Opinion - Has the World Bank lost its way? Au contraire...

A recent article by Adam Lerrick, "Has the World Bank lost its way?" (Euromoney, December 1999), questioned the role of World Bank lending to emerging market economies and called for the Bank to be more knowledge-based and geared to helping countries build the enabling environment for productive private sector investment. We share much of Lerrick's vision about the World Bank group's future role in the developing world. We fully agree, for example, that delivering knowledge and advice to clients is central to tackling global poverty. Thus the "New Bank" created by World Bank president James Wolfensohn increasingly emphasizes this role. But we disagree with major parts of Lerrick's analysis, and with a key recommendation: to eliminate the Bank's non-concessional lending role.

In a world where almost three billion people live on less than $2 a day we must use every tool at our disposal to carry out our mission to reduce poverty. Poor people in developing countries would be the losers if Lerrick's recommendation were carried out - especially the two billion of them living in countries that would be directly affected. The stakes are simply too high for us not to challenge the underlying analysis and conclusions.

Who's displacing whom?

Lerrick argues that World Bank lending through its IBRD window "displaces" private capital. We disagree. Indeed, recent research suggests quite the reverse: in countries with good policies, lending by the Bank and other multilateral agencies leverages larger inflows of private capital. It is estimated that 1% of GDP in external assistance increases private investment by an extra 1.9% of GDP in countries with good economic management.

The World Bank group's purpose is to catalyze the private sector, not to compete with it. The strategic objective of much of our lending is to help developing countries and countries in transition to create the right environment for their economies - and the private sector - to flourish. So while Lerrick sees displacement of private finance in the Bank's lending, for example, to Brazil for public sector administrative reform, to India for power sector reform, and to the Philippines for financial sector reform, we see enhancement of the scope for future private inflows.

In those countries and elsewhere, Bank support for policy and institutional reform aims to increase the economy's capacity to develop. It defies logic to believe that the Bank's lending in support of policy and institutional reforms could be causing discomfort in the private sector. A 1996 US General Accounting Office report on the World Bank, commissioned by congress to investigate this very issue, found that market participants valued the Bank's role in promoting the environment for private sector transactions.

Clearly, a functioning legal system, transparent and corruption-free public sector, sound financial sector, and healthy and educated people make a country attractive to private investors. Rather than crowding out private finance, the Bank aims to crowd it in, through improvements in the legal system, the financial sector, corporate governance, and regulations governing privatization and other market-based approaches.

Poland is a good example. There the Bank provided strong support for the key reforms of the early 1990s: privatization, financial sector reform, the creation of market-friendly legal and institutional frameworks. As the reforms took hold and private flows came in, the Bank cut back its lending, intending to rely more on non-lending products (that is, advice) targeted to Poland's preparations for EU accession. But subsequently the government requested renewed lending support for coal restructuring and rural development.

Why did the government want the Bank for these programmes? In part because of the embodied knowledge transfer and technical assistance that our lending provides. But also in part because of the sensitivity of the underlying issues, and the belief that Bank involvement - and the visibility and commitment demonstrated by World Bank financial involvement - would help provide the basis on which to build a political consensus.

In the government's judgment, the Bank's presence has greatly facilitated the restructuring of Poland's coal mines by providing independent analysis of the economic outlook for the mines and by building confidence by supporting social programmes for retrenched miners.

Nor is it only transition economies whose journey from state capitalism the Bank has supported. Consider Argentina, where we have been long and closely involved. There we backed the large-scale privatization programme of the early 1990s. Because Argentina's track record was then weak, we required up-front action to divest the state telecommunications utility before loan approval. The government complied fully - and then some - boosting the programme's credibility. Subsequently, we continued to support Argentina's programme, including for reforms at the provincial level.

In late 1998, we provided policy-based financial support when the reverberations of the east Asia crisis reduced Argentina's ability to tap into private markets. This demonstrates a further important point: that Bank financial support for development - including private sector development - can be crucial for countries that have had access to private markets, when for reasons outside their control that access suddenly dries up and puts their reform programmes in jeopardy.

Most recently, in 1999, we provided a policy-based guarantee which helped Argentina place a large debt issue at a time when investors generally were not disposed to emerging market debt. Meanwhile, IFC (International Finance Corporation) and Miga (Multilateral Investment Guarantee Agency) have supported and complemented the Bank's efforts. The latest and most innovative example is IFC's recent syndication of investment in Argentina's privatized postal service.

The irony is that in the end, once reform efforts are successful, it is Bank lending that is displaced by private capital, rather than vice versa as Lerrick argues. And this is exactly as it should be. The typical pattern is for a country to climb the ladder of policy and institutional reform, which in turn makes it attractive to foreign creditors and investors, preparing the way for ultimate graduation from the Bank, once sustainability of access on reasonable terms is assured.

This is apparent both at the country level, for example, in Chile, Korea, Malaysia, and Poland, and at the aggregate level. Indeed, throughout much of the 1990s, as more countries did in fact begin climbing the ladder, private financing to the developing world increased and IBRD lending decreased.

Sudden vulnerability

But the journey is not always along a straight line, as illustrated by Korea. During the 1960s, its low per-capita income and lack of creditworthiness made it eligible for IDA's concessional assistance; it went on to borrow from IBRD in 1968 and to become an IDA donor during the 1970s; and it graduated from the Bank in 1994, but returned to the IBRD window in 1997-98.

The east Asia crisis demonstrated the vulnerability of many middle-income countries to volatile private flows. It also heightened the need for vital structural and social reforms for which a number of countries sought IBRD financing.

The Bank's programme in Korea, for example, supported the adoption and implementation of important financial sector and corporate governance reforms, market-opening reforms, including the foreign direct investment act and the foreign capital inducement act that led to a surge in foreign direct investment, and labour market and social security reforms. Complementing the Bank's effort, IFC invested in financial institutions after the crisis broke, bringing in internationally accepted standards of accounting and catalyzing investors unwilling to reenter on their own.

Similarly in Thailand, the Bank supported reforms of the financial sector and corporate governance, as well as the expansion of efficient anti-poverty programmes, such as means-tested cash and in-kind transfers to the most vulnerable groups.

In Malaysia, the Bank helped the government to safeguard budgetary allocations for health and education. In all these cases, IBRD financial assistance went hand-in-hand with the kind of intensive policy and institutional support that translates into long-term structural reform and poverty reduction. It did not crowd out private financial flows.

Lerrick concludes from his erroneous analysis of displacement that the Bank should stop lending to middle-income countries, and should focus its work with these clients exclusively on advisory services. This would be a mistake. The Bank group's effectiveness with clients is enhanced by its ability to provide both lending and non-lending services. The mix is tailored to country circumstances, but in many cases, lending and advice are bundled together.

Important though knowledge and advisory services are, they can become far more powerful in leveraging policy and institutional change when clients feel that a lending relationship with the Bank--underpinned by the discipline of commitments on both sides and timelines--can help to promote consensus and implementation.

Equally, the operational experience of lending preparation and supervision generates keeps the Bank's advice practical and focused. The Bank group would be less effective in pursuing the policy dialogue and promoting reform without the IBRD lending window.

Lerrick correctly observes that the development paradigm has grown more complex during the Bank's life. In earlier years, the prevailing paradigm saw the primary constraint to development as the lack of capital, and capital transfer was thus central to the Bank's mission during that era. To some extent this orientation grew out of the Bank's initial focus on rebuilding war-torn Europe; but the focus on financial and engineering solutions remained for a long time after our client base had shifted to the developing world.

Today, good policies and institutions covering a broad array of macroeconomic, legal, judicial, financial sector, environmental, and social concerns are widely recognized as essential to sustained growth and poverty reduction. Increasingly, good policies and institutions are also being seen as essential for disaster management, as we have seen in the responses to the recent earthquakes in Turkey, hurricanes in the Caribbean, cyclones in India, and so on.

But what Lerrick fails to recognize is how the Bank's approach to development has evolved to reflect the complexity of the new paradigm, and how our lending instruments also have evolved to embody both financial and advisory services. Lending has come to focus less on the hardware and bricks and mortar of development, the tangibles that are so often more effectively provided by the private sector, and more on the software and policy and institutional reforms needed for a healthy and stable private sector, institution-building, and social development.

From hardware to software

In telecommunications, for example, the Bank has not financed investment in new capacity for several years, relying instead on the private sector, often in collaboration with IFC and Miga. However, the Bank actually finances more projects in the sector today, focusing on helping governments build regulatory capacity and design mechanisms for private participation.

This movement from hardware to software is broad-based and deep-seated (Figure 1). In 1980, for example, the power sector accounted for 20% of IBRD lending. Today, reflecting the much increased private sector participation, the power sector accounts for only 2% of IBRD lending. And even that 2% is different, focusing much more on public policies and institutions, regulatory frameworks, tariff setting, environmental issues, and so on, than on machinery and equipment.

In India, for example, we are helping reform-minded states address decades-old fiscal problems rooted in the power sector to dismantle the bankrupt state electricity boards, privatize generation and distribution, and put in place new pricing and regulatory policies.

At the other end of the spectrum, lending for education, health, nutrition, and so on has expanded fourfold, from 6% of lending in 1980 to 26% in 1999. And, while we used to hire architects and engineers to build schools and clinics, we now hire education and health specialists, economists, and financial analysts to help to put school and health systems on a sustainable financial footing, applying market-based principles in the pursuit of learning and health outcomes.

Another rapidly growing area is the financial sector, for which the share of IBRD lending has also expanded fourfold over the period. At the same time, the substantive content of these operations has evolved away from the funding of credit lines, which proved to be unsustainable absent the proper regulatory and prudential environment, to supporting financial sector reform and capital market development.

The final flaw in Lerrick's case for giving up IBRD lending is that the Bank would need to rely on "significant aid contributions from the industrialized nations". In other words, Lerrick would have the Bank scrap IBRD's self-sustaining, successful mix of capital market borrowings and loans, and instead depend on direct aid funding from major donor nations to establish and operate what he calls the desired "intellectual architecture for regulating the flow of private resources to developing countries", and to fund IDA grants for a number of countries that currently borrow from the Bank on IBRD terms.

This is simply not realistic. In a time of severely constrained foreign aid budgets, it is highly doubtful that donors would be able to provide and sustain the needed level of funding. It is difficult enough to secure the resources needed to fund current IDA programmes. Under the Lerrick proposal, IDA also would lose the contribution from IBRD net income, and its requirements for donor funding would only increase.

Lending trends

Many of Lerrick's arguments about Bank lending are misleading, especially the charge that the Bank inappropriately channels the majority of its flows to several large developing countries. Yes, the 11 countries cited by Lerrick received about 70% of new IBRD commitments during the 1993-99 period. But these 11 countries are home to over half the world's people, and to almost 80% of the people, and of the poor people, who live in IBRD countries (figure 2).

Though the country mapping between lending shares and population shares is not exact, the broad point remains: it should hardly be surprising that much of the Bank's lending is concentrated in such countries. That is where the bulk of the global development challenge lies.

Nor are the conclusions sound that Lerrick draws from the declining share of IBRD lending to non-rated countries, from 41% in 1993 to 1% in 1999 (figure 3). The underlying pattern of Bank lending did not change significantly during the 1990s. What did change was that many previously non-rated borrowers began to enter the capital markets for the first time, and therefore obtained ratings.

This migration from "non-rated" to "high-yield", while it does point in a healthy direction that will ultimately have implications for the Bank's relationship with these borrowers, does not mean these countries no longer need support from the Bank. Besides, as these countries graduate from Bank assistance, others that now receive credits from the Bank's concessional IDA window will take their place as they graduate from IDA and become eligible for IBRD loans. A better measure for assessing the changing balance of lending is thus the share of Bank lending to countries with investment-grade ratings; this share remained broadly constant at about 30% throughout the 1990s.

Lerrick implicitly equates having a rating - even a high-yield rating - with having full access to the needed volume and terms of market financing. Yet we know that countries with such ratings do not have sustained access to credit markets and that the maturities they can obtain tend to be inappropriate for long-term development projects. Moreover, many countries gain initial market access in recognition of good performance on the policy front. But policy improvements tend to be fragile, and must be bolstered by continuing development efforts. Immediately cutting back on the Bank's development assistance to such countries, as Lerrick recommends, is not the way to ensure the long-term sustainability of reforms nor to promote the adoption of reforms in the first place.

Looking beyond financial access, the critical success criterion remains development impact. Middle-income countries--even those with strong credit ratings--are riddled with policy and institutional imperfections, some localized in particular geographic regions, some concentrated in particular sectors, some more pervasive. World Bank assistance helps countries to reduce their policy and institutional imperfections and realize the full economic benefits of stable and sustained capital flows. Indeed, a number of the 11 countries cited by Lerrick have federal structures, and we are working with them at the state/provincial level to promote fiscal sustainability, efficient and equitable social programmes, and so on.

We also have strong urban and local government programmes designed to address municipal finance, zoning, and other sub-national policy and institutional reforms for improving the provision of local public goods and services and the efficiency of economic activity on the ground. Policy-based loans to support such efforts will enhance private sector flows, not displace them. Complementary transactions by IFC and Miga with second- and third-tier companies, small and medium-scale enterprises, and others can help to demonstrate the benefits through specific operations.

Judging success

Lerrick argues that because Bank operations carry government guarantees, there is no incentive to ensure their success. This is untrue. The Bank's objectives are to promote development, and its projects are designed, monitored, and evaluated with that objective in mind. The Bank invests heavily in independent evaluation, and its Operations Evaluation Department (OED) is unique among development institutions in the scale and scope of its work.

The quality of newly approved operations has been improving steadily over the past few years, reflecting the internal renewal programme the Bank has carried out under president James Wolfensohn. Since the average project life is five to eight years, OED completion ratings are only beginning to reflect these changes. Their full impact will show up several years from now. But even then, perfect scores are unlikely, and even undesirable. Given the inherent riskiness of the development business, they could indicate we were not pushing the envelope far enough in our operations.

High stakes

We subscribe fully to Lerrick's view of the critical importance of the World Bank group's advisory and knowledge transfer functions, and their special relevance to emerging market economies. Indeed, we have taken steps to become a "knowledge bank". But Lerrick's recommendation that we phase out IBRD lending is totally without merit. Divorcing advisory services and policy dialogue from IBRD lending as he suggests would have negative developmental consequences not only for IBRD borrowers, and also for IDA-eligible countries, given the important contribution that IBRD net income provides to the IDA programme. The poor throughout the developing world would suffer.

The Bank plays a vital role in countries at various stages of development, from the very poorest countries, which need broad-based IDA concessional assistance and advice in building capacity and policy frameworks for private sector development and poverty reduction, to the middle-income countries, which need more focused IBRD support and advice in addressing the second-generation reforms essential for competing in today's global marketplace. Given the synergies with IFC and Miga and with our global programmes and research, no other agency can play this role so well. Nor can we expect private investors to stand in for the Bank. They are neither inclined nor equipped to engage governments in policy dialogue on the underlying social, economic, and governance issues.

The Bank group and other public institutions need to work together with the private sector to complement each other and to make sure that the promises of globalization reach all the world's citizens. Strong coalitions will be needed to attract investment, create jobs, promote technology and skills transfer, and foster social responsibility. It is not by crippling any of the actors, but by enhancing the efforts of all, that we will be able to make a real difference.

The stakes could not be higher.

Figure 1 - Distribution of World Bank lending, fiscal 1980 (left) and 1999 (right)

Source: World Bank

Figure 2 - Share of 11 IBRD countries

Figure 3 - Share of IBRD lending by S&P credit rating, fiscal 1993 to 1999