The Evolving Role of Multilateral and Subregional Development Banks

The Evolving Role of Multilateral and Subregional Development Banks
Photo: The European Investment Bank, Luxembourg, March 8, 2014 (photo by Wikimedia user Palauenc05 licensed under the Creative Commons Attribution-ShareAlike 3.0 Unported license).
Multilateral development banks (MDBs) have long played an important role in international development finance. Subregional development banks (SRDBs) have had a more limited function, until the emergence of a few dynamic institutions in recent years. This paper explores the origins of MDBs and SRDBs; considers key issues and trends in their purpose, governance and financing; and explores challenges and opportunities that MDBs and SRDBs face in a changing global development environment. Origins of Multilateral and Subregional Development Banks The current international monetary and development architecture has a long history, going back to the establishment of the International Monetary Fund and the International Bank for Reconstruction and Development (IBRD, better known as the World Bank) at Bretton Woods in 1944. Set up at the end of World War II with the goal of providing international monetary stability and helping reconstruction of the war-torn countries of Europe and Asia, these two institutions created the foundations for a multilateral approach to global monetary management and development finance. With the recovery of Europe and Japan during the 1950s, the World Bank’s focus turned to providing financial assistance to the developing world, supported by the creation in 1956 of the International Finance Corporation (IFC), and in 1960 of the International Development Association (IDA), respectively the private sector and soft-loan arms of the World Bank. This was complemented by the foundation of the InterAmerican Development Bank (IADB) in 1959, of the African Development Bank (AfDB) in 1964 and of the Asian Development Bank (AsDB) in 1966, each to assist the development of countries in their respective regions. The European Bank for Reconstruction and Development (EBRD) was set up in 1991, following the collapse of the Soviet Union, to assist with the transition of countries in the former Soviet sphere. This group of institutions is generally referred to as “Multilateral Development Banks” (MDBs). In addition, numerous subregional development banks (SRDBs) were set up in various parts of the world, with the European Investment Bank (EIB) established in 1958 to support the European Economic Community, which became the European Union. Many other subregional development banks were subsequently set up in Latin America, Africa, Asia, Europe and the Middle East. The MDBs and SRDBs are rooted in four key drivers of the geopolitical reality of the post-World-War II 20th century. First, the Cold War ideological divide, which was reflected in the MDBs for many years by the absence of countries from the Eastern Bloc: This was remedied after the fall of the Iron Curtain. Second, the recognition of the need for global and regional financial and development institutions in an increasingly globalized economy: The establishment of the United Nations in 1945 created the apex of a global governance structure of which the MDBs and SRDBs are a part, providing essential financial and technical services to developing countries. Third, the division of the world into the industrial North and the developing South: This distinction remains deeply embedded even today in the mandate, financing pattern and governance structures of the MDBs. With the rapid economic development of many Southern countries, the rationale for this distinction is increasingly challenged as no longer relevant. Northerners question whether MDBs deserve continued support from Northern taxpayers, and Southerners question whether MDBs continue to serve the interests of their Southern members. At the same time, SRDBs, which are generally based on an exclusive regional membership, have become more attractive to Southern countries. Finally, a growing and persistent interest in forming regional and subregional development organizations in the interest of enhancing economic cooperation and integration: A first wave of regional and subregional development banks was set up in the 1970s, followed by the establishment of additional such banks in subsequent decades. Purpose, Governance and Financing of MDBs and SRDBs The principal purpose of MDBs and SRDBs is to support the development of their member countries by providing financial resources, technical assistance and knowledge services. Traditionally, the international development banks have focused their support on infrastructure, agriculture and industry, but from the 1980s onward, support from MDBs has also been increasingly extended to education, health and social development, environmental protection and financial sector reform. Moreover, from the mid-1990s onward MDBs developed a strong focus on poverty reduction as the overarching goal of their engagement in member countries. It is debatable whether this was largely the result of an alignment with the poverty focus of the international development community as reflected in the Millennium Development Goals, or of policy directions imposed by the Northern members. The fact that SRDBs generally remained more closely focused on support for infrastructure development, and less on social and poverty reduction goals, would tend to support the latter argument. Another important agenda item for MDBs and some SRDBs has been support for regional cooperation and integration, although they had limited success in this regard, not least because of the political difficulties hampering regional cooperation in many regions. Finally, while early on MDBs mostly supported investments in individual development projects, over time they increasingly addressed sectoral and national investment, policy and institutional concerns, driven by the recognition that these broader aspects are critical to project success and wider development impact. SRDBs generally have devoted less attention to these issues and hence have tended not to link their support to sector or country-wide reforms. The governance structure of MDBs and SRDBs generally is similar: Member countries contribute to the financing of the institutions, usually loosely in proportion to the size of their economies, and their financial contribution in turn determines the extent to which they have a voice in the governing bodies of the respective institution. However, there is one key difference between MDBs and most SRDBs. MDBs draw substantially on the financing of nonrecipient or nonregional members, who accordingly have a substantial say in the orientation and operations of MDBs. In contrast, the membership and financing of most SRDBs draws only on countries from the particular region or subregion. For example, EIB’s membership is restricted to European countries, and all member countries draw on the financial support of EIB. The Andean Development Corporation (CAF) similarly has only South American members (with Spain the only exception), and the Eurasian Development Bank has only former Soviet Republics as members. The financial structure of MDBs generally follows the pattern established by the World Bank Group. Like the IBRD, MDBs have a “hard-loan window” that functions basically like a bank. It borrows in the capital markets, underpinned by risk-bearing capital of the institution—that is, capital contributions, both paid-in and callable, from the member countries—and on accumulated reserves. The borrowed funds are lent to credit-worthy client countries at cost-covering terms. These terms are generally more favorable to the recipient countries than what they would have to pay in direct market borrowing—if they have market access at all—due to the high credit rating of MDBs. In addition, as with IDA, other MDBs—except EBRD—also have a “soft-loan window,” representing in essence a revolving fund, under which grants from the better-off member countries are channeled to the poorest countries at highly concessional terms in the form of grants or zero-interest credits. MDBs generally require sovereign guarantees from the governments of recipient countries, except when they lend directly to private sector entities, and enjoy preferred creditor status—that is, they are at the top of the list of creditors receiving payment when countries experience debt distress. The financial structure of SRDBs varies considerably, but most are set up like the IBRD as development banks, with varying capital structures and degrees of concessionality in their funding sources. They also tend to have considerable flexibility in how they structure their financing instruments for public and private recipients, including drawing in some cases on the development of Islamic finance modalities. Regarding the amount of development finance provided by MDBs, overall nonconcessional commitments by MDB in 2012 amounted to about $70 billion, while concessional commitments were about $21 billion. IBRD and IFC combined accounted for about 47 percent of total nonconcessional commitments, while IDA dwarfed the other MDB soft-loan windows with some 70 percent of the total concessional financing. Note, however, that MDB nonconcessional commitments were unusually high in 2009 and 2012 in response to the global financial crisis, with the World Bank’s IBRD showing by far the greatest spike in lending. During that period, IBRD more than doubled its average annual commitments from about $13 billion to some $30 billion. Data for SRDBs are not readily available for all the institutions. However, drawing on the annual reports of a sample of these organizations, one finds that they fall into two groups: three large SRDBs—EIB, CAF and Islamic Development Bank (IsDB), which are major players comparable to MDBs—and the others, which are generally much smaller than MDBs. For example, the Caribbean Development Bank approved loans for $163 million in 2012 and the Black Sea Trade and Development Bank €161 million (about $214 million). Two SRDBs, the OPEC Fund with $6.77 billion of new commitments in 2012 and the Eurasian Development Bank with $1.17 billion, occupied a middle ground between the small SRDBs on the one hand and the three large SRDBs and the MDBs on the other. Thus, while superficially there are substantial similarities between MDBs and SRDBs in terms of purpose, governance and financial structure, on closer inspection there are not only significant differences between MDBs and SRDBs but also among SRDBs. These differences, together with a changing global and regional environment, present them with a variety of challenges and opportunities. Challenges and Opportunities for the MDBs The first challenge is the changing nature of the MDBs’ membership and client base. Over the past decade, the distribution of countries across per capita income status by the standard World Bank classification has dramatically shifted. Especially notable is the substantial drop in the number of low income countries (LIC) from 61 to 36 between 2003 and 2013, as many of them graduated to lower middle income (LMIC) status. At the same time many LMICs graduated to upper middle income status (UMIC) and those, in turn, graduated to high income (HIC). An important side effect of this shift is that now a vast majority, about 80 percent, of the world’s poor people—those living at less than $2 per day—are to be found in middle income countires (MICs). At the same time the number of countries in fragile and conflict-affected situations has now reached 51, according to the OECD, with 23 of them being MICs. This shift in client base provides MDBs with both challenges and opportunities. On the one hand, as more and more countries move up the income ladder, the political case for using the tax dollars of HICs to support development becomes more difficult to make, especially for the growing number of UMICs. And as a sizeable number of client countries experience fragility and conflict, the task of assisting them is that much harder than in more stable and conflict-free situations. On the other hand, the fact that most of the world’s poor live in MICs and that a sizeable fraction of MICs are fragile states does provide an opportunity to justify continued intensive MDB support for MICs. At the same time as the client base for MDBs is shifting, the functional demands on these institutions are also changing. As noted above, over the recent decades MDBs moved from a predominant focus on infrastructure and agricultural and industrial sector growth to a focus on poverty reduction. Looking ahead, there are additional challenges: climate change, urbanization and infrastructure gaps. These challenges are likely to be recognized by the new global compact on post-2015 sustainable development goals, which is currently being negotiated under a U.N. umbrella. MDBs have considerable operational capacity to respond to these challenges, while continuing to focus on poverty reduction. A third area where MDBs are challenged is that of their governance. As the relative economic weight of developing countries has increased in recent years, especially with the rise of China and other large MICs, the traditional distribution of voice and vote in the MDBs is outdated. OECD countries, and especially European countries, have resisted changes in the capital structure and the composition of the governing boards of MDBs, as in the IMF, that would enhance the representation and influence of borrowing members. This has greatly raised the relative attractiveness of SRDBs for the developing countries, since in those institutions they do not have to contend with the influence of OECD countries, which are not members, with the exception of EIB. It has also led to attempts by some MICs to set up new international development banks, such as the BRICS Bank now being promoted by Brazil, Russia, India, China and South Africa. Another such initiative is the proposal by China to set up an Asia Infrastructure Investment Bank, which would involve only regional members and potentially compete head-on with AsDB and the World Bank. The tensions around governance are likely to be particularly problematic for the soft-loan windows of the MDBs, which depend on regular replenishments of resources from members, traditionally from the OECD countries. With a potential reduction in the voice and vote of OECD countries in the MDBs comes the risk of their reduced willingness to contribute to these replenishments. This would have to be offset by increased contributions from the rising economic powers. One of the key questions for the MDBs is whether or not they can overcome the obstacles to their governance reform so as to reflect more effectively the emerging world. The challenge of governance of MDBs is directly related to the challenge of their financing. There are increasing constraints on OECD country aid budgets, caused both by fiscal retrenchment and by the perception that increased incomes in the developing world have reduced the need for aid. This constrains the ability and willingness of OECD countries to contribute both to the soft-loan replenishments and to capital increases of the hard-loan windows of the MDBs. These trends could be offset by increased contributions from MICs, but that would require that MICs develop a much greater sense of ownership of these institutions. This will be difficult to achieve unless the governance structure is changed. It is interesting to note that during the last capital increase for the World Bank in 2010, MICs were willing to make substantially higher contributions but were blocked by the OECD countries that did not want to see their voice and vote diluted. Another option for MDBs is to seek access to the newly established global climate funds that in the coming decades will likely be made available for climate change mitigation and adaptation. However, this requires that MDBs gear up their capacity to deliver effective support for climate change programs and that they are regarded by the donor and recipient countries as credible and trustworthy institutions for intermediating these funds. Finally, MDBs could further intensify their efforts to raise special-purpose funding from their members. This would likely be only a short-term palliative and also risks further aggravating the problems caused by excessive use of earmarked funding from particular donors in setting up trust funds managed by MDBs. In the absence of new funding, another solution to the MDBs’ financing challenge has lately gained a lot of attention: changing the MDBs’ financial modalities and policies. IBRD recently changed its risk management policies to allow it to increase lending without increased capital contributions. IDA in its most recent replenishment accepted loans in addition to grants from its member countries to be able to deliver increased financing to its recipients. AsDB is proposing to combine the financial resources of its hard- and soft-loan windows to allow it greater financial leverage and thus increase the amounts it can lend without an increase in member contributions to either of the windows. As long as these solutions are carefully designed and implemented not to undermine the long-term financial capacity of the institutions and their triple-A ratings, they provide a one-time breathing space. But they should not be confused with long-term solutions. A final set of challenges for MDBs is intensified competition. First, there is the increased competition of some of the existing SRDBs (EIB, CAF, IsDB) and potential new ones (BRICS Bank). And some of the currently weaker SRDBs may increase their role, such as the Eurasian Development Bank, especially if and when China joins, as is currently under consideration. Second, a number of important “vertical funds”—development finance institutions providing support in special areas—have recently gained traction, such as the Global Fund to Fight AIDS, TB and Malaria. They have clearly focused and results-oriented agendas, inclusive governance arrangements and flexible operational modalities, which make them attractive to donor and recipient members alike. Third, MDBs face long-standing, but recently increased, competition for donor resources in the OECD countries from bilateral aid channels, which tend to be more attractive politically at home. And then there are the nontraditional official donors, such as China, and new private donors, such as foundations like the Bill and Melinda Gates Foundation, which in some countries and some sectors contribute more than the MDBs. Fourth, as countries have gained greater access to private capital markets, private financial flows have far outstripped official and private aid flows. Finally, with the rise of the international consulting industry, think tanks and academic centers, MDBs are no longer the main providers of development knowledge and capacity building support. In addition, in many developing countries the supply of local technical expertise has dramatically increased in recent years, which reduces the demand for externally provided advice. Under these circumstances it is critical that MDBs maintain their competitive edge when it comes to demonstrating their effectiveness to clients. They will need to hone their technical capacities and effectively package their financial and knowledge services in supporting development programs in their client countries. Challenges and Opportunities for SRDBs The large SRDBs (EIB, CAF, IsDB) have been successful in the recent past in building on their strengths: strong ownership by their member countries; a limited set of areas of engagement, such as infrastructure; relatively simple and flexible operational modalities, which have made them attractive to borrowers; and innovative financing modalities, including the development of Islamic financing modalities in the case of IsDB. These SRDBs also face challenges in an increasingly fragmented and competitive international aid architecture, but if they maintain their nimble operational and financing approaches they should be able to continue serving their members well in the foreseeable future. Recent and potential new entrants—such as Eurasian Development Bank, BRICS Bank and Asian Infrastructure Investment Bank—could significantly add to this tier of international development banking institutions. In contrast, the many small and hitherto ineffectual SRDBs, among them most of the African SRDBs, will face continued severe challenges: Their members have limited financial resources or are not sufficiently supportive due to regional political rivalries or conflicts; their institutional capacities are weak or nonexistent; their financial ratings are low; and hence their ability to contribute financial and technical resources to their members is extremely limited. Many of these institutions will limp along: Few, if any, will be shut down, as perhaps they should be, while few, if any, will be able to raise their game substantially in terms of financial and technical services. In Africa, the AfDB is partnering with SRDBs to assist them in developing greater institutional capacities, but so far this has not resulted in significant progress. Ultimately, what will be required is greater political and financial engagement by the lead countries in Africa—particularly Nigeria and South Africa—in making these institutions work, while at the same time avoiding being seen by their smaller members as overbearing and stifling the voices of others. Conclusion MDBs and SRDBs cover a wide spectrum in terms of history, purpose, governance and finance, but they also share some common elements, challenges and opportunities. MDBs face important changes in their authorizing environment, as traditional donor support weakens; newly emerging economic powers are given limited opportunities to increase their financial participation, voice and vote; and the competitive environment for these traditional development banks has become increasingly challenging. For the managements and the members of the MDBs it will be critical to consider the long-term implications of a weakened role of multilateral institutions. In a world that is becoming increasingly interconnected, and yet has few truly multilateral institutions addressing global and regional development issues in an effective manner, it would seem paradoxical to let MDBs wither away. Instead, an ambitious agenda to strengthen and expand the role of MDBs should be explored. This is a topic that the G-20 should address. For SRDBs, the challenges are different. The large and thriving SRDBs will likely continue to benefit from their stronger membership support, less-complex governance structures, simpler mandates and lesser dependence on grant contributions than the MDBs and their soft-loan windows. Looking ahead, these institutions will have to make sure that their competitive advantage is not eroded by poor management or failure to adapt to changing member needs, such as climate change adaptation. The smaller and relatively ineffectual SRDBs are on the opposite end of the spectrum: They play very limited roles, have little or no real institutional and financial capacity, and suffer from weak and fractured member support. They deserve greater attention from their larger regional members in terms of political and financial support and from the MDBs in terms of technical assistance, but their future is not promising at this juncture beyond playing very limited niche functions. Ultimately the key to effective engagement in the rapidly changing development environment is for MDBs and SRDBs to be strategic in defining and promoting effective long-term visions of their role, governance and financing structures; to be nimble and responsive to member and clients needs in implementation; and to reach out to partners across the whole spectrum of the increasingly fragmented international development architecture with the goal of forming effective stakeholder alliances that identify and scale up successful development solutions. Managements of the institutions have a critical leadership role to play in achieving these objectives. But they will only be able to succeed if their membership is truly engaged and supportive of the multilateral principles embodied by these institutions. Johannes Linn is senior resident scholar at the Emerging Markets Forum and nonresident senior fellow at the Brookings Institution. He previously served as vice president at the World Bank.

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