World Bank

Last year the World Bank adopted a new “cascade” approach that intended to maximise finance for development by prioritising private solutions wherever possible:

  In what world would this “cascade” algorithm make sense? Without a good answer to that question, the cascade risks looking like ideology rather than sound development finance advice.

World Bank economist Tito Cordella has published a fascinating theoretical exploration of this question “Optimizing Finance for Development”, focused on the optimal sequencing of the three possibilities: reform, subsidies (risk mitigation), or public funding.

But as economists are wont to do, Cordella strips his model down to the bare minimum needed to analyse the question in hand. Yet his model contains some ingredients that could help us think about the cascade more broadly. Moreover, it is not always obvious how to connect his stylized model back to reality. This blog post tries to do that. Before proceeding, it should be noted that World Bank research economists do not speak for the Bank and so this is not an attempt to hoist the Bank on its own petard: what matters are the arguments being made, not who is making them.

As an economist, the first question Cordella asks is: which is more efficient, public or private? When Cordella writes that “to focus on the policy relevant trade-offs, most of the analysis features the case in which the private sector has an efficiency advantage”—that’s because for him when the public sector is more efficient the solution is trivial: the public sector should do it. That is a significant departure from, “if the private sector can do it, it should.”

But I suspect many people may feel that even basing the choice between public or private on efficiency is too reductive. Many North Americans fundamentally object to the idea of socialised medicine—for example—whilst many Europeans find the American health system equally objectionable. Societies have different ideas about fairness and equality. We could interpret “efficiency” more broadly, meaning that we want to satisfy social preferences in the most efficient manner possible. Or we could see the role of the Bank as setting out the costs of achieving various social outcomes and leaving it to the political process to decide what’s worth the price.

In Cordella’s model, public and private are assumed to have the same cost of capital but differing levels of efficiency across projects, which shows up in the form of different rates of financial return: greater efficiency means higher returns. Beneath the abstraction of a model, what do financial returns mean in the context of public provision? Some public projects charge user fees (e.g., utilities) but the government can also capture financial returns via incremental economic activity, which is taxed. Efficiency is a simple model parameter, but in reality the analysis of public versus private efficiency would (should) be complex: all else equal, perhaps public schooling is more efficient because it reaches the less well-off, and lower inequality is good for growth and tax revenues. Perhaps public roads are more efficient because they have a larger economic impact on overall economic activity than a toll road. The model also recognises that efficiency is not just about returns that can be internalised financially—projects create externalities. Cordella assumes externalities are the same under public and private provision, but that is merely because he is not interested in that aspect of the problem; the theoretical implications would be trivial: all else equal, if positive externalities are larger under public provision, the public should do it.

Cordella is focused on the set of projects where the private sector has an efficiency advantage, but the returns are not sufficient to induce investment. For these, there is an interesting problem of whether, and how, to bear the costs of overcoming that. His model introduces two helpful ideas: policy reforms that improve the commercial viability of projects can come at a social cost, and subsidies to induce private participation can be too expensive. This is a useful contribution to policy debates over “blended finance” which thus far have had little to say about when levering the private sector is not worth the trouble.

The analysis reveals that sequencing of the cascade algorithm only matters because governments are unable to perfectly fit instruments to projects. If subsidies and reforms are precise and project-specific, sequencing is irrelevant. But if the cascade approach is implemented in stages where, in effect, the “reforms department” does as much as it can with its instruments first before passing on the residual of projects to the “subsidies department,” then the sequencing is important. Cordella finds that contrary to the “cascade” it is best to apply subsidies first, and crowd-in the projects which are close to commercially viable at low cost, before turning to reforms when they come at a meaningful social cost. If reforms are cost free, the implications are trivial: do them. Cordella concludes:

The objective of maximizing private finance for development may conflict with the objective of optimizing finance for development.

However, the cascade is motivated by something that does not feature in Cordella’s model: the scarcity of public funds. There is no government budget constraint in the model. It could be introduced by assuming the cost of public finance is increasing in the quantity of public projects, so that “efficiency” becomes combination of costs and returns. The effect on Cordella’s model would be to expand the set of projects where the private sector has an efficiency advantage, and thus candidates for the cascade. Presumably the cost of financing subsidies would also reflect the increasing cost of public finance and the last-resort public option would become less often feasible, so the importance of reforms would rise. Behind the cascade model lies the idea that developing countries have reached the limit of fiscal space, so choosing private solutions where they are available is the only way of getting more done.

A counter argument is that if an economy can afford to pay for a new airport, for example, via users fees high enough for a private provider to make profits, then it should also be able to afford to pay those fees to a government-run airport or to pay via taxation. If the government has a profitable investment opportunity, it should be able to raise finance without seeing its cost of capital increase. Of course, if the government would be less efficient—perhaps it faces capacity constraints that aren’t about money but are about human resources—then that would settle it. But the cascade’s “private if possible” rule makes sense if the scarcity of public funds dominates efficiency considerations, otherwise relative efficiency should be the deciding factor. And if the public sector is equally efficient, in the sense of being equally able to capture financial returns, then it should also be able to find the money. The public budget should not be regarded as fixed, irrespective of what positive return investment opportunities that the government faces.

Maybe there are too many “shoulds” in the previous paragraph. Governments may not be able to finance all their positive-return projects. The cascade could be justified as a second-best solution for a second-best world. It may also be better seen as a signal that the Bank is now more receptive to collaborating with the private sector, rather than as a rule to be followed to the letter. But even on a more sympathetic reading, a stated policy of unconditional preference for private provision may be hard to sustain.

Opinion in some of the Bank’s shareholder countries is turning against private finance. More importantly, citizens of partner countries are reading stories like this: the American contractor Bechtel is lobbying the Kenyan government to choose conventional public procurement for a new Nairobi-Mombasa expressway, because it claims the financing cost under a PPP will be five times higher ($15bn versus $3bn). There is no mention of World Bank involvement in this project, but it’s a useful example. Kenya is a country with public debt approaching unsustainable levels so perhaps choosing private financing for this expressway would preserve fiscal space for something else, such as an investment in public rural roads.

What’s more, straight comparisons of financing costs can be misleading, because they obscure who carries the can for cost overruns under the two models (we should not assume a construction firm has the client’s best interests at heart, especially if advocating a cost-plus over a fixed-cost contract). The right choice is not obvious, so advice from the World Bank could be useful here. A flow chart that points straight to the private sector is not.

Cordella’s model sets aside theoretical possibilities if the implications are trivial. It may seem trivial to conclude that the choice between public and private finance should juggle both public financing constraints and comparative efficiency, but the cascade doesn’t work that way. And it should. 

Debt relief wiped away much of Africa's sovereign debt, but after a decade of growth, debt stocks are rising again. Here's a look at the numbers, and how we got here again.

Remember debt relief?

Twenty years ago, Bill Clinton was president, Bono was still a rock star, and the jubilee movement to forgive poor countries' debts was perhaps the central preoccupation of development policy debates. The IMF and World Bank's Heavily Indebted Poor Countries initiative (aka HIPC) got the ball rolling in 1996, but it took another two decades of Bob Geldof concerts and negotiations between the Bretton Woods institutions, Paris Club creditors, and the debtors for the process to culminate with (hypothetically) 100 percent debt relief for 36 countries—30 of which were in Africa.

Part of the reason you don't hear so much about debt relief any more is that it worked, at least for a while. Countries like Ghana saw its debt fall from 120 percent of GDP in 2000 to just 12 percent in 2006. Mozambique's fell from over 200 percent down to the mid-20s over a similar time period. While we should be careful about assigning a causal role to debt relief, economic growth rates across Africa were strong over the next decade, and the "Africa Rising" narrative took hold.

Fast forward to 2018, and some of those same countries are gradually accumulating fairly significant sovereign debts again, which have led to talk of a new African debt crisis.

The graphs above are based on the World Bank's International Debt Statistics, where we've pulled out numbers for the eight low- or lower-middle income African countries with the highest debt-to-GDP ratios today (ignoring a couple of small countries with total GDP below 10 billion dollars).

A few simple facts stand out:

Sudden fall: Several countries saw a dramatic decline in debt stocks after they benefited from the Multilateral Debt Relief Initiative in 2005.

Gradual rise: The countries shown were chosen precisely because they have run up debts recently. In raw numbers, the figures look more extreme—Ghana's total sovereign debt is more than double today than it was at its peak before debt relief—but Ghana's economy has grown at a steady clip, so as a proportion of GDP the figure has risen only gradually.

Commercialization: In the 2000s, most of the debt was owed to multilateral institutions like the World Bank and IMF and bilateral creditors who formed the Paris Club. Today, a much larger share of African debt is held by private banks and bondholders, so the dynamics of any hypothetical workout would be considerably different.

After stepping down as director of the IMF's Africa Department last year, my colleague Antoinette Sayeh wrote an essay for CGD reflecting on what could have been done differently:

In this my first post-IMF piece, I focus on whether the volume of Fund financing for SSA frontier markets… should have been greater, and whether such financing could have helped contain the indebtedness of those countries, many of which issued sovereign bonds… Has the Fund actually adapted to the need for [non-concessional loans]to these countries as they climb up the income ladder?

Poor countries need development finance. The question is where they're going to get it.

Economic growth converted a number of major African economies from low- into lower-middle income countries, and as Antoinette notes, in the process they seem to have fallen into an awkward middle ground: not facing any imminent crisis, they were too successful for most kinds of concessional finance from the multilateral financial institutions, but still fragile enough that the cost of finance from commercial creditors was high.

One consequence is that the cost of debt service (i.e., repayment flows not debt stocks) have bounced back more quickly than debt stocks

Our analysis suggests the IMF has had a perennial bias toward optimism—and hence inaction—in the face of Africa's recent debt accumulation. Swearing "never again" after the last bout of debt relief, the World Bank and IMF agreed to periodically monitor borrowers and issue joint Debt Sustainability Analyses, which are basically forecasts of a country's economic growth, exports, government revenue, and debt levels. We downloaded the archived PDFs of these reports for the two most-heavily indebted African countries, Ghana and Mozambique, and decided to look at how well the forecasts panned out.

On economic growth, the Bank and Fund performed pretty well (though for a slightly earlier period, my former colleague Ben Leo found some evidence of over-optimism in IMF growth projections for Africa as well). Forecasts were rosy, and reality mostly lived up to expectations. Contrast this with recent European crises. There the IMF was faulted for its wildly optimistic forecasts of growth rates in Greece, Spain, Italy, and Portugal (see Figures 2-6). No debt workout was needed, was the implicit message, because Greece could tighten its belt and grow its way out of distress. Each year, Greek GDP declined, and each year the IMF said they were about to turn a corner.

While the Bank-Fund growth forecasts were much better for Ghana and Mozambique, their forecasts of the countries' debt levels have been comically wrong, year after year. As debt levels rose, the official Debt Sustainability Analyses predicted they would flatten out and soon fall. But they didn't. And this was not a one-off mistake. As the saying goes, "fool the IMF once, shame on Ghana; fool the IMF every year while your debt levels soar, maybe shame on the IMF too."

To be fair to the Fund, Ghana and Mozambique are special cases. From 2011 to 2015 the Ghanaian government, feeling flush with potential oil revenues, basically told the IMF to take a hike. And the Mozambican government engaged in secretive borrowing while keeping both its creditors and citizens in the dark.

Nevertheless, reading the Debt Sustainability Analyses and looking at these graphs, the impression is that the World Bank and IMF treated their advice as forecasts. They repeatedly cautioned both countries to restrain their borrowing and spending, and forecast that they would comply. In hindsight, neither country had any intention of doing so.

Are countries borrowing too much, or are multilateral institutions lending too little, forcing poor countries toward more expensive commercial loans? In either case, several African economies appear to be on course for a new period of debt distress and pressure for fiscal austerity. More, not less, multilateral lending in Africa might be a partial solution. Otherwise, it may soon be time for Bono and Bob Geldof to dust off their guitars.

Thanks to numerous colleagues for comments. This post emerged from discussions with Masood Ahmed, Nancy Birdsall, Alan Gelb, John Hurley, Charles Kenny, Todd Moss, Mark Plant, Vij Ramachandran, and others, but the views expressed are ours alone.