Saving the World Bank

Sebastian Mallaby

From Foreign Affairs, May/June 2005

Summary:  The next World Bank president will confront a nearly impossible challenge: saving the institution from a curious alliance of conservatives and radical activists that threatens to undercut its financial viability and effectiveness. Failure to head off the danger will mean the gradual decline of the best tool the world has for managing globalization, just when that tool is more needed than ever.

Sebastian Mallaby is a Washington Post columnist and the author of The World's Banker: A Story of Failed States, Financial Crises, and the Wealth and Poverty of Nations.

Criticism of the bank's soft-loan operation arises because the weakest developing countries -- those that qualify for soft loans -- have trouble repaying them. Up until the 1990s, this problem was papered over with a policy of issuing enough new loans so that the old loans could be repaid and relying on donor governments to make grants that flowed back to the bank as debt payments. But in 1996, the bank finally acknowledged that many of its debts were not payable. In response to a left-wing chorus (now echoed, curiously, by the Bush administration), it promised to forgive some. Then, in 1999, it forgave a few more. And now it faces calls for a third, and far more radical, round of debt relief: antipoverty groups such as Oxfam are demanding that the bank cancel 100 percent of its claims on 33 highly indebted poor countries (HIPCs).

From the point of view of poor countries, debt relief is welcome. But from the point of view of the World Bank, debt forgiveness today means less money to make future loans. Currently, a fifth of the bank's new soft loans are paid for with repayments on past loans, including from countries such as China or the Philippines that have, with the World Bank's help, grown rich enough to graduate out of soft lending. When they peak 20 years from now, repayments are expected to finance fully half of the bank's new soft lending. Forgoing some or all of these "reflows" would be a blow to the bank's financial model.

Past versions of debt relief have protected the bank by having rich governments compensate the soft-loan fund for lost repayments. The British government is currently touting a proposal that follows this model. The Bush administration, however, has a different plan: that the bank cancel debts on its own, without compensation. If this proposal is extended to the 33 HIPCs, in 2025 the bank's soft-loan window will be a fifth smaller than it would otherwise be. The Bush administration also wants the bank to convert its soft loans into grants, depriving it of yet more repayments. In 2003, under pressure from Washington, the bank started to make grants from its soft-loan fund; over the next three years, grants will make up 30 percent of the fund's transfers. The financial consequences of this shift will accumulate gradually, because the bank's soft loans require no repayment in the first decade. But by 2035 the soft-loan kitty will have shrunk by a tenth as a result of the switch to grants, and the shrinking will continue thereafter.

So the combination of Bush-style debt relief and grants, with no new support from rich governments, will undermine the bank's ability to put fresh money on the table. This weakening, moreover, could set off an unstoppable vicious cycle. If HIPCs have their debts canceled, other poor countries and their civil-society advocates may demand equal treatment, depriving the bank of even more resources. If some countries get the benefit of grants instead of loans, more may soon demand them. And if the bank has less money, its professional excellence will decline -- triggering further deterioration of its ability to attract funding. Rich countries' current willingness to contribute to the World Bank depends on its status as a large and sophisticated provider of credit, which sets it apart from smaller grant-making government agencies. If the bank shrinks and provides grants, its special attraction fades. The U.S. Congress and European parliaments may decide that they prefer to support their own national aid efforts.

Once you start picking at the bank's intricate mechanism for financing soft loans, it is not hard to imagine the whole system unraveling. The bank could fall into the kind of low-performance, low-resource equilibrium that characterizes most UN agencies.

OUT OF CHINA?

Even more ominous than the threat to the bank's soft-loan wing is the threat to its commercial operation. And again the challenge comes from a curious alliance of liberals activists and conservatives.

Free-market economists have long argued that the commercial window of the bank has become obsolete. In 1990, Stanford's Jeremy Bulow and Harvard's Kenneth Rogoff advanced an early version of this argument. A decade later, their view was echoed by a congressional commission on international institutions headed by Carnegie Mellon's Allan Meltzer. Their case is that the bank was designed for a world of capital controls and infant financial markets in borrowing countries -- a world in which there was a clear role for an institution that borrowed money on Wall Street and passed it along to developing nations. But now, the better-off developing countries that borrow commercially from the bank -- China, Mexico, Brazil, and so on -- can access private capital on their own; if one of these governments wants to build hospitals, it can sell bonds in the United States or Europe. The World Bank, the argument goes, should therefore let private capital markets finance development without its mediation.

Many conservatives charge that in addition to being obsolete, the World Bank's commercial lending may actually harm developing countries. Bulow and Rogoff argue that the availability of World Bank credit -- which remains cheaper than credit from profit-seeking private lenders -- encourages developing countries to overborrow, heightening the risk of financial crisis. They cite Argentina as an example: in the years leading up to the 2001 default, the bank plowed capital into Argentina. Yet as Paul Blustein shows in his new book, And the Money Kept Rolling In (and Out), it was private lenders who were recklessly stuffing credit down Argentina's throat during the mid- to late 1990s, marketing the country's bonds with the same overheated hype that inflated the technology bubble. World Bank lending was at most a marginal contributor to this dynamic.