion of private finance was mobilized by PSWs in 2016, hardly a sufficient contribution to addressing annual SDG financing gaps in the trillions.
Some inside and outside these institutions are urging them to evolve from lenders to mobilizers—a change that does not mesh well with PSW financial models that favor profitable lending for their own account. Guarantees, for example, account for only about 5 percent of PSW commitments but generate about 45 percent of private finance mobilized.
All this suggests an urgent need to change PSW business models to maintain their financial sustainability while doing much better on mobilization and development impact. Two factors are critical for meeting this challenge: enhanced risk management capability and greater flexibility regarding risk-adjusted returns. Crowding the private sector into projects with high development impact can be advanced by disciplined use of blended finance to reduce or share risk, boost returns, or form a partnership in which one party accepts delayed or below-market risk-adjusted returns.
Adapting the PSW model
PSWs need a better way to be effective and efficient partners in blended finance arrangements. To this end, I have proposed that special purpose vehicles (SPVs) with separate balance sheets be added to the PSW toolkit. They would be purpose-built for taking on more risk, while the core PSW balance sheets would retain their AAA rating and their profitability. The SPVs would target pervasive gaps in capital markets such as limited early-stage finance for firms, local capital markets, and pre-operational infrastructure projects; and scarce finance for the riskiest project tranches like junior equity or debt. The SPV financial goal would be simply to preserve shareholder equity at the entity level.
The basic idea is for the two parts of the PSW—the SPV and core operations—to offer a seamless continuum of products and services to clients. In some cases, this would make deals bankable that otherwise would not pass credit committees. In others, it would make scale and larger deals possible. And in still others, it would mean a smooth handoff from the SPV to the core PSW operations when clients or markets are ready for commercial finance and growth.
Capitalizing such SPVs would offer attractive features to MDB PSW shareholders:
The new capital requirement would be relatively small compared to PSW core balance sheet needs.
The resources funding the SPV would take the form of shareholder capital rather than one-time contributions to individual donor trust funds or reliance on IDA replenishment resources. SPV capital adequacy and the need for possible capital increases could then be periodically assessed.
The SPV shareholder and governance structure could be established de novo, that is, without dilution worries for shareholders that do not wish to participate.
Shareholders would be deploying their new capital in a way that directly advances the institutional change they seek—more openness to innovation, more mobilization, and a greater focus on areas and projects with high development impact.
A better approach than creating an SPV for each MDB would be to establish just one SPV that all MDBs could access. It could be structured in a way that facilitates both collaboration across MDBs to gain more access to SPV resources as well as healthy competition to ensure that the best projects are selected.
One other desirable innovation would be to allow private investors to participate in capitalizing the SPV. A public-private SPV would give risk-tolerant private impact investors and philanthropists a chance to participate in funding projects where mobilization and development impact are high. For their part, public shareholders would not have to bear the whole burden of capitalizing the SPV. Private shareholders would of course then rightly expect to have a seat at the governance table. This seems both logical and sensible if public and private shareholders are united around the same mission. As we’ve seen in other public-private partnership spheres, the private sector can introduce efficiencies and innovation that accelerate institutional change.
One-quarter of the world’s school-age children live in East Asia and the Pacific. In the past 50 years, some economies in the region have successfully transformed themselves by investing in the knowledge, skills, and abilities of their workforce. Through policy foresight, they have produced graduates with new levels of knowledge and skills almost as fast as industries have increased their demand for them. Yet, tens of millions of students in the region are in school but not learning. In fact, as many as 60 percent of students remain in systems that are struggling to escape the global learning crisis or in systems where performance is likely poor.