The author adapted this blog from his prepared remarks at a recent CGD event as part of Annual Meetings week.
Every multilateral development bank (MDB) is now confronted with the question of what to do with middle-income countries (MICs), given the need to focus on the Sustainable Development Goals in general, but very concretely on goal #1—poverty eradication—which will be difficult to achieve based on recent trends. MDBs are very important for MICs, but at the same time MICs are vital for MDBs. This is essentially a two-way relationship. Without MICs, MDBs will be less innovative, will have less knowledge and, importantly, will require more capital from shareholders. I will explain why I believe so in this short blog.
Colombia´s recent developments
The experience of my own country, Colombia, is an important MIC example. Despite the challenging times brought by the dramatic decline in oil prices from 2014-16, which cut exports in half, Colombia did not fall back. On the contrary, the largest external shock since the Great Depression did not stop economic growth and social progress. A few years ago, negative external shocks were the main cause of recessions and reversals in many social indicators—but not any longer. Access to financing, strong economic institutions, adequate economic policies, and sustained development strategies are key to help countries adjust to shocks while moving social and economic progress forward. The results are not entirely due to MDBs, but it is clear that they played an important role.
MDBs can play a critical role in ensuring that this is the norm rather than the exception. Through more than 60 Development Policy Loans (DPLs) with MDBs during the last ten years, and countless technical missions, Colombia was able to access valuable information, obtain feedback, and secure funding in amounts close to $2 to $3 billion a year (an amount that is similar to what the country received directly from international financial markets). This is part of the explanation as to why the economy was more resilient.
MDBs are Key for MICs
Firstly, MDBs help address market volatility.
Although Colombia holds a BBB rating and has wide access to international capital markets, external shocks and spikes in volatility can limit the ability to get adequate external funding, as was the case during the 2008 financial crisis, when the markets shut down completely.
But beyond these very specific and extreme situations, there is a good case to make in favor of the role of MDBs from a financial point of view for the following reasons:
Countries can maintain market confidence because investors acknowledge that governments will be able to access external financing from MDBs during difficult market conditions. Therefore, risk premiums and bond rates are generally lower, and suffer less during periods of stress, if governments are able to show that they have continued access to financing from MDBs. Not depending entirely on markets is desirable as it allows countries to have overall lower rates, which is crucial especially for countercyclical policies.
Countries can avoid expensive debt in difficult times. This gives governments more space for countercyclical policies to offset negative external shocks (allocating more resources to investment than to debt service is extremely valuable).
MDBs loans improve the tenor, rates, and amortization profiles of public debt, thus improving risk profiles.
Secondly, having access to MICs know-how, information, best practices, and lessons-learned has been key to MDBs properly implementing many reforms, avoiding the pitfalls of engaging in trial and error system. One good and recent example is the Carbon Action Peer Exchange (CAPE) which helped Colombia access useful information to advance towards a more sustainable and low carbon economy, including the introduction of carbon taxes. The same applies to the Carbon Price Leadership Coalition (CPLC), both using the World Bank’s Platform. This goes in two directions: MICs can also become a good source of evidence-based policy interventions for low-income countries (LICs).
Other examples of the benefits of working with MDBs include the city of Bogotá, which is building its first Metro line. The MDBs have been involved in the project since the first day, providing lessons learned by other countries, experts in integrated transportation systems and international bidding processes, and accurate protocols and institutional arrangements to supervise work, contracts, and related social, environmental, and resettlement aspects. The project also requires nearly $2.4 billion in financing and instruments to minimize volatilities in rates and foreign currencies’ exposure.
Finally, another area where the MDBs have been crucial in mobilizing donor funding. For example, in Colombia, the World Bank Group (WBG) and the Inter-American Development Bank play a leading role in facilitating the access to multi-donor trust funds to finance our post-conflict and green agendas, and recently, the spillovers of the migration phenomena. MDBs bring credibility, knowledge of the field, and adequate vehicles for operational management of resources.
And Vice Versa: MICs are key for MDBs
On the innovation side, MICs typically demand new and innovative products from MDBs. For example, after the devastating effects of La Niña in 2010-2011, Colombia was one of the first countries that asked the WBG to create and design insurance instruments to reduce its fiscal vulnerability to natural disasters. As a result, all WBG clients now have access to mechanisms such as the CAT-DDO, a contingent credit line that provides liquidity in critical events, or the Pacific Alliance CAT Bond issued in early 2018 that covers up to $1.36 billion of seismic events in the four member countries of the Pacific Alliance, Chile, Colombia, Mexico, and Peru (which incidentally already collected a $60 million payment as a result of the 2019 earthquake). The diversification of risk led to a lower cost to the bond, than would have been the case if each country acted individually. This group of MICs asked the World Bank to structure the product as a AAA-rated bond issued by the Bank where the investor loses some of the capital in the event of an earthquake in each one of the four countries. The main point here is that the need of four MICs led the Bank to engage and innovate, with potential benefits for other MICs as well as LICs that want to issue similar structures in the future.
Another good example is the creation of Financiera de Desarrollo Nacional (FDN), a Colombian infrastructure bank. The government took the initiative of creating this institution in order to correct some market failures in infrastructure finance, but at the same time improve the corporate governance relative to previous experiences. The MDBs were invited to participate either as shareholders (which IFC and CAF did) or lenders (both of them plus IDB-Invest). FDN has committed resources to projects that surpass what the AIIB has done to date.
And finally, BID Lab (formerly MIF or Fomin) has been a laboratory for innovation with social impact bonds, green bonds, and sustainable bonds. Structuring these asset classes, developing a market, and hopefully ensuring that they bring lower borrowing costs to MICs, and greater social or environmental impact to the lender, is a crucial role for MDBs. Building on this experience, and in order to increase the impact of these classes of bonds, MDBs should help solve some of the coordination failures that exist in ensuring that the funds are used for purposes that clearly help achieve the SDGs, and that help the borrower in reducing the cost of funds.
MICs need specialized support to face challenges such as: (i) the implementation of social and green agendas (including post-conflict in Colombia) that will help reach SDGs and Nationally Determined Contributions of the Paris Agreement, (ii) the closing of subnational socioeconomic gaps, (iii) the execution of large long-term infrastructure projects, (iv) the strengthening of national and local capabilities, (v) the improvement of productivity and competitiveness, and (vi) the involvement of the private sector through innovative market mechanisms.
Hence, I make the case that:
MICs need strong MDBs that can respond to their needs and confront development challenges.
The private sector has a key role to play in development. Thus, there is a clear need to strengthen institutions like IFC or IDB-Invest. I am convinced that these are highly relevant institutions for MICs given their capacity to leverage resources in all economic sectors, with a special focus on those small and medium enterprises that need specialized tools to grow and become highly productive and competitive.
MDBs should continue to provide access to financing and services to MICs, as has been the case in the past. Given the inequality that exists in various MICs, the vulnerability to unpredictable shocks, and the subnational disparities, the importance in providing global and regional public goods, MDBs are as important as they have ever been for this group of counties. They are not a substitute for domestic revenue mobilization, they are indeed a good complement.
From a financial sustainability perspective, the MDBs need to have a diversified portfolio to maintain their strong financial position and compensate for the much-needed shift into riskier countries. In order to have strong and sustainable MDBs it is necessary to have an adequate asset diversification, high loan quality, and profits that can be reinvested. A mix of borrowers is better than excessive concentration in higher risk countries. Inadequate risk diversification puts more pressure on capital from shareholders.
The world is a much better place now that it has ever been. But the risk of rolling back is always there and is multidimensional. We need strong MDBs to help us all confront old and new challenges alike.