China Is Not Ten Feet Tall
How Alarmism Undermines American Strategy
In the past five years, the world has created the International Criminal Court; the Global Fund for AIDS, Tuberculosis, and Malaria; and the Kyoto carbon-trading system. Scarcely a month goes by without statesmen, high-level commissions, and civil-society activists calling for the creation of yet another institution: to manage postconflict reconstruction, to handle sovereign bankruptcies, to supplement or supplant existing bodies such as the United Nations. World leaders have focused less, however, on sustaining the good global institutions already in existence. A case in point is the World Bank, where an incoming president will soon confront a nearly impossible challenge: saving the bank from the same caste of statesmen, high-level commissions, and civil-society activists.
After 60 years of operation, the World Bank is large and lavish; it does not exude an aura of fragility. Its main complex in Washington, D.C., is an extravagance of glass and steel -- a contrast with the rundown UN headquarters in New York, where part of a ceiling collapsed two years ago. The bank's projects encompass an extraordinary range of goals, from road building to female literacy efforts to civil-service reform, and are spread across almost 100 countries. The institution gives out around $20 billion in loans and grants each year, a volume roughly 25 percent greater than total U.S. aid, three times the size of Germany's aid program, and seven times the combined output of all the UN agencies (although, to be fair, UN and government aid programs consist almost entirely of grants, rather than the bank's less generous grant-loan combination). When James Wolfensohn, the outgoing bank president, visits one of the borrowing countries, he is often treated like a head of state -- no surprise given the bank's financial clout in aid-dependent nations.
In terms of global governance, the bank's financial strength is a huge asset. Whenever a crisis demands an immediate big-money response, the United States and its allies, which dominate the bank's board, are quick to demand the bank's assistance. After the peso collapse of 1994, the World Bank pumped $1 billion into Mexico's financial system to help resuscitate the country. After Bosnia's Dayton accord in 1995, the World Bank led the charge for reconstruction. During the emerging-market crisis of 1997 and 1998, the bank supplied billions of dollars to the submerging Asian, Russian, and Brazilian economies. After the United States toppled the Taliban regime in Afghanistan, the bank proved its usefulness again, not least by supplying Afghanistan with an excellent new finance minister, Ashraf Ghani, an ex-World Bank economist. Most recently, in the wake of Asia's tsunami, the bank pledged a quarter of a billion dollars to affected regions before the Bush administration had even woken up to the magnitude of the crisis.
Beyond the brute fact of its financial strength, the bank's influence on development thinking gives it a key role in managing globalization. Its staff of 10,000 forms the greatest concentration of bright development experts anywhere. Its chief economists are often world-class figures: the 1990s featured Lawrence Summers, later the U.S. treasury secretary and president of Harvard, as well as the Nobel laureate Joseph Stiglitz. For better or (sometimes) worse, the bank's shifting intellectual fashions -- the integrated rural development of the 1970s, the macroeconomic adjustment of the 1980s, the current strategy of focusing assistance on a short list of countries with good policies -- have defined the outlook of the global development profession. The bank, in short, is at the forefront of one of the world's most critical challenges: how to turn a sliver of the rich world's wealth into progress against poverty.
But despite its continued status as a financial and intellectual powerhouse, the World Bank is endangered. Critics on both the left and the right are pressuring the bank to curtail the very activities that give it financial clout, while forcing on it restrictions that damage its effectiveness and professionalism. If they get their way, the bank will face a gradual decline into mediocrity. The challenge for its next president will thus be stiff: waking the world up to the risk of losing the World Bank at a time when it is more needed than ever.
THE TROUBLE WITH DEBT RELIEF
To understand the vulnerability of the World Bank, you have to consider its finances. The bank, after all, really is a bank: its core operation raises capital by selling bonds to investors in the rich world, then lends the money to developing countries at a slight profit. But in addition to such commercial lending, the bank has a subsidized window: rich countries donate money to its kitty every three years, and the money is lent out to developing nations. The terms of these "soft" loans are highly generous, but the bank does demand repayment and charge various small fees. The profits on commercial lending and these fees -- plus investment earnings generated by accumulated capital -- cover the World Bank's administrative costs.
This financial structure has served the bank well over the years, which is why the bank is far more professional than UN agencies. Because it does not depend entirely on the unreliable largesse of rich governments, it can afford a staff of hard-driving Ph.D.'s who would not be there if they were not paid handsomely. Recently, however, both parts of the bank's operation -- the commercial lending on the one hand, the soft loans on the other -- have faced attacks from both the left and the right, as well as pushback from some borrowers.
Criticism of the bank's soft-loan operation arises because the weakest developing countries -- those that qualify for soft loans -- have trouble repaying them. Up until the 1990s, this problem was papered over with a policy of issuing enough new loans so that the old loans could be repaid and relying on donor governments to make grants that flowed back to the bank as debt payments. But in 1996, the bank finally acknowledged that many of its debts were not payable. In response to a left-wing chorus (now echoed, curiously, by the Bush administration), it promised to forgive some. Then, in 1999, it forgave a few more. And now it faces calls for a third, and far more radical, round of debt relief: antipoverty groups such as Oxfam are demanding that the bank cancel 100 percent of its claims on 33 highly indebted poor countries (HIPCs).
From the point of view of poor countries, debt relief is welcome. But from the point of view of the World Bank, debt forgiveness today means less money to make future loans. Currently, a fifth of the bank's new soft loans are paid for with repayments on past loans, including from countries such as China or the Philippines that have, with the World Bank's help, grown rich enough to graduate out of soft lending. When they peak 20 years from now, repayments are expected to finance fully half of the bank's new soft lending. Forgoing some or all of these "reflows" would be a blow to the bank's financial model.
Past versions of debt relief have protected the bank by having rich governments compensate the soft-loan fund for lost repayments. The British government is currently touting a proposal that follows this model. The Bush administration, however, has a different plan: that the bank cancel debts on its own, without compensation. If this proposal is extended to the 33 HIPCs, in 2025 the bank's soft-loan window will be a fifth smaller than it would otherwise be. The Bush administration also wants the bank to convert its soft loans into grants, depriving it of yet more repayments. In 2003, under pressure from Washington, the bank started to make grants from its soft-loan fund; over the next three years, grants will make up 30 percent of the fund's transfers. The financial consequences of this shift will accumulate gradually, because the bank's soft loans require no repayment in the first decade. But by 2035 the soft-loan kitty will have shrunk by a tenth as a result of the switch to grants, and the shrinking will continue thereafter.
So the combination of Bush-style debt relief and grants, with no new support from rich governments, will undermine the bank's ability to put fresh money on the table. This weakening, moreover, could set off an unstoppable vicious cycle. If HIPCs have their debts canceled, other poor countries and their civil-society advocates may demand equal treatment, depriving the bank of even more resources. If some countries get the benefit of grants instead of loans, more may soon demand them. And if the bank has less money, its professional excellence will decline -- triggering further deterioration of its ability to attract funding. Rich countries' current willingness to contribute to the World Bank depends on its status as a large and sophisticated provider of credit, which sets it apart from smaller grant-making government agencies. If the bank shrinks and provides grants, its special attraction fades. The U.S. Congress and European parliaments may decide that they prefer to support their own national aid efforts.
Once you start picking at the bank's intricate mechanism for financing soft loans, it is not hard to imagine the whole system unraveling. The bank could fall into the kind of low-performance, low-resource equilibrium that characterizes most UN agencies.
OUT OF CHINA?
Even more ominous than the threat to the bank's soft-loan wing is the threat to its commercial operation. And again the challenge comes from a curious alliance of liberals activists and conservatives.
Free-market economists have long argued that the commercial window of the bank has become obsolete. In 1990, Stanford's Jeremy Bulow and Harvard's Kenneth Rogoff advanced an early version of this argument. A decade later, their view was echoed by a congressional commission on international institutions headed by Carnegie Mellon's Allan Meltzer. Their case is that the bank was designed for a world of capital controls and infant financial markets in borrowing countries -- a world in which there was a clear role for an institution that borrowed money on Wall Street and passed it along to developing nations. But now, the better-off developing countries that borrow commercially from the bank -- China, Mexico, Brazil, and so on -- can access private capital on their own; if one of these governments wants to build hospitals, it can sell bonds in the United States or Europe. The World Bank, the argument goes, should therefore let private capital markets finance development without its mediation.
Many conservatives charge that in addition to being obsolete, the World Bank's commercial lending may actually harm developing countries. Bulow and Rogoff argue that the availability of World Bank credit -- which remains cheaper than credit from profit-seeking private lenders -- encourages developing countries to overborrow, heightening the risk of financial crisis. They cite Argentina as an example: in the years leading up to the 2001 default, the bank plowed capital into Argentina. Yet as Paul Blustein shows in his new book, And the Money Kept Rolling In (and Out), it was private lenders who were recklessly stuffing credit down Argentina's throat during the mid- to late 1990s, marketing the country's bonds with the same overheated hype that inflated the technology bubble. World Bank lending was at most a marginal contributor to this dynamic.
Bulow and Rogoff also argue that the bank should cease making commercial loans because they conceal a subsidy. The bank raises cheap money thanks to its AAA rating, which in turn reflects rich countries' pledge of "callable capital" to the bank -- in other words, rich countries provide free insurance to the bank's commercial operation. If borrowers threaten to default on the bank's loans, rich shareholders can use their political leverage to beat them into line or even provide bilateral grants that make default unnecessary. In the Bulow-Rogoff view, this hidden subsidy makes the bank's commercial lending suspect -- especially when it is to countries in no obvious need of any subsidy, such as booming China.
Yet even though this "free insurance" claim is true, the value of the insurance is only significant when the bank lends to countries with a high risk of default -- a category that excludes robust borrowers such as China. So, in fact, the "hidden subsidy" that troubles Bulow and Rogoff has an attractive built-in adjuster: financially strong countries get no subsidy of any size, while weaker countries -- the ones that deserve a subsidy -- do. And to the extent that the bank's commercial lending locks rich countries into a free-insurance subsidy to poorer ones, what is not to like? Rich countries need to be arm-twisted into giving more aid, especially aid that is given out in a coordinated, multilateral fashion.
The fundamental response to this case against the bank's commercial window, however, is that commercial lending is crucial to the bank's financial health. That the financial advantage of commercial lending so often goes unmentioned is a measure of the world's indifference to such a key global institution. For the price of a small implicit insurance premium, the United States and its allies keep the World Bank active in strong developing countries, allowing it to earn a profit on its loans and therefore to sustain the professional standards that make it an important tool of U.S. and European foreign policy.
THE LEFT-WING OBJECTION
This free-market case against the World Bank's commercial activities has gained credence among many in the Bush administration. At the same time, it has been reinforced by left-wing critics who attack commercial lending for their own reasons. It is this confluence of right and left that threatens the bank's commercial lending.
The left-wing case is not that private capital should be left to finance development on its own; it is that the bank should finance a utopian version of development. The bank's lending, in the left-wing view, should be tied to exacting environmental and social standards: it should do no harm to rain forests, it should not disturb the lifestyles of indigenous peoples, and it should be entirely untainted by corruption. These goals are laudable. But the left has driven the bank to build cumbersome environmental, social, and anticorruption "safeguards" into its projects that, despite the good intentions behind them, ultimately hinder progress in these areas.
If you count the compliance costs incurred by borrowers, such safeguards raise the cost of the bank's commercial lending by as much as $300 million a year. For countries such as Brazil, China, or South Africa, which have the option of borrowing private capital, these costs and the associated hassle can make World Bank loans effectively more expensive than those of private lenders, even with the bank's lower interest rates. The consequences of this have begun to show up in the bank's loan portfolio. Between 1995 and 1997, the bank's commercial-lending operation pumped out a bit more than $15 billion per year; in 1998 and 1999, the volume jumped to about $20 billion a year because of bailout lending during the emerging-market crisis. But starting in 2000, something extraordinary happened: the bank's commercial lending slumped to around $11 billion -- a drop of nearly a third from precrisis levels. And the sharpest reduction came in the type of lending to which the bank is best suited: funding for large infrastructure projects that require technical sophistication and long-term financing. For it is such projects that are most likely to fall foul of environmental and social safeguards.
In the four years since this collapse, the bank has struggled in vain to build back to previous commercial-loan volumes. A team of officials is trying to tackle the cumbersome internal procedures that make the bank unattractive to clients, but progress has been glacial. Any proposal to loosen an environmental or social safeguard triggers opposition from civil-society activists, who often have the ear of the bank's rich-country board members in a position to block action. This activist resistance frequently has a perverse effect: when the bank's environmental standards are so demanding that borrowers prefer to seek money elsewhere, dams and roads are built without the bank's involvement, which means the end of oversight altogether. But despite its self-defeating quality, the activist resistance continues anyway, making it nearly impossible to streamline internal procedures and revive lending.
The bank, under attack from both the left and the right, thus faces the prospect of attrition in both its soft and its commercial lending. Only its third source of income -- the investment profits on its accumulated capital -- promises to continue at the current level. These investment profits come to around $1 billion a year, far less than the bank needs to sustain operations. As of 2004, its administrative budget was $1.7 billion, and on top of that the bank was expected to divert $300 million of its commercial-lending profits into its soft-loan fund and $240 million to help finance the 1996 and 1999 rounds of debt relief. The bank, as it is currently structured, has to earn around $1.2 billion a year over and above its $1 billion endowment income. If a dwindling loan portfolio makes that impossible, it will be forced to cut costs and give up its exacting professional standards.
WRESTLING WITH THE OCTOPUS
The single biggest obstacle to efforts to rally the world to the bank's defense is the perception that the institution is a sprawling mess, sluggish and unfocused. If the bank were truly a mess, the task for its next president would be simple: fix the management chaos, and the financial troubles will become easier to deal with. Most incoming World Bank presidents have acted on this theory. Following Barber Conable's dramatic attempt at reorganization in the 1980s and Lewis Preston's persistent tinkering in the early 1990s, Wolfensohn sought to revitalize the bank with private-sector management ideas. But all of these reformers have discovered that the scope for improving the bank's management is limited: most of the institution's shortcomings reflect forces that its president can barely influence -- the result of the demands of the same people who decry its failures.
The most common criticism of the bank is that it is sluggish. The charge is in many ways fair: although the bank is more efficient than most multilateral agencies, it can still take two years to design and get a project through the board before implementation even begins. Part of the reason for this sluggishness is that no profit motive compels speed. But it is also that social, environmental, and anticorruption safeguards require all manner of time-consuming precautions. (In the case of one especially sensitive project, the bank commissioned an environmental and social impact assessment that ran to 19 volumes.) This sort of slow perfectionism cannot be corrected by the bank's management alone. The safeguards exist because the bank's critics have lobbied the U.S. Congress and other legislatures to demand them. Since the bank depends on these political masters for contributions to its soft-loan kitty, it is hard-pressed to resist them.
The bank is also slow because of its board, the group of 24 government officials who represent its lending and borrowing shareholders. Corporate boards tend to meet once a month at most; their officers are part-timers who seldom challenge the chief executive. The World Bank's board, in contrast, holds formal sessions twice a week and informal meetings on most other days; nearly all its members devote themselves to the World Bank full time, and they are supported by busy teams of bright officials from their various finance ministries who are temporarily posted to the bank. The board members, in turn, report to government departments in their home capitals, where more mandarins oversee the bank's overseers. This vast, far-flung machinery generates a constant flow of queries and directives, and the bank's beleaguered staff is forced to respond with e-mails, briefings, phone calls back and forth, and sometimes with doorstop-sized reports justifying the bank's activities. The bank's slowness, in other words, reflects a governance structure that the new president cannot hope to change without considerable help from the bank's key shareholders.
A similar conclusion holds for another familiar critique of the bank: that it is insufficiently focused. Four years ago in these pages, Jessica Einhorn pointed out that the bank has spread into sector after sector over its 60-year history and almost never withdrawn from one. But once again, it is important to ask why the bank has taken on such a bewildering range of projects. It is not simply that self-aggrandizing bank bureaucrats are bent on expanding their power; it is that shareholder governments are forever driving the bank into new areas -- sometimes against the judgment of its leaders and staff.
In 1994, for example, the bank's bosses tried to resist U.S. pressure to get involved in postwar Bosnia. But the Clinton administration got its way, and the bank obediently plunged in, adding postconflict reconstruction to its many other specialties and setting a precedent that later sucked the bank into Kosovo, East Timor, and Afghanistan. In 2000, to cite another example, the bank was not especially active in education. But the Clinton administration, acting in alliance with Oxfam, embarrassed the bank into redoubling its effort in this field, and when rich countries launched a drive for universal primary schooling, they turned to the World Bank to lead it. Indeed, scarcely a year goes by without the group of highly industrialized nations plus Russia (G-8) announcing some lofty global goal -- on HIV/AIDS, private-sector promotion, and so on -- and then turning to the World Bank to do something about it. No matter that other global institutions are already active in these areas. (Education is supposedly the province of UNESCO, and the World Health Organization ought to lead the field on HIV/AIDS.) Because the bank is more effective than these bodies, it is forever called on to expand its mission.
So the bank's lack of focus, like its sluggishness, reflects the political sea in which it swims. Its major shareholders, who often denounce the bank's failings while helping to cause them, need to experience a Pogo moment: as the character in Walt Kelly's comic strip said, "We have met the enemy and he is us."
UNDER NEW MANAGEMENT
If the United States and its allies are serious about managing globalization, they need to improve on their cavalier approach to the World Bank and other key global institutions. They should not advocate debt relief or a switch from loans to grants or demand that the bank withdraw from middle-income countries without thinking through the consequences for the World Bank's finances. And they should think more seriously about the reasons for the bank's managerial shortcomings -- especially when these shortcomings stem from their own demands.
A reevaluation should start with the bank's oppressive board structure. Even board members agree that the system is wasteful. The direct cost of the board's staff and operations runs to $56 million per year; the indirect costs are even more crippling. The microscopic second-guessing of project proposals slows business down without adding to quality; staff focus too much on the documentation needed to get proposals through the board and too little on project implementation. In a saner system, the board would meet monthly, not twice a week. And its members should be senior officials based in their home-country capitals, not resident full-timers. This remodeled board would be less likely to quibble about project details and more likely to weigh in on strategic questions -- such as what the bank can do to solidify its financial foundations.
Solidifying those foundations is going to take political as well as financial capital. It will require facing down the activists who have forced the bank to adopt excessive rules on the environment, corruption, and the protection of indigenous peoples. It will involve standing up to these lobbies when they gang up against particular bank projects. In one notorious case five years ago, lobbyists persuaded Congress to protest a bank project in China, which was said, on the basis of no evidence, to threaten Tibetan interests. Rather than defend the bank, the Clinton administration caved -- a decision with large financial consequences. Over the next two years, an exasperated China cut its borrowing from the bank by two-thirds, and the bank was forced to adjust to the near loss of its biggest and most creditworthy client. If the institution's new president is to succeed, there must be no more fiascos of this kind. The bank must not be forced to drop projects because of baseless activist campaigns, and it must be given political cover in Congress and in European parliaments so that it can streamline its safeguards.
Making this happen will take a fundamental shift in the attitudes of rich countries. The bank's leading shareholders will have to recognize that they have set the institution up for failure. They have declared grand development objectives, then done little to support the bank in its efforts to achieve them. They have nobly proclaimed utopian goals, then left the bank to take the blame for not advancing them. Such hypocrisy has set the world's best development institution on a course of steady but preventable decline. If Washington and its allies are serious about managing globalization, this decline must be stopped.