Banking and Financial Services of
the United States House of Representatives
Senior Advisor to the Chairman of the
International Financial Institution Advisory Commission
March 23, 2000
Mr. Chairman, it is a privilege to address you and the members of the Committee.
The focus of my remarks will be the Multilateral Development Banks.
In the debate that has followed the release of the Meltzer Commissions report, the most important message has passed virtually unnoticed. All sides agree on the two key issues. First, the goal of the Banks is the alleviation of poverty among the poorest members of the world. Second, the effectiveness of the institutions must be dramatically increased if this goal is to be achieved and the use of donor country taxpayer monies to be justified.
This consensus has been publicly announced across the entire political spectrum ranging from Treasury Secretary Summers and World Bank President Wolfensohn to House Majority Leader Armey and Senate Banking Committee Chairman Gramm. The message is clear: the American people are generous and ready to increase aid resources for the poorest countries significantly if effectiveness is assured.
Collectively, the World Bank Group and its three regional counterparts (the African Development Bank, Asian Development Bank, and Inter-American Development Bank) deploy 17,000 people in 170 offices around the world, have obtained $500 billion in capital from national treasuries, hold a loan portfolio of $300 billion and each year extend a total of $50 billion in loans to developing members.
There have been tectonic shifts in the global economy since the founding of the World Bank in 1944. Yet the development banks continue on the same open-handed and antiquated course. Until the 1980s, the Banks were the dominant source of international resources for emerging economies. Capital controls prevailed; financial markets were immature; foreign investment interest in developing economies was minimal. Now the net $18 billion provided by the World Bank to developing countries over the last 7 years is dwarfed by the $1,450 billion contributed by the private sector.
There is a wide gap between the Banks rhetoric and the reality of their operations.
The Banks claim to devote their efforts to countries denied access to private sector resources and to social projects that cannot command the interest of private lenders. Yet five key facts on which all participants, including the Banks themselves, agree, belie this image:
1. the dominant share (70%) of World Bank funds is devoted to 11 countries with ready access to private sector capital. The 7 leaders are China, Argentina, Russia, Mexico, Indonesia, Brazil, and Korea;
2. the funding provided to these countries is insignificant to them, only 1% of the resources received from the private sector;
3. just as the Banks only lend to governments, private investors finance health, education, and institutional reform every time a developing country sells bonds in the global capital market;
4. money is fungible eliminating any link between Bank financing and specific projects or policy reforms;
5. countries only implement reforms if they wish to reform and no amount of funds offered or withheld will alter the outcome.
The logical conclusion of these facts is that in countries with substantial domestic and foreign resources, Bank lending does not add to available funds and does not influence the policy reform process. All that is occurring is the provision of subsidized fiscal and balance of payments financing.
The overlap between the World Bank and the regional banks is almost complete. They compete for donor funds, clients, and projects. All Banks operate at the national level and their patterns of lending are virtually identical. Four to six of the most creditworthy borrowers, all with easy capital market access, monopolize non-aid resource flows: 90% in Asia; 80-90% in Africa; 75-85% in Latin America. In Africa, the three largest borrowers over the last 3 years, both from the African Bank and the World Bank, accounting for 80% of all loans were Morocco, Tunisia and Algeria. Pure public sector finance excluding social and infrastructure programs accounts for 35-40% of total flows; across all regions and among all institutions.
The failures of many development programs trace their origin to perverse incentive systems created by the Banks in both the recipient countries and in the lending institutions themselves. Incentives to lend for lendings sake are built into the structure of the Banks. Internal budget resources and advancement are awarded where loan volumes concentrate, not where the number of projects is highest or where technical assistance and knowledge transfer are favored over funding.
There is no counterbalance to the incentive to lend, for the host government guarantee required on all loans has divorced project failure from risk of loss to the Bank. The major incentive to ensure individual project success is eliminated while the incentive to channel large sums to the most creditworthy governments is intensified. The end result is a self-evaluated 55-60% failure rate of World Bank projects to achieve satisfactory sustainable results and a concentration of loans in countries with strong ratings and ready access to private sector resources. In Africa, the failure rate reaches 73%.
The costs of the development banks are high. Though the Banks claim to be self-supporting and cover operating expenses through surcharges to borrowers, in truth, the annual cost to members has reached $22 billion. The share of the United States exceeds $5 billion per annum. Fifteen billion dollars reflects cash expenditure, while $7 billion represents a conservative valuation of the annual allowance for risk on the portfolio of emerging market loans.
The principal recommendations of the Commission regarding the development banks are:
All financing to countries that enjoy substantial capital market access (as denoted by an investment grade international bond rating) or per capita income in excess of $4,000 (in year 2000 constant terms) would be phased out over the next 5 years. The focus of institutional financial effort should be on the 80 to 90 poorest nations without access to private sector resources. This ensures that development aid adds to available resources. Over the last 7 years, only 21% of World Bank loans and 37% of combined loans and concessional credits were extended to countries with 1999 per capita income below $2,000 without investment grade ratings.
All country and regional programs in Latin America and Asia should be the primary responsibility of the Asian and Inter-American Development Banks. Costly duplication and confusion arise from the overlap of function and resource flows between the World Bank and its regional partners.
The World Bank should concentrate on the production of global public goods and serve as a centralized resource for the regional banks. Global public goods include treatment of tropical diseases and AIDS, rational safeguarding of environmental resources, inter-country infrastructure, tropical agricultural technology, and the creation of best managerial and regulatory practices.
Development agency intervention tools must create the correct incentives, assure performance and have independent evaluation of results. The Commission recommended that:
1. poverty alleviation grants to subsidize user fees, paid directly to the supplier upon independently verified delivery of service, should replace traditional Bank tools of loans and guarantees for physical infrastructure and social service projects; and
2. lending for institutional reform should be conditional upon implementation of specific institutional and policy changes and be supported by financial incentives to promote continuing implementation.
The World Bank and the regional banks should write-off in entirety their claims against all heavily indebted poor countries (HIPCs) that implement an effective economic development strategy under the Banks supervision.
A number of objections have been raised to the Commissions recommendations:
The phasing out of lending to middle-income countries and to countries with substantial access to private sector finance will eliminate loans to 60% of the worlds poor. This is the wrong criterion. The objective should not be the number of poor people. Scarce development resources should be concentrated on poor people without alternative financing. China has 25% of the developing worlds population but holds $150 billion in foreign exchange reserves. Total World Bank subsidized loans of $1 billion per year are insignificant to China compared to annual foreign investment of $60 billion. To those that have few resources to call upon, it is survival. In countries where financing is abundant, the Banks should continue to offer technical assistance.
The Banks claim that countries would ignore their advice unless subsidized financing is offered. International institutions are the only consultants that pay clients to take advice. Yet the World Banks own research shows that countries only implement reforms when they choose to reform and that, because money is fungible, links between specific programs and loans are weak. Since the volume of lending to the major borrowers is insignificant in relation to private flows, there is no leverage over borrowing governments.
The Banks claim that private lenders do not lend for social purposes such as health, education, or institutional reform. They neglect that the Banks insist that recipient governments guarantee repayment. When private lenders receive the same guarantee, they are not concerned about how the loan is used. Every time a developing country sells bonds in the capital market, bond buyers finance change.
The World Bank claims that curtailing loans to middle-income countries will reduce funds available to the poorest. Not so. The Bank lends at interest rates that only cover the cost of funds plus administrative expenses. The Banks net income is derived from earnings on equity capital and market investments unrelated to development. More importantly, loans to middle-income countries use up the Banks limited borrowing capacity, thereby reducing funds for the most needy nations.
World Bank President Wolfensohn claims that middle-income countries will default on existing loans if no new loans are forthcoming. First, this statement is nonsensical. By defaulting a country destroys its credit standing in world markets that supply 98% of its foreign resources. No country would do that. Second, the corollary of this position is that the World Banks major borrowers repay existing loans with the proceeds of new loans and that the World Bank never expects to be repaid but only to roll-over and increase existing credit to countries with alternative sources of funding.
Bank lending allegedly provides a signal of approval to the private sector but signaling need not entail loans. Published reviews of institutional and policy environments would convey the same information more effectively. Now that private sector finance is 50 times that of Bank offerings, the argument has lost plausibility. The only major Bank borrower where loans exceeded 5% of private sector flows over the last 7 years was Russia, an economy in which perhaps investors regret following the Banks lead.
The World Bank claims that valuable programs will be eliminated by the Commissions proposals. Every valuable program addressed under the current system will receive equal attention under the proposals whether it be maternal health in Bangladesh; legal reform in Thailand; social security and financial sector reform in Brazil and Mexico; or AIDS initiatives in Africa. Only the format and the providers would change.
The Bank fears that it will lose its global perspective if the regional banks assume the primary lending function. Why can not the World Bank benefit from the experience of the other development banks and continue to serve, and indeed increase its role, as a supplier of technical services to the developing world?
The World Bank claims that increased reliance on grant funding is politically na´ve. Donor countries will not provide the requisite financing. If effectiveness is assured and no funds can be expended prior to independently verified results, thereby ensuring the responsible utilization of taxpayer monies, grant funding is easily justified and should be forthcoming on a significantly increased scale. The need to compete for public resources will sharpen Bank program effectiveness.
The size of grant funding necessary to support any desired level of development programs is substantially less than the amount of loans required for the same purpose. A Bank loan of $100 million is easily replaced by a grant of $5-10 million per year. The remainder of the resources is easily obtained through standard private financing channels. The aid component of the Bank loan is only 5-10% per annum of the loan amount: the difference between the private sector cost of finance and the Banks lending interest rate.
The Banks claim that the absence of an obligation to repay grant aid leads to a lack of discipline on the part of recipients. To the contrary, the Commissions proposal imposes increased discipline by an obligation to pay an assigned portion of the costs on a current basis as opposed to the deferred 20-50 year schedule of development credits.
The Banks claim that private sector funding is too volatile while official financing is stable. First, stabilization in times of financial crisis is the responsibility of the IMF. Second, markets rebound quickly. Within 3 months of the crisis, South Korea borrowed $4 billion in the capital markets with 5 and 10 year maturities. During the 3 months following Brazils financial disruption, 20 issues totaling $12 billion were sold to international investors by Latin American sovereign borrowers, including $2 billion by Brazil itself, with 5 to 20 year maturities.
Current expenditures are too much for ineffective programs but too little for effective programs. If the institutions do not redefine their areas and methods of intervention and increase their effectiveness dramatically, they will be relegated to insignificance in the development process.
Finally, I would like to address briefly a number of the political aspects of the reform process which Prof. Calomiris has discussed. First, the American taxpayers are not going to tolerate the waste of the current operations. Second, the continued use of the institutions as tools of U.S. foreign policy will not be tolerated by the rest of the world. Discussions are already occurring at two of the major regional banks regarding the repurchase of the U.S. shares. If this is proposed and refused by the United Sates, the alternative will be the creation of new regional institutions without U.S. participation.
It is time for the United States to return to the unprecedented definition of a nations interest that it espoused in 1944. It defined its position in terms of the peace and prosperity of the rest of the world. It differentiated the concepts of interest and control. This was the spirit that created the Bretton Woods institutions. Global economic growth, political stability and the alleviation of poverty in the developing world are in the national interest of the United States.