Author: Rakan Aboneaaj
MDBs for a Global Future: Centering Borrowing Country Perspectives
We live in a world confronted by multiple global crises. Many of these crises—like climate change and global pandemics—defy national borders and will require unprecedented levels of investment to be contained. Global public goods (GPGs) like emissions mitigation or the development of new antibiotics are key to a less crisis prone world, but they have been underinvested in. Multilateral development banks (MDBs) like the World Bank are well positioned to address many of these global challenges by virtue of their size, reach, and scope. The challenge ahead is how to transform—and transform quickly—these organization so they are more relevant for today’s world.
As part of a major new CGD initiative, MDBs for a Global Future, we are exploring how the MDBs can be transformed for the challenges of the coming decades, what those changes to the MDB system look like in practice, and what adequate financing and technical assistance is required.
An effective transformation of the MDB system can’t happen from Washington alone—what emerging markets and low-income countries alike want from the MDB system will need to be front and center. To ensure borrower perspectives are a major part of the conversation, we held an event with finance officials from Egypt, Uruguay, Senegal and Nigeria on MDB reform alongside the Annual Meetings. Now, we’re following it up with more in-depth discussion from two more finance ministers.
Nadia Al Fettah, the Minister of Economy and Finance of Morocco, and Michel Patrick Boisvert, the Minister of Economy and Finance of the Republic of Haiti, kindly agreed to write essays on what they see as the most important role for the MDBs in addressing current and long-term global challenges, and how they’d like to see the system evolve. Both ministers emphasize the need for MDBs to take on a larger role in providing GPGs and to increase both their financial and technical support. To do so, they both call for MDBs to adopt new instruments and policies and argue that financing must both increase in volume and be used more efficiently. Success also depends on reaching consensus among shareholders and alignment between international institutions, developing countries and other development partners.
Minister Al Fettah calls for MDBs to be at the forefront of the international community in supporting the protection of GPGs, especially climate, biodiversity, and global health, and to be more proactive in anticipating and helping developing countries prepare for future crises. She calls for and lays out a plan for “a comprehensive and profound reform of the current multilateral system, combining efficiency and inclusiveness and conditioning the transition of the global system towards a more integrated, prosperous, fair and sustainable one, capable of better managing possible future crises.”
Minister Boisvert focuses on actions the MDBs and other international actors like the International Monetary Fund can take to address food insecurity, climate change, fragility, unemployment, and migration, which impede progress in growth and development. The Minister emphasizes the need for policies to account for country and regional contexts and promote—rather than stifle—national productivity and income growth.
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Hybrid Capital and SDRs for the Uninitiated
More than a year after the IMF general allocation of Special Drawing Rights (SDRs) and the G20 promise to recycle $100 billion of SDRs, how much has been achieved? The quick answer: $60 billion has been pledged, and there is hope that the United States will contribute another $21 billion. But how will the recycled SDRs be used?
The IMF would like to absorb about $65 billion through the Poverty Reduction and Growth Trust (PRGT) and the Resilience and Sustainability Trust (RST), which leaves about $35 billion looking for a home. As we have noted elsewhere, multilateral development banks (MDBs) seem a logical place to use some SDRs. However, MDBs are still without any SDRs, despite being on the frontlines of the main challenges we face, especially climate finance and achieving the Sustainable Development Goals (SDGs). MDBs have been snubbed by SDR holders looking for recycling options because of the technical hurdles.
The first challenge lies in the mechanics of the SDR system: not everyone can hold SDRs. Only certain institutions and countries are prescribed holders. Some MDBs have this status, and some do not. Also, the G20 has insisted that recycled SDRs maintain their reserve asset characteristic; they must be easily recalled if needed and not put at too much risk. But MDB investments are long term and riskier than, say, government bonds. So using SDRs at the MDBs is not a natural fit.
Some MDBs are considering using a hybrid capital structure to overcome these problems. In this blog, we briefly explain the nature of hybrid capital and how SDRs might come into play.
What is hybrid capital?
The most obvious question regarding hybrid capital is, what makes it hybrid? Suppose you have money to invest. You could purchase equity (that is, company shares), thus making you an owner who will share in the enterprise’s profits. Or you can buy fixed-income securities (that is, bonds), through which you lend your money to the company with the promise of reimbursement plus interest.
Hybrid capital (or synthetic security) is a fixed-income financial instrument with both equity and debt properties. It is sold to investors as a fixed-income instrument (like a bond), and it does not dilute the capital of the MDB. But the terms offered by the instrument make it look like a permanent investment in the institution: it has a perpetual maturity (i.e., the MDB never intends to pay off or redeem the loan). However, the MDB does offer the investor the opportunity to cash in the bond after an extended period, say 10 years. The hybrid capital would rank senior to paid-in capital but junior to other unsecured debt. However, given the MDBs’ AAA-rated financial management, the risk of lost hybrid capital is minimal. Furthermore, some funds invested in the hybrid capital will be held in reserve should a lending country need to retrieve its SDRs prematurely.
From an accounting perspective, hybrid capital will be considered equity on the MDB balance sheet. This allows the MDB to raise money to increase its loanable funds by issuing bonds, which the hybrid capital guarantees. This so-called leveraging of hybrid capital is regulated by shareholders, who decide how much the MDB can borrow from capital markets. Typically, the MDBs can borrow three to four times the equity value on capital markets and thus lend that much more. Credit rating agencies have broadly accepted this use of hybrid capital. Therefore, the MDB’s credit rating would not be at risk from leveraging the hybrid capital.
Where do SDRs fit in?
MDBs that are looking to expand their lending need more capital. But many of their shareholders are facing fiscal constraints. They cannot spend money from their budgets to increase MDB capital.
The 2021 allocation increased countries’ SDR holdings, and in many advanced countries these assets are sitting unused in country coffers. Investing these unused SDRs in MDB hybrid capital has four advantages:
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There is no direct cost to the investing country as the SDRs were a gift from the IMF.
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The government does not cede control of its SDRs, as it is lending them to the MDBs and can get them back if needed.
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The loan is very low risk compared to other investments.
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Each SDR invested leverages three to four times as many loanable funds.
Hybrid capital is not a perfect substitute for increasing paid-in capital. But it does give shareholders an immediate and low-cost opportunity to support the expansion of MDB loans.
Future of Development Forum
A half-day global virtual event to examine the pressing questions the development community must address in the coming decades.
Climate change, conflict, food insecurity, and pandemics. These global challenges are growing in urgency and complexity—and they are not confined by borders. While wealthy countries are aging and their growth rates are faltering, the traditional manufacturing-led path to rapid growth in poorer countries is narrowing.
In the face of headwinds to global prosperity and increasing geopolitical, economic, global health and environmental insecurity, development agencies and multilateral institutions are struggling to keep pace. How will development cooperation and institutions evolve to address the issues that have come to define the current and future development era? Do we have the will to establish policies today in preparation for a world and global economy that will look radically different in 30 years?
Rightsizing the MDB System in the Polycrisis Era
For both rich and poor countries, the climate crisis is no longer looming. It is all around them. Yet, as thousands gather in Sharm el-Sheikh for COP27, scientists have just confirmed that we are nowhere near where we need to be on greenhouse gas emissions reductions.
We can expect a raft of finance promises to emerge from the meetings, many focused on contributions to the arbitrary climate finance target of $100 billion per year, first set in 2009. But very credible analysis suggests that we need an additional $1.3 trillion in climate finance by 2025 and $3.5 trillion by 2030 to achieve a “sustainable, resilient and inclusive recovery.” (See also this report of the Independent High-Level Expert Group on Climate Finance.)
Regrettably, adding to all the other crises the world is facing a crisis of confidence. For good reason, many doubt we have the collective will and capacity to spend and invest on the scale needed.
And yet, in the midst of all this gloom, we need to remind ourselves that we already have a set of multilateral development banks (MDBs) that collectively have the potential scale, reach, knowledge, and tools to play a much bigger role in confronting these challenges. MDBs collectively committed about $63 billion in climate finance in 2021—$50 billion to low-income countries (LICs) and middle-income countries (MICs). But they can do much more.
Recall that MDBs were originally conceived as part of the response to a global catastrophe. They were launched after a world war when the focus was on reconstruction of destroyed infrastructure and productive capacity. Our time is not so different. We face the challenge of reconstructing infrastructure, industries, agriculture, and health systems-partly to address serious damage already evident, partly to reduce future damage, and partly to adapt them to new climate and health realities.
A significant MDB contribution to the goal of $1.3 trillion in additional climate finance by 2025 is essential. The authors of the analysis posit a target of $126 billion by 2025 in additional MDB non-concessional climate finance. That number assumes countries do their part in boosting domestic resource mobilization in a very difficult global economic environment, and the private sector doubles its own finance contribution. But there are broader SDG finance needs, which have only increased in the wake of the pandemic, war, and reversal of progress on poverty, educational attainment, and food security. It makes no sense to scale up climate finance at the expense of tackling poverty reducing programs or by cutting back investments in human and physical capital for the most vulnerable.
We don’t know yet what these additional SDG finance needs are, but let us assume as an illustrative exercise, that they add a similar amount, another $125 billion, to the total annual finance needed from MDBs. That would suggest that we need an MDB system that can generate an additional $250 billion in annual commitments.
That sounds like a lot. But it adds relatively small increments to the financial capacity of the developing world. It amounts to 5 percentage points of GDP for LICs and less than 1 percentage point (0.75 percent) of GDP for MICs. Compare that to pre-pandemic research by the IMF which concluded that the average LIC needed to spend an additional 15 percentage points of GDP in 2030 to achieve the SDGs and the average MIC an additional 4 points.
Can we get to that number? Actually, it seems more feasible than you might think if we pursue all the pathways available. Below are four parts of an ambitious but feasible strategy.
1. The gorilla in the room is, of course, general capital increases (GCIs) for MDBs. The arguments for putting aid dollars into MDB capital are compelling. These are banks that leverage capital dollars. Over the lifespan of the IBRD, cumulative shareholder contributions of $20 billion has supported $800 billion in lending. There is no other financial channel that can generate that kind of leveraging in support of tested development programs.
Adding capital to MDBs is also much more efficient than adding more small trust funds and financial intermediaries. There are already more than 50 separate climate finance entities falling under the umbrella of the World Bank Group. They all have separate budgets, governance structures, and missions, but few have robust finance allocation systems that channel funds to their most productive use.
But we heard a deafening silence on capital increases during the annual meetings of the IMF and World Bank, as well as the G20 meeting, last month. Contrast that to the aftermath of the Global Financial Crisis when every major MDB received a capital increase. Yet the magnitude of the GFC shock, especially to the developing world, was far smaller.
Reasonably sized MDB capital increases would move us much of the way toward the $250 billion annual addition to lending A CGD proposal suggests a green capital increase of $32 billion in paid in capital for the IBRD and the IFC. Using the ratio of new capital to lending for the previous capital increase, the additional capital would allow for $100 billion in additional annual lending through 2030. Capital increases for the other MDBs could be added, perhaps prioritizing spending for other priorities urgent for particular regions—education, health, and poverty progress reversals—as well as climate finance.
2. Capital increases would be much more productive if combined with prudent measures to use MDB capital more efficiently. The independent panel convened by the G20 to assess MDB capital adequacy concludes that there is significant scope for MDBs to expand combined lending while maintaining MDB institutional ratings. The panel offers a set of specific recommendations that, if implemented across the system and at scale, would increase collective lending capacity by hundreds of billions of dollars over the medium term. And the recommended innovations have strategic value beyond simply increasing MDB lending capacity. They offer ways to mobilize more of the wall of private capital seeking credible SDG investment on a scale that MDBs have thus far been unable to achieve. And from a political economy perspective, a two-part package of capital increases and more effective use of the existing balance sheet is much more likely to get broad shareholder support than either could on its own.
3. For concessional MDB finance, particularly from IDA, there is also room for more efficiency. Several CGD pieces argue that IDA could make significantly more use of its untapped equity, including through issuing new debt to markets which could be concessionalized through grants. IDA currently has $179 billion in equity, $175 billion in net loans outstanding and $21.9 billion in market borrowing. Even assuming a conservative 1:2 leverage ratio appropriate for IDA, more market borrowing could generate significant new lending funds.
4. More productive and better targeted use of SDRs also needs to be on the table. Several MDBs are exploring whether SDRs can be a source of financing for loan operations. Two basic models are being considered. In the first, SDRs are lent to the MDB and the MDB on-lends them to client countries for institution-specific purposes. This is similar to what the IMF is doing with its long-established Poverty Reduction and Growth Trust and its new Resilience and Sustainability Trust. In the second model, donor countries lend SDRs to the MDB as hybrid capital that can then be leveraged to mobilize three to five times the loanable funds (under consideration by the African Development Bank). Both models require auxiliary financial structures to preserve the risk-free and redeemable nature of the SDR loans. But the second uses MDB leverage to generate more lending.
Finally, increases in MDB financial capacity need to be tightly linked to progress on significant reforms. Changes in MDB models to strengthen their support for global public goods (GPGs) are needed as much as more financial firepower. As suggested in this note, the model changes should include a shift toward more catalytic instruments to help countries mobilize more GPG finance from both public and private sources, consolidation and rationalization of donor concessional finance for GPGs, building a structure for collaboration across MDBs, and targeting impact and outcomes, not just finance inputs.
While the focus is on the MDBs. It is also important to recognize that they are part of a much larger—and financially much bigger—network of public development banks (PDB). These PDBs span the spectrum from subnational to national and regional banks with a portfolio of $23 trillion. Aligning their activities with the SDGs and the goals of the Paris Agreement will add multiples of targeted climate financing to current flows. One important role the MDBs, and particularly the World Bank, can play is to accelerate and facilitate the process of alignment for the larger PDB community.
In sum, we already have a multilateral system capable of responding to the polycrisis with the right reforms and the right financial capacity. We do not have to invent a new system. Shareholders can give it enough financial firepower if they act on the different fronts described here. And because of MDB leverage, the additional lending capacity can be achieved through a combination of not unrealistic amounts of additional capital and concessional resources and more efficient use of those resources. But farsighted, resolute leadership is essential to move this agenda forward. One hopes that it will emerge during COP27 and its aftermath.