Category: Blog
A Valentine’s Day Gift for the AfDB’s Campaign for SDR Recycling—But Now We Need More Heart
Months of innovative work by AfDB staff have resulted in an attractive SDR recycling scheme that overcomes a major hurdle by successfully embodying the reserve asset characteristic. And it will allow leveraging SDRs to multiply their lending power 3-4 times. Now politicians have to step up and commit their SDRs. And Europeans need to show more heart and put aside the legal blockage to recycling outside the IMF.
The African Development Bank (AfDB) took a big step forward in recycling special drawing rights (SDRs) yesterday (February 14), when their staff gave an informal briefing to the Executive Board of the International Monetary Fund (IMF) on their plans to use recycled SDRs as hybrid capital to boost the Bank’s lending.
Why is it a big step?
The AfDB presented the first fully worked-through proposal to recycle SDRs outside the IMF. To date, SDRs have only been recycled through the IMF’s Poverty Reduction and Growth Trust (PRGT) and Resilience and Sustainability Trust (RST). But those trusts cannot absorb the $100 billion of SDRs that the G20 committed to recycling. So other avenues for recycling were needed.
What took so long?
The G20 insisted that any scheme to recycle SDRs maintain the “reserve asset characteristic” of the SDR—that is, it is low risk, and lending countries can redeem their SDRs on demand. There is no precise definition of the reserve asset characteristic (details here), and it is up to each country to decide whether its use of SDRs maintains the reserve asset characteristic. The AfDB worked very hard over the last year to find a mechanism that IMF staff consider no riskier than recycling through the PRGT or the RST. It also allowed contributing countries access to their recycled SDRs should they urgently need to tap their reserves.
Why is recycling through the AfDB an excellent idea?
The AfDB is a triple-A rated institution by Fitch and Standard & Poors, two of the major credit rating agencies. It is has unrivalled regional, country, and sector expertise and vast experience in lending to African countries.
Countries with excess SDRs can lend them to the AfDB, which will hold them as hybrid capital (see our explanation of hybrid capital here). The AfDB will then leverage that capital by issuing bonds.
With its current gearing ratios, the AfDB’s lending capacity will increase by 3-4 times the number of SDRs invested. By contrast, for every SDR invested in the RST, the IMF can lend less than one SDR.
What kinds of loans will the AfDB make?
The AfDB will use the SDRs to put the African continent on the path to meeting the Sustainable Development Goals, focusing on projects supporting climate mitigation and adaptation, green growth, and food security, which will also allow them to combat poverty through the creation of jobs and expand regional integration.
But for this to happen, donors must step up soon!
The technical hurdles to recycling SDRs through the AfDB have been overcome. Politicians in advanced economy countries have no more excuses. They must make the call to recycle their SDRs to the AfDB. There are preliminary indications that the UK will recycle SDR 500 million this way. But for the hybrid capital to work, at least five donor countries are needed. Governments have hesitated to commit without a viable technical solution, but now there is one. Which other countries will step up? Canada? Saudi Arabia? Japan? Norway? Korea? Australia?
What about the European Union countries?
European Union countries appear to be prohibited from recycling through the AfDB. In October 2021, the President of the European Central Bank stated to the IMF’s International Monetary and Financial Committee (emphasis added):
We take note of the discussions on channelling SDRs to vulnerable countries. National central banks of EU Member States may only lend their SDRs to the IMF if this is compatible with the monetary financing prohibition included in the Treaty on the Functioning of the European Union. Retaining the reserve asset status of the resulting claims is paramount. This requires that the claims remain highly liquid and of high credit quality. The direct financing of multilateral development banks by national central banks of EU Member States through SDR channelling is not compatible with the monetary financing prohibition.
But perhaps there is some hope. In her statement to the same committee in April 2022, the President said:
For EU national central banks to contribute to the RST, it is essential that claims on the RST have reserve asset status. According to the preliminary stance of the ECB, as agreed by the Governing Council, the arrangements to ensure that claims on the RST have reserve asset status are acceptable overall – subject to a number of conditions.
The innovative work done by the AfDB has shown that their hybrid capital model maintains the reserve asset status of the SDR much as the RST does.
We hope that European politicians and technicians show some heart and recognize this achievement. They can reinterpret or modify the legislation that appears to be blocking EU countries from participating in this worthy endeavor.
Is the European Investment Bank Finally Transforming Itself Into a Development Bank?
The European Investment Bank’s (EIB) 2022 annual results and operational plans for 2023-2025 are out. The top line: EIB financing in 2022 fell from EUR93.6 billion in 2021 to EUR72.45 billion. However, EIB lending to countries outside of the European Union (EU) grew from EUR7.2 billion in 2021 to EUR 9.18 billion.
2022 has not been short of challenges for the bank, not least because of the war in Ukraine and the related and interlinked developments that have given rise to threats of economic recession in Europe and increasing pressure on national budgets, as well as the imperative to end Europe’s energy dependency on Russia. The EIB’s energy investments alone increased from EUR15.4 billion in 2021 to EUR20.9 billion in 2022.
But what do these results and forward-looking plans tell us about the future of the EIB? Is it finally metamorphosising into a development bank?
By way of background, the EIB is fully owned by the EU Members States and is one of the largest public banks in the world, with around EUR550 billion on its books. But its primary focus is on investment inside the EU. Its finance packages are associated with large public infrastructure projects. It operates in 118 countries, with its activities beyond Europe representing only around 10 percent of its portfolio, and few staff deployed outside its Luxembourg headquarters. As part of the process of reform of the European Financial Architecture for Development, which came to a head in June 2021, the EIB was criticised for its risk-averse lending approach for operations outside the EU; limited staff presence in developing countries; and lack of capacity to carry out advisory and policy dialogue, especially at country level. The conclusion on multiple fronts was that the EIB needed to improve its business and managerial practices, set a different approach to risk-taking, and increase its presence on the ground to become an effective development bank.
In response, in September 2021, the EIB announced that it would reorganise its activities outside the EU by setting up a branch for its external lending and increase its presence on the ground through regional hubs. EIB Global, the bank’s new branch was officially launched in January 2022. Yet, its strategy remains elusive, its head has yet to be appointed and it has only set up one hub in Nairobi, Kenya and another planned in Abidjan, Côte d’Ivoire.
High development impact interventions haven’t exactly been forth-coming for the bank in the year since their announcement: despite increased capital, in fact, 2022 was a particularly risk-averse year for EIB Global. On paper at least, the bank intends to increase its risk profile and become a development bank. Whether that change materialises remains to be seen.
EIB Global financing in 2022 and in the future
In 2022, EIB Global saw an increase in its financing from EUR7.2 billion in 2021 to EUR9.18 billion. Under this envelope, sub-Saharan Africa received the largest share (28 percent), closely followed by the EU southern neighborhood 27 percent (see Figure 1). In 2022, the EIB supported Ukraine with EUR1.7 billion, including EUR668 million in loans for small and medium-sized enterprises (SMEs) and for agriculture and EUR1.05 billion in loans to cover urgent financial needs and restore critical infrastructure.
Figure 1: EIB Global financing by geographic region, 2022, EUR billion
Source: EIB 2022 Activity report.
In 2022, given the difficult macroeconomic situation, EIB Global prioritised investment in small and medium-sized enterprises (SMEs), but it has also committed to increasing its investments in digital transition and human capital, with a specific focus on the health sector (see Figure 2). With energy independence from Russia and access to critical raw materials at the top of the EU’s agenda, EIB Global doubled down on investments in sustainable energy and access to natural resources in 2022, and is projecting a further increase in 2025. Whether EIB Global will U-turn on its commitment to end financing for fossil fuel energy projects from the end of 2021, given the EU scramble for alternatives to Russian oil and gas across the globe, remains a question.
Figure 2: EIB Global financing by public policy goal, 2021-2025, EUR billion
Source: EIB operational plan 2023-2025
EIB Global risk profile
The EIB has been heavily criticised for its risk-averse culture. In 2022, only half of its financing was for high-risk investments. While the annual report shows that the EIB’s own “higher risk activities”—under its own balance sheet—have surged (from EUR0.3 billion to EUR2.1 billion), its mandate activities—those backed by an EU guarantee—have plunged from EUR4.8 billion to EUR2.5 billion. With a stringent statutory risk policy, the EIB is highly dependent on the provision of guarantees by the EU to engage in high-risk lending. As the negotiations for EU guarantees under the European Fund for Sustainable Development Plus (EFSD+) are still ongoing, disbursements slowed down significantly in 2022 and will likely remain sluggish in 2023 given long approval processes. However, the bank puts forward an optimistic picture of its higher risk financing which it expects to increase to 80 percent of total funding between 2023 and 2025 (see Figure 3).
Figure 3: EIB Global financing programme and share of higher risk and mandate activity, 2020-2025
Source: EIB Operational Plan 2023-2025
Don’t hold your breath, however. There is much to do to unlock the potential for the EIB to become a development bank. And its risk approach is the key.
The World Bank Should Ramp Up Finance for Climate, But Not at the Cost of Development
The World Bank Group Evolution Roadmap makes three financing asks of donors and shareholders: capital for IBRD, continued support for IDA, and grants to support climate projects. I think donors and shareholders should support a capital increase and strengthen commitments to IDA. But they should not provide more grants to support climate activities at least until (i) IBRD lending to support mitigation has been reformed and expanded and (ii) major cost-effectiveness and equity concerns of existing grant mechanisms are addressed.
The World Bank already acts as a trustee for twelve climate-related financial intermediary funds, which together have raised over $48 billion, mostly spent on grants for mitigation and in particular clean energy (see forthcoming work by my colleagues Clemence Landers, Nancy Lee, and Sam Matthews).
More than four fifths of this finance is used in middle-income countries, a proportion unlikely to change, given the mitigation focus. Zack Gehan and I have been developing scenarios for future economic growth and electricity consumption that suggest low-income economies will still be responsible for less than five percent of electricity consumption in 2050 even if they considerably outperform growth expectations. And mitigation subsidies in low-income countries have to be larger for the same reduction in emissions, because the cost of capital is higher.
Climate funds are not cost-effective tools of greenhouse gas reduction. Most funds do not publish any data on emissions avoided per dollar of subsidy, but available data suggests funded projects vary by more than 100-fold in terms of cost effectiveness. The Bank Group’s use of subsidies in general has led to minimal leverage (often 1:1 or less) and proven extremely difficult to scale. Even if they were be used more effectively, grants are the wrong instrument for mitigation. Given the aim is to shift countries along the abatement cost curve toward activities that have marginally unfavorable in local economic returns but positive global externalities, large volumes of marginally below market finance (i.e., IBRD lending) is a more appropriate tool than smaller volumes of grant finance.
Despite this, worldwide, official development assistance (ODA) is already being diverted to support the targeted $100 billion in (supposedly) new and additional climate finance, nearly all of it to subsidize mitigation projects. There is every reason to think this dynamic would be repeated by donors with regard to additional ODA provided through the World Bank Group.
Low-income countries will suffer the most from the effects of climate change, a problem they have played almost no part in creating. Development (and thus development finance) is a powerful force for adaptation. Redirecting effective development finance from low-income countries to subsidize ineffective mitigation activities in richer countries is a triple loss for mitigation, adaptation, and development.
Instead, donors and shareholders should support the IBRD to do more on mitigation through policy lending operations. Combined with using the financial value of callable capital to borrow more from the current base, an IBRD capital increase which leverages lending capacity 10:1 or more could significantly expand finance for mitigation. These resources can be made more attractive to borrowers if packaged as large-scale, low transactions-cost climate policy lending rather than project finance. Additional ODA funding to subsidize mitigation in middle-income countries should only follow increased support for IDA, reform, and expansion of IBRD climate mitigation lending, and the development of cost-effective grant models for climate funds.
A Bigger Mission Must Mean More Financial Ambition at the World Bank
Building on a roadmap requested by its shareholders, the World Bank’s board and management are discussing updates this week to its mission to respond to the global transboundary challenges threatening human prosperity. It is more evident than ever that climate change, biodiversity loss, pandemic risks, and conflict matter profoundly for development—which would make it devastating if shareholders miss this chance to transform the Bank by thinking too small.
The largest Bank shareholders have embraced calls for truly ambitious action to meet this once-in-a-generation opportunity. In October 2022, the G7 with Australia, Netherlands, and Switzerland asked the World Bank to “incorporate tackling global challenges as a core strategic priority alongside country anchored work,” in a paper which was widely distributed but not formally published. Germany’s development minister said that the Bank should “make it more attractive for developing countries to use World Bank loans for climate action and biodiversity conservation.” Last month, US Treasury Secretary Janet Yellen said: “the United States wants to see quicker progress on the World Bank’s plans to expand its lending capacity to address climate change and other global crises.”
Yet it is also evident that the need for external finance for emissions reductions is concentrated in upper middle-income countries[i] that face intensely competing demands for development investment and a tendency to forego climate-friendly spending given tight budgets.[ii] These and other middle-income client countries have clearly signaled the importance of sustained attention to development and poverty reduction amidst any greater focus on global challenges. Low-income countries are similarly concerned—IDA has experienced declining donor contributions since its 17th replenishment and currently faces shrinking outlays starting in 2024 as the result of high country demand related to high inflation, food insecurity, and other shocks.
In response, the Bank’s high-income shareholders have underscored that “global challenges and traditional development are interlinked and mutually dependent” while at the same time committing to “continued strong support for low-income countries.” The October G7 nonpaper was clear: “this process [of World Bank evolution] must deliver benefits for all shareholders.”
But now the rubber meets the road. The Bank’s management looks likely to live up to these requests and propose an expansion of the current corporate targets of “ending extreme poverty and boosting shared prosperity”—the “twin goals”—for greater ambition on global challenges. Management will likely also make efforts to respond to the G20 Capital Adequacy Framework (CAF) recommendations to stretch existing capital further—which will be necessary if the Bank is to help meet the $180 billion per year in financing that the Stern-Songwe report estimates is needed for climate action (in 2022, the World Bank Group lent $33 billion in IBRD countries and provided $38 billion in IDA countries).[iii]
It is right to start the evolution process with an update of the mission and metrics. This will need to include a “rules-based and targeted approach to assessing cost and benefits” to provide incentives for investments and reform with cross-border spillovers, as laid out in the roadmap. Greater effectiveness and efficiency in lending and granting is also crucial, and there is a similar need for clear policy commitments from the borrowing member countries to make faster progress on all goals, with more skin in the game for global public goods like climate mitigation where relevant and pandemic preparedness, among others.
But shareholders can’t simply give the Bank a new mission statement and call it a day. They need to signal now that a “better” bank requires a “bigger” bank. Only if shareholders live up to the ambitions they themselves have set can we expect fundamental operational and financial reform to result. We need a concrete financial target that can deliver on the evolved role—with no trade-offs for the poorest.
The G7 nonpaper fudges this point in its section on financial capacity, restricting its coverage to the CAF. Yet the CAF on its own likely won’t cover needs. To fill the gap, there are multiple options available including a general or specific capital increase as well as other proposals circulating—the Bridgetown Agenda, all things special drawing rights (SDRs), new international taxes on the super-wealthy, etc. All are possibilities but the key is to spend future political and advocacy capital on the big picture reform and financing package rather than the details of each specific financing source.
This year could be decisive for a new international financial architecture—one that could move the needle to deliver on both development and transboundary prosperity. There are many high-level opportunities in the coming months: the Macron-Mottley Summit in June, the SDG Summit in September, the World Bank Group/IMF Annual Meeting in Marrakech in October, and COP28 at the end of November. But the longer the Bank’s biggest shareholders stay mum on the overall package of support, the higher the likelihood that we get more business as usual and/or unacceptable tradeoffs, and more unconvincing fodder for summits and high-level meetings even while the Earth literally burns.
More financial capacity at the World Bank is not a blank check—it is an incentive for all to do what it takes.
To learn more about CGD’s work on MDB reform, visit our project page.
[i] Of course, high-income countries and the largest consumers within those countries are most on the line for emissions reduction but they do not require external finance to move ahead.
[ii] Witness Brazil’s recent scuttling of an asbestos-laden warship in the Atlantic Ocean, a move that environmentalists said would cause “incalculable damage to marine life and coastal communities.”
[iii] Other consortia believe the amount required from the entire system is much larger—up to $1 trillion according to the Bridgetown Initiative.