Barbara A. Upton: THE EVOLVING ROLE OF THE MULTILATERAL DEVELOPMENT BANKS

Date: 05-03-2001

Barbara A. Upton, project director, The United States and the Multilateral Development Bank Project, Center for Strategic and International Studies, Washington, D.C., presented this paper at the East-West Center's workshop on "The Evolving Role of Development Banks" held in Honolulu on April 25.

The purpose of this paper is to provide brief background information on the five multilateral development banks (MDBs - the World Bank, the Asian Development Bank, the Inter-American Development Bank, the African Development Bank, the European Bank for Reconstruction and Development) and discuss the evolution of their role from inception until the present. The last section of the paper will discuss current issues and areas in which there is major disagreement about the role of the institutions.

The Role of the MDBs: At the Outset a Clear and Simple Mandate

The multilateral development banks were established, in most cases at the instigation of the United States, as innovative financial vehicles to provide loans to countries and projects around the world where the funds would have a high economic rate of return, but where perceived risk would preclude private financing. The governments of member nations own the MDBs and funded their initial expenditures directly with the convertible currency subscriptions of the wealthier members (initially the victorious Western allies after World War II).

The institutions' unique financial advantage is provided by their "callable capital" feature. Each country's capital subscription is divided into two parts. The first or "paid-in" portion can be used to finance expenditures directly. However, the second and larger part of the subscription - callable capital - is never actually transferred to the institution but is regarded as legally available and is used to guarantee the bank's borrowings on international capital markets. In this way wealthy countries are able to make available much more money to the institution than they are required to pay out from their own budgets, unless the institution cannot repay its borrowings and must make a "call" on its callable capital - a situation that has never occurred.

This mechanism for financing the MDBs was established when the World Bank was created at the Bretton Woods conference near the end of World War II. Although the first borrowers from the World Bank were war-ravaged European countries and Japan, the bulk of funding soon was directed toward the larger, wealthier developing countries that could afford the institution's credit terms - which had to be hard enough to cover the bank's cost of borrowing most of its funds on the international bond market. The MDB system was expanded to provide more funding to the wealthier Latin American countries with the creation of the Inter-American Development Bank (IDB) in 1959, headquartered, like the World Bank, in Washington, D.C.

The financial leverage feature of these institutions proved to work very well. Loans were extended for a wide variety of purposes but especially for the construction of such infrastructure as power plants, roads, and potable water systems. In almost all cases, the recipient government guaranteed the loans, protecting the MDB from arrears or default if the project did not prove financially viable. As the multilateral banks gained a cushion of financial reserves, diversified their risks across countries and sectors, and enjoyed nearly perfect repayment rates, it became possible for the wealthier members to finance new funding increments or "replenishments" largely by callable capital. By the 1990s about 98 percent of new capital was being provided to the older multilateral banks in callable capital form.

An Expanding Mandate

As the Cold War intensified, the MDBs came to be seen as one of the free world's tools for combating communism. Both the size and the country coverage of MDB lending were extended, as were the types of projects for which the institutions provided funding. The Asian Development Bank (ADB), based in Manila, was established in 1966 as the U.S. military buildup in Vietnam accelerated.

In the 1950s it became clear that the callable capital funding mechanism that enabled the MDBs to transfer significant resources to developing countries at low cost to the donors precluded the institutions from lending much to the large group of countries that could not repay loans made at near-market interest rates. These countries were not victims of a capital market imperfection, as it was often said the richer borrowers were. No amount of better information or ability to spread risk would enable countries such as Honduras, Bolivia, Bangladesh, or most Sub-Saharan African countries to repay loans on terms that would cover the costs of capital on international bond markets.

Therefore, the MDBs formed companion institutions or separate lending "windows" that operated on a completely different financial basis. These windows lent to the poorer countries convertible currency donations from wealthier members plus funds provided by repayments of principal and interest from previous loans. Loan repayments built up slowly at first because these MDB "soft loan windows" generally lent for 40 years with a 10-year grace period, with interest at only 1 to 2 percent per year.

With the creation of these soft loan affiliates or windows the intellectual rationale for the programs also changed. Although the MDBs had been established as public financial intermediaries to remedy imperfections in world capital markets unprepared to lend to war-devastated countries or remote, unknown parts of the globe, the soft loan windows were aid vehicles like the U.S. government's direct bilateral foreign aid program. By the mid-1990s, the net disbursements being provided by the MDBs in the form of concessional loans to the poorer countries exceeded the transfers provided on hard terms to the wealthier countries.

The uses of MDB funds from both the hard and soft loan windows also broadened. Cold War security concerns impelled the Western allies, led by the United States, to want to provide resources to some countries faster than traditional MDB infrastructure construction programs allowed. Likewise, both security concerns and humanitarian interests led to large MDB transfers to developing country governments for programs such as integrated rural development and urban development. These programs were intended to permit recipient governments to undertake investments to improve the incomes and living conditions of disadvantaged groups, thereby reducing the likelihood that they would support communist insurgents. Although the MDBs generally have not funded humanitarian relief (that is, food and other aid that is meant to be directly consumed to meet an immediate humanitarian need), beginning in the 1970s, they have devoted sizable funding to investment programs intended to benefit poor groups (for example, credit, land titling, and extension services for poor famers, improvements in urban shelter for the poor, and many types of expenditures for health, population, and education programs).

The early 1980s brought two more expansions in the types of programs funded by the MDBs. Although program loans, or financial transfers for general budget support, had been made previously, the amount of such lending was greatly increased during the 1980s. The theory was that if this funding were available from the MDBs (as well as from the World Bank's international monetary counterpart, the International Monetary Fund), it would induce developing country governments to adopt better economic, financial, and sectoral policies, provided that the lending was accompanied by appropriate policy reform conditions. MDB loans were also used to support various types of debt work-out programs agreed between borrowing governments and their private creditors during the international debt crisis of the 1980s.

Another type of MDB activity that was greatly expanded during the 1980s was lending in direct support of private projects. Consistent with the U.S. administration's strong support for the private sector, the World Bank dramatically expanded the programs of its small specialized affiliate, the International Finance Corporation (IFC), to take equity positions and provide loans on nearly commercial terms to private enterprises in the developing world. For these investments, developing country governments did not provide guarantees as they did for other World Bank programs. The regional development banks quickly established similar programs. In 1988, the World Bank Group further expanded with the U.S.-led creation of a Multilateral Investment Guarantee Agency (MIGA) to provide a multilateral official source of political risk insurance for private projects.

The newest type of MDB entity to be created was the Global Environment Facility (GEF), a multilateral mechanism to provide grants to address four types of global environmental problems. This entity, although managed by its own secretariat and governing bodies, is headquartered at the World Bank.

Two of the four regional development banks evolved somewhat differently. The African Development Bank (AfDB), established in Abidjan by the African nations themselves in 1964, only welcomed non-African members in 1982. However, it had created its concessional lending window in 1972 to which the developed countries, including the United States, contributed before they became bank members.

The European Bank for Reconstruction and Development (EBRD) was the brainchild of French president Francois Mitterrand and his adviser Jacques Attali, who desired a European-led institution to help reintegrate Central and Eastern Europe into the European mainstream. Although initially cool to the idea, the United States eventually became the largest shareholder and shaped the direction of the institution in a way that differed in key features from the older MDBs. The EBRD, headquartered in London, is required to lend 60 percent or more of its resources to private sector or privatizing entities and can lend only to countries moving toward democracy. It does not have a concessional lending window.

By the end of the millennium the "MDB system" had grown dramatically, both through planned expansion to incorporate the desire of someone - often the U.S. - for it to undertake a new function and through buildup of financial resources, as the decades of hard window lending generated huge reflows of loan principal and sizable amounts of net income. (MDB net income is used to pay administrative costs of the institution, to establish reserves, and in some cases is transferred to the soft loan affiliate to expand the resources available for concessional lending.)

The "MDB system" is now able to provide developing countries with more than $50 billion in new loan and equity commitments annually. (Actual total annual lending varies substantially according to global economic conditions and country needs.) Not only has the size of MDB programs grown substantially, but the relative importance of these programs as a part of the official U.S. relationship with developing countries has grown even more.

The relative role of the U.S. bilateral aid program is perceived by many to have been declining for a number of years, while funding for bilateral economic aid has declined substantially in recent years to about $8.6 billion in FY1999. Of this amount, more than $1.8 billion is used for economic support for Israel and Egypt. Bilateral aid has declined for numerous reasons, including the inability of several administrations to agree with Congress on aid priorities, the perceived greater cost effectiveness of multilateral aid, especially the MDBs; and, at times, poor leadership at the U.S. Agency for International Development (USAID). Funding provided to developing countries through UN agencies has declined also. In addition to MDB financial commitments forming a larger part of U.S.-supported transfers to developing countries, the United States has encouraged the MDBs to assume functions that in earlier eras would have been performed by U.S. agencies directly. The United States has elected to support MDB leadership for even such politically delicate chores as coordinating reconstruction in Bosnia and Kosovo and managing a trust fund to support economic development in the West Bank and Gaza strip.

A More Difficult and Complex Mission

In their early years the MDBs benefited from a clear mandate that they were well equipped to fulfill - financial intermediation to overcome imperfections in capital markets that failed to channel sufficient resources to substantial parts of the world. To this was gradually added another mandate that the MDBs could also accomplish with relative ease - the channeling of large sums to countries and governments judged worthy of support for Cold War reasons. There were arguments, at times heated ones, in the United States and between the United States and other MDB members about which countries, regions, or sectors should receive more resources at the margin. There were also disagreements about the total amount the United States should contribute to the MDBs in a particular year. However, the basic purpose of and need for the MDBs were not questioned seriously in the United States.

Likewise, the performance of the institutions was quite easy to monitor because it largely involved checking on whether funds went to the approved countries. In this era MDB and U.S. officials routinely used the ratio of MDB funds transferred to borrowers, compared with MDB administrative expenses, as a measure of institutional efficiency and success.

By the 1990s, the environment in which the MDBs operated had changed. International capital markets had grown enormously in size and interest in providing funding for lucrative opportunities throughout the world. Countries that were perceived to be pursuing sound policies were able to secure substantial private funding, and in some cases funders were willing to overlook major policy flaws if other aspects of the investment were sufficiently enticing. Specialized investment vehicles that were more suited to developing country risks had been devised. Although official development finance from Western governments was declining about 10 percent in net terms from 1991 to 1997, net flows from private sources increased more than fivefold - from about $50 billion to more than $250 billion. Net disbursements from the MDBs remained quite stable, ranging from about $13 billion to about $17 billion.

Although the 1997-1998 global economic crisis produced a decline in private flows of about 11 percent in 1997, by the spring of 1999 there were numerous reports of renewed access to private markets by even the more severely affected countries. There also were indications that the crisis had spurred private investors to develop more in-depth knowledge of developing country borrowers and, hence, greater ability to differentiate among borrowers and provide financing on terms deemed more commensurate with risk. By 2000 net long-term resource flows from private sources to developing countries had risen again to nearly $260 billion. Clearly, the lack of interest in soundly performing developing countries on the part of private sources of capital - the problem that had sparked the creation of the MDBs - had changed significantly.

The 1997 authorized history of the World Bank recognizes the change in circumstances that has eroded the need for the MDBs as classic financial intermediaries and the subsequent implicit shift in their raison d'etre.

"One of the authors of the World Bank's first authorized history (written in 1973) was preoccupied with whether the Bank would be able to "change its spots" from being mostly a bank to mostly a development agency. That question is no longer widely contested; the Bank, without abandoning some of its bankerly attributes, is generally credited with having become, not just a, but the, leading development agency of its time."

At about the same time, the end of the Cold War decreased the perceived need of the Western allies to provide resources to buttress friendly regimes. Therefore, with the motivation diminishing to transfer resources to developing countries for containing communism or to remedy capital market imperfections, the spotlight turned to the concrete accomplishments of the loans provided by the MDBs and other taxpayer-supported sources of finance to developing countries.

By the early 1990s, a substantial body of material had been produced on the results of the wide array of official financial transfers to developing countries. These studies differed greatly in methodology, in coverage, in findings, and in interpretation of results. However, the conclusions clearly did not bear out the once prevalent assumption - that simply transferring resources to poor countries would predictably lead to increased economic growth, development, poverty reduction, and perhaps even political pluralism and democracy. Similarly, there were doubts in a number of cases that politically motivated transfers had succeeded in establishing lasting and valuable political ties. Therefore, in the future it would be difficult for official financial and aid institutions to justify their continuance, let alone their growth, primarily on their skill at transferring resources. Instead, they would need to show that those resources had accomplished desirable objectives.

The World Bank itself recently concluded: "Foreign aid has concentrated too much on the transfer of capital....Disbursements....were easily calculated and tended to become a critical output measure for development institutions. Agencies saw themselves as being primarily in the business of dishing out money, so it is not surprising that much went into poorly managed economies - with little result."

The MDBs under Fire

How the MDBs have responded to these changes in global conditions and the differing perceptions about their role has drawn fire from many quarters. Conservative groups have long charged that the MDBs encourage too large a role for the public sector, compete with private financiers to fund potentially profitable projects, and lend to corrupt and dictatorial regimes. Recent MDB programs to directly support private projects especially have been criticized as interfering with markets and providing unjustified subsidies to both private firms and developing country governments. Ian Vasquez of the Cato Institue wrote about a World Bank-IDB loan for a gas pipeline in Brazil: "If the lending agencies are not supplanting sources of private finance, then they are second guessing the market's judgment about the financial worthiness of such investment."

The MDBs have been criticized by those on various points of the ideological spectrum for being ineffective and secretive bureaucracies that make large loans even when the borrowers' policies are not adequate to use them productively. Many observers have criticized the MDBs, along with other institutions, for failing to recognize or take decisive action on the policy failings in developing countries that gave rise to the 1997-1998 global financial crisis. In testimony before Congress, the former general counsel of the Inter-American Development Bank asked: "How can it be that Mexico, before the 1994 peso devaluation, and Indonesia, most recently, have been described by the World Bank as 'star' performers, and that the crisis, requiring billions of dollars in bail-out money, comes upon the IMF and the World Bank as a surprise?" The Financial Times similarly noted:

"Indonesia has been consistently praised for its sensible macro-economic and monetary policies. But the weaknesses have been at the micro-economic level; in the explosion of ill-regulated banks, and the concentration of business and political power in the hands of a tiny elite, unaccountable to any but the 76-year old president. Institutions like the IMF, the World Bank, not to mention friendly governments, have failed to spell out the dangers of such weaknesses in good time."

More damaging, probably, has been the blistering critique that has been levied at the MDBs by some of the staunchest advocates of development aid. A wide spectrum of U.S. nongovernmental organizations (NGOs) that are active on development or environmental issues, supported by mainstream U.S. foundations, have been strongly critical of the MDBs' activities for more than 10 years and remain so today. A number of these groups banded together in the "Fifty Years Is Enough" coalition in 1994 in observance of the fiftieth anniversary of the Bretton Woods Conference that drew up plans for the World Bank. The critiques of this group have been laid out in detail in a series of books published in the last decade by mainstream publishers.

According to this group's major criticisms, MDB programs do not effectively reduce poverty, do not respond to the perceptions and wishes of those they purport to help, and do not reflect enough concern for human rights or governance issues. MDB projects damage the environment, and frequent promises to fix problems or support beneficial initiatives have not materialized. In another frequent theme, MDB actions, especially on the ground in developing countries, are not consistent with their stated policies, and the institutions seek to hide these discrepancies behind restrictive confidentiality policies that limit public access to their key operating documents.

Much of the NGO critique of the MDBs is based on incidents or reports concerning the World Bank. However, the four regional institutions - although some are considered by many NGOs to follow better practices - often suffer because critics fail to distinguish among institutions. Although in the last several years the MDBs have made major attempts to persuade NGOs that they have gone far toward remedying these problems, there is little evidence that the critics have been satisfied. One of the major NGO spokesmen on the MDBs summed up the World Bank's reform efforts as follows:

"World Bank actions under Wolfensohn increasingly have revealed a pattern. The charismatic, passionate President makes spectacular personal gestures and supports worthy but peripheral institutional commitments to please the Bank's politically correct constituencies. Often there is little follow-through, and little to no significant impact on operations...The deepest, strongest bureaucratic pull in the direction of the 'culture of loan approval' is fatally reinforced. The octopus-like bureaucracy emits an immense ink cloud of reports that for 20 years have identified the same problems, but the reports like all their predecessors have no lasting operational consequences...Meanwhile the institution risks mutating into an entity for which public support may be harder and harder to justify."

Critics continue to point to a number of fairly recent reports about both the quality of work, particularly of the World Bank, and whether the institution complies with its benign-sounding policies in its activities on the ground in developing countries. The World Bank itself concluded in November 1997:

"The latest results indicate that the proportion of projects rated as having likely sustainability has inched upward from 46 percent in FY1990-95 to 48 percent in FY1996...the overall result is sobering: in about half of Bank operations it is uncertain or unlikely whether the benefits will be sustained over the longer run."

An NGO that often works alongside the World Bank on population issues, Population Action International, concluded:

"The quality of (World Bank) project design has also been an issue...While Bank projects across all sectors suffer from deficiencies in design, the complexity of HNP (health, nutrition, population) projects make them more vulnerable to design-related implementation problems...Frequent and effective monitoring remains critical to the successful implementation of social sector activities, including complex HNP projects. Yet supervision of population activities has been another major stumbling bloc for the Bank."

Finally a Congressional Research Service report found:

"Recent preliminary investigations by the (World Bank's Inspection) Panel substantiate complaints that environmental and social elements included in (World Bank) loan agreements are not always carried out. According to one observer, it can too often be the case that once a loan is approved, the bank in question considers the matter closed and "moves on to other things," with little on-going supervision and little effort to assure that environmental and other conditions or requirements are being met."

CONTINUED AT: http://www.eastwestcenter.org/events-en-detail.asp?news_ID=51