Monday, 20 March 2017

On MDB Balance-Sheet ´Optimization´

The Communiqué released by G20 Finance Ministers and Central Bank Governors Meeting[1] in Baden-Baden last weekend carries, beneath embarrassingly dropping their commitment to free global trade, a less noted declaration:
Given scarce public resources and the key role of the private sector for sustainable economic development, we welcome the work by Multilateral Development Banks (MDBs) on mobilising private capital. We call on MDBs to finalise Joint Principles by our next meeting and develop Ambitions on Crowding-in Private Finance by the Leaders Summit in July 2017. We look forward to the joint MDBs’ reports on the implementation of the MDBs Balance Sheet Optimisation Action Plan.”
What do they mean by MDBs Balance Sheet Optimisation and why does it matter?
Let´s quickly revisit MDB history. The IBRD (World Bank) was created as a sister organization to the IMF following the Bretton Woods conference of 1944. In 1960, in a period when many poor countries were shedding their colonial status to turn independent, the World Bank created a concessional window, the International Development Association (IDA). Other multilateral development banks (MDBs) were created, such as the African development bank (AfDB), Asian Development Bank (AsDB), and the Inter-American Development Bank (IADB), following the example set by the World Bank with two separate windows, a concessional and a non-concessional. Concessional windows act like trust funds and are regularly replenished by cash contributions from MDB member governments. Non-concessional windows, by contrast, are largely financed by MDBs issuing bonds at low interest cost.
MDBs enjoy developed-country guarantees, a preferred borrower status and consequently investment-grade ratings. The MDB core competence is the selection, monitoring and enforcement of loans and other financial investments that foster human and physical investment not reached by private finance because of high risk and weak or non-existent institutions for the enforcement of financing agreements. It has therefor been argued that financing global public goods may distract MDBs from their core competence  [2], including poverty reduction in low-income countries.
The legacy MDBs are still dominated by Western governments. Especially AsDB governance is skewed: Japan remains the largest shareholder and decision maker although China is by now the larger economy. As long as such governance issues are not seriously addressed by raising voices, votes and contributions by China (and India), uneven representation has a negative impact on capital resources (to which China could amply provide) and hence lending capacity. 

The inception and creation of the NDB and the AIIB, dominated by China (and other BRICS), this 2010s decade has - surely more than by pure coincidence - let to US Treasury-led efforts to merge concessional and non-concessional windows at the MDBs in order to uphold the lending capacity of Western-dominated MDBs despite their relatively weak equity endowment[3]. The pressure to close the concessional windows of MDBs is bound to rise with the announced cut of USAID money under the first Trump budget as this cut will translate into lower replenishment pledges by the US.

The AsDB 2015 decision to merge its concessional and non-concessional balance sheets pioneered the approach to raise leverage on MDB capital. Under the AsDB merger, the assets of the concessional loan window, the Asian Development Fund (AsDF), was treated as equity and brought onto the bank’s core balance sheet. The AsDF equity, comprised of $30.8 billion in loans outstanding and $7.2 billion in liquidity/receivables, effectively tripled AsDB capital to $53 billion. The Washington-based Centre for Global Development (2016) estimates that the move increased the AsDB lending capacity by 50%. AsDB has in January 2017 released the new regulations for the AsDF[4]. Likewise, the IADB merged its two windows at the beginning of 2017.

Reforms are also ongoing in other international financial Institutions. The IDA, following its 18th Replenishment, plans to leverage its capital for non-concessional loans through a private-sector set-aside window. The African Development Bank (AfDB) is opening its non-concessional window to the poorest countries. Also IFAD - an MDB and a spezialized UN agency -  is exploring options for changing the financial architecture, so as to increase the size of the programme of loans and grants.
The AsDB merger has been described as “win-win-win”[5]: AsDF countries see expanded access to lending; AsDB countries also see expanded access (on non-concessional terms); and  AsDF donors see a 50 percent reduction in their contributions to the grant fund as a result of a smaller pool of countries. Is this too good to be true - a free lunch?

To approach the answer, let us have a look at a simplified MDB balance sheet, with
(Assets) A= $ +γ(EC + ENC) + R = D + EC + ENC = L (Liabilities).
$ denotes cash, γ the leverage ratio of the loan stock to the sum of concessional equity EC and non-concessional equity ENC, and R reserves on the MDB asset side. The liability side consists of MDB debt D and equity E, which can be split into EC and ENC. Let´s denote the ratio EC/ ENC by ε.

Now we can see when the MDB windows merger will bring the advertised results:

·         On the supply side of the MDB balance sheet equation, the ratio of concessional to non-concessional equity ε determines the additional lending potential of the windows merger. The more concessional equity can be merged into non-concessional equity (a higher ε), the more bang for the buck can be expected.
·         On the demand side, composition of borrowers—those requiring concessional lending terms and their size relative to non-concessional borrowers – will define the leverage ratio γ as non-concessional lending raises the leverage ratio while concessional lending will reduce it toward 1.

Table 1: MDB Balance Sheet Ratios
Equity ratio ε
Leverage ratio γ
Sources: Moody´s; CDG (2016); MDB annual reports; own calculations.

The net result on the MDB lending capacity will depend on how much additional finance the balance-sheet reform produces, and how much of the additional resources is absorbed by a higher concentration of fragile & conflict affected countries in the remaining pool of IDA countries. The World Bank balance sheet lends itself to the optimization proposed by the G20: Both the equity ratio and the leverage ratio are comparatively high, so that lending capacity can be increased significantly by the window merger. In contrast, the room for manoeuvre is quite limited for both the IADB and the AfDB, albeit for different reasons.
The IADB had, already before the 2017 merger, wound down the concessional window (FSO) to such an extent that the equity ratio tends toward 0, so there was virtually no concessional equity left to be merged into non-concessional equity. 
It has been argued by an AfDF working group that AsDB merger would result in “lower levels of concessional funding for Asian LICs, in particular on ´non-bankable´ social infrastructure spending. It is also likely to reinforce a pre-existing bias in the AsDB for ´bankable´ projects in the profitable energy, telecommunications and transport subsectors or in agroindustry”[6].

Table 2:  Eligibility to Access ADF Funding
- Number of countries (out of 54 total) -
                                       Creditworthiness to sustain ADB financing
Per capita income
above the ADF/IDA
operational cut-off

30 AfDF-only
3 blend-eligible
4 AfDF-Gap
3 AfDB-only

This would be fatal in Africa where fragile and conflict affected countries are plenty and where the majority of countries (Table 2) still depends on concessional lending.

[2] Buiter & Fries (2002), What should the multilateral development banks do?, EBRD Working Paper No. 74.
[3] Most publications in that direction have been published by the Centre for Global Development (CGD). See CGD (2016), Multilateral Development Banking for This Century’s Development Challenges. For an alternative view, see Reisen, H and C Garroway (2014). The Future of Multilateral Concessional Finance. Deutsche Gesellschaft für Internationale Zusammenarbeit (GIZ). 
[5] See CGD (2016), Multilateral Development Banking for This Century’s Development Challenges, op.cit., p.35.
[6] ADF Working Group (2014), ‘ADF-14 Innovative Financing Approaches’, Options Paper, Box 3.