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Why and how multilateral development banks should operate in middle-income countries

Expert Comment

Written by Chris Humphrey, Annalisa Prizzon

Image credit:Benjamin le Roux Image license:Unsplash

To address the climate crisis at a meaningful scale and make faster progress towards the Sustainable Development Goals, multilateral development banks (MDBs) must remain strongly engaged in middle-income countries (MICs)*. MICs are central to setting the planet’s ecosystem, economies and societies on a sustainable path from now to the middle of the 21st century. MDBs are well placed to help MICs navigate this transition, but need to rethink their approach to do so effectively.

The role of MDBs in MICs has long been controversial, growing even more so in recent years. Since at least as far back as the 2000 Meltzer Commission on the future of the IMF and the World Bank, MDB non-borrower shareholders – led by the US – have pushed MDBs to focus on low-income countries (LICs) and to ‘graduate’ MICs from MDB lending as their economies grow and they access international capital markets. One recent example was the MDB response to the Covid-19 pandemic: concessional lending to LICs rose sharply, but the growth of non-concessional finance for MICs – many of which were badly affected by the crisis – was much slower.

For some MICs, non-concessional borrowing from MDBs is less appealing once non-financial factors are taken into account, particularly for transformational infrastructure projects. MDB lending is at times not aligned with the priorities of emerging economies and comes with high indirect costs related to policy conditionalities, rigid rules and lengthy negotiations and processes. These factors help explain the rise in official Chinese lending as well as the creation of two new MDBs: the Asian Infrastructure Investment Bank and the New Development Bank.

1. Sustainable development in MICs is critical to achieving the global goals of poverty eradication and low-carbon transition

The ambitious Agenda 2030 aims to eradicate poverty for all people everywhere, including in emerging economies. Over 60% of the world’s poor live in MICs, many in regions of entrenched and extreme poverty like northeast Brazil, southern Mexico and parts of rural India. A World Bank report estimated that 82% of the 120 million people expected to fall back into extreme poverty as a result of the Covid-19 crisis live in MICs. Development efforts in MICs are essential to have any hope of eradicating extreme poverty globally.

The planet’s climate trajectory is also deeply linked to the evolution of infrastructure in MICs. These countries are building infrastructure at a rapid rate to accommodate growing economies and populations. Since this infrastructure will remain in place for decades, it is critical to ensure it is as sustainable as possible. Efficient transport networks, rational patterns of urban growth and low-carbon energy systems are key. Some of the largest MDB borrowers are upper-middle-income countries that are also major greenhouse gas emitters (Indonesia and Mexico, for example). Other MICs are following in their footsteps and will lock in high carbon emissions patterns for decades unless action is taken now.

MDBs can play a major role in addressing these twin challenges, as explicitly noted by the US and other G7 nations in their recent infrastructure initiative. MDBs can finance complex projects at a larger scale with longer maturities than other development partners, and at better terms than international capital markets. These financial advantages combine with unparalleled technical expertise related to sustainability and development impact. This set of attributes means that MDBs are better placed than other development institutions to provide and finance global public goods to reduce poverty, mitigate climate change, prepare for pandemics and achieve other development goals. MDBs are trusted partners with long experience in MICs, continuing to operate in these territories even as bilateral donors prioritise their programmes in LICs.

2. Working in MICs benefits LICs too

MICs are poles of economic growth, generating opportunities and investment for LICs in their regions. Examples include Kenya, Nigeria and South Africa in their respective parts of Africa. As the World Bank’s 2016 Forward Look puts it: ‘Middle-income countries contribute to regional development through a spillover effect, acting as engines for growth, offering markets for trade, and providing a source of remittances.’ These growth and trade hubs can strengthen an entire region’s economy. Supporting continued sustainable growth in MICs, launching targeted investments and providing policy advice to develop economic and infrastructure linkages with neighbouring countries should be core aspects of MDB regional growth strategies.

Much of the vaunted expertise of MDB staff comes from the practical knowledge and experience gained from decades of designing and implementing projects in MICs around the world. MDB staff can transfer these skills and lessons learned to LICs that are further behind in their development trajectory. If MDBs do not engage directly with MICs, the hands-on, applied knowledge of MDB staff will deteriorate, weakening their ability to transfer best practice experiences on social innovations, institutional reform or complex infrastructure projects to LICs.

MIC lending also generates substantial net income, funding MDB research budgets and transfers to concessional lending windows. MIC loans strengthen MDB balance sheets in the eyes of bond markets, underpinning their superlative access to finance. All of this greatly enhances the ability of MDBs to help LICs. An MDB that lends only to LICs would be very difficult to sustain financially. LICs take smaller loans that are more expensive to prepare relative to loan size; they also face more challenges in implementation and have a higher repayment risk.

3. MICs still value MDB assistance, but MDBs need to change how they operate in MICs

In a recent ODI survey analysis in client countries of MDBs, the vast majority of government respondents were of the opinion that what MDBs offer – financial and technical assistance, policy advice, research and convening power – remain highly relevant for supporting socio-economic development in their countries. Even if they have access to alternative sources such as international capital markets, more than half of respondents in Latin America – most of them borrowing at non-concessional terms from MDBs – found the provision of MDB finance extremely important for their countries. About half of respondents in countries borrowing at non-concessional terms believed that their demand would increase in the medium term, while only 16% expected that it would decline. Emerging economies value the ability of MDBs to combine targeted financing with highly sophisticated technical expertise and policy advice, as well as their ability to crowd in private investment.

The key challenge is to better match what MDBs are offering and how they do so with the needs of MICs. What should MDBs do differently?

Focus on long-term investment objectives rather than short/medium-term ‘needs’. Policies on how MDBs engage with MICs should shift away from criteria and processes that graduate countries from MDB funding and instead focus on what shareholder countries are trying to achieve. The European Investment Bank – the largest MDB in the world, with nearly €100 billion in lending in 2021 – is a case in point, with 90% of its lending going to its European Union members. The operational driver is not some abstract idea of whether a country ‘needs’ MDB support or not, but rather setting specific investment objectives agreed by shareholders and using the bank’s balance sheet to make them happen. That may mean direct investments in projects that are not attractive to private investors, or credit enhancements, technical assistance and policy advice if a project is close to being market-ready.

Work toward stronger country platforms and country-owned processes. To support the transition to a low-carbon economy, MDBs need to work in a more coordinated fashion through country platforms led by recipient governments and including major development partners (as proposed by the G20 Eminent Persons Group). Country platforms can facilitate coordinated MDB support to design multi-year investment programmes, build the project pipeline, advise on policy and regulatory frameworks and crowd in private investors. MDB projects and programmes that fit into existing domestic policies and a strong country-owned process are two of the factors behind the current success of the Just Energy Transition Partnership (JETP) in South Africa and the new wave of country platforms being developed in other emerging countries.

Make lending from MDBs simpler. MDBs need to reduce excessive bureaucracy and speed up loan approval and disbursement. The project cycle from concept to first disbursement in many MDBs is very long – more than two years at the World Bank on average, and longer for complex infrastructure projects. In the aforementioned ODI survey, more than half of government respondents thought that procurement and financial management rules were complex, rigid or unfamiliar, the most cited disadvantage of negotiating and managing grants and loans offered by MDBs. Simplifying lending from MDBs also includes balancing the priorities of borrower and non-borrower countries on environmental and social safeguards.

Rethink the approach to climate change mitigation and other global public goods. Future reforms will need to deal with the long-standing tension between MDBs as well-placed institutions that finance global public goods (given their multi-country operations and areas of intervention) and their current country-based financing and resource allocation mode. This would include the use of different instruments (guarantees, insurance, buydown of financial terms), allocation mechanisms (expanding regional or thematic windows on top of the country allocation) or cross-subsidisation between projects, especially from non-concessional country-level loans. Beyond instruments, the shift to a low-carbon economy should be framed in terms of the potential for job creation, economic growth and poverty eradication. Creative private sector mobilisation mechanisms tailored to MIC needs should also be explored: these could include co-financing arrangements for public sector borrowers that blend non-concessional MDB resources with private financing at slightly higher financial terms for high-impact sustainable infrastructure projects.

4. MDBs offer good value for money to shareholders (particularly under fiscal consolidation)

At a time when many shareholder governments are attempting to balance their books, investing in MDBs – especially in their non-concessional windows – offers excellent value for money to mobilise financing at scale. Cumulative MDB development lending since their establishment equals at least 20 times the total paid-in shareholder capital for the African Development Bank and 40 times for the International Bank for Reconstruction and Development (Table 1), and counting. The total paid-in capital of legacy MDBs contributed over their entire history amounted to just over $50 billion in 2020, equivalent to less than one-third of the official development assistance budgets of donors reporting to the Organisation for Economic Co-operation and Development in a single year. Expanding lending to emerging countries can be achieved with only a modest cost increase for taxpayers in shareholder countries, and without significantly crowding out resources for the poorest countries. With efforts under way to optimise MDB balance sheets via risk transfer mechanisms and improved financial management – notably along the lines of the G20’s independent report on MDB capital adequacy – this performance could improve even further.

Paid-in capital and total lending to 2020

Conclusions

MDBs have a critical role to play both in MICs and in countries lower down the income spectrum. Sustainability in MICs is central to achieving global development targets, and well-designed and targeted MDB projects in MICs can yield significant environmental, social and economic returns for the entire planet. All country groups along the income spectrum, whether they borrow from soft or hard windows, agree that MDB support is key for their development strategies. As public finance resources remain scarce, crises multiply and deepen and the need to tackle climate change becomes ever more urgent, strengthening MDB support to MICs offers very high value at a low cost to shareholder governments.


*Referring here to countries borrowing at non-concessional terms from MDBs.