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A G7 trade and investment plan to promote prosperity

Written by Maximiliano Mendez-Parra, Chris Humphrey

Hero image description: Secretary of State for International Trade Liz Truss G7 call Image credit:Simon Dawson / No 10 Downing Street Image license:CC BY-NC-ND 2.0

As chair of the G7, the UK has promised to promote prosperity by ‘championing free and fair trade’ at the summit. Professed support to international trade is welcome.

However, if the sum of the G7’s ambitions to promote prosperity is to simply reduce barriers to trade, then the summit will be a major opportunity missed. As a vision for supporting a global recovery, it pales in comparison with China’s Belt and Road Initiative, which aims to increase economic integration, value chain growth and market creation through trade, but also significant public and private investment. G7 countries should be considering how both trade and investment can support recovery.

The UK has also committed to ‘support the poorest nations to grow alongside us’. This focus on the poorest countries is consistent with the international response to the Covid-19 crisis, which has focused on providing additional resources to low-income countries. A commitment to support the poorest countries is commendable, but any strategy for a global recovery also needs to consider middle-income countries (MICs).

How then could the G7 set out a more ambitious trade and investment plan that promotes prosperity in both lower- and middle-income countries?

Building more resilient value chains

Despite predictions of a major reconfiguration of global supply chains to near-shore production, the companies that lead many value chains have made little effort to produce such transformation. Rolling back value chains from the shape they have adopted would significantly affect global efficiency and productivity and, given the interconnectedness of the world economy, it will likely backfire.

The G7 could set out measures and proposals that would increase the robustness and resilience of global value chains. The most immediate concern relates to the development of new and more sustainable value chains in critical products and inputs. A global agreement to eliminate trade restrictions on imports and exports of pharmaceuticals, vaccines and medical inputs needs to be considered to support these efforts.

The development of robust and sustainable value chains must also include critical industrial inputs. For example, increasing the production of zero emissions vehicles will require a deep reconfiguration of supply chains. The production of batteries requires lithium and rare earth minerals, many of them located in resource-rich but income-poor countries.

The development of the relevant value chains for car batteries should involve the creation of partnerships involving firms and governments. These partnerships should aim to secure the adequate and reliable supply of critical inputs. They should also serve as a decisive instrument of development in these countries. In this sense, these partnerships should encompass [MF1] trade, investment and aid to secure the development of productive and trade capacities in relevant countries. Trade and investment policy, in this context, should not only look to eliminate existing barriers, but also promote the mutual benefits of the partnership.

G7 countries could also lead trade reforms that would enable the benefits of digital technologies to be more widely shared. The pandemic has accelerated the adoption of digital technologies to trade goods and services, and this could lead to a significant expansion in global productivity if facilitated by appropriate regulatory reforms. This also applies to remote working, and the need to consider more flexible approaches to taxation (e.g. tax residence criteria) and labour legislation that would allow the hiring of workers located in different part of the world. G7 countries could lead reform in this area, for instance making it easier to hire non-resident workers from developing countries. There is also a discussion to be had on how taxes collected can be shared with the host country.

Reinforcing the multilateral agenda can help address many of these issues. In addition to getting the WTO Dispute Settlement Mechanism operating again, there is a need to advance in many other areas, including digital trade, domestic regulation and WTO reform. G7 countries must signal their support for these initiatives.

Enable multilateral development banks to build sustainable infrastructure in middle-income countries

G7 nations should also spearhead measures to remove the barriers holding back multilateral development banks (MDBs) from scaling up sustainable infrastructure investment in middle-income countries.

MICs have been severely hit by the crisis, with GDP plunging by 7% across Latin America in 2020, 8% in India, 7% in South Africa and 5.6% in Malaysia. MICs account for three-quarters of the world’s population and one-third of global GDP. These countries are also in the midst of the transition towards industrialisation and urbanisation – wrenching changes that are remaking their economies and societies. In many ways, they are the hinge upon which global development prospects depend.

MIC governments are under intense pressure to invest in infrastructure essential to support economic growth, participation in job-creating global value chains and better living conditions for their people. This means roads, rail, port facilities, electric power, water and sanitation, ICT and more. These infrastructure facilities will lock in patterns of economic activity, social relations and carbon emissions for decades to come. It is in the interests of the entire global community that MICs make these infrastructure facilities as smart and sustainable as possible. Our planet’s future depends on it.

Any chance of achieving meaningful progress in reducing global poverty also depends on MICs. Over 60% of the world’s poor live in MICs, many in pockets of entrenched poverty that can lead to social instability and hold back an entire country’s development progress. An estimated eight in 10 of those falling back into extreme poverty as a result of the Covid-19 crisis are in MICs. At the same time[MF3] , fast-growing MICs act as poles of economic dynamism to pull up the countries around them by stimulating regional economic activity, creating jobs, making cross-border investments and generating all manner of positive spill-over effects.

Despite the importance of MICs to global development goals, MDBs have been pushed by some major shareholders to wean MICs off MDB lending. The argument is that MICs can access market-based financing, and so should not be eligible to borrow from MDBs. This misses the point. MDBs were designed to undertake certain types of investments that will lead to outcomes beneficial to all shareholders – wealthy non-borrowing countries and developing borrower countries alike. For example, the European Investment Bank (EIB) has a loan book more than double the size of the World Bank’s MIC lending window, including projects in some of the world’s richest countries, including Germany, the Netherlands and France. European Union (EU) member countries view EIB financing as an effective way to achieve policy and investment priorities, in partnership with the private sector. The same logic applies to the World Bank and regional MDBs operating in developing countries, only more so since needs are greater and capacities lower.

Weak demand for MDB loans is often pointed to as a sign that MICs don’t need MDB assistance. In reality, many factors limiting MIC demand for MDB loans are endogenous to the MDBs themselves –operational policies, bureaucratic practices and small lending amounts that MICs find impractical, especially for major sustainable infrastructure investments. The World Bank takes on average more than two years to begin the first disbursement, or longer for an infrastructure project. For governments under extreme pressure to deliver results, that is unacceptable.

It’s no surprise that many MICs are willing to turn to Chinese export finance or bond markets, even if it means higher public debt, lower quality and less climate-friendly projects. If MDB policies drive away the countries most critical to global development, that is not an argument to work less with MICs, but rather to reform MDBs.

Sustainable infrastructure is key for MICs, and the major MDBs have been unable to provide meaningful support at the scale needed. They do not have the financial envelope due to capital restrictions, they have a host of operational policies seemingly designed to block infrastructure lending, and they prioritise poverty, social and institution-building projects instead. As a result, many MICs simply don’t look to MDBs when it comes to large-scale infrastructure, especially with Chinese bilateral financing at hand. The turn away from infrastructure has been a major mistake by the MDBs, and is a key factor behind the recent creation of the China-led Asian Infrastructure Investment Bank and New Development Bank. The rise in lending over the past year from the Asian Infrastructure Investment Bank (lending to government has grown almost threefold in 2020 versus 2019) also demonstrates that, when banks are well capitalised and well managed, there is still demand to grow borrowing.

With the right policies and sufficient financial capacity, the World Bank and regional MDBs can build a platform oriented around sustainable infrastructure to re-engage with MICs. As part of their efforts to promote global prosperity in the wake of the Covid-19 crisis, the G7 nations should broaden their efforts to complement their laudable support for the neediest with an agenda of engagement with MICs. Working through the MDBs, the fiscal resources needed would be minimal, and the potential long-term impact on global prosperity and sustainability immense.

G7 nations can reinvigorate engagement between MDBs and MICs in three areas:

1. Financial capacity to lend at scale

  1. Review options to loosen conservative capital adequacy frameworks while retaining a AAA bond rating, to make the most of shareholder capital.
  2. Inject fresh paid-in capital to the non-concessional lending windows of the World Bank and major MDBs. The amounts needed are a small fraction of annual bilateral DAC aid flows, and can be used to leverage much greater lending amounts for decades into the future due to the MDB model of issuing bonds on international capital markets.
  3. Ramp up balance sheet optimisation techniques, including syndication platforms for public sector lending; risk transfer techniques modeled on those pioneered by the African Development Bank (AfDB) in 2018; and portfolio guarantees from official agencies and sovereign wealth funds, as Sweden’s SIDA does.
  4. Create non-voting share class for institutional investors within the MDB capital structure to mobilise more private sector resources for development.

2. Strengthen coordination among MDBs and other development actors to maximise impact around an agenda of sustainable infrastructure

  1. Push MDB management to prioritise multi-year country platforms organised around specific sustainable infrastructure challenges such as renewable electricity generation and distribution, low-carbon transport systems and sustainable water supply, bringing together development partners, government agencies and the private sector to combine long-term planning and technical assistance, catalytic public sector investments and reforms to spur greater private investment.
  2. Dedicate more effort and financing (including from MDB net income) to developing a pipeline of critical sustainable infrastructure projects eligible for financing. This could be a joint service funded by different MDBs, possibly managed by the Global Infrastructure Hub, that would be a ‘public good’ benefiting MDBs, national development banks and private financiers alike.
  3. Help promote sustainable infrastructure in developing countries as an asset class for institutional investors by continuing the ongoing work of the IFC, EBRD, AIIB, GuarantCo and others to strengthen local capital markets, design more uniform contract templates and sharing MDB project data to demonstrate track record and allow investors to build more robust risk models.

3. Address policy constraints within MDBs

  1. Reduce excessive MDB bureaucracy in project approval and implementation processes by striking a better balance between the quality control oversight favoured by non-borrower shareholders and speed and ease of use favoured by borrowers.
  2. Scale up initiatives like the World Bank’s P4R that make greater use of a country’s own frameworks and focus on achieving results, recognising that the long-term goal is for countries to have their own strong standards rather than having them imposed externally.
  3. Refine environmental and social safeguards to maintain standards but make them less legalistic and ex ante, and instead oriented towards allowing countries to set their own priorities and processes while requiring minimum results.
  4. Implement incentives for to project staff and build internal feedback and learning systems that encourage more innovation and calculated risk-taking, recognising that the risk-averse style of existing MDB management holds back change.