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.

Bulow and Rogoff also argue that the bank should cease making commercial loans because they conceal a subsidy. The bank raises cheap money thanks to its AAA rating, which in turn reflects rich countries' pledge of "callable capital" to the bank -- in other words, rich countries provide free insurance to the bank's commercial operation. If borrowers threaten to default on the bank's loans, rich shareholders can use their political leverage to beat them into line or even provide bilateral grants that make default unnecessary. In the Bulow-Rogoff view, this hidden subsidy makes the bank's commercial lending suspect -- especially when it is to countries in no obvious need of any subsidy, such as booming China.

Yet even though this "free insurance" claim is true, the value of the insurance is only significant when the bank lends to countries with a high risk of default -- a category that excludes robust borrowers such as China. So, in fact, the "hidden subsidy" that troubles Bulow and Rogoff has an attractive built-in adjuster: financially strong countries get no subsidy of any size, while weaker countries -- the ones that deserve a subsidy -- do. And to the extent that the bank's commercial lending locks rich countries into a free-insurance subsidy to poorer ones, what is not to like? Rich countries need to be arm-twisted into giving more aid, especially aid that is given out in a coordinated, multilateral fashion.

The fundamental response to this case against the bank's commercial window, however, is that commercial lending is crucial to the bank's financial health. That the financial advantage of commercial lending so often goes unmentioned is a measure of the world's indifference to such a key global institution. For the price of a small implicit insurance premium, the United States and its allies keep the World Bank active in strong developing countries, allowing it to earn a profit on its loans and therefore to sustain the professional standards that make it an important tool of U.S. and European foreign policy.

THE LEFT-WING OBJECTION

This free-market case against the World Bank's commercial activities has gained credence among many in the Bush administration. At the same time, it has been reinforced by left-wing critics who attack commercial lending for their own reasons. It is this confluence of right and left that threatens the bank's commercial lending.

The left-wing case is not that private capital should be left to finance development on its own; it is that the bank should finance a utopian version of development. The bank's lending, in the left-wing view, should be tied to exacting environmental and social standards: it should do no harm to rain forests, it should not disturb the lifestyles of indigenous peoples, and it should be entirely untainted by corruption. These goals are laudable. But the left has driven the bank to build cumbersome environmental, social, and anticorruption "safeguards" into its projects that, despite the good intentions behind them, ultimately hinder progress in these areas.

If you count the compliance costs incurred by borrowers, such safeguards raise the cost of the bank's commercial lending by as much as $300 million a year. For countries such as Brazil, China, or South Africa, which have the option of borrowing private capital, these costs and the associated hassle can make World Bank loans effectively more expensive than those of private lenders, even with the bank's lower interest rates. The consequences of this have begun to show up in the bank's loan portfolio. Between 1995 and 1997, the bank's commercial-lending operation pumped out a bit more than $15 billion per year; in 1998 and 1999, the volume jumped to about $20 billion a year because of bailout lending during the emerging-market crisis. But starting in 2000, something extraordinary happened: the bank's commercial lending slumped to around $11 billion -- a drop of nearly a third from precrisis levels. And the sharpest reduction came in the type of lending to which the bank is best suited: funding for large infrastructure projects that require technical sophistication and long-term financing. For it is such projects that are most likely to fall foul of environmental and social safeguards.

In the four years since this collapse, the bank has struggled in vain to build back to previous commercial-loan volumes. A team of officials is trying to tackle the cumbersome internal procedures that make the bank unattractive to clients, but progress has been glacial. Any proposal to loosen an environmental or social safeguard triggers opposition from civil-society activists, who often have the ear of the bank's rich-country board members in a position to block action. This activist resistance frequently has a perverse effect: when the bank's environmental standards are so demanding that borrowers prefer to seek money elsewhere, dams and roads are built without the bank's involvement, which means the end of oversight altogether. But despite its self-defeating quality, the activist resistance continues anyway, making it nearly impossible to streamline internal procedures and revive lending.

The bank, under attack from both the left and the right, thus faces the prospect of attrition in both its soft and its commercial lending. Only its third source of income -- the investment profits on its accumulated capital -- promises to continue at the current level. These investment profits come to around $1 billion a year, far less than the bank needs to sustain operations. As of 2004, its administrative budget was $1.7 billion, and on top of that the bank was expected to divert $300 million of its commercial-lending profits into its soft-loan fund and $240 million to help finance the 1996 and 1999 rounds of debt relief. The bank, as it is currently structured, has to earn around $1.2 billion a year over and above its $1 billion endowment income. If a dwindling loan portfolio makes that impossible, it will be forced to cut costs and give up its exacting professional standards.