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“There should be a new ethics of global development that includes the private sector, because it's the only way to get to the kind of volume we need to end poverty,” Kim said. To get there, he continued, multilateral development banks need to work together.
Hear more in the clip below.
This is also a special episode of the podcast—it's my last as host, as I am leaving CGD for a new role. Thank you for listening these past three years, and please stay tuned for more episodes of the CGD Podcast.
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.
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.
An economist explores the question
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.
A different motivation
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.
Unconditional support for private finance is untenable
Opinion in some of the Bank’s shareholder countries is turning againstprivate 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.
To say that John Bolton, President Trump’s latest pick for National Security advisor is a well-known UN critic would be an understatement. But it’s well worth noting that he has opinions about the IMF and the multilateral development banks too.
In a post-election opinion piece, Bolton affirmatively invoked an earlier call to shut down the IMF, made nearly twenty years ago by former US officials who had in turn been out of office for at least ten years. There’s not much value in debating the merits of the IMF today based on the institution’s performance during the Asian financial crisis circa 1998.
But I do want to focus on Bolton’s ideas about the World Bank and other multilateral development banks. Bolton argues that the development banks should be privatized, except for “the one for Africa.” (For the record, it’s called the African Development Bank). His argument is two-fold: the world is awash in private capital today, rendering the MDBs irrelevant; and, US support for the MDBs is subsidizing lending to “our competitors.”
But the panel’s conclusion was clear. We should not confuse public aims, which require public financing in some form, with the aims of private investment. This confusion also plagues President Trump’s much-touted infrastructure plan, which relies overwhelmingly on tax breaks for private firms, an approach that will likely waste public resources and not achieve its stated aims in key areas of public infrastructure like roads and bridges.
When it comes to the MDBs, the range of endeavors we call global public goods—mitigating the effects of climate change, avoiding fast-moving pandemics that can leap from poor countries to rich ones in a matter of months, working across countries to manage the flow of refugees fleeing violence in their home countries—all of these call for a response at the international level, and none can be adequately addressed by relying exclusively on private capital.
Fortunately, the MDBs have already proven themselves to be effective in these and other parts of the global development agenda. They certainly could be more effective, which is why CGD’s panel has offered a range of recommendations for reform. But removing them from the equation entirely would be devastating.
As for Bolton’s argument that the United States is subsidizing the competition by supporting the MDBs, most of the MDBs’ heavily subsidized lending and grants today go to Sub-Saharan Africa, the region that Bolton seems to be ok with supporting through the development banks.
That’s not to say that US backing, and that of other major shareholders (including China), does not act as a subsidy on the banks’ other activities. Yet, setting aside support for the very poorest countries, direct US capital contributions to the World Bank over the entire 75-year history of the institution have totaled $2.8 billion. That’s less than 10% of what the United States spends annually on foreign assistance.
Is this modest support “subsidizing” our competitors? In part, that depends on whether you see a zero-sum global economy, or one in which growth in poorer countries means new export markets for US goods and services, as well as more stable societies that are less prone to the global public “bads” that afflict the world today.
Bolton would do well to listen more closely to our military leadership, which has gone out of its way to praise the role of the MDBs in supporting the goal of avoiding military conflict. For example, as Commander of US Southern Command, Admiral James Stavridis wrote of the Inter-American Development Bank’s “tremendously positive influence” on Latin America based on what he saw on the ground in his region of operation.
US leadership at the IMF and World Bank has been essential to their strength over many decades, particularly when it comes to ensuring that they have adequate resources to do their jobs. That’s why the timing of Bolton’s pick could be particularly troubling at the World Bank, where negotiations for a capital infusion from the United States and other member countries are coming to a head. The US Treasury has already been taking a hard line with the institution, demonstrating considerable reluctance to put more money in. With Bolton at the White House, Treasury hard-liners now have a powerful ally next door.