Southern-Led Development Finance (Rethinking Development) [1 ed.] 1138391247, 9781138391239, 9781138391246, 9780429422829

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SOUTHERN-LED DEVELOPMENT FINANCE

Southern-Led Development Finance examines some of the innovative new south-south financial arrangements and institutions that have emerged in recent years, as countries from the Global South seek to transform their economies and to shield themselves from global economic turbulence. Even before the Covid-19 crisis, it was clear to many that the global economy needed a reset and a massive increase in public investment. In the last decade southern-owned development banks, infrastructure funds, foreign exchange reserve funds and Sovereign Wealth Funds have doubled the amount of long-term finance available to developing countries. Now, as the world considers what a post-Covid-19 future will look like, it is clear that Southern-led institutions will do much of the heavy lifting. This book brings together insights from theory and practice, incorporating the voices of bankers, policymakers and practitioners alongside international academics. It covers the most significant new initiatives stemming from Asia, tried and tested examples in Latin America and in Africa, and the contribution of advanced economies. Whilst the book highlights the potential for Southern-led initiatives to change the global financial landscape profoundly, it also shows their varied impacts and concludes that more is needed for development than just the technical availability of funds. As governments and businesses become frustrated by the traditional North-dominated mechanisms and international financial system, this book argues that southern-led development finance will play an important role in the search for more inclusive, equitable and sustainable patterns of investment, trade and growth in the post-Covid landscape. It will be of interest to practitioners, policy makers, researchers and students working on development and finance everywhere. Diana Barrowclough is Senior Economist at UNCTAD, based in Geneva, Switzerland. Kevin P. Gallagher is Professor of global development policy in the Frederick S. Pardee School of Global Studies and Co-Director of the Global Economic Governance Initiative at Boston University, USA. Richard Kozul-Wright is Director of the Globalisation and Development Strategies Division in UNCTAD, Switzerland.

Rethinking Development

Rethinking Development offers accessible and thought-provoking overviews of contemporary topics in international development and aid. Providing original empirical and analytical insights, the books in this series push thinking in new directions by challenging current conceptualisations and developing new ones. This is a dynamic and inspiring series for all those engaged with today’s debates surrounding development issues, whether they be students, scholars, policy makers and practitioners internationally. These interdisciplinary books provide an invaluable resource for discussion in advanced undergraduate and postgraduate courses in development studies as well as in anthropology, economics, politics, geography, media studies and sociology. Innovation for Development in Africa Jussi S. Jauhiainen and Lauri Hooli Women, Literature and Development in Africa Anthonia C. Kalu Rural Development in Practice Evolving challenges and opportunities Willem van Eekelen Using Evidence in Policy and Practice Lessons from Africa Edited by Ian Goldman and Mine Pabari Southern-Led Development Finance Solutions from the Global South Edited by Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright

For more information about this series, please visit: https://www.routledge.com

SOUTHERN-LED DEVELOPMENT FINANCE Solutions from the Global South

Edited by Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright

First published 2021 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 52 Vanderbilt Avenue, New York, NY 10017 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2021 selection and editorial matter, Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright; individual chapters, the contributors The right of Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright to be identified as the authors of the editorial material, and of the authors for their individual chapters, has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks, and are used only for identification and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging-in-Publication Data Names: Barrowclough, Diana, editor. | Gallagher, Kevin, 1968– editor. | Kozul-Wright, Richard, 1959– editor. Title: Southern-led development finance : solutions from the Global South / edited by Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright. Description: Abingdon, Oxon ; New York, NY : Routledge, 2021. | Series: Rethinking development | Includes bibliographical references and index. | Identifiers: LCCN 2020015964 (print) | LCCN 2020015965 (ebook) | ISBN 9781138391239 (hardback) | ISBN 9781138391246 (paperback) | ISBN 9780429422829 (ebook) Subjects: LCSH: Economic development—Developing countries. | Economic development—Finance. | Development banks—Developing countries. | Finance—Developing countries. | Developing countries— Foreign economic relations. Classification: LCC HC59.7 .S5963 2021 (print) | LCC HC59.7 (ebook) | DDC 332.09172/4—dc23 LC record available at https://lccn.loc.gov/2020015964 LC ebook record available at https://lccn.loc.gov/2020015965 ISBN: 978-1-138-39123-9 (hbk) ISBN: 978-1-138-39124-6 (pbk) ISBN: 978-0-429-42282-9 (ebk) Typeset in Bembo by codeMantra

CONTENTS

List of illustrations List of contributors List of acronyms

vii xi xv

Introductory issues and roadmap to Southern-led development finance 1 Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright PART 1

Southern-led development finance – rationale, innovations and implications 19 1 Solidarity and the South: the new landscape of long-term development finance and how to support it 21 Diana Barrowclough and Ricardo Gottschalk 2 The new development banks and the financing of transformation in Latin America and the Caribbean 49 Rogério Studart and Luma Ramos PART 2

Long-term finance – banks, funds and other sources of private and public investment 3 The ‘new’ in the New Development Bank and implications for Africa Talitha Bertelsmann-Scott and Cyril Prinsloo

83 85

vi Contents

4 The neoliberal transformation of development banking: the Indian experience C. P. Chandrasekhar 5 Chinese development finance in the Americas Kevin P. Gallagher 6 Scaling up finance for the sustainable development goals: experimenting with South–South models of multilateral development banking Ricardo Gottschalk and Daniel Poon 7 A connected and sustainable future – comparing lessons from Southern-led regional banks and networks, CAF and the Islamic Development Bank compared Rohini Kamal and Rebecca Ray

109 123

153

181

8 Towards a regional financial architecture: the East Asian experience 205 Mah Hui Lim PART 3

Regional transformation and growth in practice – it’s more than money 9 Industrial structure, intra-regional trade and financial cooperation in South America: challenges, links and hidden opportunities André Biancarelli, Célio Hiratuka and Fernando Sarti 10 Physical integration in Latin America, a review of recent experiences and policy lessons Ricardo Carciofi and Romina Gayá

223

225

249

Index 293

ILLUSTRATIONS

Figures 1.1 International loans by Southern-led national banks already dwarf the total loans of multilateral development banks (Year 2016, $US billion) 1.2 Turning South – the new center of gravity of developmental finance 2.1 Infrastructure spending as % GDP 2.2 Infrastructure investment levels across LAC 2.3 Financing of public partnerships in Latin America 2.4 Costs of BNDES loans 2.5 AIIB board of directors 3.1 Nigeria’s external debt 3.2 High-level overview of the NDB’s governance structure 4.1 Issues of new equity and corporate bonds as % of GDP 4.2 Share of private placements in corporate bond issues (%) 4.3 Outstanding corporate debt as % of GDP 4.4 Share of debt securities outstanding by principal issuers (%) 5.1 The consortia approach 5.2 Chinese development finance compared 5.3 Regression equation 6.1 Total disbursements and private co-financing, selected MDBs, 2016 6.2 Loan levels and gearing ratios, selected MDBs and NDBs 7.1 Country representation in governance, CAF, and IADB 7.2 Credit-receiving countries, CAF, and IADB, 2006–2015 7.3 IsDB shareholders (%)

24 27 56 57 58 68 71 93 98 115 115 116 117 127 133 138 157 165 184 185 186

viii Illustrations

7.4 IsDB group cumulative financing% since inception for top shareholding countries 187 7.5 IBRD percentage total shares 2015 188 7.6 Infrastructure finance as a share of total approvals, CAF, IsDB, and IADB 195 7.7 Sustainable infrastructure finance as a share of total approvals, CAF, IsDB, and IADB 195 7.8 IsDB infrastructure finance by year and sector in million US$ 2000–2016 198 8.1 Net financial flows for three ASEAN countries, 1990–2013 207 8.2 Growth of Asian local currency bond markets (excluding Japan) 212 8.3 Foreign holdings of LCY government bonds, 1998–2015 212 8.4 Percent change in equity indices of five ASEAN countries 215 9.1 World trade (exports) index, January 2005−January 2015 (2005 = 100) 227 9.2 Capital flows to emerging market economies as a share of GDP, 2000−2016 228 9.3 Current account as a % of GDP, terms-of-trade index (2010 = 100) and real effective exchange rate (2005 = 100), selected countries, 2000–2014 230 9.4 Industrial production index, 2000−2014 ( January 2005 = 100) 231 9.5 Exports, imports and the trade balance of manufactured goods in selected South American countries, 2000−2014 234 9.6 FDI flows by region: UNASUR, the world and developing economies, 1990–2014 (%) 243 9.7 Ratio of FDI to GFCF in UNASUR, developing economies and the world, 1990−2014 (%) 244 10.1 Latin America intra and extra-regional trade. Exports and imports. Simple average, 2014 255 10.2 South America: integration and development hubs 264 10.3 FOCEM: Regular contributions and fund availability by member country and Program IV (2015 budget) 273 10.4 International Network of Mesoamerican Highways (RICAM) 279 10.5 Exports/total generation 280 10.6 MIDP institutional design 283

Tables 1.1 A significant change in scale and scope – the new Southernled landscape 23 1.2 Stronger together – credit ratings of selected institutions and their member countries 30 1.3 Southern-led initiatives for long and short-term finance by main goal 42

Illustrations  ix

1.4 Main features of selected development banks discussed in the chapter 2.1 National development banks in LAC: selected operational and financial indicators-2016 2.2 A comparison between new and existing multilateral development banks 2.3 NDB – overall and corporate governance 3.1 NDB executive positions 3.2 First seven projects financed by the New Development Bank 3.3 International CRAs – BRICS and select African markets 5.1 China’s global funds 5.2 Country distribution of Chinese development finance 5.3 Largest loans 5.4 Green development finance in Latin America 5.5 Variable description 5.6 Regression results 5.7 China’s oil-backed finance in LAC 5.8 Thematic coverage of ESS 5.9 ESS procedures 6.1 Loan-to-equity ratios, selected MDBs, 2009–2016 6.2 China: Selected national, bilateral and regional investment funds 7.1 Selected balance sheet items, CAF and IADB, in millions of US$, as of year-end 2015 7.2 Sector distribution of CAF and IADB lending, 2011–2015 7.3 IsDB OCR infrastructure approvals by year from 2000–2016, by sector 7.4 World Bank and IsDB projects in IsDB member countries (million US$) 7.5 Infrastructure sector shares IsDB and World Bank in IsDB member countries 8.1 Selected financial indicators of ADB, EIB and BNDES 9.1 Annual compound growth rate of manufacturing, and valueadded as a share of GDP, selected South American countries (%) 9.2 Share of geographic destinations in South America’s exports of manufactured and non-manufactured goods, 2000, 2008 and 2014 (%) 9.3 Share of South America’s manufactured goods in its total exports, by destination (%) 9.4 Share of manufactured goods in total imports of selected South American countries, by origin (%) 9.5 South America’s imports by origin, 2000, 2008 and 2014 (%) 9.6 COSIPLAN’s portfolio of projects, 2015, by axis of development and integration 9.7 COSIPLAN’s portfolio of projects by subsector, 2015

43 61 70 72 97 101 105 129 134 134 135 139 140 141 148 148 164 170 190 197 198 199 200 218 232

235 236 236 237 246 247

x Illustrations

9.8 COSIPLAN’s portfolio of projects: funding sources, 2015 247 10.2 Latin American membership to regional trade and integration agreements (selected countries) 254 10.4 FOCEM programs: description, goals and approved resources 272

CONTRIBUTORS

Diana Barrowclough  is a Senior Economist in UNCTAD Division on ­ lobalization and Development Studies. She led the project on south-south reG gional financial integration on which this volume is based, in addition to co-authoring the Trade and Development Report and other UNCTAD publications. Some recent publications include ‘Southern Banks and the Green New Deal’ (UNCTAD 2020 forthcoming); ‘Solidarity and the South: New Directions in Long-Term Development Finance’ (UNCTAD 2018, Ed. with R. Gottschalk); ‘South-South Liquidity Systems - Collaboration Towards Resilience’ (Palgrave 2020). She has a PhD in Economics from the University of Cambridge. Talitha Bertelsmann-Scott is the former Head of the Regional Observatory at the South African Institute of International Affairs. She is a trade policy, regional integration, private sector development and monitoring and evaluation expert; and has extensive experience in the area of the regional integration and the regional bodies of Southern, Western and Eastern Africa, including SADC, SACU, COMESA, ECOWAS and the EAC. Her experience follows from closely researching and advising on the SA-EU TDCA and subsequent negotiations of the Southern and East African regions’ EPAs. She has also worked in the past with Christian Aid in London to develop the organisation’s position on global trade issues. Andre Biancarelli is Professor of economics at University of Campinas (UNI-

CAMP) – Institute of Economics; Researcher at the Center for Studies of Current Trend and Economic Policy (Cecon) and Coordinator of the Developmentalist Network (RedeD). He holds undergraduate, Masters and a PhD in economics from the University of Campinas. His experience in Economics includes focusing on Balance of Payments issues and International Finance. Publications in

xii Contributors

English include ‘New Features of the Brazilian External Sector Since the Great Global Crisis’ (chapter, 2017) and ‘Macroeconomic Policy for a Social-Oriented Development Strategy - The Brazilian Case’ (2016) among others. Ricardo Carciofi is currently a Research Fellow of the Buenos Aires Institute

for Research in Economic Sciences (IIEP) at the University of Buenos Aires, Argentina, and is also a Consultative Member of the Argentine Council of Foreign Relations. He was formerly Director of the Institute for the Integration of Latin America and the Caribbean at the Inter-American Development. C. P. Chandrasekhar  is Professor at the Centre for Economic Studies and Planning, Jawaharlal Nehru University. Recent publications include (with Jayati Ghosh) ‘Crisis as Conquest: Learning from East Asia’ (Orient Longman), ‘The Market that Failed: Neo-Liberal Economic Reforms in India’ (Leftword Books) and (with Simran Kumar and Kiran Karnik) ‘Promoting ICT for H ­ uman Development: India’ (Elsevier). He is a regular columnist for Frontline (titled Economic Perspectives), Business Line (titled Macroscan) and The Hindu web edition (titled Economy Watch). He is an Executive Committee member of IDEAs (International Development Economics Associates), an international network of economists engaged in the promotion of teaching and research using heterodox approaches to economic issues. Kevin P. Gallagher is Professor of global development policy at Boston Uni-

versity’s Frederick S. Pardee School of Global Studies, where he directs the Global D ­ evelopment Policy Center. He is the author or co-author of numerous books and publications including ‘The China Triangle: Latin A ­ merica’s China Boom  and the Fate of the Washington Consensus’, ‘Ruling Capital: Emerging Markets and the Reregulation of Cross-Border Finance’ and ‘The Clash of ­Globalizations: Essays on Trade and Development Policy’. He currently serves on the United Nations’ Committee for Development Policy and co-chairs the T-20 Task Force on I­ nternational Financial Architecture at the G-20. Romina Gayá is a Professor of International Economics at the Instituto de Investigaciones en Ciencias Económicas (IICE), Universidad del Salvador (USAL). She is also experienced as an Economic Consultant for international organisations, governments and the private sector. Ricardo Gottschalk is an Economist at UNCTAD, Geneva. He was previously a Research Fellow at the Institute of Development Studies at the University of Sussex, United Kingdom, where he was the director of the MPhil in Development Studies (2001–2004) and Programme Convenor of MA Globalisation and Development (2008–2009); and Principal Lecturer at the Department of Economics, Middlesex University of London, where he was Programme Leader of the BA Financial Services. Publications include an edited volume ‘The Basel Capital

Contributors  xiii

Accords in Developing Countries: Challenges for Development Finance’ (2010) and co-edited the books ‘Achieving Financial Stability and Growth in ­A frica’ (2016), ‘Inequality in Latin America: Issues and Challenges for the 21st Century’ (2006) and ‘International Capital Flows in Calm and Turbulent Times: The Need for New International Architecture’ (2003); as well as ‘Solidarity and the South: New Directions in Long-Term Development Finance’ (UNCTAD 2018, Ed. with D. Barrowclough). He holds a BA in Economics at the University of São Paulo; and MA and DPhil in Economics at the University of Sussex, United Kingdom. Rohini Kamal is a Non-resident Post-doctoral Research Fellow with the Global

China Initiative. She investigates the socioeconomic, environmental and distributional impacts of energy policies, with a focus on impacts of energy financing made by Chinese and other key regional banks and development institutions. Richard Kozul-Wright  is Director of the Globalisation and Development

­Strategies Division in UNCTAD. He has worked at the United Nations in both New York and Geneva. He holds a Ph.D in economics from the University of Cambridge UK. He has published widely on economic issues including, inter alia, in the Economic Journal, the Cambridge Journal of Economics, The Journal of Development Studies, and the Oxford Review of Economic Policy. His latest books include the Resistible Rise of Market Fundamentalism (with Paul Rayment), and, in collaboration with Kevin P. Gallagher of the Boston University, A New Multilateralism for Shared Prosperity – Geneva Principles for a Global Green New Deal. He is one of the key members of the Working Group on the Rights of Future Generations, an initiative based in Dubai, United Arab Emirates. Mr. Kozul-Wright is a frequent contributor to newspapers worldwide on economic issues: such as the Financial Times, The Guardian, Le Monde, El País, Project Syndicate, among others. Mah Hui Lim has a multi-disciplinary background in finance, economics and politics, with a BA (Honors) in Economics from the University of Malaya, a Masters in International Affairs, a Masters in Sociology, and a PhD in Development Studies from the University of Pittsburgh. He did research in and taught Politics, Sociology and Political Economy at Duke University, Temple University and the University of ­M alaya prior to becoming a banker. He is a Senior Fellow in the Asian Public Intellectuals Program of the Nippon Foundation. Dr. Lim worked in numerous international banks in New York, ­Tokyo, Hong Kong, Singapore, Jakarta and Manila. Thereafter, he served as city councilor in Penang Institute representing civil society. He is the lead ­author of ‘Nowhere to Hide: The Great Financial Crisis and Challenges for Asia’, published by Institute of Southeast Asian Studies, Singapore, 2010. Daniel Poon is currently affiliated with the IBRAC Institute of China-Brazil Studies, having previously worked as an Economist at UNCTAD, where he

xiv Contributors

carried out the research presented in this volume. He was formerly a Researcher with the North-South Institute (NSI) and a Visiting Scholar with the Institute of World Economics and Politics (IWEP) at the Chinese Academy of Social Sciences (CASS) in Beijing, as well as with Trade and Industrial Policy Strategies (TIPS) in Pretoria. Mr. Poon holds a Master’s degree from Carleton University’s School of Public Policy and Administration, and a BA from McGill University (political science and economics), with a specialisation in Chinese and Asian development policy strategies. Cyril Prinsloo is currently affiliated with the South African Institute of International Affairs, where his research focuses on infrastructure financing and development in Africa, as well as Africa’s interaction with strategic global partners such as the US, EU, China and the BRICS bloc. He is also a Fellow of the Global Governance Futures – Robert Bosch Foundation Multilateral Dialogues programme. Previously he worked as an economic development consultant, providing technical assistance and capacity building support on trade and investment, regional integration and infrastructure development to various international development partners, governments and Regional Economic Communities across Southern and Eastern Africa. He holds an MA in International Studies from the University of Stellenbosch. Rebecca Ray is a Post-doctoral Research Associate with the Global Development

Policy Center. She coordinates the Center’s research on development finance in Latin America, and is the lead editor of ‘Development Banks and Sustainability in the Andean Amazon’. Rogerio Studart is a Distinguished Associate of the Global Federation of Competitiveness Councils, Non-resident Associated Senior of Brookings Institution and Senior Academic Guest, Boston University. His publications include ‘Infrastructure for Sustainable Development: The Role of National Development Banks’, co-authored with Kevin Gallagher, Global Economic Governance Initiative research paper 007, 10/2016.

ACRONYMS

ADB ADF Af DB Afri-ID AIIB ALADI ALALC ALBA-TCP AoA ASEAN AU BNDES BoG BOT BRICS CABEI CADF CAF CAF CAN CARICOM CDB CELAC CLAIFUND CLO

Asian Development Bank Asian Development Fund African Development Bank Africa Infrastructure Desk Asian Infrastructure Investment Bank Latin American Integration Association Latin American Free Trade Association Bolivarian Alliance for the People of Our America Articles of agreement Association of Southeast Asian Nations African Union Brazil National Development Bank Board of Governors Build-operate-transfer Brazil, Russian Federation, India, China and South Africa Central American Bank for Economic Integration China–Africa Development Fund Andean Development Corporation (Corporacion Andina de Fomento) Development Bank of Latin America Andean Community Caribbean Community China Development Bank Community of Latin American and Caribbean States China–Latin American Industrial Cooperation Investment Fund Collateralized loan obligation

xvi Acronyms

CMC COSIPLAN

Consejo Mercado Común South American Infrastructure and Planning Council (Consejo Suramericano de Infraestructura y Planeamiento) CPF Promotion and Finance Commission CRA Contingent Reserve Arrangement CRA Credit Rating Agencies CRPM MERCOSUR’s Commission of Permanent Representatives CSO Civil Society Organisations DBSA Development Bank of Southern Africa DFI Development Finance Institute DRM Domestic Resource Mobilisation EBRD European Bank of Reconstruction and Development ECLAC United Nations Economic Commission for Latin America and the Caribbean EIB European Investment Bank ESF Environmental and Social Framework EU European Union EXIM Export–Import Bank FDI Foreign direct investment FOCEM Structural Convergence Fund of MERCOSUR (Fondo Para la Convergencia estructural del Mercosur) FONPLATA Financial Fund for the Development of the River Plate Basin FTAA Free Trade Area of the Americas GDP Gross Domestic Product GFC Global Financial Crisis GIF Global Infrastructure Facility GTI Inter-institutional Technical Group HIPC Highly Indebted Poor Country IADB Inter-American Development Bank IBRD International Bank for Reconstruction and Development ICA Infrastructure Consortium for Africa IDA International Development Association IDB Inter-American Development Bank IDC Industrial Development Corporation of South Africa Limited IIRSA Initiative for Integration of the Regional Infrastructure in South America (Iniciativa para a Integração da Infraestrutura Regional Sul-Americana) LAC Latin America and Caribbean LOC Lines of Credit LPI Logistics Performance Index MCCA Central American Common Market MDB Multilateral Development Bank MER Central American Regional Electric Market MERCOSUR Southern Common Market

Acronyms  xvii

MIC MIDP NAFTA NBF NDB NDB NDFI NEPAD NEPAD–IPPF NGO OAS ODA ODI OECD PAHO PFM PIDA PIDA-PAP ppp PPP RICAM RTA SAFE SDGs SICA SIECA SIEPAC SOE SRF SSA TIM UA UCS UNASUR UNECA UTF WB

Middle Income Country Mesoamerican Integration and Development Project North American Free Trade Agreement NEPAD Business Foundation National Development Bank New Development Bank National Development Finance Institute New Partnership for Africa’s Development NEPAD Infrastructure Project Preparation Facility Non-Governmental Organisation Organization of American States Official Development Assistance Overseas Development Institute Organisation for Economic Cooperation and Development Pan-American Health Organization Public Financial Management Programme for Infrastructure Development in Africa PIDA Priority Action Plan Private-public partnerships Plan Puebla Panamá International Network of Mesoamerican Highways Regional Trade Agreements State Administration of Foreign Exchange (China) Sustainable Development Goals Central American Integration System Central American Economic Integration Subsystem Central American Electrical Interconnection System State Owned Enterprise Silk Road Fund Sub-Saharan Africa International Goods Traffic Unit of Account Use of Country Systems Union of South American Nations (Unión de Naciones Suramericanas) United Nations Economic Commission for Africa FOCEM’s Technical Unit World Bank

INTRODUCTORY ISSUES AND ROADMAP TO SOUTHERN-LED DEVELOPMENT FINANCE Diana Barrowclough, Kevin P. Gallagher and Richard Kozul-Wright

Developing and developed nations alike face enormous financing challenges over the coming decades as they seek to foster structural transformation in a manner that is stable, inclusive, and green. Even before the Covid-19 crisis and lockdown policies in early 2020, it was clear to many that the global economy needed a re-set and massive increase in public investment, as it faced tipping points with respect to financial instability, economic inequality, and social unrest, and a climate breakdown. As countries around the world struggled to contain the spread of coronavirus, the social and economic pains caused by lock-down revealed long-standing cracks and dependencies that were not only unsustainable, but were also a source of fragility to all. Many commentators see the crisis as a chance to rebuild the economy in a better way, including authors in this volume. Few voices, if any, suggest this should be a private sector role – rather, around the globe, it is public banks, development banks, and regional financial institutions to whom they have turned. These institutions are the focus of this book, and in particular those from the South, as these have been by far the outstanding source of long-term, patient, and catalytic finance, and in the magnitudes required. To finance global infrastructure gaps alone in such a manner, there is a gap of 2.1% of global GDP on an annual basis from now until 2030 (Bhattacharya et al. 2019). For decades, developing nations have asked the advanced economy for financial assistance to achieve these broader goals. Such finance was sometimes promised and seldom delivered. When such financing did come, it often accentuated rather than alleviated these problems and came with tight strings attached. Over the past decade, the global south has moved to catalyze its own savings to meet its own needs on its own terms. This volume stems from the ­extraordinary trends in South-South financial cooperation of the last decade and highlights what is needed to take it to the next level. It takes a fresh approach to address some new emerging challenges on both the supply and demand side of

2  Diana Barrowclough et al.

South-South development finance, and identifies some lessons learned in the last decade to help move from “potential” to concrete outcomes for inclusive and sustainable development of the kind needed in today’s post-Covid world. As described in this volume, South-South development financing initiatives have achieved much progress in recent years: the creation of new development finance institutions (AIIB, NDB), the consolidation and expansion of existing ones (multilateral development banks such as IsDB, national development banks such as BNDES, CDB), and new investment programs (Belt and Road Initiative, NEPAD-IPPF). In a very short time, Southern-led banks have become the largest sources of development finance in some developing regions, dwarfing the traditional multilateral lenders. Southern-led and Southern-oriented banks now amount to more than $1 trillion, even without including the more than $7 trillions of dollars in Southern-owned Sovereign Wealth Funds and Foreign Reserves that could potentially be re-oriented towards development. At the same time, in a parallel and related move, the South has been setting up and strengthening mechanisms to meet official liquidity needs (FLAR, BRICS CRA, Chiang-Mai), as complement to the long-term finance instruments. In addition, South-South FDI has grown dramatically since the early 2000s. The authors gathered here include practitioners from the world of banking and finance, policymakers, and academic experts, each bringing a different perspective that links theory, case-study examples and evidences from interviews, and a pragmatic observance of political economy. Three chapters focus attention on the Asian region, where some of the most recent and largest changes have emerged; three on Latin America, which has a longer history of experimenting with different models and which has also been a major recipient of some of the Asian funds; one chapter on Africa, where the needs are greatest but financial capacities remain the least; and two chapters taking a more global overview. The chapters paint a picture of a massive change in the financial landscape, with a great deal of new potential emerging whilst at the same time noting there are still important gaps and limitations that remain. All the authors note the scale of new financial resources that are now p­ otentially available, and the particular role that development banks can play as opposed to commercial lenders or investors which are much more constrained in terms of what they can finance. Several focus on the potential for increased investment in green and climate-change oriented activities (Gallagher, Gottschalk and Poon, Kamal and Ray among others); a chapter on Chinese banking describes an innovative “consortia” approach that goes beyond the simple provision of finance to include commercial partnerships that can directly impact production and exports (Gallagher). At the same time, countries need to be ready to take advantage of the moment: almost all the authors note the need for governments to have in place a co-ordinated and coherent plan that can furnish the appropriate demand to rise to the opportunities created by the new supply. It is much more than just having some “shovel ready projects” on hand for the development banks (­although this already is a challenge in some areas), and rather countries and indeed regions need regional plans for smart infrastructure and logistics that can spur innovation

Introductory issues and roadmap to southern-led development finance  3

and inter-regional trade. Chapters by Studart, Gallagher, Carciofi, and Bertlesmann highlight the need to create institutions that can interface between lenders and borrowers to ensure the opportunities are grasped in a useful and transformative way. Even with all the new institutions and enlargened existing ones described in this volume the fact remains that scaling up is difficult, involving mismatches of timing, maturities and mandates and the needs are immense. Traditional sources do not seem able to ramp up finance as they might be expected to help meet the global challenges of the Sustainable Development Goals, and more recently, the consensus emerging for development to be Green. Countries still face massive constraints in terms of what they can finance and how. Development Banks remain under-funded for the essential heavy lifting; gaps remain in areas such as concessional finance (critical for LICs), financing for dealing with shocks, especially natural disasters which are becoming even more frequent and destructive. Long-standing essential needs such as water remain unfinanced, just as new and important areas are emerging such as the digital economy. Moreover, the phenomenal growth of South-South finance has not been even – some parts of the world remain extremely under-funded, particularly in Africa. And while the volume does not devote particular attention to the long-standing multilateral institutions, it is important to note they too are not sufficiently financed nor governed appropriately for the tasks expected of them. Unhelpful and intrusive conditionalities remain in place despite the concerns of many developing countries and the “voice” of developing countries remains well below their economic weight. Potentially only countries at their last resort and with no other funder will choose to use them.

1.  Rationale – why we need regional integration and development banks In recent years, this argument has not needed to be made as much as in the past because the potential catalytical role of banks with a long-term and more socially oriented mandate – especially public banks – has become widely appreciated once again. There is also an appreciation of the role of banks in terms of creating credit, as well as guiding it to the desired purposed (see Eurodad 2017; Macfarlane and Mazzucato 2018; UNCTAD 2019 among many others). As described in the chapter by Studart and Ramos, this reflects the rejection (once again) of the mistaken idea that banks can be nothing more than an intermediary between savers and investors. Even if some still believe that loans must be predicated by savings first – an idea that misunderstands the essential credit-creating role of banks – in developing countries this would be highly unlikely to happen because savers are for various reasons especially unwilling to lock their capital into long-term projects. A second reason this canard has been abandoned is that in developing countries, banks are too weak and fragile to bear the burden of the liquidity and maturity mismatches – which is already difficult in the most advanced and deep financial markets. Alternatively, perhaps the re-found fashion

4  Diana Barrowclough et al.

for development banking rather reflects the acceptance of the evidence – in both the north but particularly the South – of the positive contribution made by public banking in development now and in the past. The volume opens with the experience of Latin America as a region, in part because it has strongly promoted regional integration in recent decades and also because it experienced all the ups and downs of the fashion (or some would say ideology) with respect to development banking. In the first half of their chapter, Studart and Ramos set up the case for why development banking is needed in the first place, before heading into the details of the Latin American development banking experience. The authors show that during a period of history while new development banks were being created around the world, in Latin America banking was rather in decline. Ideological pressure meant that many national development banks privatized or overhauled, to the extent that the number of banking institutions virtually halved between the years 1988–2013. Those that remained had a narrower mandate. They did appear to improve efficiency, and the new expectations following the crisis of 2007–2008 that banks should play a counter-cyclical role meant that some banks were re-capitalized or profits re-­ invested, meaning they could increase lending with their own resources. However, the question remains whether this expansion is sufficiently useful to address the enormous infrastructure financing gaps in the region. The authors compare the models operating in Chile, Mexico, and Brazil, before turning their attention to the new possibilities that opened up with the emergence of big new multilateral banks from the South, in particular the AIIB and NDB. Although these big new contributors can help significantly by scaling up the financial resources available, other obstacles remain just as important, in particular, the need to create a pipeline of projects, for which particular technical and technological capacities are needed at both public and private sectors. This is lacking in most parts of the developing world. This lack could to an extent be resolved through the creation of special “origination platforms” dedicated to identifying potential projects and mitigating uncertainties associated with their early stages. It is particularly difficult in Latin America because the systematic reduction of national development banks has created a vacuum in terms of many of the muchneeded capacities. The new South-South institutions such as the AIIB and NDB could play an important role in this regard, over and above the provision simply of finance. At the same time, however, the authors warn, this can only happen if the new multilateral banks do not fall into the old prejudices and modus operandi of the historical multilateral banks. These solutions are not technical, but rather depend on the appropriate mindsets and the always needed political will.

2.  The “special offer” of banks from the south Political will and support for development banks from the south has certainly changed the landscape for long-term development finance in recent decades –

Introductory issues and roadmap to southern-led development finance  5

but does this mean that the Southern banks can live up to the high hopes placed in them? Expectations are that the new range of Southern-led financial institutions will make a dramatic difference in scaling up the availability of financial resources, especially if existing multilateral development institutions can take a leaf out of their book and make the most of their potential. Taking a broad brush approach, Barrowclough and Gottschalk show that the mechanisms and resources that are owned or controlled by the South now potentially offer trillions of dollars’ worth of support through national holdings of foreign reserves, national development banks and sovereign wealth funds, and also southern regional banks and funds – in addition to what has always been available to the south through the global multilateral World Bank and Regional banks. The center of gravity for development finance has thus shifted firmly southwards. In addition to significantly increasing the total sums of lendable finance available, the Southern banks are also lending much more quickly, arranging loans in a matter of weeks rather than months and even years. The conditionalities that are typically attached with World Bank loans are also notably absent (although this is not necessarily a good thing if it undermines environmental or labor standards). At the regional level, the sense of solidarity that is fueling the movement can have very real tangible benefits, as measured in the ability of multilateral banks to obtain credit on international financial markets at lower levels of interest or better terms than individual countries could obtain alone. The new banks also seem to be more open to partnering with the private sector, as well as being more open to support productive activities and green investments. The Southern-led banks are lending heavily to infrastructure and in particular to renewable and “green” infrastructure. However, the authors also caution about excessive optimism and note that some long-standing concerns and themes remain unchanged. Not all regions have been served equally and some of the smaller and poorer countries and regions remain extremely under financed for what is needed, in particular in ­A frica. Countries that are less likely to set up strong national banks are in turn less likely to benefit from the opportunities created by the new regional ones. Moreover, despite their efforts to scale up resources for long-term investment, Southern development banks continue often to adopt a conservative approach to lending, following quite closely to the patterns established by the old multilateral lending institutions. The three major Credit Rating Agencies have still maintained a strong grip over the international credit markets on which many banks and borrowers still depend, and their criteria for rating the banks and funds are not very transparent. As long as the banks and funds find themselves caught in the balancing act – real or perceived – between financing activities that will make a strong impact on development without making a competitive financial return, then they may not make as much difference as is hoped for. This kind of tension is also evident in the question of concessional lending, according to the authors. The historical multilateral banks have always been important in terms of providing this through their soft windows, with about 30%

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of their total lending until recently being in the form of concessional lending. However, this may change in the coming years and this is important because none of the new Southern-led banks have clear institutional set-ups to provide concessional lending, even if some levels of subsidies are provided by those banks that have treasury or central bank support. Hence, there remains much to be done to support these new institutions, to ensure they can fulfill their potential to be real game-changers. It may come as a surprise to learn that the largest source of development finance in Latin America is from China’s two global development finance ­institutions – the China Development Bank and the Export-Import Bank of China, as shown in the chapter here by Kevin Gallagher. Gallagher’s analysis shows that, contrary to the suggestions of some, Chinese development finance is complementing rather than directly competing with other forms of development and private finance. The majority of the development finance from China flows to infrastructure and energy, sectors long neglected by Western-backed financial institutions and the private sector. Moreover, Chinese finance tends to flow to countries that are neglected by those actors as well, largely concentrating in ­Brazil, Venezuela, Ecuador, and Argentina. Gallagher also notes that both Latin American hosts and Chinese investors need to work more diligently to jointly maximize the benefits of this newfound development finance and minimize the risks. Investments in large infrastructure projects are endemic to social and environmental problems, debt sustainability, and corruption. To its credit, Gallagher shows that unlike some Western counterparts China does not put policy conditions on its lending to host country governments but rather relies on host “country systems”. However, there is a difference between policy conditionalities – lending on condition of privatization, governance standards, etc. – and project-level due diligence. Many projects that China is financing are raising concerns about debt sustainability and social and environmental conflict. Many of these risks can be anticipated and mitigated with the proper due diligence policies – at the host country and the DFI level. Gallagher suggests that a South-South dialogue takes place to ensure that such policies are in place in a manner that respects mutual sovereignties and that also allows all parties to maximize benefit and minimize risk.

3.  Going in a different direction The Chinese model stands in contrast therefore with the story told in the ­chapter by C. P. Chandrasekhar which rather shows an example where a country did not take the leading role of South-South development finance that could ­otherwise have been anticipated, given its economic size, historical context, and the intellectual contribution it has made elsewhere. In India’s immediate post-­independency years, there was a strong commitment to developmental banking and the Indian financial system comprised a diverse variety of banks and financial institutions.

Introductory issues and roadmap to southern-led development finance  7

Numerous banks specialized in particular sectors or long-term activities and dedicated their technical competence and financial resources to ­agriculture, housing, shipping credit, power, tourism, renewable energy, and small industries. Many were financed directly from government budget or s­ urpluses held by the Reserve Bank of India, and hence benefitted from having a relatively low cost of capital, which in turn facilitated lending for long-term purposes at relatively low-interest rates. In the early 1990s however, it was argued these banks should also obtain resources from the capital market. Moreover, it began to be questioned whether there was any need for specialized institutions that concentrated on the longterm perspective. As Chandrasekhar describes, after some years of this, the distinction between developmental and commercial banks was blurring. This led to the argument that development banks should no longer be allowed the privilege of concessional capital and should be on the same footing as the commercial banks. (As opposed to an argument they should focus on being more developmental, as is discussed at the end of this Introduction). Next came the Indian Government’s decision to phase out the main all India development financial institutions. The emphasis changed too – with the remaining state-owned banks being expected to focus more on profitability, shareholder value and corporate governance, whilst at the same time juggling an awkward mix of developmental goals alongside the goals of neoliberalism. The upshot of these changes has been a fundamental and negative change in India’s financial structure, argues the author. It became reliant on the use of periodically rolled over short-term funds to finance longer-term debt and grew increasingly fragile. Foreign investment has been volatile, and the gap in finance available eventually filled by a sharp increase of foreign capital inflows following Quantitative Easing in the north, leading to increasing liquidity in the domestic economy and an explosion of credit. Lending increased dramatically not only to houses and consumer loans for automobiles etc., as one might expect, but also into industry and even infrastructure sectors such as steel, roads, and ports. However, Chandrasekhar warns, this is not a positive picture. First, foreign capital flows can and have dried up very quickly in other parts of the world. Second, commercial banks typically prefer to lend to short-term purposes and this high-risk strategy of lending long-term may rather reflect their belief that losses will be covered by the Government. (While government had stepped back from public investment, it had at the same time stepped forwards to encourage Public-­Private Partnerships or private investments – to the extent there appeared to be an i­mplicit sovereign guarantee to these loans). At the same time, the lack of development of a local bond market meant the corporate sector had little choice but to turn to the one remaining source of finance, the banks, for longer-term funding. Both these factors are supported by suggestions that the high number of defaults and non-performing loans would, in normal circumstances, have provoked concerns about insolvency and perhaps triggered a run on the banks.

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4.  Africa and new options In Africa, countries are looking for ways to prepare themselves better for the potential embodied in Southern lenders such as the New Development Bank and others. The chapter by Bertlesmann and Prinsloo describes the changing landscape of infrastructure finance in Africa, showing how new donors from developing countries such as China have increasingly played a critical role as an alternative to the higher interest rates and conditionalities offered by the traditional lenders such as the World Bank. The continent has mapped out its need and designed a plan, clearly articulated in the Programme for Infrastructure Development in Africa. This was endorsed officially by the heads of state of the African Union, in partnership with the New Partnership for Africa’s Development (NEPAD), the African Development Bank (Af DB), and the United Nations Economic Commission for Africa (ECA). Its overall goal is to promote socio-economic development and poverty reduction throughout Africa, through improved access to regional and domestic infrastructure networks. The most critical of these include projects in transport, energy, information and communication and of course water and the sums that are needed are large – estimated as being at least $7.5 billion annually. Hence the African continent has a plan for development, but this is not the same thing as being able to finance and implement it. The authors note that the vast sums needed are resulting in a renewed focus on involving the private sector – however following a model that has changed little over decades and relying on continued partnership with traditional multilateral development banks that have not kept pace with the changing needs and demands of today’s global environment. Unchanged from the conditions prevailing during the latter part of the last century, many multilateral development banks today continue to insist on strict loan conditions, and with layers of bureaucracy, these banks find themselves with access to large amounts of funding but deceasing calls for borrowing. Governments are instead looking elsewhere, including Official Development Assistance, the private sector and increasingly new donors and banks such as the BRICS institutions. At the time of writing, the authors note the NDB had made only a very small contribution to Africa’s infrastructure deficit. The bank’s early lending was spread across all the member nations, and in its first tranche of lending, the loan to South Africa’s electricity transmission was significantly smaller than to other countries. They suggest ways this could be increased in the future. One is to co-finance and partner with other African banks, and they seek ways to increase this in the future. They note that the NDB could work more closely with the major African banks without introducing negative elements of competition. For example, Southern Africa’s largest development bank, the DBSA, has developed a niche within the renewable energy sector and this could be expanded more widely in the region were finances forthcoming. The NDB’s use of issuing bonds through domestic markets, rather than on international bands markets, could

Introductory issues and roadmap to southern-led development finance  9

be complementary to the work of the DBSA and not competitive – because the NDB is roughly 60 times larger than DBSA it was unlikely they would be competing for funding similar projects even if raising funds on the same financial markets. Moreover, the DBSA could provide local knowledge, networks and presence to complement what was offered by the NDB. Similarly, with regard to South Africa’s Industrial Development Corporation (IDC), there appears to be a divergence in the types of activities undertaken and projects likely to receive funding, so they could be complementary rather than competitive. The IDC focuses on financing manufacturing activities. Similar examples could be found in other countries. The authors further argue that expanding the banks’ membership on the African continent should also allow for most investment into ­A frican infrastructure, and to allow the NDB to align more closely with the plans outlined for the continent by the African Union.

5.  Scaling up – new challenges, experimental responses The chapter by R. Gottschalk and D. Poon argues that most long-standing ­multilateral finance institutions are unnecessarily limiting their lending impact, by having a conservative loan approach and relying on too narrow a capital base. On the question of gearing ratios of loans to equity, the authors find that several African banks are lending at ratios of less than 2; compared to ratios of around 5 for the European Investment Bank and in sharp contrast to the Chinese Development Bank, at 11. The authors summarize various ways that banks could increase their lending capacities, even without increasing their capital. These included being allowed to relax capital requirements, to take advantage of the “headroom” that exists without putting at risk the high ratings they have been granted; or merging concessional with non-concessional windows in development banks’ balance sheets, to increase their equity capital and therefore boosting leverage capacity; and in particular making callable capital more transparent so that credit rating agencies can consider them as part of equity for calculating the gearing ratios. The main contribution of the chapter shows how the Articles of Agreement of the Asian Infrastructure Investment Bank has opened the door for increased lending in the future. Alongside the ordinary operations that are financed from “ordinary resources”, which consist of “authorized capital stock of the Bank, including both paid-in and callable shares”, the Articles also allow for special operations financed by “special funds resources”. Importantly, these two types of operations may separately finance elements of the same project or program. It remains to be seen how the AIIB will use this special feature of its AoA, but it does appear to be a way that the bank can increase its scale of project loans whilst at the same time respecting the statutory limit to its gearing ratio. The design is seen by the authors as a de jure gearing ratio that is aimed at ensuring the banks access to international capital markets, without endangering its receipt of the highest credit ratings, whilst also creating a conduit that allows for financing to

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be scaled up beyond those statutory limits. Certainly the evidence that China’s Development Bank is willing to follow a much higher gearing ratio suggests that the AIIB could also be willing to experiment with much higher ratios, over time. This finding is important because, as the authors argue, current MDBs have found that their ability to raise resources on international capital markets is constrained by their narrow capital base and their conservative lending approaches, which are designed to maintain high credit ratings. As shareholders show l­ittle appetite to increase capital, despite some encouraging rhetoric, the banks risk losing their relevance at precisely the time they are needed most. The new Southern-­led MDBs therefore may be taking a leadership role in terms of offering examples of new forms of governance and design to promote scaling up as well as through the sheer firepower of their operations. Any study of the role of the AIIB cannot ignore of course the particular role of China, as its main shareholder and with veto power that makes it seen as a new phase of China’s international engagement. However, as noted by various authors in this volume, China’s experiment with development banking did not start with either the AIIB nor the New Development Bank nor the Belt and Road Initiative. It has been providing significant financial assistance since the early 2000s, through its national development banks CDB and China Exim and other funds and programmes. All of these experiences hint at its willingness to experiment with different forms of institution building and different forms of South-South and multilateralization finance.

6.  Benefits of being borrower-led Perhaps one of the most important points for scaling up and taking on a more diversified portfolio of loans is that the Southern banks are essentially borrower-led and members have a shared vision. Solidarity is more than just a mantra; it has tangible benefits including local expertise and understanding that can catalyze lending in instances that might otherwise not attract finance, as well as high repayment rates of loans once taken. Being borrower-led also means that banks are well positioned to react to governments’ increased demand for long-term investment during periods of weak economic growth, and to bridge the gap between periods of high political will and periods of full government coffers. This counter-cyclical role is well described in the chapter by Kamal and Ray, which shows that how two Southern-led development banks – the Development Bank of Latin America (CAD) and the Islamic Development Bank (IsDB) – compare positively compared to northern-led banks the Inter-American Development Bank (IADB) and the World Bank. Being borrower-led means the banks can respond to borrower demand, even though their relatively lower levels of callable capital and low-credit ratings of member nations act to limit their ability to raise capital on international capital markets. To address some of these limitations, Kamal and Ray examined banks’ infrastructure loans and in particular clean investment loans, using methodology

Introductory issues and roadmap to southern-led development finance  11

developed by the UNFCCC Clean Development Mechanism to compare their relative performance. The authors find the Southern banks have been more creative, maintaining multiple lending and investment windows in the same institution, which allows smoother collaboration and blending instruments to support hard to finance or complex projects. The Southern banks were also found to participate in multilateral funds, even as small minority partners, thereby enabling them to learn from their larger counterparts about new types of loans and projects. Being borrower-led further endowed them with access to in-depth knowledge of potential risks of large projects, including environmental and social risks that could support lending; and relying on local staff and experts gives greater flexibility that could also support lending. At the same time however, the authors note that some important risk reducing mechanisms are lacking, including procurement oversight and dispute resolution mechanisms.

7.  Evolving processes As noted in the Latin American examples, the evolution of development banking occurs not in a vacuum but strongly nested within broader political contexts. The political economy processes underlying the emergence of some of largest new Southern-led institutions is explored in the chapter by Mah Hui Lim. A former banker, his practical insights may be especially prescient given the potential some see in today’s confluence of economic pressures and instabilities, for a repeat of the economic and financial crises of the last decade. Lim describes the hopes that were initially placed in the Bretton Woods institutions when created in 1945, and the breakdown and disappointments that followed the financial deregulation and liberalization in the 1980s and 1990s. Starting with the Latin American debt crisis in the 1980s, followed by the Mexico in the mid-1990s, and then Asia and Russia in the late 1990s. The Asian crisis in particular was not the boom and bust of a normal business cycle, he argues, but rather the result of speculative and erratic financial flows, the dramatic reversal of which led to a drastic fall in currencies that ballooned foreign currency debt and bankrupted corporations and banks alike. The medicine given by the IMF to Indonesia, Thailand, and South Korea was once again the “one-size-fits-all” prescription that had been used in Latin America, despite the fact the causes of crisis were different in the Asian case. As Lim argues, among the many hard lessons the Asians learned from this experience were the need for self-reliance, to lessen dependence on the international financial institutions, and to strengthen regional cooperation and resources to deal with crisis. This provided the impetus for Asian nations to search for an alternative regional financial architecture. Before the crisis, there had been no structure or forum to deal with regional financial issues, except for a forum of central bankers that had been established in 1991 and really only became active in the years after the crisis. Lim has written elsewhere about the “defensive” crisis-prevention mechanisms instituted in Asia, such as the Chiang Mai Initiative, whose purpose is

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to cooperate and pool resources together to overcome regional economic and financial crisis. These are briefly described but the chapter rather focuses on the “developmental” mechanisms, whose purpose is to establish policies and institutions that promote greater economic integration and higher growth in the region. Both, he notes, are important and complementary. Thus the chapter provides a former professional banker’s view of the important mechanisms that emerged, including the ASEAN+3 Finance Ministers Meeting, at which the creation of an Asian Bond Markets Initiative was discussed alongside other financial and fiscal issues; and the role of the Executive’s Meeting of East Asian and Pacific Central Banks EMEAP, which is an active promotor of Asian bond markets. The importance of exchange rate mechanisms and capital flows co-ordination is also described, because unregulated flows of “hot money” can not only cause harmful appreciation of currencies, they contribute to boom and bust modes and short-term debt that provokes instability and fragility that undermines the developmental objectives of increasing trade and investment in the region. The main vehicle chosen by the Asian policy leaders to achieve this more developmental objective is through the development and integration of the region’s financial system, and in particular through the development of a regional bond market. It was argued that this could be a useful way not only to recycle the region’s massive foreign reserves, but also to provide the long-term loans needed for infrastructure investment and capital development, and which were under-provided by the existing banking system which focused only on shortterm loans. Lim describes how the Asian bond market grew extremely rapidly but he warns that this is in fact a potential source of great instability to the region. It is not true to argue that having bonds in local currencies is a protection against currency reversals, because local bonds can be purchased by foreign as well as domestic investors. The second part of the chapter focuses on the role of regional development banks, and Lim argues that in their zeal to correct Asian economies’ over-reliance on the banking system, there was inadequate attention paid to the risks associate with direct financing through the capital markets vis-à-vis the benefits of using indirect financing through intermediary banks. The lessons that long-term credit banks played in the economic development of Japan, South Korea, and Germany have not been sufficiently well understood. The successful emergence of the Asian Infrastructure Investment Bank in 2015, despite strong resistance from the United States is contrasted with Asia’s inability to set up an Asian Monetary Fund in 1997, when the United States also objected. It signals the declining influence of the United States in the international financial system. However, the AIIB is focusing only on large scale infrastructure, and more development banks are needed especially to support industry – potentially a regional bank for micro, small, and medium enterprises could be established. Moreover, a question still remains about the business model these banks should follow – what is the acceptable level of profit, and should profits be maximized at the expense of the public good? Lim concludes by arguing that regional and

Introductory issues and roadmap to southern-led development finance  13

national development banks should adopt the concept of socially acceptable rate of return rather than maximizing shareholders’ returns. They should undertake projects that are financially sound, ecologically sustainable, promoting long-run growth and welfare maximizing. They should also be run by professionals, without political interference, being in the best practices of corporate governance of both the public and private sectors combined.

8.  What else is needed – more than just money The need for many capacities and capabilities over and above that of finance is a message further reiterated by other authors in this volume. Chapters by Barrowclough and Gottschalk, Gallagher and Studart, all argue that support is needed is the demand side of the equation, which is just as important in the development finance equation as the supply side that is being addressed by the new sources of funding becoming available. For some this could be embodied in the use of national country systems, “consortia” partnerships between banks, business and governments, or the creation of special origination platforms; other equally important measures to support the demand side are covered in the chapter by C ­ arciofi and Gayi. Their study on three distinct experiences of physical integration and connectivity in Latin America shows that investing in regional infrastructure is not just a technical question that can be dealt with by infrastructure specialists. It depends crucially also on co-ordination and planning at the level of sectoral policies, project selection, regulatory convergence as well as investment plans and financing mechanisms. This is a challenge that involves not only financial and institutional resources but also considerable reserves of political capital as well. The three Latin American examples described by Carciofi and Gayi were different in their ambitions and members, but some common themes also stand out that are interesting for the future. The Initiative for the Integration of Regional Infrastructure in South America (IIRSA), which aimed to integrate transport, energy, and communications in South America, began with a rather informal mechanism of inter-governmental dialogue and cooperation. In time this was then supported by the creation of the regional inter-governmental body UNASUR, which helped to solve some of the inherent obstacles when integrating national policies with regional agreements. (It did not however succeed, in the authors’ view, to solving other obstacles that would have helped with the goal of physical inter-connectivity such as addressing the lack of intra-regional trade and intra-industrial exchange or cross-border investment that was also needed). The MERCOSUR Structural Convergence Fund (FOCEM) focused more on the Southern Cone of Latin America, and aimed to reduce disparities between larger and smaller countries and to promote structural convergence. Finally, the Mesoamerican Integration and Development Project (MIDP) aimed at the central region, again focused on regional investments in transport, energy, and telecommunications.

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Summing up this wealth of experiences, the authors conclude that while finance is obviously essential – and lack of finance remained a handicap in some cases, especially when finances came only from national budgets and were not leveraged more highly – it is not the only thing that matters. Crucially all three institutions required other, non-financial kinds of support. This included the co-ordination and cooperation of a vast number of sectoral agencies from all the member countries. Regional development banks played a useful function in terms of technical expertise and policy dialogue, as well as finance. The private sector was also involved, through specific avenues that were tailored to the specific needs and rules of the individual member countries. Hence the authors conclude, all dimensions involved in processes of regional physical investment need to flow together; basic political understandings, intra-regional trade and a favorable climate for cross border investments, institutional rules that provide clear signals, and clear cut decisions that help ensure investments and projects support the overarching goal (which in this case was regional connectivity.) The chapter by Biancarelli reinforces this message. Even with the strong support for regional integration processes that marked the early 21st century – which included the creation of the Union of South American Nations (UNASUR) and the rejection of the United-States Free Trade Area of the Americas, as well as the creation of several regional currency mechanisms and payment systems, and a reserve pool the FLAR in addition to support for Southern-led development banking, and moreover novel goals for the region such as reducing asymmetries between members – tangible outcomes in terms of catalyzing intraregional production and intraregional trade proved to be very hard to establish. Integration of production and industrial complimentarity remained weak; intra-regional trade remained weak. It seemed that the financial “bonanza” years following the economic crisis of 2007 were even more difficult than the “commodity boom” years, in terms of encouraging inter-regional investment, FDI, wealth sharing, and trade. With trade in particular, the rise of export-oriented southern manufacturers such as China made the environment for Latin American intraregional industrialization even more difficult. Biancarelli’s conclusion is that bolstering South America’s efforts towards development, and productive and financial integration requires more than finance and even more than overarching supporting institutions, there is also a need for the design and implementation of appropriate policies, intervention measures, and coordinated strategies (among countries and public/private agents) to achieve these goals. In the current circumstances, the most promising (or unique) approach he argues is to focus on the development of regional infrastructure, including transport, communications, and energy, which would be an important means of achieving physical integration, reducing logistical costs and obstacles, and enabling a greater degree of intraregional trade and investment. It would also foster complementarity of production and help make regional exports more competitive in global markets.

Introductory issues and roadmap to southern-led development finance  15

9.  The historical multilateral lenders – what role remains? Firepower, leadership and governance issues The pages in this volume paint a picture of strengthening government support for regional multilateral public and developmental banking that is very different from what is occurring in the West, where governments have been reluctant to increase the capital base of the long-standing global Multilateral Development Banks. This contrast is stark, not least because the needs for a more concerted effort have been increasingly apparent not only since the global financial crisis, but also in light of the new ambitions inherent in the SDGs and even the newly emerging concept of a Green New Deal. In this last decade, it is the emerging market and developing countries that took the lead in expanding the finance available for these, to the extent that development banks from the south now dwarf the size of the Western-backed multi-lateral development banks. This volume has not focused attention on the World Bank because so much has been written about this already, and our goal is to direct attention to the new and to the South. However, it is notable that rather than welcoming these Southern-­led institutions into an evolving system of development finance institutions across the world, the West has been quick to criticize them, including for potentially failing to meet environmental safeguards and other best practices in the West. This may have important implications for development, which are not considered directly by the chapters in the volume and therefore briefly highlighted below. One issue concerns financial firepower. Hinting at a step-change, last year the shareholders of the World Bank Group followed the lead of the Southern governments and backed a $13 billion capital increase. According to the World Bank, the capital injection will double its capacity – lifting its potential lending to nearly $80 billion in 2019 compared to $59 billion last year. As shown in this volume, scaling up is very difficult to achieve and so this increase in development finance should be supported – however what is also required is that the World Bank leads by example in terms of best practices and governance because the finance alone will not be enough. First, while the Bank’s increase seems big, it will not by itself redress the strange disconnect that continues to yawn between what developing countries need and want, and what the Western-backed institutions offer. An extra $21 billion lending is small when compared to the trillions of dollars estimated for sustainable infrastructure (an annual 3.3 trillion USD by some estimates) and the continued lack of credit available for small and medium sized businesses (another 2.5 trillion needed). Moreover, as shown in the chapters here, it is small compared to what the banks in this volume offer. And yet, as the only truly global bank (the ISDB, described in chapters by at least two authors here is global compared to the other regional banks but it is present only in Islamic countries), one could argue that it should be THE global multilateral development bank, and with a 70+ years history as well. It has 189 members some of whom are very rich. And yet, in the

16  Diana Barrowclough et al.

wake of the financial crisis, and while the rest of the world has made major injections to fuel their development banks, the Western DFIs stood relatively still. The point is not that the Southern-banks should compete with or even replace the World Bank; they should be complements in a broad-reaching and diverse network where different kinds of banks can specialize and thrive, making different offers that reflect their particular advantages be it in terms of expertise, knowledge, and reach. All are needed, and all have their role to play in shouldering the challenge of long-term investment where social or environmental returns may come fast but financial sustainability comes slow. The second issue therefore is governance. Going back to the Zedillo Commission report on World Bank governance in 2009, Southern-led banks have long been concerned that the World Bank has been plagued by an unequal shareholder decision-making structure that pits industrialized countries versus developing ones, and that the bank has placed onerous conditionalities and safeguards on projects that slow down project completion and do not necessarily improve development outcomes. This was a powerful incentive for many of the Southern institutions to emerge in the first place; as described in these pages and some have directly addressed these issues. The BRICS’ New Development Bank has an equal shareholder voting structure where the founding shareholders have an equal vote regardless of the amount of quota shares a member has contributed. The AIIB has put in place a set of streamlined environmental safeguards that claim to be greener than the World Bank’s and to take far less time and be far less onerous. Time will tell if these innovations have staying power, but they signal that Southern-led banks have a different vision for DFIs. It is time for the World Bank to determine what its proper niche is in this evolving system of DFIs, to embrace the other institutions, and to decide where it wants to excel. If the World Bank wants to lead by example it will need to reform its inherently unequal shareholder voting system, the way it leverages private sector financing, and its social and environmental safeguards. The case-studies and examples of other models of developmental banking explored in this volume lead us to ask the question – Can the World Bank put in place a more equal decision-making system like the NDB and other DFIs such as the Development Bank of Latin America (CAF) that have more equal structures in place? Can new capital reduce the pressure on banks to continue to ‘sweat’ their balance sheet in risky ways to increase leverage – including taking loans off-balance sheet, and the collateralization, securitization, dicing and splicing that caused so many problems in the US mortgage markets just a few years ago? Similarly, the Bank’s renewed calls to sweeten the pill for private sector investors by leaning ever more heavily on the State without offering much in return have a “same old” flavor that rightly causes concern. Private investment has already fallen sharply across the board despite record profits, so relying on it for the low-profit or non-­ profitable activities for which DFIs are designed should not be very appealing.

Introductory issues and roadmap to southern-led development finance  17

The third issue regards leadership. For example, can the World Bank’s new environmental safeguards and policies improve environmental and social conditions in a manner that better acknowledges host country capacities and needs? Germany’s decades’ old Kf W and Latin America’s CAF have instruments whereby if a borrower cannot meet particular standards, they provide financial and technical support to build capacity to meet them. The World Bank’s new policy has traces of this approach; can it improve outcomes? If the World Bank’s new capital increase can help the bank lead by example in terms of governance and outcomes, it can again be seen as an effective DFI. If it does not use this opportunity to reform, developing countries will continue to look to and create alternative institutions, and cannot be blamed for doing so.

References Bhattacharya, A, Gallagher K.P, Munoz Cabré M, Jeong M and Ma X (2019), Aligning G20 Infrastructure Investment with Climate Goals and the 2030 Agenda, Foundations 20 Platform, a report to the G20. Eurodad. 2017. Public development banks: Towards a better model. Discussion paper. European Network on Debt and Development. Macfarlane, L. and Mazzucato, M. 2018. State investment banks and patient finance: An international comparison. IIPP working Paper No 2018-01. UCL Institute for Innovation and Public Purpose. UNCTAD. 2019. Financing a global Green New Deal, Trade and Development Report 2019. United Nations: Geneva and New York.

PART 1

Southern-led development finance – rationale, innovations and implications

1 SOLIDARITY AND THE SOUTH The new landscape of long-term development finance and how to support it Diana Barrowclough and Ricardo Gottschalk

1. Introduction The many innovations in Southern-led development finance appear as one of the most significant trends of the new century. Trillions of dollars’ worth of Southern-owned currency reserves, Sovereign Wealth Funds, Development Banks credit swaps and bond issuances have transformed the development finance landscape. Existing banks and investment funds boosted their scale, scope, and mandates and entirely new ones came from nothing to become operational within a surprisingly short time. Moreover, Southern solidarity seems more than just a mantra; it is a mandate with real meaning for its members and practical implications that could promise qualitative differences in terms of governance and lending decisions, compared to those offered elsewhere. This chapter sketches briefly the most significant ways in which the landscape has changed, before addressing the important question of how to ensure these new or enhanced institutions can meet the immense investment expectations. If they live up to their promise, they could massively increase the capital available for the long-term investment needs expressed in the Sustainable Development Goals (see Table 1.1). They could bring qualitative differences too – if they prove to be more willing to invest in productive activities, more “green” and responsive to local needs, more streamlined in administrative requirements and less conditional. For such advantages, developing countries appear willing to pay the higher cost of capital compared to loans from the World Bank or other Northern-led sources. However, there are no inherent guarantees they can or will do this. First, these new Southern-led sources of finance may look so large compared to traditional lenders in part because the latter were always under-financed compared to the magnitude of the task. It is possible that even the best-capitalized of the new Southern institutions will find themselves constrained by the same challenges besetting traditional Northern-based ones. Moreover, the euphoria generated by

22  Diana Barrowclough and Ricardo Gottschalk

the new opportunities should not erase lessons learned about why some development banks stumbled in the past. Finally, the new landscape is still far from complete – despite the addition of new players and the expansion of existing ones, it is somewhat ad hoc and many gaps remain, especially in the poorest countries and regions. In short, support from national and international policymakers remains essential if the new South–South sources of finance are to grasp the opportunities created by a scaling up of investment finance and to fulfill their development potential.

2. Charting a new, Southern-led landscape The many southern initiatives to boost long-term finance for development have changed the map of development finance significantly. It is true the map remains somewhat incomplete and ad hoc – reflecting the fact the initiatives emerged on a piecemeal basis and are not a coordinated southern effort to break with the old order. Nonetheless, the new institutions are doing things in a different way. Also, each new institution is slightly different in what it offers and how it operates. Together, they have the potential to help fill important institutional and financing gaps in a system that otherwise failed to reform despite the crisis of 2007–2008 and its fallout (Grabel, 2015) and potentially can provide real benefits to a financial architecture that has long been under stress. In terms of individual initiatives, there are too many to mention by name here. This section classifies them broadly into two categories – national and multinational activities. These categories are chosen because of their implications for governance and decision-making, rather than the scale or ambition of operations. Multilateral institutions have attracted most of the media and political interest; however, national ones are also extremely important, and together, their collaboration through linked-up networks whereby regional systems engage actively with national banks and national financial systems may prove to be one of the most transformative opportunities created by this new landscape. Table 1.1 summarizes some of the funds currently and potentially available for development. Some figures such as those from new southern banks and funds are still modest in face of the long-term financing needs of developing countries, but, as argued further below, the potential for significant expansion exists, provided southern governments further enhance their support to these institutions in the coming years. On the other hand, it also needs to be remembered that some finances are “borrowed” and cannot necessarily be relied upon – such as the foreign reserves based on short-term capital inflows that owe more to global capital markets than physical trade. These can abruptly reverse as global financial conditions change.

a. National initiatives are looking outwards One of the major themes of the last decade has been the way that national public lenders and investors have enhanced their role to go beyond their territorial

Solidarity and the South  23 TABLE 1.1. A significant change in scale and scope – the new Southern-led landscape

Southern national

Southern multilateral Global multilateral (WBG)

Mechanisms and institutions

$ value potentially available

Foreign reserves1 National development Banks2 Sovereign wealth funds3 Development banks and investment funds4 World Bank Group, MIGA 5 Af DB, ADB, IADB5

$6.7 trillion $400 billion $6.3 trillion $302 billion $300 billion $197 billion

Source: Development Banks’ annual reports, World Bank Development Indicators and SWF Rankings, the latter accessed on 12/02/2018. Available at: https://www.swfinstitute.org/ sovereign-wealth-fund-rankings/. Note: 1 Foreign reserves (minus gold) of 111 developing countries in 2016. 2 Corresponds to total foreign loan portfolios of CDB, China Exim and BNDES in 2016. 3 Total includes all SWFs listed on SWF Rankings minus those funds from Australia, Canada, Ireland, New Zealand and United States. 4 Potential lending capacity of AIIB, NDB and CAF, based on banks’ total equities and a loan-equity gearing ratio of 5, plus China’s backed investment funds, as reported in Gottschalk and Poon (2018). 5 Banks’ total assets, 2015.

boundaries and become providers of development finance at the regional and even global south level. For example, there are now more than 250 national development banks in the developing world alone (UNCTAD TDR, 2015, 2019) and some of these are now immense, dwarfing long-standing multilateral institutions such as the World Bank and becoming major lenders for their regions and beyond. Brazil and China have been among the most pro-active developing countries to use their national banks to support southern investments, and their banks are now significant international players, providing external financing as part of their standard operations. (Admittedly, this may be motivated more for the purpose of supporting national companies than to support South–South solidarity per se, but the trend remains). The China Development Bank (CBD), Export and Import Bank of China (China EXIM) and Brazil’s BNDES have increased their assets and loan portfolios very rapidly in the ten years between 2006 and 2016. For example, the stock of international loans held by China’s banks for the years 2006–2016 at just less than $400 billion was already larger than the global total of loans by the World Bank ($300 billion), and the total portfolio of China’s banks would obviously be larger still if one included their domestic loans. The BNDES’s stock of loans at $187 billion, of which 13% was in foreign currency, is not too far behind, if compared to those of the larger regional development banks (Figure 1.1). What is particularly impressive is that the larger multilateral development banks have been around for over 50 years or more, as compared to these national banks that only started to become actively engaged in outward operations from the early 2000s onwards. The impacts from the perspective of recipient

24  Diana Barrowclough and Ricardo Gottschalk

20.3

AfDB

94.6

ADB

82

IADB

300.5

World Bank

24.4

BNDES

98.1

China Exim bank

277.9

CDB 0

FIGURE 1.1

50

100

150

200

250

300

350

International loans by Southern-led national banks already dwarf the total loans of multilateral development banks (Year 2016, $US billion).

Source: Authors’ estimates, based on banks’ annual and financial reports. Note: WB: Sum of net outstanding loans of the IBRD and of the IDA, 2016 financial year; IADB: Outstanding loans of ordinary capital, fund for special operations and other funds; ADB: Outstanding loans of ordinary capital resources and ADF, as of 1 January 2017; Af DB: Net loans of Af DB only; China Exim bank: International cooperation loans only; CDB: International loans only; BNDES: values are merely indicative, based on loans in ­foreign currency.

countries are potentially very considerable. As described by Bertelsmann-Scott and Prinsloo (2018), Chinese financing of investment in African infrastructure alone accounted for almost $21 billion in 2015 and dwarfed the total investments to the region made by at least nine other countries combined (France, United Kingdom, Japan, Germany, India, Brazil, United States, Canada and South Korea). Together, these nine countries invested just over one-third of that total amount. Another major national provider of investment finance emerging in many developing countries is that of Sovereign Wealth Funds (SWF). SWFs are a public investor, often seed-funded from government revenues earned by exports of commodities such as oil and gas, and they are now so plentiful and well-financed they could potentially (if not currently in practice) change the game for long-term developmental investment (see Barrowclough, 2015; UNCTAD TDR, 2015, 2019). Several features of SWFs stand out particularly in this context of Southern-led development finance. It is not just their size – although the fact the total global value of assets held in SWFs is estimated at around $7 trillion is definitely part of it. This is an order of magnitude far greater than what is available through the world’s largest multilateral institutions, whose lending firepower is still measured in billions of dollars. Another reason they are attracting attention is that of that $7 trillion, developing countries own or control as much as $6 trillion.

Solidarity and the South  25

This reflects a flurry of activities in the years since the early 2000s, related to the emergence of extremely large current account surpluses in many commoditybased developing countries and some East Asian non-commodity exporters. Between the years 2000 and 2015, as many as 52 new SWFs opened worldwide, compared to just 15 funds for the 20 years before that, and of those new funds, more than 40 are owned by the South (Barrowclough, 2015). Developing countries also account for the world’s largest ones – of the 42-plus SWFs with more than $10 billion assets, 32 belong to developing and transition economies. Also, size is not the only thing that matters ‒ funds do not need to be massive to be useful, and much smaller funds can play an important role in areas where other sources of finance are less forthcoming. The latest estimate of assets held by nine SWFs in Sub-Saharan Africa at around $8 billion is admittedly extremely small compared to the $3 trillion holdings of both Asia-Pacific and MENA regions, but nonetheless, could make a significant difference in the country if well invested. However, this dramatic change in the landscape of Southern-led financial institutions does not automatically translate into an effective change in the availability of finance for development. This depends on the mandate and the political will. Some funds, such as stabilization funds, have a macroeconomic stabilization mandate and hence can support counter-cyclical lending and investment but should not be counted on for the long term. Also, many developing countries’ SWFs are actually pension and life funds, and insurance companies, whose long-term mandate is to provide a cash-stream to cover pension liabilities or as a savings vehicle. They could be directed to more long-term developmental (infrastructure) activities, but for this to happen, however, certain obstacles would have to be overcome. Many funds have clear rules that forbid them to invest abroad (or in infrastructure projects; not all yet have the appropriate transparency, accounting and accountability mechanisms in place. Lack of transparency is a continued concern and criticism that hinders their use.

b. Southern-led multinational or multilateral initiatives The burst of national, South–South activity described above has been overshadowed by the second major theme that captures most media and development interest, namely that of multi-national or multilateral, activities. The lack of reform in the global financial system prompted some developing countries to take much bolder steps by creating South–South development banks that can by joining forces across a number of countries, greatly increase their footprint. These initiatives reflect in particular the disillusionment with the government structures, patterns of lending and especially the conditionalities associated with lending by the Bretton Woods institutions and some of the leading regional banks.1 The Bank of the South (based in South America), the BRICS New Development Bank (NDB) and the Asian Infrastructure Investment Bank (AIIB) are new southern institutions that are fully controlled and in some cases fully owned by the developing countries themselves. AIIB has already raised some $100 billion

26  Diana Barrowclough and Ricardo Gottschalk

capital stock; the NDB has $50 billion in subscribed capital, and the Bank of the South has an initial promised capital of $20 billion. Existing Southern regional banks and funders have also scaled up their resources and in some cases re-engineered themselves to serve better the pressing needs of their regions. The 17 members of Latin America’s CAF opened up the membership to take on new members from the hard-hit Caribbean states and in 2015 agreed a capital increase of $4.5 billion. Their counter-cyclical role increased from 2015 under the rubric of “contingent operations” and further capital was accessed through different markets around the world. Similarly, the Development Bank of Southern Africa (DBSA) initially established in 1983 as a South African government financed development bank with the mandate to provide finance for infrastructure development, expanded in 2013 its mandate to enter the entire African continent. Within two years it was devoting just under a quarter of its $929 million portfolio to infrastructure investment in countries outside South Africa, including Kenya, DRC, Mauritius and Zambia among others (Bertelsmann-Scott and Prinsloo, 2018). In other parts of the developing world such sums may not seem large, but in Africa, investment is comparatively so low that this contribution is extremely significant for its recipients. The total volume of infrastructure investment financed by DBSA is now roughly three times larger than that of the regional development bank for West Africa and dwarfs other regional banks.

c. Creating a new center of gravity Taken together, these national, sub-regional and supra-national initiatives, whether new or enhanced versions of what already existed, mean that the landscape of the global financial architecture now looks very different compared to just a decade ago. This could have some negative consequences as well as positive ones, given it is in part a response to deficiencies in the global financial architecture and more time is needed to see what this implies for development in practice. Nonetheless, the trend is clear – the center of gravity is gradually moving southwards. As described above, the scale of finance potentially available to developing countries, controlled and governed by developing countries, has at least doubled. Annual disbursements are significantly higher, when Southern banks (including national ones) are added to the picture. Moreover, this finance is held by institutions whose reach is focused more at the regional level than the global; and whose footprint of ownership is centered more around the South rather than the North. As shown in Figure 1.2, there is a movement to the lower right-hand quadrant. Some of the new Southern-led institutions have many northern members as well – such as the AIIB, which is therefore sited somewhat “north-east” of institutions that have only a few northern members, such as the Latin American bank CAF (with Spain and Portugal as members). Other important new features of this landscape include leaner and

Solidarity and the South  27

FIGURE 1.2

Turning South – the new center of gravity of developmental finance.

Source: Authors’ estimate based on banks’ annual reports, expanding on Abdelwahab (2017). Ownerhsip calculated according to member country voting rights, rach calculated according to geographical dispersion of loans.

fairer governance structures, less conditionality and higher speed in loan approvals and disbursements. The speed of loan disbursement, for example, from initial project identification to board approval, was around 25 months for the World Bank and 13 months for the African Development Bank, compared to less than one year, potentially just six months, for the regional banks. 2 Other differences (and some similarities) are discussed below. It is worth noting that the developmental implications of this are not necessarily all positive – there may also be some negative implications, reflecting the fact the trend is driven in response to the deficiencies in the existing multilateral arrangements as well as its more pro-active rationales.

3. Doing things differently? With the flurry of new and evolving institutions led by the South, there is the expectation of a mixture of special, Southern-flavored benefits, both financial and non-financial. Alongside fascination for the massive increase in funds now potentially available, it is also assumed Southern-led institutions will do things differently compared to the traditional lenders of the past, even the developmental

28  Diana Barrowclough and Ricardo Gottschalk

ones. It is not just the issue of providing long-term finance, because Northernled development banks have also played this role, being the primary providers of long-term finance for development, with a funding base comprised of long-term liabilities that match aptly with long-term investment needs. Similarly, it is not just about providing counter-cyclical finance; because Northern-led development banks and SWFs have also done this in the past, stepping in to provide medium-term finance that helps countries sustain economic activity and jobs and protect vulnerable productive capacities.3 Moreover, it is not just about providing technical expertise in the design and operation of major long-term infrastructure and other projects, because Northern-led banks have also done this. They accumulated precious knowledge of local needs and capacities, and management experience and other skills (Studart, 2020; also Chandrasekhar, 2014).4 Compared to this history, it seems that what is new about the enhanced and new southern institutions is (a) their capacity (actual and potential) to scale up financing very rapidly and (b) their perceived ability to experiment with new forms of funding, lending and doing business. Beyond their core characteristics, shared with other development institutions ‒ Southern development banks have demonstrated in recent years a growing ability to play the role of catalyst, partnering with other financial institutions that would otherwise not support such long-term projects. And Southern-led SWFs are also starting to be thought of in ways that did not occur so much before. There is still a long way to go before many funds invest in other developing countries over more traditional markets (some of the biggest Southern-led deals in recent years have been focused on the finance sector in the North), but the potential for market returns in the south should help to change this. Over the last two decades, a number of such funds have been established with the purpose of domestic greenfield infrastructure investment in developing countries, including not only the major Gulf Funds but also funds from Kazakhstan, Malaysia, Angola and others (Barrowclough, 2018; Gelb et al., 2014). The Southern-led institutions are also expected to, and are already, doing things differently on various other fronts: in how they manage governance issues, how they liaise with the private sector, what types of partnerships they form, how they fund themselves and what types of loans they provide. This section teases out some reasons why this is the case and its potential impact.

a. Mandate, ownership and governance Southern-led institutions are usually expected to have a better “fit” between their mandate, ownership and governance structures – if only for the reason that this was one of the reasons prompting their birth in the first place. The slow pace of governance reforms towards more equal power sharing, long and complex processes of loan approval and strict (and often damaging) conditionality by the Bretton Woods institutions and leading regional development banks encouraged developing countries to seek alternatives by creating large new development

Solidarity and the South  29

banks and funds. Their creation has been timely, given, on the one hand, the financing needs for regional integration and other development goals; and on the other, the amounts of foreign savings that China and other emerging economies currently hold. These savings (including those in SWFs) are in most cases invested in low yield assets in developed countries. However, they could be better employed to finance the unmet developmental needs of the developing world, which could give much higher economic and social returns. NDB was established at the Sixth Summit (Fortaleza, Brazil, July 2014), with the specific mandate of “mobilizing resources for infrastructure and sustainable development projects in BRICS and other emerging and developing economies” (BRICS, 2014, paragraph 11). Following the agreements reached at the summit, each member country ‒ Brazil, the Russian Federation, India, China and South Africa ‒ has contributed an equal equity share despite their different economic sizes and per capita incomes, to ensure that the bank does not reproduce the ownership pattern of the IMF and the World Bank, with concentrated shareholding by a few Western countries. Two emerging features of the bank have been the speed of loan approval ‒ six months from the date of project identification and willingness to engage in partnerships in order to tap into the expertise of other development banks and strengthen its own technical capacity. AIIB was established in October 2014 in Beijing, with operations formally launched in January 2016. There are currently 84 approved members, the majority of which are from within the Asian region (AIIB, 2018). A significant share of the authorized capital stock of $100 billion is the contribution of China, giving the country veto power on decisions such as structure, membership and capital increases, which require at least 75% of the votes. AIIB faced considerable scrutiny at the time of its announcement, with questions arising about issues of governance, standards and transparency. Moreover, concerns were raised that the bank was being created as part of an effort to displace existing multilateral banks. However, similar to NDB, AIIB has demonstrated since it started its operations not willingness to compete but, rather, to cooperate with other multilateral development banks through co-financing and other means. In Latin America, the Bank of the South (Banco del Sur) is a sub-regional entity whose founding member countries are all from South America: Argentina, the Plurinational State of Bolivia, Brazil, Ecuador, Paraguay, Uruguay and the Bolivarian Republic of Venezuela. Established in 2009 with a promised initial capital of $20 billion, it aims to promote economic development and regional integration in the South American sub-region, by supporting infrastructure projects, knowledge generation and the advance of technical capacities to support alternative forms of productive development, the latter with an emphasis on the social economy and cooperativism (Buonomo, 2016). Hence, when these banks or funds are described as being “Southern-led”, this is not just words, but a reminder they are a response to a very different world compared to that which existed during the post-WWII environment of Bretton Woods. At a recent UNCTAD meeting, one Southern-led development Bank

30  Diana Barrowclough and Ricardo Gottschalk

which now has more than 50 member countries and total financial approvals in 2016 of $12.2 billion, said, “while solidarity is not in our name it is in our DNA” and emphasized that the principle of solidarity governs the bank’s relationships with and among shareholders. Reflecting this sentiment, other Southern banks agreed on the importance of making no distinction between members in terms of whether they were net donors or net recipients – all members could potentially be either. Linked to this is a related issue of whether to treat members differently, according to their different needs and capacities, or whether all should be treated the same. Should borrowers with limited payment capacity be offered concessional loans, and to what extent should cross-subsidization be the mechanism to finance it, in the absence of a development fund? Answers to these critical questions will be different according to the preferences and goals of individual institutions and countries – underscoring the benefits of having a larger choice of banks and other sources of finance. Similarly, the issue of whether all borrowers should be offered the same terms for loans, irrespective of differences for example in their perceived risk. Most (but not all) representatives of Southern-led institutions argued that differential pricing was wrong as it did not support the principle of solidarity and cooperativeness. It would also not help countries put in place better policies. Others argued that it was furthermore wrong to do this when countries were already under stress. Certainly, almost all countries are stronger together than apart. As shown in Table 1.2, the credit rating of regional institutions is typically higher than most TABLE 1.2 Stronger together – credit ratings of selected institutions and their member

countries S&P ratings

ISDB Bank and members

AAA AA AA− A+ A− BBB+ BBB− BB+ BB BB− B+ B

IsDB Kuwait; UAE Qatar

B−

CAF Bank and members

CAF Chile

Malaysia; Saudi Arabia Indonesia; Kazakhstan; Morocco Azerbaijan Turkey Bangladesh; Oman Bahrain; Jordan Burkina Faso; Cameroon; Pakistan; Nigeria; Suriname; Uganda Egypt; Iraq; Lebanon; Tajikistan

Spain Portugal, Colombia Brazil Argentina

Source: IsDB Annual Report 2016 and Trading Economics, accessed on 27/02/2018. Available at: https://tradingeconomics.com/country-list/rating; S&P ratings, at https://www.spratings. com/documents/20184/1022795/Sovereign+Ratings+Infographic+Final+2017/4416e8fa9a92-4252-9aff-adef050f9fcd.

Solidarity and the South  31

if not all its members, even the rich ones. Countries therefore benefit significantly from membership, permitting them to borrow at lower costs than if they borrowed directly from international markets. This implies that risks among individual countries are pooled with the Bank itself playing an equalizing role, despite the disparate ratings among countries. Solidarity therefore brings tangible benefits to all; distributed according to need. Given that, there is a balance to be considered between scaling up and solidarity. Development Banks are usually state-owned, they raise funds in capital markets as well as sometimes get capital infusion from national budgets; their purpose is to provide loans for projects designed to contribute to overall economic development. National and international development banks have different funding structures, and each brings them both advantages and disadvantages. National development banks often have a more diverse funding base, which includes, in addition to national capital markets (and in the case of larger banks, international capital markets as well), budgetary resources. In times of crises or when budgetary resources are constrained, they may be able to count on the role of central banks, which can step in by extending credit lines that these banks can intermediate. As a banking regulatory body, central banks can also increase these banks’ ability to lend by designing banking capital and other rules that are tailored to the specific characteristics of these banks, such as their longer-term liabilities vis-a-vis commercial banks (Griffiths-Jones and Gottschalk, 2016). On  the downside, resources available on the national capital markets may be limited and tapping into the international capital markets may be very costly, especially if their national governments do not have a high sovereign rating, which tends to be the case among most developing countries. In contrast, sub-regional development banks have a business model in which their main funding sources are the international capital markets. On the contrary, this can be seen as a positive feature, provided these banks have creditworthy shareholders and are awarded high credit ratings, which gives them the ability to raise resources in these markets at lower costs. Indeed, sub-regional banks that include non-borrowing developed (or emerging) countries tend to have a greater capacity to lend more and at more favorable terms to member countries. This may come at the cost of compromising solidarity. On the other hand, sub-regional development banks that have only the borrowing countries themselves as shareholders tend to have a limited lending capacity. This is particularly the case among the African sub-regional banks. In order to enhance their lending capacity, one method may be to attract part of the large foreign reserves and sovereign wealth funds of emerging and other economies, to be invested in such banks, thereby enhancing their capital structure so that they can fully meet their mandates. Some sub-regional development banks in Africa already have emerging countries such as China as shareholders, which means that the institutional set up is already in place to expand their capital base.

32  Diana Barrowclough and Ricardo Gottschalk

The new cross-south development banks, in turn, had great potential to scale up from their inception, thanks to having some strong shareholders. The BRICS NDB has the large emerging economies of Brazil, China, India and Russian Federation (in addition to South Africa) as main owners of the bank, and the bank has the choice of tapping into the domestic capital markets of these economies to raise funds for loans, in addition to international capital markets. Indeed, in July 2016, NDB issued three billion yuan-denominated green bonds, equivalent to $448 million, on the China Interbank bond markets, as part of the bank’s initial strategy to explore local currency bond issuances not only in China but also in the capital markets of the other BRICS countries (NDB, 2017; Wu, 2016). Tapping into national capital markets is a novelty that differentiates the new banks from the old multilateral banks, giving them more choices in terms of funding sources as well as flexibility, for instance by making it less risky to provide loans in local currencies. Going forward, NDB could expand its membership in order to increase its capital base and therefore be able to scale up lending considerably. Like NDB, AIIB’s main funding mechanism is through bond issuance, in both regional and global markets. AIIB, in particular, has not only large emerging economies as shareholders but also many leading developed countries, while China maintains a controlling position. The latter, of course, is a very important feature of the AIIB. It permits that the bank experiment with new institutional arrangements – namely, its special funds (Gottschalk and Poon, 2018), which gives the bank the possibility of scaling up its lending capacity beyond what a traditional international bank can achieve.

b. Forming partnerships; links with the private sector Collaboration is already a theme word for many multilateral development banks but the hopes are high that the Southern-led banks will enhance this. Internal evaluation documents by the older multilateral banks such as the ADB, for example, raised concern about the lack of co-financing arrangements and urged the bank to do more to mobilize funds from other sources (ADB, 2011). As early as ten years ago, the ADB signed a formal MOU with the IsDB to promote cofinancing between the two institutions. By last year the IsDB was their thirdlargest partner, and pipeline facility was prepared for $6 billion co-financing that included transport, energy, health and PPPs (with $2.5 billion from ADB and $3.5 billion from IsDB).5 The IsDB target for co-financing is already at 100% and the ADB announced a co-financing target of 100% by 2020, compared to its currently levels of 80%, which are already up sharply from just 4% in 1976. Among the new development banks, NDB has sought to engage in partnerships with other financial institutions right from the beginning of its operations, as seen earlier. To this end, the bank has signed cooperation agreements with global and regional multilateral banks as well as with sub-regional institutions. As for the AIIB, in 2016 six of its nine loans were for projects co-financed with ADB, the European Bank for Reconstruction and Development and the World

Solidarity and the South  33

Bank (AIIB, 2018), thus showing strong willingness to form partnerships with other international banks. Will these new and enhanced Southern-led institutions interact differently with the private sector compared to the more Northern-led development or commercial banks? Attracting private sector support for infrastructure and other long-term investment has long been a goal for many governments, despite evidence that the lion’s share of long-term investment always comes from the public and not the private sector. Typically governments seek to involve private finance or expertise through the Public Private Partnership model, despite the chequered experience with this in many other countries and persistent claims that the public sector too often carries an unfair share of the costs whilst receiving too few of any benefits (e.g., Eurodad, 2017). Will South–South PPPs be any different from the North–North or North–South ones of the past? The major MFIs seem to think so, according to the 2015 World Bank/IMF publication “From billions to trillions”, and PPPs are a major plank of the infrastructure masterplans that currently exist for each region of the world, such as the Programme for Infrastructure Development in Africa (PIDA) or China’s Belt and Road Initiative. However, so far, the rise of Southern-led financial institutions has not led to a concomitant increase in PPPs in developing countries, judging by the World Bank Private Participation in Infrastructure database (Barrowclough, 2018). Nor is there any inherent reason to believe South–South PPPs would be any different from North–South ones. Governments still need to give equal consideration to the use of more conventional methods of providing infrastructure, such as public provision or procurement, as opposed to assuming that more complex arrangements will always be better. Evidence shows these are often more costly and do not provide such broad or universal coverage (see Barrowclough, 2018; UNCTAD TDR, 2015).

c. Loan portfolios: are Southern-led institutions more willing to support productive economic activities and green investments? Alongside the benefits of scaled-up finance, it is also hoped that Southern-led institutions will have more appetite for supporting infrastructure and other activities that the private sector and commercial lenders have been unwilling to support (e.g., Bhattacharya and Romani (2013), Gallagher and Koleski (2012), Ocampo (2016), among others. The traditional lenders such as the World Bank lent annually only between $50 and $70 billion to infrastructure over the 2008–2015 period, which is far too low for what is needed, reflecting the disengagement from these areas by the traditional multilateral institutions over the years. Hopes are high that Southern-led institutions will be different.6 It does appear so ‒ among the Chinese banks, CDB is a primary provider of long-term finance for infrastructure projects, such as railways, roads and telecommunications, and for largescale investments in basic and heavy industries, such as petrochemicals. In 2014, mining, energy, transport, telecommunications and other activities described

34  Diana Barrowclough and Ricardo Gottschalk

as infrastructure accounted for 56% of total loans (UNCTAD, 2016:28). China Exim Bank’s mandate is to support China’s exports and imports of mechanical and electronic products, equipment and high-tech products, as well as overseas investments of Chinese companies (China Exim Bank, 2014; Poon, 2014). These banks are also looking outwards. CDB has contributed finance to countries along the Belt and Road route, which in 2016 amounted to US$12.6 billion in such areas as energy, telecommunications and industrial capacity. Together with CDB, China’s Exim Bank has strongly supported China’s strategic partnership with other developing countries. In Africa, it gave finance to “the development of high-speed railway, expressway and regional aviation networks (the ‘Three Networks’)” through loans (part of these concessional) and other assistance mechanisms (China Exim Bank, 2013:33, 2014:9). Although its priority since 2016 is the Belt and Road initiative, it continued to support African countries via loans to promote China–Africa infrastructure and industrial cooperation.7 Similarly, the Brazilian BNDES has expanded its international operations, supporting regional economic integration and therefore investment promotion in neighboring countries, as well as strengthening Brazil’s economic links with fast-growing developing regions, particularly Africa. In South America, for instance, the bank has played a very important development-supporting role by lending to small countries such as Ecuador as well as larger ones such as Argentina, to finance economic infrastructure. In Africa, it has extended loans to large national construction companies investing in infrastructure and other projects. Another distinctive contribution from the Southern national development banks is their willingness to experiment with new types of loans. For more than a decade, China has offered commodity-backed or resource-secured loans, which are a significant source of finance for many emerging and developing countries. These can be huge – estimated to account for as much as $132 billion already in the years between 2003 and 2014 (Brautigam and Gallagher, 2014), and included oil-backed loans to Angola, Congo-Brazzaville, Ghana, Sudan, Brazil, Ecuador and Venezuela, among others. CDB has been a key provider of these forms of loans. Through a triangle operation, it makes a loan to the host government, on the basis of either direct repayment in the usual way or payment via commodity sales pledged to Chinese State-Owned-Enterprises, such as the CNPC or NODC or Sinodec (Gallagher and Koleski, 2012).8 Another distinction is their orientation towards green finance. In its first year of operations, of the seven loans approved by NDB worth $1.6 billion, as many as six were for renewable energy. Declarations from the banks’ senior managers indicate that this initial emphasis on green projects has not been accidental, but part of a strategy to build an image that identifies the bank as intimately connected with future trends and concerns. In a similar vein, it has sometimes been suggested that Southern-based MDBs can capitalize on their strengths and partially compensate for their weaknesses by focusing on green and sustainable infrastructure projects.

Solidarity and the South  35

Thus, palpable gains as a result of the growing international operations of national development banks, initial operations of the new banks and refocusing of existing ones include a greater focus on industrial infrastructure projects (including green ones), in addition to the scaling up of financing to developing countries.

d. Macroeconomic coherence The benefits of having alternative sources of credit creation and intermediation became clear during the latest economic crisis as Development Banks increased their lending counter-cyclically at just the time many private banks were scaling back. According to a World Bank survey of 90 development banks across developed and developing countries, in the post-crisis difficult years 2007–2009, these banks increased their loan portfolios more than three times as much as private banks operating in the same countries (by 36% compared to an increase of just 10% ‒ de Luna-Martinez and Vicente, 2012). Some Sovereign Wealth Funds can also, as discussed above, play this role. Whilst it is too soon to say what will be the record of the new South–South and Southern-led banks, the expectations are that, by their nature, they will follow similar behavior, even if counter-cyclical lending is not an objective explicitly mentioned in their mandates, as is the case, for instance, of the EIB. More generally, to the extent that the new sources of finance will support investment in infrastructure, industrialization and diversification in developing countries it should help governments achieve a more coherent fit between all the different aspects of their developmental aims and policies.

4. Some things are not different a. Concerns about regional imbalances Even with the new growth of Southern-led initiatives, some long-standing concerns and themes remain unchanged. One is that not all regions have shared equally. In particular, smaller or poorer countries and regions that are less able to set up national Development Banks may miss out on the opportunities of linking with the new cross-south, or regional and global Southern-led institutions. Whether in terms of MDBs, or SWFs, some regions are much better served than others, which is a problem for development and a potential problem for solidarity. Among the three main developing regions, Latin America and the Caribbean stands out as one that has had, in addition to national development banks – notably BNDES as seen earlier – sub-regional development banks actively scaling up financing towards southern initiatives to support regional integration and other international development goals. Such banks include the Central American Bank for Economic Integration (CABEI), the Caribbean Development Bank and the Andean Development Corporation [Corporación Andina de Fomento (CAF)]. CAF, the biggest of the three, was created with a mandate to promote

36  Diana Barrowclough and Ricardo Gottschalk

sustainable development and regional integration. At present, the bank supports the strengthening of its members’ national productive sectors, particularly the development of value-added products and services, as well as job creation and the promotion of access to social services, including education, health, water and sanitation.9 In Asia, China’s CDB and China Exim Bank have been prominent players in promoting South–South projects both in Asia itself and in every other developing region in the world, as discussed earlier. In addition, the region is also host to IsDB (see also above). Based in Saudi Arabia, the bank’s goals are to support economic development and social progress. To achieve these goals, it supports through equity participation and grant loans its member countries, which are spread out throughout developing Asia, Africa and South America. In contrast, in Africa, strong national and sub-regional financial institutions that could provide large-scale support to regional development, and that are both based in the region and wholly owned by African countries, are still missing. This gap is not due to lack of financial institutions in the region. Africa has several long-established sub-regional development banks, with a very clear mandate to support regional integration and development. Taking the five main such banks from the region, namely the Central African States Development Bank, the West African Development Bank, the Development Bank of Southern Africa, the East African Development Bank and the Preferential Trade Area Bank (operating in eastern and southern Africa); these are very small in terms of total assets. DBSA is the biggest of all, with total assets at about $5.5 billion dollars whereas the EADB and BDEAC have assets less than $500 million. The DBSA also stands out from the others because it is wholly owned by a single country, South Africa, the largest economy in the region with strong interest in supporting regional integration. The bank has expanded loans fairly rapidly since the global financial crisis (Humphrey, 2015), both to South Africa itself and other countries from the African continent (see above), but it is still very small compared to the scale of assets and loans of banks from other developing regions and, of course, with Africa’s development financing needs. South Africa also has the Industrial Development Corporation (IDC), which is a national development financial institution whose mission is to support sustainable economic growth both in South Africa and on the rest of the African continent. Nonetheless, Gottschalk and Poon (2018) shows that both DBSA (wholly owned by South Africa, as just mentioned) and IDC are not just small in terms of assets and outstanding loans, but, also, have very low loan-to-equity gearing ratios, implying that their lending capacity is even more restricted than it could have been the case. Given South Africa’s economic weight in the African region and its prominent role in SADC and other regional initiatives, one could expect the country to strengthen its national banks and increase their leverage capacity so that these institutions can become more effective levers of regional development. Nigeria is the other economic heavy weight on the continent that could also have a more prominent role in supporting African development. By 2010, it had five national development finance institutions, but none of them seemed to have

Solidarity and the South  37

an international role, at least not on a significant scale.10 This is in contrast with Nigeria’s commercial banks, which have been very active abroad providing commercial loans in the African region (Ajakaiye and Tella, 2016). Thus, the strengthening of national and sub-regional development banks are undoubtedly positive responses to shortages in the international development finance architecture. Yet, the provision of development finance remains largely insufficient and uneven. As just discussed, African sub-regional development banks and national development banks have small capital bases and therefore limited lending capacity. This is an issue that needs to be tackled in the coming years.

b. The continued power of CRAs Despite their efforts to scale up resources for long-term investment, southern development banks are concomitantly adopting a conservative approach to lending, in broad conformity with the wider loan patterns set by the old multilateral lending institutions. The fact is that, despite the shift of power towards the East and South and the emergence of new cross-south international development banks, three international credit rating agencies – S&P, Moody’s and Fitch – have maintained their grip over the international credit markets on which many, if not all, investors and borrowers depend. Their criteria for rating the international development banks is not very transparent and do not seem to take full account of the specific characteristics of such banks, such as their ownership structure or their preferred creditor status. On the contrary, it penalizes policies that do not follow the neoliberal orthodoxy. This is an area in urgent need of reform.11 Among other initiatives, the creation of southern-based credit rating agencies has been suggested, to reflect the new emerging reality of a far more complex and diverse landscape, with new funding sources and borrowers, many of which now are based in the South. However, in this rapidly changing landscape rules are not set in stone, and what shape they will take in the future depends very much not only on such dominant agencies but critically on how the new actors play the game. In this environment in which much of new norms and standards are still in flux, NDB and AIIB could take advantage of their strong shareholders’ membership to test the markets by increasing their loan-capital gearing ratios above what the long-established banks have done over the many years they have been in operation. Building a strong lending track-record as these new banks have already started doing can further help them leverage more for a given amount of capital, while maintaining or even further improving their international credit ratings. On the other hand, it may come at the cost of solidarity and development focus, if it means that banks do not support projects that are less attractive on narrow financial, if not economic, terms. There is, therefore, a need for a proper discussion about fact that most development banks perform a difficult balancing act between remaining economically viable, whilst still developmental. The way they resolve this tension is an aspect on which there is very little public information. Anecdotal evidence suggests that most are cross-subsidizing some of their more developmental projects through

38  Diana Barrowclough and Ricardo Gottschalk

profits made on more commercial ones. As long as a credit-rating agency calls the shots, it may not make much difference whether banks are Southern-led or Northern – unless there is an explicit criterion for evaluating projects and deciding which to support.

c. What future for concessional lending? In one sense, this tension is highlighted in the role of concessional lending. Multilaterals institutions such as the World Bank and the large regional banks have always played an important role with respect to concessional loans, provided through their soft windows. Until recently, about 30% of their total loan portfolio was in the form of concessional lending (UNCTAD, 2016:36). This may change in the coming years, as a result of reforms in these banks aiming to enhance their lending capacity. Some of these reforms took the form of a merger of balance sheets whereby banks’ resources stationed in their development funds were merged with their ordinary resources. This has been the case with two large regional banks: the ADB and the IADB. A possible negative consequence of these reforms is less availability of concessional lending. The World Bank, in turn, has permitted that IDA, its concessional window, to raise resources in the international capital markets. This measure may also affect the bank’s capacity to continue providing concessional lending on the same scale as before. These changes are important, even in the current context in which new finance providers are scaling up lending and new banks are entering in operation. The reason is that none of these new Southern-led banks has a clear institutional set up to provide concessional loans, even though some level of subsidy may have been provided in the past by those banks that have central bank and treasure support, such as China’s Exim bank. Unlike the old multilateral banks with concessional windows, the new banks, spearheaded by China, do not differentiate between borrowing and non-borrowing countries. They did not create parallel structures to cater to the specific needs of low-income countries, which still require concessional lending to avoid the buildup of foreign debt, which can become unsustainable leading to deep crises, as has happened in the past. Chinese authorities are pointing to a model of international financial assistance in which loans will be non-concessional, even though the intention will be to provide them at “below” market rates (Gottschalk and Poon, 2018). It would be important, therefore, that the South open a new front of institutional initiatives for the provision of long-term concessional lending so that the poorest countries are not left further behind.

5. How to support this new opportunity for development The earlier sections in this chapter sketched out the rationale and processes by which Southern countries are strengthening their national and sub-regional development banks, creating cross-South development banks, and establishing other institutions or mechanisms for raising finance. The primary purpose of these

Solidarity and the South  39

initiatives has been to supplement the amount of financing for long-term investments on offer globally, and to better support human and economic development. They show there is the potential for a real change in the game. But, they also show that some things have not changed, and need to stay high on policy makers’ radar screens to ensure these new opportunities for development can really deliver. Many positive comments have been made on the contribution that Southern development banks have made in the past few years on the international stage, and little has been said about the challenges they are likely to face, or the lessons that could be learned from failures in the past, or indeed how to treat failure at all. Now they face high expectations about what they will be able to deliver in the coming years. The likely tasks are many ‒ from scaling up financing for infrastructure and green technologies to promoting regional integration projects, not to mention supporting low-income borrowers with concessional lending, especially those often hit by natural disasters and other shocks. There is the notion that a division of labor between South- and North-based institutions is shaping up so that Southern banks can concentrate on activities where they are thought to have a comparative advantage. But it is still not certain what roles each bank will be taking up, partly because the landscape is shifting quickly and the long-established development banks are also responding to the new landscape and trying to redefine their roles in the international arena. Whatever scenario materializes, Southern institutions will likely have to expand lending vigorously in order to keep up with growing borrowers’ expectations and demands. They will confront a major constraint, which is their current limited capital base. One response to that is to expand membership; another is that existing shareholders contribute more capital, which members may do if they want their development institutions to have a prominent role in the years ahead. Both options have pros and cons. Expanding membership too broadly can dilute the sense of solidarity or weaken the southern-voice in governance, and this needs to be weighed up against the benefits of bringing in new capital. On the contrary, some developing countries do not have the same budgetary constraints that advanced economies raise as reasons for their unwillingness to expand their capital contribution to the MDBs. Their more rapid growth rates and younger populations in principle give them more fiscal room to provide additional funding to their own financial institutions. (That said, they have more limited revenue-raising capacity and high needs compared to advanced economies, an issue that needs to be tackled. South–South cooperation on international tax matters would be a good way to start going about it, to address tax avoidance and evasion by large corporations as well as international illicit flows.) Alternatively, in the context of restricted budgetary resources, developing countries could draw on their SWFs to inject new capital in their development banks. This would give SWFs what they currently lack to invest in development projects: technical expertise, which development banks have in abundance. This would be a win-win situation: SWFs are entities with long-term liabilities that would greatly benefit from investing not just in long-term assets but above all investing in the people and the long-term prosperity of their own countries and

40  Diana Barrowclough and Ricardo Gottschalk

regions. By implication, the prosperity of these countries’ future generations is, after all, the very reason why they were created in the first place. This would be a welcome change to a situation in which these funds invest instead, in jittery, Northern-based financial markets. As argued earlier, development banks could, in addition, insist on a longerterm view of economic and social returns. One way is to test the narrow, shortterm view of markets and credit rating agencies by expanding lending beyond and above what has been considered acceptable for a given amount of capital. The current loan-to-capital ratios, set long ago by the World Bank, are clearly low and thus room exists to raise these ratios. The new banks NDB and AIIB are backed by China, a strong shareholder, which gives them the war chest needed to go for higher ratios. This, in turn, could open the way for other banks to follow so that, in the process, a new benchmark could be set to the benefit of both lenders, which would be using their own capital more effectively, and country borrowers, who would be having access to greater availability of financing for development. Unfortunately, AIIB and NDB, in their quests for credibility, are adopting a rather conservative approach on this matter, but there is still time to change tactics and see how markets respond. Other southern initiatives to scale up funding for development have included the creation of investment funds and platforms, many of which are focused on infrastructure development. As reported earlier, China has been behind the largest funds, backed by China’s national development banks and other Chinese State entities, and whose resources can be channeled directly to development projects not only in the form of equity participation but also loans, and indirectly via development banks. While some of these funds are primarily focused on Asia’s infrastructure development, regionally dedicated funds outside Asia such as the China–Africa Development Fund that are exclusively or mostly backed by China also exist, as part of China’s international cooperation initiatives. In 2016, CAD Fund investment decisions in Africa had reached an accumulated value of US$4.1 billion, covering a wide range of projects, from highway and regional airline networks to energy and resource sectors (CDB, 2016; also Gottschalk and Poon, 2018). Africa itself has its ongoing initiatives, including NEPAD’s Infrastructure Project Preparation Facility, aimed at providing technical expertise and leveraging private capital for infrastructure projects. Although some of the African-led funds have been around long enough to have some successful stories, the fact is that they are too small (even those that have China as a contributor), especially compared to Chinese-led funds, and therefore new ways might be explored to strengthen them. The picture thus emerging is one where new institutional and operational arrangements based on multiple partnerships within and across developing regions, led by the South (albeit with some northern involvement as well), to scale up finance for the infrastructure and other projects that are essential for the achievement of several SDGs. To a large extent, this kind of cooperative modality mirrors the sorts of modus operandi the new development banks are eagerly adopting. In their first couple of years of operations, they actively sought

Solidarity and the South  41

collaboration with exiting MDBs, to take advantage of their accumulated knowledge and expertise they are still lacking as well as of their soft windows in projects involving concessional loans (Morris and Gleave, 2016). In addition, the new banks are collaborating closely with the national financial systems and development banks, particularly from the BRICS countries, such as Brazil (BNDES) and China (CDB), which have large banks with a strong track record and deep pool of expertise. By partnering both with international and national banks, these new banks have the potential to become the nub of a worldwide network of development banks. The main strength of such a network would be its diversity in terms of expertise, focus and geographic reach. Greater diversity in the international financial and monetary landscape is welcome, and the additional resources that the new institutions are already starting to provide can have a significant positive impact in terms of generating more long-term financing for development. However, while the rationale of this network is to build on the strengths of individual banks thereby maximizing the use of the current global pool of knowledge and expertise on development finance embedded in these institutions, there is the risk that weaker banks and regions with greater needs and also larger funding and expertise deficits are being left out. There is, in particular, a risk that large swathes of Africa will be marginalized, partly for lacking development banks that are sufficiently strong to support Africa development and engage in meaningful partnership with banks outside the region. The way forward, here, might be not to create new and more institutions but to try to build on what Africa already has. This means, in other words, to expand and enhance Africa’s sub-regional development banks, and strengthen the national ones such as South Africa’s IDC, so that they can have a more prominent presence and thus be able to carve out their own space and role on the African continent. Finally, to make the most of the opportunities in today’s new development finance landscape, it would help to give equal billing to the demand side of the equation as well as supply. The availability of finance is not on its own sufficient – what is also needed are projects, articulated in a developmental plan, and supported by the appropriate legislation, industrial and competition policies and regulations (Carciofi, 2018; Studart, 2020). This challenge was met in the past by developmental governments at the national level in many countries and now needs to be revived and expanded to the regional level. As shown in Table 1.3, Southern-led initiatives include both short-term, essentially preventative and long-term, more developmental financing vehicles. There can be some blurring of functions depending on the conditions. The different activities and functions of government represented in each of the rows can be considered separately, but in practice their impacts are inter-dependent. If development banks are able to support long-term productive investment and transformation that impacts on trade this may be expressed both through the payments system (not shown above, but another locus of many new Southern-led initiatives) and potentially reduce the threat of balance of payments crisis (row 1) (Table 1.4).

China-bilateral swaps measured in many billions of dollars

Regional credit swaps

Regional bond issues, backed by Central Bank of Government

PPPs

Regional development banks and funds

The World Bank records 305 projects in 2017 with a total value of $93 billion, considerably lower than in previous years

A large number exist including AIIB, IDB,CAF, Banco del Sur, FONPLATA, FONASUR, BCIE, NDB More than 250 already. Major National outward investors include development Brazil’s BNDES, China’s CDB banks operating at and Exim Bank, South Africa’s regional level DBSA Sovereign wealth More than 60 in developing and funds transition countries, including at least 10 in Africa alone

Latin America’s FLAR Asia’s Chiang Mai initiative AMF ACF

Regional liquidity sharing pools

1. Preventative – coping with balance of payments crisis

2. Developmental – promoting regional investment

Examples

Form of integration

Main goal

Indicative values

$400 billion

Estimated Some SWFs have regional development as part of their official mandate $6.3 and invest long-term in regional infrastructure and other enterprises. trillion However, most invest in much the same way as national commercial investors; generally across the developing world SWFs are not used as much for development as they could be PPPs are being strongly promoted at national and regional levels but there $93 billion are many concerns about their cost to governments, failure to harness additional investment from the private sector, and other disappointing outcomes. Many countries are returning to more traditional public investment modes Potential new tool for raising capital but does not solve the problem of need for technical support or other expertise

National banks are very diverse, but many are playing an important new role, spreading their interests abroad, in particular at the level of the region

Regional development banks are designed for and are the ideal candidates $302 billion to provide long-term investment

These are not long-term financiers in the sense of development banks but distinctions can blur as some liquidity pools lend funds for quite long periods. Also, perception that countries or regions are well supported against BOP crisis may likely encourage long-term investment (and vice-versa) Depending on the length and conditions these may also be blurred with longer-term sources of finance

Issues/comments

TABLE 1.3 Southern-led initiatives for long and short-term finance by main goal

Sub-regional

National

Caribbean Development Bank BDEAC; BOAD; DBSA; EADB; PTA Islamic Development Bank

Economic development and social progress

Regional integration

Cross-south

All developing regions

African countries

0.4–5.5a

Sub-regional

No

(Continued)

Yes, in the aftermath of the global financial crisis

Countercyclical role

African No continent Latin America Yes and the Caribbean Central America

All developing regions Asia, Africa and the Caribbean

Latin America and Africa

Geographic reach

The Caribbean

Sub-regional

Regional

Yes

Yes

International operations

1.0

6.1

Regional integration; poverty and inequality reduction Sustainable development and regional integration

CABEI

341.9

1,484.7

188.0

21.8

National development; regional integration; internationalization of national companies National development; infrastructure projects; international cooperation China’s exports and imports; overseas investment of Chinese companies; south–south cooperation Industrial development and innovation

Stock of loans US$ billion Year 2016

CAF

IDC

China Exim Bank

CDB

BNDES

Policy goals-sectoral focus

TABLE 1.4  M ain features of selected development banks discussed in the chapter

Solidarity and the South  43

Infrastructure and sustainable development; initial focus on renewable energy projects

Infrastructure development

Economic development and regional integration in the South-American sub-region

BRICS NDB

AIIB

Bank of the South

Source: Authors’ elaboration, based on various sources.

Cross-south

Policy goals-sectoral focus

1.7

1.6

Stock of loans US$ billion Year 2016

Sub-regional

Cross-south

Cross-south

International operations

BRICS countries; other developing countries All developing regions South America

Geographic reach

Not yet

Not yet

Countercyclical role

44  Diana Barrowclough and Ricardo Gottschalk

Solidarity and the South  45

Acknowledgements This chapter includes findings of research carried out as part of an UNCTAD Development Account project on pro-growth macroeconomic cooperation among developing countries managed by Diana Barrowclough, and related research for the Trade and Development Report conducted by both authors. An earlier version of this work has been disseminated as an UNCTAD Research paper No. 24, UNCTAD/ SER.RP/2018/6. Findings have been discussed at inter-governmental meetings, workshops and seminars co-hosted by UNCTAD in collaboration with UNECLAC; the South African Institute of International Affairs (SAIIA); the Ministry of Foreign Affairs, Government of Ecuador; the Union of South-American Nations UNASUR; and the Global Economic Governance Unit, University of Boston. Thank you to D. Poon and C.P. Chandrasekhar for helpful comments on earlier drafts. Opinions and errors remain the authors’ own.

Notes 1 The history of conditionality embedded in IMF-World Bank loan programs is long, in the case of the WB starting back in the late 1970s as part of its structural adjustment programs. By the mid-2000s, conditions attached to loans were both broad and deep covering areas such as public financial management reform, budget process, social reforms and private sector conditions. Many related to privatization (See among others Ahmed et al. (2014), Eurodad (2017), OECD (2014), World Bank, 2007, 2016, 2017). Since then, conditionalities have been streamlined in some cases but many remain and are a significant deterrent for many countries and enterprises seeking loans. This topic is addressed briefly below, and in more detail in a separate paper by the authors. 6 These figures are actual and projected MDB lending for infrastructure by the following MDBs:EIB, EBRD, IsDB, IADB, AsDB, Af DB and WBG (G20, 2011:Figure 8). 7 In a similar vein, while the new multilateral AIIB, together with China’s Silk Road Fund, is expected to support China’s Belt and Road initiative, there have also been suggestions that the strategy should include Africa, by means of focusing on industrial relocation from China to the region (Lin, 2015). 8 CDB (and also other Chinese banks) is also involved in the form of triangular consortia, whereby it (working with the Ministry of Finance or Ministry of Commerce and commercial banks) lends to firms in foreign countries offering grants, import credit, non-concessional or concessional loans, or direct FDI (Gallagher and Koleski, 2012). 9 CABEI is a bank created primarily to promote regional integration. The bank also supports poverty and inequality reduction, the insertion of member countries of Central America in the global economy and environmental sustainability. The Caribbean Development Bank has as its main mission poverty reduction through social and economic development, and the promotion of economic integration and cooperation in the Caribbean region. Lending policies prioritize productive enterprises and social and economic infrastructure (Caribbean Development Bank, 2016).

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Solidarity and the South  47

CDB (2016). Annual Report 2016. Available at: http://www.cdb.com.cn/English/bgxz/ ndbg/. Chandrasekhar CP (2014). National development banks in a development perspective.. In: UNCTAD (ed.), Rethinking Development Strategies after the Financial Crisis – Volume II: Country Studies and International Comparisons, pp. 21–30. United Nations; Geneva and New York: UNCTAD. China Exim Bank (2013). 2013 Annual Report. The Export-Import Bank of China. China Exim Bank (2014). 2014 Annual Report. The Export-Import Bank of China. De Luna-Martinez J and Vicente CL (2012). Global survey of development banks. World Bank, Policy Research Working Paper No. 5969, Washington, DC. Eurodad (2017). Public Private Partnerships, Defuse the Ticking Timebomb, European Network on Debt and Development, October 2017. Gallagher K and Koleski K (2012). The new banks in town: Chinese finance in Latin America. Inter-American Dialogue Report, February. Gallagher K and Kring W (2017). China’s Global Development Consortia, presentation at the South African Institute of International Affairs/UNCTAD seminar “Finance and Development Experiences in South-South Collaboration from Africa, Asia and Latin America”, Johannesburg, May 2017. Gelb A, Tordo S, Halland H, Arfaa N and Smith G (2014). Sovereign wealth funds and long-term development finance: Risks and opportunities. World Bank Policy Research Working Paper, WPS6776, World Bank, February. Gottschalk R and Poon D (2018). Scaling Up Finance for the Sustainable Development Goals: Experimenting with Models of Multilateral Development Banking. United Nations; Geneva and New York: UNCTAD. UNCTAD/GDS/ECIDC/2017/4 Grabel I (2015). Post-crisis experiments in development finance architectures: A Hirschmanian perspective on “productive incoherence”. Review of Social Economy Vol 73, issue 4, pp. 388–414. Griffiths-Jones S and Gottschalk R, eds. (2016). Achieving financial stability and growth in Africa, Routledge, London and New York. G20 (2011). Supporting Infrastructure in Developing Countries. G20 MDB Working Group on Infrastructure, June. Humphrey C (2015). Challenges and opportunities for multilateral development banks in 21st century infrastructure finance. G-24 Working Paper Series on Infrastructure Finance and Development, June. Lin JY (2015). Industry transfer to Africa is good for all. China Daily, 20 January. Morris S and Gleave M (2016). Realizing the Power of Multilteralism in US Development ­Policy. Washington DC: Center for Global Development. NDB (2017). NDB 2016 Annual Report. Available at: https://www.ndb.int/wpcontent/uploads/2017/10/NDB-ANNUAL-REPORT-2016.pdf. Ocampo JO (2016). Regional financial cooperation, presentation at the Global Economic Governance Initiative/UNCTAD seminar “Developmental Financial Institutions: Leadership and Learning from the South”, Presentation at Global Policy Governance Center, Boston University, October. OECD (2014). Case studies on leveraging private investment for infrastructure. Development Cooperation Directorate, DCD/WKP/(2014). Poon D (2014). China’s development trajectory: A strategic opening for industrial policy in the South. UNCTAD Discussion Paper No. 218, December. Rice X and Blas J (2013). Nigeria SWF makes maiden in-vestment. Financial Times, September 1.

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Studart R and Ramos L (2020). The new development banks and the financing of transformation in Latin America and the Caribbean. In: Barrowclough D, Gallagher K P and Kozul-Wright R (eds.) Southern-Led Development Finance, pp. 49–82. London and New York: Routledge. UNCTAD (2016). The role of development banks in promoting growth and sustainable development in the south, December. United Nations; Geneva and New York: UNCTAD/GDS/ECIDC/2016/1. UNCTAD (2017). Financing for development: Issues in domestic public resource mobilization and international development cooperation. Note by the UNCTAD Secretariat to the Trade and Development Board, Intergovernmental Group of Experts on Financing for Development. UNCTAD TDR (2015). Trade and Development Report 2015: Making the International Financial Architecture Work for Development. New York and Geneva: United Nations Publication. Sales No. E.15.II.D3. World Bank (2007). Conditionality in Development Policy Lending. Washington DC: World Bank, November. World Bank and IMF (2015). From billions to trillions: Transforming development finance post 2015-financing for development: Multilateral development finance. Development Committee Discussion Note, prepared jointly by the African Development Bank, the Asian Development Bank, the European Bank for Reconstruction and Development, the European Investment Bank, the Inter-American Development Bank, the International Monetary Fund, and the World Bank Group for the April 18, 2015 Development Committee Meeting. World Bank Group (2016). Private participation in infrastructure (PPI). Annual Update. World Bank Group (2017). Private participation in infrastructure (PPI). Half Year Update. Wu Y (2016). BRICS bank issues RMB green bonds. China daily, 20 July.

2 THE NEW DEVELOPMENT BANKS AND THE FINANCING OF TRANSFORMATION IN LATIN AMERICA AND THE CARIBBEAN Rogério Studart and Luma Ramos1

1. Introduction The world urgently needs to address three daunting challenges. Growth levels to be substantially higher to lay the foundation for lasting, inclusive prosperity. And to reach the sustainable development goals, long-term investments are needed to improve access to energy, clean water, accessible transportation, and more inclusive and cleaner urban environments. Finally, nations need to move the world onto a low-carbon growth path and to mitigate the dramatic consequences of global warming. Properly executed, massive sustainable infrastructure investment can help address these challenges, and pave the way to a more prosperous, inclusive, and sustainable future. Not surprisingly, a significant number of communiqués coming from global forums, such as the G-20, have elected boosting such investment as one of the primary goals set in international institutions and even national authorities. The estimated additional volumes of investments needed globally are in the order of $90 trillion or more, much more than the currently existing global investment stock. Over 60% of it takes place in emerging market and developing countries. In developing nations, and particularly in Latin America and the Caribbean region, the focus of our analysis, the challenge is overwhelming. Public and private sources of investment financing are knowingly limited, and the cost of capital tends to be significantly higher than in developed nations. Domestic private banks often lend with maturities and other credit conditions that are incompatible with the type of investment needed, and their securities markets are relatively shallow and concentrated in a small number of large, internationalized ­ companies. Development banks from developing and developed nations working in collaboration can and should be part of the solution to this problem. Historically they have been part of multilateral, regional, and national strategies to promote

50  Rogério Studart and Luma Ramos

transformation, by fostering the origination, by financing, co-financing, and crowding-in private capital. However, making DBs part of the solution will require rethinking public strategies and policies, and revitalizing existing both multilateral and national institutions. This process of cultural and institutional change can be facilitated and sped up by international cooperation, and it is in this context the creation of new multilateral development banks – such as the Asia Infrastructure Investment Bank (AIIB), and the New Development Bank (NDB) – may present an opportunity. The change in culture and modus operandi of the multilateral system that they may help unlock public and private resources in developing nations towards transformational investment. This chapter discusses the potential role that these new institutions have and how developing countries may benefit from them entirely – and it is structured accordingly. Section 2 presents an analytical view of the potential of development banks as agents of growth and transformation. Part 3 discusses the financing implications of the changes required for sustainable development, with a focus on infrastructure. Sections 4 examines the emergence of new multilateral banks, and the impact they may have on changing “hearts and minds” about development banking and in helping build innovative platforms to foster infrastructure investment. Section 5 analysis the development-banking landscape in the region, with a more detailed look at its largest development institution – Brazil’s BNDES – to assess the state of readiness to Latin America DBs to seize the opportunity and benefit from cooperating with new development banks. Section 5 presents our findings and conclusions.

2. Development banking, growth and transformation Like in many other economic phenomena, economists have distinct visions of the role and ultimate functioning of financial institutions and markets. This separation sets the stage for the understanding of the actual and potential role of development banks. For most economists, financial institutions are mere intermediaries between savers and investors, and cannot affect in the long run the supply of capital and the investment levels. Savers’ intertemporal preferences of assets ultimately shape the amount and conditions of resources available to finance consumption, production, and investment needs, and the real rate of interest represents the reward paid for postponing the use of these resources. In this view, the efficiency of the financial system depends upon their capacity to playing this intermediary role in the most cost-efficiency and frictionless matter. It is what one of these authors elsewhere called the “prior-saving approach,” whereby the forces of thrift ultimately determine the pace and the path of development (Studart, 1995). Because this view assumes that market forces also lead to higher microeconomic efficiency, government interventions represent an unnecessarily misallocation of resources. And these distortions end up with undesired macroeconomic shortcomings – such as lower levels saving, investment, and growth.

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This approach has become the analytical core of different mainstream views on development banks, and of how economists often justify their existence. There are two main sets of “exceptional cases” that are used to explain the roles of such institutions. First, in the early stages of financial development, state-owned financial institutions (SOFI) may efficiently cover for the inexistence of market forces that can guide credit creation and the efficient intermediation of savings. Development and deepening of such market forces, perceived as a natural outcome of free market forces, should make such public institutions less necessary. A logical result of such a view is that the insistence on maintaining them not only demonstrates an irrational dirigisme, often associated by authors persuaded by this view as signs of capture or pure corruption,2 that can only delay further the development of market forces and institutions – a recipe, as mentioned, for inefficiency, poor longterm growth performance, and development (e.g., McKinnon, 1973; Shaw, 1973). Second, SOFIs can be justified by very particular malfunctioning of market forces. As summarized by Castro (2017): Intuitively, the framework on market failures departs from the overall assumption that, under certain conditions, the free market will always arrive at a Pareto optimal result, where an economic outcome is said to be optimal if it is impossible to make any individual better off without making other worse off (First Welfare Theorem). In that perspective, only in very specific situations will the market “fail”, and government intervention can raise economic welfare. These failures occur in cases with the presence of I) public goods; ii) externalities; iii) asymmetric information; and iv) market power. The existence of DBs is justified, therefore, to the extent that these institutions can reduce such failures and, so, (probably) enhance overall welfare. This mainstream approach, however, only partly seems useful to explain two main historical facts around development banking. First, SOFIs were often created in moments where a significant increase of resources was needed to produce fundamental transformation – be it through the building or rebuilding of infrastructure or logistics, the promotion of meaningful innovation and the rearrangements of resources. Because such investments have changed the countries structurally, intermediation based on savers’ evaluating return and risk of assets is logically impossible – simply because past frequency distribution cannot be a guide to outcomes. It was the case of the creation of the contemporary multilateral banks, such as the World Bank, and many national development banks (NDBs hereafter) as part of the effort to rebuild the infrastructure and productive sectors destroyed by war or natural disasters. Second, the “prior-saving argument” does not match with the fact that most of largest NDBs nowadays are extremely active in well-developed economies (e.g., Germany and South Korea), or countries engaged in producing rapid transformations as part of their national

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development programs (e.g., China, Brazil, and India). For that, there is a need to go beyond the “prior-saving” approach. Here is where some critical dissent views come handily.

a. Beyond the “prior-savings approach” As mentioned, most economists adhere to the view that financial intermediaries and markets play an ancillary role in market economies. Others, however, see it differently. For instance, for those that adhere to Keynes’s (1936) principle of effective demand, it is banks’ credit-creating capacity makes it possible for investors’ “animal spirit,” rather than savers’ intertemporal preference, to determine aggregate demand. It is also the conclusion of those persuaded by Joseph Schumpeter’s view of growth and business cycles. In his theory of economic development, Schumpeter (1911) knowingly pointed to technical innovation as the primary source of dynamism, change, and renovation of market economies. But in his framework, it was credit-creating banks that enabled entrepreneurs to buy the resources needed to realize their visions – changing resource allocations and the production function simultaneously. In Schumpeter’s words in a later work: The carrying into effect of innovation involves, not primarily an increase in existing factors of production, but the shifting of existing factors from old to new uses….If innovation is financed by credit creation, the shifting of the factors is effected not by the withdrawal of funds — “canceling the old order”— from the old firms, but by the reduction of the purchasing power of existing funds which are left with the old firms while newly created funds are put at the disposal of entrepreneurs: the new “order to the factors” comes, as it were, on top of the old one, which is not thereby canceled. (Schumpeter, 1939: 111–112)3 The fact that financial conditions can determine investment levels and type makes them also an important determinant of productive capacity and potential output in the long-run – that is, they are also important to determine the path of development. How the general credit conditions are determined, and how particular financial structure is conducive to growth and development is often taken for granted in those analyses. Keynes’s narrative on the role of banks and securities markets in investment finance and funding presents an interesting view on that (Studart, 2017).

b. Development banks, financial conditions, and functionality For Keynes the liquidity needed for investment did not, and could not, depend on prior savings.4 But it is instead often provided by ex-nihilo credit creation

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(Carvalho, 2016). About the role of securities markets in his narrative,5 Keynes offered the concept of “investment funding”. In his view, deposit-taking commercial banks had very limited capacity and desire to hold long-term positions, being naturally averse to widening maturity mismatches. So, if overall liquidity preferences, including that of bankers, remained the same, investment finance, not savings, could indeed become a determent to investment-led growth. The existence of securities markets, Keynes submitted, could mitigate this problem by providing institutions mechanisms of reducing maturity mismatches by issuing securities. From a macroeconomic viewpoint, the macro process of income multiplier could even facilitate funding, by creating financial surpluses that could be sources of demand for securities. This distinction between the functions of “financing” and “funding” is not meant to explain how “markets work” – even because it requires strong assumptions about liquidity preference of banks and securities holders through the process of growth. But it allows for an interesting interpretation of the institutional characteristics of different financial structures in financing long-term undertakings. For instance, in the capital-market based financial structure, the provision of long-term financing depends on the existence and relative stability of primary and secondary markets. The primary markets, when working properly, bridge the demand for long-term assets with the demand of those agents that have long-term commitments – such as pension funds – or contingent liabilities structure – such as insurance companies. In turn, these markets rely on continuous trading to provide the liquidity to otherwise illiquid assets. The finance-funding narrative also allows for understanding the “destructive” power of finance. Keynes, for instance, alerted about the dangers of the securities markets behaving as “beauty contest” (Keynes, 1936).6 In this situation, players start pricing shares not based on what they think their fundamental value but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value to be. This situation is the basis of Minsky’s financial fragility hypothesis that indicates how asset price booms and bursts can produce misallocation of resources. And, even worse, they can lead to a crisis by triggering debt-deflation processes followed by output and employment crises – like the one observed in the most recent 2008 global financial crisis. In sum, the finance theory anchored on Keynes’s and Schumpeter’s narratives allows to understand the disruptive nature of different types of financial institutions and markets – both when it comes to its transformative and its destructive forces. It also permits to understand how financial “architectures” represent solutions to financing problems in decentralized, market economies. It also allows for an assessment of the “macroeconomic efficiency” – or “functionality” – of different structures that go beyond the assessment of microeconomic/financial indicators.7

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If a Keynes–Schumpeter approach is used, banks are not just intermediaries, but also enablers of creation, and reallocation of existing resources towards production and investments. In turn, financial structures should not be viewed as ahistorical objects, but the result of the evolution of institutional settings, determined by policy, market responses, and even circumstances. Finally, development banks should be innovations that allow the enhancement of functionality, by promoting shifts, either dramatic or systematic, of such frontiers. When guided by a consistent national strategy, these banks help support an investment horizon that can help entrepreneurs in their long-term decisions. They can even facilitate the emergence of innovations that can increase of private financial resources to long-term, more uncertain investment undertakings – if they have the expertise and the strategic vision about new sectors and new technologies (Griffith-Jones and Cozzi, 2014).8 This view does allow a reasonable explanation of why they became so common after the II World War. In practice, these institutions often offer instruments that do not exist or are offered limitedly in other parts of the system. As indicated by Studart and Ramos (2016), the most common are: • •

• • • •

Direct lending to ultimate long-term borrowers, guarantees schema or equity finance for complex and highly uncertain investments; Intermediated lending – providing credit to private lenders (e.g., commercial banks), earmarked for further intermediation to the designated sectors or firms as part of an overall strategic approach; Public securitization – purchasing existing loan portfolios of private lenders. Guaranteed market securitization – insuring private lenders’ loan-backed or mortgage-backed securities. Partial credit guarantees on private loans to, and securities issuance by, ­ultimate borrowers. Market liquidity provision – public portfolio investments aimed at increasing the financial market’s depth.

Historically, development banks have been at their best when those instruments were used in support of a dynamic vision and strategy of growth and structural transformation. They mobilized broader resources than would otherwise be possible given the levels of productive and/or financial development. And they financed public goods, which often produce modest returns but have significant long-term externalities. In addition, the creation of innovative instruments, that requires significant sunken costs, can play a Schumpeterian role in financial innovation – this has been for instance the case of infrastructure and green bonds. If properly developed, they allow from “crowding-in” potential private capital towards transformational investments that otherwise would not be feasible at the prevailing financial conditions (Studart, 2017).

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In sum, development banks have been at their best when they were more than just intermediaries of public funds, or when they fill the gaps created by market failures (Studart, 2005; Mazzucato, 2013). They have done so when they were players in niches that, albeit critical to long-term growth and development, only exceptionally attract traditional private investors and institutions.

c. Evolving views on the role of development banks Worldwide, after the Second World War, development banks were created to be part of efforts to build infrastructure and logistics and help promote industrialization. They received support from policy makers and academia.9 From the 1970s however, a different approach emerged in Western academia and multilateral institutions and was embraced by many developing nations – in the African and the Latin American continents. Multilateral development banks, like the World Bank, increasingly were seen as conduits for foreign assistance, and advocates of more liberal, supposedly marketfriendly development models. This was particularly the case after the 1980s, when those institutions emerged as a critical part of structural adjustment policies implemented after the debt crisis in the early 1980s. As part of the “financial repression hypothesis,” national development banks in turn were increasingly down-looked as impediments, rather than promoters, of higher and better allocation of capital. Those were years when for instance Latin America and the Caribbean suffered the largest reductions of the number, size, and scope of action of their NDBs. Paradoxically, the 1990s saw the rise of different perspectives on the role of development banks – for at least two reasons. First, as anticipated by DiazAlejandro (1985) in his classic paper, a significant number of structural adjustment processes and financial liberalization experiences in developing nations ended up in instability and crises, and the collapse of investment. Second, many emerging countries, from Japan and South Korea to China, managed to develop financing architectures, using state-owned institutions and interest rates controls, that were very successful in fostering high levels of investment, rapid growth, and development (Studart, 1995b; Studart and Gallagher, 2016). In the 2000s, this more positive view became more widespread, for two similar reasons: first, the 2008–2009 North Atlantic financial crisis has raised additional doubts on the mainstream assumption that liberalization is the appropriate road to financial deepening, or just a recipe for economic instability and crisis. Second, development banks were pushed to use their leveraging capacity as part of internationally concerted countercyclical efforts, particularly through the socalled G-20 process. Finally, there is clear perception that investments are needed everywhere to overcome the low-growth, high unemployment trap around the world, and to promote the transformations needed to put the world on a lowcarbon, climate smart path. Most of such investments are related to filling significant global and national infrastructure gaps, and development banks may be critical in helping fill them – which we discuss next.

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3. Infrastructure and transformation As indicated by many studies (see e.g., World Bank, 2017), any measure of infrastructure gaps is discretionary. It involves projected rate growth, including sectors, which indicated how demand for economic infrastructure will grow. Also, it encompasses projections and ambitions concerning the pace and path of inclusiveness of economic growth, which in turn indicates the pressures over social infrastructure. With these caveats, most estimates show that the size of the challenge is one of the most significant among other regions, developed or developing, due to the long history of low investment in Infrastructure and Logistics. For instance, as indicated in a recent report (McKinsey, 2016), from 1992 to 2013, China invested in average 8.3% of its GDP in infrastructure – more in economic infrastructure than all North America and Western Europe combined. Latin America in turn, invested only 2.4% of its GDP (Figure 2.1). Not surprisingly, according to the United Nations Economic regional commission (ECLAC), infrastructure deficits are critical to national and regional prosperity – particularly when it refers to transport, energy, water and sanitation, and telecommunications. According to many other studies (IDB, 2013, 2014; ECLAC, 2011), to fill this gap, investments would have to increase to 5% of GDP for a prolonged period, from the current 2% to 3%. If such estimates are correct, the region requires additional investment of $120–150 billion a year (based on the region’s 2013 GDP). Compared to global needs, or even the needs of other emerging-market economies, the infrastructure gap may seem small. For instance, a study (Tuesta, 2015)

10 9 8 7 6 5 4 3 2 1 0

China

FIGURE 2.1

India Developed Middle East Eastern Other Africa Asia and Europe Emerging Oceania Asia

Infrastructure spending as % GDP.

United Western Latin States and Europe America Canada

Transformation in Latin America and the Caribbean  57 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0.00

Public FIGURE 2.2

With Private Participation

Infrastructure investment levels across LAC.

indicates the worldwide gap – for business-as-usual (BAU) needs – is around US$1.4 trillion, whereas in all emerging markets it is US$400 billion. But overall LAC gap is around US$200 billion. Most of such needs, as indicated by a recent report (Tuesta (2015) are related to Brazil (Figure 2.2). The exceptional nature of the problem in the region, which makes it very hard to fill existing infrastructure gaps, results from the failure to counter the decline of public investment with a significant rise of private investment (Studart and Ramos, 2016). And this overall result is not for lack of trying by national governments. Indeed, there has been a consistent improvement of environment for private investors.10 For instance, using a benchmarking index that assesses the capacity of the countries to carry out sustainable public private partnerships (PPPs) in infrastructure,11 the average overall ranking for the region improved by nearly ten points between 2009 and 2014. This higher raking was due to improvements in all six categories (legal and regulatory framework, institutional framework, operational maturity, investment climate, financial facilities, subnational adjustment factor). And it was the regulatory and institutional framework categories that improved the most, as many countries have updated their PPP and concession laws and set up new PPP agencies or specialized units within existing institutions. Not only has private participation in infrastructure responded timidly to this better environment, but the State was “left with the bill” for a significant part of such participation: one-third of all financing to PPPs and concessions came from public sources such as development banks, state and national banks, export credit agencies, and other public authorities and companies.12 In addition, from 2010 to 2014 about half of all PPP deals in Latin America received some form of government support through direct or indirect contributions, with payment guarantees being the most common type of support (Figure 2.3).

58  Rogério Studart and Luma Ramos 35 30 25 20 15 10 5 0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Bonds

FIGURE 2.3

Equity

International Financial Institution Support

Loans

Financing of public partnerships in Latin America.

This picture is even worse for projects that are critical for its physical and economic integration – that is, of projects that consist of coordinated provision among two or more neighboring nations’ governments of infrastructure and its services.13 These investments are critical: they not only enhance growth prospects, but also the reduction of costs and facilitation of intraregional trade of goods and services. They are important parts of creating economies of scale and scope and a larger market for local producers, which logically create productivity and competitiveness gains beyond those produced by national infrastructure investments. Not surprisingly, there have been regional initiatives, such as the Banco del Sur 14 to create specialized regional institutions to deal with this specific problem. Despite these benefits, not only LAC continues to be one of the worst physically integrated continents after Africa. And efforts to overcome this lack of integration have been rare in the region’s history, which have often favored North–South economic integration. One rare exception in this history is that of the South American Council of Infrastructure Planning (COSIPLAN), constituted by infrastructure and planning ministers of all members of the Union of South American Nations (UNASUR). The council publishes a list of projects every year consisting of transport, energy, and communications projects that promote regional connectivity and create sustainable economic and social development in South America. Since the creation of UNASUR the number of projects and estimated investment has grown year after year, except for 2014. However, many projects that were included in the pipeline had not made any progress since 2008 or before were excluded – an indication that the overall pipeline could be much more than the list of projects disclosed by COSIPLAN. In 2015, the number of projects

Transformation in Latin America and the Caribbean  59

increased again, and in 2016 it included 581 integration projects (593 only in 2015) amounting to an investment estimated at US$191.4 billion (182.4 billion in 2015) distributed throughout the nine “integration hubs” in whole South American territory.15 COSIPLAN’s list encompasses high impact works for the integration and socioeconomic development of the region, but only reflects only a limited part of the infrastructure gap for regional integration. As a matter of fact, this list is modified and subject to successive updates not as a reflection of the actual integration needs, but because of the territorial planning process undertaken by the countries. It is a list of projects that, in addition to having that impact, are perceived by their governments as not only being technical, but also “financeable.” From whatever angle one looks, the Latin American region faces at least three major challenges in increasing investments in infrastructure. The first one results from government budgetary constraints, sometimes self-imposed, that makes it very difficult to raise public investments at the levels needed. Second, limited capabilities in the public and private sector constraints the pipeline of projects required. Finally, long-term financing is limited, as there is a lack of institutions and instruments that can “close the dots” between potential providers of funds (e.g., institutional investors) and those in need of them (developers). To achieve the last two goals simultaneously, a new financing architecture may be necessary. And, as indicated in earlier works (e.g., Gallagher and Studart, 2016) NDBs should be focal points to develop such a design. Multilateral and regional development banks should also have an important role to play. This is what we will start discussing hereafter.

4. Development banking in Latin America Since the 1950s, multilateral development banking has been dominated by the World Bank, and two regional banks: the Inter-American Development Bank and the Development Bank of Latin America – until recently named Corporacion Andina de Desarollo (CAF). Those institutions maintained relatively stable business models and governance since they were created. NDBs, which abounded until the 1980s, suffered significant reduction in number and the scope of action. Since 2015, two large new multilateral development banks were created by nations of the “South”: the AIIB and the NDB. This section analyses the characteristics of these new institutions, and the opportunities they represent for the making development banking a source of transformation for the region. While new development banks are being created around the world, Latin American development banking has been in decline for at least three decades. In the 1980s and 1990s, the numbers of these institutions suffered a significant decline, and those left had their mandates often limited to intermediation of funds. One of the few exceptions is BNDES, which in the 2000s expanded its operations and their scope, becoming one of the largest and most active development banks in the regions. More recently, BNDES itself is under pressure that

60  Rogério Studart and Luma Ramos

threatens its own business model and, more importantly, its role as an instrument of transformation. This is what we will see next.

a. Latin America: development banking under ideological pressure Latin American NDBs, like those in different developing regions, operate in bank-based financial systems, where securities markets have a limited role in financing long-term and riskier undertakings in an environment of still limited financial depth.16 When it comes to long-term financing, domestic private sector financing is extremely limited in most of these economies, except somewhat in Chile. Mostly, but particularly in case of Brazil, long-term financing is mainly provided by public banks in general, including its main development bank (BNDES). In the number of NDBS in LAC has significantly fallen in the past 30 years, as the 1980s and 1990s financial reforms in the region meant the closure and/or overhaul of the business models of a significant number of public banks. Most NDBs were privatized, closed, or restructured, a process which was reflected in the decrease in membership of the Latin American Association of Development Financing Institutions (ALIDE) from 171 institutions in 1988 to just 79 in 2013. Most of the surviving NDBs did improve their “efficiency” however, as measured by standard performance indicators (Stallings and Studart, 2005). More recent studies, such as World Bank (2012) and De Olloqui et al. (2013), confirm that this positive trend has continued: public banks in the LAC region seem to have achieved degrees of efficiency and operational performance that match and sometimes even exceed that of private institutions. Lately, these banks have been mandated with the difficult task of playing a countercyclical role. For that purpose, some public banks were capitalized, or their profits were reinvested, which allowed them to increase lending with their own resources. In addition, they could increase their access to resources coming from international financial institutions – such as the World Bank, the Inter-American Development Bank and the Latin American Development Bank (CAF) – which were also mandated by their shareholders to expand their lending as a contribution to the global countercyclical efforts. The overall result was a significant increase in the total assets, and particularly in the loans, of regional NDBs, as shown below. Such an expansion was well spread among the following traditional target sectors: (i) agriculture and rural investment (25.7%); (ii) housing, construction and infrastructure (18.9%); and (iii) trade (12.1%). The main beneficiaries were small and medium-sized enterprises (38.9%), but very large ones also benefited with 19.5% of the total disbursements. Most contracts, 62% of the total, are long- and medium-term loans. Despite this rapid expansion, NDBs remained extraordinarily solid, both operationally and financially, as indicated below (Table 2.1). The question that remains is how this expansion has been useful in addressing the enormous infrastructure financing gap in the region. From earlier analysis

Transformation in Latin America and the Caribbean  61 TABLE 2.1  National development banks in LAC: selected operational and financial

indicators-2016

Banco de la Nación Argentina Banco de Inversión y Comercio Exterior (BICE) Argentina Banco Nacional de Desenvolvimento Econômico e Social (BNDES) Brasil Fondo para el Financiamiento del Sector Agropecuario (FINAGRO) Colombia Banco de Comercio Exterior de Colombia (BANCOLDEX) Colombia Corporación Financiera Nacional (CFN) Equador Nacional Financiera (NAFIN) México Banco Nacional de Comercio Exterior (BANCOMEXT) Mexico Corporacion Financiera de Desarrollo (COFIDE) Peru

Total assets/ Loans/ GDP (%) total assets (%)

ROAE (%)

Operating ROAA profit/average (%) equity (%)

Net interest margin (%)

9.7

11.04

−8.09

−8.97

−1.88

2.73

0.12

43.64

10.26

10.31

4.02

5.01

15

39.64

9.08

12.2

0.82

2.76

1.1

81.93

6.41

10.79

0.68

2.15

1.91

0.85

9.2

0.97

3.31

8.5

2.91

2.04

14.46

5.05

7.11

0.3

0.81

1.82

44.85

3.26

5.18

0.21

3.29

2.03

5.73

2.83

5.56

0.58

1.52

(Stallings and Studart, 2005; Studart, 2017) three cases are interesting in this respect: Brazil, Chile, and Mexico. The latter two will be briefly reviewed below, whereas the former will be analyzed in more detail in the subsequent sections. Chile is one of the most successful cases in financing infrastructure, with private sector resources backing and a large experience in private-sector participation in the infrastructure undertakings. Certainly, despite the swings in

62  Rogério Studart and Luma Ramos

national politics in the past two decades, different governments have been extraordinarily consistent in building an infrastructure financing architecture, and which subsequently became a state policy with cross-party support. Two institutional advancements were crucial in this regard: the creation of the Ministry of Public Works (MOP in Spanish) in 1993, and within it the establishment of one department specialized in concession plans in 1995. The latter department has an important role in originating projects, preparing bidding documents, and managing and supervising the planned works. The concession system is based on a very efficient risk managing and sharing system, which includes the possibility that the government may grant certain guarantees or cover certain risks so that socially profitable infrastructure concession could be viable. Thus, it sought to free up public resources for infrastructure that, while socially necessary, could be socially unviable by paying a fee or toll. One of the main features of this action was the risk sharing. The Chilean concession system is based on the general principle that risks should be transferred by the concessionaire, to the extent that can be controlled by it. If the risk is not diversifiable or fully transferable to the market, the state must assume full or in part. In this vein, the Ministry of Public Works helps control the risk of construction, commissioning, and delivering engineering projects almost definitive way to the concessionaire. Other risks, arising for instance from changes in the design, availability of materials and equipment, transportation costs, and change in unit prices, etc. must be borne (managed and diversified) by the concessionaire. Another relevant feature of this model is the strong regulatory framework that protects the investors. This is based on two main legal “pillars”: the 1991 Concessions Law and its 2010 Amendments. Together they worked to create an enabling environment for PPPs and addressed all phases of a PPP project, from the proposal to the eventual transfer of the completed asset at the end of the concession’s agreement. In addition, Chile provides strong legal protection and minimum income guarantees for all investors. For instance, in 2005, a currency risk management program was put in place, whereby the government began to insure concessionaires against exchange rate risk if financing had been secured in foreign currency.17 This program shifted financing currency risk from the concessionaire to the government by requiring the government to reimburse the concessionaire if the peso weakened below an agreed level, but, in turn, requiring the concessionaire to pay off the government if the peso strengthened. With regards to the funding model, the concession system is project finance, and has three well-defined types of structure: bridge loan for construction, and in anticipation of the issuance of infrastructure bonds; and long-term credit during the operation and long-term loans. In the case, a bank loan is secured during construction, and after which an infrastructure bond is issued to fund the operation of the concession (when the concessionaire is already operating the service).18 The second mechanism separates the risks of construction, operation,

Transformation in Latin America and the Caribbean  63

and the absence of negative carry. Its disadvantages are the risk of interest rate for long-term refinancing, the banks’ ability to finance large projects and the demand for greater guarantees to the project promoters. The third type has become very competitive, partly because banks have extended deadlines to compete with the first embodiment.19 Thus far the results of this infrastructure financing architecture are good. Between 1995 and 2008, 55 projects – in highways, intercity roads, and airports – were implemented under the concessions systems and voluminous direct public investment, representing a total of investment of close to US$11.5 billion. Already in 2014, the total of projects was 68 in an amount of US$17,635 billion. It is important to highlight that over 120 companies, including foreign investors from at least eight countries, have participated in concessions bid. In addition, the system has incorporated new actors such as insurances firm, risk rating agencies, banks, construction enterprises, and infrastructure operators. Another interesting example is Mexico – for quite diverse reasons. NAFINSA was the main Mexican development bank; however, it suffered significant retrenchment in the 1980s and now is mainly dedicated to the financing of small and medium-sized companies. The predominant source of financing for the sector continues to be the State and its dedicated public bank, BANOBRAS (National Bank of Constructions and Public Service), an institution was created in 1933 with the sole objective of intermediating resources for projects receiving direct or indirect public funding in the areas of infrastructure and provision of public services. In addition, an important objective of the bank is to support the institutional strengthening of state and local units of government, and to further sustainable development. BANOBRAS-supported project goals include defined targets in areas such as a development of basic social infrastructure, enhancement of national competitiveness, support to economic growth, and generation of significant net public benefits.20 BANOBRAS is also responsible for managing the National Infrastructure Fund, national trust fund that was created in 2008 with the mission to finance infrastructure. This fund provides grants, loans, and guarantees (for stock, credit, damage, and political risk), subordinated lines of credit, and grants for technical assistance, with initial capitalization and its own operating revenue sources. FONADIN was assigned to support and coordinate investments focusing on the highways, ports, airports, environment, urban mass transportation, communication, water, and tourism projects.21 To crowd-in private resources to infrastructure investment, BANOBRAS has shifted its focus away from traditional direct financing since 2001. It has fostered the development of instruments to boost municipal access to credit, enhance the provision of technical assistance, and work towards the strengthening of the sub-national debt market through guarantees and development of the project financing market. More recently emphasis has been placed on assisting projects that generate their own income streams, with private participation in development and operations.

64  Rogério Studart and Luma Ramos

In addition to providing very long-term financing channel, BANOBRAS has a had key role in bearing project financing risks that are not usually taken by private sector and enable leveraging of the maximum private participation in projects with high net public benefits, but higher risk and lower levels of financial profit. On the other hand, it provides know-how for the planning, design, construction, and final transfer of projects developed by the private sector. FONADIN also allows BANOBRAS to have a central role in fostering public–private partnerships. Today, the fund is one of the most important conduits for PPPs in Mexico. The financial capacity of this architecture is substantial, but insufficient. In 2012, FONADIN authorized support for more than US$2.4 billion in projects.22 In recent past, all the federal toll roads under PPP projects have received support from FONADIN. In the Private Equity program, FONADIN has committed US$400 million to support eight different private equity funds, with a total market cap of US$2.4 billion. This is particularly relevant because México simply did not have these kinds of funds pre-2009, conforming USTDA (2014). As mentioned above, the Mexican authorities have also made extraordinary efforts to attract private financing to infrastructure investment, particularly by supporting the development of new instruments. Two cases are important to mention. The first one is the so-called Development Capital Certificates23 (CKD’s), a hybrid capital/debt security, designed primarily for the financing of long-term infrastructure projects in Mexico and to finance investment mid-size Mexican companies. These CKDs are listed in the stock exchange, which ensures market discipline and transparency, and have been a useful instrument to tap funds specialized in infrastructure development. To make sure that these financial products are consistent with the best interests of members, investors, beneficiaries and other stakeholders, the National Banking and Securities Commission has established specific regulation regarding CKD’s issuances, including shareholders’ rights and responsibilities. Additionally, this commission has developed monitoring and surveillance processes according to with best international practices. The second example of efforts to attract private resources is the National Infrastructure Program for 2014–2018. It is a very broad program of Mexico’s federal government that aims to increase the country’s economic growth and productivity, based on three guiding principles: (i) sustainable urban development, (ii) balanced regional development, and (iii) intermodal connectivity (upgrading the interconnection of highway networks, ports, airports, and cities). This plan also includes the participation of Mexican public banks, complementing commercial banks’ lending, with adequate risk sharing, that could allow increasing credit growth, in areas that are not fully covered by commercial banks, like infrastructure and SMEs.24 The Chilean and Mexican cases seem to be extremely representative of the reality of infrastructure financing in the region. Only very few, like Chile,

Transformation in Latin America and the Caribbean  65

succeeded in creating a strong private participation in financing any long-term undertakings, particularly infrastructure. Several of them have public dedicated banks and funds that either channel or complement budgetary resources or funds coming from international financial institutions. Even though there is significant evidence that part of the problem of infrastructure financing must do with the supply of “bankable” projects, lack of interested private investors limited significantly their availability of finance at reasonable costs. This leaves infrastructure investment very vulnerable to changes in fiscal and/or external financial conditions. Finally, private and public resources to finance sustainable infrastructure investment seem to be even more scarce.

b. Brazil’s BNDES Founded in 1952, the Brazilian Economic and Social Development Bank (BNDES) has had a catalytic role in promoting transformational investments in different phases of Brazil’s socioeconomic development (Studart and Ramos, 2016). BNDES’s history is profoundly connected with Brazil’s post-war development. In the early years, its primary role was to finance economic infrastructure projects and develop the steel industry that was critical for industrialization-based consumer durables (Studart, 1995). Already in the 1960s, it helped finance the development of the consumer goods industry. BNDES played a fundamental role in the 1970s import substitution programs that strengthen several industrial input-producing sectors (e.g., petrochemical industry) and equipment and even created entirely new ones (e.g., information technology and microelectronics). Indeed, BNDES helped shape what is now the most diversified industrial sector in Latin America (Castro and Souza, 1985). During the 1980s, in addition to its other mandates, BNDES promoted the expansion of the energy exports, agriculture, and promoted social integration. In the 1990s, it was a critical part of the federal privatization program, by assisting in the sale of large State-owned Brazilian companies. The overall financial performance of BNDES has been impressive in the past decade. Disbursements have been multiplied by more than four times (on average US dollars), whereas profits almost quadrupled. This performance is partly due to its role in supporting two large government-sponsored investment programs, the growth acceleration program (PAC in its Portuguese acronym) and the logistics investments program (PIL), and the countercyclical role it played in the aftermath of the 2009 crisis.25 BNDES became one of the largest financial institutions in Brazil – in addition to becoming one of the five largest development banks (be it national, regional, or multilateral) in the world. This market position did not come without challenges. And one of them became increasingly controversial in Brazil: its funding strategy. Indeed, until very recently the main sources of funding to BNDES were provided by investments of “quasi-public” funds (PIS-PASEP and FAT)

66  Rogério Studart and Luma Ramos

associated with social insurance and workers’ safety nets, returns of its outstanding loans and equity investments, bond issuance, and/or borrowing from multilateral institutions. This has changed since 2009 when BNDES stepped in to fill the post-crisis 2008 crisis created by the retrenchment of private financing. Incapable of tapping the market at a pace compatible with the expansion of its loan portfolio, BNDES’ funding became highly dependent on transfers from the National Treasury and the volume of resources coming from it increased substantially, becoming higher than 50% of the total. This extraordinary growth of transfers from Brazil’s national treasury revived an old controversy on the societal costs of promoting industrial policies, and therefore on the validity of the BNDES funding strategy. The problem lies in the fact that Brazil does not have a developed term-structure interest rates curve (or yield curve) because most private debt instruments have short maturities. For that reason, BNDES uses the so-called TJLP, the acronym for the long-term interest rate, which is the benchmark rate created by BNDES, around which it sets the interest rates charged on its loans. Since its creation, TJLP has been set systematically below the Treasury interest rates, even the rate on their most liquid bonds (SELIC) – as can be seen below. As the participation of Treasury loans to BNDES reached historical levels, critics raised a concern about the fiscal impact of such transactions. For many of them, the difference between the roll-over cost of the national public debt and the long-term interest rate charged by BNDES represents a fiscal burden, “handouts” that are higher than the societal benefit coming from the projects financed. In addition, some claim that the BNDES strategy to lend to large companies and/ or exporters should not have been part of its mandate as an instrument of public policy, as it supposedly created unnecessary distortions in the macroeconomic supply of credit (e.g., Lazzarini et al., 2011). Others, like these authors (e.g., Studart and Ramos, 2016) argue that the lack of private long-term financing and high short interest rates makes it necessary for BNDES to set an interest rate that is less volatile than Treasury rates and compatible with the maturity structure of the projects and investments it supports. In addition, attention is brought by the same approach to the important role that BNDES loans play in directing investment as part of broader industrial policy, and their externalities and multiplier effects (on production, employment, and competitiveness). It is important to notice that there has been a convergence of TJLP towards Treasury interest rates, including SELIC, over the years, particularly in the years when they declined and/or became less volatile. This debate does not settle quickly and would deserve a document of its own. For our purposes, here, however, we emphasize that the increasing dependency on semi-fiscal sources of funding creates challenges for the bank model. Not surprisingly, much before 2015, there had been raised pressure on BNDES to adjust its pricing (and reduce the differential with Treasury bond rates), to widen the co-financing of larger projects, and to just downsize. Therefore, for

Transformation in Latin America and the Caribbean  67

financial and political reasons, this model needs to evolve if BNDES wants to expand its relevance in addressing the significant challenges faced by Brazil – particularly those related to the improvement of existing infrastructure and logistics.26 The challenges of BNDES nowadays, however, go far beyond solving its funding problems. In fact, after the impeachment of former president Dilma Rousseff in July 2016, a new economic team was appointed and there was a replacement of leadership in BNDES, and significant changes of orientation happened. The first one was associated with the pressure put on BNDES to make an anticipated repayment of its debts with the National Treasury starting with a R$100 billion (US$30 billion) in December 2016.27 Another important change was very recently announced by BNDES senior management concerning the pricing system method and the creation of the TLP (long-term interest rate). Even though the acronym of the new rate seems like the earlier one (TJLP), this change has important governance and operational consequences. Concerning the governance of this policy instrument, the TJLP was set quarterly by the National Monetary Council, which includes representative the ministries of finance and planning, as well as of the central bank. This composition allowed the final decision to be determined by the overall development strategy set by the executive branch, but also influenced by the monetary policy objectives. The new TLP will be determined solely by the central bank, which is guided by targeting price stability. Finally, BNDES is moving towards a “transversal” approach in its interventions. The bank seemingly will cease to promote “sectors” and large firms and/ or exports of services. It is introducing the use of external auditing firms for large-scale infrastructure projects with a financing of more than R$1 billion and of more than R$500 million in other sectors. BNDES participation will be limited to 80% of the cost of projects. As is currently proposed, they will focus on six categories of investment with differentiated financial conditions: education, health, innovation, export promotion, MSMEs, and infrastructure projects are priorities. It is still very early to draw conclusions about these changes. But it is worth discussing some possible consequences. The first one refers to the transfer of resources back to the National Treasury. Given the significant fall in the demand for its resources in the past two years, BNDES is experiencing a moment of high liquidity. According to its capital position, it is unlikely that BNDES will have any difficulties in maintaining its current lending – which is, as mentioned earlier, the lowest level since 2008. However, when investment demand increases, the institution is likely to be under pressure to expand its lending and will have little capacity to do so. The second question refers to its new pricing policy. It remains to see how this directive is implemented, but some observations should be made. First, TJLP is already set using several variables in consideration, including Treasury

68  Rogério Studart and Luma Ramos

bonds. Changes in the rate were implemented with a certain delay and a significant amount of discretion. The lag was necessary to avoid volatility in TJLP, which would make it inconsistent as a rate guiding long-term undertakings, such as infrastructure projects. And the discretionary approach was meant to avoid TJLP ending up being pro-cyclical – a role of development banks since the 2009 crisis, which has been supported by G-20, multilateral institutions and think tanks. In addition, the new TLP will be set monthly and will peg a rate that for the past decade has not only been very volatile, and significantly higher than TJLP. Indeed, according to several recent reports, including Santander (2017) and Torres (2017), if the TLP had been used as a reference rate on BNDES loans, except for 2006, it would be systematically higher than TJLP – which in turn has already been one of the highest interest rates in the world for the past decade. When adopted, the TLP may end up being too high to be relevant in financing long-term investment, and BNDES may cease to be a potential instrument for countercyclical policies, when needed. Indeed, it may even turn to be pro- cyclical, given that in the past Treasury rates have behaved that way (Figure 2.4). Finally, there remain some question marks around the change of orientation of BNDES operational policies towards a horizontal support for investments. Until now, it is unclear how this new guidance will be able to handle the fact that BNDES has traditionally been an industrial policy instrument, providing support to specific government programs and initiatives that usually target sectors – and not crossing issues. How this problem will be dealt with will evidently be fundamental to not only define the future of this institution, but also the role that BNDES may have in structural changes that Brazil required. 40,3

NTN-B + 2,5% TJLP + 2,5% aa

21,9

21,4

14,8

17,9

16,0

13,0

8,8

14,3

13,1

10,5

FIGURE 2.4

Costs of BNDES loans.

2015

2014

2013

2012

2011

2010

2009

2008

6,7 2007

2006

2005

2004

2003

2002

8,7

2016

23,3

Transformation in Latin America and the Caribbean  69

5. New multilateral banks in the block Since 2015, two large new multilateral development banks were created by nations of the “South.” The AIIB is mainly a Chinese initiative but ended up having 57 members. And the NDB was an effort of the so-called BRICS nations (Brazil, Russia, India, China, and South Africa), and still are completely owned by these five nations, but whose articles of the agreement allow for a future increase in membership outside its founding members. A snapshot comparing the “new DFIs” with the existing ones gives us a very interesting picture of what they stand for (see Table 2.2). From this, it is possible to observe that both initiatives represented an attempt to shift “the balance” towards more representation of EMEs. This change had been frustrated systematically in the discussion of “voice and representation” at the World Bank in the aftermath of the 2008 crisis and the elevation of the G20 ministerial grouping to a leader forum. Notwithstanding that, another important rationale for the new institutions relates to the (interrelated) failure of the existing DFIs in being a platform to raise finance to fill the infrastructure gaps of their developing members. The AIIB was first proposed by Chinese President, Xi Jinping, in 2013 and was established by a Memorandum of Understanding signed by 21 countries. The total authorized capital was US$100 billion, with initial subscribed capital of $50 billion. As pointed out by Callaghan and Hubbard (2016), the AIIB has a governance structure that is like the other MDBs, with two critical differences: it does not have a resident board of executive directors and the AIIB’s articles give more decision-making authority to regional countries and the largest shareholder country, China. Last January, when it celebrated its first year of operations, it already had 57 members represented at their non-resident Board of Executive Directors by 12 “constituencies.” Fourteen of the G-20 nations are AIIB members, but following its Articles of Agreement, regional members hold 75% of the total voting power in the Bank. Its operations are to be focused on Asia, but its procurement is open to all its members. The figure below shows the AIIB executive board organization (Figure 2.5). Despite its short life, the AIIB had already invested over $1.7 billion in nine projects across Europe, Asia and the Middle East, an amount that exceeded significantly the target of $1.2 billion set by Jin Liqun, its president, for 2016.28 And, recently, its president said that it plans to increase operations gradually, investing US$3–5 billion in 2017 and around $10 billion in 2018. Following what was indicated at the time of its creation, AIIB’s strategic guidelines are around the issues of sustainable infrastructure and furthering physical and trade integration – particularly among Asian nations, but also beyond. It prioritizes cross-border sustainable infrastructure, ranging from roads and rail to ports, energy and telecoms across Central Asia, and the maritime routes in South East and South Asia, and the Middle East, and beyond. It also aims at devising innovative solutions that catalyze and mobilize private capital, in partnership with other MDBs, governments, and private financiers.

94.4 100 2.5 Africa

223

280

11.5

Developing world

80 Nigeria 8.87% US 6.53% Japan 5.46%

Authorized capital (US$ billion) Subscribed capital (US$ billion) Financing to the public sector in 2015 Region of operations

15.90% 7.37% 4.76%

188 US Japan China

Number of members Largest shareholders

1963

1944

African Development Bank

Foundation

World Bank

Asia

5.6

164

162

67 Japan 15.70% US 15.60% China 6.50%

1966

Asian Development Bank

TABLE 2.2 A comparison between new and existing multilateral development banks

Developing world

n.a..

100

5 Brazil Russia India 20% China South Africa 50

July 2014

New Development Bank

Asia

n.a.

100

72.2

January 2016 57 China India Russia

26% 7.50% 5.90%

Asian Infrastructure Investment Bank

70  Rogério Studart and Luma Ramos

Transformation in Latin America and the Caribbean  71 Regional seats Executive Director

% of Vote

China

28.8%

Indonesia

10.2%

India

8.3%

Russia

7.9%

Australia

6.1%

Saudi Arabia

6.0%

Turkey

5.7%

S. Korea Thailand

5.3% 3.3%

Germany

9.5%

U.K. Brazil

FIGURE 2.5

Non-regional seats

8.0% 0.9%

Countries represented China Cambodia, Indonesia, Laos, Myanmar, Sri Lanka India Iran, Kazakhstan, Russia, Tajikistan Australia, New Zealand, Singapore, Vietnam Kuwait, Jordan, Oman, Qatar, Saudi Arabia, U.A.E. Azerbaijan, Brunei, Georgia, Krygyz Rep., Pakistan, Turkey Israel, S. Korea, Mongolia, Uzbekistan Bangladesh, Malaysia, Maldives, Nepal, Philippines, Thailand Austria, Finland, France, Germany, Portugal, Spain Denmark, Iceland, Norway, Poland, Sweden, Switzerland, U.K. Brazil, Egypt, S. Africa

AIIB board of directors.

In addition, since its inception, AIIB is mandated to cooperate with existing multilateral development banks, including the World Bank and the ADB.29 Several of the projects supported by AIIB were co-financed by these two other institutions – like the recently approved $600 million loan to construction of the TransAnatolian gas pipeline (TANAP), which will connect Azerbaijan to Europe, partnering with the World Bank.30 It can do that because its management structure, business model, safeguard policies,31 and even governance are very like those of the World Bank and ADB – the only significant difference being, of course, who holds the largest shares. Early fears of some analysts that the AIIB would represent a lower bar in their treatment of social and environmental safeguards seem now misleading.32 It would be however misguiding to view the institution as independent in relation to China’s national strategies. Indeed, it is becoming evident that from a Chinese national viewpoint the AIIB is an instrument to help implement its One Belt One Road (OBOR) policy, aiming at reshaping its trade and investment future along the lines of a 21st century Silk Road.33 The NDB represents altogether a different type of multilateral arrangement – one that is seemingly evolving throughout time. To start with, it was established as part of a very particular cooperation agreement among five emerging markets economies from different regions of the world, different economic sizes and different global geopolitical roles – the so-called BRICS. The initiative started at the fourth BRICS Summit in New Delhi (2012), where the leaders of Brazil, Russia, India, China, and South Africa directed Finance Ministers to examine the feasibility and viability of a new DFI, also focused on mobilizing resources for infrastructure and sustainable development projects in BRICS and other emerging economies, as well as in developing countries.

Administration Corporate communications

Strategy

Partnerships

Source: Bertelsmann-Scott et al. (2016).

Information technology

Risk management

Economic research Human resources

Responsibilities

VP – Chief Administration Officer

Authority over the activities of the bank

Chair, Board of Governors

Russia

VP – Chief of operating staff

Chair, Board of Directors member Decisions on an operational basis, including approving budget

Brazil

Position

Participation in corporate governance

Responsibility

Position

Overall governance

Country

TABLE 2.3  N DB – overall and corporate governance

VP – Chief Operations Officer

Regional offices

Operational compliance Project procurement

Chief of Operating Project lending Staff

President

Headquarter host

China

South Africa

VP – Chief Financial Officer Treasury and portfolio management Finance Budgeting Accounting functions

South African Regional Centre Day-to-day Housing of the bank’s Housing of operations of the main operations the bank’s bank first regional center

President

India

72  Rogério Studart and Luma Ramos

Transformation in Latin America and the Caribbean  73

After two years, a working group dedicated to the matter presented a proposed Agreement, which was finalized in the 2014 sixth BRICS Summit in Fortaleza, Brazil. The leaders signed the Agreement establishing the NDB, stressing that the NDB should “strengthen cooperation among BRICS and will supplement the efforts of multilateral and regional financial institutions for global development, thus contributing to collective commitments for achieving the goal of strong, sustainable and balanced growth” (NDB, 2017). The governance structure is extremely different from those of other DFIs, including the World Bank and the AIIB. As mentioned earlier, control continues to be restricted to the founding members, but its Articles of Agreement allows for future expansion of the membership. And the participation in the strategydefining and decision-making process is very much guided by a “division of labor” within both overall and corporate governance, as indicated above (Table 2.3). This structure seems to facilitate a significantly operational drive towards partnerships with national and regional development banks. Operations are thus far reflecting this drive. For instance, in 2016, the Board of Directors of the NDB approved seven investment projects totaling over US$1.5 billion. All projects are in founding member countries, and support infrastructure projects, more than 75% of which are sustainable and mainly renewable energy generation. It is very difficult at this stage to speculate how operations will evolve. However, according to Griffith-Jones (2014), after a period of 20 years, the bank could be lending US$34 billion annually, and the stock of total loans would reach almost US$350 billion. This will depend on the evolution of lending and, especially, the leverage ratio that the bank will adopt. In addition, membership will be open to borrowing and non-borrowing members. It means that developed countries can participate in lending money and emerging countries can either lend or borrow. Nevertheless, applicants must also be admitted by a “special majority.” According to NDB (2014a), developing countries will hold at least 80% of the voting power, relegating developed countries to a maximum of 20%, with a ceiling of 7% for the non-founding member. Additionally, the BRICS together can never have less than 55% of the total votes. Hence, it can be said the NDB will be ruled by its early founders.

6. Findings and conclusions Financing is an important challenge, but certainly not the only one needed to be addressed to fill the infrastructure gaps in Latin America. Surpassing this barrier may require building an architecture that can simultaneously facilitate the creation of a substantive pipeline of projects and promote the financing to pre-construction and post-construction phases. For developing nations, the task of developing such architecture can be daunting. To start with, a few countries have public and private capabilities and/or access to the technology needed to create a pipeline of technically sound, socially inclusive, and environmentally sustainable infrastructure investments. Without such pipeline, it is difficult to

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raise public investments efficiently, or attract private financiers, or even to promote adequate public–private partnerships. This chapter suggests that a new international architecture – based on an alliance of national, regional, and multilateral development banks – could help planning, originating on facilities, creating uncertainty mitigating innovations (e.g., currency risk guarantee funds, securitization structures), and to attract domestic and, particularly, international institutional investments. In Latin America, promoting such an alliance requires a different look about development banking. As described above, since the 1980s the number and role of NDBs as promoters of transformative investment have been systematically reduced in the region. Brazil’s BNDES has been one significant exemption, by keeping a central instrument in implementing long-term development strategies – but even that institution now under great pressure to reduce its relevance. This trend is completely at odds with what happened in other parts of the world, such as in Europe and Asia, where strong public financial institutions had important roles in achieving high levels of infrastructure investment and other types of transformative investments. In addition to a change of “minds and hearts” about development banking, a strategic alliance between the new MDBs and existing regional and national development banks could be a pillar to create “origination platforms.” Such platforms would provide finance and technical assistance so that national and subnational governments can identify potential projects, prioritize their execution according to their social and economic impacts and develop mechanisms to guarantee that they are climate smart. Such a strategic alliance could promote new mechanisms to reduce the early financial cost of potential infrastructure projects through co-financing structures. It could also help mitigate financial risks through guarantees and by working on the preparation of issuance of specialized debt instruments, such as infrastructure and green bonds. By creating specialized funds for such activities, this alliance could promote pools of experts, both from the public and private sectors that can help in leveraging resources to maximize and leverage public spending. Finally, an initiative like this could increase significantly the intermediation of public and private pools of funds. Foreign aid, rather than used directly to fund projects, could be channeled to guarantee funds – for currency and other sovereign risks – aiming to maximize access to private finance and crowding-in resources in the international markets. And institutions like the World Bank could be extremely useful in creating such new instruments. Last but not least, the emergence of the new multilateral banks, such as AIIB and the NDB, could present a renewed opportunity to advance such an alliance. Being dominated by Southern countries, members may be less resistant to promote partnerships with developing nation governments and institutions that are less hierarchical than the one currently in place. In addition, and perhaps most importantly, the NMBs bring a new perspective on development banking from the one that has prevailed in the existing multilateral institutions.

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Annex – Banco del Sur: motivations and challenges Bank of South, or Banco del Sur, is a development bank in Latin America and was created to financing each other’s development projects. Launched in 2007, it was officially established in December of 2013 by its seven founding countries members – Argentina, Bolivia, Brazil, Ecuador, Uruguay, Paraguay, and Venezuela. Its headquarter is in Caracas, Venezuela, with planned branch expansions in Buenos Aires, Argentina, and La Paz, Bolivia. The expected capital to be paid in by its founding members is US$7 billion; however, its maximum approved capital it US$20 billion. Venezuela, Argentina, and Brazil would each contribute $2 billion. They have a year after ratification to pay in their shares. Ecuador and Uruguay would donate $400,000. Bolivia and Paraguay each would add $100,000. The payments can be made in four annual installments. Other countries can contribute to a maximum of $3 billion. All contributors will receive shares. These shares can be bought and sold on the secondary market, according to Doleac, C. (2015). Bank of South has very ambitious proposals and objectives. They include especially the promotion of integration and competitiveness in South America. It created expectations of an alternative architecture for the region that would contribute to overcoming the vicious circle of conditioning the financial dynamic on the fragility exhibited by volatile markets, the pressure to provide profitable differentials to compete in attracting volatile international capital, the use of public guarantees for speculative or advantageous enrichment, and the recurring drainage due to capital flight and placement of savings overseas. (Marchini, 2006) According to the Articles of Agreement the Bank have the mandate to promote development projects in key sectors of the economy, with a focus to improve competitiveness and technological and scientific development, adding value to commodities production in member countries; social sector projects to reduce poverty and social exclusion; finance projects to strengthen South American integration. It expected to create and to administer special funds for social solidarity and disaster relief, by providing passive and active financial operations and services. The bank was first proposed in a very distinct context. As Munevar and Reis (2015) claim, this group of states shared a set common economic policies: an increase in welfare expenditures as well as the implementation of targeted income transfers; rejection of the interference of the IMF and the World Bank in the design of economic and social policies; renewed support to a regional integration process based on the creation of new political  and  economic

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schemes such as UNASUR, ALBA, and the Banco del Sur. Together with a process of political realignment, the region experienced an economic boom of historic proportions. The combined effect of an increase in the demand for commodities from China and significantly improved terms of trade allowed the countries in the region to recover quickly from the crisis of the late nineties. In this new international context, economic growth for the founding countries (Argentina, Brazil, Bolivia, Ecuador, Paraguay, Uruguay, and Venezuela) rebounded dramatically.34 It happened in a context of renewed economic strength that the governments of the region began to discuss the idea of creating its own development bank would secure their independence from the Bretton Woods institutions interests, to obtain autonomy and “policy space” to implement different development policies, new initiatives to enhance region’s sovereignty and responsive to their citizens. In addition, in 2007, IMF loans to Latin America had decreased from 80% of its portfolio to less 1%, as countries like Venezuela, Brazil, and Argentina repaid their loans. Therefore, the Bank also arose at a time of serious difficulties for the existing international financial institutions. However, since its inception, the Bank has faced setbacks and conflicts. At the first, president of Venezuela, Hugo Chavez, favored an institution in which political concerns would come before technical considerations, and where conditionalities would not be part of the policy tools of the bank. In the meantime, the President of Argentina highlighted the importance of having an alternative lender of last resort for the countries of the region, as well as establishing a technical institution shielded from the political positions of the different governments. Besides that, in operational and governance practices, Argentina and Brazil opposed some radical measures the other members wanted. For example, they wanted the Bank to finance large private corporations, whereas the smaller countries wanted to focus on local sustainable projects. Argentina and Brazil wanted to use the same lending standards as other international banks did. The smaller countries wanted no conditions attached to its loans – a measure that that would help the smaller projects but could lead to higher default rates. In light of all these disagreements, Ortiz and Ugarteche (2008) claimed that ten special problems created challenges for the new institution: (i) governability; (ii) privileges and exemptions; (iii) funding; (iv) investment portfolio; (v) lack of a strong leadership; (vi) eligibility by type of institution; (vii) distribution of investments among member countries and different terms of financing (concessional); (viii) procurement; (ix) participation and transparency; (x) social and environmental safeguards. Even though its president and board have been elected this year, this bank is still not operational, and doesn’t have an estimated time to start. The economic and political turmoil faced by many of countries members has slowed progress on the creation of the Banco del Sur.

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Notes 1 Rogerio Studart is senior fellow at the World Resources Institute, and non-resident senior fellow of the Brazilian Center for International Relations (CEBRI), and Luma Ramos is Ph.D. at the Institute of Economics, Federal University of Rio de Janeiro. The opinions here expressed are not necessarily those of their respective institutions. 2 For instance, see Lazzarini et al. (2011). More on this later. 3 Schumpeter’s approach seems like Wicksell’s view that credit creation could move the economy from a macroeconomic equilibrium primarily by forcing the reallocation of resources. However, Wicksell’s (1898) is embedded in the general equilibrium tradition which maintains, in its pure form, that full and most efficient use of resources are the natural equilibrium position, to which the system tends to return after the initial monetary shock created by credit expansion. 4 t]he ex-ante saver has no cash, but it is cash which the ex-ante investor requires… For finance … employs no savings” (Keynes, 1937b: 665–6), and “… in general, the banks hold the key position in the transition to a higher scale of activity” (Keynes, 1937b: 668). 5 And he was intensely criticized for that: after all, those markets were the loci where savers and investors meet. So, his critics concluded, the “long-term” interest rate was still determined by savers’ preferences (see Carvalho, 2016). 6 It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees” (Keynes, 1936). 7 A financial system is functional to the process of economic development when it expands the use of existing resources in the process of economic development with the minimum possible increase in fragility and other imbalances, that may halt the process of growth for purely financial reasons” (Studart 1995, p. 64). 8 In this sense, Mazzucato and Penna (2015) created a typology, state investment banks, and argued that they play a central role in developing social capabilities, promoting capital accumulation, supporting the catch-up process, and fostering technical change; in many instances, they also represent a “lead agency,” coordinating a network of actors in latecomer countries’ development efforts (Mathews, 2006). In order to do this, a development bank/SIB may work as an agency to nurture knowledge development; invest in infrastructure; promote strategic trade (such as import substitution, securing sources of materials) and financial leverage; prioritize investments in existing strategic sectors (reinforcing comparative advantages); create “national champions” that are able to compete in international markets; and provide coherence to economic policies (Reinert, 1999; Mathews, 2006; Etzkowitz and Ranga, 2009). 9 This has been the case in the early years of the multilateral institutions created after the Second World War with direct support of the United States – such as the World Bank, the Asian Development Bank, the African Development Bank and the Inter-American Development Bank; and of a myriad of NDBs created in different part of the world, such as Brazil’s BNDE, Mexico’s NAFINSA, Chile’s CORFO and the Korea Development Bank, just to mention few. 10 This indicated by data from Infrascope, a database that records contractual arrangements with and without investments in which private parties assume operating risks in low- and middle-income countries (as classified by the World Bank). Indeed, private participation has increased: between 2010 and the first half of 2015, 572 projects reached financial closure in Latin America with total investment amount of almost US$376 billion. In this group, the sector with largest investment share was electricity, with 33% followed by telecom, with 32.3%. The type of PPI with largest share in investment was greenfield project, with 56% of the total. For the methodology and access to the database, see: http://ppi.worldbank.org/methodology/ppi-methodology.

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Economic Comission for Latin America and the Caribbean (ECLAC). (2011). The economic infrastructure gap in Latin America and the Caribbean. Facilitation of transport and trade in Latin America and the Caribbean, 1(293). Santiago, Chile. Etzkowitz, H.; Ranga, M. (2009). A trans-Keynesian vision of innovation for the contemporary economic crisis: ‘picking winners’ revisited. Science and Public Policy, December 2009, 36:10, 799–808. Griffith-jones, S.; Cozzi, G. (2014). The roles of development banks; how they can promote investment, in Europe and globally. Paper presented in June 2014 at the JICA Jordan workshop. Available at https://pdfs.semanticscholar.org/cbce/da1f357669b 24882dc90d7f b32e9871dee73.pdf. Griffith-Jones, S. (2014). A BRICS Development bank: A dream coming true? UNCTAD Discussion Paper No. 215. Hsu, S. (2017). How China’s Asian infrastructure investment bank fared its first year. Forbes. Available at https://goo.gl/3yc3PZ. Inter-American Development Bank (IDB). (2013). Rethinking Reforms: How Latin America and the Caribbean Can Escape Suppressed World Growth. Latin American and the Caribbean Macroeconomic Report, Washington, DC. Inter-American Development Bank (IDB). (2014). Megacities and Infrastructure in Latin America: What Its People Think. Infrastructure and Environment Department, Washington, DC. Keynes, J. (1936). The General Theory of Employment, Interest and Money. London: Macmillan. Lazzarini, S.; Musacchio, A.; Bandeira-de-Mello, R.; Marcon, R. (2011). What Do Development Banks Do? Evidence from BNDES, 2002–2009. Brasil: Social Science Research Network (SSRN). Lorenzen, C.; Barrientos, M.; Babbar, S. (2001). Toll Road Concessions: The Chilean Experience. PFG discussion paper series, no. 124. Washington, DC: World Bank. Marchini, J. (2006). ¿Quién financia a quien hoy en América Latina? First International Symposium on Public Debt and Savings and Investment Alternatives for the Peoples of Latin America. Mathews, J. (2006). “Catch-up Strategies and the Latecomer Effect in Industrial Development.” New Political Economy 11: 313–335. Mazzucato, M. (2013). The Entrepreneurial State: Debunking the Public vs. Private Myth in Risk and Innovation. London: Anthem Press. Munevar, D.; Reis, M. (2015). A new proposal for the Bank of South. CEPROEC Documento de Trabajo 2015_08. Mazzucato, M.; Penna, C. (2015). Mission-Oriented Finance for Innovation: New Ideas for Investment-Led Growth. London: Policy Ntework/Rowman & Littlefield. Mckinnon, R. (1973). Money and Capital in Economic Development. Washington, DC: Brookings Institution. McKinsey Global Institute; Woetzel, J.; Garemo, K.; Mischke, J.; Hjerpe, M.; Palter, R. (2016). Bridging global infrastructure gap. Available at https://goo.gl/9wYic1. New Development Bank (NDB). 2017. Towards a greener tomorrow: Annual Report 2016. Shanghai. New Development Bank (NDB). 2014. Agreement on the New Development Bank. Fortaleza, Brazil. Ortíz, I.; Ugarteche, O. (2008). El Banco del Sur: Avances y desafíos. CADTM, 7/10/2008. Reinert, E. (1999). The Role of the State in Economic Growth. Journal of Economic Studies 26: 268–326.

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Santader. (2017). Brazil — Monetary Policy. “De-Jaboticabizing” Brazil, Part I: End of TJLP is a First Step Toward More Rational Credit Market. Adriana Dupita. Schumpeter, J. (1911). The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle. Cambridge, MA: Harvard University Press. ______. (1939). Business Cycles: A Theoretical, Historical, and Statistical Analysis of the ­Capitalist Process. London: McGraw-Hill. Shaw, E. (1973). Financial Deepening in Economic Development. New York: Oxford ­University Press. Stallings, B.; Studart, R. (2005). Finance for Development Latin America in Comparative Perspective. Brookings Institution Press and the Economic Commission for Latin America and the Caribbean (ECLAC). Studart, R. (1995). Investment Finance in Economic Development. London: Routledge. ______. (2005). The state, the markets and development financing. ECLAC Review, 85, 19–32, LC/G.2266-P/I. ISSN: 02512920. ______. (2017). Finance for transformation: A post-Keynesian perspective on global sustainable development. In Dow S, Jespersen J and Tily G (eds.) Money, Method and Contemporary Post-Keynesian Economics, pp. 83–96.London: Edward Elgar Publishing. Studart, R.; Gallagher, K. (2016). Guaranteeing finance for sustainable infrastructure: A proposal. In: Sirkis, A. (ed), Moving the Trillions a Debate on Positive Pricing of Mitigation Actions. Available at https://goo.gl/Yfml9U. Studart, R.; Ramos, L. (2016). Financing sustainable infrastructure in the Americas. GEGI Working Paper 007-07/2016. Available at https://goo.gl/kF7CBG. Torres, E. (2017). A Extinção da TJLP: Um salto no escuro. BNDES Journal of Economics, 334. Available at http://web.bndes.gov.br/bib/jspui/handle/1408/12056 Tuesta, D. (2015). Infrastructure investment in Latin America Pension funds, capital markets and fnancial regimes. BBVA Reseach. Presented at Pre Conference Workshop for Capital Markets Regulators. South Africa - November 25, 2015. United States Trade and Development Agency (USTDA). (2014). Major Infrastructure Projects in Mexico. Washington, DC: The Seneca Group LLC. Wicksell, K. 1898. Interest and Prices, translated by R. F. Kahn, London: Macmillan (1936). World Bank. (2012). Financial development in Latin America and the Caribbean. Available at http://goo.gl/URmPkM. ______. (2014). World Development Indicators Database. ______. (2017). Spending Better, Not Necessarily More, Key to Improving Infrastructure in Latin America and the Caribbean. Washington, DC: World Bank.

PART 2

Long-term finance – banks, funds and other sources of private and public investment

3 THE ‘NEW’ IN THE NEW DEVELOPMENT BANK AND IMPLICATIONS FOR AFRICA Talitha Bertelsmann-Scott and Cyril Prinsloo

1. Introduction In recent years the massive global infrastructure investment need, which is most pronounced in Africa, has come under the spotlight again. Global agendas like the G20 have given infrastructure investment prominence as a critical area to ensure global economic stability and promote inclusive growth. At the national level, there is also an emphasis on political campaigns around infrastructure investment. Most recently Donald Trump made extensive promises during his campaign about large sums of infrastructure investments that would create jobs, promote local production and ‘make America great again’. The vast sums involved, however, means that governments alone cannot finance their country’s investment needs and all governments have to rely on assistance from banks, donors and the private sector to co-finance projects. The private sector has more recently been identified as the Holy Grail to unlocking financing challenges and numerous papers and plans have looked at how the private sector can be encouraged to invest available funds into large infrastructure projects. This emphasis sometimes overlooks the fact that other critical actors, like multilateral development banks (MDBs) and donors, face significant challenges in an environment that has dramatically changed since the heyday of global infrastructure investment after the Second World War. The purpose of this article is to provide an overview of the changing landscape of infrastructure financing in Africa, by taking a look at the historic involvement of MDBs and how this landscape and the role played by MDBs has changed over recent years. New donors from developing countries, like China, have increasingly played a critical role in financing infrastructure across the world, as Middle Income Countries (MIC) opt to borrow from them at easier conditions, albeit at higher interest rates, as offered by the traditional MDBs,

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like the World Bank (WB). Chinese investment complements other new donors’ involvement, like India, Brazil and South Africa. Seeing the rapid pace at which these donors can move have left developing countries somewhat disenchanted with traditional institutions, creating a climate in which China could take a lead role in reshaping the infrastructure financing landscape by creating (rival) MDBs to invest in infrastructure that would not only contribute to economic development in recipient states but also support their own economic development by gaining access to key raw materials and creating demand for their domestic construction industry. The most significant of these is the Asian Infrastructure Investment Bank (AIIB), which has made an impressive contribution to infrastructure development in the East. The changed environment described above has provided the ideal background against which the BRICS nations, which include Brazil, Russia, India, China and South Africa, could create their own MDB, the New Development Bank (NDB), with a dedicated African Regional Centre. The jury is still out on how this new source of financing is likely to influence the infrastructure financing landscape on the continent and whether it can play a positive contributing role to regional integration. It is also unclear whether it will promote the implementation of continental plans like the African Union’s (AU) Programme for Infrastructure Development (PIDA). The first seven projects of the NDB does not really give an indication on how it could contribute to Africa’s regional projects or whether it aims to align with continental plans. The chapter concludes that the NDB is off to a good start even though it has only made a very small contribution to Africa’s infrastructure deficit by supporting South Africa to develop its transmission lines to connect newly established renewable energy projects into the main grid. The NDB is delivering on its early commitments to promote sustainable infrastructure projects. The AU and its individual member states should welcome the new entrant to infrastructure financing given the enormous task at hand on the continent and explore ways in which the NDB can expand its membership in Africa, which would allow for more PIDA support in the longer term.

2. Africa’s infrastructure deficit and MDB response Africa’s infrastructure investment needs are massive and growing. The infrastructure deficit in Africa results in poor connectivity making trade expensive and uncompetitive. Poor access to electricity not only dampens manufacturing capacity and the services sector but also has a significant impact on health and education. Poor access to clean water equally negatively impacts Africans’ well-being and results in poor agricultural outcomes as little arable land is under irrigation. The World Bank has estimated that the continent needs $95 billion of investment annually in order to ensure that the continent has adequate and universal access to infrastructure.1

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In order to focus attention and coordinate efforts on addressing the continent’s infrastructure needs, the Programme for Infrastructure Development in Africa was drawn up and officially endorsed by the AU Heads of State in 2012. PIDA is an AU initiative in partnership with the New Partnership for Africa’s Development (NEPAD), the African Development Bank (Af DB) and the United Nations’ Economic Commission for Africa (UNECA). The overall goal of PIDA is to promote socio-economic development and poverty reduction in Africa through improved access to integrated regional and continental infrastructure networks and services. The PIDA Priority Action Plan (PIDA-PAP) defines the most critical areas for infrastructure investment up to 2020, which consists of 51 programmes and 433 projects in transport, energy, information and communications technology (ICT) and water. The cost estimate of these projects is around $68 billion or $7.5 billion annually.2 The cost estimate for Southern Africa is around $12 billion. There is a strong sector preference for energy and transport in the PAP, recognising the contribution these sectors make to trade and economic development. The vast sums necessary to implement PIDA have resulted in a renewed focus on involving the private sector in infrastructure projects, as bilateral donor assistance, MDBs and domestic resource mobilisation will simply not be enough to reach the PIDA targets by 2040. PIDA-PAP therefore also focuses on the enabling environment that will attract the private sector and donors to PIDA projects. Several programmes have been implemented by the PIDA partners and donors that support PIDA to strengthen Africa’s capacity to attract financing as well as to ensure adequate project preparation, monitoring of progress, lessonlearning and understanding how national priorities often supersede regional ambitions. MDBs still perform an important role in infrastructure financing in Africa, investing in areas where other financiers are reluctant to go. Their interventions have been deemed mostly successful. This success has been attributed partly to the effectiveness of the model they employed: by leveraging paid-in capital from their members through international debt markets, MDBs have been able to secure additional capital relatively cost-effectively, to be extended to borrowers at low-interest rates with long maturities. Those attractive borrowing options, combined with decades of development knowledge and understanding, have made MDBs a preferred infrastructure development partner for many countries. The model has changed little over the past six decades. Instead of ramping up investments to keep pace with the growing need for infrastructure financing on the African continent, however, MDBs increasingly have experienced difficulty in finding an adequate response to the needs of middle-income countries, which nowadays exist in a global environment markedly different from conditions prevailing during the latter part of the last century. In their insistence on strict loan conditions, placing social and environmental concerns at the centre of those conditions and adding bureaucratic layer upon

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layer to their operation, traditional MDBs now find themselves with access to large amounts of funding but decreasing calls for borrowing. MIC clients are increasingly looking elsewhere, including at the private sector and at new donors and banks, to finance their infrastructure projects. There are also a number of organisation-specific factors that influence the appetite of countries to access loans from MDBs. Factors such as business processes (that are unnecessarily bureaucratic resulting in unnecessary delays) and new financial players (such as the entry of new bilateral development partners and private financiers) have reduced demand and utilisation from African countries. If MDBs wish to remain relevant to their clients on the continent, they will need to ensure that they respond adequately to the needs of their prospective borrowers. New entrants like the New Development Bank are potential catalysts for a further renewal in the way in which infrastructure financing is approached. The NDB would do well to learn from the experience of other MDBs and financial institutions operating on the continent. It is within this climate that the BRICS nations developed the concept of their own MDB. Politicians have often positioned the Bank as an alternative to traditional development finance institutions (DFIs). The paragraphs following the directive in 2012 to examine the feasibility and viability of such an institution were directly followed by four paragraphs critical of traditional, Western-led DFIs and the slow pace of structural reform in these organisations. However, in contrast, officials within the bank, mostly hailing from public and private financial institutions themselves, have taken a more nuanced approach, indicating a keen interest to work with other DFIs to address infrastructure funding deficits across developing countries. Apart from slow reform in traditional DFIs, a key impetus to establish the bank was also the emergence of the BRICS as a global political and economic force. BRICS is currently home to more than 40% of the global population, 25% of global territory, and nearly a quarter of global GDP. As the grouping gathered momentum, the agenda of the BRICS has grown from focussing solely on post-recession recovery, to including security, health, climate change and economic development, among others. The need for infrastructure development to drive economic growth together with the availability of domestic savings across the BRICS and the Global South provided an optimal opportunity to leverage the BRICS towards pursuing finance needs required to address the infrastructure funding deficit. By the year 2015, China had gross domestic savings as much as 49% of GDP, India had 30% and Russia 29%, and South Africa 20%, compared to levels of around 21% for OECD member countries on average (World Bank 2017)3. Considering that the NDB has committed to only one project in Africa to date, namely a South African project with Eskom, costing $180 million, it shows that the NBD will remain a very small player in the medium term within the context of PIDA unless the NDB can attract more African members that collectively focus on the priority areas as identified in the PIDA-PAP.

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3. Alternative infrastructure financing sources There are a variety of reasons why countries have increasingly been able to draw financing from other sources. Combinations of strong growth and sound macroeconomic management have made these countries, especially MICs, attractive for foreign investors or commercial lenders. Equally, some of these MICs in Africa have been able to tap into global debt capital markets.4 The following section highlights a number of key alternative sources of financing in Africa, including private sector financing, official development aid (ODA), local development finance institutions, as well as direct engagement from countries like China.

a. Private funding The private sector has become a critical investor in infrastructure financing on the continent, accounting for more than half of total external financing.5 Over the last decade or so, private investment into infrastructure in Sub-Saharan Africa (SSA) grew by 9.5% per annum, whereas it declined significantly during the same period in countries like Brazil and India. In fact, SSA is the fourth largest recipient of private sector funding. In SSA, the top ten recipients include South Africa, Nigeria, Kenya, Tanzania, Ghana, Sudan, Ivory Coast, the DRC, Benin and Uganda.6 However, in 2013 of the US$17 billion in private sector investment in SSA, less than 2% went to countries other than South Africa and Nigeria and to sectors other than telecoms. Whereas the telecom sector has been receiving almost all of the private sector investment in SSA in recent years, there seems to be a definite levelling off since 2012, with interest growing in the electricity sector. Within the electricity sector, private sector interest lies almost exclusively in generation capacity with distribution and transmission functions being left entirely to national governments. The reasons for private sector interest in the past in telecoms are four-fold, namely the clear costs associated with such projects, the low risk exposure during development and construction, the easy securitisation of revenue streams as well as the private sector’s control over the management of the investment. With growing saturation levels in the telecoms sectors, investors are now exploring opportunities in land fibre optic technologies, establishing internet exchange points and connecting SSA states to sub-marine cables.7 According to the Infrastructure Consortium for Africa (ICA) 2014 Survey of private sector investors, more than 50% of respondents said that they would continue to invest in those sectors where they are already active. This implies low prospects for attracting private sector investment into areas outside of telecoms and electricity. Within the electricity sector, 88% of investors indicated that they would be increasing their investments. The most attractive countries identified, included the larger MICs, South Africa,8 Kenya and Nigeria.9

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However, the World Bank reports that investors are increasingly looking beyond the traditional recipients as opportunities abound in SSA countries with sound macro-economic policies that have remained stable despite the commodity price slump.10 From the ICA and other surveys conducted on the private sector in their choice of investment destination in infrastructure projects, four key elements emerged as critical to their investment commitment, including the project feasibility, the country political risk, profitability and legal and regulatory framework. “Constraints such as bureaucratic delays, policy uncertainty, lack of transparency and insufficient institutional capacity remain a challenge.”11 According to a McKinsey report,12 three-quarters of SSA do not have a large enough GDP to support projects that are larger than US$100 million. Project feasibility and the project preparation phase come up repeatedly as a key inhibiting factor to investment as the costs associated are high with no guarantee of eventual profits. “The shortage of adequately prepared or bankable projects was a much bigger challenge than finding project finance.”13 If governments or MDBs are not facilitating investment by completing the project preparation phase, it is very rare for a private sector investor to take on this responsibility. Under the African Union’s New Partnership for Africa’s Development (NEPAD), the NEPAD Business Foundation (NBF) works actively to attract the private sector to invest in infrastructure projects. Basing its work on the Programme for Infrastructure Development in Africa that has identified the gaps in infrastructure financing on the continent, the NBF launched the Africa Infrastructure Desk (Afri-ID) to support the efforts of PIDA by coordinating the private sector and mobilising their resources to implement infrastructure projects that present commercial opportunities for members of the desk. The Afri-ID is therefore a multi-stakeholder platform bringing together the private and public sectors, multilateral finance/development agencies and other stakeholders with the common purpose of accelerating regional infrastructure development in Africa.14 The Afri-ID has managed to attract private sector investment to five port and rail projects on the continent, predominantly in Southern and Eastern Africa, but is actively seeking additional projects for public private partnerships. The real success factor here is that the private sector was attracted to projects outside of telecoms and energy, showing that with multi-stakeholder collaboration under a strong coordinating body any sector can be made attractive to the private sector. However, regional projects rarely involve private sector investors as the challenge of working with multiple governments and project directors prove too uncertain.

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b. ODA This section discusses the role of Official Development Assistance (ODA) from the OECD countries to African infrastructure development. These countries have predominantly given infrastructure investment assistance indirectly via capital contributions to the World Bank and the African Development Bank. Bilateral assistance on a country-by-country basis has continued but here the focus has generally been away from the traditional infrastructure sectors of telecoms, transport, energy, water and sanitation. A recent Overseas Development Institute (ODI) report found that ODA remains the largest single source of external development finance at country level and its flows are growing, even in MICs.15 Of these flows it is estimated that just under half goes to infrastructure spend.16 Via the World Bank and the Af DB, support for large scale infrastructure investment projects remains an important contribution by OECD countries. At the World Bank, infrastructure lending represented 47% of all global lending in 1980. Over time, however, infrastructure as a target sector for such aid has varied. During the late 1990s and early 2000s, the Bank’s emphasis on policy lending and human development funding left infrastructure to the regional banks and the private sector, which lowered infrastructure as a share of lending to below 30%. That downward trend ended around 2005, as infrastructure’s importance to growth and poverty alleviation received greater recognition, and the role of multilateral assistance, in particular, began to be considered essential.17 The clear advantage of ODA, WB and Af DB funding is that the loans and grants go to areas where private sector interest is low. Whereas the private sector tends to stick to countries and sectors where they perceive the risk to be low, governance to be strong and where the ease of doing business is high, ODA is spread more evenly amongst SSA. Further the ODA community can operate in fragile states.

c. China China has a large and visible presence on the African continent when it comes to infrastructure financing. However, determining the scale of its commitment and projects under implementation remains difficult, as the country does not participate in any formal data recording processes like other OECD donors under the DAC. It is also clear that there has been a marked slow-down in Chinese investment on the continent, partly due to the slowdown of the Chinese economy, but the ICA in 2014 also reported a slow-down in road and rail projects that would normally have attracted Chinese investment.18 In 2014 it invested US$3.9 billion, which is a massive drop from an average US$13 billion per annum the three years prior. The projects of choice remain in road and rail, although China’s two

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largest investments in 2014 went to a port and airport development, which could indicate a change in China’s sector choice for the foreseeable future. It is clear, though, that China is involved where the private sector fears to tread. Ghana and Ethiopia have emerged as the highest recent recipients of Chinese infrastructure finance, followed by Nigeria, Cameroon and Zambia. It has generally been understood that Chinese funding follows resource extraction, which was confirmed in reports by the ICA and the World Bank. However, Brookings found that while Chinese financing in resource-rich countries is still double the average volume of those flowing to non-resource-rich countries, this gap has sharply diminished over time. The cumulative average of Chinese financing to resource-rich countries doubled from $300 million to over $622 million between 2005–2008 and 2009–2012. But over the same period, Chinese commitments to the non-resource-rich countries leapt from $43 million to $285 million—a 550 percent increase! A trend that has emerged from Chinese lending to African countries is that lending does not merely focus on financing, but also includes technical assistance that accompanies these loans – particularly infrastructure loans. This illustrates that increasingly MDBs no longer have the sole mandate on development knowledge, eroding one of their key competitive advantages. A positive change has been a cooperation agreement signed between the Af DB and China establishing a ‘Growing Africa Together Fund’, which has resulted in a joint financing project of Tanzania’s Bus Rapid Transport System. The direction and volume of Chinese investment will have to be followed with interest in coming months and years as the slow-down reveals Chinese priorities in times of limited resource availability.

d. Local development finance institutions In Africa alone there is estimated to be more than 140 DFIs, comprising national and multinational institutions, as well as those with different mandates (e.g., universal, sectoral, import–export, etc.).19 National Development Finance Institute (NDFIs) play an important role not only in domestic resource mobilisation but also in building partnerships towards more effective onwards lending from the MDBs. NDFIs often have particular niches that MDBs can leverage – for example, the Development Bank of Southern Africa (DBSA) has a particular focus on project preparation, including the technical skills, procedures, etc. to undertake this. Generally speaking, NDFIs understand the environment and business culture within which a project is planned better, largely due to their on-the-ground presence and being staffed with locals, ultimately allowing an improved assessment of

The ‘new’ in the New Development Bank  93

risks for various projects. Where NDFIs are involved, the project oversight role can be shared between the national DFI as well as the MDB concerned although this does not always seem to work well. There is a significant precedent of MDBs leveraging the expertise of NDFIs – for example, the Af DB has over the years extended numerous lines of credit (LOC) to the DBSA, which the DBSA in turn used to fund infrastructure projects in the region.20 Equally, one of the first loans extended by the NDB to Brazil was similarly a LOC to its NDFI, the Brazilian Development Bank (BNDES21), to fund renewable energy projects in the country.

e. MDBs’ important role Despite the structural challenges faced by MDBs (political economy constraints, business processes, etc.) and the plethora of alternative financing options available to countries, this is not to say that MDBs have become irrelevant. MDB’s main competitive advantage over other sources of financing remains the extremely low cost at which they can provide financing. Whereas concessional loans from MDBs can attract less than 1% interest, a grace period of 10 years, and a maturity of 20–50 years, an equivalent loan from private financiers can carry interest rates as high as 7% with maturities of below ten years. Such expensive loans further compound a debilitating characteristic of African countries: indebtedness. Across Africa, numerous countries found reprieve from unsustainable debt following the World Bank and IMF’s Highly Indebted Poor Country (HIPC) initiative that saw debts being cancelled to assist countries to return to more sustainable debt levels. Nevertheless, following the abundance of external financing options and increased capacity to service debts many countries have again become highly indebted. The case of Nigeria is illustrative (see Figure 3.1 below): 5,000

Billion (Naira)

4,000 3,000 2,000 1,000 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Multilateral FIGURE 3.1

Paris Club

London Club

Promissory Notes

Nigeria’s external debt.

Source: CSEA analysis using data from Debt Management Office (2015). Note: “Others” include: bilateral and commercial (eurobonds) debts.

Others

94  Talitha Bertelsmann-Scott and Cyril Prinsloo

Following the Paris club debt cancellation, which constituted a major portion of Nigeria’s external debt pre-2006, the country’s external debt profile has been largely dominated by debts from multilateral creditors since 2005. After the dip in 2006, Nigeria’s external debts have been rising steadily since 2007, reaching 78% of the 2005 level in 2015. Besides multilateral creditors, bilateral and commercial (Eurobonds) creditors (‘others’ in Figure 3.1) have increasingly played key roles in Nigeria’s borrowing patterns since 2011.

4. New Development Bank a. Origins of the NDB While it is generally agreed that the idea for the bank arose in New Delhi, the exact origin is contested. It appears that December 2011 was the earliest mention of a possible BRICS fund, proposed by Samir Saran and Vivan Sharan of the Observer Research Foundation in an op-ed, although their suggestion seems to more closely mirror the Contingent Reserve Arrangement (CRA).22 The first news reports to specifically mention the possibility of the BRICS forming a development bank appeared in February 2012.23 These reports claim that the driving force behind the idea is India, although Russian officials also claim ownership of the original idea. The concept note for the bank’s establishment was however drafted by officials within the Indian Ministry of Finance, and its contents were presented at both the BRICS Academic Forum of that year and the New Delhi Summit. The summit was the fourth in the group’s history and only the second since the accession of South Africa and represented a golden moment for the BRICS. At the time, the five BRICS countries were standout performers in a depressed global economy, while developed Europe and the United States were still battling in the aftermath of the 2007–2008 global financial crises (GFC). The group’s economic importance and growing geostrategic weight meant the New Delhi summit carried significant clout but also drew high expectations. The New Delhi Declaration (March 2012) offered the first mention of the NDB, stating: We have considered the possibility of setting up a new Development Bank for mobilizing resources for infrastructure and sustainable development projects in BRICS and other emerging economies and developing countries, to supplement the existing efforts of multilateral and regional financial institutions for global growth and development. We direct our Finance Ministers to examine the feasibility and viability of such an initiative, set up a joint working group for further study, and report back to us by the next Summit.24

The ‘new’ in the New Development Bank  95

The 2013 summit in Durban, South Africa, moved the bank out of this exploratory phase, and into more concrete planning, announcing an agreement inprinciple on the New Development Bank in the eThekwini Declaration: Developing countries face challenges of infrastructure development due to insufficient long-term financing and foreign direct investment, especially investment in capital stock. This constrains global aggregate demand. BRICS cooperation towards more productive use of global financial resources can make a positive contribution to addressing this problem. In March 2012 we directed our Finance Ministers to examine the feasibility and viability of setting up a New Development Bank for mobilising resources for infrastructure and sustainable development projects in BRICS and other emerging economies and developing countries, to supplement the existing efforts of multilateral and regional financial institutions for global growth and development. Following the report from our Finance Ministers, we are satisfied that the establishment of a New Development Bank is feasible and viable. We have agreed to establish the New Development Bank. The initial contribution to the Bank should be substantial and sufficient for the Bank to be effective in financing infrastructure.25 This was accompanied by a full statement announcing the intention to form the bank, as well as revealing discussions on the creation of a $100 billion CRA, a sister-initiative of the NDB that would offer a pool of financial resources to the BRICS in times of financial instability.26 The bank and the CRA were officially established the following year at the BRICS summit in Fortaleza, Brazil.27 Over the following year, a President, Vice-President and Board Members of the NDB were appointed; and construction of the Bank headquarters on the 22nd floor of the China Financial Information Centre in Shanghai also began.28 The bank’s Board of Governors met for the first time in Moscow in July 2015 on the side-lines of the group’s 2015 summit in Ufa. Following the summit, the Ufa Declaration, noting progress on the establishment of the bank, stated that ‘we expect the NDB to approve its inaugural investment projects in the beginning of 2016’.29 The Bank’s headquarters have since been established in Shanghai (March 2016). At the Bank’s first annual meeting in July 2016, two key milestones had been reached: the bank had successfully extended four loans to its member states (all bar Russia) and it had also issued its first ‘green’ bond on the Chinese bond market in Yuan, which would finance sustainable infrastructure projects. By the bank’s second annual meeting, further milestones included extension of another three projects (including one in Russia), with loan extensions now totalling $1.5 billion, as well as an agreement from the Board of Governors (BoG) to expand the membership of the bank. It is expected that during its third year of operations, the NDB will finalise the criteria for membership of new members, as well as finalise the setup of its African Regional Centre in Johannesburg, South Africa.

96  Talitha Bertelsmann-Scott and Cyril Prinsloo

b. Structure, capital and membership The Bank’s structure is outlined in the ‘Agreement on the New Development Bank’, including details on membership, voting, capital, shares, organisation and management of the NDB, among others. As each NDB member will contribute equal amounts of capital to the bank, so responsibilities are equally shared among the founding members. Each member country appointed one representative (and one alternate) to the Board of Governors. Each governor will exercise voting power in accordance with his or her country’s share of voting capital. Governors must be ministerial-level appointments, and in the case of the five BRICS will consist of the respective finance ministers. The board will have ultimate authority over the activities of the bank and will meet at least once a year. Russian Finance Minister Anton Siluanov will be the first chairperson of the board. The Board of Directors will make decisions on an operational basis, including approving the bank’s budget. It will consist of ten members, five of whom will be appointed by each BRICS country, with the remainder decided by a vote of the Board of Governors. The Brazilian representative will be the first chair of the Board of Directors. South Africa’s representative on the board will be former Reserve Bank governor Tito Mboweni. Day-to-day operations of the bank will be undertaken by a five-person executive, consisting of one president and four vice-presidents, each appointed by one of the five BRICS countries. India has nominated the first president. Details of the appointed members of the executive can be found in Table 3.1 and an overview of the organisational structure of the bank in Figure 3.2. The NDB will have a maximum authorised capital of $100 billion, with an initial subscribed capital of $50 billion (the balance to be recruited from additional members). This initial capital will be fully funded by the five BRICS members, each of which will contribute $10 billion. Of this $10 billion, each will only have to physically pay in $2 billion,30 with the rest callable only if the bank needs it. It is extremely uncommon for banks to call on their capital, with the African Development Bank, for example, having never issued a call. The $2 billion in capital will be paid over a period of seven years, with an initial instalment of $150 million, and subsequent instalments growing incrementally. In November 2015 the South African parliament passed the New Development Bank Special Appropriation Bill which provided for South Africa to make its first contribution.31 All five members provided their initial capital contribution simultaneously, in January 2016. By December 2016, the Bank’s annual financial statement indicated that $1.5 million of capital had been paid up by its members. Like all development banks, the NDB will use this capital base to raise additional funds on global credit markets. The bank’s gearing ratio – the proportion between capital and borrowed funds – will be set at the global norm of 1:1, meaning that borrowed funds cannot exceed the bank’s capital base. The NDB has already started raising additional capital by issuing its first ‘green’ bond in

• • • • • • • • • • • • • • •

VPa – Chief Financial Officer Brazil

Russia

China

Vladimir Kazbekov

Zhu Xian

Vice-President, World Bank

Director of External Relations, Vnesheconombank

Brazil Special Representative to the IMF

President, BOA Merrill Lynch Southern Africa

Chairperson, ICICI Bank

India South Africa

Previous position

Country

Paulo Nogueira Batista

Kundapur Vaman Kamath Leslie Maasdorp

Name

Development finance

Development finance

Government

Private finance

Private finance

Previous sector

a

VP = vice-president.

Source: Maswanganyi, N., ‘BRICS New Development Bank allocates formal duties to vice-presidents’, Business Day, 26 November 2015. http://www.bdlive.co.za/ world/2015/11/26/brics-new-development-bank-allocates-formal-duties-to-vice-presidents, accessed on 4 May 2016.

VP – Chief Operations Officer

VP – Chief Administration Officer

VP – Chief Risk Officer

• Chief of operating staff

President

Treasury and portfolio management Finance budgeting Accounting functions Economic research Risk management Strategy Partnerships Human resources Information technology Administration Corporate communications Project lending Operational compliance Project procurement Regional offices

Responsibilities

Position

TABLE 3.1 NDB executive positions

The ‘new’ in the New Development Bank  97

98  Talitha Bertelsmann-Scott and Cyril Prinsloo

FIGURE 3.2

High-level overview of the NDB’s governance structure.

Source: NDB. http://www.ndb.int/about-us/organisation/organisation-structure/, accessed 25 April 2017.

2016. Green bonds are tax-exempt bonds, the capital of which is ring-fenced for promoting energy efficiency infrastructure. The NDB managed to raise an additional RMB3 million ($450 billion) through this bond in China.32 In 2017/2018 the NDB plans to issue a similar bond in China and India, as well as other member countries after that.33 Another key milestone for the bank, likely in 2018, would be to obtain a credit rating from key international credit ratings agencies (CRAs). The Bank had already achieved an AAA credit rating with a stable outlook in China from two prominent Chinese CRAs (China Cheng Xin International Credit Rating Company and Lianhe Credit Rating Company).34 A higher credit rating indicates to investors a less risky investment, which in turn means that investments are likely to be safer, but earn less returns. In contrast, a lower interest rating indicates a higher risk investment, for which those seeking investment would have to pay higher compensation – in the case of an MDB higher interest rates on the bonds issued. Given that MDBs pass capital raised on capital markets on to their member countries with minor costs levied on top of that to cover their own operating costs, the interest rate offered by the MDB on the international capital market inevitably impacts on the countries via higher interest rates on loans.

The ‘new’ in the New Development Bank  99

The BRICS will be the only members during the NDB’s initial phase, with each BRICS country having equal voting power in the decision-making structures of bank. The remaining $50 billion will be issued to other members upon invitation from the bank, with the membership open to any member country of the UN system. Non-founding members will face a number of restrictions on their voting power, namely that the five founding members can never have less than 55% of total voting share, that non-borrowing members (typically developed countries) outside the founding five can never have more than 20% of total voting share, and that no individual member outside the founding five can have more than 7% total voting share. In effect, this means that the BRICS will always maintain majority control and that developed countries are unlikely to gain more than 20% voting power. Only developing economies can borrow from the bank. A number of countries have indicated their willingness to join the bank, including Turkey, Iran,35 Bangladesh36 and Venezuela,37 among others. A more complete indication of who might join the bank can be found in the Chinese-led AIIB, which is likely to have similar membership. The AIIB’s membership base currently stands at 57 members, including all of the BRICS countries. The most notable omission from this membership is the United States, which strongly opposed the AIIB and publicly rebuked the likes of the United Kingdom for joining the bank. Japan has also not applied for membership. At the Bank’s second meeting of its BoG (March 2017), the terms and conditions for adding new members had been approved, with final criteria for selection of new members expected in the third quarter of 2017. Adding new members would require a careful consideration from the NDB. Unlike the AIIB and other MDBs, who opened up its membership to all countries, the NDB is likely to be more selective of those countries they invite. While this would mean they can cherry pick like-minded countries, it also means that they won’t necessarily have the political clout that the AIIB gained from having well established and stable economies as members. Therefore, there are likely a number of criteria the NDB will consider when inviting new members. Some of the criteria highlighted by the Cheng Xin International and Lianhe that led to the Bank’s high domestic credit score in China included: 1 2 3 4 5 6

Strong support from its founding members given NDB’s political and economic importance, High level of paid-in capital and its timely infusion, Great potential for future business growth in developing countries and emerging markets, Sophisticated governance structure and risk management system, Operational efficiency supported by flat governance structure and concentrated decision-making mechanisms, Highly experienced management team with long-serving executives in the banking sector, including multilateral development institutions.

100  Talitha Bertelsmann-Scott and Cyril Prinsloo

Based on points 4–6 above, it is clear that the NDB has established a reputable organisation with significant growth potential operating in emerging markets (point 3). When reaching out to potential new members, they will look to countries that will offer clear political support and buy in, which is likely to also significantly contribute to confidence that capital contributions will be paid in-full and on time (points 1 and 2 above). As the Bank looks towards receiving the highest possible credit rating from international CRAs, they will also look for member countries with high credit ratings themselves, which influences the rating received by international CRAs. Last, the NDB will also look to countries that have high capacity to borrow from it, as lending is vital to ensure its financial sustainability.

5. The first seven NDB projects At the end of its second year of operations (April 2017), the NDB had undertaken to finance seven projects across all its member countries, totalling financial commitments of more than $1.5 billion. The NDB looks to double this amount in the third year of operations by financing an additional 15 projects, bringing total commitments up to $3 million.38 Initially, the projects to be financed by the bank was a bit ambiguous, given the bank’s broad mandate to finance ‘infrastructure and sustainable development’ projects. However, from the projects that have already been financed (see Table 3.2 below), there is focus on sustainable infrastructure projects, rather than other sustainable development projects such as education or healthcare. Within the infrastructure subset, particularly energy generation from renewable sources (wind, solar, and hydro) has attracted financing from the bank, but it has also financed a road infrastructure project. The overarching focus, however, has been on ‘sustainable’ infrastructure, factoring in not only financial returns and economic considerations, but equally ensuring adequate environmental and social safeguards are in place and that social returns are realised. A number of key characteristics have emerged following commitments from the NDB for the first seven projects. First, the bank has favoured a very ‘hands-off’ approach. One of the key frustrations of borrowers with traditional MDBs has been the onerous loan procedures required by the financiers, despite similar process already being in place in countries. For example, despite public financial management (PFM) and environmental and safeguards frameworks (ESF) and processes already in place in countries, often MDBs mandated additional safeguards which not only added to the bureaucratic burden, but also made loans more timely and expensive. The NDB has therefore placed particular focus on the use of country systems (UCS) to facilitate loans, rather than imposing their own procedures. A UCS approach is, for example, reflected in the bank’s ESF. The Bank’s approach in individual member countries has been informed by an internal analysis of countries’ respective PFM and ESF processes. Where the bank has identified gaps it will

BNDES

ESKOM

EDB/IIB

South Africa

Russia

Sovereign

Sovereign

ESKOM

US$100 million Non-sovereign EDB/IIB

US$180 million Sovereign guaranteed

Nord Hydro-Bely Porog + other subproject(s)

ESKOM

Sub-projects

Sub-projects

End-user/on-lendee

Lending modality

Renewable energy (wind power)

Renewable energy (wind, solar etc.) Upgrading major district roads Renewable energy (solar rooftop PV)

Target sector

National financial Renewable energy (wind, solar, intermediary etc.) (NFI): two-step loan Sovereign Renewable energy guaranteed (transmission) project loan National financial Renewable energy (hydro-power) intermediary + green energy (NFI): two-step loan

Sovereign guaranteed: three tranches Government of Government of Sovereign project India Madhya Pradesh finance facility PRC Shanghai Lingang Sovereign project loan Hongbo Government New Energy Development Co. Ltd. Project loan PRC Fujian Government Investment and Development Group

Canara Bank

Borrower

US$300 million Non-sovereign BNDES

RMB 2 billion (US$298 million)

Pinghai

Brazil

RMB 525 million (US$81 million)

Lingang

US$350 million Sovereign

Madhya Pradesh

China

US$250 million Sovereign guaranteed

Canara

Sov./non-sov.

India

Loan Amount

Project

Member

TABLE 3.2 First seven projects financed by the New Development Bank

The ‘new’ in the New Development Bank  101

102  Talitha Bertelsmann-Scott and Cyril Prinsloo

supplement its efforts with capacity building or technical assistance to countries to bridge those gaps. The NDB’s ‘hands-off’ approach is further characterised by the comfortability it has with on-lending for two of the projects already financed (to Canara Bank in India and BNDES in Brazil). Second, the NDB has also, despite its infancy, displayed a sophistication in terms of financial offerings to countries. This is displayed through the multiple financing methods and offerings available to member states, including both sovereign and non-sovereign guaranteed loans, as well as a mixture of different financial intermediaries, including state-owned entities (SOEs), national DFIs, other MDBs and private financial institutions. Sophistication and integrity of the organisation has further been recognised by Cheng Xin International and Lianhe in the high domestic credit rating given to the bank in the Chinese market. Ahead of its bond issuance in the Indian market, the NDB will likely reach out to Indian CRAs to provide them with a rating for that market, which should either corroborate or contradict findings from these two Chinese CRAs. Third, the NDB has displayed an eagerness to work with other development finance institutions. In line with this ambition, the NDB had signed a memorandum of understanding with five national development finance institutions.39 As highlighted above, it has already provided financing for on-lending to the BNDES. In other cases, the bank has either provided financing directly to SOEs (as in the case of the loan to Eskom, South Africa’s national energy utility), or directly to national governments (as in the case of China). In India, financing was provided to Canara bank, a private financial institutions for further on-lending targeted at renewable energy projects and in the case of Russia, financing is being channelled through two financial institutions to finance two hydro generation projects. At the same time, the NDB has further signed cooperation agreements with a number of established MDBs, including the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB) and AIIB. Fourth, the NDB has undertaken to not only tap into their own domestic funds by raising bonds in its member countries, but also to extend loans in domestic currencies. By raising bonds domestically, the NDB ensures that domestic savings are employed to finance sustainable infrastructure. Raising bonds domestically is not only important to ensure that domestic funds are employed to promote sustainable growth in countries, but equally allows for easier lending in domestic currencies. MDBs have typically favoured lending in USD, but this has resulted in significant exchange risks for borrowers. Borrowing in domestic currencies helps countries to mitigate this risk. Last, beyond the expectations of particularly NGOs and CSOs, the NDB has emerged as an environmentally and socially conscious lender. Initially, many were concerned that the bank would neglect environmental and social considerations at the cost of economic growth, especially since some of the banks’ founding member countries do not have a particularly good track record in this

The ‘new’ in the New Development Bank  103

regard. However, concerns have since somewhat abated following the roll out of projects as the bank has displayed sincere efforts in addressing these concerns. At the same time, the bank has displayed a commitment towards transparency by having key documents, policies and even minutes of BoG meetings publicly available via its website and providing regular consultations with concerned groups – perhaps beyond the level of engagement these groups have come to expect from other MDBs.

6. NDB impact on infrastructure financing a. How does the NDB differ from existing financial sources? From the outset, the NDB has not sought to operationally deviate radically from the business model employed by traditional MDBs. Instead, they have focused on ensuring greater efficiency in their operations by speeding up operations, ensuring greater South–South cooperation, eliminating currency exchange risks, and building partnerships with countries and other financial institutions. Thus far, they have made significant strides towards achieving these goals. In terms of speeding up operations, the NDB has managed to extend seven loans within two years of operations, while the adoption of a UCS approach is likely to facilitate loans faster. Greater South–South cooperation has been achieved through issuing bonds within domestic markets, rather than on international bonds markets, to lend to other developing countries. By raising bonds in domestic currencies and financing projects in domestic currencies (with China being the first and only country thus far, but with the intention to extend this approach), countries are also able to better mitigate for currency exchange risks. Last, the NDB’s intent to build partnerships has been illustrated by their willingness to work with other stakeholders, including public and private and those from both developed and developing countries. Despite the NDB’s aptness for partnership, more can be done in this regard. One clear example is greater cooperation with domestic DFIs. In the case of South Africa, there remains significant scope for the NDB to cooperate with national DFIs. The DBSA, for example, has in addition to its expertise built up in project preparation, over the years also developed a niche within the renewable energy sector. In early pronouncements from the NDB on where they see the bank improving on the services provided by MDBs, both renewable energies and a more efficient project preparation phase were mentioned as target areas. This clearly aligns neatly with the DBSA and whereas it might introduce an element of competition to the local financing landscape, there is a large potential for collaboration and for the DBSA to scale up with NDB support through, for example on-lending. DBSA’s total assets, in 2014, were roughly $2.7 billion for its national operations and just under $1.1 billion for its international operations, bringing total assets close to $4 billion, which makes the DBSA an estimated 60 times

104  Talitha Bertelsmann-Scott and Cyril Prinsloo

smaller than the NDB, resulting in the likelihood of competing for funding similar projects less likely. Although the NDB would likely be able to raise capital cost-effectively, the DBSA has the local know-how, networks and presence to facilitate loans more efficiently. Similarly with regard to the Industrial Development Corporation (IDC) in South Africa, there appears to be a divergence in the types of activities undertaken and projects likely to receive funding from the NDB. The IDC’s particular area of expertise has been in financing manufacturing activities. In 2015, 45% of funding approvals were to the manufacturing sector. While these two examples are particularly related to South Africa, similar examples could be drawn from other countries. As noted earlier, beyond mere financing, finding actual bankable projects remains critical. Getting a project to a bankable stage can cost between 5% and 10% of actual projects costs, with little to no guarantee that the project will actually come to fruition. Many financiers, and most notably private financiers, are unwilling to carry this risk. Within the Articles of Agreement of the NDB, provision is made for the establishment of special funds outside the normal capital of the bank. The first of such funds mooted has been a project preparation facility, which would assist countries in developing bankable projects. The NDB is yet to set up this project preparation facility, but this will be crucial to African countries.

b. Expanding the NDB – which African countries could join? As noted earlier, some of the key considerations likely to come into effect when the NDB invites other member countries to join the bank include political commitment, high credit ratings from international CRAs and countries with considerable borrowing capacity. Initially, it appears the bank will target 15 countries for membership. However, the attractiveness of NDB membership might be compromised by the arrangement that 55% of the shares will always be reserved for the founding members. It remains unclear how attribution of shares to other developing countries will operate (e.g., on an equal basis or in line with capital commitments) and if countries would be willing to play second fiddle to the founding members who will each individually retain an 11% shareholding. Typically there is also a steep learning curve in engagement for a county with an MDB. Given that each MDB has its own processes that public officials might not be familiar with, many countries tend to, once they have borrowed successfully from an MDB, return for repeat business. Provided that the NDB would rely greatly on the UCS approach, this learning curve should be easier for most countries. At the same time, given that member countries are required to make a meaningful capital contribution to the bank to benefit from its services, it should instil significant confidence to the bank and CRAs that countries would have the political buy-in to actually use the NDBs’ services.

The ‘new’ in the New Development Bank  105 TABLE 3.3 International CRAs – BRICS and select African markets

S&P

BRICS

Africa

Moody’s

Fitch

Country

Rating

Outlook

Rating

Outlook

Rating

Outlook

South Africa Brazil China India Russia Angola Botswana Egypt Ethiopia Kenya Morocco Namibia Nigeria Tunisia

BB+

Negative

Baa2

Negative

BB+

Stable

BB AA− BBB− BB+ B A−/A−2 B− B B+/B BBB−

Negative Negative Stable Positive Negative Negative Stable Stable Stable Stable

Negative Stable Stable Stable Negative

Stable Negative

Stable Negative Positive Stable Negative Stable Stable Stable Stable Positive Negative Stable Negative

BB A+ BBB− BBB− B

B BB−

Ba2 Aa3 Baa3 Ba1 B1 A2 B3 B1 B1 Ba1 Baa3 B1 Ba3

B B B+ BBB− BBB− B+ B+

Stable Stable Negative Stable Negative Negative Stable

Source: Sidiropoulos and Rawhani. http://www.saiia.org.za/opinion-analysis/credit-rating-agenciesthe-problem-or-part-of-the-solution, accessed 25 April 2017.

The number of African countries with investment-grade credit ratings (i.e., above ‘sub-investment’ grade) are fairly limited. The following Table 3.3 notes that among the top three international CRAs, only Botswana and Namibia have received investment grade credit ratings from at least two of the major international CRAs.40

7. Conclusion Africa’s infrastructure needs are massive and growing with every year that investment targets are not met. At present this deficit is estimated to be around $95 million per annum, but climbing steadily. The AU, in partnership with key African institutions including NEPAD, UNECA and the Af DB, has developed a comprehensive assessment of what investment is needed, in which countries and in which sectors. The assessment is then followed with an action plan of how to address the deficits, namely through the PIDA-PAP. Globally, on the continent, in sub-regions and at the various national levels there is renewed attention and commitment towards filling the infrastructure investment deficit. All potential sources are being explored and tapped, ranging from the traditional MDBs, to National DFI’s, ODA, new donors like China and the private sector. A certain disenchantment with the way in which traditional MDBs operate and the fact that borrowing from them has become cumbersome with bureaucratic

106  Talitha Bertelsmann-Scott and Cyril Prinsloo

layers and safeguards, MIC have increasingly been looking at the other sources of financing from which to borrow. It is in this landscape and atmosphere that the BRICS New Development Bank was born. From first mentioning of the potential bank in 2011 to the creation of the bank in 2015 and first disbursements in 2016, the NDB has shown that it aims to be an efficient new entrant to the market, having taking note of constraints faced by MDBs and their clients hitherto. Six of the first seven projects are in the renewable energy sector, making good on the BRICS promise that sustainable infrastructure would be the NDB’s key intervention area. The projects also show that the bank has favoured a ‘hand-off’ approach with a determined preference for UCS; that the bank is offering sophisticated lending packages; that it wants to become a key ally of traditional MDBs; that it is serious about lending in local currencies and that it is making good on its promise of being an environmentally and socially conscious lender. From the outset, the NDB has not sought to operationally deviate radically from the business model employed by traditional MDBs. Instead, they have focused on ensuring greater efficiency in their operations by speeding up operations, ensuring greater South–South cooperation, eliminating currency exchange risks, and building partnerships with countries and other financial institutions. Thus far, they have made significant strides towards achieving these goals. However, the bank can still improve on working with domestic DFIs and focusing on support for project preparation phases. The NDB is off to a good start even though it has only made a very small contribution to Africa’s infrastructure deficit. Expanding the banks membership on the African continent should allow for more investment into African infrastructure and allow the NDB to align more closely with the continental plans. The AU and its individual member states should welcome the new entrant to infrastructure financing given the enormous task at hand on the continent and actively work towards soliciting membership opportunities from the Bank. Note: This draws on findings from various past research assignments carried out by SAIIA, among others on behalf of the Development Bank of Southern Africa, Oxfam South Africa and the Global Economic Governance Africa Programme.

Notes 1 Diop, M., Li, Y., Yong, L. and Ato Ahmed Shide, H.E. 2015. Africa Still Poised to Become the Next Best Investment Destination. World Bank. http://www.worldbank. org/en/news/opinion/2015/06/30/africa-still-poised-to-become-the-next-greatinvestment-destination Accessed on 28 April 2017. 2 African Union. 2017. PIDA-PAP Progress Report, March 2017. 3 World Bank (2017), DataBank, accessible on https://databank.worldbank.org/home.aspx 4 Adams P.(2015) Bank to the Future: New Era at the AfDB, Briefing Note, 1502. London: Africa Research Institute. 5 Gutman, J., Say, S. and Chattopadhyay, S. 2015. Financing African Infrastructure: Can the World Deliver? Brookings, Global Economy and Development at Brookings.

The ‘new’ in the New Development Bank  107

6 Gutman, J., Say, S. and Chattopadhyay, S. 2015. Financing African Infrastructure: Can the World Deliver? Brookings, Global Economy and Development at Brookings. 7 Submarine fibre optic cables run along the east and west coast of Africa with recent links planned and in construction to lay cables that link South Africa to the Middle East. Connecting landlocked countries via terrestrial networks to the submarine cables will ensure faster and cheaper internet connections for all of SSA. 8 The state owned energy provider in South Africa, Eskom, has indicated that it would no longer off-take independent power producers’ contributions to the national grid at a fixed price, a decision that might well affect investment prospects into the South African energy sector. 9 ICA. 2014. Infrastructure Financing Trends in Africa 2014. ICA Report – 2014. Infrastructure Consortium Africa. 10 Diop, M., Li, Y., Yong, L. and Shide, A. 2015. Africa still posed to become the next great investment destination. China Daily, 30 June 2015. http://www.worldbank. org/en/news/opinion/2015/06/30/africa-still-poised-to-become-the-next-greatinvestment-destination. 11 ICA. 2014. Infrastructure Financing Trends in Africa 2014. ICA Report – 2014. Infrastructure Consortium Africa. 12 Cloete, R., Faulhaber, F. and Zils, M. 2010. Infrastructure: A long road ahead. In Africa’s Path to Growth: Sector by Sector. http://www.mckinsey.com/global-themes/ middle-east-and-africa/africas-path-to-growth-sector-by-sector. 13 ICA. 2014. Infrastructure Financing Trends in Africa 2014. ICA Report – 2014. Infrastructure Consortium Africa. 14 NBF. 2015. NBF 2015 Integrated Report: Turning the Gears of Africa’s Transformation. NBF. www.nepadbusinessfoundation.org. 15 Prizzon, A., Greenhill, R. and Mustapha, S. 2016. An Age of Choice for Development Finance: Evidence from Country Case Studies. ODI. www.odi.org. 16 Addison, T. and Anand, P.B. 2012. Aid and Infrastructure Financing – Emerginc Challenges with a Focus on Africa. Working paper 2012/56. Unu-Wider Working Paper. 17 Gutman, J., Say, S. and Chattopadhyay, S. 2015. Financing African Infrastructure: Can the World Deliver? Brookings, Global Economy and Development at Brookings. 18 ICA. 2014. Infrastructure Financing Trends in Africa 2014. ICA Report – 2014. Infrastructure Consortium Africa. 19 Calice, P. 2013. African Development Finance Institutions: Unlocking the Potential. AFDB Working Paper 174, May 2013. 20 http://www.afdb.org/en/news-and-events/article/afdb-approves-5th-line-ofcredit-to-dbsa-7707/. 21 Banco Nacional de Desenvolvimento Econômico e Social. 22 Saran, S. and Sharan, V. 2011. It’s time for a BRICS Fund. Russia & India Report Online, 14 December 2011. http://in.rbth.com/articles/2011/12/14/its_time_for_a_brics_ fund_13396. 23 Ustinova, A. 2012. BRICS Bank to be discussed at March Summit, Russia Official Says. Bloomberg Business Online, 27 February 2012. http://www.bloomberg.com/news/ articles/2012-02-23/india-said-to-propose-brics-bank-to-f inance-developingnations-projects. 24 BRICS. 2012. Fourth BRICS Summit: Delhi Declaration, 29 March 2012. http:// www.brics.utoronto.ca/docs/120329-delhi-declaration.html. 25 BRICS. 2013. BRICS and Africa: Partnership for Development, Integration and Industrialisation, 27 March 2013. http://www.brics.utoronto.ca/docs/130327statement.html. 26 BRICS. 2013. Statement by BRICS Leaders on the Establishment of the BRICS-Led Development Bank, 27 March 2013. http://www.brics.utoronto.ca/docs/130327brics-bank.html. 27 BRICS. 2014. Agreement on the New Development Bank, 15 July 2014. http:// www.brics.utoronto.ca/docs/140715-bank.html.

108  Talitha Bertelsmann-Scott and Cyril Prinsloo







4 THE NEOLIBERAL TRANSFORMATION OF DEVELOPMENT BANKING The Indian experience C. P. Chandrasekhar

1. Why development banks? Development banking, or the use of specialised financial institutions to finance lumpy, long-gestation investment projects, has been ubiquitous in developing market economies seeking to accelerate growth, especially since the Second World War. Most often state-owned or sponsored, such institutions were created because developing countries are characterised by an absence of markets for long-term finance. Two factors explain that absence. The first is that given the greater uncertainty associated with the outcome of investment decisions in backward economies, savers are unwilling to directly finance and lock their capital in long-duration projects through investments in equity or bond markets. Such markets tend for long to be limited in size and relatively illiquid. The second is that while banks dominate the financial sector in these countries, they are often too weak and fragile to bear the burden of the liquidity and maturity mismatches associated with transforming deposits by savers, who expect their holdings to be withdrawable on demand, into financing for investments in long duration and relatively illiquid projects. Because these features are typical of developing market economy environments, the presence of specialised institutions serving as vehicles of long-term financing has not been restricted to countries where, and periods when, governments were pursuing dirigiste strategies, with emphasis on state intervention and planning. Rather even with the onset of liberalisation, the role of such institutions in some form has been recognised. That is development banking has not been discarded altogether. But in some contexts, such as India, the institutions engaged in and the methods adopted for development financing have changed with the adoption of measures of “economic reform” that privilege the market mechanism as opposed to state action and regulation. This chapter is concerned

110  C. P. Chandrasekhar

with examining the nature of the transformation of development banking that occurred in India when it moved from a state-directed industrialisation strategy to market-led development, and the relative efficacy of the alternative means of long financing in the two contexts (see also Chandrasekhar, C. P. (2016).

2. The creation of a development banking infrastructure in India After Independence in 1947 when the Indian government declared its intention to launch on a state-led development strategy within the framework of a ‘mixed economy’ with a significant role for the private sector, an important component of its industrialisation thrust was the creation of a development banking infrastructure. The process started immediately, with the setting up of the Industrial Finance Corporation (IFCI) in July 1948 to undertake long-term term-financing for industries.1 In addition, State Financial Corporations (SFCs) were created under an Act that came into effect from August 1952 to assist state- or provinciallevel, small and medium-sized industries with credit. In January 1955, the Industrial Credit and Investment Corporation of India (ICICI), the first development finance institution in the private sector, came to be established, with encouragement and support of the World Bank in the form of a long-term foreign exchange loan and backed by a similar loan from the US government financed out of PL 480 counterpart funds.2 Two other major steps in institution building were the setting up of IDBI as an apex term-lending institution and the Unit Trust of India (UTI) as an investment institution, both commencing operations in July 1964 as subsidiaries of the Reserve Bank of India. That the development banks were special institutions was reflected in the role the central bank had in the development-financing infrastructure. An Industrial Finance Department (IFD) was established in 1957 within the Reserve Bank of India (RBI) and the central bank began administering a credit guarantee scheme for small-scale industries from July 1960. With a view to supporting various term-financing institutions, the RBI set up the National Industrial Credit (Long-Term Operations) Fund from the year 1964–1965. Finally, the IDBI, which served for long as the apex development finance institution was owned by the Reserve Bank of India. A range of other specialised financial institutions were, over time, set up as part of the development banking infrastructure. These included the Agriculture Refinance Corporation (1963), Rural Electrification Corporation Ltd., Housing and Urban Development Corporation (HUDCO), National Bank for Agriculture and Rural Development (NABARD, 1981), EXIM Bank (1982), Shipping Credit and Investment Company of India (1986) (later merged into ICICI Ltd. in 1997), Power Finance Corporation, Indian Railway Finance Corporation (1986), Indian Renewable Energy Development Agency (1987), the Tourism Finance Corporation of India (1989), and the Small Industries Development Bank of India (SIDBI), with functions relating to the micro, medium and small industries sector taken out of IDBI (1989).

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The RBI’s Working Group on DFIs classified them as functionally consisting of (i) term-lending institutions (IFCI Ltd., IDBI, IDFC Ltd., IIBI Ltd.) extending long-term finance to different industrial sectors, (ii) refinancing institutions (NABARD, SIDBI, NHB) extending refinance to banking as well as non-banking intermediaries for finance to agriculture, SSIs and housing sectors, (iii) sector-specific / specialised institutions (EXIM Bank, TFCI Ltd., REC Ltd., HUDCO Ltd., IREDA Ltd., PFC Ltd., IRFC Ltd.), and (iv) investment institutions (LIC, UTI, GIC, IFCI Venture Capital Funds Ltd., ICICI Venture Funds Management Co Ltd.). (RBI 2004: Section 1.4.3) There were, in addition, State-/regional-level institutions such as various SFCs and State Industrial Development Corporations. As institutions were established, the scope of development banking in India increased. The average annual assistance provided by the leading development financial institutions rose from Rs. 29 million during 1948–1952 to Rs. 137 million during the following five years (1953–1957) and Rs. 450 million during 1958–1962. This growth then accelerated to take the annual average assistance to Rs. 1,088 million during 1963–1966 and Rs. 1,442 million during 1967–1971 (Kumar 2013). But even in 1970–1971 disbursements by all major financial institutions (including investment institutions such as the Life Insurance Corporation [LIC], Unit Trust of India [UTI] and General Insurance Corporation [GIC]) amounted to just 2.5% of gross fixed capital formation. It was after the mid-1970s that the DFIs gained substantially in importance, with the assistance disbursed by them amounting to 10.7% of Gross Fixed Capital Formation (GFCF) in 1990–1991 and 15.5% in 1994–1995. Then, matters began to change. The ratio of disbursals to GFCF hovered just below the 1994–1995 level for a few years and collapsed to 10% in 2001–2002, 4.6% in 2002–2003 and 2.3% in 2004–2005. Though there was a marginal revival towards the end of the decade, the figure slipped back to its low levels. What is more telling is the ratio of disbursals to fixed capital formation in the private corporate sector, which was the main beneficiary of DFI loans and equity investments. DFI disbursals rose from 24% of fixed capital formation in the private corporate sector in 1970–1971 to an average of 54% over the decade ending 1985–1986 and 58% in the following decade. That figure then fell to less than 15% over the decade ending 2015–2016.

3. Changing direction The reason for the dramatic decline over the decade ending 2004–2005 was of course the decision taken by the Indian Government to phase out the main all India development financial institutions on the grounds that their presence prevented the realisation of a major objective of neoliberal reform, which was the

112  C. P. Chandrasekhar

creation of a level playing field and encouraging competition among financial institutions. The issue here was quite clear. Given the special role assigned to them, development banks were not expected to compete for funds in the open market. Their funds came from other sources: the government’s budget, the surpluses of the Reserve Bank of India and bonds subscribed by other financial institutions. Given the reliance on such sources and the implicit sovereign guarantee that the bonds issued by these institutions carried, the cost of capital was relatively low, facilitating relatively lower cost lending for long-term purposes. Moreover, banks were persuaded into holding DFI bonds by including them in the securities that qualify to be instruments that banks must hold as part of statutory liquidity ratio (SLR) requirements.3 Interestingly, in India neoliberal reform has targeted the existence of such specialised institutions. The Report of the Committee on the Financial System, set up when neoliberal reform was initiated in 1991, noting that ‘at present DFIs have privileged and concessional access to resources’, held that they ‘will over time have to obtain their resources from the capital market’ (p. 110). Moreover, the committee questioned the need for specialised institutions serving principally as providers of long-term finance. In its view: In the context of enlarging the area of competition between the various players in the field there is also need to re-examine the sharp dichotomy that exists between working capital finance and term loans. This distinction was perhaps relevant when the responsibility between commercial banks on the one hand and the DFIs on the other were clearly demarcated…as the economy acquires greater sophistication, and as the totality of the financing package assumes importance, this distinction is bound to get blurred and the roles of DFIs and commercial banks would come closer as has happened in other countries. (p. 109) This tentative view was transformed into a firm position in the Report of the Committee on Banking Sector Reform released in 1998. That report argued as follows: The Committee has taken note of the twin phenomenon of consolidation and convergence which the financial system is now experiencing globally. In India also banks and DFIs are moving closer to each other in the scope of their activities. The Committee is of the view that with such convergence of activities between banks and DFIs, the DFIs should, over a period of time, convert themselves to banks. There would be only two forms of intermediaries, viz., banking companies and non-banking finance companies. If a DFI does not acquire a banking licence within a stipulated time it would be categorised as a non-banking finance company.

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The justification for the conversion of development banks into banks was soon linked to the need for a level playing field. For instance, the Industrial Investment Bank of India (IIBI) in a written reply to the Parliamentary Standing Committee on Finance 1999–2000 (Standing Committee on Finance 2000) argued as follows: Since compartmentalisation of activities leads to greater transactions cost and inefficiency, no financial intermediary can survive competition if it does not allow itself flexibility to change. In the new financial environment, IIBI is of the opinion that a financial player may be either placed naturally for resources like a commercial bank or may be a pure financial service provider and retailer like the NBFCs. Still another option is to build a financial supermarket where all the services are available under a single umbrella. The advantages are that they would be free to choose the product mix of their operations and configure activities for optimum allocation of their resources. The CEO of ICICI also testifying before the Standing Committee made clear what this meant in terms of emphasis: When we were set up, our role was to meet long term resource requirements of the industry. With liberalisation the role has slightly changed. It became developing India’s debt market, financing India’s infrastructure development, etc. With globalisation, I think, the role is set to change further. Now we have to stress on profitability, shareholder value, corporate governance, while at the same time not losing sight of our goals – the goals that were originally set for us – and the goals that were set up in the interim with liberalisation. Thus, the case being made was that a combination of banks and non-bank finance companies (NBFCs) could replace the specialised DFIs as sources of long-term finance. In keeping with this view, in time, the all India development finance institutions, which with budgetary and central bank support and implicit sovereign guarantees were seen as distorting the playing field for commercial banks, were abolished. Some were allowed to atrophy whereas others like the IDBI and the ICICI were allowed to create commercial banks, with which the development banking arms were subsequently ‘reversed merged’. For example, on 30 March 2002, the Industrial Credit and Investment Corporation of India (ICICI) was, through a reverse merger, integrated with ICICI Bank. The reverse merger followed a decision (announced on 25 October 2001) by ICICI to transform itself into a universal bank that would engage itself not only in traditional banking but investment banking and other financial activities. Continuing with this policy, Parliament approved the corporatisation of the IDBI, paving the way for it to establish IDBI Bank as a subsidiary and then merge with the bank as well.

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The net result of this attrition of development banking was a fundamental transformation of the character of long-term financing in India with attendant implications. To start with, within the remnants of the old development banking framework, the institutional structure of financing changed. If we examine the relative roles of different kinds of institutions in development financing since 1970, we find that in the early 1970s and till the end of the 1980s, the All India Financial Institutions (IDBI, ICICI and IFCI) dominated disbursals of resources accounting for between two-thirds and almost three-quarters of total disbursals. During this time the specialised institutions set up to support small and medium industries at the state and national levels (SIDBI, the SFCs and the SIDCOs) accounted for between 15 and 30% of disbursals and the investment institutions (LIC, GIC and UTI) saw their share rising from less than 10 to about 20%. As noted earlier, disbursal of assistance by the All-India institutions collapsed after 2001, as the DFIs were transformed or closed. A corollary was the growing importance of the investment institutions (the LIC, GIC and UTI) in development financing. Even the small industry-focused financial institutions saw a decline after 2000 for a short period, but registered a robust revival as the SIDBI took on an important role. But overall, old style development finance was in longterm decline.

4. The limited role of the bond market This implied that the gap between the needed long-term finance and the availability of such finance which the DFIs sought to close was now wide open, at a time when the financial sector had turned much more complex because of financial liberalisation. There was a need to fill the gap once again. However, corporate bond markets, which could mediate investments by savers in longterm bonds issued by firms to finance long-term investments failed to take off. Yet, there is little evidence that the gap is being addressed by the emergence of a corporate bond market. India’s efforts to activate its corporate debt market, not least by periodically raising the ceiling on investment by foreign portfolio investors in corporate bonds, are yet to succeed. Mobilisation of capital through the issue of corporate bonds has just about crept up to 4.4% of GDP (Chart 1). Though that is much larger than the 0.2% of GDP for mobilisation through new equity issues, it is way short of the figure (varying from 15 to 50%) for most similarly placed emerging markets. Relative to the size of its economy, India’s corporate bond market is undoubtedly small. This is the case even though in recent years large flows of household savings away from deposits to mutual funds have increased the flow of investments into debt funds, which allocated resources to corporate bonds as well. In many instances, savers are influenced by intermediaries to take on risks they do not understand.

Neoliberal transformation of development banking  115

Moreover, the market seems to be one in which arms-length sales are the exception rather than the rule. Much of the corporate bond sales in India occur through the private placement route, with the share of such issues in the total standing at around 95% in recent years (Chart 2). Overall, the accumulated value of outstanding corporate bonds stood at 16.3% of GDP at the end of March 2018 (Chart 3), whereas that ratio for government securities was around 33% and general government debt is placed at close to 70% of GDP. Even the ownership of government securities is skewed, with commercial banks accounting for 40% and insurance companies and provident funds for another 29%. Clearly, in the risk-return calculations that ordinary savers and specialised financial institutions like insurance companies and pension funds are making, corporate debt has failed to qualify as a large target (Figures 4.1–4.3). 5.00

4.39

4.00

3.40

3.81 2.83

3.00

3.58

3.32

2.00 1.00

0.15

0.16

0.12

0.07

0.17

0.21

2011-12

2012-13

2013-14

2014-15

2015-16

2016-17

0.00 Equity FIGURE 4.1

Bonds

Issues of new equity and corporate bonds as % of GDP.

2016-17

95.59

2015-16

93.07

2014-15 2013-14

97.72 86.69

2012-13 2011-12

95.51 88.01

80.00 82.00 84.00 86.00 88.00 90.00 92.00 94.00 96.00 98.00 100.00 FIGURE 4.2

Share of private placements in corporate bond issues (%).

116  C. P. Chandrasekhar 20.00 15.00

12.04

12.97

13.06

14.04

14.67

15.77

16.35

10.00 5.00 0.00 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 FIGURE 4.3

Outstanding corporate debt as % of GDP.

5. The search for other sources of long-term investment finance If the DFIs are in long-term decline and bond markets are not growing fast enough to take their place, there are three other likely sources from which funds could flow to financing of long-term investment projects. One is the emergence of new NBFCs focused on such financing, with encouragement from the government or set up by the government. Typical examples of such NBFCs are the Infrastructure Development Finance Company (IDFC), the Infrastructure Leasing and Financial Services (IL&FS), the India Infrastructure Finance Company Limited and a range of housing finance companies (such as the Dewan Housing Finance Limited). While some of these are owned by private promoters and investors and or by commercial banks, they are all established with encouragement from the government. The second could be an enhanced role for commercial banks in long-term financing. And the third could be greater reliance on foreign finance for investment projects. All of these are playing a role in 21st century India, but with consequences that are not all benign. That all of these have played a role comes through from evidence on structural changes in the pattern of ‘net’ resource flows to the commercial sector. To start with, banks continue to play an important role in financing the commercial sector, with non-food credit flows to the commercial sector amounting to an average of 50% of total flows in the five years ending 2012–2013 and 47% in the subsequent five years. Second, foreign sources of non-bank funds, in the form of commercial borrowing, issue of depository receipts, and foreign direct investment amounted to a significant 16–22% of total flows to the commercial sector. Finally, in flows from non-bank domestic sources, new domestic sources such as private placement of debt and equity (especially the former), subscription of commercial paper issues by non-banks, credit from housing finance companies and flows from ‘systematically important non-deposit taking NBFCs’ have become important. This trend also has embedded in it a considerable degree of mismatch of maturity. In addition, flows of this kind reflect a substantial degree of layering within the financial sector. According to the Financial Stability Report of the Reserve Bank of India of December 2018: NBFCs were the largest net borrowers of funds from the financial system with gross payables of around ₹7,458 billion and gross receivables of around

Neoliberal transformation of development banking  117

1% 4% 13%

General government Financial corporations Private banks

82%

FIGURE 4.4

Non-financial corporations

Share of debt securities outstanding by principal issuers (%).

₹560 billion as at September-end 2018. A breakup of gross payables indicates that the highest funds were received from SCBs (scheduled commercial banks) followed by AMC-MFs (asset management companies-mutual funds) and insurance companies… The choice of instruments in NBFC funding mix clearly demonstrates the increasing role of both LT (longterm) Loans (provided by SCBs and AIFIs (all-India financial institutions)) and CPs (commercial papers) (subscribed to by AMC-MFs primarily and to a lesser extent by SCBs) and a declining share of LT debt (held by insurance companies and AMC-MFs). Implicit in this is the use of periodically rolled over short-term funds to finance longer-term debt. In sum, capital mobilised through securities issues by financial intermediaries is clearly being used to finance lending to corporations and businesses. According to data from the debt securities database of the Bank for International Settlements, in the distribution of outstanding debt securities issued by the principal sources, the share of financial corporations stood at 82%, as compared with 13.4% for general government, and 4% for non-financial corporations (Chart 4) (Figure 4.4).

6. ‘Flexibility’, fragility and risk Each of these developments has increased the fragility of instability in India’s financial structure. Developments in the commercial banking segment support the view that transforming the development finance institutions into commercial banks was a blunder. With the continued absence of a market for corporate bonds, an important structural break occurred in banking policy and performance in the period after 2003 till 2013, when compared to the years from 1991 to 2003. While the effort to attract foreign direct and portfolio investment, particularly the latter, had begun in the early 1990s with some effect, the real change

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occurred in the years after 2003. While initially liberalisation did increase inflows into the country, large capital flows, which were substantially in the form of portfolio capital, were a later development. Till 1993–1994 total net inflows amounted to less than a billion dollars. Subsequently, foreign investment flows rose sharply to $4.2 billion in 1993–1994 and averaged about $6 billion during the second half of the 1990s. However, there were more significant changes subsequently. During the first decade of this century these inflows rose to $15.7 billion in 2003–2004, and then rose to $70.1 billion in 2009–2010, despite the fall in crisis year 2008–2009. Subsequently, after averaging an average of around $64 billion during 2000–2013, the figure fell because of the ‘taper tantrum’ in 2013–2014.4 But flows bounced back to $73.6 billion in 2014–2015, before falling to $35 billion the next year. In sum, despite volatility the trend has been one of a sharp increase after 2003. This increase would not have been possible without the relaxation of sectoral ceilings on foreign shareholding and the substantial liberalisation of rules governing investments and repatriation of profits and capital from India. But liberalisation began rather early in the 1990s, whereas the boom in foreign investment flows occurred much later. These direct and portfolio flows of foreign capital affect domestic money and asset markets. One counterpart of the capital inflow surge was an increase in the overhang of liquidity in the domestic economy. Reflective of that overhang was a dramatic expansion of the deposit base of banks from Rs. 1.93 trillion in 1990–1991 to Rs. 9.6 trillion in 2000–2001, Rs. 52.1 trillion in 2010–2011 and Rs. 107.6 trillion in 2016–2017. Because banks do not have the option of sitting on deposits that they must accept and pay interest on, the surge in the deposit base would have forced banks to seek out new avenues for investment and lending. While the ‘flexibility’ offered by financial liberalisation helped in this context, the fact that fiscal reform had after 2003 shrunk the space for parking funds in safe government securities was a source of pressure. The result was an explosion in credit growth. While the ratio of scheduled bank credit to GDP stood at around 20% through much of the 1980s and 1990s, it rose by two-and-a-half times between 2000–2001 and 2011–2012, to touch 51.4%. This increase, it must be noted, occurred in a period that includes the high growth years between 2003–2004 and 2008–2009, which makes the rise in the ratio of credit to GDP even more significant. The high expansion in the universe of borrowers and the level of exposure per borrower this implies does increase risk. But associated with that is higher returns. So long as the boom lasts, this points to a huge expansion in profit-making opportunities in the banking area. Moreover, post-liberalisation changes have made banking extremely important from the point of view of the financing of economic activity. Prior to liberalisation the understanding was that banks could provide long-term funding to industry and the housing market only to a limited extent. Being dependent on

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relatively small depositors who would like to hold their savings in highly liquid deposits, lending to long-term, illiquid projects would result in maturity and liquidity mismatches. So the resulting shortfall in the financing of long-term investment had to be met by creating specialised financial institutions with access to more long-term capital directly from the government or the central bank, or through pre-emption of a part of the resources of commercial banks. Liberalisation involved ending that dichotomy, with banks now being encouraged to foray into term lending of different kinds. As banks sought to expand their volume of lending, and their universe of borrowers, there were two sets of sectors that gained in share. The first comprised of retail advances, covering housing loans, loans for automobile and consumer durable purchases, educational loans, and the like. The share of personal loans increased from slightly more than 9% of total outstanding commercial bank credit at the end of March 1996 to close to a quarter of the total by the mid-2000s. This was a ‘natural’ diversification, because they were either loans of short-term maturities that could also be easily pooled and securitised, or they were loans that were backed by implicit collateral, which was the asset financed. In fact, housing loans accounted for a very large share of the total. What was less natural was a second direction of change. This was that despite the huge increase in credit provision, the share of credit going to industry stood at around 40% of total bank credit, not too far below pre-reform levels of about 50%. What is more long-term loans to corporates, including for infrastructure accounted for a significant share of this lending. The share of infrastructural lending in the total advances of scheduled commercial banks to the industrial sector rose sharply, from less than 2% at the end of March 1998 to 16.4% at the end of March 2004 and as much as 35% at the end of March 2015. That is, even as the volume (though not share) of lending to industry in the total advances of the banking system has risen, the importance of lending to infrastructure within industry has increased hugely. Sectors like steel, power, roads and ports, and telecommunications have been the most important beneficiaries. For commercial banks, which are known to prefer lending for short-term purposes, this turn to lending to infrastructure was a high-risk strategy. Three factors could explain the latter tendency. The first, is demand pressure from the large corporate sector, now deprived of financing from the development finance institutions. After the Indian government chose to dismantle its development banking infrastructure, investors in capital intensive projects had to turn to the remaining main source of financing, the banks, for long-term funding. The demand for financing of private capital intensive projects was strengthened by the widening infrastructural gap that resulted from the self-imposed restrictions on public investment stemming from fiscal conservatism. The government declared that given its fiscal ‘constraints’, crucial infrastructural investments had to be undertaken either through the private sector or through public–private partnerships. This placed the onus of finding the finance for such

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projects partly on the government, which in this instance owned the banks. So, it was natural that the banks would be under pressure to lend to projects varying from roads and ports to power and steel. Finally, this situation suited the banks as well, which were under pressure to lend, given the expansion in their deposit base that resulted from the foreign capital inflow-generated overhang of liquidity in the system. They needed to keep credit flowing to match the expansion of deposits and needed to find new borrowers. Since the government was interested in facilitating capital intensive private investment, especially in the infrastructural area, it could be presumed that the financing of such projects would be backed by the government in case of liquidity problems or even default. There appeared to be an implicit sovereign guarantee. The net effect of these multiple factors was a sharp increase in lending to capital intensive projects, including those in infrastructure, where maturity and liquidity mismatches were significant. But once this tendency of lending large sums to a single project or business group began, it did not stop with such projects, but was extended to other areas of corporate lending as well. In practice, the failure of these projects to generate the revenues needed to bear the debt service costs associated with their high debt to equity ratios, led to defaults, even in cases where much effort at restructuring was made. The result was a sharp increase in non-performing assets on the balance sheets of the public banks, place now in excess of 12% of total advances. As the Economic Survey 2016–2017 recognised, if the banks had not been publicly owned, this would have threatened at least some of the banks concerned with insolvency, perhaps triggered a bank run, forced bank closure and even precipitated a systemic crisis. A second source of potential instability is the large increase in foreign capital flows into India. As noted above, underlying the credit boom that India experienced was the liquidity infusion resulting from the large inflow of foreign capital into the country. A substantial proportion of such inflows was in the form of portfolio investments in India’s debt and equity markets. Foreign investors were exploiting their access to cheap money in global markets to engage in a form of carry trade – borrowing cheap in dollars and investing in rupee securities that yielded much higher returns, so long as the rupee did not depreciate sharply in the interim. This form of flow was volatile because any expectation of an interest rate rise in countries that were the source of capital or any fear of currency depreciation in the host country can trigger an exodus of capital, and precipitate a crisis. Even in the case of borrowing by domestic corporates aiming to exploit the availability of low-cost capital abroad to mobilise cheap resources to finance long-term investment at home, inadequate hedging makes them prone to stress when interest rates abroad rise or when the currency depreciates at home. Such borrowing has increased for a number of reasons. Foreign investors have overcome their reticence to invest in Indian bond issues, even if they still show a preference for the private placement route. The government has substantially

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relaxed ceilings on external commercial borrowing by the corporate sector, resulting in significant increases in borrowing abroad by corporations. And, above all the Indian government has decided to exploit to the full the country’s access to borrowing from the World Bank and Asian Development Bank, on the one hand, and the new sources of ‘multilateral’ lending on commercial terms such as the Asian Infrastructure Investment Bank and the New Development Bank. For example, despite China’s dominance in these institutions and India’s strained relations with China, India is one of the largest borrowers from the AIIB. As of June 2018, while AIIB’s total loan portfolio stood at around $4 billion, lending by it to India was a significant $1.3 billion. Given the terms of such borrowing, this is another source of fragility. To these sources must be added the fragility implicit in relying on new forms of long-term financing from the NBFCs created as alternatives to the old DFIs. As noted earlier these entities tend to rely on relatively short-term deposits for their capital. Using that to finance capital intensive investments or long gestation projects would involve liquidity and maturity mismatches that can lead to fragility. This is precisely what happened, as the government cajoled publicly owned banks to lend for large corporate investments, resulting in mega-sized debt defaults. Bank exposure is not just directly to corporates, as the yet unfolding IL&FS sags reveals. It is now clear that banks also invest in bonds issued by the non-bank financial companies, which in turn use that capital to lend to business of various kinds. Given the structure of this activity, NBFCs need to constantly roll-over debt to sustain their operations and meet their own payments commitments. The fragility this gives rise to was illustrated by the experience of two different NBFCs, Industrial Leasing &Financial Services and Dewan Housing Finance Limited, both of which have defaulted on payments due to issuers of short-term paper, leading to a liquidity crunch for other NBFCs that the government is attempting to address. When a large player like IL&FS defaults on debt, the flow of credit to the rest of the non-bank financial sector tightens, resulting in ‘liquidity’ problems that can precipitate collateral default and increase the risk of more systemic effects. In sum, India’s decision to give up on old style development financing, in a situation where the government is committed to a form of austerity and the bond market is inadequately developed, has generated NPAs that ‘reform’ was supposed to prevent, led to large scale default and rendered the system prone to instability and crises.

Notes 1 In 1975 the IFCI set up a Risk Capital Foundation in the form of the IFCI Venture Capital Fund to provide soft loans to first generation and technocrat entrepreneurs. IVCF later managed funds of the Venture Capital Unit Scheme of the Unit Trust of India. 2 Public Law 480 enacted in 1954 in the US allowed for the use of surplus agricultural produce (especially wheat) from the US as food aid to developing countries through

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sale at concessional terms including payment in local currency, with the local currency funds being used for US diplomatic and development expenditures in the country concerned. 3 Besides meeting conventional cash reserve requirements banks in India are required to meet a specified ratio of liquid assets (consisting of cash, gold and specified RBIapproved securities) relative to their net time and demand and time liabilities. 4 All figures from the Reserve Bank of India’s database at www.rbi.org.in.

References Chandrasekhar, C. P. (2016). National development banks in a comparative perspective. In Rethinking Development Strategies after the Financial Crisis – Volume II, Country Studies and International Comparisons, pp. 21–30. UNCTAD, United Nations: New York and Geneva. Economic Survey 2016–2017. Government of India (1998). Report of the Committee on Banking Sector Reforms, April, New Delhi (Chairman: M. Narasimham). Kumar, S. (2013). Decline of Development Banking During Financial Liberalization (1992– 2004) in India: Determinants and Implications. PhD thesis submitted to Jawaharlal Nehru University. New Delhi. Narasimhan, M. (1991). Report of the Committee on the Financial System, Nabhi Publications, India. Narasimham, M. (1998). Second Committee on Banking Sector Reforms, Reserve Bank of India, Mumbai. Reserve Bank of India (2004). Reserve Bank of India (2015). Financing for Infrastructure: Current Issues and Emerging Challenges. Keynote address by Shri Harun R Khan, Deputy Governor, Infrastructure Group Conclave of SBICAP, Aamby Valley City. 8 August. Available at http://articles. economictimes.indiatimes.com/2015-01-08/news/57838197_1_infrastructure-projectsurban-infrastructure-infrastructure-financing. Standing Committee on Finance (2000).

5 CHINESE DEVELOPMENT FINANCE IN THE AMERICAS Kevin P. Gallagher

1.  The need for development finance in Latin America Development banks have a unique role to play in Latin America and the ­Caribbean (LAC) and in emerging market and development countries across the globe. At their best, development finance can help financial markets be more counter-­c yclical, can fill infrastructure gaps, and help generate structural change, all while helping economies make necessary low carbon and socially inclusive transitions. LAC financial markets in general, and external capital flows to LAC in particular, tend to be pro-cyclical—surging during economically prosperous periods and stopping during downturns. Development banks can and have played a key role to provide counter-cyclical financing during downturns in order to spark economic recovery and trigger structural transformation throughout the region’s economies. Moreover, private markets in LAC tend to concentrate in short-term investments rather than in long run investments such as infrastructure. Latin America and the Caribbean face a significant infrastructure gap, with more than US$170– 260 billion needed in infrastructure investments annually over the next decade (ECLAC, 2011). Development banking into infrastructure, when timed correctly, can enhance counter-cyclical goals while also plugging gaps in long-run finance. According to the International Monetary Fund (IMF), infrastructure spending has the highest multiplier impact during a downturn (IMF, 2014). In an examination of LAC, World Bank researchers found that for every 1% increase in spending and upgrading of infrastructure in the region could add as much as 2% points of annual economic growth in growth over the long run (Calderón and Serven, 2010). An Inter-American Development Bank (IADB) study shows that a 1% reduction

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in transport costs would increase exports by as much as 4% in Mexico and 7.9% in Colombia (Mesquita-Moreira et al., 2013). Development banks have also been asked to play an enhanced role in meeting the Sustainable Development Goals (SDGs) that pledge to both “ensure access to affordable, reliable, sustainable and modern energy for all,” and to “develop quality, reliable, sustainable and resilient infrastructure, including regional and trans-border infrastructure, to support economic development and human well-being, with a focus on affordable and equitable access for all” (United Nations, 2015). The geographical location of Latin America and the Caribbean endows the region with abundant wealth in natural resources, but also a particular vulnerability to climate change. The extraction of such resources can also often strain sources of livelihoods and threaten biodiversity as well as sources of water and sustenance for people and economies over the long run. Moreover, the over-­ reliance of economic activity in natural resources has also been characterized with dramatic boom and bust cycles that have hindered the development process in the Americas for over a century (Bertola and Ocampo, 2012). In terms of climate change, LAC is only responsible for approximately 12.5% of global greenhouse gas (GHG) emissions, but is disproportionately impacted by climate change as many areas in the region are seriously affected by droughts, flooding, cyclones and the El Nino-Southern Oscillation (ENSO) phenomenon (Maplecroft, 2014). Damages resulting from extreme weather related to climate change have not only jeopardized socioeconomic activities but also eroded wealth accumulated from previous episodes of economic growth. According to a joint study by the IADB with the United Nations Economic Commission for Latin America and the Caribbean and the World Wildlife Fund, the annual economic costs of climate change in LAC are $100 billion per year (IADB, 2012). There is even less private finance for climate change mitigation and adaptation, the region faces a $100 billion annual gap in finance for climate change mitigation and adaptation (IADB, 2012). The region is also the most unequal in the world, with the richest 10% holding over 70% of the region’s wealth. At the region’s $4 per day poverty line, one in four persons in LAC is poor; one person out of seven in the region earns $2.50 per day—the World Bank’s definition of poverty. Whereas the private marketplace tends to concentrate on the more wealthier aspects of LAC society, development finance can help address structural inequities as well. Many LAC countries have their own national development banks, and have access to regional and sub-regional banks such as the Development Bank of Latin America (CAF), the Caribbean Development Bank, the Central American Bank for Economic Integration, and the Inter-American Development Bank. And of course, the World Bank Group has had a long history in the region as well. Since 2005 however, China’s two global policy banks, the China Development Bank (CDB) and the Export-Import Bank of China (CHEXIM), have emerged to become among the largest sources of development financing to Latin

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American governments. This report measures the extent of Chinese development finance in the Americas and compares Chinese development finance with the traditional sources of development finance in the region.

2.  China’s development finance institutions in context Unlike the Western countries that have been reluctant to increase the capital base of the Multilateral Development Banks, China is increasing the paid in capital for its two global policy banks and has helped capitalize two new multilateral development banks in the New Development Bank and the Asian Infrastructure Investment Bank. Even before these new institutions get fully operational, China is emerging as the global leader in development finance. In recent years China has helped establish two new multilateral development banks in the Asian Infrastructure Investment Bank and the New Development Bank. China has also co-established at least 13 regional and bi-lateral funds with a number of country as well. This section provides an overview of these banks and funds.

a.  China’s policy banks go global Two of China’s policy banks, the China Development Bank (CBD) and the Export-­Import Bank of China (CHEXIM) already hold more assets than the combined sum of the assets of the Western-backed multilateral development banks. CHEXIM and the CBD have over $2 trillion in assets, whereas the Western-­backed banks hold just over $700 billion. That said, CDBs international holdings are just 30% of total assets, putting the two banks’ international assets at around $675 billion, giving China’s policy banks roughly the same amount of global assets of the major development banks. These two “policy banks” as they are called in China, provide non-­ concessional and concessional (in the case of the CHEXIM) finance in virtually every corner of the world. The CDB holds over $1.4 billion in assets with roughly $375 overseas—more than the World Bank Group’s International Bank for Reconstruction and Development. In just over a decade, China has doubled the amount of development finance in the world economy. During 1994 reforms of the financial sector, the Chinese government created CDB and CHEXIM as “policy banks,” whose loans would explicitly support the government’s policy objectives (Bräutigam, 2009, 79). Prior to 1994, policy lending had been the responsibility of the “Big Four” Chinese banks (Bank of China, China Construction Bank, Agricultural Bank of China, and ICBC), so the new policy banks were designed to free the Big Four to act as commercial banks. In separating policy from commercial lending, the government sought to reduce bank managers’ moral hazard. If managers could blame all their losses on policy loans, they had an incentive to direct their commercial loans toward highrisk, high-return projects. The creation of separate policy banks would hold the

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commercial banks accountable for rational, market-based lending (Water and Fraser, 2012). CDB and China CHEXIM follow slightly different mandates, which both revolve around strengthening Chinese industry. CDB mainly supports China’s macroeconomic policies—laid out in the Five-Year Plans—focusing on eight areas of development: electric power, road construction, railway, petroleum and petrochemical, coal, postal and telecommunications, agriculture and related industries and public infrastructure. An estimated 73.7% of CDB’s total new loans went to these sectors (CDB, 2017) In contrast, the China CHEXIM Bank’s mandate is to: facilitate the export and import of Chinese mechanical and electronic products, complete sets of equipment and new- and high-tech products, assist Chinese companies with comparative advantages in their offshore project contracting and outbound investment, and promote international economic cooperation and trade. (CHEXIM, 2017) CHEXIM achieves these objectives through the use of export credits, loans to overseas construction and investment projects and concessional loans. Although the government designed the reforms to divorce policy and commercial lending, Chinese banks continue to mix these lending categories. Steinfeld points out that the government still forces the nominally commercial banks to bail out state-owned enterprises (Steinfeld, 2000). At the same time, the policy banks have become quite commercial. Former CDB head Chen Yuan married the bank’s policy objectives with sound commercial loans so that CDB has high profits and a balance sheet that is even healthier than China’s big commercial banks (Downs, 2011). CHEXIM also lends much of its capital at or near commercial rates and boasts a low share of nonperforming loans (Bräutigam, 2009; Gallagher and Irwin, 2015). The structure of Chinese development finance is fairly unique relative to the Western-backed MDBs. We term China’s development financing approach the “consortia approach” and depict this in Figure 5.1. The CDB will lead a delegation to a host country and discuss with that country what kind of project that the country seeks finance for—most often some mix of energy, industry and infrastructure. The CDB will provide non-concessional finance to the host country government as individual loans or lines of credit, which can be tied to exports. CHEXIM can often also be at the table, providing the country with concessional finance and buyer’s trade credits related to the project. What is more, in some cases the Chinese Ministry of Finance and/or Ministry of Commerce will provide grant support to the host country for the project level as well. The process does not stop there. The China consortia can also provide support for Chinese commercial entities. The Ministries of Finance and Commerce have prioritized many of China’s “national champion” companies as targeted

Chinese development finance in the Americas  127

CDB CHEXIM MOF MOFCOM

Chinese Firms

Host Country Grant

FIGURE 5.1 

Fiscal subsidy Seller’s (export) credit

Buyer’s (import) credit Non-concessional loan Concessional loan

Investment Support

FDI

The consortia approach.

Source: Gallagher and Chin (2017).

for global expansion in an effort to globalize China’s industrial policy and offers certain forms fiscal support for such efforts. What is more, the CDB offers financing for overseas foreign direct investment and CHEXIM will offer seller’s (export) credits. In 2009 the Chinese petroleum giant China National Petroleum Corporation received at $30 billion line of credit for overseas expansion activities, remarking that “The credit agreement is of great importance for CNPC to speed up its overseas expansion strategy and secure the nation’s energy supplies” (Nicholson, 2009). At a signing for a line of credit for the Chinese telecommunications firm Huawei to “go global,” Chen Yuan, then Chairman of the CDB said “the CDB is more than willing to apply and leverage the experience we’ve accumulated in our many years of work on development finance…to help these companies…become global enterprises” (Sanderson and Forsyth, 2012). Indeed, according to work by Gallagher and Irwin (2014), between 2002 and 2012 the CDB and CHEXIM provided Chinese firms with more than $144 billion for their global expansion, with the CDB accounting for more than 64% of the total financing. In addition to the CDB and CHEXIM, Chinese commercial banks are also often part of the consortia—required by the state to be a component of certain projects. China became Brazil’s largest trading partner in 2009, and to further bolster trade and investment in resources and infrastructure, China’s commercial banks have been making strategic moves into Brazil’s financial sector, positioning themselves more prominently for trade finance and as capital providers in the

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region. In 2009, Bank of China opened its first branch in Brazil. In May 2015, during Chinese Premier’s visit to Brazil, BoC built on top of CDB’s announcement that the state policy lender would provide a US1.5 billion loan to Brazil’s energy giant Petrobras, and CDB’s promise to lend $39.5 billion (having already agreed to loans of $23.7 billion in projects with Petrobras), by noting that, with China surpassing the US as the world’s biggest market for Brazilian products, the bank is “dedicated to provide all kinds of financial services” to Chinese companies in Brazil and to Brazilian firms that want to do more with China (Weihua and Pengfei, 2015). The Chinese government’s “Going Global” policy has brought this amalgamation of commercial and policy lending to the international stage. In 1998, then President Jiang Zemin championed the internationalization of Chinese investment and lending. He argued that “Regions like Africa, the Middle East, Central Asia, and South America with large developing countries [have] very big markets and abundant resources; we should take advantage of the opportunity to get in” (Yuan, 2009). As Downs (2011) points out, CDB is the main bank supporting this strategy with loans to Chinese and foreign companies overseas. Bräutigam adds that “the Eximbank has been at the center of China’s strategy of ‘going global’” (Bräutigam, 2009, 112).

b.  China-backed development funds China has also pioneered a host of bilateral and regional development funds. These funds combine to add upwards of $178 billion in development finance provided by the Chinese in recent years and are exhibited in Table 5.1. A major portion of these investments are in Asia as part of China’s broader Belt Road Initiative, with the largest being the $54 billion Silk Road Fund established in 2014 with investment from state institutions including the CHEXIM and CDB and replenished in May 2017. The fund is open to investors from other countries as well and has provisions to expand maritime connectivity between China and the rest of Asia (Central, South and Southeast Asia, the Middle East), North and Northeast Africa, and Europe. A related fund is the Green Ecological Silk Road Investment Fund, a private equity fund for improving the ecological environment in the region. In the larger Eurasian region, investments include the China–Central and Eastern European (China-CEE) Fund—set up to facilitate financing of projects to enhance inter-connectivity in the region, specifically in Eastern Europe— and the bilateral Russia-China Investment Fund (RCIF) established by two government-­backed investment vehicles, the Russian Direct Investment Fund and China Investment Corporation (CIC). The RCIF will invest 70% of its capital in Russia and other CIS countries (currently Azerbaijan, Armenia, Belarus, Kazakhstan, Kyrgyzstan, Moldova, Tajikistan, Turkmenistan, Uzbekistan, and Ukraine) and 30% in China.

Chinese development finance in the Americas  129 TABLE 5.1  China’s global funds

Chinese development funds in the world economy $USB Asia Silk Road Fund The Green Silk Road Fund China–ASEAN Fund (with ADB)

54.0 4.8 1.0

Eurasia China–Central and Eastern Europe Investment Fund Russia–China Investment Fund China–Russia Regional Cooperation Development Investment Fund Russia Direct Investment Fund China–VEB Innovation Fund The China–Kazakhstan Production Capacity Cooperation Fund

4.0 2.0 14.0 10.0 1.0 2.0

Latin America and Caribbean CELAC–China Investment Fund China–LAC Industrial Cooperation Fund China–LAC Investment Fund (with IADB) China–Mexico Investment Fund China–Portuguese Speaking Countries Cooperation Fund China–Brazil Investment Fund

20.0 10.0 5.0 2.4 1.0 20.0

Africa China–Africa Development Fund Africa Growing Together Fund (with Af D) China–Africa Production Capacity/Industrial Cooperation Fund

10.0 2.0 10.0

Global South South–South Climate Fund South–South Cooperation Fund Total

3.2 2.0 178.0

Source: Gallagher and Chin (2017).

Over the last decade China has created a significant platform of public and private investments in Africa. To date the largest of such initiatives is the China– Africa Industrial Capacity Cooperation Fund Company Limited (CAICCF), jointly established by the China Foreign Exchange Reserves and Export-Import Bank of China. With $10 billion in pledges, the fund would support infrastructure development, particularly in the transit sector, as well as provide financing for manufacturing and agriculture projects. Among the state-backed funds is the China–Africa Development Fund (CAD Fund), a Chinese private equity fund ­fi nanced by the CDB, set up in order to stimulate investment in Africa by

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Chinese companies in power generation, transportation infrastructure, natural resources, and manufacturing. This fund has $10 billion in pledges and has disbursed upwards of $2 billion. The Africa Growing Together Fund (AGTF), is a fund inside the African Development Bank financed by the People’s Bank of China, is to finance eligible sovereign and non-sovereign guaranteed development projects in Africa. In the larger arena China seeks to strengthen South–South relations and contribute to global development. To this end, China announced the creation of the $3.1 billion South–South Climate Cooperation Fund in a China–U.S. joint presidential statement on climate change in September 2015, to be used to finance initiatives in developing countries worldwide to combat climate change. China also pledged $2 billion in the creation of a South–South Cooperation Fund aimed to assist developing countries in implementing their post-2015 development agenda, as announced last year at the United Nations Sustainable ­Development Summit at the UN headquarters in New York. Plans to create an Academy of South–South Cooperation and Development was also announced, with the aim to facilitate studies and exchanges by developing countries on theories and practices of development suited to their respective national conditions. Chinese finance also plays a prominent role in the Latin America and the Caribbean—with $58.4 billion in funds in the region. The largest are the $20 billion CELAC-China Investment Fund for infrastructure projects, the China– Brazil Investment Fund, and the $10 billion dollar China–LAC Industrial Cooperation Fund for medium- and long-term financing for industrial investments. Investments in the region further include the China–LAC Cooperation Fund, initiated by the Chinese Government to finance projects in LAC region in areas including education, water conservancy, and energy. The Fund is housed at the Inter-American Development Bank and includes a private equity (PE) fund administered by the Export-Import Bank of China. In addition to these, the China–Mexico Investment Fund was set up to support Chinese and Mexican companies investing in infrastructure, mining, and energy projects in both countries.

c.  New multilaterals In addition to making stepwise contributions in paid in capital to its two global policy banks, China recently helped found two global development banks, the New Development Bank (NDB) and the Asian Infrastructure Investment Bank (AIIB). The NDB was launched in July 2015 by Brazil, Russia, India, China and South Africa—collectively known as BRICS countries. The NDB provides financing to developing countries to help finance sustainable infrastructure projects, releasing its first set of financing packages for clean energy and largely financed from green bond issuances in the Chinese market, in the spring of 2016. Each BRICS member is expected to put an equal share into establishing the startup capital of $50 billion with a goal of reaching $100 billion. Under the

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current arrangement membership will be limited to BRICS nations, though future members will eventually be added—with the BRICS countries always holding a minimum of 55% voting power. The Asian Infrastructure Investment Bank (AIIB) was created to support infrastructure construction in the Asia-Pacific region. The AIIB was proposed by China in 2013 and formally started operations in December 2015 after the Articles of Agreement (AoA) entered into force with ratification from 17 member states holding 50.1% of the shares. This is in accordance with the AoA that requires ratification from 10 member states holding a total number of 50% of the initial subscriptions of the authorized capital stock. By July of 2017 the AIIB had 80 members and prospective members, including six from Latin America in Argentina, Bolivia, Brazil, Chile, Peru, and Venezuela. The Memorandum of Understanding (MoU) specifies that the authorized capital of AIIB is $100 billion and the initial subscribed capital is expected to be around $50 billion. AIIB’s investment capacity could reach $250 billion by the end of 2020 in accordance with provisions made in its AoA. The Bank will largely co-finance projects with the World Bank (WB) and Asian Development Bank (AsDB), particularly in the first years of its operations.

d.  China and the MDBs China now has a stake in all the major MDBs, including the World Bank (WB), Asian Development Bank (ADB), African Development Bank (Af DB), Inter-­ American Development Bank (IADB), the European Bank for Reconstruction and Development (EBRD), and the European Investment Bank (EIB). The Chinese have contributed US$22.92 billion to these institutions. China’s largest contribution is to the ADB, at US$11.32 billion, or 6.47% of the capital and with a voting share of 5.47% (voting share consisting of the sum of a members’ basic votes and proportional votes as a percentage of the total). China also contributed US$10.94 billion contribution to the WB—or 4.9% of capital stock and with a voting share of 4.42%. China’s capital in the IADB is the smallest, at US$3.74 million. China’s capital contributions, and thus its voting share in these institutions, are still relatively small. At the World Bank, despite being the second largest economy in the world China has the 3rd in IBRD rank in terms of voting shares and the 3rd at the ADB, at 4.42 and 5.57% respectively. Conversely, the United States enjoys much larger voting shares in these institutions. Indeed, the US holds 15.02% of the vote at the WB and 12.75% of the vote (behind Japan) at the ADB.

3.  Chinese development finance in Latin America Since 2005 when the CDB and CHEXIM began providing loans to LAC governments, China’s policy banks have provided upwards of $140 billion in loans to governments in the LAC region. China’s contributions have increased major

132  Kevin P. Gallagher

development finance to the region by over 50% during this period—China’s finance was $140 billion and the World Bank (WB), Inter-American Development Bank (IADB) and Development Bank of Latin America (CAF) provided. There is no easy way to measure Chinese bank loans to Latin America. Unlike the World Bank, the IDB, and the CAF, Chinese banks do not regularly publish detailed figures regarding their loan activities. A number of years ago the Global Economic Governance Initiative at Boston University and the Inter-American Dialogue began collecting data on Chinese loans to Latin America, our database is freely available as the “China-Latin America Finance Database.” Following the lead of scholars such as Bräutigam, who examine government, bank and press reports in both China and borrowing countries in order to compile a list of loans and their characteristics. This method is highly imperfect. Although we have gone to great lengths to ensure reliability by confirming reports in both China and LAC, our estimate should not be taken as a precise figure. On the one hand, we may have underestimated Chinese finance in Latin America because we do not examine many loans under $50 million. On the other hand, we may have overestimated the total in the event that the most recent loans are partially or entirely cancelled or if a line of credit is not fully committed (see Gallagher and Myers, 2016). This section of the report has four comparative sections. The first section analyses the annual flows of China’s development finance to LAC, compared to the flows of the CAF, IADB, and the WB—and in general to China’s flows to Africa. The second part discusses China’s “loans for oil” agreements in LAC and compared to Africa. The third part performs a “market analysis” to analyze the extent to which the terms of Chinese development finance contrast with those of other multilateral development banks (MDBs) and private markets. The last part of the section compares the social and environmental safeguards of China’s policy banks with those of the other major MDBs operating in the region.

a.  Flows of Chinese development finance to LAC Since 2005, CDB and CHEXIM have provided $141 billion to Latin American governments, compared to $85.5 billion by the World Bank and $117.8 by the IADB, and $55.1 billion by the CAF (for these comparisons we include only the sovereign loans of China and the other regional lenders and not the equity arms) (Figure 5.2). The lion’s share of Chinese finance has occurred since 2009; however, with $136 billion compared to $66.1 billion by the World Bank, $89.1 by the IADB, and $42.5 by the CAF. During the period, Chinese banks combined averaged $11 billion annually compared to $7 billion for the World Bank, $9.8 billion for the IADB, and $4.5 billion for CAF. Seventy-six percent of Chinese development finance in LAC has come from the CDB and the rest from CHEXIM. Reliable data using a similar methodology is compiled for Africa by the China Africa Research Initiative at the Johns Hopkins School for Advanced International Study (SAIS-CARI). From 2005 to 2015 (the latest year when comparable data exists, China’s two policy banks provided $99 billion

Chinese development finance in the Americas  133 Development Finance in the Americas (2005 to 2016)

40,000 35,000

US Billion

30,000 25,000

China Banks IBRD IADB CAF

20,000 15,000 10,000 5,000 -

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

FIGURE 5.2 

Chinese development finance compared.

Source: Gallagher and Myers (2016).

to African governments (compared to $120 billion for LAC during the same period). Though larger in dollar volume to LAC, China’s policy loans to Africa were approximately 2.6% of GDP compared to less than 2% for LAC (Brautigam and Gallagher, 2014). Chinese banks also provided financing to a significantly different set of countries than the IFIs and Western banks. From 2005 to 2016, 93% of Chinese lending went to Venezuela, Brazil, Ecuador, and Argentina (Table 5.2). Venezuela and Ecuador receive 9% of IDB loans and less than 1% of World Bank loans. IFIs and Western Banks instead dominate lending to Mexico, Colombia and Peru. Only Brazil and Argentina have received significant shares of finance from both Chinese and Western sources. Chinese banks also differ from IFIs by directing the majority of their loans to infrastructure, energy, and mining. Chinese banks channel 52% of their loans into infrastructure, 31% in energy extraction, distribution and power generation, 8% to mining, and the rest in trade finance (1%), budget support (1%) and miscellaneous projects. Infrastructure, Energy, and Mining are 91% of China’s loan portfolio to LAC, standing in stark contrast to the World Bank and the IADB, where only 34% of World Bank loans go into infrastructure, energy, and mining, 29% of IADB loans do, and 44% of CAF loans go to infrastructure, mining and energy. Instead, the IDB and World Bank direct more than a third of their loans toward the health, social, and environment sectors, which receive no Chinese investment. In terms of individual countries and projects, the ten largest financial packages from China’s policy banks to LAC governments are shown below (Table 5.3). The ten largest loans and lines of credit listed here are not surprisingly flowing to the largest overall recipients of Chinese development finance—Venezuela,

134  Kevin P. Gallagher TABLE 5.2  Country distribution of Chinese development finance

$USB Venezuela Brazil Ecuador Argentina Bolivia Trinidad and Tobego Jamaica Mexico Costa Rica Barbados Guyana Bahamas Peru Total Top four share

62.2 36.8 17.4 15.3 3.5 2.6 1.8 1 0.395 0.17 0.13 0.099 0.05 141.44 93%

TABLE 5.3  L argest loans

Date

Country

Lender

Commodity- Amount Purpose backed? ($USM)

8/1/2010

Venezuela

CDB

Oil

20,255

7/1/2010

Argentina

CDB

–

10,000

5/1/2009 2/27/2016

Brazil Brazil

CDB CDB

Oil Oil

10,000 10,000

1/6/2015

Ecuador

CHEXIM

–

5,296

4/19/2015

Venezuela

CDB

Oil

5,000

11/19/2013 Venezuela

CDB

Oil

5,000

1/6/2015

Ecuador

CHEXIM

–

5,296

1/6/2015

Ecuador

CHEXIM

–

5,296

6/1/2011

Venezuela

CDB

Oil

4,000

Total

80,143

Various infrastructure projects, housing Revamp Argentina’s train systems Exploit pre-salt oil fields Debt financing for Petrobras Finance transportation, education, and healthcare projects Joint Financing Fund – Tranche B Joint Financing Fund – Tranche C Finance transportation, education, and healthcare projects Finance transportation, education, and healthcare projects Joint Financing Fund – Renewal of Tranche A

Chinese development finance in the Americas  135

Argentina, Brazil, and Ecuador. In Venezuela, the majority of all the financing goes into a join fund between Venezuela and China that is largely used for energy and infrastructure and also some housing and health programs. Brazil has received significant financing for oil exploration and to finance debt for Brazil’s state-owned oil company, Petrobras. Whereas the largest financial packages have come from the CDB for those countries, the CHEXIM has provided the largest loans to Ecuador, financing large transportation and energy projects, as well as education and health. These top 10 financing arrangements are $80.1 billion, or 57% of all Chinese development finance in LAC. Gallagher and Yuan (2015) analyzed the extent to which development banks in LAC engaged in “green financing” in the region from 2007 to 2014 (the only years of matching data across 11 development banks). The authors used a methodology derived from the International Development Finance Club (IDFC) that the CDB, CHEXIM, CAF, and many other national and sub-regional banks are members of and that was synced with methods of the MDBs (IDFC, 2014). The authors estimated that the annual amount of green finance was about $61 billion and accounted for 20% of total commitments provided by 11 development in LAC during the same period. The majority of green financial flows in LAC are in climate mitigation representing 55% of all green finance, climate adaptation (11%), and water and sanitation (33%). In all then, climate finance amounts to just over $40 or $5.9 billion per year. Drawing on that work, Table 5.4 exhibits the flows of green finance from China’s banks relative to the CAF, IDB, and WB. TABLE 5.4  Green development finance in Latin America

IDB (USM) Mitigation

Adaptation Other Total Total

Hydroelectric power Renewable energy/ energy efficiency Sustainable transport Other mitigation Disaster Adaptation Water and sanitation Green finance Finance Percent green

CAF

WB

China Banks

1,098

1,075

939

240

416

200

2,345

2,058

3,551

263

2,429

29

3,888

–

297 708 10,360

2,901 120 4,438

1,126 1,510 2,637

– – –

10,861 37,105 29%

13,128 62,335 21%

18,176 83,721 22%

Source: Authors adaptation from Gallagher and Yuan (2015).

–

7,575

8,038 94,152 9%

136  Kevin P. Gallagher

The two China banks, the CAF, IDB, and WB financed $55.2 billion in green projects during this period, or 82% of the green finance in the region. Of these, the IDB provides the largest amount of green financing to LAC governments at $18 billion during the period, though the CAF has the highest proportion of its total financing going toward green projects at 29%. The Chinese policy banks have the least amount of green finance flowing to the region both in terms of total volume and in terms of the bank’s total portfolio during the period. China’s development finance that is green is only $8 billion, representing just 9% of its total loans to the region. China’s banks are the largest financiers of hydroelectric power in the region, which is categorized as “green” by the IDFC, to approximately $7.5 billion, and also has financed wind power and energy efficiency in Ecuador and sustainable transportation in Peru. With respect to hydropower, it is important to highlight that, according to the IDFC definition, hydropower plants can be labeled green, “only if net emission reductions can be demonstrated.” Especially in the Americas, it is not clear whether all the cleaner energy projects in the region could be classified as green. This stipulation is not to be taken lightly, especially in the Latin American case where tropical hydro-electric projects have long been associated with increases in methane emissions and emissions from associated deforestation. Comprehensive reviews of estimates find that tropical hydroelectric plants tend to emit 7–15 times more emissions than non-tropical hydropower, and 2–3 times more emissions than gas, oil, or coal plants (Barros et al., 2011; Steinhurst et al., 2012). What is more, hydroelectric power projects have been widely shown to be the source of other environmental and social problems beyond climate change such as loss of water and habitat, the displacement of people and indigenous livelihoods, and beyond (Laurance et al., 2009).

b.  Determinants of Chinese development finance to LAC In general, there are four broad reasons why CDB and CHEXIM provide development finance to foreign governments—to diversify the countries’ foreign exchange reserves, to help China’s firms “go out,” to gain access to natural resources and technology, and for geopolitical reasons such as gaining allies and being a “responsible power.” While difficult to capture all of these elements in statistical analyses, there is some econometric evidence to support these possibilities for LAC. China has trillions of dollars in foreign exchange reserves that are low yielding. Financing foreign governments through development banks is an opportunity to diversify those holdings. As Kong and Gallagher (2017) discuss, the aftermath of the 2008 global financial crisis increased pressure for the Chinese government to preserve and enhance the value of its massive FOREX reserves worth more than three trillion U.S. dollars. On the one hand, the global financial crisis dealt a huge blow to the financial sector in the West, making it a risky proposition for China to invest in Western financial institutions. On the other hand, following

Chinese development finance in the Americas  137

the global financial crisis the U.S. Federal Reserve Bank adapted a quantitative easing policy, which weakened both the U.S. dollars and the Treasury bill yields. In this context, a growing consensus among Chinese policymakers and scholars that China should use its FOREX reserves. Second, the CDB and CHEXIM are key vehicles for the Chinese state’s “going out” strategy. Formally put forward at the Second Plenary Session of Fifth Plenum of the 15th Chinese Communist Party’s National Congress in 2000 and then incorporated into the country’s 10th Five Year Plan (2001–2005) for Economic and Social Development in 2001, the “going out” strategy sets out overseas investment a strategic focus of China’s economic development. Subsequently, both the 11th Five Year Plan (2006–2010) and 12th Five Year Plan (2011–2015) called for the Chinese companies to accelerate their “going out.” To assist the implementation of the “going out” strategy, the CHEXIM and the CDB coordinated with the state’s principal development planner the National Development and Reform Commission (NDRC) and established “special loans” and “equity loans” for overseas investments, respectively. According to Kong and Gallagher, the public circulars these two policy banks issued together with the NDRC in 2003 and 2005, respectively singled out four priorities as the targeted areas for their special credit programs. They include overseas resource development projects which can make up for the relative insufficiency of domestic resources; overseas productive projects and infrastructure projects which can give impetus to the export of domestic technologies, products, equipment, and labor services, etc.; overseas research and development centers which may utilize internationally advanced technologies, management experiences and professional talents; and, overseas enterprise acquisition and merger projects which can improve the international competitiveness of enterprises and accelerate exploration of international markets. Third, globalizing Chinese finance for energy around the world through the CDB and CHEXIM is perceived to enhance the country’s quest for natural resource security. This perception has gained traction against the backdrop of the country’s growing dependence on foreign energy and natural resources. Driven by its rapid economic development and insufficient supplies at home, China became a net importer of oil, natural gas, and coal in 1993, 2007, and 2009, respectively. To fuel its development at home, China has increasingly turned to the global energy markets, with foreign supplies accounting for one third and two thirds of its domestic consumption of natural gas and oil in 2015. With all forms of imported fuels included, China’s total energy import dependence has surged from 4.6 to 14.3% between 2000 and 2015. In lieu of this, China has gradually adopted a new energy security concept that puts increasing emphasis on international cooperation and global governance. For instance, over the past 15 years China has issued a total of three Five Year Energy-­Sector Plans (i.e., the 10th, 11th, and 12th), all of which have highlighted the role of international energy and natural resource cooperation in its engagement with the world on energy.

138  Kevin P. Gallagher

= FIGURE 5.3 

0

+

1

+

2

+

Regression equation.

Fourth, there is some evidence that China’s overseas lending is driven by international political economy drivers such as the want to “export” its model of development, to gain allies, and to be a responsible leader in the world economy. Jin Liqun, the new head of the China-led Asian Infrastructure Investment Bank recently said, “Now that China has developed, it is our turn to contribute”— China is emerging as a leader in providing global public goods.(Helleiner, 2014; Kynge and Pilling, 2017). According to Lin and Wang (2017) that China’s development finance is also based on mutual benefit or hutong youwu “exchanging what I have with what you have,” adding that thus “this concept of cooperation links aid and trade naturally” (Lin and Wang, 2017, 91). To what extent do these factors drive China’s development finance to Latin America? This part of the report performs an econometric analysis to estimate the determinants of Chinese development finance in Latin America. Drawing on early studies of the determinants of development bank finance in general (Kilby, 2009) and Chinese overseas finance in particular, and using the newly created data on Chinese development finance to LAC, a regression equation is constructed as follows (Figure 5.3): According to the literature, development finance (DF), is a function of the sum of a number of institutional and political variables, and the sum of economic factors. The institutional factors most commonly drawn on in econometric analyses are the extent to which development finance is a function of creditor country attempts to gain political allies (divergence), the drive for energy security (eng-Dep), and the extent to which a host country is politically stable (ps). These variables are quantified and described in the table below. Economic factors are the size of incomes and level of population in a host nation—indicating the nature of demand (gdppc; population)—and the nature of macroeconomic stability, often measured by the inflation rate (inf ) (Table 5.5). Another key factor, in some ways both political and economic, is the nature of economic ties between the host country and the creditor nation. For this I measure two variables. First is (tradelac) which calculates the percentage of exports from country i of its total export basket—indicating how important China trade is for the host country and for China’s import basket. Another is (ChinaX) which calculates imports to China from country X as a share of world imports. These are two ways to examine the extent to which China’s economic ties are driving development finance decisions. The two variables are not used in the same regressions however, but run with the other control variables separately, somewhat acting as a robustness check. There are only 41 observations of the dependent variable (log of total investment and thus summing a number of loans to country i annually in year t from

Chinese development finance in the Americas  139 TABLE 5.5  Variable description

Abbreviation Variable name

Theoretical aspect

lnDF

Logged level of Dependent loans to LAC variable nations

eng_dpd

Energy dependence of investor Vote distance

divergence

Energy security Political alignment

Gdppc

GDP per capita Domestic (constant) market potential

Pop

Population of recipient Inflation annual change Governance indicator

Inf

Ps

Tradelac

Proportion of country import in China’s total Latin American import

Chinax

Proportion of export to China in total exports for Latin American countries

Description

Investment data come from reports from the four banks, as well as matching news reports. Logarithm is used to reduce the distortion of single large loans Energy net import per energy consumption from World Development Index (WDI) The UNGA vote difference between recipient and investors. UN vote is used by Dreher 2009 and Piccone 2016, and used in the “US friend” calculation of Kilby’s models; this study adds the total vote difference between investor and recipient in a single year as a variable GDP per capita from WDI, measured by constant US$2,010 (similar to Fleck and Kilby, 2005, who use PPP GDPPC). It is used as an indicator for recipient wealth and consumption potential Population WDI. Indicates size of market

Macro stability

Inflation, consumer price annual percentage change, from WDI

Political stability

Governance indicator from World Bank. The indicator usually ranges from 2 to −3, with higher score indicating more stable governance Merchandise trade matrix (product groups, imports in thousands of dollars) from UNCOMTRADE. The data provides China’s import from different partners in South and Central (including Mexico) America. The proportion is calculated by dividing the annual import from a single country with the annual import from the region Merchandise trade matrix (product groups, imports in thousands of dollars) from UNCOTRADE. The data provides export to China from different partners in South and Central (including Mexico) America. The proportion is calculated by dividing the annual export to China with the annual export to the world from a single country

Economic alignment

140  Kevin P. Gallagher TABLE 5.6  Regression results

Variables

(1) lninv

(2) lninv

Chinax

0.174*** (0.0598) 4.54e−05 (6.13e−05) −0.117** (0.0540) 0.318*** (0.104)

−0.0331 (0.0898) 8.58e−05** (4.13e−05) −0.0327*** (0.0616) 0.352*** (0.0838) 0.0273 (0.0358) −1.567** (0.613) 1.26e−08** (5.90e−09)

Gdppc divergence eng_dpd Inf Ps Pop Tradelac Constant Observations R-squared

2.872** (1.275) 41 0.332

0.775 (0.970) 41 0.574

(3) lninv

(4) lninv

4.95e−05 (5.93e−05) −0.132** (0.0602) 0.388*** (0.104)

8.05e−05* (4.07e−05) −0.0456 (0.0587) 0.376*** (0.0910) 0.0146 (0.0307) −1.561** (0.607) 1.72e−09 (1.54e−08) 0.0486 (0.0767) 0.717 (0.825) 41 0.577

0.0752*** (0.0155) 2.614** (1.111) 41 0.351

Robust standard errors in parentheses *** p < 0.01, ** p < 0.05, * p < 0.1.

2005 to 2016). Thus there are four models run with the above equation. The first and third models focus on the two LAC specific variables (tradelac and ChinaX) and core control variables, the second and fourth models add the full amount of control variables found in the literature (Table 5.6). Models 1 and 3 would predict that the key drivers of Chinese development finance to LAC are the extent of economic ties between a host country and China’s economy and the increasing level of energy dependence that China is experiencing. Furthermore, in these regressions it also would appear that there is a significant geopolitical correlation involved as well. Given that the sign on (divergence) is significant and negative, there would be evidence that increases in Chinese development finance would be correlated with a convergence in UN voting between China and the host country. When these variables are incorporated into a larger model however, it would appear that the key drivers of Chinese development finance in LAC is a function of China’s growing energy dependence and to some extent (at the 90% level) on the size of the market in the host country. Interestingly in both models Chinese development finance tends to be correlated with countries that are less politically stable, indicating that China’s quest for resources and markets override conventional concerns about political stability (or macroeconomic given that (inf ) is not significant).

Chinese development finance in the Americas  141

Given the smaller sample size it is hard to put the utmost confidence in all of these analyses, but this analysis does provide some evidence that China’s quest for resources, market driven concerns, and ties to key LAC countries are at least in part determinants of China’s increasing development finance to LAC.

c.  Commodity-backed finance An innovation largely unique to Chinese development finance in the region is the fact that approximately half of all loans and lines of credit from China’s policy banks are secured by oil shipments. Many refer to these loan packages as “loansfor-oil” deals with Latin America have reached $74.4 billion in only four years. Venezuela has negotiated six such loans since 2008, totaling $44 billion. Brazil signed one for $10 billion in commitments in 2009. Ecuador signed a $1 billion loan-for-oil in 2009 and a second in 2010. In 2011, it added two more worth a total of $3 billion (Table 5.7). A loan-for-oil deal generally combines a loan agreement and an oil-sale agreement that involves two countries’ state-owned banks and oil companies. The money flows in a triangular pattern. First, CDB grants a billion-dollar loan to an oil-exporting government like that of Ecuador. Ecuador’s state oil company, Petro Ecuador, signs a contract to sell Chinese oil companies hundreds of thousands of barrels of oil per day until the loan has been paid back, perhaps 10 years. Chinese oil companies purchase the oil at market prices and deposit their TABLE 5.7  China’s oil-backed finance in LAC

Date

Country

Entity

Amount

4/18/2016 12/16/2016 2/27/2016 11/17/2016 11/1/2007

Ecuador Brazil Brazil Venezuela Venezuela

4/18/2009

Venezuela

11/19/2013 4/19/2015

Venezuela Venezuela

Government 2,000 Petrobras 5,000 Petrobras 10,000 PDVSA 2,200 BNDES and 4,000 PDVSA BANDES and 4,000 PDVSA Government 5,000 Government 5,000

5/1/2009 7/1/2010 7/1/2011

Brazil Ecuador Ecuador

Petrobras Petroecuador Petroecuador

8/1/2010 6/1/2011

Venezuela Venezuela

Government 20,255 BANDES and 4,000 PDVSA Total 74,455

10,000 1,000 2,000

Description Fiscal support and infrastructure Debt financing Debt financing Oil sector development Funding infrastructure, other projects; Joint Fund Tranche A Funding infrastructure, other projects; Joint Fund Tranche B Joint Financing Fund – Tranche C Joint Fund Renewal – Tranche B (increased by $1 billion) Exploit pre-salt oil fields 80% discretionary, 20% oil 70% discretionary, 30% oil-related Infrastructure and discretionary Joint Fund Renewal – Tranche A

142  Kevin P. Gallagher

payments into Petro Ecuador’s CDB bank account. CDB withdraws the interest payments and principal repayment, a pre-agreed-upon amount that might reach 30% of the total oil revenue, directly from Petro Ecuador’s account. The rest of the revenue returns to Ecuador. In Africa, commodity-backed loans generally finance infrastructure projects and are secured not only by oil but a variety of methods and commodities. For example, Ghana’s loan for the Bui Dam was secured and repaid by the sale of 38,000 tons of cocoa to China each year for the 17 year life of the line of credit (Habia, 2009). Ethiopia secured its credit line with its entire annual exports to China (mainly sesame seeds). One of Zimbabwe’s loans was secured with profits from a joint venture diamond mine, while another was secured with a platinum concession. In Africa, the nations with commodity-backed finance from China include Angola, Congo-Brazzaville, Democratic Republic of the Congo, Equatorial Guinea, Ethiopia, Gabon, Ghana, Nigeria, Sudan, and Zimbabwe. Angola and Ghana appear to have received the highest amount of commodity-secured finance commitments. Angola used US$4.5 billion in oil-backed credits for infrastructure between 2004 and 2009, and has since received new commitments of US$6 billion from CHEXIM (later apparently scaled down, by the Angolans, to US$3 billion) and US$2.5 billion from ICBC. Most of this financing has come through CHEXIM. Ghana has received US$3.56 billion in three separate commitments (Bräutigam and Gallagher, 2014). The recipients of Latin America’s commodity backed loans from China are Brazil, Ecuador, and Venezuela. Venezuela received more than half of these loans. Most loans to LAC are provided by the China Development Bank to stateowned enterprises in LAC, rather than finance directly to governments as is the case of the CHEXIM in Africa. Two Chinese loans to LAC are supplier’s credits from PetroChina to PetroEcuador. PetroChina is part of the large Chinese stateowned oil company Chinese National Petroleum Corporation. With the exception of a few lines of credit to Venezuela that are co-financed with Venezuela that go to infrastructure projects, the bulk of China’s “loans for oil” finance to LAC is for oil exploration and extraction.

d.  Market analysis Obtaining information on the financial terms of development bank loans—­ Chinese or otherwise—is a difficult task. Drawing on available information and personal interviews, Gallagher and Irwin (2015) compared the terms of China’s development finance with those of other MDBs and with approximations in private markets. In a nutshell, China does not require policy conditions on its loans, charges somewhat similar interest rates, and can require purchases of Chinese goods and services as a component of the financing agreement. Chinese development banks generally charge higher rates, though Chinese banks charge commercial rates on their largest loans. Still, some small loans, most categorized as foreign aid, do carry concessional or subsidized interest rates. In a

Chinese development finance in the Americas  143

nutshell, the CDB offers largely non-concessional financing and the CHEXIM offers both non-concessional and concessional finance to its government borrowers. The fact that the Chinese rates are higher is largely due to the fact that Western interest rates have been very low. The countries that obtain the majority of China’s loans have had a more difficult time borrowing from the MDBs and from international capital markets (Argentina until recently, Brazil’s Petrobras, Ecuador, and Venezuela). China’s rates slightly higher for many countries in the region, but not for those with less access to international capital. According to Gallagher and Irwin (2015), CDB offers interest rates that exceed the World Bank, IDB and Andean Development Corporation (CAF) rates. As one example, in 2010, CDB offered Argentina a $10 billion loan at 600 basis points above LIBOR. The same year, CAF’s rates on loans to Argentina ranged from 155 to 235 basis points above LIBOR. The World Bank’s International Bank for Reconstruction and Development (IBRD) charged Argentina a spread of roughly 85 basis points. The Chinese interest rate is hundreds of basis points larger than both CAF and IBRD rates. In 2009, CDB gave Brazil a $10 billion loan at 280 basis points over LIBOR. The IBRD gave Brazil a $43.4 million loan in 2000 at a variable spread of 30–55 basis points. The authors were unable to confirm IDB interest rates on specific loans, the general rates posted on both IADB and WB web pages are well below the Chinese rates. CHEXIM Bank subsidizes its smaller loans on the grounds that they constitute development aid for low-income countries, although these loans constitute only a fraction of total Chinese lending. The subsidized rates on small loans are somewhat lower than those of the US Ex-Im Bank for similar projects. CHEXIM Bank’s lowest interest loans were its 2% loans to Jamaica and Bolivia in 2010. In order to offer these loans, CHEXIM Bank receives subsidies directly from the Ministry of Finance and secures part of the financing in commodities. China budgets these subsidies as official development aid, although OECD countries prohibit mixing export credits with development aid. To compare China and other MDB interest rates on loans to different countries, the authors use the OECD’s country risk premiums to compensate for the fact that some countries are riskier than others. While the US Ex-Im Bank charged 1.5–2.5% above the OECD risk premium, China CHEXIM Bank’s interest rates on small loans ranged from 0.31% below the premium to 0.69% above it. From the US Ex-Im Bank’s perspective, these rates undercut US Ex-Im rates and make Chinese deals more competitive. From China CHEXIM’s perspective, it is blending export promotion with development aid to offer lower-cost options to countries in need. Data from Ecuador’s Foreign Debt Bulletin bears out the finding that China’s interest rates are closer to private rates than development bank rates. In 2011, rates on CDB and CHEXIM loans exceeded those from all banks other than Russia EXIM, including private banks. In 2013, CHEXIM’s $312 million loan was Ecuador’s most expensive loan of the year. The same year, CHEXIM also gave a small, concessional 2% loan of the type discussed above. This data provides a direct comparison between similar-maturity and similar-purpose loans

144  Kevin P. Gallagher

to the same country in the same year, and it shows clearly that China’s interest rates are on the high end. Chinese lending has more in common with the traditional source of large, market-rate infrastructure funding for Latin America, which comes mainly from the private banks and the sovereign bond market. Latin American governments have traditionally relied on sovereign bond emissions and loans from Western commercial banks for large infrastructure and industry loans. Unlike the IFIs, these lenders prefer infrastructure and industry loans in order to guarantee their profits. The banks and bond lenders do not subsidize interest rates, so that borrowing governments pay a high premium for their high-risk home markets. Chinese lending is comparable in both quantity and maturity to private market lending to Latin America. While China lent the region $15 billion in 2013, private lenders lent an estimated $17 billion. In a number of cases, China’s lending to Latin American countries comprises a significant portion of its total stock of external public debt. In Venezuela and Ecuador, China clearly lends far more than commercial banks. Even in regional powerhouses Brazil and Argentina, Chinese lending constitutes over 10% of total debt stocks. The quantity of Chinese lending is thus at a comparable scale to private commercial lending. To compare China’s development loans with the private market, Gallagher and Irwin used two sets of financial data to compare private market interest rates with Chinese interest rates. First, they looked at Bloomberg data on coupon rates for sovereign debt emissions by the borrowing governments. If the governments had not issued sovereign bonds in approximately the same year with similar maturity, we found coupon rates for sovereign debt emissions by other governments with the same debt rating. Second, they consulted the sovereign debt interest rate according to J.P. Morgan’s Emerging Markets Bond Index Plus (EMBI+). The EMBI+ spread represents the interest rate spread above US Treasuries of a government’s previously issued dollar-denominated sovereign debt and Brady Bonds as traded on the secondary market. Gallagher and Irwin’s comparison found that Chinese interest rates are closer to market rates than IFI rates, though measurably lower. For example, Ecuador paid 6.9% and 6.35% interest on two 2010 dam loans from China CHEXIM. CDB is charging Ecuador 7.25% for the first loan-for-oil, 6% for the second, and 6.9% for the third. There is no easy private-market equivalent, since Ecuador has not issued sovereign bonds since 2005, when its ten-year bonds paid 9.375%. The average coupon rate for governments with B- Bloomberg Composite Ratings for 7- to 23-year maturity in 2009–2011 was 7.8%. The EMBI+ spread on Ecuador’s 2005 bonds in the secondary market in 2010–2011 ranged from 7.5 to 10%. The Chinese rates are thus similar but lower. In Argentina’s case, Gallagher and Irwin also found that the Chinese rates also appear similar but lower. Argentina paid 600 basis points above LIBOR on a 2010 CDB loan, which today adds up to roughly 6.5%. The same year, Argentina offered sovereign debt with similar maturity at rates ranging from 7.82 to 8.75%.

Chinese development finance in the Americas  145

As with Ecuador, the average coupon rate for governments with B- ­Bloomberg Composite Ratings for 7- to 23-year maturity in 2009–2011 was 7.8%. J.P. ­Morgan’s EMBI+ spread for Argentina from 2009 to 2011 ranged from 8 to 10%. Thus the Chinese rate clearly falls below the private market rates. B ­ razil’s stateowned oil company, Petrobras, also received China’s financing at lower rates than it can access on the private market. Its $10 billion loan from CDB in 2009 carried an interest rate of 2.8% over LIBOR, or roughly 3–4%. Also in 2009, Petrobras issued corporate bonds worth $1.5 and 2.5 billion at 6.875 and 5.75%, respectively. Again, Chinese banks charge less than the private market. In Venezuela’s case, the Chinese banks charged rates well below those of the private market. CDB gave the $20 billion loan at a floating rate of 50–285 basis points over LIBOR, or roughly between 1 and 4%. Meanwhile, Venezuela has issued sovereign debt at rates more than twice as high—between 7.75 and 12.75% from 2009 to 2012. Its EMBI+ spread for the same period has ranged from 10 to 12%. Compared to the cases of Ecuador and Argentina, this interest rate differential is surprisingly large. Gallagher and Irwin argue that this difference stems from the Chinese banks’ use of equipment purchase requirements and oil supply contracts. The purchase requirements allow Chinese banks to reduce their exposure to default risk and offer lower interest rates. China’s 2010 “loan” of $10 billion to Argentina is a credit line for state-owned Chinese railway companies. Even if Argentina defaults on the loan, the Chinese government doesn’t lose everything—the railway companies have still made billions of dollars’ worth of sales. As a result, CDB can charge Argentina a lower rate on its loan than private lenders, which have no affiliated railway companies. The loans-for-oil arrangement allows China to make loans to otherwise non-creditworthy borrowers by reducing the risk of borrower default. As CDB founder Chen Yuan has stated, “backing loans with oil shipments effectively keeps risks to a minimum level.” CDB can siphon interest directly out of the oil payment, ensuring that if the country wants to export oil to China, it will have to pay back the loan. Lower default risk means lower risk premiums and reduced interest rates. Looking at the low interest rates on Venezuela and Ecuador’s loansfor-oil, it does appear that CDB has reduced its risk considerably through the loan-for-oil arrangements. Some have suggested that China’s oil contracts are exploiting the Latin American borrowers, but Gallagher and Irwin (2015) assert that there is no evidence for this assertion. In fact, financing terms in loans-for-oil agreements seem better for the South American countries. Ecuador is the only country to reveal details on its loans-for-oil. Ecuadorian oil analyst Fernando Villavicencio argued that the terms, which include crude oil differentials and deal premiums, “represent million-dollar losses for the Ecuadorian state.” However, the prices that Ecuador published are in line with its recent prices for commercial deals. All reports on Venezuela and Brazil’s loans-for-oil indicate that the Chinese oil companies are paying market-based prices.

146  Kevin P. Gallagher

These lower interest rates allow nations with little access to global capital markets to borrow when they cannot afford the interest rates charged by the private market. Argentina and Ecuador have had difficulty accessing global credit markets given that they defaulted on their sovereign debt in 2001 and 2008–2009, respectively. The Venezuelan government has also alienated private investors. As a result, the sovereign debt markets charge Argentina, Ecuador and Venezuela roughly 8–12% more than US Treasuries. These are four to six times higher than interest rate spreads for South American countries with similar-sized economies. For example, Colombia and Peru pay roughly 2% more than Treasuries. Chinese banks loaned disproportionately large amounts to these high-risk countries, compensating for the lack of sovereign debt lending. Because of China’s risk-reducing arrangements, including equipment purchase requirements and loans-for-oil, Chinese banks have taken up lending to risky countries abandoned by conventional sovereign lenders. As energy economist Roger Tissot argues, Chinese financing is often the ‘lender of last resort.’ It is not a cheap one, but due to the concern the international financial community has over Venezuela and Ecuador, and the large risk premiums they would charge, Chinese lending is an attractive option. (See Myers et al., 2011) Indeed, China’s surrogate sovereign lending has helped Ecuador heal after its default by covering its budget deficit. Only two years after the default, Ecuador largely regained investor confidence. Government bonds are performing better than any others in Latin America. Ecuador’s sovereign debt spreads dropped from crisis-time values of over 40% down to 10% and have continued to decline to 6.2% today. Because of the influx of Chinese funding, government investment has been able to drive record economic growth. Gallagher and Irwin assert that by taking the place of shell-shocked sovereign lenders, China gave Ecuador a second chance to rebuild investor confidence.

e.  Social and environmental policies Chinese development finance is also subject to different social and environmental standards than the other major development banks operating in the region. Whereas the IADB, WB, and CAF all have a set of mandatory standards and procedures that cover a variety of social and environmental themes, China’s development banks defers such exercises to the host country’s regulatory system. To mitigate the risks associated with environmentally sensitive projects many development banks have established their own environmental and social polices for various aspects of the project cycle. Commonly referred to as “environment and social safeguards (ESS),” they have been defined as “rules or institutions that

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help ensure that investments meet minimum social, environmental, and governance standards. These rules and institutions can come from a recipient country or the investor” (Larsen and Ballesteros, 2014, 16). ESS can bring benefits to a variety of actors in the development banking process. Of course, development banks that conduct projects with minimal harm to the environment and communities can better provide public goods and help allocate scarce natural and economic resources in a more efficient manner. For the development banks themselves, ESS can create better project effectiveness by mitigating the social and environmental risks of a project and helping to address the broader development goals of their charters. Identifying ahead of time that a particular project could cause environmental degradation and/or create mass social conflict is important to maintaining project schedules and creating more certainty regarding future costs. When such risk is not accounted for the costs can be unexpectedly high, resulting in project overruns and sometimes resulting in project cancellation. Moreover, problem projects can tarnish the image of a development bank and decrease its ability to provide future services in a country or region. These same benefits hold for national governments that need to manage debt burdens and political constituencies in a manner that will maximize national benefit. ESS can help developing countries build institutions to address market failures such as environmental externalities and meet their own broader development goals and international obligations. Engaging local communities and civil society through ESS can also bring benefits by helping communities assume ownership of projects through letting their voices and concerns be heard and incorporated. Designed properly, ESS can also reduce the vulnerability of communities from certain projects and thus improve their livelihoods of such communities. Gallagher and Yuan (2017) compare the ESS across 11 different development banks operating in LAC. For this report, I will extrapolate just the larger banks that have been the node of comparison thus far—IADB, WB, and CAF. There are a variety of themes that are covered across these banks, as are there a variety of procedures required to address those themes. The most important distinction to make is that while the CAF, IADB, and WB standards are mandatory standards, the Chinese banks are voluntary guidelines. For example, CHEXIM’s policy reads: The host country’s environmental policies and standards are the basis for evaluation. Offshore projects of the host country should abide by the requirements of their laws and regulations and obtain corresponding environmental permits. When the host country does not have a complete environmental protection mechanism or lacks environmental and social impact assessment policy and standards, we should refer to our country’s standards or international practices. (CHEXIM, 2007, Article 12(4))

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The variety of thematic coverage across the major development banks compared in this report are exhibited in Table 5.8. In terms of thematic coverage, the difference across banks resides in two areas: climate change and labor and health. Many banks have integrated climate change into their safeguard policies while CHEXIM and CAF have yet to do so (though the CAF is in the process of doing so now). On the contrary, the policies of the World Bank, IDB and CAF do not cover labor issues (Table 5.9). Although the various development banks have similar thematic structures, the procedures by which development banks carry out and enforce these themes vary more significantly. As shown in Table 5.8, each bank applies ex-ante and project review of environmental impact assessments at the pre-lending stage, and establish links between the compliance of environmental regulations and disbursement. TABLE 5.8  Thematic coverage of ESS

Pollution prevention Biodiversity Climate change Indigenous rights Involuntary resettlement Labor and health Cultural heritage

World Bank

IDB

CAF

CHEXIM

CDB

X X X X X – X

X X X X X – X

X X – X X – X

X X – X X X X

X NA NA NA NA NA NA

Source: Author’s adaptation of Gallagher and Yuan (2017). TABLE 5.9  ESS procedures

Ex-ante environmental impact assessments Project review of environmental impact assessments Industry-specific social and environmental standards Require compliance with host country regulations Require compliance with int’l environmental regulations Public consultations with affected communities Grievance mechanism Independent monitoring and review Establishing covenants linked to compliance Ex-post environmental impact assessments

WB IADB CAF

CHEXIM CDB

X X

X X

X X

X X

X X

X

X

X

–

–

X

X

X

X

X

X

X

–

–

–

X

X

X

X

–

X X X –

X – X –

– – X X

– – X X

– – X X

Source: Authors adaptation of Gallagher and Yuan (2017).

Chinese development finance in the Americas  149

Regarding environmental standards, host countries environmental regulations are the bottom line for all banks, and the World Bank, and IADDB also require clients to comply with international standards and procedures as well. Put another way, the World Bank and IADB have mandated safeguard systems, whereas the rest of the sample defer or partially defer to country systems. All the banks except CDB include public consultations with affected communities in their environmental assessments—although CDB and BNDES do not have an explicit statement regarding this issue, it does not mean they do not apply this requirement in implementation (Ray et al., 2015). For disputes on environmental issues, only two banks (World Bank, IADB) have project-level grievance mechanisms. During the project cycle, only the World Bank requires an independent monitoring and review of the environmental compliance. The IADB does not require ex-post assessment while the rest do have this requirement.

4.  Looking forward: seizing opportunity, rising to challenge China’s global policy banks are welcome and promising new entrants in LAC’s development finance landscape. China’s policy banks are well capitalized and experienced in providing overseas finance that offer benefits to both creditor and borrower countries. Unlike Western-backed development finance, Chinese development finance comes with no policy conditionality. What is more, China has numerous institutions it can draw from that could blend instruments in a way that MDBs can not. After 15 years of implementing the “go out” strategy, the two Chinese policy banks have become indispensable lenders for LAC governments. There are indications that China will sustain the leadership in development finance in LAC in the next few years as World Bank and IDB continue reducing their commitments to the region due to the region’s gloomy economic outlook and China needs overseas markets to export its production capacity. The available financial sources are promising for LAC and can play a significant role in reviving the economy if they are deployed in a strategic way. China’s development finance in LAC has demonstrated a demand-driven pattern. The majority of finance supported strategic infrastructure and energy projects in borrowing countries. However, this approach can be very risky for both sides. For LAC countries, reliance on natural resources and extractives-linked infrastructure will further peg the region’s economy to the commodity cycle that has restricted LAC’s development for decades. For Chinese investors, in the unique political and social context of LAC, investment can be easily in jeopardy if risks such as social and environmental risk are not adequately addressed and mitigated. The current safeguard systems of CDB and CHEXIM need to be upgraded in order to protect their overseas investment from potential risks. Although China Banking With increasing focus on the “going out” strategy, more and more Chinese companies will look for overseas opportunities and need more than guidance to make profitable investments.

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China has pledged to increase exports to $500 billion and foreign investment to $250 billion by 2025. In addition to the $140 billion in bilateral loans since 2005, China also set up $58.4 billion in multilateral finance platforms for Latin America. To coordinate this relationship, in 2015 China teamed up with the Community of Latin American and Caribbean States (CELAC) and put together a cooperation plan to allocate these funds and discuss broader issues such as industrialization, infrastructure, and sustainable development. China has a clear Latin America strategy: invest and trade with Latin America to gain access to strategic natural resources and strategic markets for national champion firms and policy banks. LAC needs more of a strategic plan for China. Many countries in the region have “shovel ready” projects for development banks, but they are too often just roads to mines or presidential pet projects, rather than regional plans for smart infrastructure and logistics that spur innovation and inter-regional trade. CELAC needs to be credited with having the promise of a regional institutional body set up to address these issues and have a unified approach to China, but it lacks any significant staffing and, as the political trends in the region change, it may soon lack presidential level backing as well. Regional blocs in Latin America come and go as political and economic winds change, with each new set of governments creating their own short-lived initiatives. CELAC could become part of a tripartite body to formulate and implement a regional China plan—along with the Development Bank of Latin America (CAF) and The United Nations Commission for Latin America and the Caribbean (ECLAC). The CAF is a regional development bank, without the United States and Canada at the helm, that now rivals the Inter-American Development Bank for total financing to Latin American governments—and is the leader in terms of infrastructure finance. ECLAC has been providing sound economic advice for decades from a LAC regional perspective. ECLAC has the facilities and convening power for regional discussion on economic issues and CAF has proven itself to be a legitimate regional development financier of the region that can rise above economic and political swings. A tripartite body with these three organizations would be able to administer and perhaps even match funds (through the CAF) the boon of funds coming in from China. At the same time, the collective group could serve as a knowledge leader regarding the most productive and regional use of such funds by leveraging the intellectual resources of ECLAC at the same time that it could and establish CELAC as a regional platform to engage China. In the absence of reform at the Western-backed development banks or a new source of optimism in the private sector, Latin American governments have to be thankful that Chinese finance is available. That said, the onus is on Latin American governments to make this new finance work for long-term economic growth that is socially inclusive and environmentally sustainable. The region can’t afford not to put together a regional plan to deal with China, but CELAC can’t do it on its own. It will need to team up with the CAF and ECLAC, and come up with a plan to manage the $500 billion in trade and $250 billion in finance on offer.

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References Barros, Nathan, Jonathan J. Cole, Lars J. Tranvik, Yves T. Prairie, David Bastviken, Vera L. M. Huszar, Paul del Giorgio and Fábio Roland. (2011). “Carbon Emissions from Hydroelectric reservoirs linked to Reservoir Age and Latitude. Nature Geoscience, Volume 4, Issue 9, Pages 593–596. Bértola, Luis and J. A. Ocampo (2012), The Economic Development of Latin America since Independence, Oxford: Oxford University Press. Bräutigam, Deborah (2009), The Dragon’s Gift: The Real Story of China in Africa, Oxford: Oxford University Press. Brautigam, Deborah and Kevin P. Gallagher (2014), “Bartering Globalization: China’s Commodity-Backed Finance in Africa and Latin America,” Global Policy, Volume 5, Issue 3, Pages 346–357. Calderón, César and Luis Serven (2010), “Infrastructure in Latin America,” Policy Research Working Paper 5317, Washington, DC: World Bank. China Development Bank (CDB) (2017), Strategic Focus. http://www.cdb.com.cn/­ English/gykh_512/khjj/, last accessed July 14, 2017. China Export Import Bank (CHEXIM) (2017), China Export-Import Bank, “The ­Export-Import Bank of China,” n.d. July 14, 2017. http://english.eximbank.gov.cn/­ profile/intro.shtml, last accessed July 14, 2017. Downs, Erica (2011), “Inside China, Inc: China Development Bank’s Cross-Border Energy Deals,” John L. Thornton China Center Monograph Series No. 3, Brookings Institution, March 2011. Dreher, A. (2009), “IMF conditionality: Theory and Evidence,” Public Choice ­Volume 141, Pages 233–267. Economic Commission for Latin America and the Carribean (ECLAC) (2011), “The Economic Infrastructure Gap in Latin America and the Caribbean,” Bulletin FAL, Issue No. 293 - Number 1/2011. http://www.cepal.org/transporte/noticias/­ bolfall/6/42926/FAL-293-WEB-ENG-2.pdf, last accessed July 14, 2017. Fleck, Robert K. and Christopher Kilby (2010). “Changing aid regimes? U.S. foreign aid from the Cold War to the War on Terror,” Journal of Development Economics, ­Volume 91, Issue 2, Pages 185–197. Gallagher, Kevin P. (2016), The China Triangle: Latin America’s China Boom and the Fate of the Washington Consensus. New York: Oxford University Press. Gallagher, Kevin P. and Amos Irwin (2014), “Exporting National Champions: China’s OFDI Finance in Comparative Perspective,” China and the World Economy, Volume 22, Issue 6, Pages 1–21. Gallagher, Kevin P. and Amos Irwin (2015), “China’s Economic Statecraft in Latin America: Evidence from China’s Policy Banks,” Pacific Affairs, Volume 88, 1 March 2015, Pages 98–121. Gallagher, Kevin P. and Fei Yuan (2015), Greening Development Finance in the Americas, Boston, MA: Global Economic Governance Initiative, Boston University. Gallagher, Kevin P. and Fei Yuan (2017), “Standardizing Sustainable Development: Comparing Development Banks in the Americas,” Journal of Environment and Development, Volume 26, Issue 3, Pages 243–271. Gallagher, Kevin P. and Gregory Chin (2017), Development Finance with Chinese Characteristics, Boston, MA: Global Development Policy Center, Boston University. Gallagher, Kevin P. and Margaret Myers (2016), China-Latin America Finance Database, Washington, DC: Inter-American Dialogue. Helleiner, E. (2014), Forgotten Foundations of Bretton Woods, International Development and the Making of the Post War Order, Ithaca, NY: Cornell University Press.

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Inter-American Development Bank (2012), The Climate and Development Challenge for Latin America and the Caribbean: Options for Climate Resilient Low Carbon Development, Washington, DC: Inter-American Development Bank. International Development Finance Club (IDFC) (2014), IDFC Green Mapping for 2014, Paris, International Development Finance Club. International Monetary Fund (2014), World Economic Outlook, 2014, Washington: International Monetary Fund. Kynge, James and David Pilling (2017), “China-Led Investment Bank Attracts 25 New Members,” Financial Times, January 24, 2017. Kilby, Christopher (2009), “The Political Economy of Conditionality: An Empirical Analysis of World Bank Loan Disbursements,” Journal of Development Economics, Volume 89, Issue 1, Pages 51–61. Kong, Bo and Kevin P. Gallagher (2017), “Globalizing Chinese Energy Companies: The Role of Policy Banks,” Journal of Contemporary China, Volume 26, Issue 108, Pages 834–851. Larsen, G. and A. Ballesteros (2014), Striking the Balance: Ownership and Accountability in Socila and Environmental Safeguards, Washington, DC: World Resource Institute. Laurance, W. F., M. Goosem, and S. G. Laurance (2009), “Impacts of Roads and Linear Clearings on Tropical Forests,” Trends in Ecology and Evolution, Volume 24, Pages 659–669. Lin, Justin Yifu and Yan Wang (2017), Going Beyond Aid: Development Cooperation for Structural Transformation. Cambridge, United Kingdom: Cambridge University Press. Maplecroft (2014), Vulnerability Index to Climate Change in the Latin American and Caribbean Region, Caracas: CAF-Development Bank of Latin America. Mesquita-Moreira, Mauricio, Juan S. Blyde, Christian Volpe Martincus, and Danielken Molina (2013), Too Far to Export: Domestic Transport Costs and Regional Export Disparities in Latin America and the Caribbean, Washington, DC: Inter-American Development Bank. Myers, Margaret, Kirk Sherr, and Roger Tissot (2011), “How Is China Changing Latin America’s Energy Sector?” Latin American Advisor, July 22, 2011. Inter-American Dialogue. http://www.thedialogue.org/page. cfm?pageID=32&pubID=2710, accessed January 12, 2012. Nicholson, Chris (2009), “Chinese Oil Company Gets $30 Billion Loan for Acquisition,” New York Times, Sep 9, 2009. http://www.nytimes.com/2009/09/10/business/ global/10oil.html, accessed February 21, 2017. Piccone, Ted (2016), The Geopolitics of China’s Rise in Latin America, Washington: Brookings Institution. Ray, Rebecca, Kevin P. Gallagher, Cynthia Sanborn, and Andres Lopez (2015), China in Latin America: The Social and Environmental Dimension, London: Anthem Press. Sanderson, H. and M. Forsythe (2012), China’s Superbank: Debt, Oil and Influence How China Development Bank is Rewriting the Rules of Finance, Bloomberg 2012. Steinfeld, Edward (2000), Forging Reform in China, Cambridge: Cambridge University Press. Steinhurst, W., P. Knight, and M. Schultz (2012), Hydropower Greenhouse Gas Emissions: State of the Research, Cambridge, MA: Synapse Energy Economics, Inc., 24 pp. http:// www.cusli.org/Portals/0/f iles/conference/2014/Hydropower-GHG-­E missionsFeb.-14- 2012.pdf. United Nations (2015), “Goal 9: Build Resilient Infrastructure, Promote Sustainable Industrialization and Foster Innovation,” Sustainable Development Goals, New York: United Nations. http://www.un.org/sustainabledevelopment/infrastructure-industrialization/. Water, Carl E. and Fraser J. T. Howie (2012), Red Capitalism, Singapore: John Wiley & Sons Singapore Pte Ltd. Weihua, Chen and Mao Pengfei (2015), “Chinese Banks Boom in Brazil,” China Daily, 25 June, 2015. http://usa.chinadaily.com.cn/world/2015-06/25/content_21095481. htm, last accessed July 14, 2017.

6 SCALING UP FINANCE FOR THE SUSTAINABLE DEVELOPMENT GOALS Experimenting with South–South models of multilateral development banking Ricardo Gottschalk and Daniel Poon

1. Introduction The 2030 Agenda for Sustainable Development, adopted in September 2015 by the United Nations General Assembly, brought to the attention of the international community the critical challenge of how to finance the various initiatives and programmes needed to support its new goals ‒ the Sustainable Development Goals (SDGs). As a starting point to address this challenge, the Third International Conference on Financing for Development took place in July 2015 in Addis Ababa, Ethiopia. The conference outcome, known as the Addis Ababa Action Agenda for Sustainable Development, provided a blueprint that sought to identify various possible sources of finance and mechanisms to support the SDGs. However, even an optimistic assessment indicates that possible new financing sources and the mobilisation capacity of the proposed mechanisms fall far short of the resources needed to adequately support the 17 SDGs and their 169 targets embedded in the 2030 Agenda for Sustainable Development. Therefore, the international development community recognizes that much more needs to be done in this area in the coming years. Multilateral development banks (MDBs) can serve as effective institutional mechanisms to help finance the SDGs. This possibility is due to their clear mandate to support development-oriented programmes, in-house expertise and track record on identification, development, risk assessment and management of complex projects, and balance sheet structure matching long-term liabilities with long-term assets. A limiting factor, however, has been MDBs’ conservative loan approach and narrow capital base, which constrain their ability to scale up lending significantly. Because the prospect of significant capital expansion is not on the agenda of developed country governments in the near future, development banks have been exploring alternative ways to enhance their lending capacity.

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This chapter discusses some of the new modalities MDBs have been adopting or considering for adoption to relax their lending constraints. The chapter explores, in particular, the Asian Infrastructure Investment Bank (AIIB) model for scaling up as a new experiment that may provide significant sums of development finance, as well as inject new ideas for operational improvements in other banks. It focuses on AIIB’s articles of agreement and argues that such articles give the bank a potential institutional mechanism to become an important intermediary in channelling sizeable amounts of official (but also private) resources to development-oriented projects around the world. Indeed, the odds are that the AIIB institutional setup may place the Bank ahead of its peers in terms of scale of loans. Although this may entice (or create competitive pressures for) other development banks to follow a similar path, the fact is that the AIIB model is not the only way forward to scale up finance for development. Other multilateral financial institutions can forge alternative paths towards scaling up that are aligned to their rules, culture and modus operandi. Following this introduction, Section 2 briefly reviews the Addis Ababa Action Agenda and argues that MDBs have a business model that makes them very appropriate instruments to leverage resources to development objectives. Section 3 presents recent proposals on how to reroute, through MDBs, resources managed by institutional investors towards development finance, but it also highlights possible downside risks. Given the lending constraints MDBs currently face, Section 4 provides an examination of loan-to-equity gearing ratios of multilateral and national development banks. This section shows that gearing ratios vary considerably among development banks, partly due to the fact that each bank faces specific structural, institutional and cyclical factors shaping their lending practices; but the observed variation also suggests a possibility for institutional experimentation in the level of a bank’s loan operations for a given amount of equity capital. Section 5 then links provisions for special funds in the AIIB articles of agreement, with the creation of China-backed investment funds, to suggest that the special funds mechanism could be an institutional experiment to scale up a form of development finance with greater focus on long-term, non-concessional flows. Finally, Section 6 concludes and asks the question: What does the AIIB model mean for the world? It suggests as a possible answer that the AIIB institutional set-up can be seen as an innovative way forward to scale up financing for the SDGs.

2. The Addis Ababa Action Agenda, institutional investors and development banks The 2030 Agenda for Sustainable Development and its SDGs are not small in ambition. The SDGs cover the economic, social and environmental sectors and are also expected to address cross-cutting issues such as inequality – including in gender, human and development rights, and access to justice. Goal 9, on industry, innovation and infrastructure, has eight targets, including developing sustainable and resilient

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infrastructure, promoting industrialisation and supporting technology development.1 Their levels of ambition, however, require a whole range of new financing sources and mechanisms that the Addis Ababa Action Agenda (Addis Agenda) of July 2015 did not go far enough to identify or earmark for development. The Addis Agenda followed the structure initially set out in the 2002 Monterrey Consensus, adopted at the first International Conference on Financing for Development. The Addis Agenda emphasized first domestic public resource mobilisation and, second, international development cooperation, as part of its plan to scale up finance for development. On domestic resource mobilisation, the Addis Agenda highlighted the important need to address illicit financial flows and tax capacity issues that result in substantial resource erosion by States. On international development cooperation, a major initiative was the establishment of a global infrastructure forum to help address the global financing gap in infrastructure development. However, on both counts, the Addis Agenda failed spectacularly to come up with fresh ideas or mechanisms or, above all, any new commitments from the international community for a substantial scaling up of resources for development finance.2 The lack of international commitment for resource scaling up comes at a time of sluggish global economic growth and of an austerity-dominated mindset among most country governments from around the world (UNCTAD, 2017). The austerity drive, in particular, seems to persist, and places a limit on the prospects for a substantial increase in official resource flows for development – albeit with some notable exceptions (e.g., China). In this context, it is inevitable that the focus of generating additional financing for development has been shifting away from national government budgets, towards financial resources under the management of institutional (and other) investors. However, such investors are characterized by a strong short-term bias in their investment decisions. In the case of pension funds, for instance, the Inter-agency Task Force on Financing for Development reports that, for the seven largest pension markets in the world, 76% of their total portfolio is invested in liquid assets, and less than 3% in infrastructure projects (United Nations, 2017:57).3 This short-term focus is not limited to pension funds or other institutional investors. Official investors such as central banks and sovereign wealth funds also invest largely in low-yield liquid assets. The challenge, therefore, is how to persuade international investors to shift away from their short-term orientations and towards a longer-time horizon, so that a larger part of their portfolio can be invested in long-term projects. The main issue revolves around the obstacles they face to invest more long-term, especially in the area of infrastructure development, which is sorely needed to meet most of the SDGs. Another main issue relates to the long-term maturity of investment projects, which increases perceived risks and uncertainty about the future. In addition, infrastructure projects, in particular, generate social benefits, which are higher than private benefits, a difference the private sector does not internalize in its calculations. Obstacles can also be associated with regulatory frameworks that increase costs or complexity, or that implicitly favour short-term returns.

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Basel III rules on capital and liquidity requirements for banks, for example, tend to inhibit availability of finance for long-term investments, while crossborder projects, which are important to increase connectivity and trade between countries (considered a main lever to achieve the SDGs), require a regulatory framework that is often significantly more complex than within border projects. Obstacles can also be internal to investors, such as a pension fund or insurance company, related to corporate compensation packages in which managers are incentivized to enhance short-term performance rather than pursue long-term goals. Institutional investors, moreover, lack in-house expertise to assess the risks of long-term projects, or the capacity to supervise them (United Nations, 2017; Arezki et al., 2016; UNCTAD, 2016; Inderst and Stewart, 2014). A further issue is that the larger institutional investors are concentrated in the developed countries, which have a home bias that deters them from investing in other countries, particularly developing countries, which are perceived as a higher risk asset class (Philips, 2014; Philips et al., 2012; Gottschalk, 2003).4 Moreover, barriers to investing in developing countries are not just based on perception. Institutional investors face fiduciary rules according to which they cannot invest in projects that are below investment grade, which is the case for most developing country projects (Group of 20, 2017:4).

a. MDBs: bridging the infrastructure gap? Development banks could help bridge finance from institutional investors to development projects. MDBs, in particular, have operated internationally and been a major feature of the development finance architecture for many years. Since their creation, these banks have played a fundamental role in funding global and regional public goods, and in providing long-term finance to developing countries. They can certainly continue to play such a role, and in particular become major financial tools in support of the 2030 Agenda for Sustainable Development. Their ability to tap into international capital markets at reasonably low costs, and to collaborate with other partners, including private actors in co-financing development projects, is among their major strengths. Moreover, MDBs’ accumulated experience with complex infrastructure and green projects places them in a particularly strong position to help meet the new goals of the 2030 Agenda for Sustainable Development, such as the development of productive capacities and environmental sustainability. The World Bank and the main regional development banks ‒ the African Development Bank (Af DB), the Asian Development Bank (ADB) and the InterAmerican Development Bank (IADB) – have been, over the years, important contributors to global development knowledge, and have had an uncontested role in creating and shaping development policies and solutions in different parts of the world. Despite their prominent roles, their aggregate lending is limited. In 2016, the World Bank and the three regional development banks mentioned above lent in aggregate only $77 billion. These figures are not much higher

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Billions of dollars

100 80 60 40 20 0

AfDB

ADB Disbursements

FIGURE 6.1

IADB

WB

EIB

Private co-financing

Total disbursements and private co-financing, selected MDBs, 2016.a

Source: Authors’ elaboration, based on banks’ annual reports and MDBs (2017), annex Table 6.1. a

On disbursements, Af DB includes African Development Bank, the African Development Fund and the Nigeria Trust Fund; ADB includes loans and grants from ordinary capital resources, Asian Development Fund and other special funds for grants; IADB includes ordinary capital resources, the Fund for Special Operations and other funds; World Bank includes the International Bank for Reconstruction and Development (IBRD), the International Development Association (IDA), the International Finance Corporation and Recipient-Executed Trust Funds; EIB includes all resources, loans, equities and guarantees. On private co-financing, it is total long term. IADB includes the Inter-American Investment Corporation; the World Bank includes the International Finance Corporation and the Multilateral Investment Guarantee Agency.

than the $64 billion the European Investment Bank (EIB) alone lent in the same year (see Figure 6.1). EIB is thus the largest MDB in the world in terms of annual loan disbursements and borrowing. Its operations will be briefly discussed further below (in Section 4), in the context of the discussions on MDBs’ gearing ratios. Overall, financing from the MDBs has not been sufficient to meet the needs of developing countries. In particular, as existing MDBs shifted significantly away from financing infrastructure over the past few decades (Griffith-Jones et al., 2016:7–8; Humphrey 2015a:3–4; Chin, 2014:367–370), the financing gap in the developing world in this regard is huge. To meet the growth and development needs of developing countries, infrastructure spending would have to increase to a level of $1.8–2.3 trillion per year by 2020, from the level of $0.8–0.9 trillion per year observed in the recent past (Bhattacharya and Romani, 2013). Taking the Ss more broadly, UNCTAD estimates the annual financing gap in key SDGs sectors at $2.5 trillion for the period 2015–2030 (UNCTAD, 2014:142–145). Although private sector investment in infrastructure has grown since the early 1990s (Fay et al., 2011), continued future growth is limited by a number of factors, including risk aversion, as pointed out earlier. MDBs can play a critical role not only in providing financing for infrastructure directly, but also as market makers, by creating and providing financing instruments that better share risks between creditors and borrowers, and over

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time. They can also help mitigate informational deficiencies facing the private sector by providing screening, evaluating and monitoring functions and, where needed, their own capital resources, thus partnering with private investors in cofinancing. MDBs, in addition, can help address the need for low-income countries to have access to loans for financing infrastructure projects at subsidized rates.5 As mentioned above, the main binding constraint of existing MDBs for scaling up lending to support the 2030 Agenda for Sustainable Development is their lending capacity due to their limited capital base and their conservative lending practices.

3. Alternative models towards bridging the financing gap In this context, proposals have cropped up in the recent past on how to raise MDBs’ leverage capacity in order to bridge the financing gap. The report of the Inter-agency Task Force on Financing for Development 2017 highlights four channels through which development banks can help leverage finance for infrastructure and other development-related projects. The first has to do with their mobilisation capacity by borrowing from international capital markets, which relates to their traditional funding operations. The other three relate to their ability to attract private capital as co-investors in developmentoriented projects, by providing guarantees and other instruments to cover different sorts of risk, technical assistance and best practices, to ensure alignment with broader developmental goals (United Nations, 2017:16). These are laudable practices that development banks have successfully adopted in the past several decades, and which should be expanded. A major obstacle for further expansion through borrowing from the international capital markets, however, is, first, the limited size of MDBs’ equity capital: in the cases of two large MDBs ‒ ADB and the World Bank ‒ these were (until recently) at $18 and 40 billion, respectively (Humphrey, 2017:11). The second obstacle is the relatively low loan-to-equity gearing ratios of MDBs, which reflect their conservative approach to lending (see detailed discussion in Section 4 below). Unless development bank shareholders contribute more capital, or are willing to extend more loans with the current amount of equity capital, new ways have to be explored to relax the capital constraints facing existing MDBs. Expansion of banks’ equity capital may take place basically through apportionment of new capital by their shareholders, and/or by adding net incomes to their reserves.6 Since the creation of the large MDBs several decades ago, shareholders have contributed new capital through general capital increases, but the main source of equity expansion over the years has been by adding undistributed profits to the banks’ reserves (Humphrey, 2017, 2015a:8). Developed countries, which are the main shareholders of the large MDBs, have not signalled a willingness to inject more capital in the near future, despite their stated commitment to the SDGs, and the fact that they are likely to benefit – directly and indirectly – from the achievement of the goals, which are global in nature. Moreover, while MDBs are generally profitable (to varying degrees), shareholders have increasingly used banks’ profits to pay for their contributions to the

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replenishment rounds of the banks’ concessional funds, as well as to create trust funds whose resources are earmarked by donors for specific projects (Humphrey, 2017:13–14). In this sense, the proliferation of trust fund vehicles can be seen as a way to boost the financial resources of existing MDBs (and other multilateral organizations), albeit with a limited focus on infrastructure (see Box 6.1). More recently, the use of trust funds has become a key component of so-called “blended finance”, which involves degrees of concessional financing to attract private capital (Deloitte, 2017; World Economic Forum, 2015). However, as the concept and impact of trust funds is still a work in progress, and has been the subject of other studies (Pereira, 2017; Romero, 2013), this issue is not further explored in this chapter.

Box 6.1  Trust funds and multi-bi aid Trust funds have been an increasingly important feature of lending patterns of existing MDBs. This institutional mechanism provides donor countries with a third option beyond the traditional channels of bilateral and multilateral official development assistance. In general, trust funds channel resources to multilateral development organisations or MDBs that conduct project implementation, but the funds are earmarked for specific purposes and cannot be used at the discretion of the implementing organisation. In this way, these trust funds are considered as a “multi-bi” institutional vehicle – a hybrid mechanism that channels concessional funding through multilateral organisations, while retaining bilateral priorities (World Bank, 2017c).7 By one estimate, the role of trust funds has grown quickly in the past 20 years, reaching a level of $19 billion in 2012, which represented almost 60% of total multilateral aid flows, and almost 20% of bilateral aid flows. In terms of organisational distribution, 61% of trust fund resources are channelled through various United Nations organisations, with the World Bank being the second largest recipient, at 20%. Other organisations, such as regional development banks and the European Union, also received 4 and 2% of trust fund resources, respectively (Reinsberg et al., 2015:538–539). As infrastructure financing by existing MDBs has declined significantly over the past few decades, trust funds also generally reflect this trend. For example, single-donor trust funds are estimated to account for over 70% of trust funds (by value), compared with less than 30% for multi-donor trust funds. Single-donor trust funds, in turn, allocated roughly 75% of their resources to social sectors (40%) and humanitarian aid (35%). Only approximately 10–15% of single-donor trust fund resources are designated for economic infrastructure and productive sectors. The sectoral allocation of multi-donor trust funds is generally similar, but with less financing for humanitarian aid (15%) and slightly more for economic infrastructure and productive sectors (over 20%) (Reinsberg et al., 2015:540–541).

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Instead, the remainder of this section discusses other possible experiments in how development banks may address this major constraint on the scaling up of loan disbursements. Besides an increase in capital, which is desirable but politically difficult, Humphrey (2017) suggests relaxing banks’ capital requirements to allow for higher leveraging, since banks currently have some “headroom” to do so without putting at risk the high ratings they have been granted over the years by the credit rating agencies. Another option consists of merging development banks’ balance sheets of the concessional with the non-concessional windows, thereby increasing the banks’ equity capital (by putting the funds of the concessional window into their reserves) and therefore their leverage capacity. Other options include allowing: the concessional window to obtain its own rating and raise resources in the international capital markets; loan swaps between MDBs in order to reduce portfolio concentration, which can improve their ratings and, again, their leverage capacity; callable capital to be made more automatic and transparent so that credit rating agencies may consider them as part of equity for calculation of gearing ratios (as opposed to their current practice of taking into account only paid-in capital); and loans to be removed from MDBs’ balance sheets by selling these to private investors (Humphrey, 2017). Some of these ideas have already been adopted by the MDBs. In 2015, the ADB Board of Governors approved the merger of its Asian Development Fund (ADF) with its ordinary capital resources. Taking effect from January 2017, the bank’s merger has led to the increase in the resources of the bank’s ordinary capital from about $17.3–48.1 billion. The consequence has been a substantial expansion of the bank’s lending capacity (ADB, 2017, 2015).8 In late 2016, IADB took a similar step by approving the transfer of the assets of its Fund for Special Operations to the bank’s ordinary capital resources, which also took effect from January 2017. In addition, IADB made an exposure exchange agreement with other MDBs to diversify its portfolio of loans to reduce its risk profile (IADB, 2017). Unlike the ADF of the ADB and the Fund for Special Operations of the IADB, The World Bank’s International Development Association (IDA) has remained separate from the World Bank ordinary capital resources. IDA shareholders, instead, sought and received triple-A ratings from credit rating agencies, with which it can raise resources on international capital markets (World Bank, 2016).9 ADB in its 2017 annual report states that concessional finance will continue to be provided to poor countries on the same terms and conditions as before (ADB, 2017). Because such loans will come from the bank’s ordinary capital resource window, and given that ADF will continue to operate by providing grants only, it seems that cross-subsidisation will have to increase. After all, the additional resources used in concessional finance will be raised in the international capital markets, which require market returns. The World Bank, in turn, will use its leveraged soft window to also increase loans to IDA borrowing countries, but this will henceforth include non-concessional loans ‒ or, at least, loans with lower levels of concessionality (World Bank, 2017a: figure 9).

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The last proposal, regarding MDBs taking part of their loans off their balance sheets, does not necessarily mean the bank ends its engagement with the project that the loans were originally financing. The bank, instead, designs, implements and supervises the project but does not own the loan. This is an example of a modality of an off-balance sheet operation that MDBs already adopt extensively and that may grow even further in the future, albeit not without important downside risks (see Box 6.2). In addition, off-balance sheet operations may take other forms and involve more complex arrangements. A growing trend has been the establishment of joint investment platforms in which MDBs and private actors are partners in investment projects. In this partnership, the MDBs are expected to provide resources such as technical expertise (for project design, preparation and monitoring), guarantees and insurance, while the private sector participates by contributing financial resources to the project. Examples of joint platforms are EIB’s project finance (in which the bank engages in public–private partnership projects (PPPs)); the World Bank’s Global Infrastructure Facility (GIF), in which the bank co-invests by providing technical expertise and facilities; and the European Bank for Reconstruction and Development Equity Participation Fund, in which the bank and private actors co-invest in equity (United Nations, 2017; Arezki et al., 2016).10 Other initiatives involve the creation and/or management of special funds with multi- or single-donor support focused on infrastructure development, and also with the aim of attracting private investors. These include: a IADB’s Infrastructure Fund (InfraFund) to facilitate investment in infrastructure through identification and preparation of bankable projects,11 and also the Regional Infrastructure Integration Fund, in which IADB provides technical assistance for the development of integration projects in the Latin America and the Caribbean region (IADB, 2017); b ADB’s Leading Asia’s Private Sector Infrastructure Fund (LEAP), which provides co-financing to non-sovereign infrastructure projects and seeks private sector participation through different modalities, including PPPs, joint ventures and private finance initiatives12; c Africa 50 with strong sponsorship of Af DB, aimed at developing bankable projects and attracting private capital from long-term institutional investors13; and d New Partnership for Africa’s Development (NEPAD) Infrastructure Project Preparation Facility (NEPAD-IPPF) which has Af DB as a trustee serving as legal owner, holder and manager of the fund (Af DB, 2017). Some of the funds are old enough to have already built a track record on leverage capacity since their creation. NEPAD-IPPF, for instance, has leveraged investment financing of over $7 billion since its establishment in 2005. Notwithstanding this, funding contribution in aggregate has been disappointingly low. The World Bank’s GIF has a total funding size of $84.4 million, of which China

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is the largest contributor with $20 million.14 The size of NEPAD-IPPF’s fund is currently $92 million, and the size of IADB’s Regional Integration Fund is $20 million (IADB, 2017). Their sizes pale in comparison with the China-­ created funds reported in Section 5 below, portions of which could be channelled through AIIB.15

Box 6.2  MDB originate-to-distribute model – upsides and downsides Concerning off-balance sheet operations, Arezki et al. (2016) propose that MDBs change their current modus operandi more radically from the o ­ riginate-­ to-hold model to the originate-to-distribute model for PPP infrastructure projects. Under the originate-to-hold model, banks use their funding base to ­finance loans that they keep in their balance sheets until maturity. Under the originate-to-distribute model, banks originate the loans but then syndicate these loans (by bringing in the participation of other banks), or sell all or part of the loans in the secondary loan markets (Bord and Santos, 2012). While this kind of practice is not new among MDBs, Arezki et al. (2016) further propose that, under the originate-to-distribute model, development banks could use collateralised loan obligations (CLOs), a financial instrument that investment banks used intensively in the 2000s, until the global financial crisis. This instrument means packaging the loans for a pool of investors. Moreover, it allows for the slicing of loans into tranches with different levels of seniority, and therefore can attract investors with different risk profiles. The argument is that the use of CLOs would enable MDBs to play to their strengths by designing and structuring projects but having them off their balance sheets. At the same time, it would bring in parts of the resources under the management of international investors that are currently invested in short-term assets. In addition, the authors suggest the bundling of infrastructure projects and their financing through large-scale bond financing to attract large institutional investors. The downside of the originate-to-distribute model using CLOs is that it could attract short-term capital to projects that are essentially long-term, and that may become volatile and raise the risk of default (United Nations, 2017:59). In the event that CLOs become a problem, this could cause reputational damage to the MDB, and affect its rating and ability to raise capital, even if its balance sheet were not directly affected. As regards the idea of MDB engagement in PPPs, the fact is that such an engagement is already the case. However, the evidence on performance of PPP projects is that results have been disappointing and in many instances countries are reappraising them. MDB involvement above what has been the case to date is not necessarily a guarantee that outcomes will significantly improve (Barrowclough, 2015; UNCTAD, 2015: chapter 6).

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More recently, MDBs have joined efforts to measure how much private capital they raise through co-finance. These comprise both direct and indirect mobilisation of private capital, which occur as a result of their recourse to tools and initiatives such as investment risk mitigation, co-investment including with non-traditional investors, and development of new financial products.16 According to recent estimates, in 2016, total co-financing by MDBs and other multilateral development agencies amounted to $163.6 billion, of which $49.9 billion was the result of direct resource mobilisation and $113.7 billion of indirect mobilisation (MDBs, 2017).17 Of this total, $68 billion was invested in infrastructure (GIF, 2017).18 Broadly speaking, the figures on private co-financing are of a similar order of magnitude to the disbursement figures from the large long-established MDBs, as reported in Figure 6.1. This suggests that, roughly, for each dollar of financing on the bank’s balance sheets, there is at least another dollar that the bank has demonstrated can be leveraged from private markets through co-financing. This one-to-one proportion, however, is not confirmed by disaggregated values, also displayed in Figure 6.1. With the caveat that private co-financing does not include short-term capital, figures for individual MDBs show accentuated variation. At one end, EIB exhibits a 1.4 ratio of private co-financing to bank’s disbursements. In the mid-range, WB and ADB have a 0.8 and 0.7 ratio, respectively. At the low end, Af DB and IADB have ratios in the range of 0.2–0.3. This variation might be explained, in part, by the fact that EIB operates mostly in Europe, a region that can attract private capital for long-term projects more easily. In contrast, Af DB and IADB operate in regions that private investors assess as riskier to engage long-term. Notwithstanding these figures, MDBs’ leverage capacity can go much farther. A major leverage tool at the disposal of MDBs is their risk mitigation instruments, but, according to the Group of 20 ‒ IFA Working Group (2017), less than 5% of infrastructure projects financed by MDBs use such instruments.19 To shed further light on alternative ways to directly enhance the lending capacity of MDBs, the next section contrasts the loan-to-equity gearing ratios of MDBs vis-à-vis those of selected national development banks (NDBs). The subsequent section discusses the AIIB institutional mechanism for scaling up based on special funds, which can be considered as an alternative model from existing MDBs. A key advantage of AIIB’s special funds is their primary focus on finance projects in infrastructure and other productive sectors.

4. Gearing ratios of MDBs and NDBs Of the main obstacles that currently constrain MDBs’ lending capacity, of central significance are the rules and norms related to a development bank’s extent of loan operations for a given amount of shareholder capital, known as the bank’s loan-to-equity “gearing” ratio. At the heart of the financial models of existing MDBs is the ability to raise resources inexpensively by selling highly rated triple-A bonds on international

164  Ricardo Gottschalk and Daniel Poon TABLE 6.1 Loan-to-equity ratios, selected MDBs, 2009–2016

Af DB ADB CAF EIB World Bank (IBRD)

2009

2010

2011

2012

2013

2014

2015

2016

Annual average

1.6 2.6 n/a 5.3 2.9

1.7 2.7 n/a 5.7 3.3

1.9 2.8 2.3 5.7 3.4

2.0 3.0 2.4 5.4 3.6

2.0 2.9 2.3 5.2 3.6

2.1 3.1 2.2 5.6 3.8

2.0 3.3 2.1 5.2 3.9

n/a 3.6 2.1 5.4 4.3

1.9 3.0 2.2 5.4 3.6

Source: Authors’ elaboration based on respective banks’ annual reports.

capital markets. To maintain their triple-A bond rating, existing MDBs have adopted a conservative approach to lending operations to reassure rating agencies and MDB bond investors that bank financial resources are sufficient to cover any potential loan losses. Among the selected MDBs shown in Table 6.1, EIB, which is owned by member States of the European Union, has the highest average annual gearing ratio – 5.4. Thus, for every €1 of EIB shareholder equity, the bank extended €5.4 in outstanding loans. By contrast, Af DB had the lowest average gearing ratio – 1.9 – among selected MDBs. All things being equal, a lower gearing ratio denotes shareholder equity that is being leveraged less to provide financing for development projects. The World Bank’s IBRD, which provides non-concessional loans, has gradually increased its gearing ratio over time  ‒ after only recently deciding to raise the “ceiling” of its ratio to 5 ( Humphrey, 2015a:10; Kroeber, 2015:28). As Humphrey (2017:9) has argued: The problem is, no one is sure just how much capital is necessary to preserve an AAA rating. This is a difficult question to answer for MDBs, because of their unique characteristics and the fact that, unlike private financial institutions, MDBs have no regulator. As a result, shareholders, MDB staff and bond rating agencies all have different ideas about MDB capital adequacy. Shareholders would like to see their capital work harder, but because MDB finance and risk departments manage their own interactions with bond markets and credit rating agencies, they tend to favour cautious financial policies. To help visualise selected MDBs and NDBs in relative context, Figure 6.2 organizes these according to loan-to-equity gearing ratios and loan disbursement levels. Although MDB and NDB gearing ratios are not strictly comparable,20 the NDBs nonetheless serve as important comparators by which to assess the scale of lending by existing MDBs (Studart and Gallagher, 2016; UNCTAD, 2016). The analysis reveals the potential for experimentation in bank gearing ratios and, in particular, provides some insight into the potential lending practices of AIIB

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Outstanding Loans (US$ billions, 2016)*

1,400 1,200 1,000 800 600 400 200 0

0

2

4

6

8

10

12

Average Annual Loan-to-Equity Ratio (2009-2016)* AfDB ADB CAF EIB WB (IBRD) DBSA IDC BNDES India EXIM JBIC KDB CDB FIGURE 6.2

Loan levels and gearing ratios, selected MDBs and NDBs.

Source: Authors’ elaboration based on respective banks’ annual reports. Latest available, or most available, year(s).

based on the institutional experience of China’s national development banks, such as the China Development Bank (CDB). Below, three broad groupings can be discerned from the respective operations of these MDBs and NDBs. At the lower end of the spectrum of gearing ratios are the large MDBs (Af DB, ADB and World Bank), CAF and the South African NDBs Development Bank of Southern Africa (DBSA) and IDC.21 Among the MDBs, their low loan-toequity gearing ratios confirm their conservative lending approach, aimed at ensuring that their high credit ratings are not compromised, as just suggested. Likewise, both NDBs of South Africa are likely aimed to safeguard sustained growth in lending operations and to maintain an adequate credit rating to ensure continued access to capital markets at reasonable rates. Institutional credit ratings closely tied to the country’s sovereign credit rating, relatively weak economic growth and macroeconomic fundamentals (among other factors, such as political risk) in South Africa are all factors that contribute to reinforcing the need to adhere to conservative loan-to-equity gearing ratios.22 At the middle of the spectrum of gearing ratios are the MDB EIB and NDBs such as the Brazilian Development Bank (BNDES), the Export–Import Bank of India (India EXIM), the Japan Bank for International Cooperation ( JBIC) and the Korea Development Bank (KDB). EIB has both a bigger loan portfolio and gearing ratio than any of the other long-established MDBs. Created in 1958, EIB in the past has allocated a significant proportion of its total loans to infrastructure. Its bigger financing role and relatively higher gearing ratio is, in part, explained

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by the fact that it is a regional bank in which all owners and most borrowers are developed countries. Moreover, the bank lends in euros and it surely can count on the support of the European Central Bank if a need arises. EIB expanded its portfolio of loans strongly during the global financial crisis, thus playing a strong countercyclical role, with the aim of helping sustain income and investment levels across Europe and protect the region’s infrastructure and productive capacity from the effects of a deep economic downturn. This countercyclical role is part of EIB’s mandate. NDBs such as BNDES and KDB have historically played a very prominent role in the development of their countries and have had budgetary support from their national Governments (UNCTAD, 2016). Finally, at the higher end of the spectrum of gearing ratios is China’s CDB. CDB was created in 1994 under the direct leadership of China’s State Council, as the country pursued financial and economic reforms and sought to better extricate policy-based lending from commercial-based lending. CDB provides medium-to-long-term financing to serve China’s major economic and social development strategies. Today, CDB is the world’s largest NDB (by assets) and China’s largest bank for foreign investment and financing cooperation, longterm lending and bond issuance (UNCTAD, 2016:26–27; CDB, 2015). In 2015, CDB had RMB 8,865.4 billion ($1,365,687 billion)23 in outstanding loans and advances, which accounted for 70.3% of the bank’s total assets. The bank’s estimated average annual loan-to-equity gearing ratio for 2012–2015 was 11.1, a level notably higher than that of most other selected NDBs, but at a similar level to private banks (Humphrey, 2015a:9). CDB benefits from the relatively high-grade country credit rating assessment of China: in 2015, China had an AA-rating from S&P, the fourth-highest credit rating level. Aside from sustained levels of rapid growth and strong macroeconomic management of the domestic economy, CDB enjoys an implicit guarantee from the Government of China. Although State ownership is not uncommon among NDBs, in CDB’s case, it issues long-term bonds that carry zero risk in terms of capital requirements for the State-owned commercial banks that buy them. State banks, which account for nearly half of total assets in China’s banking sector (Martin, 2012), treat these bonds as assets with risk-free returns on depositors’ funds. This bond market structure permits CDB to provide loans with substantially longer terms than those offered by commercial banks and most other NDBs (UNCTAD, 2016:28). Although this chapter does not comprehensively consider all the factors that influence the loan-to-equity gearing ratios of respective MDBs and NDBs, and these ratios should be viewed as rough estimates, the focus of this section on the variation in gearing ratios between banks hints at the ability to potentially experiment with operational settings in NDBs, notably in the case of China’s CDB. Indeed, the term “exploration” (探索) in Mandarin Chinese is frequently used by leading Chinese policymakers in reference to the country’s domestic experience in development finance ( Jin, 2017; Caijing, 2015; Chen, 2012). Considering the pressing need to reform global economic governance and to scale up development finance, combined with the newly created China-led MDBs, the question

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remains whether greater experimentation ‒ with loan-to-equity gearing ratios in particular ‒ can also take place in multilateral development banking. This issue is discussed in the next section.

5. Scaling up: the role of AIIB special funds With the recent establishment of the New Development Bank (BRICS Bank), launched in July 2015, and AIIB, launched in January 2016, there is some expectation that these new MDBs will help spur the reform of global economic governance and expand the possibilities for policy and institutional experimentation among developing countries (Grabel, 2015; Chin, 2014). At the same time, the new MDBs could also improve upon the practices of existing MDBs by, for example, finding a better balance between the need for high standards and safeguards in project lending, and the imperative for large and rapid loan dispersions (Humphrey, 2015a:13–14; Kozul-Wright and Poon, 2015). One of the most contentious issues surrounds the lending capacity of these new MDBs. A number of existing studies have adopted different methodologies to estimate the scale of lending (Griffith-Jones et al., 2016; Humphrey, 2015b; Kroeber, 2015; Griffith-Jones, 2014),24 but these have generally relied on superimposing the operational features of existing MDBs to make projections on the potential lending behaviour of the new MDBs. From an institutional perspective, however, this section contends that China’s experience with its own NDBs is very likely to inform its approach to experimentation with the operational features of the new MDBs, particularly the AIIB. On the issue of loan-to-equity gearing ratios, Griffith-Jones et al. (2016:18) have noted that AIIB’s articles of agreement (AoA) only permit, by a super majority vote, a maximum loan-to-equity ratio of 2.5 of the bank’s “unimpaired subscribed capital, reserves and retained earnings included in its ordinary resources” (AIIB, 2015:8, emphasis added). This provision is found in article 12, paragraph 1 of AIIB’s AoA. The term “ordinary resources” consists of “authorized capital stock of the Bank, including both paid-in and callable shares”, as set out in article 8 (AIIB, 2015:6–7). However, in article 10, paragraph 1 of AoA, it is clearly outlined that the operations of the bank will consist of two types: (a) ordinary operations financed from ordinary resources; and (b) special operations financed from “special funds” resources. Importantly, these two types of operations may separately finance elements of the same project or programme. The remainder of article 10 establishes a clear partition between ordinary resources and special funds resources. Paragraph 2 states that ordinary resources and special funds resources “shall at all times and in all respects be held, used, committed, invested or otherwise disposed of entirely separately from each other”. Financial statements of AIIB will list ordinary operations and special operations separately. Paragraph 3 ensures that there can be no mixing of funds between the two types of operations, that ordinary resources, “under no circumstances,

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be charged with, or used to discharge, losses or liabilities arising out of special operations or other activities for which Special Funds resources were originally used or committed”. Paragraph 4 stipulates that expenses directly related to ordinary operations will be charged to the ordinary resources of the bank, while expenses directly related to special operations will be charged to the special funds resources (AIIB, 2015:7).25 It remains to be seen how AIIB will utilise the special funds provisions found in its AoA. In principle, however, insofar as special funds can contribute to the same projects as ordinary funds, AIIB’s AoA appear to create a way to increase the scale of infrastructure project loans, while respecting its stated statutory limit of the gearing ratio.26 As the AIIB has secured a triple-A credit rating from the three major international credit ratings agencies (AIIB, 2017), the institutional design appears to maintain a de jure gearing ratio aimed at ensuring the bank’s access to international capital markets, while also creating a conduit that allows for development financing to be de facto scaled up beyond statutory limitations.27 This institutional design is reinforced by provisions in AIIB’s AoA that are careful to maintain a clear partition, in accounting and administrative terms, between ordinary resources and special funds resources. Moreover, China’s experience with the high gearing ratio of CDB suggests a pragmatic institutional willingness to experiment with raising AIIB’s gearing ratio, over time. Two further considerations help to accentuate the institutional features of AIIB’s special funds provisions: existing orientation of trust funds and China-backed investment funds. In contrast to the orientation of trust funds by existing MDBs (and other multilateral organisations) (as discussed in Box 6.1 in Section 3), the provisions in AIIB’s AoA that allow ordinary resources and special funds resources to separately finance elements of the same project or programme, constitute an institutional design that will likely further amplify the bank’s dedicated focus on infrastructure and other productive sectors, resulting in a far higher proportion of AIIB special funds’ investment in these areas.

a. China-backed investment funds While existing trust funds have traditionally channelled concessional development finance, there are increasing signs that Chinese policymakers are experimenting with forms of long-term, non-concessional development finance provided by a range of recently established national, regional and bilateral investment funds. For example, in remarks about the Silk Road Fund (SRF, discussed further below), considered as China’s latest sovereign wealth fund, the governor of the People’s Bank of China, Zhou Xiaochuan, indicated that the SRF will adopt at least a 15-year time horizon for equity investments, rather than the 7-to-10-year horizon adopted by many private equity firms, to account for slower returns on infrastructure investment in developing countries (Kozul-Wright and Poon,

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2015). Zhou also positioned the role of development finance as in between that of concessional and commercial finance, but “slightly tilted” toward the latter (Caixin, 2017).28 As Lin and Wang (2015:16) have argued: As some established donors are constrained by their heavy debt burden and slow growth, development financing will come less from ODA [official development assistance], but more and more from the Other Official Flows (OOF), OOF-like loans, and OOF-like investments from development banks in emerging economies. There, the prospect of China’s SouthSouth Development Cooperation (SSDC) is likely to expand. For instance, Chinese President Xi Jinping and Premier Li Keqiang have made fresh commitments to invest in Africa and Latin America. These loans are not necessarily ODA, but more likely to be OOF-like loans and OOF-like investments due to the nature of large infrastructure projects. In recent years, China has also established a growing number of purpose-built national, regional and bilateral investment funds to provide equity financing. These various funds will be, in all, endowed with about $99.4 billion in investment capital, selective portions of which could potentially be funnelled through AIIB (and/or the BRICS bank) special funds (see Table 6.2).29 To avoid double-counting, this calculation does not include related bilateral investment funds that receive capital from other China-backed investment funds. For example, in December 2015, SRF invested $2 billion in establishing the China–Kazakhstan Production Capacity Cooperation Fund, in partnership with Kazakhstan’s National Export and Investment Agency (Kaznex Invest), to provide financing for bilateral projects related to China’s “Belt and Road” initiative (Chen, 2015). More recently, in May 2017, the China–Brazil Production Capacity Cooperation Fund was officially launched, with initial capital of $20 billion to invest in projects in Brazil related to infrastructure, manufacturing, agribusiness and technology. It is reported that $5 billion of the fund’s capital will be provided by Brazilian sources such as BNDES and Brazil’s State-owned Federal Savings Bank (Caixa Economica Federal), and $15 billion from Chinese sources, including the $10 billion China–Latin American Industrial Cooperation Investment Fund (CLAIFUND) (Xinhua News), 2017. The $99.4 billion total should be considered an upper-bound estimate of these funds’ potential financial firepower (notwithstanding a future decision to increase the number of funds and/or the overall capital size of existing funds). For example, the China–ASEAN Investment Cooperation Fund is an open-ended private equity fund focusing on investments in infrastructure, energy and natural resources. It is sponsored by China EXIM and other institutional investors, and has an initial fund size of $1 billion, with a total target fund size of $10 billion.30 The China–Central and Eastern Europe Investment Cooperation Fund was initially incorporated with $435 million, with second phase funding of $1 billion becoming operational in 2017.31 Similarly, the China–Russia Regional

China–Kazakhstan Production Capacity Investment Fund China–LAC Cooperation Fund (private equity fund) China–Latin American Industrial Cooperation Investment Fund (CLAIFUND) China–Brazil Production Capacity Cooperation Fund China–Africa Production Capacity Cooperation Fund China–Russia Regional Development Investment Fund Total

China–Africa Development Fund China–ASEAN Investment Cooperation Fund China–Central and Eastern Europe Investment Cooperation Fund Silk Road Fund

b

a

2017 99.4

15.4

10

[20]

2017

2016

10

3

[2]

2015

2015

2015

40

1

2013

2014

10 10

Fund sizeb (billions of dollars)

2007 2013

Created

National Development and Reform Commission

CLAIFUND and Chinese institutions ($15 billion) SAFE, China EXIM

SAFE, CDB

China EXIM

SAFE, China Investment Corporation (CIC), China EXIM, CDB SRF

China EXIM

China Development Bank (CDB) China Export–Import Bank (China EXIM)

Chinese investors

–

BNDES, Caixa Economica Federal ($5 billion) –

–

–

–

Hungarian Export–Import Bank –

– –

Other investors

This table is not a comprehensive list of China-backed national, regional and bilateral investment funds. For example, the $2.4 billion China–Mexico Investment Fund and the $10 billion United Arab Emirates–China Joint Investment Fund have not been included, either due to lack of information or uncertainty over their status. Also, China’s bilateral investment funds with developed countries have not been included. See also Zhang (2014). Other related initiatives, such as establishing a $10 billion Shanghai Cooperation Organisation development bank, have yet to materialise. Figures in square brackets are not included in total.

Source: Authors’ elaboration.

8

7

6

5

4

3

1 2

Name

TABLE 6.2  China: Selected national, bilateral and regional investment fundsa 170  Ricardo Gottschalk and Daniel Poon

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Development Investment Fund has an initial fund size of $1.5 billion, with a target fund size of roughly $15.4 billion.32 SRF was created in 2014 and is the main financial vehicle supporting China’s Belt and Road initiative. Considered as China’s latest experiment with sovereign wealth funds, it was initially capitalized with $10 billion and has a target fund size of $40 billion. SRF is jointly owned by four State institutions: State Administration of Foreign Exchange (SAFE), with a 65% stake; China Investment Corporation (CIC) and China EXIM, each with a 15% stake; and CDB with a 5% stake (Kozul-Wright and Poon, 2015). In a recent speech, chairman of the board of directors Jin Qi said that SRF has already made investment commitments of $6.8 billion, of which almost 80% consists of equity financing ( Jin, 2017).33 At the recent Belt and Road Forum, SRF was provided with roughly $15 billion, bringing its fund size to $25 billion (Belt and Road Forum for International Cooperation, 2017). For its part, the China–Africa Development Fund (CADF) is a subsidiary of CDB and is also considered as one of China’s sovereign wealth funds. CADF was the first Chinese equity fund dedicated to fostering China–Africa economic ties, and invests in Chinese firms with economic and trade activities in Africa, as well as in African firms and projects invested by Chinese firms. The fund does not seek controlling or majority stakes, and financing can take the form of direct equity investment (in ordinary shares of a firm or project); quasi-equity investment (preference shares, convertible bonds, other hybrid instruments); and fund investment (fund-of-funds) (Cummine, 2015).34 Following the Third Forum on China–Africa Cooperation, CADF was established with $1 billion in capital in 2007 and committed funds were increased over time: $3 billion in 2009, $5 billion in 2012 and $10 billion in 2015. However, by the end of 2016, CADF had reportedly only been able to invest $4.4 billion in African countries (CDB, 2017; China Daily, 2016). It is also important to note that investment funds listed in Table 6.2 do not include Chinese funds (or portions of funding arrangements) that are intermediated by existing MDBs. For example, the China–LAC Cooperation Fund consists of two parts: part one is a $2 billion China Co-Financing Fund for Latin America and Caribbean Region, which is managed by IADB for investment in areas including education, water conservancy and energy; part two is a $3 billion private equity fund administered by China EXIM with funds provided from Chinese institutions, with a focus on areas including energy and natural resources, infrastructure, agriculture, manufacturing, high-tech and information technology (China–CELAC Forum, 2015). Only part two of the China–LAC Cooperation Fund – the $3 billion private equity fund – is included in Table 6.2.35 The discussion above is not to suggest that only these China-backed investment funds will make use of AIIB’s special funds institutional mechanism. Rather, these investment funds could help act as “first-mover” or “cornerstone” investors to mobilize additional financing from other (international and domestic) public and private sector sources. While these investment funds should not

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be considered as part of a monolithic Chinese State, their common underlying trait of State ownership could at times lead to degrees of investment coordination among different investment funds and institutions – particularly in the context of the Belt and Road initiative. In this sense, the notion that China’s competitive advantage is “based on the willingness and ability of a nation and its firms to invest aggressively” (Poon, 2014:14) appears likely to extend beyond the remit of China’s domestic economy, with increasing relevance on the global stage. As Zhou Xiaochuan of the People’s Bank of China has hinted, investment funds such as SRF can act as catalysts for other (State) financial institutions in a selected project’s equity and debt financing. Initially, SRF and other public and private investors would make joint equity investments in the project. China EXIM and CDB could subsequently extend loans for debt financing, and CIC could provide further equity financing. With AIIB (and the BRICS bank) in operation, these could also cooperate with SRF in arranging equity and debt financing (Kozul-Wright and Poon, 2015). In this context, it is not inconceivable that other China-backed investment funds could fit into this overall structure of project financing, either directly as initial co-financiers alongside SRF or by channelling resources through the AIIB special funds mechanism. Indeed, it is perhaps through such kinds of strategic financing arrangements that Chinese policymakers may be able to experiment with improving upon existing MDB practices in the provision of large and rapid loan dispersions. From a broader perspective, some have already contended that China has gradually established parallel structures and institutions to a wide range of international organisations in areas such as financial and monetary policy, trade and investment, security policy and diplomatic forums (Heilmann et al., 2014; Huotari and Hanemann, 2014). While much of the international community remains fixated on advancing forms of “blended finance” to draw in private sector capital, the discussion in this section helps to position AIIB’s special funds mechanism and China-backed investment funds as part of China’s emerging institutional architecture in international development cooperation. This parallel blended finance architecture appears set to experiment with providing forms of long-term non-concessional development finance, while retaining a distinctive feature of public sector ownership.

6. Summary and conclusions The world currently faces the critical challenge of scaling up development finance, an indispensable requirement for the realisation of the SDGs. The unique characteristics of MDBs place them as key development institutions to help the world in this task. As this article argues, they have the right sort of technical expertise and capacity for the design, implementation and supervision of complex, long-term development projects, particularly in infrastructure, which are vital for the achievement of most SDGs. In addition, they have extensive experience in leveraging private resources for development projects through the

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provision of financial resources and instruments, from seed money to guarantees and insurance. MDBs’ ability to raise resources in international capital markets, however, is constrained by their narrow capital base and by their conservative lending approach to maintain high credit ratings, and in this way protect their ability to borrow internationally at relatively low costs. Given the current lack of commitment by MDB shareholders to provide substantial capital increase, MDBs face the risk of losing their relevance as international development players precisely at a time when they are most needed. In this sense, the long-established MDBs could be said to face a competitive challenge from newly established MDBs, which seem to have the financial firepower to become leading development finance institutions in the years ahead. In the face of these challenges, the long-established MDBs have recently undertaken a number of initiatives to raise their lending capacity. This chapter reports the most important ones, including balance-sheet mergers between soft and hard windows, changes in portfolio profile to reduce portfolio concentration risks, and the establishment of co-investment platforms. The chapter also discusses ‒ and critiques ‒ proposals suggesting that MDBs change their business models and start to operate more like private investment banks by packaging loans and distributing them to private investors with different risk profiles. Against this backdrop, the article presents the AIIB model as an alternative to leverage resources for infrastructure development, through the use of “special funds” resources that are treated separately from the bank’s ordinary resources, but may finance different parts of a same project or programme supported by ordinary funds. This gives the bank greater capacity to finance different sorts of projects in infrastructure and other productive economic sectors, which are at the core of its mission. AIIB’s special funds institutional mechanism is then placed in the context of national, regional and bilateral investment funds created by China in recent years, which could provide significant additional resources for the purpose of financing complex, multi-year projects, such as the Belt and Road initiative, that cover several countries. To date, these funds are comprised mainly of public resources, but to the extent that AIIB’s intermediation role involves nonconcessional loans, the bank could build on its track record in this regard and would likely be able to increasingly attract private sector capital as co-investors in its development projects. The likelihood, therefore, is that such funds will gradually parallel the co-investment platforms set up by the existing MDBs, in terms of pooling together both private and public resources, while still maintaining a distinctive feature of public sector ownership and control. China’s experiment with development banking as an instrument of its international development initiatives did not start with the BRICS bank or AIIB. Since the early 2000s, China has significantly increased the provision of financial assistance to developing countries, using a variety of sources of funds and programmes, particularly its national development banks (CDB and China EXIM).

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The establishment of the BRICS bank with China as an equal shareholder, and AIIB, in which China is a main shareholder with veto power, can be seen as part of a new phase of China’s international engagement, where it is actively experimenting with institution-building and the multilateralisation of its development finance. The AIIB model may be seen as unique in that its principal shareholder is a State that has the resources and is eager to promote development finance both at home and abroad. But the message that China’s recent experience ‒ and the steps the country is undertaking towards greater international engagement ‒ truly conveys is that availability of financial resources is not all that matters, but, rather, that political will and innovative ideas are central pieces to build up a strategy to enhance financing for development. As the world moves towards taking concrete steps to implement the 2030 Agenda for Sustainable Development, the leading advanced economies will have no option except to either try to emulate China’s model or to propose clear alternatives for substantial financial scaling up, at the peril of inescapably losing their central position in the international development arena. Note: Earlier versions of this paper were disseminated at an expert meeting on Financing for Development, 8–10 November 2017, UNCTAD, Geneva, and as an UNCTAD Research paper ECIDC/2017/4. The authors thank Richard Kozul-Wright, Alex Izurieta, Chris Humphrey, Valpy FitzGerald and Jorge Maia for comments provided on earlier drafts of this article. All errors and omissions are the full responsibility of the authors. All references to dollars ($) are to United States dollars, unless otherwise stated.

Notes 1 Available at https://sustainabledevelopment.un.org/topics/sustainabledevelopmentgoals. 2 For a critical assessment of the Addis Agenda, see, for example, Montes (2016), who stressed the lack in the Agenda of new commitments to meet the financing requirements of the Sustainable Development Goals, and in whose view the most important outcomes of the conference were limited to two new processes ‒ the proposed technology facilitation mechanism and the monitoring of progress on financing for development by the United Nations Economic and Social Council. 3 These figures are based on Willis Towers Watson (2016). 4 These are the so-called emerging and frontier markets. 5 In 2013, concessional lending by the World Bank, Af DB, ADB, IADB and the European Bank for Reconstruction and Development totaled $20 billion, which represented 30% of their total loan portfolio (UNCTAD, 2016:36). 6 This is the case since the two main components of banks’ total equity are paid-in capital and reserves. 7 See http://fiftrustee.worldbank.org/Pages/FIFSOverview.aspx. 8 See also Birdsall et al. (2014) for a detailed appraisal of ADB’s initial merger proposal. 9 See also Humphrey (2017:11) for a detailed discussion of the MDB’s initiatives to enhance its lending capacity. 10 For more detailed information about these platforms, see EIB (2017), World Bank (2017b) and Rosca (2016).

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7 A CONNECTED AND SUSTAINABLE FUTURE – COMPARING LESSONS FROM SOUTHERN-LED REGIONAL BANKS AND NETWORKS, CAF AND THE ISLAMIC DEVELOPMENT BANK COMPARED Rohini Kamal and Rebecca Ray 1. Introduction Southern-led multilateral development banks (MDBs) play a key role in harnessing global capital to ensure financing for the sectors most important to borrowers, especially infrastructure. As the International Monetary Fund (IMF) highlighted in its Fall 2014 World Economic Outlook, infrastructure spending was key to developing countries’ ability to weather the crisis, and continues to be key in pulling countries through the current period of faltering growth (IMF 2014, Chapter 3). This chapter draws lessons from the experiences of Southern-led MDBs to inform the decisions around sustainable infrastructure facing their members by examining in detail two Southern-led development banks: the Development Bank of Latin America (CAF) and the Islamic Development Bank (IsDB). CAF is discussed specifically as it contrasts with its Northern-led regional peer, the InterAmerican Development Bank (IADB), in order to highlight the opportunities and challenges specific to the Southern-led strategy. IsDB is contrasted with World Bank’s investments in the countries that IsDB operates in. The World Bank was selected due to the scale of its investments in the relevant countries, offering the opportunity to make a meaningful comparison. Being borrower-led development banks, CAF and the IsDB are well positioned to react to governments’ increased demand for infrastructure during periods of weak economic growth, and bridge the gap between periods of high political will and periods of full government coffers. The same is true for newcomers in this field, including the New Development Bank (NDB), recently formed by Brazil, Russia, India, China, and South Africa, and the Asian Infrastructure Investment Bank (AIIB), recently formed through the initiative of China but boasting 74 member countries.

182  Rohini Kamal and Rebecca Ray

Specifically, this chapter explores the extent to which Southern-based MDBs have been successful in supporting sectors explicitly prioritized by the NDB and the AIIB: infrastructure and sustainable infrastructure in particular. The chapter examines the extent to which being borrower-led helps the banks respond to borrower demand and identifies ways in which their structure helps address some of the challenges associated with financing sustainable infrastructure. In examining these two banks, the chapter also identifies areas on which the banks can focus going forward, especially considering the expected rise in infrastructure financing from Southern-led banks. The chapter begins with a background on the Southern-led banks to determine how borrower-led they are compared to their northern counterparts. We examine whether being borrower-driven constrains their ability to finance sustainable infrastructure. To explore their success in financing sustainable infrastructure relative to their northern counterparts, we first examine the banks’ infrastructure loans and then use the methodology developed by IDFC (2015) and the UNFCCC Clean Development Mechanism to look at sustainable infrastructure investments of the two banks relative to their northern counterparts. We find that though the CAF and IsDB are more borrower-led than their northern counterparts, some of their larger shareholding countries dominate more in governance. The banks are limited in their ability to raise capital as they have relatively low levels of callable capital and are not comprised of AAA-rated member countries, limiting their bond-issuing potential. However, we find that despite being limited in their ability to raise capital, these two smaller Southernled development banks do heavily finance infrastructure and are indeed moving more and more towards sustainable infrastructure. To address some of their limitations, we find that the banks maintain multiple lending and investment windows in the same institution, which allow smoother collaboration in blending instruments to support hard-to-finance or complex project. They also participate in multilateral funds – even as small minority partners – that allows the southern MDBs to learn from their larger counterparts about new types of loans and projects. We find that being borrower-driven leads to more sense of ownership of the banks and their operation and the ability to be more responsive to not just the needs of the borrowing countries but the ground realities of the project areas. This allows the banks to have in-depth knowledge of potential risks around large infrastructure projects, including environmental and social risks. We find that both banks rely on local staff and experts for each project, including for project approvals, which gives them greater flexibility. However, being smaller than their northern counterparts means that these banks lack several risk-reducing features, such as a procurement oversight program and dispute resolution mechanism. Based on these findings the chapter ends with key recommendations for Southern-led development banks in the area of sustainable infrastructure.

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2. Bank origins and governance CAF and the IsDB were both founded with the specific goals of forming MDBs governed by developing countries, but their governance structures are quite different. CAF’s governing body represents borrowers significantly more heavily, while Saudi Arabia has a dominant role in the IsDB. The incorporation of borrowing countries as major shareholders enables borrowing countries to have a greater sense of ownership of the projects financed by the Bank.

a. CAF CAF was founded by Bolivia, Chile, Colombia, Ecuador, and Peru in their negotiations prior to the development of the Andean Group, to fill a perceived need for an MDB governed by the same countries that borrowed from it. This stands in contrast to the other major regional MDB, the Inter-American Development Bank (IADB), in which the US has an imposing representation in governance. CAF’s governance system contains two bodies: the Shareholder Assembly meets as required for major decisions, while the Board of Executive Directors oversees day-to-day operations. Assembly and Board composition and voting power are necessarily complex, given that CAF shareholders are divided into three types: •

• •

Ten “A” shares, worth US$1.2 million each and owned by ten regional countries: Argentina, Bolivia, Brazil, Colombia, Ecuador, Panama, Paraguay, Peru, Uruguay, and Venezuela; 802,090 “B” shares, worth US$5 each and owned by the same ten countries as well as by private banks; and 93,765 “C” shares, also worth US$5 each and owned by nine other Bank members: Barbados, Chile, Costa Rica, Dominican Republic, Jamaica, Mexico, Portugal, Spain, and Trinidad and Tobago.1

The composition of the Board of Executive Directors and the distribution of voting power at the Shareholder Assembly are heavily skewed toward the core member countries that are “A” and “B” shareholders. The Board of Executive Directors is comprised of two Directors from each of the ten countries that are “A” and “B” shareholders, plus two additional Directors elected by the “C” shareholders and a final Director elected by all private bank shareholders. Most Shareholder Assembly decisions require agreement among 80% of “A” shareholders and majority of other shares. Extraordinary Assembly sessions, called for the most significant decisions such as raising capital, require a unanimous decision among “A” shareholders, plus the majority of other shares. Clearly, this arrangement gives the most power to the 10 “A” shareholders, as any combination of three of those countries can block decisions. However, a clear assessment of voting power requires an understanding of the distribution of “B”

184  Rohini Kamal and Rebecca Ray Others 4.1 TTO 1.9 ESP 6.6 PRY 2.4 PAN 2.4 URY 2.7 BRA 7.8 ARG 8.9 BOL 5.1

Other non-borrowers 11.0

PER 18.1

JAP 5.0

VEN 17.6 COL 17.4

ECU 5.1

Founding "B" shareholders (total: 63.2%) Other "B" shareholders (total: 24.1%) "C" shareholders (total: 12.6%) FIGURE 7.1

USA 30.0

Other borrowers.. COL 3.0 CHL 3.0 VEN 5.8

MEX 6.9 BRA 10.8

ARG 10.8

CAN 4.0

North American countries (total: 34.01%) LAC countries (total: 50.01%) Other countries (total: 15.98%)

Country representation in governance, CAF, and IADB.

Source: CAF (2016). Note: Chile was among the original founding “B” shareholder members, but left under Pinochet and rejoined in 1992 as a “C” shareholder. It currently has 0.5% of the bank’s B and C shares.

and “C” shares, since a majority is required in each case. Figure 7.1 shows the distribution of these shares. As Figure 7.1 shows, B and C shares are dominated by the same ten countries who are “A” shareholders, and particularly the founding members of the bank. Commercial banks and the two European members (Spain and Portugal) together comprise only 8% of the shares. Furthermore, “C” shareholders are also limited in the amount that they can borrow from CAF. They face a borrowing cap that does not apply to “A / B” shareholders, of eight times their capital shares for projects involving international integration, and four times their capital shares for other projects. In contrast, CAF’s northern-led peer, the IADB, allots representation at its governing bodies more simply: votes are allotted in proportion to each country’s capital share at the banks. This approach gives the United States the largest individual representation, with 30%, while LAC countries jointly have 50.01%. Many of the IADB’s more important decisions, such as increasing membership, allocating net income, and approving each loan through the FSO (concessional) window, require super-majorities of 75%, giving the United States effective veto power over these topics (Humphrey 2012). Each bank’s borrowers are shown in Figure 7.2, below. Brazil – the region’s largest economy – is a major borrower from each bank. But each bank also

A connected and sustainable future  185 PAN 3.4 PER 20.1

URY 5.1 BOL 5.4 VEN 6.1 ARG 8.7

FIGURE 7.2

Other 22.3 BRA 16.8

ECU 9.9

COL 16.4

DOM 2.5 URY 2.8 VEN 2.9 CHL 3.1 ECU 3.9 PER 4.7

BRA 19.1 MEX 15.2

COL 9.0

ARG 14.5

Credit-receiving countries, CAF, and IADB, 2006–2015.

Source: CAF (2007–2016), IADB (2007–2016).

lends substantially to the greatest shareholder countries in the region: Peru and Colombia for CAF, and Mexico and Argentina for the IADB. In that regard, they are each borrower-driven. In the IADB’s case, this is clearly limited by the United States’ effective veto power over important decisions, discussed above.

b. IsDB The Islamic Development Bank (IsDB) was conceptually established in December 1973 at the Conference of Finance Ministers of the Muslim Countries in Jeddah, Saudi Arabia, with a declaration of intent to launch a financial institution that would foster the economic development and social progress of Muslim countries. The Bank formally began in October 1975, shortly before the inaugural meeting of the Board of Governors of the IsDB was held in December 1975. It is headquartered in Jeddah, Kingdom of Saudi Arabia. To be a member of the Bank, the country must first be member of the Organization of Islamic Cooperation (OIC). The current membership of the Bank is composed of 57 Member States from Africa, Asia, the Americas, and Europe. The IsDB has two principal boards, the Board of Governors (BOG) and the Board of Executive Directors (BED). Every member country is represented at the BOG by a Governor, generally from the Ministry in charge of economic, finance, and/or planning affairs. In theory, the Board of Governors has all powers. But, in practice, it delegates most of its powers to the BED, except for those powers considered as the “domaine réservé” of the BOG and which are enumerated in Article 29, Section 2 of the IsDB Articles of Agreement. The BED is “responsible for the direction of the general operations of the Bank (…) and exercises all the powers delegated to it by the BOG,” according to Article 32 IsDB Articles of Agreement (IsDB 1975, 13). The BED includes 18 Executive Directors (EDs), each representing a constituency of IsDB Member Countries. Nine EDs represent a single country each (Saudi Arabia, Libya, Iran, UAE, Nigeria, Qatar, Egypt, Kuwait, and Turkey). The other nine EDs represent a constituency composed of the remaining 48

186  Rohini Kamal and Rebecca Ray

Member Countries. Except for Nigeria, which is not a top shareholder, the countries represented by their own ED are the top shareholders. Regarding voting, each Member Country has 500 basic votes plus one vote for every share subscribed. All matters before the BOG and BED are decided by a majority of the voting power represented at the meeting. BED quorum requires the presence of a majority of EDs, representing at least two-thirds of the total voting power. In the BOG, each Governor is entitled to cast the votes of the Member he represents. For the BED, each ED is entitled to cast the number of votes that counted towards his election attributed to the country they represent and such votes do not need to be casted as a unit. For example, the ED for Saudi Arabia will cast the votes attributed to Saudi Arabia; an ED representing a group of countries will vote for each country they represent, and not one vote for all countries as one constituency. No one country has over one-third of the total shares, meaning no one country can block quorum. Nonetheless, as Figure 7.3 shows, Saudi Arabia’s portion is roughly 27% of total shares, meaning that if that country pairs with one other country that has at least 6% of the total (including Libya, Iran, Egypt, Turkey, the United Arab Emirates, and Kuwait) it could theoretically block a BED meeting. Since its inception 48.3% of the Bank’s approvals went to 19 member countries in Middle East and North Africa (MENA), 30.2% went to 9 countries in Asia, 15.7% to 22 Countries in Sub Saharan Africa (SSA) and 5.8% to the 7 Countries-in-Transition (CIT).2 The top borrowing countries for 2015 were Egypt, Bangladesh, Morocco, Pakistan, and Turkey. Combined they represented 55% of total approvals in 2015 amounting to a little over US$6 billion. Of the top borrower countries Egypt and Turkey are also among the top five shareholders. The two figures below show the top credit-receiving countries for all IsDB activities (Figure 7.4).

IDN 2.3 PAK 2.6

45 more borrowers 7.8

DZA 2.6

SAU 23.7

TUR 6.5 KWT 7.0 EGY 7.1 QAT 7.3 ARE 7.6 FIGURE 7.3

LBY 9.5 NGA 7.7

IRN 8.3

IsDB shareholders (%).

Source: Authors’ calculations based on IsDB annual reports.

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BGD 14.4 EGY 7.9

Others 41.9

PAK 7.8 TUR 7.0

JOR 2.0 TUN 2.5 IDN 3.0 FIGURE 7.4

SAU 3.8

MAR 5.2 IRN 4.7

IsDB group cumulative financing% since inception for top shareholding countries.

Source: Authors’ calculations based on IsDB annual reports.

Aside from the IsDB, the largest other MDB active in IsDB member countries is the World Bank, used here for comparison in governance structure. Regarding shareholders and governance, unlike the IsDB the World Bank exists only to lend to developing countries, so not all of its member countries can borrow. Figure 7.4 shows the six top shareholders at the International Bank for Reconstruction and Development (IBRD – the World Bank’s main lender), which also have the greatest voting power. Regarding voting power, the US has the largest share of IBRD votes, with 16.54%, and is still the only country that enjoys the power of veto over decisions requiring a qualified majority. Similar to the IsDB, the IBRD’s top shareholding countries have their own Executive Director. Other member countries are represented in constituencies that are roughly made up by region and that vary considerably in size. The World Bank Board works on a mostly consensus basis with few decisions formally going to the vote. However, according Griffith-Jones (2001), the composition of the Board, and the number of the EDs, influences both the type of issue brought to the Board and the decisions taken. Thus, indirectly, the consensus does reflect the voting power of member countries. At the IBRD, borrowing countries have only 38% of the vote, and only a minority of the Chairs and the President of the Bank, who have never come from a borrowing country (Griffith-Jones 2001). The top borrowing countries in 2015 for the International Development Association (IDA), the concessional lending arm of the World Bank, are Bangladesh, India, Ethiopia, Pakistan, Kenya, and Nigeria. The top borrowing countries for IBRD are India, China, Colombia, Egypt, Ukraine, and Argentina. This is different from the IADB where power is most equitably distributed between the lending and borrowing countries. In comparison, all shareholding countries are able to borrow in the IsDB, although

188  Rohini Kamal and Rebecca Ray Non-IsDB MENA & SSA 3.4

SAU 2.9 IRN 1.5 Other IsDB cos. 10.2

LAC 8.3 Non-IsDB Asia/Pac. 21.1

USA 16.5

Other EUR 16.0

DEU 4.2 FRA 3.9 GBR 3.9 RUS 2.9 CAN 2.5 ITA 2.5

IsDB member countries (total: 14.6%) N. Amer., Europe (total: 52.5%) Other countries (total: 32.8%) FIGURE 7.5

IBRD percentage total shares 2015.

Source: Authors’ calculations based on IsDB annual reports. The countries with less than 4% and more than 2% votes are: India, Russia, Saudi Arabia, Canada, Italy, Netherlands, Spain in order of magnitude of share.

in practice the borrowing share of top borrowers are small – both for project financing (comparable to IBRD) and for all IsDB Group operations.

2. Financing infrastructure As borrower-led banks comprising of countries that do not have AAA credit rating CAF and IsDB do face some difficulties raising finances. They pursue a range of strategies to overcome this challenge, including innovative approaches to infrastructure and sustainable infrastructure finance. CAF and the IsDB primarily finance infrastructure through non-concessional loans, relying on paid-in capital. Callable capital serves as a financial backstop, an essential guarantee for the bank as it seeks to raise capital through bonds or through taking deposits (Azán and Gomez 2016, IADB 2016). However, CAF has much lower levels of callable capital than the IADB does, so its ability to draw in new capital through the bond market is still quite limited. They are further constrained by the fact that neither CAF nor the IsDB have shareholder countries with AAA ratings: a major obstacle for their own ratings and thus their ability to raise capital (Humphrey 2015). However, the two banks pursue a range

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of options to access funds for infrastructure, including co-financing with other MDBs, setting up multilateral funds and accessing green funds.

a. Paid-in capital A key difference between the IBRD and IsDB is the importance of paid-in capital of the shareholders. The 1999 UN research project “The New Role and Functions for the UN and the Bretton Woods Institutions” finds that even though at its inception, IBRD’s paid-in capital helped establish the institution, over time the Bank’s equity grew fairly steadily, “partly through additions to paid-in capital, but largely through additions to reserves out of substantial net income, which originates in the profits of loans made to developing countries” (Kapur 1999). In contrast IsDB primarily relies on its paid-in capital, which stands at US$3.6 billion. IsDB’s authorized capital stands at US$154 billion, its issued capital at US$77 billion, out of which 98.6% has been actually subscribed by IsDB Member Countries (IsDB 2014, Annex 4). The Bank raises additional money from the financing it provides to its clients, and also through the issuance of Sukuk (Trust Certificates) in the Islamic Bond Market, which can be assimilated into conventional bonds. The Bank issues Sukuk under its Medium Term Note (MTN) Program, allowing the Bank to undertake public issuances and private placement. The Bank can leverage on its subscribed and callable capital to address liquidity management problems. CAF also has much less callable capital than the Northern-led IADB and issues less debt. Antonio Recine, CAF Senior Specialist of Financial Policies and International Bond Issues, attributes this arrangement as one of three major way for CAF to maintain investment grade bond ratings, together with maintaining a diverse portfolio and remaining profitable (in contrast with the IADB, which has had years of positive and negative comprehensive income). In fact, CAF’s callable capital is just one-third the size of its paid-in capital, while IADB’s callable capital is over 24 times as large as its paid-in capital. CAF’s minimal callable capital limits its borrowing, as Table 7.1 shows. This necessarily translates to a lower level of loans that CAF has been able to extend. CAF partially compensates for this reduced bond-issuing capacity by pursuing other forms of borrowing, such as by offering deposits to member central banks and through commercial paper. Nonetheless, overall, CAF’s overall ability to extend loans is still hampered: while CAF has 72% of the IADB’s paid-in capital, its outstanding loans are just 25% of the value of the IADB’s. Through its lending windows, CAF offers concessional loans, non-concessional loans, lines of credit, and private equity. Lines of credit and partial guarantees make up the largest share of CAF approvals, with US$7.9 billion in 2015: nearly two-thirds of the total. Non-concessional loans accounted for an additional US$3.5 billion, and less than US$100 million was divided between concessional and equity operations. This is vastly different from the larger, Northern-led

190  Rohini Kamal and Rebecca Ray TABLE 7.1 Selected balance sheet items, CAF and IADB, in millions of US$,

as of year-end 2015 CAF Capital Paid-inb Callable

IADBa

Ratio, CAF/IADB (%)

4,491 1,554

6,252 151,240

72 1

20,277 328 10,781 1,084 32,470

79,690 29 29,071 3,854 112,644

25 1,131 37 28 29

Assets Loans outstanding Equity investments Cash, deposits, tradable securities Other assets Total assets Liabilities Deposits Commercial paper Borrowings, net Other liabilities Total liabilities

2,700 2,590 15,029 2,627 22,946

– – 79,759 6,785 86,544

– – 19 39 27

Sources: CAF (2016), IADB (2016). a b

IADB figures include the IIC. Paid-in capital is net of receivable subscribed capital.

IADB, which approved US$10.4 billion in new non-concessional loans in 2015, just US$2.6 billion in credit lines and guarantees, and US$282 million in concessional operations through its Fund for Special Operations (FSO) window. In addition, CAF takes deposits from member country central banks. This is highly unusual among MDBs (e.g., the IADB does not accept deposits). However, it presents two main advantages for CAF and its shareholders. First, it allows CAF to raise capital relatively inexpensively. Second, it allows CAF’s member countries an alternative for their deposits other than relying on private banks, which may have a tenuous or rocky relationship with some member countries.

b. Credit ratings of member countries Neither CAF nor the IsDB has shareholder countries with AAA ratings: a major obstacle for their own ratings (Humphrey 2015). Nonetheless, the IsDB has achieved AAA ratings from all major credit rating agencies. In a recent update, Fitch specifically attributed this rating to the bank’s “excellent” capitalization, with a high equity-to-assets ratio of 50%. In contrast, CAF has “stretched” its paid-in capital by taking deposits and by concentrating its credit operations in credit lines and guarantees. As a result, it has US$32.5 billion in assets and just $4.5 billion in paid-in shareholder equity. While this strategy does not help

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CAF’s chances of earning AAA bond ratings, it does allow the bank to avoid relying on borrowing through bonds in order to maximize its impact. The lack of AAA-rated shareholders is a particularly acute disadvantage for financing infrastructure, which necessitates long-term loans to countries with imperfect loan-repayment records. Nonetheless, CAF has a perfect record of ontime borrower repayments over the bank’s history. (Castillo and Recine attribute CAF’s perfect repayment record to a sense of ownership among borrowers, as there is no difference in the incentives of shareholder and borrower countries.) Maintaining this perfect record is crucial for keeping its current AA ratings. In fact, each of the three major rating agencies cited this repayment history as an important positive factor in recent updates (Moody 2015, Fitch 2016, Standard and Poor 2016). In addition to using its own capital for new non-concessional loans, CAF frequently blends instruments to maximize its reach. For example, CAF’s recent emphasis on PPPs allows it to blend traditional non-concessional loans with private equity or with private loans from CAF Asset Management Corporation (CAF-AM), a recently-founded subsidiary located in Panama and dedicated to attracting private investment for regional infrastructure. PPPs also allows another financial advantage: private partners usually have better credit ratings than government counterparts, and are easier to finance. For their own part, the government partners exercise a disciplinary role. As stated above, no government has ever missed or delayed a payment to CAF. As Recine put it, while the private partners are likely to have higher credit ratings, the public partners have a AAA history, if not AAA ratings. Combining these two strengths makes long-term infrastructure loans feasible. During downturns, PPPs can be an important tool for governments to harness investors’ desire for safe, long-term investment options at the same time that developing countries are most in need of investment and the higher investment multipliers that come during periods of economic slack (IMF 2014, Vasallo Magro and Izquierdo de Bartolomé 2010). However, PPPs present unique challenges in developing countries that may not have fully-formed legal frameworks in place to regulate and oversee the private-sector actors in public infrastructure sectors. For the IsDB, PPP projects are overseen internally and externally to address some of these risks. Internally, the IsDB has a back office team that oversees PPP projects implementation after Bank approval. Externally, projects are jointly supervised by the pool of lenders. Depending on the nature of the projects, one lender is often designated to lead different aspects of the project, as agent bank for example. CAF addresses the challenges posed by inadequate regulatory frameworks by assisting governments in addressing these gaps. Since CAF’s policy is to defer to country-level safeguards and standards, where national legal frameworks are lacking, CAF provides separate concessional loans and grants to develop and enforce these norms. CAF has approved between US$35 and US$50 million for these “cooperation funds” each year for the last decade.

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More commonly, CAF blends instruments by attracting co-financing from other development banks, from the private sector, and from green funds, through an arrangement known as “syndicated lending” (Williams 2014). “A/B” loans, in which CAF takes the leadership and largest share of financing responsibilities, predominate among syndicated lending schemes that involve CAF and one private co-financing partner. In these cases, CAF seeks out a private partner, but remains the lender of record and directs the process of approving and overseeing project execution. Private partners benefit from CAF’s history and relationships, which lowers repayment risk, as mentioned above. When a particular syndicated lending scheme unites CAF and another development bank, the two groups negotiate to determine which bank will oversee which aspects of the project. In these cases, CAF must ensure that its own standards are met, even if a different bank is overseeing part of the process (Azán and Gomez 2016). CAF also has a history of establishing multilateral funds. CAF pursues this option when it wants to support a particular project, but either does not have enough available financing or enough sector-specific expertise to oversee the entire endeavor. In these cases, CAF establishes a fund, commits initial capital, and then seeks complementary funds from other institutions. It followed this pattern to support the Fourth Generation (or “4G”) highway network in Colombia, in which CAF has contributed US$50 million toward an endeavor expected to use US$33 billion in financing (CAF 2014, Castillo and Recine 2016). Being a minority partner is an important step for CAF’s institutional learning. This 4G project will be CAF’s first experience with this scope of project, but by contributing its share, CAF representatives can be present at important meetings throughout the process and be better positioned to finance similar projects in the future. In another example, CAF has started a multilateral infrastructure fund, and hopes that it will eventually have hundreds of billions in capital, but is only able to commit US$50 million of its own money (Castillo and Recine 2016). By establishing a multilateral fund, CAF’s reach can exceed its own capabilities in these cases. Multilateral funds have an added benefit in attracting smaller or private partners, in their approach to risk management. As the IDFC explains, they “can provide innovative risk instruments that can help bridge the phases of infrastructure project life cycles and allow lower risk investors to take out financing when higher risk periods have passed” (Williams 2014, 15). In sum, they allow CAF to partner with investors who would otherwise eschew certain types of projects, and to participate in projects that would otherwise be too big or involve expertise that is too advanced for the bank. In addition, CAF has occasionally invested directly in public and development banks. In recent years, CAF has made equity investments in Portugal’s SOFID (US$1 million, in 2015) and Colombia’s FDN (US$50 million, in 2014), extended a line of credit for Peru’s COFIDE (US$300 million, in 2009) and directly lent to Colombia’s Bancoldex (US$300 million, in 2008).

A connected and sustainable future  193

Finally, in cases of green infrastructure projects, CAF can blend instruments by attracting concessional financing through green funds. CAF has focused on two funds in particular: the Green Climate Fund and the Moringa Fund. The Green Climate Fund, founded at the 2009 Copenhagen COP-15 meeting, is an arm of the UNFCCC established to assist developing countries in climate adaptation and mitigation. It offers concessional financing for sustainable infrastructure projects, which as Figure 7.5 shows are an increasing share of CAF’s portfolio. The Moringa Fund offers private equity investment in sustainable projects in Latin America and Africa. These two funds have allowed CAF to take environmental aspects of projects into account earlier in the approval process, to take advantage of these outside opportunities for co-financing wherever possible. For the IsDB, though infrastructure projects are typically financed through the Bank’s ordinary capital resources (OCR), the Bank has sponsored and invested in a number of separate Infrastructure funds, including the IsDB-ADB Infrastructure Fund and the Arab Financing Facility for Infrastructure, among others. In some cases, the Bank may blend concessional (interest-free loan or grant) with other non-concessional modes of finance (construction finance, leasing, installment sale, equity, etc.) to cheapen the funding. The IsDB’s 2020 Plan (IsDB 2006) states that it expects to expand interventions in focus areas within the broader sector of infrastructure, which would require innovative financing solutions. The focus on poverty and sustainable energy will require a major increase in concessional or soft-term financing, even in middle-income countries. The Bank plans to identify opportunities for developing effective cooperation models with partner development institutions, including through regional, thematic programs (for energy poverty, sustainability, etc.). The IsDB is scaling up its financing for infrastructure in member countries through new instruments. In addition to using OCR for sovereign guaranteed projects, the IsDB has established new facilities and funds including (i) PPP facilities; (ii) the Arab Financing Facility for Infrastructure and the related Arab Infrastructure Investment Vehicle, jointly set up with the International Finance Corporation (IFC) and other development partners; (iii) a new Mudaraba Infrastructure Investment Facility; (iv) an Islamic Infrastructure Fund jointly set up with the ADB; and (v) the IsDB Infrastructure Funds 1 and 2. One new Islamic financing instrument is the Restricted Mudaraba Facility structure developed by the Bank for long-term financing of private sector actors in energy sector projects. Restricted Mudaraba is an investment mode whereby IsDB provides a financing facility to be invested by a third party (called Mudarib/investor) in a specific business. The Mudarib’s right to invest is subject to specific conditions detailed in the Restricted Mudaraba Agreement (the investment agreement) between both parties. The profit accruing from the investment is shared between the parties according to specific ratios agreed upon in the Restricted Mudaraba Agreement. The Bank also co-finances project with other MDBs such as the African Development Bank, the World Bank, Asian Development Bank or with member

194  Rohini Kamal and Rebecca Ray

countries. A typical co-financing with other MDBs will resemble a parallel financing whereby each institution will finance different components of the same projects. Those components may or may not be interdependent. When they are interdependent, the agreement will typically include a cross-effectiveness provision whereby, for example, IsDB financing will become effective only after certain components financed by the co-financier have been completed, and/or funding of the same secured. For projects where co-financiers are organized as a pool of lenders, for example in PPP projects, financing documentation specifies the decision-making process regarding the implementation of the subject projects and the role and responsibilities of each lender, including administrative roles.

2. Bank lending for infrastructure Infrastructure finance is an important priority for both CAF and the IsDB, and both are shifting more and more towards sustainable infrastructure. Being borrower-led allows the banks to be closely aligned with borrowing countries’ demands, which have shown a tendency to emphasize sustainable infrastructure despite neither bank having specific mandates for it. Looking at the banks’ project portfolios, we find that despite not having a focus on infrastructure like IADB, both CAF and the IsDB emphasize infrastructure – and especially transportation – in their lending portfolios. However, infrastructure is a much more important part of the IsDB’s lending portfolio, as Figure 7.6 shows. Over the last decade, CAF has tended to lag slightly behind the IADB in its prioritization of infrastructure finance, while infrastructure has been much more important to the IsDB, often comprising over twice as much of the latter’s total portfolio as it is in either of its western counterparts. We find that infrastructure financing is especially aligned with the principles guiding IsDB’s operations and the countries they serve. Under Islamic Finance, as defined by overseeing bodies such as the Islamic Financial Services Board and the General Council for Islamic Banks and Financial Institutions (CIBAFI) as well as internal IsDB regulatory body, the investments must be equity-based, asset-backed, with projectable risk analysis that is fully known by all parties. Speculation is prohibited, and the investments must be tied to the real economy. These aspects make infrastructure investment, particularly in low-risk projects, a natural candidate for IsDB investments. Since inception, about one-fourth of IBRD and IDA commitments went to “hard” infrastructure: energy, transportation, water and sanitation, information and communication technology. For a meaningful comparison with IsDB, we looked at World Bank’s activities only in IsDB member countries, for the relevant years of 2006–2015. Figure 7.6 examines all four MDBs studied here, and shows their total value of infrastructure and sustainable infrastructure finance.

A connected and sustainable future  195 60 50 40 30 20 10 0

2006

2007

2008

CAF FIGURE 7.6

2009

2010

IsDB

2011

2012

2013

IADB

2014

2015

WB in IsDB countries

Infrastructure finance as a share of total approvals, CAF, IsDB, and IADB.

Source: Annual reports. Note: Total approvals include credit lines, guarantees, and insurance. 25 20 15 10 5 0 2006

2007 CAF

FIGURE 7.7

2008

2009 IsDB

2010

2011 IADB

2012

2013

2014

2015

WB in IsDB countries

Sustainable infrastructure finance as a share of total approvals, CAF, IsDB, and IADB.

Source: Annual reports. Note: Total approvals include credit lines, guarantees, and insurance.

Sustainable infrastructure is a growing sector for CAF and IsDB. However, neither bank has developed a system to classify new infrastructure loans as sustainable, which can complicate their supervision of this important new area. Figure 7.7 uses the methodology developed by IDFC (2015) and the UNFCCC Clean Development Mechanism (see Appendix for definition of sustainable infrastructure and methodology used for the categorization).

196  Rohini Kamal and Rebecca Ray

Over half of CAF’s new approvals each year are credit lines and guarantees, which are focused on supporting a given entity rather than a given project. As such, accurately measuring the importance of infrastructure in CAF’s overall approvals each year is challenging. This is especially true for CAF’s credit lines and guarantees for financial institutions with missions to support local infrastructure projects. With that complication in mind, this section considers the importance of infrastructure in CAF’s direct operations (leaving aside indirectly-financed projects through CAF’s general support of banks and government agencies), considered both with and without credit lines and guarantees. Including credit lines and guarantees, CAF has emphasized infrastructure slightly less than its northern-based peer the IADB over the last five years: the sector has accounted for 25% and 30% of credit operations, respectively. The same can be said for sustainable infrastructure, which accounted for 11% of CAF’s new approvals and 14% of the IADB’s approvals. However, excluding credit lines and guarantees and focusing on each bank’s lending portfolio yields dramatically different results. Among new loans, CAF has given twice as much importance to infrastructure as the IADB: 62%, compared to just 31%. Sustainable infrastructure follows a similar pattern, as CAF has dedicated over one-fourth of new loan funds to this area in the last five years, while the IADB has 15%. The largest differences arise in transportation and water/sanitation projects: each is about twice as important to CAF as they are to the IADB. In either method of measurement, CAF gives a similar or greater emphasis to infrastructure lending compared to the IADB. While the IADB was founded with an express mandate to lend in particular sectors (infrastructure and private industry) the same cannot be said for CAF, which was founded with a mandate to be borrower-led, not to lend in particular sectors. In fact, CAF officials have confirmed that CAF does not seek out proposals in particular sectors; portfolio shifts depend entirely on the borrower demands (Azán and Gomez 2016). CAF’s structure as a borrower-led institution, during an era when borrowers are demanding loans for infrastructure and industry, appears to be equally effective at channeling funds into those sectors as IADB’s specific mandate to channel financing into those sectors. The IsDB website lists total OCR loans per year since its inception under the categories shown in Table 7.3, including a subset of the years from January 2000 to August 2016. The category “others” includes public administration and trade-related activities. The Bank defines Infrastructure as energy, information and communication, transportation, water, sanitation, and urban services. Infrastructure constitutes over half the total loans every year. This division stands in stark contrast to the other MDBs profiled here. Within the broad sector of infrastructure, energy has held an important role over the last decade, as Table 7.3 and Figure 7.8 show. Transportation is another important sector, while information and communications (ICT) has been a fledging sector, making up just 5% of total loans since 2000. Nonetheless, IsDB infrastructure loans have varied significantly by borrower region, which is fitting

A connected and sustainable future  197 TABLE 7.2  Sector distribution of CAF and IADB lending, 2011–2015

Including CLs & Gs

Excluding CLs & Gs

CAF ($52.7 billion) (%)

CAF ($21.8 billion) (%)

IADB ($64.2 billion) (%)

IADB ($56.8) (%)

Non-infrastructure State/community Social programs Industry/fin/trade Other

75 15 1 58 1

70 27 18 22 4

38 19 2 14 3

69 27 19 19 4

Total infrastructure

25

30

62

31

Water/sanitation Energy Transport Other

5 7 13 1

7 7 14 1

13 17 30 2

7 8 15 1

Conventional infra.

14

15

36

16

4 9 1

3 12 1

11 23 2

3 12 1

Sustainable infra.

11

14

26

15

Green water/san Green energy Green transport Grand Total

5 2 3 100

7 5 2 100

13 6 8 100

7 5 3 100

Conventional energy Conventional transport Other

Source: CAF (2007–2016), IADB (2007–2016). Note: Green infrastructure is defined according to IDFC (2015). Hydropower is classified as “green” in the cases of run-of-the-river projects and reservoir projects with power density of at least 4.0, according to the UNFCCC Clean Development Mechanism rule (CDM, n.d.).

for a Southern-led MDB. For example, since the IsDB’s inception, most loans approved in sub-Saharan Africa have supported transportation, while most MENA and Asian loans have been in the energy sector. Since its inception, the IsDB has financed a number of renewable energy, transportation and water and sanitation projects that qualify as “sustainable” infrastructure in the IDFC methodology (See Appendix). However, as of this writing, no internal classification has been made between sustainable and conventional infrastructure. It is therefore difficult as of today to assess and single out the percentage of sustainable infrastructure relative to the overall infrastructure IsDB portfolio. To gauge infrastructure sustainability, we examined the portfolio as presented in annual reports. Due to lack of project documentation available and lack of a list of projects approved in 2013 onwards, our assessment is a partial one.

198  Rohini Kamal and Rebecca Ray TABLE 7.3 IsDB OCR infrastructure approvals by year from 2000–2016, by sector

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Average

Total (million US$)

Infrastructure Energy ICT TransWater, san. (%) (%) portation & urban (%) svcs. (%)

Total infrastructure (%)

689.2 701.1 778.7 997.0 1,272.0 1,339.5 1,469.7 2,233.6 2,569.4 4,055.4 3,445.9 3,485.4 4,150.6 4,694.4 4,641.4 5,419.9 2,209.2

15 21 13 3 24 28 19 32 24 25 35 31 27 35 43 18 33 28

68 62 64 55 61 76 67 77 81 79 75 68 56 74 82 63 63 71

5 4 14 3 11 10 16 9 12 6 7 1 3 3 2 0 0 5

22 22 26 26 24 21 25 33 30 32 28 17 9 21 22 37 8 24

26 15 10 22 2 17 6 3 14 17 5 19 17 15 15 8 23 13

32 38 36 45 39 24 33 23 19 21 25 32 44 26 18 37 37 29

4

3.8 3.3 3.0

Billions of USD

3

0.7 2

0.4 0.2 0.2 0.1 2000

0.7 0.6 0.1 0.0 0.4 0.1 0.4 0.3 0.2 0.1 0.1 0.2 0.2 0.3 0.3 0.1 0.1 0.0 2001 2002 2003 2004 Energy

FIGURE 7.8

0.9 0.2 0.3

0.7 0.1 0.4

0.4

0.3

1.5 0.1

0.4

2.3 0.2

0.7

0.8

0.7

0.6

2.4 0.1 0.7

1.3

1.0 0.6

2.2

1.2

1.1

0.4

1.0 1.0

2.0

0.7 0.4 1.7

1.0

3.4 0.7

0.7

1.8

1

0

Noninfrastructure (%)

1.1

2.0 1.0

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Transportation

Water, Sanitation & Urban Services

Information & Communications

IsDB infrastructure finance by year and sector in million US$ 2000–2016.

Source: IsDB (2016).

A connected and sustainable future  199

On a project-by-project basis for the years 2006–2012 we categorize each project as: conventional infrastructure (not qualifying as “sustainable” under the IDFC methodology), sustainable water and sanitation, sustainable hydropower,3 sustainable transportation, or other (non-infrastructure) projects. For the years we could examine in detail, 49% was devoted to conventional infrastructure and 18% to sustainable infrastructure (of which water and sanitation account for 9%, energy 4% and transport 4%).4 Tables 7.4 and 7.5 compare World Bank operations in IsDB countries to the IsDB. In absolute amounts, World Bank financing is comparable to the IsDB, which is surprising given the difference in the relative size of the two banks. Infrastructure comprises a greater share of IsDB’s portfolio than that of the World Bank. However, World Bank infrastructure projects focus much more on providing technical support and capacity building. World Bank financing also includes general projects such “rural development” or “irrigation development” projects that were not accounted for by our methodology. The proportion of infrastructure lending, particularly in Transportation and Energy, demonstrates the need for incorporating an internal sustainability classification. Indeed, in June 2012 IsDB became one of eight MDBs that have jointly committed to the sustainable transport agenda at Rio+20 United Nations Conference on Sustainable Development. Voluntary steps were taken to (i) develop a new methodology to assess the sustainability of the transport sector portfolio and (ii) promote the systematic consideration of sustainability issues at the preparation and implementation stage for new transport sector operations. The Rio+20 Commitment outlined the expectation to provide more than US$175 billion of loans and grants for transport in developing countries over the coming decade (2012–2022). As part of this process, the Sustainable Transport Appraisal Rating (STAR) system (pioneered by the Asian Development Bank) includes criteria to TABLE 7.4 World Bank and IsDB projects in IsDB member countries (million US$)

Year

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

WB

IsDB

Total loans

Total infra. %

SI % of infra.

Total loans

Infra. % total

SI % of infra.

7,392.16 8,438.74 12,577.38 17,027.75 15,886.76 13,268.79 14,253.86 13,075.93 18,320.88 17,300.63

28.03 24.33 21.91 16.72 21.31 26.48 25.37 22.35 27.44 22.81

14.09 30.52 13.74 30.64 19.92 23.67 24.38 27.65 35.39 51.14

1,469.73 2,233.63 2,569.43 4,055.42 3,445.89 3,485.43 4,150.63 4,694.44 4,641.43 5,419.91

50.21 68.17 69.21 73.48 68.02 66.41 52.96 71.01 79.96 63.12

2.83 2.34 20.02 51.06 36.3 24.06 30.22 20.28 17.01 22.64

Source: Banks’ project reports.

200  Rohini Kamal and Rebecca Ray TABLE 7.5 Infrastructure sector shares IsDB and World Bank in IsDB member countries

Year

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

WB

IsDB

Energy % of total

Transport. % of total

Water % of total

Energy % of total

Transport. % of total

Water % of total

10.67 9.48 6.48 9.06 8.01 10.03 12.91 11.03 21.84 9.33

12.35 6.55 9.22 5.02 6 10.88 4.62 3.97 2.45 7.55

5.01 8.3 6.21 2.64 7.3 5.57 7.84 7.35 3.15 5.93

18.83 31.92 24.4 24.54 34.79 30.74 26.83 35.44 42.92 17.59

25.19 33.1 30.41 31.97 27.76 17.02 9.07 20.88 22.05 37.37

6.2 3.15 14.4 16.97 5.47 18.65 17.07 14.69 14.99 8.15

Source: Banks’ project reports.

evaluate the social, economic, environmental, and risk sustainability of transport projects, and creates an aggregate sustainability score (Véron-Okamoto and Ko Sakamoto, 2014). The IsDB applied its interim modified STAR framework under the Rio+20 Agenda to assess the sustainability of projects approved in 2013 through 2015. However, that framework includes economic, social, environmental sustainability components, and is thus different from the methodology used here. Under their methodology most transportation projects assessed were found to be moderately sustainable. Economic sustainability was found to be consistently high in almost all projects. Social sustainability came next, followed by environmental sustainability. Operational sustainability was usually the lowest scoring aspect in the assessed projects. However, the share of projects rated low in sustainability (marginally sustainable) fell for subsequent years, showing an overall improvement in ratings. The details of the projects and the categorization has not been made available on the IsDB website. According to news reports, the IsDB has invested about US$2 billion in clean energy to date, and has a US$180 million pilot project to fund clean energy in its 56 member countries. We estimate that 18.2% of IsDB energy investments for the years 2006–2012 was in renewables. However, given the lack of the list of projects from 2013 onwards and the reports of additional financing for renewable energy, the percentage is likely to be higher for recent years. Bloomberg News reports that about 25% of the IsDB’s energy investments are in renewables currently (Hirtenstein 2015). The IsDB website further includes a 2019 plan for sustainable energy that focuses efficiency gains in transmission and distribution, on gas, nuclear, and on renewable energy sources (IsDB 2013). Sustainable infrastructure is poised to play a bigger role in the bank and as such a specific categorization and mandate would be useful going forward.

A connected and sustainable future  201

3. Infrastructure: risk management Infrastructure projects, especially so-called “mega-projects” such as large dams, highway systems, or railway networks, present particular risks due to their large size and the high number of unknown factors than can affect a project’s timetable, cost, and chance of successful completion, and countries’ ability to repay such large loans. As noted above, CAF and IsDB are uniquely positioned as a member-driven, Southern-led bank in facing risks related to the projects it funds. This advantage extends to risks regarding project costs, currency risks, and social and environmental risks. These risks – and Banks’ responses to them – are discussed below. Project cost overruns are an endemic risk in infrastructure financing. Banks can limit their exposure to this risk by avoiding approvals of projects that are prone to cost overruns due to overly optimistic proposals. Martha Castillo expressed that CAF’s decentralized staff “indubitably” helps CAF avoid projects that are likely to develop much higher final costs than the initial proposals might suggest (Castillo and Recine 2016). In the second stage of project proposal consideration, CAF conducts a field visit with local experts, and the final approval decision is made by local-country staff. These steps make it less likely that CAF will finance a project that is likely to cost much more than its initial proposal estimated. The Bank’s publication, “39 Years in Development” describes the risk management framework to address credit, market and operational risks, with special attention on country and liquidity risk (Véron-Okamoto and Sakamoto 2014). Monitoring portfolio quality is a key focus area of IDB’s risk management function, and is reflected in the regular assessment of the credit worthiness and repayment abilities of its member countries and other counterparts. Furthermore, adherence to risk management guidelines was closely monitored and the follow-up of project implementation was enhanced as part of an early warning system to preserve portfolio quality. Facing social and environmental risks, CAF’s decentralized operations give the Bank the same advantages as it has facing cost overrun risk. Being located in borrowing countries means that CAF staff is exposed to media coverage of proposed projects before formal project evaluation begins, and knows if it is likely that social conflict or environmental degradation will ensue. Regarding social and environmental aspects of each project, CAF defers to national standards. As Martha Castillo explained, current national frameworks often reflect important historical and political developments. In CAF’s view, trying to impose uniform norms across countries, with varying ecosystems and relationships between different social groups, ignores this context and brings new risk, by sacrificing buy-in from local governments (Castillo and Recine 2016). In fact, in many cases regional governments are global leaders in crafting comprehensive social and environmental protections, but lack the institutional capacity to follow through with these norms. In cases where CAF determines that local government capacity is unable to enforce its own norms, CAF extends concessional loans and grants, as in the cases of governments that lack regulatory frameworks for overseeing PPP projects, discussed above.

202  Rohini Kamal and Rebecca Ray

Overall, regardless of country, CAF has 14 basic social and environmental principles that apply to all of its projects, but these are not formalized into public, operational steps (Palacios 2016). As part of the accreditation with the Green Environment Facility (GEF), CAF developed its own environmental and social safeguards in 2015, though they apply only to project receiving GEF support (CAF 2015). Nonetheless, CAF is exposed to cost risk in one way that does not apply to its northern counterparts: it does not have a procurement oversight program (Humphrey 2012). IADB has a Corporate Procurement Committee that oversees Bank procurement policies and reviews individual contracts above a size threshold, and rules to prevent corruption, which prevent projects from contracting with former Bank staff, former Bank contractors, or relatives of Bank staff (IADB 2011). CAF also faces significant social and environmental risk from its lacks of a dispute resolution mechanism like the IADB’s Independent Consultation and Investigation Mechanism. Such a mechanism can raise an alarm over incipient social and environmental problems before they become catastrophic, preventing major conflict that can become an obstacle to project completion. Furthermore, they can mediate conflicts in such a way that achieves greater local buy-in and ensures greater stability over the entire project life cycle.

4. Future prospects and lessons for new MDBs CAF and IsDB both see sustainable infrastructure as a major growth area for their operations. This expectation comes not only because of the global imperative of responding to climate change, but because of immediate financial concerns, by incorporating concessional financing through partners such as the Green Climate Fund and the Moringa Fund. Furthermore, it reduces the possibility of projects being ensnared by conflict, risking the physical and economic success of the project overall. Other development banks poised to move into the areas of infrastructure and specifically sustainable infrastructure can glean several lessons from the experiences discussed here: •

•

• •

•

Incorporating local experts into every project stage, from initial proposal assessment to eventual project oversight, allows for banks to avoid projects that are likely to over-run their costs and create project-jeopardizing conflict. Incorporating borrowing countries as major shareholders can help ensure repayment of loans, as borrowing countries will share ownership in the project of the Bank. Lending for sustainable infrastructure can reduce risks and allow for the participation of green financing partners. Maintaining multiple lending and investment windows in the same institution (which both CAF and IsDB do) can allow smoother collaboration in blending instruments to support hard-to-finance or complex project. Joining multilateral funds as minority partners can allow banks to grow in their institutional capacity and learn how to oversee new types of projects.

A connected and sustainable future  203

Notes 1 Series “C” shareholder countries can become series “A” and “B” shareholders with approval of the Shareholder Assembly, by purchasing an “A” share for US$1.2 million. In doing so, their “C” shares will be converted into “B” shares with the same value (CAF 2015, 13). 2 MENA includes Algeria, Bahrain, Egypt, Iran, Iraq, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Palestine, Qatar, Saudi Arabia, Syria, Tunisia, Turkey, UAE, and Yemen. Asia includes Afghanistan, Bangladesh, Brunei, Guyana, Indonesia, Malaysia, Maldives, Pakistan, and Suriname. SSA includes Benin, Burkina Faso, Chad, Cameroon, Comoros, Cote d’Ivoire, Djibouti, Gabon, Gambia, Guinea, Guinea Bissau, Mali, Mauritania, Mozambique, Niger, Nigeria, Senegal, Sierra Leone, Somalia, Sudan, Togo, and Uganda. CIT includes Albania, Azerbaijan, Kazakhstan, Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan. 3 Hydropower is classified as sustainable in cases of run-of-the-river projects and reservoir projects with power density ratio of at least 4.0, according to the UNFCCC Clean Development Mechanism rule (CDM, n.d.). 4 IsDB (2007–2013). Note: Green infrastructure is defined according to IDFC (2015). Hydropower is classified as sustainable in cases of run-of-the-river projects and reservoir projects with power density of at least 4.0, according to the UNFCCC Clean Development Mechanism rule (CDM, n.d.).

References Azán, Soraya and Milnael Gomez. (2016). Personal interview with Fei Yuan, 22 June. CAF. (2014). “CAF approves USD 50 million investment for infrastructure development in Colombia.” Press release 19 March. Accessed 22 September 2016. https://www. caf.com/en/currently/news/2014/03/caf-approves-usd-50-million-investment-forinfrastructure-development-in-colombia. CAF. (2007–2016). “Annual Reports, 2006–2015.” http://scioteca.caf.com/handle/123 456789/2. CAF. (2015a). “Convenio Constitutivo.” https://www.caf.com/media/125601/cafconvenio-constitutivo-10032015.pdf. CAF. (2016). “Financial Statements, As of and for the Years Ended December 31, 2015 and 2014.” https://www.caf.com/media/3783077/caf_31-12-2015__ingl_s_ coninformedelosauditoresindependientes.pdf. Castillo, Martha and Antonio Recine. (2016). Personal interview with Rebecca Ray, 14 September. Fitch Ratings. (2016). “Fitch Affirms Corporacion Andina de Fomento’s IDR at ‘AA-’; Outlook Stable.” Press release, 18 February. https://www.fitchratings.com/site/ pr/999673. Griffith-Jones, Stephanie. (2001). “Governance of the World Bank.” Prepared for Department for International Development (DFID). https://www.ids.ac.uk/files/ GovernanceWorldBank.pdf. Hirtenstein, Anna. (2015). “Islamic Bank May Support Green Sukuk for Renewables Projects.” Bloomberg News, 3 November. http://www.bloomberg.com/news/articles/2015-11-03/ islamic-bank-may-support-green-sukuk-for-clean-energy-projects. Humphrey, Chris. (2012). “The Business of Development: Borrowers, Shareholders, and the Reshaping of Multilateral Development Lending.” Dissertation. London School of Economics. http://etheses.lse.ac.uk/587/. Humphrey, Chris. (2015). “Are Credit Rating Agencies Limiting the Operational Capacity of Multilateral Development Banks?” Washington, DC: G-24. http://g24. org/wp-content/uploads/2016/08/G24-CRA-October30.pdf.

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IADB. (2007–2016). “Annual Reports, 2006–2015.” http://www.iadb.org/en/about-us/ annual-reports,6293.html. IADB. (2011). “IDB Corporate Procurement Policy.” http://idbdocs.iadb.org/wsdocs/ getdocument.aspx?docnum=948065. IADB. (2016). “Information Statement 2015.” Accessed 22 September 2016. http:// idbdocs.iadb.org/wsdocs/getdocument.aspx?docnum=40253882. IDFC. (2015). “IDFC Green Finance Mapping for 2014.” Frankfurt: International Development Finance Club. https://www.idfc.org/Downloads/Publications/01_green_ finance_mappings/IDFC_Green_Finance_Mapping_Report_2015.pdf. International Monetary Fund. (2014). “World Economic Outlook, October 2014: Legacies, Clouds, Uncertainties.” Washington, DC: IMF. http://www.imf.org/external/ pubs/ft/weo/2014/02/. IsDB. (2016). “IDB Group Operations at a Glance.” Website, Accessed 23 September 2016. http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://fe68e baa6541fcf4c62134ea6d389185. IsDB. (1975). “Islamic Development Bank Articles of Agreement.” http://www.isdb. org/irj/go/km/docs/documents/IDBDevelopments/Internet/English/IDB/CM/ About%20IDB/Articles%20of%20Agreement/IDB_Articles-of-Agreement.pdf. IsDB Annual Report (2006) Website, Accessed 23 September 2016. https://www. isdb.org/sites/default/files/media/documents/2018-12/IsDB-Annual%20Report1427H.pdf. IsDB Annual Report (2013) Website, Accessed 23 September 2016. https://www. isdb.org /sites/def au lt/f i les/med ia/docu ment s/2 018 -12/IsDB -A n nua l%2 0 Report-1434H(2013).pdf. IsDB Annual Report (2014) Website, Accessed 23 September 2016. https://www. isdb.org /sites/def au lt/f i les/med ia/docu ment s/2 018 -12/IsDB -A n nua l%2 0 Report-1435H(2014).pdf. Kapur, Davesh. (1999). “Processes of Change in International Organisations.” Prepared for UN Wider Research Project ‘The New Role and Functions for the UN and the Bretton Woods Institutions.’ http://projects.iq.harvard.edu/files/wcfia/files/164_ helsinki3.wcfia_pdf. Moody’s. (2015). “Rating Action: Moody’s affirms CAF’s Aa3 rating; outlook stable”. Press release 16 September. https://www.moodys.com/research/Moodys-affirmsCAFs-Aa3-rating-outlook-stable--PR_334645. Palacios, Juan Carlos (2016). Personal interview with Fei Yuan, 21 June. Standard and Poors. (2016). “Corporacion Andina de Fomemto ‘AA-/A-1+’Ratins Affirmed; Outlook REmains Negative.” Press release 24 June. https://www.caf.com/ media/4729732/ratingsdirect research update 1663646 jul-05-2016 10 55.pdf. Vasallo Magro, José Manuel and Rafael Izquierdo de Bartolomé. (2010). “Infraestructura pública y participación privada: conceptos y experiencias en América y España.” Caracas: CAF. https://ppp.worldbank.org/public-private-partnership/sites/ppp.world bank.org/files/documents/Libroinfraestructura_ES.pdf. Véron-Okamoto and Ko Sakamoto. (2014). “Towards a Sustainability Appraisal Framework for Transport”. Manilla: Asian Development Bank. https://www.adb.org/sites/ default/files/publication/31198/sdwp-031.pdf. Williams, Holly. (2014). “Financing Sustainable Infrastructure.” Frankfurt: International Development Finance Club. https://www.idfc.org/Downloads/Publications/02_ other_idfc-expert_documents/IDFC_Financing_Infrastructure_Paper_I_and_ II_01-12-14.pdf.

8 TOWARDS A REGIONAL FINANCIAL ARCHITECTURE The East Asian experience Mah Hui Lim

1. Introduction One effect of increasing globalization in the post-Bretton Woods international financial system has been greater economic and financial instability, both domestically and globally. Banking and financial crises have occurred with higher frequency and greater intensity, the last and the most severe, since the 1929 Great Depression, was the Global Financial Crisis of 2007. Asia underwent a similar experience in 1997/1998. The failure of the traditional international financial architecture to assist Asia resolve the crisis prompted efforts among East Asian countries to create an Asian regional financial architecture (RFA). This chapter has four main sections. The first introduces the background to and limitations of the traditional international financial architecture. This leads to an examination of the factors that led to the emergence of an Asian RFA. The third section briefly overviews the two broad requirements of a RFA – namely defensive (the initiatives and mechanisms adopted to prevent or reduce the occurrence of future crises, and the management of such crises) and developmental. The fourth section focuses in particular on developmental sources of finance – beginning with a critical analysis of the Asian bond market initiatives. It then proposes the need to supplement this effort with the promotion of regional and national long-term development or credit banks as another pillar of the RFA.

2. The state of traditional international financial architecture1 The signing of the Bretton Woods agreement in 1945 was the world’s first attempt to establish an international financial architecture for the purpose of managing monetary policies between countries in order to promote financial and monetary stability and economic growth. The Great Depression of the 1930s and economic conflicts between nations marked the period between the two world

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wars. During this period, gold standard as the medium of exchange for world trade, investment and settlement was replaced by a floating exchange rate system. This led to speculative capital flows, balance of payment imbalances and competitive devaluation by countries in order to export their way out of recession. At the same time, nations erected trade barriers to protect their home industries. The upshot was a drastic decline in international trade. This provided the backdrop for nations to gather in Bretton Woods to find a solution to the world’s financial and monetary problems. The main concerns of the Bretton Wood agreement were: how to avoid the monetary chaos of the inter-war period and to replace the floating exchange rate with a more stable exchange rate system for the world; how to correct global balance of payment imbalances; and how to finance and resuscitate the wardamaged economies of Europe. New rules, procedures and institutions were set up to achieve these goals. To manage the international financial and monetary systems, a new fixed exchange rate system was established in which countries agreed to peg their currencies to the U.S. dollar that in turn was pegged to gold at the rate of $35 per ounce. The International Monetary Fund (IMF) was tasked to manage this new system and be the keeper of the rules. For example, IMF approval was required for any change in exchange rate in excess of 10% of the peg. It also stands to provide liquidity support to countries experiencing balance of payment difficulties, and finally to provide the forum for consultation and cooperation among governments. The Bretton Woods system worked for a couple of decades, mainly to the advantage of U.S., the issuer of the dollar reserve currency, until it broke down in 1971 when the U.S., faced with persistent balance of payment deficit and dwindling gold reserves, abandoned the conversion of dollar into gold at the agreed rate. The breakdown of the Bretton Woods system and the reintroduction of flexible exchange rate, coupled with the ascent of neoliberal policies, ushered in an era of financial and monetary instability again. Domestically, the industrial and financial sectors were deregulated and liberalized. Internationally, the U.S. and IMF pushed countries to dismantle barriers to free capital flows. Capital started to flow freely in and out of countries, corporations spread their wings abroad and became foot-loose, banks started to internationalize their operations with greater portion of profits derived from overseas operations. Financial deregulation and liberalization led to a litany of financial crises in the 1980s and 1990s. First was the Latin America debt crisis in the 1980s; followed by Mexico in the mid-1990s. Then it was Asia and Russia that suffered their most severe crisis in the late 1990s.

3. The Asian Financial Crisis and the emergence of RFA The roots of the Asian Financial Crisis (AFC) of 1997/1998 are many: including a huge inflow of speculative foreign capital into Asia attracted by arbitrage

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opportunities and abetted by a pegged-exchange rate regime; misallocation of capital and financial mismanagement resulting from excessive liquidity; rapid deregulation and liberalization of the financial sector without stronger supervision; an explosion of corporate and financial borrowings that were short-term and denominated in foreign currencies. The AFC was not the boom and bust of a normal business cycle, but one associated with speculative and erratic financial flows. Starved by low interest rates in developed countries, funds flowed into Asia searching for higher yields. Private capital flows into emerging markets reached $256 billion by 1997 compared to $42 billion in 1990 (Krugman, 2009a: 79).2 Figure 8.1 shows the massive influx of capital (the sum of net direct, portfolio and other investments) into three Southeast Asian countries before the Asian Financial Crisis of 1997 and the large outflows during the Asian and Global financial crises. Net financial flows into Thailand reached US$20 billion in 1996 and turned negative $10 billion in 1998, a swing of $30 billion. Similarly in Indonesia and Malaysia, the swings were too massive for the economies to absorb. Drastic reversal of capital flows led to dramatic fall in currencies that ballooned foreign currency debt and bankrupted corporations and banks alike. The baht plunged from 25 baht to 50 baht per dollar and the rupiah from 2,500 to 15,000 per dollar at the height of the crisis in 1998. What began as a currency crisis in Thailand in July 1997 soon spread to other countries like Indonesia, Malaysia and even South Korea and spilled over to the real economy. Indonesia and Thailand were the hardest hit – banks and corporations collapsed, the economy shrank and unemployment soared – and suffered output loss of 40% of GDP. The fiscal costs of the crisis were estimated at 55% of GDP for Indonesia and 35% for Thailand (Caprio et al., 2003). Net Financial Flows 30000

US$ Million

20000 10000 0 -10000 -20000 -30000 -40000 Indonesia FIGURE 8.1

Malaysia

Thailand

Philippines

Net financial flows for three ASEAN countries, 1990–2013.

Source: ADB Key Indicators for Asia & Pacific (2010a, 2014a).

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The response of international financial institutions and non-Asian countries to the AFC was timid at best and negative at worse. At the G7-IMF meeting in September 1997, Japan proposed to set up an Asian Monetary Fund to assist Asian countries suffering balance of payment difficulties to be funded by Asian countries of which Japan was willing to be the largest contributor. Both the United States and the IMF strongly opposed this Fund on the argument that it would encourage moral hazard. Most likely the reason was the U.S. did not want to set a precedent where regional cooperation or blocs could assert some degree of independence. Hence the Asian Monetary Fund never saw the light of the day (Masaki, 2007; Lipscy, 2003). Instead, the IMF provided rescue packages to Thailand, Indonesia and South Korea and, as usual, imposed its one-size fits all solution and conditions on the crisis-affected countries even though the causes of the AFC were quite different from that of the Mexican financial crisis. Unlike Mexico, the Asian governments did not over borrow; it was mainly the private corporations and financial institutions that had crushing debt, many of which were short-term and in foreign currencies leading to a double mismatch in currency and maturity. The IMF imposed over 100 conditions on South Korea and Indonesia as part of its rescue packages many of which were only remotely related to the immediate causes of the crisis. What rescued the Korean economy was the rollover of short-term debt by foreign lenders. But the IMF took this golden opportunity to totally reform and restructure the Korean economy according to its neo-liberal framework. In the case of Indonesia, the medicine given by IMF aggravated the economic ills of the country. The hike in interest rate to over 10% per annum did not stem the deluge of capital outflow (as evident in Figure 8.1); or the decimation of the rupiah that lost over 80% of its value; instead it smothered the economy as borrowers suffered crushing debt from high interest payment and ballooning principal repayment resulting from currency depreciation. It took over five years for Indonesia to recover. Malaysia also initially followed the IMF prescription but, within a few months, reversed course and implemented anti-cyclical as well as non-conventional monetary and fiscal policies that included capital control measures. These measures helped its economy to recover within two years without any assistance from the IMF. Among the hard lessons Asian countries learned from the AFC was the need to pull up their own bootstraps; to lessen their dependence on the international financial institutions and Western countries; and to strengthen regional cooperation and resources to deal with financial crisis. The failure of the existing international financial system to deal with AFC provided the impetus for Asian nations to search for an alternative RFA.3 The other impetus for greater regional financial and monetary cooperation is market considerations. While European economic and financial integration was driven more by political motives, Asian cooperation and integration is more market driven. Asian intra-regional trade and investment flows have risen over the years. Asian intra-regional trade was 54% of total trade in 2014; its intra-regional

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foreign direct investments accounted for 51% of total investments received in 2012. Asia’s intra-regional portfolio investments were less developed, making up only 15% of total portfolio assets and 20% of total portfolio liabilities in 2013 (ADB, 2014b: 43). The development of an Asian RFA would facilitate more trade and investments.

4. Asian initiatives in RFA – defensive and developmental An international financial architecture should address a number of key issues such as: the role of the U.S. dollar as the predominant international reserve currency; the current global current account imbalances and the accumulation of reserves; the exchange rate regimes of countries; regulation of national financial systems; and governance of the international financial institutions (UNECA, 2011: 21). The failure of the traditional international financial architecture to adequately address these issues prompted countries to develop their own RFA. A RFA consists of two partially overlapping parts – a regional financial system and a regional monetary system. There are two broad objectives for greater regional financial and monetary cooperation – defensive and developmental. The purpose of the defensive objective is to cooperate and pool resources together to overcome regional economic and financial crises – and with this end, the Asian region developed over time a series of institutions and mechanisms to prevent crises, to manage and resolve them. More than a decade’s worth of institution building led in 2000 to the creation of the now well-known Chiang Mai Initiative Multilateral Arrangement (CMIM), a regional arrangement of bilateral swaps and repurchase arrangements among members facing balance of payments problems; and the ASEAN+3 Macroeconomic Research Organisation (AMRO). AMRO was created in 2009 to perform functions of surveillance and monitoring of CMI economies. The Chiangmai Initiative eventually moved from bilateral to multilateral swap agreements. These two institutions play an essential role in the defensive elements of an RFA. However, this chapter focuses attention on the less discussed developmental aspect of an international financial architecture.

5. Developmental pillar of RFA The second, more developmental objective of the Asian RFA is to support increasing trade and investment flows within the region. The main vehicle chosen by the Asian policy leaders to achieve this is through the development and integration of the region’s financial system. In particular, it refers to the development of a regional bond market that is widely believed to also serve the defensive objective of the RFA. Most mainstream economist believe that the over reliance of the Asian financial system on banks is a major contributory factor to the AFC. The banking system constituted over 80% of the financial system in most Asian economies

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while their bond markets were underdeveloped. It was held that banks made short-term loans not suited for capital development, especially infra-structural development that required long-term funding. The maturity mismatch was aggravated when loans were made in foreign currencies to fund local currency investments contributing to currency mismatch. The solution international financial institutions, like ADB and IMF as well as national policy makers, promoted was to develop the local currency bond markets on the belief that these will promote regional financial stability (Park and Park, 2003). Bond market was also seen as providing a mechanism to recycle the massive foreign reserves accumulated within the region.

6. Asian bond market initiatives The ASEAN+3FM in 2003 endorsed the Asian Bond Markets Initiative (ABMI) aimed at promoting liquid and efficient bond markets to mobilize Asian savings for Asian investments. Under the ABMI, the ADB took the primary role in providing technical studies and in supporting the establishment of regional credit guarantee mechanism, regional clearing and settlement system, introducing new securitized debt instruments, and improving local and possibly regional credit rating systems (Yap, 2007: 15). An Asian Bonds Online Website was launched in May 2004. The EMEAP is an active promoter of regional bond markets. It launched the first Asian Bond Fund (ABF1) in June of 2003 harnessing the official reserves of Asian governments and the second (ABF2), a local currency bond, in December 2004. In May 2008, the 11th ASEAN+3FM Meeting agreed on a new ABMI Roadmap to further the development of regional bond markets and to make them more accessible to investors and issuers. Four key areas were addressed: (i) promoting the issuance of local currency-denominated bonds (supply side); (ii) facilitating the demand for such bonds (demand side); (iii) improving the regulatory framework; and (iv) improving infrastructure for bond markets (ADBBondsOnline Website). A steering group and four task forces were established to implement these objectives. In June 2010, the ASEAN+3 Bond Market Forum (ABMF) met in Tokyo to discuss how best to harmonize regulations and market practices in Asian local currency bond transactions. A regional bond market would entail the development of institutional infrastructures such as harmonization of tax rules, setting common standards for bond issuance, development of cross-border clearing, settlement, payment and depository systems, and regional credit rating agencies. Most of all, a developed bond market requires free convertibility and free capital flows. The sine qua non in capital markets is ample market liquidity for individual investors, the ability to buy and sell at an instant, to dip in and out of markets. Much of the discussion on bond markets is predicated on foreign investors from countries with surplus investing in local bond markets of countries with deficits.

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Foreign investors will not be encouraged to buy local currency bonds if they do not have ready and full access to local currency or be able to borrow, buy and sell the currency freely. As many Asian countries still place restrictions on availability for borrowing in local currencies, this constraint, rather than technical infrastructural issues, is the greatest obstacle to the full development of regional bond markets. An important institution promoting bond market is a bond guarantee company. In November 2010, the Credit Guarantee and Investment Facility (CGIF) was set up as a trust fund of the ADB. CGIF provides guarantee for local currency denominated bonds issued by investment grade companies in the ASEAN+3 countries. These companies are rated by either domestic rating agencies of each country, like RAM in Malaysia, or international rating agencies likely Standard and Poor’s. There is as of now still no regional rating agency for Asia. CGIF received initial capital contributions of US$700 million from ADB ($130 million), China and Japan ($200 million each), South Korea ($100 million) and ASEAN ($70 million) (CGIF website). By providing guarantee, CGIF assists companies to tap local bond markets for longer-term funding. Initially the business will not be leveraged, that is, the guarantee will be supported solely by its own capital, but as its business grows the leverage will increase.4 As at year-end 2014, CGIF guaranteed the bonds of seven companies from Indonesia, Singapore, Thailand and Vietnam with total outstanding guarantees of $740 million (CGIF, 2014).

7. Performance of bond markets Figure 8.2 shows the rapid growth of the local currency bond market in Asia (excluding Japan). This market rose ten-fold between 2000 and 2015, from $836 billion to $8.3 trillion.5 Of this amount, 60% were government bonds and 40% corporate bonds in 2105. In terms of GDP, Korean LCY bond market is 120% of its GDP, followed by Malaysia at 100%, Singapore at 80%, and Thailand at 70%. Indonesia, the Philippines and Vietnam have the least developed LCY bond markets. Government bond markets are larger than corporate bond markets in all the countries except Korea. Malaysia’s corporate bond market is highly developed because it is a major issuer of Islamic bonds (sukuk).6 A major source of financial instability to host countries issuing LCY bonds comes from the high percentage of ownership of these bonds by non-residents. The price of local currency bonds as well as local currencies rise and fall with the surge and ebb in foreign capital. For a small economy these fluctuations pose systemic risk to the economy. The percentage of foreign holdings in LCY government bond has been rising in all these countries. See Figure 8.3. This is most pronounced in Indonesia and Malaysia. In 2015, 38 and 31% of the respective governments LCY bonds are held by non-residents. Japan has the lowest percentage of government bonds held by foreigners (9%).

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Growth of Asian local currency bond markets (excluding Japan).

FIGURE 8.2

Source: ADB, AsianBondsOnline. 45 40 35

as % of Total

30 25 20 15 10 5 0

Mar 2000

Sep 1998 ID

FIGURE 8.3

JP

KR

Sep 2001 MY

Mar 2003 TH

Sep 2004

Mar 2006

Sep 2007

Mar 2009

Sep 2010

Mar 2012

Sep 2013

Mar 2015

Date

Foreign holdings of LCY government bonds, 1998–2015.

Source: Ibid.

It is widely believed that local currency bonds are less risky than foreign currency bonds because investors, rather than borrowers, take on foreign currency risks. Hence, international financial institutions like ADB have vigorously promoted local currency bond market thinking it will promote financial stability. However, like the paradox of thrift, what applies at the individual level does

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not necessarily apply at the systemic level demonstrating the fallacy of composition. While individual issuers of local currency bonds are not at risk if foreign currency appreciates, that is local currency depreciates, the same cannot be said for the economy as a whole. Erratic and rapid capital inflows and outflows into bond and stock markets whip saw the value of local currencies posing risks for the economy. Tett (2014) makes the same point that issuing local currency bonds have not spared emerging countries from volatility.

8. Critical assessment of bond market7 Mainstream economists promote local currency bond market as a source of financial stability. Bond markets (direct financing) are seen as a supplement to bank financing (indirect financing), acting as spare tire to the financial system. Many of these writers claim, with scant empirical evidence, the many supposed benefits of a well-developed bond market which include: efficient allocation of capital, effective evaluation and monitoring of investment activities, maximization of economic welfare, decreased volatility of capital flows and reduced vulnerability to financial crises (MAS, 2007: 46, 68–9; Park and Park, 2003: 10; Bhattacharya, 2011: 4–6). Others like Hakansson (1999) go to the extent of claiming that a well-developed corporate bond market “fosters an efficient corporate financial structure, the presence of rating agencies, a proliferation of financial derivatives, and other means to reduce systemic risk and avoid crises;” and Herring and Chatusripitak (2000) assert that the lack of a well- developed bond market may reduce the efficiency of an economy and may increase vulnerability to a financial crisis (cited in Bhattacharya, 2011: 6). How valid are these claims?

9. Liquidity-stability trade-off Bhattacharya (2011) postulates several hypotheses regarding the determinants of bond market development. Among these is a positive relationship between stable exchange rates and bond market development as the former poses low risks to investors and therefore encourage bond market development. However, the tradeoff between liquidity and financial/economic stability is not addressed. The sine qua non in capital markets is liquidity, the ability to dip in and out of markets. This exacerbates, rather than reduces, exchange rate volatility. An ADB article emphasized this aspect, “Common trading standards would make it faster and cheaper for investors from across the region to dip in an out of their neighboring markets” (ADB, 2010b. Emphasis added). It is exactly this divergence between the benefits of liquidity to individual investors and the macro-economic costs to host economy, particularly to smaller economies, in terms of vulnerability to volatile exchange rate and capital flows that proponents of bond markets have not addressed. On the contrary, a typical view can be found in Park and Park (2003: 2) where they wrote, “Had there been

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efficient domestic bond markets, foreign investors locked in bonds could not have left East Asia as banks and other investors hurriedly did.” But the evidence points to the contrary. During the recent Global Financial Crisis of 2007/2008, foreign investors faced with financial crisis in their home countries hastily divested their overseas investments to cover up for losses in home countries, leading to big fall in stock and bond markets of host countries. Foreign ownership in Malaysian and Indonesian debt markets have risen sharply in recent years. Indonesia’s external debt (foreign plus local currency debt) rose 230% from $129 billion to $293 billion between 2006 and 2014, while that of Malaysia doubled in six years from $110 billion to $226 billion (2009–2014). High exposure to foreign ownership of capital markets (stocks and bonds) increases the vulnerability of host economies to erratic capital flows and financial instability. During the AFC, many Asian borrowers took on foreign currency debt exposing themselves to foreign exchange risks. International financial institutions like ADB therefore promoted local currency debt as a way to transfer the currency risks to foreign creditors. While the individual borrower is relieved of currency risks, the problem reappears as exchange rate volatility at the country level. When foreign investors dump local stocks and bonds, they sell local currencies leading to depreciation of local currencies. During the taper tantrum of 2013, and the rise in U.S. interest rates in 2014, Indonesian and Malaysian currencies dropped significantly and were among the worst performers in Asia.8 The Indonesian rupiah fell from 9,000 to over 12,000 to US$1 between mid2013 and early 2014, while its stock market index fell from 5,100 to 4,200, and the Indonesian ten-year government bond yield rose by over 300 basis points. Between mid-2014 and June 2015, the Malaysian Ringgit has depreciated over 20% to US$1 = RM3.77. HSBC economists note that the ringgit is highly vulnerable to U.S. raising interest rate and investors selling long-dated bonds. The Malaysian bond market is highly correlated to the U.S. Treasury market (FT, 2015). A recent research by Akyuz (2015) validates the above points for emerging market economies. It shows how with further liberalization of capital flows and with emerging market economies becoming more integrated to international capital markets, the risks of financial instability increased. Greater foreign participation in bank debt, equity and bond markets opens more channels for transmission of shocks to the currency and capital markets. Most foreign ownership of government bonds are held not by central banks but by private investors who are fickle and footloose. Capital markets are predicated on liquidity for investors. It is this liquidity that causes extreme volatility and instability to smaller emerging market economies. This is particularly true in times of widespread financial crisis, as was the case with the collapse of Lehman Brothers in the Great Financial Crisis of 2007–2009. Despite strong macro-economic fundamentals and healthy corporate balance sheet in Asian economies, foreign investors in the stock and bond markets withdrew massive amount of funds to meet redemption and liquidity

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Pecent Change in Equity Indices

150

100 2007 50

2008 2009

0

2010 Indonesia

Malaysia

Philippines Thailand

Vietnam

-50

-100 FIGURE 8.4

Percent change in equity indices of five ASEAN countries.

Source: World Bank development indicators.

problems in their home countries, causing declines in the equity and bond markets of host countries that were greater than the drop in their countries of origin. Figure 8.4 shows the volatility in stock markets for five ASEAN countries during the 2007–2009 financial crisis. These Asian economies could not sustain massive capital flight without serious negative effects on their real economy. This is one of the dark sides of capital markets that Keynes highlighted. To quote him, “… with the development of organized investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes add greatly to the instability of the system” (Keynes, 1936: 150–151. Emphasis added). Unfortunately, mainstream literature on bond market development in Asia ignores this problem. For Keynes, the concept of liquidity applies only to individual investors and not to the investment community as a whole. It is worth quoting at length his insights on the concept and effects of liquidity: Of the maxims of orthodox finance none, (sic) surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. The social object of skilled investment should be to defeat the dark forces of time and ignorance, which envelope our future. The actual, private object of the most skilled investment to-day is to “beat the gun”… to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow. (Keynes, 1936: 155)

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10. Regional development bank9 There are two ways to finance long-term development – through indirect financing (banks) and/or direct financing (capital markets). In direct financing, borrowers approach financial markets directly through bond and stock issuance. Investors desire the ability to buy and sell securities to shorten their holding period according to their preferences. This ability to buy and sell at an instant results in price instability and in extreme cases to cycles of boom and bust. The financing is transaction oriented. After the issuance of securities, there is no relationship between borrower and investor. This is the Anglo-American model of financial development in which capital markets (stock and bond markets) predominate over bank lending. Indirect financing, refers to financing between borrowers and lenders through an intermediary, usually banks. The financial intermediary engages in maturity transformation and undertakes liquidity risks that can end up in insolvency in extreme cases. In contrast to direct financing that is transaction oriented, the building and maintenance of good relationship between borrower and lender is important. In their zeal to correct Asian economies over-dependence on banking system, mainstream economists have overlooked the risks associated with direct financing or to consider what type or mix of financing structure can best promote stable, long-term economic growth. They have neglected to understand the critical role that development and long-term credit banks have played in the economic development of countries like Japan, South Korea and Germany. During the rapid industrialization of Japan after World War II, Japanese companies depended on private banks and public postal banks to provide financing. Under the “kereitsu” system, corporations maintained close ties with banks that were enhanced through cross-holding of shares. This system was designed to achieve stable, long-term relationship and performance rather than short-term, transactional business to maximize profit (Cargill and Royama, 1988: 43–48). Long-term credit banks and trust banks working closely with the government-owned Japanese Development Bank were the main providers of capital. These institutions provided loans to targeted industries like iron and steel, railway and shipping, coals as well as manufacturing industries like chemicals, cement, and textile. To mitigate against information asymmetry and credit risks, these banks built up in-depth credit knowledge of customers and even sent staff to work in their companies for extended period. The overall conclusion of a major study on the Japanese banking system is, in the words of one of the authors, “In the economic and financial environment of the high growth era the main bank system matured and flourished. It represented a successful solution to a key developmental problem: how to finance large industrial enterprises efficiently and effectively” (Patrick, 1994: 388); and “The problems and difficulties the Japanese financial system and its banks faced in the 1990s, … do not undermine the fundamental lessons of the Japanese case” (Ibid: 406).

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Other recent experiences of successful use of public institutions for long-term development include the European Investment Bank (EIB), the Bank of North Dakota (BND), and the Brazilian Development Bank (BNDES).10 These institutions are well managed and focused on long-term funding, are not into speculative investments, and not obsessed with high and unsustainable rates of return. They have managed better over the period of the global financial crisis than the Anglo-American commercial/investment banking models. A recent paper by Bordo et al. (2011) analyzed why Canada did not suffer a banking crisis in 2008 or even earlier in the 19th and 20th centuries, while the U.S. repeatedly experienced such crises. In Canada, the federal government could charter nation-wide banks and allowed a few large banks to function in an oligopolistic but well-regulated manner. While these may be slow on innovation, they have the advantage of preserving financial stability; there were many instances of bank failures but few that led to bank panics and crisis. In contrast, banking panics and crises were recurrent in the history of the U.S. since the 1830s. The inability of weak and fragmented state banks to finance large scale and long term projects created the space for capital markets to step into their shoes. In other words, the co-existence of a fragmented banking system with an unregulated investment and shadow financial system created the conditions for recurrent financial instability. Clearly, there are costs and benefits associated with each type of financing. The type or mix of financing chosen in a country depends on its historical and current conditions and objectives of development. The primary role of finance is to serve the productive and real economy, not the other way round. The objectives of development are to create long-term, stable, balanced and equitable growth. Too often means like creating a deep and liquid financial market or the idea of financial integration is confused for ends. While capital markets are efficient in mobilizing capital to move freely and quickly across borders, they come at great social and economic costs. These have to considered and balanced. The promotion of long-term development banks at both a regional and national level should be a pillar of the RFA. Unfortunately this has not been given much attention in the present agenda. At present, the only development bank in Asia is the ADB. The size of ADB is small compared to that of EIB and BNDES. The value of loans disbursed by ADB was $10 billion compared to Euro 64 billion (US$80 billion) for EIB and Real 156 billion (US$78 billion) for BNDES. See Table 8.1. Furthermore, ADB, dominated by Japan and the U.S., each with 13% voting rights, follows closely the World Bank and IMF models of operation, while China has only 5.5% voting rights. Frustrated by the unbalanced governance structure and the slow pace of reform coming from U.S. resistance to give China a greater voice in international financial institutions, China in 2013 floated the idea of setting up a new regional/international financial institution.11 This new organization aims to finance the huge infrastructure investments requirements in Asia, estimated by an ADB study at $800 billion annually from 2010–2020.

218  Mah Hui Lim TABLE 8.1 Selected financial indicators of ADB, EIB and BNDES

In billions

ADB (2014) US$

EIB (2014) Euro*

BNDES (2012) Real**

Total Loans outstanding Loans disbursed for the year Total assets Net worth Net income

56 10 116 17 0.4

471 64 542 38 2.6

492 156 715 52 8.1

Source: Financial reports of the respective banks. Notes: * US$ = Euro 0.8; ** US$1 = Real 2.

With great speed, characteristic of the Chinese, they managed to gather 21 countries to sign a memorandum of understanding to set up the Asian Infrastructure Investment Bank (AIIB) in October 2014. Despite strong objections and pressure from the U.S., countries closely allied to the U.S., like Australia, South Korea and the U.K., joined the AIIB. As of April 2015, 57 countries signed up as prospective founding members. Japan and the U.S. did not join the bandwagon (Wikipedia). The proposed authorized capital of AIIB is set at $100 billion. If the failure of Asia to set up the Asian Monetary Fund in 1997, a result of U.S. objection, is indicative of U.S. dominance over the international financial architecture, China’s success in establishing the AIIB in 2015, despite strong US resistance, signals the declining influence of the U.S. in the international financial system. There is room for healthy competition in the field of development banks. The AIIB is focused only on financing large-scale infrastructure projects. There are other fields that are equally important to promote and finance in Asia. Among these are small- and medium-sized enterprises (SMEs) and micro-finance. SMEs make up the overwhelming majority of business enterprises by numbers in Asia. For example, SMEs make up 98.5% of businesses, and contribute 31% of GDP and 59% of employment in Malaysia (Poo, 2013). Yet most are starved of financing. Only 45% of total bank loans in the country go to businesses while 55% goes to financing household debt; and most business loans go to large or listed companies. Large scale financing from banks or from bond markets often does not reach small medium enterprises. Yet, they provide the largest amount of employment for the people. Regional and national development banks should be set up to meet the needs of these businesses. There are recent calls by the ASEAN Business Advisory Council Chairman to set up a regional bank for micro, small and medium enterprises (Lim, 2015).

11. New business model Should the new financial architecture follow the dominant EVA (economic value added) business model in the market place? Put simply, the EVA model preaches that the only and sole objective of a business is to maximize shareholders value.

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All other objectives like meeting consumers’ needs, taking care of employees’ welfare, providing high quality products, contributing to corporate governance, and meeting social responsibility are peripheral. EVA is the sole criterion used to measure the performance of every individual, department and institution. When pushed to its extreme, EVA produces distorted organizations at the institutional level, best illustrated in the banking industry. To maximize EVA, that is, to get the highest return from capital, banks are pushed to maximize leverage and to focus on businesses that use the least amount of capital, yielding the highest returns. Therefore giving out loans, the mainstay of traditional banking is deescalated as it consumes too much capital and lowers EVA. Instead activities such as trading currencies, securities, and derivatives that use less capital are promoted. The objective and model is for banks to become non-lending banks. The primary function of a bank, to provide loans, has been supplanted and replaced by the functions of speculation and trading. At a personal level, requiring bankers to maximize EVA pushes every individual banker to maximize profit. This incentive structure encourages the banker to maximize short-term rewards without regard to long-term risks and consequences (see Lim and Lim, 2010: 54–58). While there is little quarrel over the need for a project or enterprise to yield positive net present value, the larger question is what is an acceptable level of profit? Should profit be maximized at the expense of public good? This problem is particularly acute for the banking and financial industry. Banks are in the business of financial intermediation; they borrow to lend. They are in a position to borrow and lend many times their capital. In the period preceding the Great Financial Crisis, U.S. banks, especially investment banks, were leveraged up to 40 times their capital; the higher the leverage, the higher the return on capital, but the greater the risks. The era of light regulation gave banks and financial institutions the golden opportunity to cut corners, to over-leverage and to engage in risky businesses in order to achieve the objective of maximizing return to shareholders. The result was the greatest financial crisis since the Great Depression. This business model is unsustainable and generates high social and economic costs. The limits of this model are beginning to be questioned by not only some business schools but also prominent businessmen. Ho Kwon Ping, a leading businessman in Singapore and also the chairman of the board of trustee of Singapore Management University, in a speech to an international business conference, advocated a shift away from the profit-maximization model to a more balanced performance model that takes account the interests of other stakeholders (Ho, 2011). If leaders in the private sector recognize the limits of the EVA business model and the need to develop alternative business models, what more for public corporations and institutions. The regional and national development banks in the new financial architecture should adopt the concept of socially acceptable rate of return rather than that of maximizing shareholders return. These banks should undertake projects that are financially sound, ecologically sustainable, promote long-run stable growth and are welfare maximizing. Governments should pool their resources to fund these banks and set the broad objectives for these institutions. They should

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then hire professionals to manage them in accordance with those objectives and guidelines. Thereafter, there should be no political interference in the day-today management. The best practices of corporate governance in the private and public sectors should be combined.

12. Conclusion The post-Bretton Woods international financial system marked by financial deregulation and liberalization resulted in free capital flows and floating exchange rate system for many countries. Volatile capital flows have heightened financial instability and led to financial crises in many parts of emerging market economies. The failure of the current international financial architecture to assist Asia resolve the AFC in the late 1990s, particularly the objection by the U.S. and IMF to establish an Asian liquidity support fund, pushed these countries to find a regional solution to the problem. The Asian RFA has two goals (defensive and developmental objectives) and three pillars – regional forums for closer policy dialogue and coordination; a liquidity support fund (the CMIM) with an institution for economic surveillance (AMRO); and the development of local currency and regional bond market. Under the defensive objective, the ASEAN+3 countries set up mechanisms for crisis prevention, management and resolution. These included establishing a regional network and forums among political leaders and policy makers to promote better exchange of information and policy dialogues; more effective economic surveillance and early warning systems, and cultivation of peer review and pressure to maintain healthy macro-economic fundamentals. With frequent and regular meetings among the countries’ finance ministries and central banks’ officials, considerable progress has been made. The most visible and significant achievements in this area are the establishment of the now well-known Chiang Mai Initiative Multi-lateralization (CMIM) fund and the ASEAN+3 Macroeconomic Research Organization (AMRO). The first is a multi-lateral swap arrangement among the ASEAN+3 economies to provide liquidity support to member countries with balance of payment problems. The second is the economic research and surveillance organization to monitor the economic health of member countries and the region, and to provide logistic support to the CMIM. AMRO plays a critical role for the success of the CMIM fund; the more it is able to build up its capacity and credibility, the more the region is able to wean itself from IMF conditionality when accessing CMIM funds. Large swings in capital flows cause exchange rate volatility and financial instability. Mechanisms for enhancing exchange rate cooperation can reduce pressures for competitive devaluation, and capital controls coordination can lower capital flows volatility, particularly in the management of excessive capital inflows. These should form part of the toolkit in an RFA. However, there is little effort made in these two areas as many of the Asian countries are more inclined to promote freer capital flows and deeper integration with the global financial system.

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In terms of the developmental objective in Asia’s RFA, most of the effort is towards developing local currency bond markets to tap the large amount of foreign reserves held by Asian countries and to promote closer regional financial integration. However, in their zeal to promote bond markets, the risks of greater financial instability associated with capital markets are overlooked. Attention needs to be given to develop another pillar of an RFA, that is, the establishment of long-term regional and national development banks as a means to promote stable and long-term growth with less risk of volatile capital flows.

Notes 1 Parts of this section are based on the discussion in UNECA (2011). 2 All $ are in U.S. dollars, unless otherwise specified. 3 Prior to this, there was no structure or forum in Asia to deal with regional financial issues, except for EMEAP (forum for central bankers of ASEAN and other Asian countries) set up in 1991 that became active after the AFC. 4 In the 1990s ADB was a shareholder in Asia Credit, a bond guarantee company, based on the model of typical bond insurers like MBIA and AMBAC. In fact, MBIA was also a shareholder and technical manager of Asia Credit. The operation was highly leveraged as is usual for a bond insurer. During the AFC, the company experienced severe losses as claims mounted against its insured companies that were impaired. Eventually, Asia Credit was wound up suffering major losses. 5 If the Japan bond market is included, the total is $17.5 trillion. 6 Sukuk is a financial certificate issued in accordance with Sharia, Islamic laws that prohibit interest payment. Hence, the issuer sells the certificate to the investor and rents it back for a predetermined rental fee, and also promises to buy it back at a future date at par value. It is the Islamic equivalent of a bond. 7 The discussions in this and the following section are from Lim and Lim (2012: 33–36). 8 There are other variables contributing to their weak currencies. In the case of Indonesia, they are current account deficit and falling commodity prices; for Malaysia they are falling commodity prices and a major financial scandal (the 1 MDB debacle). 9 This discussion is derived from the author’s earlier paper (see Lim and Lim, 2012). 10 For more detailed discussion of these institutions, see Lim and Lim (2012: 40–44). 11 Bernanke said the reluctance of the US Congress to grant China a greater say in international financial institutions pushed China into establishing the AIIB (Pilling and Noble, 2015).

References ADB (Asian Development Bank), AsianBondsOnline Website. ADB, 2010a. Key Indicators for Asia and Pacific. ADB, 2010b. ASEAN+3 Forum Discusses Harmonizing Asia’s Bond Markets. September 28, 2010. http://www.adb.org/news/asean3-forum-discusses-harmonizing-asiasbond-markets. Accessed June 14, 2015. ADB, 2014a. Key Indicators for Asia and Pacific. ADB, 2014b. Asian Economic Integration Monitor, November. Akyuz, Yilmaz, 2015. Internationalization of Finance and Changing Vulnerabilities in Emerging and Developing Economies. Research Paper 60, January. South Centre, Geneva. Bhattacharya, Biswa Nath, 2011. Bond Market Development in Asia: An Empirical Analysis of Major Determinants. ADBI Working Paper Series, No. 300, July.

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Bordo, Michael D., Angela Redish, and Hugh Rockoff, 2011. Why Didn’t Canada Have a Banking Crisis in 2008 (OR in 1930, OR 1907, OR…)? Working Paper 17312. National Bureau of Economic Research. http://www.nber.org/papers/w17312. Caprio, Gerard, Daniela Klingebiel, Luc Laeven, and Guillermo Noguera, 2003. Banking Crises Database. Washington D.C.: World Bank, October. Cargill, Thomas F. and Shoichi Royama, 1988. The Transition of Finance in Japan and the United States: A Comparative Perspective. Palo Alto: Hoover Institute, Stanford University. FT (Financial Times), 2015. Markets. “Malaysia’s Ringgit Hits 9-year Low”. http:// www.ft.com/intl/fastft?q=Malaysia%27s+Ringgit, June 8. Hakansson, N., 1999. The Role of a Corporate Bond Market in an Economy and in Avoiding Crises. Research Program in Finance. Berkeley: Institute of Business and Economic Research, University of California. Herring, R. and N. Chatusripitak, 2000. The Case of the Missing Market: The Bond Market and Why It Matters for Financial Development. Paper presented at The Asian Development Bank Institute / Wharton Seminar, on Financial Structure for Sustainable Development in Post-Crisis Asia. Tokyo, May 26. Ho, Daniel, 2011. “F” for Ethics in Business Schools: Ho Kwon Ping. Straits Times, July 25, p. B15. Keynes, John M., 1936. The General Theory of Employment Interest and Money. London: Macmillan. Lim, Mah Hui and Joseph Anthony Lim, 2012. Asian Initiatives at Monetary and Financial Integration: A Critical Review. Research Papers No. 46. South Centre, Geneva. Lim, Mah Hui and Lim Chin, 2010. Nowhere to Hide: The Great Financial Crisis and Challenges for Asia. Singapore: Institute of Southeast Asian Studies. Lim, Wing Hooi, 2015. Set up MSME Bank, Please. The Star. SMEBiz, May 11. Lipscy, Phillip Y., 2003. Japan’s Asian Monetary Fund Proposal. Stanford Journal of East Asian Affairs 3 (1):93–104. MAS (Monetary Authority of Singapore), 2007. Asian Financial and Monetary Integration: Challenges and Prospects. Singapore: Monetary Authority of Singapore. Masaki, Hisane, 2007. Asian Monetary Fund? May 10, 2007. http://english.ohmynews. com/articleview/article_view.asp? at_code=409447. Park, Yung-Chul and Daekeun Park, 2003. Creating Regional Bond Markets in East Asia: Rationale and Strategy. Paper presented at the Second Annual Conference of PECC Finance Forum, Hua Hin, Thailand, July 8–9. Patrick, Hugh, 1994. The Relevance of Japanese Finance and Its Main Bank System. In Aoki, Masahiko and Hugh Patrick, eds. The Japanese Main Bank System: Its Relevance for Developing and Transforming Economies. New York: Oxford University Press. Pilling, David and Noble, Josh, (2015). US Congress pushed China into launching AIIB, says Bernanke, Financial Times, June 2, 2015. Available at https://www.ft.com/ content/cb28200c-0904-11e5-b643-00144feabdc0. Poo, Chermaine, 2013. Financing for SMEs. The Star Online, September 27. Tett, Gillian, 2014. Emerging markets repent of ‘original sin’. Financial Times, April 18, 2014, Available at https://www.ft.com/content/f9e44cc6-c676-11e3-9839-00144feabdc0. UNECA (U.N. Economic Commission for Africa), 2011. Reform of International Financial Architecture and Policy Implications for Africa. Policy Research Paper, No. 1. Yap, Josef T., 2007. Ten Years After: Financial Crisis Redux or Constructive Regional Financial and Monetary Cooperation? Discussion Paper Series No. 2007-05. Philippines Institute for Development Studies, June. Also websites and annual reports of Asian Development bank, Bank of Indonesia, Bank Negara, Bank of Thailand, ADBI, IMF and others.

PART 3

Regional transformation and growth in practice – it’s more than money

9 INDUSTRIAL STRUCTURE, INTRAREGIONAL TRADE AND FINANCIAL COOPERATION IN SOUTH AMERICA Challenges, links and hidden opportunities André Biancarelli, Célio Hiratuka and Fernando Sarti

1. Introduction The first decade of the 21st century was marked by important changes in the political and economic landscape of South America. The external bonanza, characterised by an extraordinary rise in international commodity prices, together with a “high tide” in the international liquidity cycle, was the basis for a period of higher growth rates. There was also a shift by national governments in ideological orientation and policy options following the failure of the liberalising reforms of the 1990s. Probably the most important outcomes of this period were the unprecedented developments in social issues. Moreover, in diplomatic terms, the regional integration process also gained a renewed impulse and meaning. The rejection of the United States-led Free Trade Area of the Americas (FTAA) and the creation of the Union of South American Nations (UNASUR, the Spanish acronym for Unión de Naciones Suramericanas), among other initiatives, seemed to pave the way for a move towards a post-liberal regionalism, different from moves towards free trade areas that were so predominant in the previous decade. Regional blocs added some novel goals to their agendas, including the reduction of asymmetries between members, socio-cultural integration and financial cooperation. Even in that favourable context, however, the economic aspects of South American integration faced limitations. The significant increase in exports and the relaxation of external constraints that had been a major problem confronting the region until the beginning of the 2000s also resulted in increased imports. Although part of this growth was directed to the regional market, a more significant share was associated with an increase in imports of manufactured goods from outside the region, especially from Asia. This reveals the difficulty in transmitting demand growth to intraregional trade. More than that, the share of intra-industry trade was also small in most sectors, revealing that integration of production and industrial complementarity in the region remains weak.

226  André Biancarelli et al.

With the unfolding of the international financial and economic crisis and the development of a complex “post-bonanza” scenario, these challenges for the region have been significantly greater than during the commodity boom, both in financial and productive terms. On the one hand, financial flows are more volatile and very sensitive to adjustments in the monetary policies of central economies. On the other hand, due to more intense international competition in the production of manufactured goods, the industrial development of South American countries that are struggling to compete with extraregional imports, especially from China, is even more difficult. In this challenging context, it is appropriate to consider whether regional integration could help countries steer through these difficult times with an agenda that fosters greater regional financial cooperation and complementarity of production, both commercially and in terms of regional foreign direct investment (FDI). In other words, it is important consider to what extent the various instruments of financial cooperation could help strengthen countries’ resilience to balance-of-payments crises and also contribute to productive restructuring. Increasing regional trade and complementarity of production (via trade and investment), promoting employment and incomes, and fostering regional competitiveness are goals that do not conflict with financial goals, such as ensuring short-term liquidity and, especially, long-term development financing. On the contrary, the former goals would support the financial goals. In that sense, this chapter seeks to analyse, through an integrated approach, the productive/commercial and the monetary/financial challenges observed in the South American integration process. Coherent with the broader agenda of post-liberal regionalism, cooperation efforts need to go far beyond trade agreements or tariff reductions. However, the argument for monetary and financial cooperation efforts could (and should) be reinforced if it is linked to the productive situation of the region. This chapter is organised as follows. Section 2 below paints a general picture of the challenging external environment that South American economies are facing today. Section 3 presents a quantitative description of industrial production as well as the productive structures of the countries of the region and their evolution. It reveals considerable heterogeneity and the threats of regression. Section 4 focuses on trade issues. It investigates extraregional and intraregional trade in South America and its slowdown in recent years. Section 5 focuses on financial integration, assessed through quantitative indicators of FDI flows and stocks. It also considers the outlook for initiatives of regional financial cooperation in the region. Finally, alternative routes to enhance regional integration are identified, with a particular focus on the opportunities opened up by regional infrastructure projects.

2. Growing challenges: South America and the global economy The alternating good and bad phases of external conditions, which have deep impacts on developing countries’ economies, are a common feature of their

Industrial structure & trade in South America  227

economic history. From 2002 to 2003 onwards, the South American region experimented during one of the positive periods, defined by Ocampo (2007) as the “Latin American bonanza”. It was characterized by a combination of historically high commodity prices and an exceptional level of financial flows. The shifts in domestic policies, especially anticyclical fiscal efforts and international reserve accumulation were important developments, but there is no doubt that the external environment was the major determinant of the good performance of the South American economies. There was a rapid increase in international trade before the 2008 crisis, not only in terms of total world trade, but also in developing countries taken as a group, as well as in South America (Figure 9.1). After the crisis, however, the main feature has been the “decoupling” of the global trend and that of developing countries. South American exports in this new context are clearly falling behind. As discussed by UNCTAD (2005), among many others, at the beginning of the process of seeming decoupling, China’s emergence in the global trade arena was the main driver of the changes. The dynamics of global trade during the first phase could be viewed as a powerful engine, with three main gears: the first one linked United States’ final consumption with China’s production; the second linked China with its Asian neighbours that produced inputs and high-tech components for Chinese manufacturing; and finally the demand from China was linked to different commodity producers, mainly in Africa and South America. From 2003 to 2008, this engine was operating at full blast, and one of its consequences was the rise in commodity prices (Figure 9.2), thanks to the third gear. After 2009, however, this dynamic

World

200

Developing Economies

South America

180 160 140 120 100 80

FIGURE 9.1

World trade (exports) index, January 2005−January 2015 (2005 = 100).

Source: UNCTADstat.

228  André Biancarelli et al.

FIGURE 9.2

Capital flows to emerging market economies as a share of GDP, 2000−2016.

Source: Institute of International Finance.

was partially dismantled with the reduction of the first chain of impulses (from the United States to China). In response, the Asian shifted its exports of manufactures increasingly to alternative markets, particularly South America, where demand remained strong. As a result, the latter’s intraregional trade, which had been robust during the pre-crisis period, began to decline. Meanwhile, the prices of basic commodities, which had slumped in 2008, began to rise thereafter. Thanks to the rebounding of China’s economy and of speculative operations in futures markets, the rapid upward trend resulted historical highs for many commodities until 2011. Thereafter, however, depending on the commodity group, there has been a declining trend, and since the second half of 2014 prices have been plummeting. This is attributed to fears of “normalisation” in international monetary conditions (discussed below), as well as to specific factors affecting each of the commodity markets and, especially, to deceleration and threats to China’s economic dynamism. On the financial side, the post-bonanza period was also different (but not exactly the opposite) from the bonanza period. International capital flows to emerging markets since the beginning of the century, have been marked by periodic oscillations (Figure 9.2) best described as “liquidity cycles”. After the surge during the bonanza period, a typical “sudden stop” occurred in 2008 and 2009, but this time the recovery was also intense and strong. In absolute terms, the levels of private financial flows in 2010 were already higher than the 2007 levels, and they kept rising until 2013. The post-crisis flows were high even as a share of GDP − far from a long “drought” that may have been expected in the aftermath of the financial turmoil in 2008.

Industrial structure & trade in South America  229

The main reason for this fast recovery, as widely recognised, were the unusual expansionary monetary conditions in central economies, a by-product of the crisis that, despite the disappointing results of the “real economy”, encouraged a strong “search for yield” in markets with higher returns. Similar to the movements of commodity prices, however, the moderation in capital flows since 2013 can be linked to a more uncertain scenario, where sources of some financial stress in different markets, have combined with continuing low dynamism, and, during the past three years, the slow “normalisation” of monetary policy in the United States. This last “threat” to an environment that had seen abundant liquidity, started surfacing in 2013 with the beginning of the first “quantitative easing” reversion and, more than two years later, resulted in the first interest rate hike by the Federal Reserve of the United States in almost a decade. Against this background, the external situation of South American economies can be described as challenging. Certainly, the bonanza period and even the relatively favourable conditions of 2010−2013 came to an end. And there are obvious vulnerabilities to a permanent reversion of the cycles from the trade and financial sides. But the situation varies among countries and, in general, it is better, than it was during the previous episodes of financial instability and international crisis. Figure 9.3 gives an idea of the effects of this changing global economic and financial environment to the external situation of South American countries since 2000. The combination of a long-term improvement in the terms of trade contributed to an appreciation of real effective exchange rates – especially in the economies with greater access to international financial markets such as Brazil, Colombia, Chile and Uruguay, and also in the Plurinational State of Bolivia and the Bolivarian Republic of Venezuela. In these latter two countries the main impact came from the price of basic commodities. In some countries more than in others, the healthy current account of the early 2000s was reduced or even turned into deficit, and once again the possibility of attracting international capital flows seems decisive.

3. Heterogeneity and regression: industrial production and structure The contrast between the “bonanza” period and the post-crisis period is quite evident in other aspects beyond external accounts. It is important to point out that the 2003−2008 period was not only a time of high commodity prices, but also of a synchronised boom in the world economy. This resulted in significant growth of global industrial production following the high growth rates of global GDP. From this angle, the picture is similar to the dynamics described in the previous section. Although industrial production accelerated in all regions between 2003 and 2008, it was much more pronounced in the emerging economies than in the developed economies (Figure 9.4). Industrial growth in the emerging economies was clearly led by Asia, driven by the growth of China. Latin America’s

230  André Biancarelli et al. 120

15

110

10

100

5

90

0

-2

80

-5

-4

70

-10

140 130 120 110 100 90 80 70 60

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Argentina

6 4 2

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6

Chile

-6

130 120 110 100 90 80 70 60 50 40

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Paraguay

110 100 90 80 70 60

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-2

-2

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-4

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60

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Uruguay

115 110 105 100 95 90 85 80 75 70

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

4

110 100 90 80 70 60 50 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

50

-4

160

FIGURE 9.3

60

0

180

Peru

70

-2

4

4 3 2 1 0 -1 -2 -3 -4 -5

80

2

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Colombia

90

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

2 1 0 -1 -2 -3 -4 -5 -6

100

4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

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110

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

3 2 1 0 -1 -2 -3 -4 -5

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140 120

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40 20

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

8

Current account as a % of GDP, terms-of-trade index (2010 = 100) and real effective exchange rate (2005 = 100), selected countries, 2000–2014.

Source: CepalStat.

performance followed the global trend closely, though it was well below that of the emerging economies. In the post-crisis period, overall industrial production continues to be led by Asia, while developed countries and Latin America are lagging behind. Until 2011, South America’s rate of industrial growth continued to closely follow

Industrial structure & trade in South America  231 250.0 230.0 210.0 190.0 170.0 150.0 130.0 110.0 90.0 70.0 50.0

World

FIGURE 9.4

Advanced Economies

Emerging economies

Emerging Asia

Latin America

Industrial production index, 2000−2014 ( January 2005 = 100).

Source: CPB World Trade Monitor.

that of the global economy. However, thereafter, it began to suffer from the effects of the crisis more severely, showing stagnation and moving away from the global trend. A more detailed analysis based on data on manufacturing output of the ten selected countries in Figure 9.4, shows considerable variation in the scale and industrial structure of these countries, as in their GDP. Brazil accounts for almost half of value added in total manufacturing in the region (48.3%). It also has the most advanced and diversified industrial structure in the region. Argentina has the second largest manufacturing sector, accounting for 17.5% of the total value added in manufacturing in the region, and for a significant industrial structure, but this is dominated by the agro-food industry. The other economies have a higher degree of specialization in primary commodities, and even these are dominated by primary activities, many of which are associated with natural resources. In the Bolivarian Republic of Venezuela (9.6%) and the Plurinational State of Bolivia (0.6%), activities related to oil and gas production are the most important, while in Chile (where manufacturing value added contributed less than 6% to regional value-added) and Peru (contributing 5.2%), mining is more significant. In other countries, the agro-food industry is dominant. Such a variation in the development of manufacturing creates considerable difficulties for increased integration of industrial production in the region, despite efforts towards greater regional integration of trade through regional agreements, as discussed in the following section.

232  André Biancarelli et al. TABLE 9.1 Annual compound growth rate of manufacturing, and value-added as a share

of GDP, selected South American countries (%) 2003–2008 annual compound growth rate manufacturing Argentina Bolivia (Plurinational State of ) Brazil Chile Colombia Ecuador Peru Paraguay Uruguay Venezuela (Bolivarian Rep. of ) World

2008–2013 annual 2000 manu. 2013 manu. compound growth value-added value-added as rate manufacturing as share GDP share GDP

9.6 5.0

3.8 4.4

17.8 15.3

15.9 13.3

4.1 9.5 5.3 4.2 7.4 n.a. 7.9 5.3

0.5 2.0 0.6 2.3 3.8 3.2 1.3 −0.6

15.1 16.9 15.0 19.4 16.7 n.a. 14.1 19.8

11.5 11.8 13.8 13.0 14.9a 11.6 12.9 n.a.

3.6

0.8

Source: World Bank, World Development Indicators Database. a

Previous year.

Nevertheless, despite the heterogeneity, the more positive external conditions during the period 2003−2008 enabled a strong increase in industrial activity in the region (first column of Table 9.1). In part, this growth was driven by domestic demand, especially in the larger countries such as Brazil and Argentina, but it was also associated with a surge in commodity exports. Growth was particularly robust in Argentina, Chile, Uruguay and Peru, although in all the selected countries growth rates were higher than the world average. In the post-crisis period, there was a clear declining trend in all these, at varying rates. In Brazil, Colombia and the Bolivarian Republic of Venezuela growth rates were below the world average. The other countries also showed a marked reduction of industrial production, although the rates were above the world average. The Plurinational State of Bolivia was the only country where the slowdown was more moderate. The difference in performance in each of the two periods resulted in diverse situations also in terms of the share of manufacturing in GDP (columns 3 and 4). For example, between 2000 and 2008, the level of industrialisation increased in Brazil and Argentina, whereas it fell sharply in the Bolvarian Republic of Venezuela and Ecuador. And between 2008 and 2013, the share of manufacturing in GDP fell in all the countries of the region. The data for the post-crisis period reveal that the stagnation of global demand and production caused by the crisis abruptly reversed the context of strong growth of the previous period. That context had reduced the competitive

Industrial structure & trade in South America  233

tensions posed by the emergence of China as a massive exporter of manufactured products to the world. The advent of the crisis, however, accentuated those tensions, intensifying the search for foreign markets as a response to the stagnation of domestic markets. It also prompted the introduction of new policies to support industrial competitiveness, thereby exacerbating the competition for exports. This analysis reveals a global landscape where the difficulties in the post-crisis scenario present a strong challenge for years to come. The next section presents an analysis of trade data to show the outcomes of this situation in recent years, and to highlight how regional trade integration has been linked to the performance of the structure of economic production in the selected countries.

4. Weak and decreasing extra- and intraregional trade The global economic slowdown had an enormous impact on global trade flows, as noted in Section 2. During the period 2003−2008, the average annual growth of global exports was 16.6%, while exports of manufactured goods grew at a rate of 14.8%. The year 2009 was marked by a drastic reduction in global export levels, followed by a recovery until 2011. From 2012 to 2014, however, the recovery lost momentum and growth was negligible. The trade performance of different regions of the world during the post-crisis period has varied greatly. In terms of the volume of exports and imports, Asia, especially China and the Republic of Korea, maintained a significant rate of growth. However, China’s imports grew at a higher rate than its exports, while the opposite was true for the Republic of Korea, which adopted a strategy of seeking foreign markets as a way to deal with the crisis, so that its export grew at a faster pace than its imports. Japan, on the other hand, suffered a decline in exports, and its imports grew at a somewhat lower rate than the world average. In the United State and in European countries, the growth rates of exports exceeded those of imports as these countries sought to boost their exports in order to protect their productive sector from the adverse impacts of the crisis. In the United States, exports (by volume) were 14.4% higher in the second quarter of 2014 than in the third quarter of 2008, whereas imports were only 3.8% higher. In Europe, despite the decline in intra-European trade, extra-European trade improved as a result of the search for external markets in response to the crisis, whereas its imports from the rest of the world fell. South and Central America, on the other hand, made a reverse adjustment, absorbing imports from the rest of the world. While export growth was 0.4% lower in 2014 than in 2008, imports were 20.8% higher. From this it can be concluded that most countries in the world have intensified their search for foreign markets, thereby consolidating the fierce competition of the post-crisis period. The selected countries in South America saw a sharp increase in total trade flows starting in 2003, and by 2008 their trade had increased threefold. Growth of their exports in total was higher than that of their imports, resulting in a growing trade surplus, which reached US$116 billion by 2006. Since then, their

234  André Biancarelli et al.

imports have grown at a slower pace, gradually reducing the trade surplus. The global crisis caused a sharp reduction of trade flows in the region in 2009, followed by a rapid recovery in 2010 and 2011, and since 2012, just as with global trade, total trade flows have more or less stagnated. However, considering only exports of manufactured goods presents a very different picture: throughout the period South America showed a trade deficit in these goods. The period 2003−2008 witnessed a significant growth of trade in manufactured goods, but the pace of growth of imports was much higher than that of exports, resulting in a trade deficit of those goods of US$178 billion in 2008. After the crisis, with the intensification of international competition, the deficit was accentuated even more, with imports continuing to grow apace until 2013, while exports only recovered to their 2008 level in 2011 and have remained stagnant ever since (Figure 9.5. As a result, the trade deficit in manufactured goods reached US$281 billion in 2014. It seems that in 2003−2008 the growth in imports of manufactured goods did not displace domestic industrial production in the countries of the region. However, since the crisis, the weak growth of domestic demand, combined with higher imports of manufactures, has pushed down the rate of industrial growth. Turning to the striking change in South American exports by geographic destination, between 2000 and 2008 growth was driven by exports to developing countries, especially to China. The growth of intraregional trade (among the ten selected countries) grew slightly below the overall average for the period, whereas the average annual growth of intraregional exports of manufactured products was slightly higher than the overall average. 500 400 300 US$ bilions

200 100 0 -100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

-200 -300 -400 FIGURE 9.5

imports

exports

trade balance

Exports, imports and the trade balance of manufactured goods in selected South American countries, 2000−2014.

Source: UNCTADstat.

Industrial structure & trade in South America  235

Also, intraregional exports account for a significant proportion of the region’s total exports, especially of manufactured goods. Between 2000 and 2008, the region’s exports to developing countries increased from 41.6 to 48.7%, whereas the share of intraregional trade fell somewhat from 23.2 to 21% (Table 9.2). This decline was mainly due to a reduction in the contribution of non-manufactured products, while the share of manufactures in intraregional exports increased from 38 to 42.3%. That is, despite the strong growth of commodity exports by countries in the region intraregional trade in manufactured goods has not been adversely affected. On the contrary, the growing importance of China as an export destination was due largely to the increase in exports of non-manufactured products. In the period 2008−2014, the growth rate of the region’s exports to all markets, except China, fell. As a result, China’s share in the region’s total exports increased to 15.1% and in the region’s exports of non-manufactured products to 18.8%. Intraregional exports of both non-manufactured and manufactured goods fell, though the share of the latter in the region’s total exports still accounted for almost 41% in 2014 (Table 9.2). However, in terms of export pattern, despite the loss in the share of manufactured goods in the regions total exports, intraregional exports continued to show a very different profile in relation to trade with other destinations ( Table 9.3). In 2014, manufactured goods accounted for 51.5% of intraregional exports, whereas they accounted for 19.4% of the region’s exports to developed countries and for only 4.6% to China. Data on imports reveal some important differences compared with exports. First, while non-manufactured products have accounted for the largest share of exports, and this share has been growing, imports are dominated by TABLE 9.2 Share of geographic destinations in South America’s exports of

manufactured and non-manufactured goods, 2000, 2008 and 2014 (%)

2000

2008

2014

Destination of exports

Total

Manufactured goods

Non-manufactured goods

Developed countries Developing countries Intraregional China Developed countries Developing countries Intraregional China Developed countries Developing countries Intraregional China

56.5 41.6 23.2 2.2 48.1 48.7 21.0 7.7 38.9 58.6 18.6 15.1

47.1 52.7 38.0 0.8 34.4 64.7 42.3 1.9 32.4 67.2 40.9 3.0

61.2 36.1 15.9 2.8 53.3 42.7 12.9 9.9 40.8 55.9 11.7 18.8

Source: UNCTADstat. Note: The data refer to the ten selected countries of South America listed in Table 3.1.

236  André Biancarelli et al. TABLE 9.3 Share of South America’s manufactured goods in its total

exports, by destination (%) Destination

2000

2008

2014

World Developed countries Developing countries Intraregional China

33.0 27.5 41.8 54.1 12.3

27.5 19.7 36.5 55.5 6.7

23.3 19.4 26.8 51.5 4.6

Source: UNCTADstat. Note: The data refer to the ten selected countries of South America listed in Table 3.1. TABLE 9.4 Share of manufactured goods in total imports of selected

South American countries, by origin (%) Origin

2000

2008

2014

World Developed countries Developing countries Intraregional China

76.6 89.2 61.1 53.9 95.0

72.0 82.8 64.8 54.0 96.2

72.8 77.0 70.1 52.1 97.5

Source: UNCTADstat.

manufactured goods, despite a slight fall in their share in total imports, from 76.6% in 2000 to 72.8% in 2014 (Table 9.4). There was a fall in the share of manufactured goods in imports from developed countries, whereas their share in imports from developing countries rose, largely due to increased imports from Asia, since participation of manufactures in intraregional imports remained relatively constant. As already pointed out, imports continued to rise even after the end of the expansion cycle, albeit at a much lower rate. Unlike exports, the increase was more pronounced in manufactured goods than in non-manufactured goods. And while the share of manufactures in total intra-regional imports fell, that share from other part of the world continued to rise. This partly reflects the tougher competitive environment observed during the post-crisis period. Regional financial or trade arrangements were not sufficient to protect intraregional imports, vis-à-vis imports from outside the region. South America’s imports of manufactured goods have risen from both developed and developing countries, particularly from China. During the period 2008−2014, imports from China, grew at an average annual rate of 11.6%, despite the slowdown of growth of the Latin American economies. The strong increase of imports from China signifies that the latter’s share of all Latin America’s imports grew from 3.3% in 2000 to 11.7% in 2008 and finally to

Industrial structure & trade in South America  237 TABLE 9.5 South America’s imports by origin, 2000, 2008 and 2014 (%)

2000

2008

2014

Origin

Total

Manufactured goods

Non-manufactured goods

Developed countries Developing countries Intraregional China Developed countries Developing countries Intraregional China Developed countries Developing countries Intraregional China

54.5 43.7 26.3 3.3 40.6 55.8 25.4 11.7 41.0 56.8 19.4 17.5

48.6 26.7 14.2 3.1 46.7 50.3 19.1 15.6 43.4 54.7 13.9 23.4

5.9 17.0 12.1 0.2 24.9 70.1 41.8 1.6 34.7 62.4 34.1 1.6

Source: UNCTADstat.

17.5% in 2014 (Table 9.5). Regarding imports, manufactured goods from China increased at a much faster pace than from other parts of the world, and even exceeded intraregional imports, reaching 23.4% in 2014, surpassing the share of intraregional imports of manufactures. The latter’s share fell from 15.6% in 2008 to 13.9%. In the case of non-manufactured goods, there was a significant increase in intraregional imports, from 12.1% in 2000 to 41.8% in 2008, followed by a decline to 34.1% in 2014. From the above analysis, it becomes clear that South American countries experienced strong economic growth between 2003 and 2008, with very great dynamism of their domestic markets. Moreover, they benefited from increased demand for and high prices of their commodities. However, they also faced fierce competition in industrial products, particularly from China and from other Asian countries that are major suppliers of manufacturing products to the world. In this context, although South American countries have considerably increased their exports, these have been highly concentrated in commodities. The result, especially after the eruption of the international crisis, has been a large and growing trade deficit in manufactured goods with a negative impact on domestic production. The indicators for manufacturing, both production and foreign trade, analysed in the previous sections show that the South American countries have been experiencing increasing difficulty in boosting industrial production, particularly in the post-crisis period, as reflected in the loss of importance of industry in the economy. The regional market has played an important role in maintaining relatively large intraregional exports of manufactured goods. In the post-crisis period, however, the regional economic flows lost out to extraregional flows. Important opportunities for intraregional trade were lost, in particular because of greater penetration of imports coming from the Asian region, notably China. Existing regional trade agreements were not enough to avoid this situation.

238  André Biancarelli et al.

The Southern Common Market, MERCOSUR, is still an incomplete free trade arrangement and an imperfect customs union. The integration of production has not been sufficiently comprehensive, either in terms of countries or sectors, to enable domestic production to withstand competition from imports of parts and components from outside the common market. Issues relating to the treatment of asymmetries in the bloc persisted throughout the period. In addition, it has a very limited common commercial policy, reflecting the absence of common regulations on trade protection, and technical, sanitary and phytosanitary standards. In the case of the Andean Community (CAN, acronym for its Spanish name, Comunidad Andina), despite having advanced more than MERCOSUR in terms of common trade protection and shared technical standards, there are still many problems relating to the lack of common rules of origin and safeguards for various sensitive products. In addition, the low degree of economic integration and manufacturing among the member countries has been an obstacle to intraregional trade expansion. Both these regional agreements are still too focused on trade and spend a lot of time resolving trade conflicts inside the blocs. They have not devoted sufficient attention to developing instruments for greater integration of industrial production inside the region.

5. Missing links: financial integration in South America a. Short- and long-term financing, and sharing of portfolio wealth As discussed in much of the literature on regional integration over the past few years, the financial dimension of integration in South America is a process that has seen a considerable number of diplomatic and institutional initiatives, but suffers from a lack of interest on the part of private financial agents. At the government level, there is regional financial cooperation, which may be divided into three kinds of initiatives as suggested by UNCTAD (2007): (i) regional cooperation to facilitate payments and short-term financing; (ii) regional cooperation to finance development (involving long-term financing); and (iii) exchange agreements and monetary unions. The first category includes regional trade facilitation mechanisms and the provision of liquidity at times of balance-of-payments difficulties. It can take the form of joint payments, clearing offices, reciprocal loan agreements and common reserves. The second includes two large types of institutions: regional development banks and regional stock markets, and the third encompasses formal agreements to coordinate policies (mainly exchange rate policy), and possible mechanisms for the adoption of a single currency. In South America, there is quite a heterogeneous mixture of the above three categories. Starting off with the third kind, the region has almost no experience of macroeconomic cooperation. Attempts at this form of cooperation have been

Industrial structure & trade in South America  239

undermined by the wide diversity and cyclical behaviour of member countries’ economies and by the national sovereignty issue. This has resulted in wholly uncoordinated approaches to policies on exchange rates and interest rates, which, generally, have inhibited long-term growth. This is probably the biggest hindrance to advancing the trade (and financial) integration process in South America, not only because the lack of coordination has an adverse impact on transactions, but also because the absence of formal harmonisation mechanisms facilitates differentiation and so-called beggar-thy-neighbour policies that are counterproductive to regional integration. Therefore, the first political challenge would be to devise approaches for effective coordination of macroeconomic policies (UNCTAD, 2011). With regard to the other two categories, the regional institutional framework is much more developed. Regarding payment facilitation (i.e., setting up joint reserves and providing regional liquidity assistance), there are three major initiatives, with different goals and results. First, a Reciprocal Payments and Credit Agreement (Convenio de Pagos y Créditos Recíprocos − CCR) was signed by members of the Latin American Integration Association (LAIA) in 1965 and began operating in 1966. Apart from facilitating trade integration itself, the aim of the agreement was to economise on scarce foreign currency by allowing members to delay payments and granting free credit to members during a four-month period, after which only the balance would be compensated. This mechanism, essential in the 1980s, is now becoming less important, and it is getting distorted, mainly because a more balanced trade relationship is required among the members, and because of the rise of advance payment systems. Another kind of initiative is the Local Currency Payments System (Sistema de Pagos en Moneda Local – SML) between Brazil and Argentina, operating since 2008 (and recently extended to Uruguay). Unlike the previous category, the aim of this system is not to defer payments or conserve foreign exchange, but rather to avoid the transaction costs of payments made in US dollars, and to reduce the need for trade credit denominated in a foreign currency. So far, the numbers or transactions and their value reported are still low, but it was gaining in importance, especially for small and medium-sized companies, and there seems to be considerable potential for reducing the costs of foreign exchange transactions. Finally, a third initiative is the Latin American Reserve Fund (Fondo Latinoamericano de Reservas − FLAR). It is based on the principle of a shared use of part of international reserves so as to increase the liquidity available to member countries at a time of balance-of-payments difficulties. Established in 1978, the FLAR currently has eight member countries, most of which are in the Andean region. Despite its modest size (with a subscribed capital of US$3.6 billion and a paid-in capital of less than US$3 billion), all available performance appraisals rate it as being quite good. In today’s challenging times, where the classical balance-of-payments problems have resurfaced in the region, this fund could serve as an important tool for its members.

240  André Biancarelli et al.

In the second category of financial cooperation – related to long-term financing – there are various institutions working in the region, but all of them are development banks − regional or subregional − and there is no regional (or integrated) stock market. The oldest regional development bank, the InterAmerican Development Bank (IDB), which was established in 1959, with half of the membership outside the region, has nonetheless been influenced by the spirit and integrationist ideas of the region. Over the past five decades, it has been an important tool for mobilising financial resources for the public and private sectors. The Bank’s subscribed capital amounted to more than US$160 billion at the end of 2014. Its disbursements have remained more or less stable over the past few years, with approvals totalling around US$13 billion in 2013 and 2014. At the end of this year, the IDB’s loan portfolio stood at US$74.6 billion. However, the Southern-led Development Bank of Latin America (Corporación Andina de Fomento − CAF) is an institution better suited to local conditions and is controlled by its beneficiaries. It differs from the IDB’s capital structure and decision-making structure, which are strongly influenced by the United States and other developed countries. The “sense of ownership” of the CAF has made it extremely successful in complementing other multilateral financial institutions. By the end of 2014, its paid-in capital totalled US$4.2 billion, for which regional development economies are almost solely responsible, and its portfolio of projects amounted to US$19.4 billion. Its annual disbursements have grown substantially over the past few years, stabilising at around US$12 billion in 2013−2014. Another initiative, the Bank of the South (Banco del Sur), was formally created in 2007, when Argentina, the Plurinational State of Bolivia, Brazil, Ecuador, Paraguay, Uruguay and the Bolivarian Republic of Venezuela signed its founding charter. Pushed by a strong rhetoric in support of regional integration it is more ambitious, but experienced serious implementation problems and is still essentially at a pre-operational stage. Differences among the partners regarding the bank’s internal power structure, allocation of resources, conditions for granting loans and even its functions (whether to be a development bank only or also a provider of liquidity in case of need) arose during the period of ministerial meetings prior to its establishment. And although an agreement establishing the bank was concluded one decade ago, there were delays in its ratification by the national legislatures of key countries such as Brazil, reflecting ongoing differences. It was launched with an initial authorised capital of US$20 billion (double the amount of the CAF’s) and an initial subscribed capital of US$7 billion, which gives it a significant potential for action. However, greater consensus will be necessary for the bank to become operational. Finally, the Brazil National Development Bank (Banco Nacional de Desenvolvimento Econômico e Social – BNDES) has been expanding its operations considerably in South America, working more and more as a domestic bank with a regional presence. Quantitatively speaking, the assessment does not concern its general numbers but its regional performance. Even in this light, figures are impressive: the bank’s disbursements for infrastructure and other sectoral projects

Industrial structure & trade in South America  241

in the region exceeded US$1 billion in 2010, which represents more than 45% of the disbursements made under the BNDES Exim trade finance line. This percentage has been rising constantly since the early 2000s, with a total portfolio of projects of this type amounting to over US$20 billion (almost half of which would be funded by the bank). However, it should not be considered as replacing, or even as perfectly complementing regional or subregional long-term financing sources. Unlike the IDB, CAF and the plans for the Bank of the South, the charter of BNDES, restricts its funding only to Brazilian companies or to branches of multinational companies established in Brazil. Thus, the regional transactions of the bank only cover Brazil’s exports of goods and (more frequently) engineering services performed by Brazilian companies in neighbouring countries. This certainly contributes to improving the internal infrastructure of several Latin American economies, but it does not necessarily support the physical integration of the region. A similarly positive picture of regional financial cooperation (at least in terms of the institutional frameworks), however, is not seen in the second dimension of regional financial integration, alluded to earlier, namely the participation of the private sector. In an effort to quantify this phenomenon, Biancarelli (2010) found a very low degree of financial sharing among South American economies  – around 4% of the total external wealth for portfolio assets, compared with 20% for Asia and far below that of the EU. Therefore, when considering an approach that combines the financial and productive dimensions of regional financial integration in this region, it is necessary to depart from this reality (which has probably worsened since the financial crisis), summarised by the author as follows: There is a large gap between the official intentions and the effective functioning of financial integration; between the formal structure and the real importance of the region to the most important financial actors inside each country… Contrary to the apparent features of the regional integration process in Asia, in South America the negotiations, the diplomacy and the official intentions and ambitions are not accompanied by the private sector’s support and effective participation. (Biancarelli, 2010:134) However, portfolio finance is not the only kind of external financial asset (or liability) of a country. The relationship between “effective” financial integration and that of the industrial structure and trade can be best observed when taking into account more “productive” capital flows and stocks.

b. FDI flows and stocks Section 4 above showed that trade flows among the major economies of South America played an important role in offsetting the trend of specialisation in commodity exports, driven by the rise in demand and in international prices of those

242  André Biancarelli et al.

products. During the commodities cycle, increased exports and trade surpluses removed the external constraint and allowed a period of freer and higher growth. This growth increased demand for manufacturing, which was largely met by the region’s imports from China. However, this demand also served to strengthen intraregional trade. In the post-crisis period, on the other hand, the external situation has deteriorated, and global competition for manufactured goods has led to increasing imports from Asia, particularly China, displacing not only domestic production, but also intraregional trade. In this context, the existence of mechanisms to promote integration of trade and industrial production − including the creation of regional value chains − and particularly intraregional trade in manufactured goods, can be important. Foreign direct investment could potentially stimulate greater integration, especially if it is associated with intraregional industrial specialisation so as to create regional value chains and greater complementarity of production, as in the Asian region. However, FDI in the region has instead reinforced specialisation in the stages of the value chain for more intensive natural resource production mainly for extraregional exports. Just as with trade flows, greater intraregional FDI could stimulate manufacturing and service activities, and counter the tendency towards excessive specialisation in commodities. Existing data, however, show a relatively small amount of FDI stock from the region in the total amount received. Considering all countries, the share of intraregional investment inflows in the total stock of investment inflows was low at only 5.8% in 2012. In absolute terms, Brazil accounted for the largest share of investments from countries within the region (32%), but even this represented only 3.1% of the total stock received from all countries. The same is true for Colombia, Ecuador and the Bolivarian Republic of Venezuela where inward FDI stocks from the region were lower than the total it received from all countries. In contrast, the other countries of South America received a much larger share of intraregional FDI. Especially for Uruguay, and also for Argentina, Paraguay, Peru and the Plurinational State of Bolivia, the share of intraregional inward FDI in their total stock was significant. The same broad picture can be observed in FDI flows. Looking at the UNASUR as a whole (including Guyana and Suriname besides the ten South American economies examined above) and from a longer-term perspective, shows the growing participation of these economies in global FDI flows over the past decade. Despite the upheavals in Brazil, the country remained a major recipient of FDI, with flows of more than US$60 billion annually, even during the difficult period of 2011−2014 (Figure 9.6). The more recent FDI movements were similar to those of the 1990s, but only in quantitative terms. During that decade, FDI inflows were driven by the privatisation of State-owned enterprises, especially in Brazil and Argentina. In general, these investments were directed to non-tradable sectors, raising

Industrial structure & trade in South America  243 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0%

FIGURE 9.6

UNASUR/Word

UNASUR exc. Brazil/Word

UNASUR/Developing Countries

UNASUR exc. Brazil/Developing Countries

FDI flows by region: UNASUR, the world and developing economies, 1990–2014 (%).

Source: UNCTAD.

concerns – largely confirmed in subsequent years – about their effects on these countries’ external accounts. In the recent “wave”, FDI flows were attracted by the dynamism of the national markets in the region, and were also aimed at the acquisition of commodity-producing companies. This later led to increasing receipts in foreign currencies (especially during the commodity boom), partly offsetting the growing burden of FDI outflows. However, the potential benefits not just contributed to improving the balance of payments. As shown in Figure 9.7, the ratio of FDI to gross fixed capital formation (GFCF) was higher in the UNASUR countries – historically and during the recent cycle – when compared to those of the world average and the average for developing countries as a whole. Although a significant proportion of these recent flows to the region were in the form of mergers and acquisitions, they increased the share of FDI in gross fixed capital. Nevertheless, from the perspective of structural transformation, regional integration of production and the building of intraregional value chains, evidence indicates that the opportunity presented by the positive trend was missed. This was not only because of the low level of intraregional FDI and the differences in the relevance of regional investors to each host economy. It was also because the region failed to take advantage of FDI inflows to pursue a strategy of internationalisation of regional companies, which would be essential for the regional integration of productive structures. This has been partly because of strong asymmetries in UNASUR countries’ FDI inflows and outflows. During the first half of the 2000s, some companies, especially Brazilian, Chilean and Colombian companies were observed to be seeking greater

244  André Biancarelli et al. 35.00 30.00 25.00 20.00 15.00 10.00

-

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

5.00

World FIGURE 9.7

Developing economies

UNASUR

Ratio of FDI to GFCF in UNASUR, developing economies and the world, 1990−2014 (%).

Source: UNCTAD.

internationalisation of their operations, and the emergence of “multilatinas” appeared to be a positive and novel development in the region. But, as described above, adverse conditions in the post-crisis era, particularly concerning trade and financial flows, and many other aspects of economic dynamics, undermined such a strategy. As result, it has lost momentum in recent years.

6. Hidden opportunities: infrastructure investment and physical integration The analyses presented in the previous sections suggest a pessimistic outlook in South America, especially when considered in relation to the development goals. This study views development not only in terms of economic growth, but also in terms of the sophistication of the production structure (industrialisation) and the reduction of social disparities. Additionally, the study has sought to analyse the recent achievements of regional integration and the current challenges to it, especially its financial and productive dimensions. In line with the structuralist tradition and the “post-liberal” regionalism that has prevailed (at least in official rhetoric) in the region since the last decade, the assumption here is that regional integration can, and should, be used as a tool for or a path to development, and not only for trade promotion. Bearing this in mind, the study first described challenging international conditions, in which the positive impulses of the so-called bonanza period, both in trade and financial respects, were replaced by uncertainties, volatility and fierce

Industrial structure & trade in South America  245

competition from China in the post-crisis period. It was argued that, despite the worse situation compared to a few years earlier, the external position of the majority of countries in South America was better than it was during previous international crises. Section 3 examined the driving forces, consequences and phases of international trade. Besides contrasting the pre- and post-crisis periods, the main finding was that intraregional trade, and its positive contribution to much- desired structural change in the economies of the region, has lost momentum since 2009. Certainly, in today’s challenging environment, this particular engine of growth, productivity and regional integration of production is weaker than before. Whereas China once had a positive impact on the development of the region, since the beginning of the present decade this is no longer the case, at least in the sense of the way development is considered in this study. Looking at the financial dimension of regional integration (Section 4), it is observed that there is an effective set of official initiatives (mechanisms, banks and projects) for short-term and, especially, development financing in South America. However, this solid institutional base contrasts with that of major private agents, which have a weak presence and very little interest in regional financial integration. The analysis also shows that inward FDI flows and stocks in the region, which could be an obvious channel for trade and technology, have been declining following the crisis, while there have been high levels of extraregional inflows into the major economies. In brief, the main conclusion is that market forces alone, in this specific international context, will not bolster South America’s efforts towards development and productive and financial integration. There is also a need for the design and implementation of appropriate policies, intervention measures and coordinated strategies (among countries and public/private agents) to achieve these goals. In the current circumstances, the most promising (or unique) approach is to focus on the development of regional infrastructure, including transport, communications and energy, which requires considerable investment. Such infrastructure would be an important means of achieving physical integration, enabling a greater degree of intraregional trade and investment. It would also foster complementarity of production and help make regional exports more competitive in global markets. In terms of transport infrastructure, there is an evident need to improve the connections between countries, through various transport modes. Furthermore, it is important to note that the countries of the region have abundant energy resources, although those resources are distributed unevenly among them. Thus, energy interconnectedness could generate significant gains in terms of supply and costs. Despite all these benefits from infrastructure development, a study by Perrotti and Sánchez (2011) indicates that in recent decades South American countries have reduced their infrastructure investments from an average of 4% of GDP between 1980 and 1985 to 2.3% between 2007 and 2008. The same study estimates that it would be necessary to invest 5−8% of regional GDP to build sufficient infrastructure to support the development of the region.

246  André Biancarelli et al.

Although investment in infrastructure has fallen short of what is needed, a positive development is the existence of a common approach to regional infrastructure projects under the Initiative for the Integration of the Regional Infrastructure of South America (IIRSA). The IIRSA was launched in 2000 with the central aim of promoting the modernisation of regional infrastructure. It is based on an action plan that seeks to consolidate information and investment projects for the development of the region, and to monitor investments in infrastructure projects based on a regional vision agreed upon by the 12 participating countries. Since 2009, the IIRSA constitutes a technical forum of the South American Council of Infrastructure and Planning (COSIPLAN) within the framework of UNASUR. One of the main strengths of the IIRSA has been its building of a portfolio of projects that orders, prioritises and promotes infrastructure investment in the 12 member countries around several development and integration axes (Table 9.6). This has allowed the process to move forward independently of political or economic hardship faced by the region over the past decade. In 2015, its project portfolio consisted of 593 projects, amounting to a total of US$182 billion. Of these, 19% had been completed projects, 32% were in the process of implementation, 29% were in the pre-implementation phase and 19% were in planning. In terms of sectors covered by IIRSA projects, transportation, especially road transport, accounts for the largest number (Table 9.7), followed by generation and interconnection of energy, which account for about 29% of total project investments. Projects associated with telecommunications, on the other hand, account for a very small proportion of the total value of projects. Finally, a very important issue concerns the financing of IIRSA/COSIPLAN projects. Their main sources of funding are national governments, which account for 40% of the total estimated investments (Table 9.8). The private sector is involved in 85 projects and contributes 23% of the total investments. Multilateral TABLE 9.6 COSIPLAN’s portfolio of projects, 2015, by axis of development

and integration Axis

No. of projects

US$ million

Amazonas Andino Capricornio Escudo Guayanes Hidrovia Parana-Paraguai Interoceânico Central Mercosul Chile Peru Brasil Bolivia Del Sur Total

74 66 82 20 92 63 124 24 48 593

22,421 28,614 16,315 4,581 7,328 11,615 56,169 31,432 4,147 182,435

Source: UNASUR/COSIPLAN.

Industrial structure & trade in South America  247 TABLE 9.7 COSIPLAN’s portfolio of projects by subsector, 2015

Subsector

No. of projects

%

US$ million

%

Air transportation Roads Rail Inland waterways Coastal Multimodal Border crossings Energy generation Energy interconnection Telecommunications Total

25 262 67 75 38 14 47 25 31 9 593

4.2 44.2 11.3 12.7 6.4 2.4 7.9 4.2 5.2 1.5 100

6,930 59,473 47,903 2,887 10,945 624 917 42,066 10,650 42 182,435

3.8 32.6 26.3 1.6 6.0 0.3 0.5 23.1 5.8 0.0 100

Source: UNASUR/COSIPLAN. TABLE 9.8 COSIPLAN’s portfolio of projects: funding sources, 2015

Source

No. of US$ projects million

National governments 330 Private 85 IDB 37 CAF 30 Various 13 Binational 11 Provincial government s 11 FOCEM – MERCOSUR’s Structural 10 Convergence Fund FONPLATA – Fund for the Development of the 6 River Plate Basin European Union 4 Private banks 3 Goverment of China 3 World Bank 3 BNDES – Brazil National Development Bank 2 JBIC – Japan Bank for International Cooperation 2 Local goverments 1 Undefined 80 Total 631

Cost of completed projects (US$ million)

69,736 13,748 42,900 4,650 4,629 1,151 2,856 795 3,280 1,342 5,848 1,409 2,071 200 819 404 299

0

180 75 118 0 400 0 173 69 157 0 186 0 2,100 2100 46,685 170 182,436 26,113

Source: UNASUR/COSIPLAN.

agencies such as the IDB, CAF and in the future, the South Bank, are also potentially important participants in a significant number of projects, but they account for just over 4% of total investments. They also provide technical assistance and support for analysis and structuring of the projects.

248  André Biancarelli et al.

Given the downturn in the commodity cycle and its effect on national governments in the region, it has become increasingly important to secure new sources of financing in order to expand investment in the region. The size, “sense of ownership”, expertise and leveraging capabilities of the institutions described in Section 5.a indicate that they should assume responsibility for this task. To conclude, even in difficult times, there are still opportunities for regional development in South America. In particular, priority should be given to COSIPLAN’s infrastructure projects, which can foster trade relations and regional integration of production, reduce logistic and energy costs, and strengthen the existing financial institutions in the region.

References Biancarelli A (2010). La dimensión financiera de la integración en América del Sur: una evaluación de las alternativas y una tentativa de cuantificación. UNCTAD/Virtual Instituto Virtual, Integración regional en América Latina: Desafíos y oportunidades. United Nation: New York and Geneva, UNCTAD. UNCTAD/DTL/KTCD/2010/3 Ocampo JA (2007). La macroeconomia de la bonanza económica latinoamericana. Revista de la Cepal, 93, December. Perrotti DL and Sánchez RJ (2011). La brecha de infraestructura en América Latina y el Caribe. Recursos naturales e Infraestructura Series No. 153. Santiago, Chile, United Nations publication. UNCTAD (2005). Trade and Development Report 2005: New Features of Global Interdependence. New York and Geneva, UNCTAD. UNCTAD (2007). Trade and Development Report 2007: Regional Cooperation for Development. New York and Geneva, UNCTAD. UNCTAD (2011). Trade and Development Report 2011: Post-Crisis Policy Challenges in the World Economy. New York and Geneva, UNCTAD.

10 PHYSICAL INTEGRATION IN LATIN AMERICA, A REVIEW OF RECENT EXPERIENCES AND POLICY LESSONS1 Ricardo Carciofi and Romina Gayá

Introduction While trade and economic integration in Latin America has been a recurrent theme in the literature, the focus has usually been on the so-called “negative agenda” – that is, the removal of the several obstacles that hinder integration, such as tariffs and non-tariffs barriers. However, integration seems to occur in a spaceless world. Furthermore, it is usually assumed that physical integration is a matter of secondary importance or, at the most, a technical question to be dealt with by infrastructure specialists.2 Quite on the contrary, physical integration – that is, the means to connect and beat distance and geography efficiently – is an important ingredient of the integration process. Not only because transport costs have a significant influence on trade but also because the improvement of infrastructure has a substantial impact on the economic and social geography. In fact, the removal of tariff and non-tariff barriers can have little impact on trade flows when shortages and low quality of infrastructure and custom delays result in high trade costs (Mesquita Moreira et al., 2008). Moreover, the development of physical integration entails substantial capital investments as well as policy and institutional resources. Even when infrastructure projects may be carried out by the private sector there is a heavy need for regulatory involvement by the public sector. In spite of the importance of physical integration, the actual progress of regional connectivity encounters singular challenges that are not easy to overcome. On the one hand, integration processes do not adjust to a common model, and institutional and political issues are idiosyncratic to each case. On the other hand, economic incentives for the development of regional infrastructure are different from those relevant at national level. The purpose of this chapter is to review some selected experiences of Central and South America along the last 15 years.

250  Ricardo Carciofi and Romina Gayá

The discussion attempts to draw lessons that could foster deeper physical integration in those regions. After this introduction, Section 2 highlights some key features of Latin American integration and puts across conceptual issues regarding connectivity infrastructure. The Sections 3 and 4 will be devoted to the discussion of two experiences in South America: the Initiative for the Integration of Regional Infrastructure in South America (IIRSA) in the early years of the past decade and that was followed suit by UNASUR from then on, and Southern Common Market (MERCOSUR)’s Structural Convergence Fund (FOCEM). IIRSA is an institutional mechanism created in 2000, aimed at coordinating intergovernmental actions adopted by the 12 South American countries with a view to building a common agenda to execute projects for the integration of transport, energy and communications infrastructure.3 Since 2011, IIRSA has been attached to South American Infrastructure and Planning Council (COSIPLAN) as its technical forum for South American physical integration planning issues in the UNASUR framework.4,5 FOCEM is a regional fund in force since 2006 to finance projects that contribute to reduce asymmetries among MERCOSUR countries. The Section 5 refers to Central America, particularly to the Mesoamerican Integration and Development Project (MIDP). MIDP was launched in 2008 and succeeded a previous mechanism aimed at encouraging integration. MIDP’s goal is to strengthen regional integration and to promote economic and social development in ten Mesoamerican countries.6 MIDP encompasses a full portfolio of infrastructure projects, including the Central American Electrical Interconnection System (SIEPAC) that led to formation of the regional electricity market. At this point it is important to make explicit the reasons for the choice suggested above. On the one hand, IIRSA-UNASUR (COSIPLAN) and MIDP have common elements of institutional design. Both cases involve a substantial degree of inter-governmental cooperation with the technical and financial support of regional financial institutions (the Inter-American Development Bank – IDB, the Andean Development Corporation – CAF, the Central American Bank for Economic Integration – CABEI, the Financial Fund for the Development of the River Plate Basin – FONPLATA, the United Nations Economic Commission for Latin America and the Caribbean – ECLAC). Additionally, the two initiatives deal with a comprehensive integration agenda where infrastructure is an important chapter of the whole picture. On the other hand, FOCEM is a regional fund that resembles the design of the European funds though in a very different institutional setting. In sum, in all of them infrastructure for integration ranks as a priority issue but institutional and funding mechanisms are quite different. The final section gathers policy lessons derived from the cases dealt with. Conclusions are aimed at an audience either involved in regional integration and trade or those approaching the issue from the academic side.

Physical integration in Latin America  251

1. Physical integration: some key issues that are relevant for analyzing the Latin American case Most of the economic literature on regional integration has been marked by the approach adopted by Balassa (1962): the key actors of the process are countries that dismantle tariff and non-tariff barriers among bloc members, the domestic market moves towards free circulation of goods (and services) and they gradually coordinate other dimensions of economic policy. Thus, the analysis is focused on allocative efficiency and welfare issues. There is no explicit consideration to space – at the most, transport cost is a parameter that should be fed into the picture. Physical integration appears in the scene when geography and distance barriers are taken into account. The simplest notion is related to the deployment of infrastructure that favors connectivity between countries and reduces transport costs associated with international trade and location.7 However, transport infrastructure is not the only tool for physical integration: energy and telecommunications facilities are good examples of a wider category. What is relevant for trade and the location of economic activities is not only the brick and mortar of infrastructure (“hardware”) but also the quality of the services provided by it – the design and proper regulation for accessing the facilities are key determinants of actual transport costs. Also, infrastructure location is a starting point for the deployment of logistics activities that are carried out by the private sector either in the production phase or in wholesale and retail distribution.8 Additionally, trade facilitation issues, such as compliance with customs procedures, constitute the “software” of international exchange and a relevant item of transaction costs.9 Therefore, the actual operation of infrastructure requires a complex set of additional investments and regulations that make them available for different users. In sum, the supply of connectivity infrastructure – either transport or other categories – is not the result of market forces but it is intertwined with strategic goals and policy decisions. Table 10.1 illustrates some basic data regarding logistics and infrastructure of Latin American countries. The region ranks in the middle of the Logistics Performance Index (LPI) ranking and it has worsened in absolute terms between 2007 and 2014. Only a few countries have improved their performance and all except Chile lag behind most competitive developing countries in Asia. In terms of the infrastructure component, most Latin American economies’ performance is worse than the aggregate logistics indicator. There is abundant literature devoted to the importance of geography and space for the location of economic activity.10 As explained in different models, market size, transport costs and economies of scale are relevant for the analysis of concentration and dispersion of product and labor markets across different regions within a single country.11 But transport costs are also important for the way in which countries trade with each other, and there is evidence of the role played by transport infrastructure.12,13 Moreover, as this chapter argues, the

252  Ricardo Carciofi and Romina Gayá TABLE 10.1 Logistics performance index (LPI): general index and infrastructure index:

rank position Country or region

LPI rank

Latin America (simple average) Central America (simple average) Costa Rica El Salvador Guatemala Honduras Nicaragua Panama South America (simple average) Argentina Bolivia Brazil Chile Colombia Ecuador Guyana Paraguay Peru Uruguay Venezuela Mexico Memo: developing Asia (selected countriesc)

Infrastructure rank

2007a

2014b

2007a

2014b

74.5 78.2 72 66 75 80 122 54 74.2 45 107 61 32 82 70 141 71 59 79 69 56 34.0

79.6 ↓ 78.5 ↓ 87 ↓ 64 ↑ 77 ↓ 103 ↓ 95 ↑ 45 ↑ 82.8 ↓ 60 ↓ 121 ↓ 65 ↓ 42 ↓ 97 ↓ 86 ↓ 124 ↑ 78 ↓ 71 ↓ 91 ↓ 76 ↓ 50↑ 39.0 ↓

74.7 84.0 67 68 104 79 138 48 71.5 47 109 49 34 85 72 142 63 57 70 59 53 35.2

85.1 ↓ 94.2 ↓ 99 ↓ 72 ↓ 88 ↑ 124 ↓ 130 ↑ 52 ↓ 83.3 ↓ 63 ↓ 133 ↓ 54 ↓ 41 ↓ 98 ↓ 94 ↓ 105 ↑ 97 ↓ 67 ↓ 90 ↓ 74 ↓ 50 ↑ 38.6 ↓

Source: World Bank (2014b). Notes: a 150 countries. b 160 countries. Taiwan China and Thailand.

c

Selected countries: China, India, Indonesia, Malaysia,

investments and location of infrastructure cannot be detached from the trade and integration strategy in place. The Latin American experience shows that several regional agreements have set up specific mechanisms for improving connectivity and infrastructure aimed at reducing transport costs. It is interesting though that the goals, institutional design and resources do not conform to a unique model, as discussed in Sections 3–5. Before going into the defining elements of the different arrangements, this section discusses conceptual issues that pave the way for further analysis. The remaining part of this section deals with three topics. First, we propose some distinctive features of regional integration in Latin America. We consider this is a necessary background in order to understand the efforts and initiatives dealing with the more specific aspects of physical integration. Second, the section also presents some key aspects of integration projects: externalities, asymmetries, resource mobilization (including financial, fiscal and institutional resources)

Physical integration in Latin America  253

and the multidimensional impacts of infrastructure projects – economic, social and environmental ones. Though the discussion is fairly general, the approach  and topic selection are those that are more meaningful for the Latin American case. And, finally, the section presents the analytical matrix that will be used for reviewing the actual regional experiences. It is suggested to concentrate the attention on the economic and the institutional background where physical integration takes place, the composition of the investment portfolio and the identification and analysis of main projects, including financing, execution and participation of private sector.

a. Relevant features of Latin American integration and trade strategies Even when the wording of public speeches and official documents may induce the reader to think of a single Latin American bloc, this is far from reality. In practice there are different clusters and sub-regional groupings. Some of them are more related to trade issues while political goals are at the core of other agreements. The following list and Table 10.2 illustrate the point. The Hemispheric accord under the umbrella of the Organization of American States (OAS) co-exists together with the Community of Latin American and Caribbean States (CELAC for its Spanish acronym). The Latin American Integration Association (ALADI for its Spanish acronym) is a scheme of broad membership dating back to 196014 and it is focused on trade agreements. Then the sub-regional groupings come to the floor: North American Free Trade Agreement (NAFTA) where Mexico is a prominent member15; the Caribbean Community (CARICOM) and the Central American Integration System (SICA for its Spanish acronym) in the Caribbean and Central America, and when turning to South America, UNASUR, the Andean Community (CAN for its Spanish acronym), the Pacific Alliance (AP) and MERCOSUR co-exist with each other. In recent years, the Bolivarian Alliance for the People of Our America (ALBA-TCP for its Spanish acronym) – an initiative led by Venezuela – has been very active in promoting both a political and economic cooperation agenda. It is true, the scope, depth and nature of the different agreements is diverse. Also, the origins and history of each bloc is long and has been evolving through time – for example, the five-year old UNASUR contrasts with Central American integration efforts dating back to mid-20th century. More recently, the creation of the Pacific Alliance is a new scheme whose members share a similar design of trade strategies. In sum, there is not a single region but a network of many agreements and compromises where individual countries participate in more than scheme at the same time. A second defining feature of Latin American integration is that extra-regional trade is relatively more important than intra-regional trade (Figure 10.1). Also, the composition of trade flows is different: in most countries, intra-regional exports have a higher technological content than exports to the rest of the world. However, the picture presents important sub-regional differences: Central

X X

X X

X

X

X

a

X

X

X X X X X X X X X X X X X X X X X X X X X

X

X Xg X

X

X

X

X X

X X

X

X X

X

NAFTAd OASe Pacific Alliance SICAf

X X X X X

X

X

X X X X X

UNASUR

ALADI and ALBA-TCP also include Cuba. b Other CARICOM member countries are Antigua and Barbuda, the Bahamas, Barbados, Belize, Dominica, Grenada, Haiti, Jamaica, Montserrat, Saint Kits and Nevis, Saint Lucia, Saint Vincent and the Grenadines and Trinidad y Tobago. c CELAC also includes Cuba, Dominican Republic and CARICOM member countries. d NAFTA member countries are Mexico, Canada and the United States. e OAS member states are CELAC members plus Canada and the United States. f SICA also includes Belize and Dominican Republic. g Bolivia signed its protocol of accession to MERCOSUR in 2012.

X

X

X

X

X

X

X X X X X

Source: Authors’ elaboration.

Argentina Bolivia Brazil Chile Colombia Costa Rica Ecuador El Salvador Guatemala Guyana Honduras Mexico Nicaragua Panama Paraguay Peru Suriname Uruguay Venezuela

ALADIa ALBA-TCPa CAN CARICOM b CELACc MERCOSUR

TABLE 10.2 Latin American membership to regional trade and integration agreements (selected countries)

254  Ricardo Carciofi and Romina Gayá

Physical integration in Latin America  255 100% 80%

42%

48% 60%

62%

60%

79%

82% 79%

59%

64% 71%

73% 75% 74% 71%

60%

67% 76%

81% 89%

95%

40% 58%

40%

33% 24%

FIGURE 10.1

Peru

Paraguay

Nicaragua

Mexico

Honduras a

Guyana a

Guatemala

Ecuador

El Salvador

Dominican Rep. a

Colombia

Costa Rica

Chile

Bolivia a

Belize a

Argentina

Latin America and the Caribbean

19% 11%

5%

Venezuela a

29%

Uruguay

18% 21%

41%

36%

27% 25% 26% 29%

Suriname a

21%

0%

52% 40%

38%

Brazil

20%

Rest of the world

Latin America intra and extra-regional trade. Exports and imports. Simple average, 2014.

Source: Authors’ elaboration with data from Dataintal and Comtrade. Note: a 2013.

American countries trade more among themselves than their South-American counterparts.16 In recent years intra-regional trade is growing slowly, particularly when attention is paid to volumes rather than values, though it is not a linear trajectory. Trade arrangements have positively contributed to intra-regional trade.17 There are several reasons that hinder a more intense intra-regional trade. First, similar factor endowment is a relevant feature for defining the shares of regional vs. extra-regional flows. Precisely, the early theorizing about the need for regional integration emphasizes the advantages of diversification of economic activities, lower dependence on traditional commodities and improving the chances of technical innovation and economies of scale.18 Further, since most countries have comparative advantages in natural resources – mining, fossil fuels and agriculture – product differentiation is low and intra-industrial trade is limited. This contrasts to other regional integration process (e.g., the European Union, EU) where in spite of similar factor endowments there are significant intra-industry trade flows based on product differentiation and gains from economies of scale. Second, macro-economic instability is another disruptive element.19 In principle, export concentration in a few primary products – this is particularly the case in South America – renders economic cycles associated with commodity prices.

256  Ricardo Carciofi and Romina Gayá

In this context, intra-regional might help to sustain output and employment. However, cycles are not synchronic and the sources of instability have frequently gone beyond commodity prices. In this context, the case for intra-regional trade does not look as a powerful tool. Moreover, macro instability might be an obstacle for keeping open trade flows during downturns and location of economic activity tends to favor bigger and more developed markets. Under these circumstances, intra-industrial trade is low. MERCOSUR is an exception.20 Bilateral trade between Argentina and Brazil is significant, and is mostly the result of corporate agreements of the automotive industry and policy regulation.21 As a third element and regarding extra-regional market access, Latin American countries do follow quite different trade strategies. Most of Central America, Panama, Dominican Republic, Mexico, Chile, Colombia and Peru have sought market access to regional trade agreements (RTAs) involving the United States, Canada and extra-regional partners in Asia and the EU. MERCOSUR, Ecuador and Bolivia conduct most of their extra-regional flows along multilateral rules. Fourth, though several sub-regional agreements subscribe to the concept of custom unions, there are significant obstacles to the internal circulation of goods. Trade of goods tends to flow more freely than services in the case of the different sub-regions: Central America, CARICOM, CAN and MERCOSUR. CARICOM and the Pacific Alliance have also managed to achieve a substantial degree of liberalization of trade services, but they are exceptions.22 Other sub-regional blocs resemble imperfect customs unions where a substantial proportion of trade is tariff free, though extra-zone goods are subject to tariff duties when circulating from country to country inside the bloc. Also, since members of the same union have different RTAs with non-members, regional trade is conducted under different rules of origin. As a consequence, the creation of a single market for each sub-region is still work in progress. There is another side to the weaknesses of custom unions: there is no either tax collection or budgetary allocations for the production of regional public goods.23 Finally, the integration process in Latin America has been dominated by an intense mechanism of inter-governmental coordination. There are several reasons that explain coordination modality. The relatively low degree of intraregional trade, structural asymmetries among members of the same bloc, uncoordinated economic cycles are all relevant explanatory variables. The final result is that supranational bodies are weak entities with very limited policy decisions at regional level (Motta Veiga, 2003). Institutions are confined mostly to administrative tasks but there are no responsibilities – nor resources – located at the regional level. As commented in Sections 4 and 5 FOCEM and SIEPAC are to some extent an exception. All the features presented above are relevant for a proper framework at the time of making reference to physical integration in the Latin American context. Let us consider the following consequences. First, from the point of view of improving infrastructure facilities for trade, it is obvious that project identification has to pay due notice to this two-tier structure of trade (regional and

Physical integration in Latin America  257

extra-regional). This is particular so in South America, where countries have larger territories and borders are located deep in the hinterland. On the other hand, depending on geographical location and the composition of trade, several countries conduct much of their extra-regional trade through facilities that are also shared by intra-regional flows. So, regional and global integration push in the same direction but this is not always the case. Second, since extra-regional trade has been dominant infrastructure facilities have been built up accordingly.24 In most cases, transport modalities are articulated around port hubs. As a consequence, intra-regional trade tends to be a user of facilities devoted to global and extra-regional destinations. The development of infrastructure networks serving the hinterland and intra-regional that goes through it is costly. Moreover, if traffic demand is weak returns may not offset costs; economic and social dividends if positive, might accrue in the long run. Third, cross border infrastructure development – transport, energy and telecommunications – requires coordination with neighboring countries. Because regional institutions are weak and lack investment resources, coordination remains in the domain of bilateral agreements where enforcement looks easier. At the other extreme, decisions concerned with inland facilities aimed at global (and regional) trade are a domestic matter. In such a context, investments face a lower risk and infrastructure projects that exhibit the dual role – global and regional – look more competitive.

b. Improving connectivity: the challenge of infrastructure development As explained above, the reduction of transport costs contributes to trade expansion and, as consequence, to aggregate growth. It is convenient to look at some data that shows the importance of infrastructure as a factor of competitiveness for Latin American countries. A counterfactual estimate on the impact on export performance associated with an improvement of infrastructure quality (Portugal-Perez and Wilson, 2010, p. 27) concludes Overall, the results show that improvement in infrastructure quality would bring the greatest benefits in terms of export growth. The analysis of the effects of these factors on trade flows provides useful information to guide policymakers on which might be the area or areas in which resource allocation would bring the greatest benefits. Among our four indicators, physical infrastructure has the greatest impact on exports in almost all specifications, and samples. The two landlocked countries of South America show the greatest impact of infrastructure improvement: for example, if Bolivia were able to attain half of the quality of the Chilean infrastructure index, exports would grow 49.1%, while a similar improvement of infrastructure in Paraguay would increase its exports by almost 47%.

258  Ricardo Carciofi and Romina Gayá

The evidence seems fairly conclusive and confirms that infrastructure development may have positive effects on trade and growth. The question that emerges is what are the limiting factors that arrest a reduction of transport costs through a better and more efficient infrastructure.25 The following discussion makes reference to economic and financial issues that show their implications for public policies at national level and also for integration strategies. Project identification and project appraisal. Investment projects need to have a careful analysis and a proper assessment. There should be a clear understanding that projects solve bottlenecks and reduce transport costs. This requires not only an estimate of the economic and social return but also an explicit factoring of externalities and environmental impacts. Further, infrastructure projects entail a whole arrangement of policy decisions that are a necessary ingredient of the process. In sum, investment projects require a careful planning that goes through the stages of project analysis. In order to do so, it is necessary to rely upon a solid institutional structure in government agencies. This is not always the case. The most visible consequences are delays, selection sub-optimal projects, or environmental and social collateral damages. Additionally, externalities and network effects are difficult to quantify (IMF, 2014) Investment projects, finance and macroeconomic variables. The previous paragraph underlines the microeconomic aspects of project selection. However, infrastructure projects usually involve significant amounts of capital relative to the size of the economy or any other fiscal parameter. Furthermore, projects may take a long construction period and their repayment involve many years. As domestic savings may be scarce, it is necessary to rely upon foreign finance. The positive side is that investment projects can be carried out despite the lack of local capital. However, foreign finance is levied through the issue of long-term debt in hard currency. Given macro instability, volatility of real exchange rates can be an obstacle to service external debt. This is more relevant since just a few projects collect user charges, and in most cases they are financed through fiscal resources. So, the ability to develop infrastructure projects is tightly connected to public debt sustainability. During the past two decades, there have been several infrastructure projects led by the private sector under different contractual arrangements – concessions, private–public partnerships (ppp), construction, maintenance and operation, “build, operate and transfer” (BOT) schemes, to mention just a few. The participation of the private sector helps to relieve the burden of investment finance for the public treasury. However, given the long-term risks involved in infrastructure projects – mainly, construction and economic risks-most schemes need to be supported by state guarantees that imply a contingent liability for the state budget (Bull, 2004). The Latin American experience with public finances has been characterized by pro-cyclical behavior in most cases (CEPAL, 2014). Thus, capital investment tends to rise during boom periods thereby creating pressures for implementing projects that have not carefully analyzed. In this regard, the availability of finance provided by multilateral and regional institutions – World Bank, IDB and CAF

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among others – is a key input for project development, particularly for countries whose country risk is higher than interest rates charged by multilaterals.26 Location. The geographical location of new infrastructure is a critical decision. The literature on regional economics has pointed out that market size, economies of scale, agglomeration and high transport costs lead to spatial concentration. Large urban areas cluster around extensive markets, harbors and hubs of maritime transportation. Thus, the improvement of transport and logistic infrastructure in metropolitan areas may increase inter-regional divergence (center-periphery dynamics). However, there are counterbalancing forces that might induce spatial dispersion 27 and this is the case associated with declining transport costs. At the same time, when hubs and networks between high and low growth regions favor connectivity, the reduction of transport costs may lead to further problems for lagging regions – distance is a natural protection barrier (Martin, 1998). Thus, better transport infrastructure alone is not a remedy for the distant and lagged hinterland. An array of other policy actions should be in place to offset divergence. Sequencing: Relying upon infrastructure to connect isolated regions may not always be an efficient solution. Should economic activity and trade develop first or is infrastructure the starting step? The location trade-off is clearer when intra-regional trade begins to flow along new routes that go deeply into the hinterland – such is the case of land transportation. In order to develop new infrastructure to service the rising demand, there is a need of substantial trade volume. It may be very costly to pave the way for new projects when demand forecasts are uncertain. Capital has alternative uses and partial utilization of infrastructure means sunk costs for quite a long time period. Reducing transport costs as a tool for regional integration. To a great extent, the points raised above apply to any decision leading to allocate resources to improve network infrastructure. The relevant question is how to deal with transport costs in the context of regional integration. To begin with, there is a more general question regarding economic efficiency. RTAs may shift revealed comparative advantages away from traditional activities. Therefore, the reduction of transport costs may partially offset those effects. Additionally, as shown by Venables (2003), regional integration in the context of high transport costs will induce economic concentration in the larger markets.28 So, there are economic advantages associated with better connectivity among countries belonging to the same bloc. However, the characterizing feature of infrastructure development in the context of regional integration is coordination among members. In fact, traded goods – similar considerations apply to energy and telecommunications – will flow through a regional transnational network. A proper and efficient planning requires analyzing the components of the entire network. There are several reasons that justify that approach: weakest links in the network will diminish final outcomes. Thus, if country A improves its network but partner country B does not conduct a similar effort, the result is unbalanced: better infrastructure in country A is equivalent to a tariff reduction

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to imports coming from country B. Further, the global competitiveness of the region is not increased since the network improvement is partial. Additionally, as indicated above, projects may have cross border externalities – either positive or negative – that need to be offset somehow via monetary or non-monetary mechanisms. This is very clear in the case of infrastructure and development projects located in border areas. It may be the case that country A investments in the area may lead to negative externalities in country B that require a proper compensation. Or when positive, externalities may induce country A not to invest since it cannot ripe all the benefits associated with the project. Clearly, if projects appraisal were conducted at regional level these effects would entirely internalized. Coordination for infrastructure development in the context of regional integration faces three difficult challenges. First, it may be the case that needed projects have asymmetric returns – so net benefits are biased towards one the participating countries. As a consequence, economic incentives for improving the regional network are not the same. Second, even in the case of similar socio-economic returns associated with each project, country risk may sharply differ from one to another – that is, each country member applies its own discount rate. To some extent macroeconomic coordination would help to reduce differences in country risk. Yet, the tool may be of limited use. Both obstacles disappear with the provision of some regional public good that would offset asymmetries and differences in country risk. This can be implemented through outright monetary compensation to the worse off country at the expense of a regional fund. Another remedy is regional financing by a multilateral institution where both countries are members of it. This is a key aspect that explains why regional banks play an important role both in South American and Central American initiatives of physical integration: these institutions are both providers of finance and technical knowledge that is detached from the immediate interest of member countries. The third challenge is related to the institutional architecture of regional integration. Infrastructure planning for the region as a whole may require an effective degree of delegation of authority at regional level. As was pointed out above, supranational entities have not worked in the Latin American case. Coordination is strictly kept at the inter-governmental level. However, given that the decision-making process is on shaky grounds, rules are not clear and decisions may be easily reverted, the consequence is that country investment decisions try to minimize the risk entailed by coordination. Therefore, infrastructure projects related to a regional network specifically oriented towards better connectivity may be postponed on several grounds: the need for complementarity projects, externalities, overall returns are low vis-à-vis alternative decisions, differences in country risks that lead to divergent decisions and the lack of binding decisional rules at regional level. In sum, the previous discussion has stressed that development of infrastructure services aimed at trade requires careful planning – macro issues, trade strategies

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and intra-regional balances among members of RTA – are at stake. The planning and decision-making mechanism will have to take note of a shifting picture. Precisely, infrastructure projects imply a long-term capital allocation within a changing environment. Plans and projects should be continually updated. Physical integration at the regional level poses significant challenges when coordination mechanisms rest on weak grounds. To the extent that is so, countries will tend to favor decisions that can have a dual role of serving global and regional trade flows. Specific compromises on investments that require a high degree of complementarity of neighbor countries and/or that entail low returns for the investor country due to externalities have a low degree of viability. Capital allocation to this end needs to have compensation mechanisms that are lacking in most Latin American regional agreements.

c. Analytical matrix for reviewing Latin American experiences of physical integration As initially explained, the following three sections are devoted to the review of different initiatives aimed at physical integration: IIRSA-UNASUR (COSIPLAN), FOCEM and MIDP. Even when the goals exhibit some similarity, the political and economic context and the institutional setting of each case are very different from one to another. It would take a long detour to present a complete narrative of each case.29 Even when the actual Latin American experience has a rich history, description does not look as the more promising approach. As the previous discussion shows the development of physical infrastructure aimed at regional integration is confronted with specific challenges that need to be solved by coordination mechanisms. So, the interesting question is to analyze how each institutional arrangement is able to sort out the obstacles arising from the need to build up regional connectivity. Thus, the contents of the following sections are organized according to a common scheme. On the one hand, the chapter summarizes the main features of each of the cases – brief historical references, institutional organization, relevant trade and economic data. On the other hand, the discussion turns to the more analytical issues that are related to the questions posed above and several topics are addressed in this context. First, the text puts emphasis on the mechanisms of project identification and the linkages to regional and national planning – that is, the buildup of the regional investment portfolio and its technical (planning) support. Second, the sections comment upon the modalities for project finance and to the extent to which investments are supplemented by regional funds. In particular, the analysis addresses the role of multilateral financing. As explained above, regional banks have the potential to perform more than one function: they are a source of finance at similar cost to every member, they can provide direct or indirect technical assistance at low or near zero cost (concessional funding), and, to some

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extent, these institutions can offer certain level of coordination that is based upon its technical knowledge at regional level. Finally, the chapter explains the institutional arrangements that characterize each one of the three initiatives. Particular attention is devoted to decision rules adopted by member countries.

2. South America: IIRSA-UNASUR (COSIPLAN), a new integration initiative a. Main features At the turn of the new century, Brazil took the lead and launched a new integration initiative: in October 2000, President Fernando Henrique Cardoso hosted a Summit of South American Presidents. That meeting meant the starting point of a process that would end up in the creation of UNASUR almost ten years after Brasilia’s founding Summit.30 With the benefit of hindsight, the episode cannot be accounted for as an isolated Brazilian decision. A series of events precipitated so as to give birth to a unique strategy that, one way or the other, fitted the interests of most South American countries at that time. With differences and nuances of history, subsequent events ended up fueling the original idea: the creation of a Southern regional block. The initial strategy had peculiar features that deserve some attention. The text below comments upon two of them: scope and focus of the initiative. It is worth noting that South America had never viewed itself as a subregion. Around 2000 South American countries clustered around either CAN or MERCOSUR, with a relatively hybrid status for Chile (a former member of the Andean Pact which had RTAs with CAN members and MERCOSUR). Aside those sub-regional bodies, countries kept their belongings to Grupo de Río  – more recently CELAC – and the OAS. However, in the multiple attempts that took place in the 20th century to bring together Latin American countries, there are no traces of the creation of a Southern block in the Americas. If there existed any project along those lines, it never got materialized. This time was different: the year 2000 marks the starting of a series of efforts aiming at creating a South American entity. It is beyond the limits of this chapter either to provide a detailed discussion of the reasons that gave rise to such a strategic move or describe a historical account of it.31 However, a brief mention to the more obvious elements is helpful to understand the basic geopolitical forces that are at play at that time. First, the importance of Brazil in the sub-region is an outstanding feature and, in this context, there have been several attempts to expand its role as a regional leader (Lima, 2008). As is clear today, geography, population and economic magnitudes may induce those intentions, however, they do not define by themselves the effectiveness of regional leadership.32 Second, Brazil’s need to gain firmer sub-regional footing was challenged, to some extent, by the growing importance of NAFTA and Mexico’s role in that agreement. Third, in 2000 Argentina and

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Brazil had convergent and defensive views on trade issue vis-à-vis US attempts of implementing the Free Trade Area of the Americas (FTAA). Fourth, MERCOSUR successful experience of the 90s may have also inspired the idea that by creating a sub-regional space would help to the gradual enlargement of the trade agreements of the Asunción Treaty.33 In fact, the internal agenda of MERCOSUR has actually followed those steps during the last five years – Venezuela and Bolivia have almost completed the accession process.34 Leaving aside the motives of individual countries and potential convergences, the ambition of creating a South American integration entity involves a major challenge. A closer look at some basic indicators provides a hint of the contrasts between the Southern block and other regions (Table 10.3). In particular, South America shows a relatively low degree of intra-regional trade and its economic size is just 30% of the other potentially competing blocs. It is also interesting to note the disparity with European indicators: while South America has more than 80% of Europe’s population and represents less than ¼ of Europe’s gross domestic product (GDP), the geographical extension is almost four times bigger. The relatively low population density and the distances involved mean that infrastructure development requires quite a substantial amount of resources.35 At the time of deciding that the South American sub-region needed to make a leap forward towards integration a key decision was taken: the priority was placed on physical integration – basically, all transport modalities.36,37 Thus, the need to create a specific mechanism to work on the subject: IIRSA.38 From the institutional perspective IIRSA has been a mechanism for dialogue and agreement on issues of physical integration among South American governments.39 Trade and economic issues were de facto kept off the agenda. There were practical considerations for doing so. First, not only South America was a new entity but it also never had confronted an effort of such a scale: the goal was to increase connectivity for the sub-region as a whole. Therefore, the magnitude of the project deserved a more concentrated effort. Second, there existed the belief that TABLE 10.3 South America, NAFTA and EU: basic indicators, 2014

Region

GDP (US$ billion)

Population (million people)

Area (million km2)

Share of intraregional trade (average exports and imports) (%)

East Asia a EU NAFTA South America

18,776 18,495 20,490 4,173

2,084 502.9 474.3 411.0

13.3 4.5 21.8 17.7

43.0b 63.0b 42.4 20.4b

Source: Authors’ elaboration with data from IMF, Eurostat, DATAINTAL, COMTRADE and CIA World Factbook. Notes: a East Asia includes: Brunei Darussalam, Cambodia, China, China, Hong Kong SAR, Indonesia, Japan, Philippines, Rep. of Korea, Singapore, Thailand and Vietnam. b 2013.

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the other dimensions of integration – particularly, on the economic sphere  – could be handled by the other entities – MERCOSUR and CAN.40 Third, IIRSA adopted a comprehensive view to the development of physical integration that required quite an in-depth analysis of the territory. Such a concentrated focus carried out an equivalent effort in terms of agenda and work dynamics. A cursory review at IIRSA’s annual work program and technical studies reveals a persistent attempt to keep the focus con infrastructure and connectivity.41 At the same time, the attention to the different dimensions acting in the territory – economic, social, environmental – posed the need for a more comprehensive approach of regional planning.42 Given the institutional constraints, in practice, it was difficult to carry out such a work agenda and the practical implementation of related decisions. From 2011 onwards, the Council for Infrastructure and Planning (COSIPLAN) at UNASUR is responsible for the coordination of physical integration in South America. The main tool for organizing the technical work at a regional scale was the concept of “development hub” – that is, the identification or geographical areas (hubs) along which trade flows were concentrated.43 Thus, the entire South American geography was divided up in ten different “hubs” (Figure 10.2) where infrastructure facilities were mapped together. A detailed analysis of the hubs led to the identification of the more visible needs.44 The process has also been supported by technical cooperation of regional banks: CAF, IDB and FONPLATA have allotted staff and non-reimbursable resources for a wide collection of sectorial studies and reports.45,46 The three

Andean Hub

Peru-BrazilBolivia Hub

VENEZUELA Paramaribe Cayonre GUYANA GUYANE COLOMBIA GJRNAME ECUADOR

Capricorn Hub

Southern Andean Hub FIGURE 10.2

Amazon Hub

PERU Lima

BRASIL La Paz BOLIYIA

Paran- Paraguay Waterway Hub

PARAGUAY

CHILE

Guianese Shield Hub

URUGUAY ARGENTINA

BRASIL

Central Interoceanic Hub MERCOSURChile Hub

Southern Hub

South America: integration and development hubs.

Source: www.iirsa.org.

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institutions have forged an agreement that led to the creation of Technical Coordination Committee that regularly keeps the burden of organizing the technical works that feed the dialogue among member governments. Countries proposals led to a selection of projects aimed at solving more pressing demands – either new developments or an improvement of existing facilities – thereby conforming a regional portfolio. It is interesting to note that projects are not only aimed at cross-border purposes but also provide connectivity to the hinterland. This is a practical illustration of the network effects that characterize infrastructure development that was pointed out in the previous section. The significant number of projects (579 in October 2014 – US$163.3 billion) and the different stages of project development47 have required the concentration of scope on a selected number of priority projects.48 Transport accounts for 89% of projects and two-thirds of total investments. Energy accounted for 9% of the total number of projects and 33% of the investments. Member countries decided to identify 31 “structured projects”, in turn composed of 88 individual investments. The selection was made paying attention to impact on connectivity, completion of feasibility studies including environmental approvals, and financial viability – either through budget resources or other scheme of financing (multilateral, private sector, etc.). Most of the current efforts of IIRSA-UNASUR (COSIPLAN) on infrastructure are now concentrated on the Integration Priority Agenda (IPA).49 From the point of view of the process along the past 15 years, South America has moved towards a formal institutional design and a growing complexity of Agenda (ECLAC-UNASUR, 2014). Nowadays, UNASUR is a multilateral agreement with multiple goals that are dealt with by nine Councils. At the end of the day, the founding idea of promoting a unique effort concentrated upon physical integration has fallen into a wider context. If there were initial attempts at creating a specific arrangement for regional infrastructure development, the logic of a more comprehensive agenda eventually prevailed. This is not the outcome envisaged for the initial promoters of IIRSA. On one hand, the starting institutional design sought the creation of a relatively insulated scheme where planning and ministers of public works had the dominant role. It was assumed that this model would ensure to keep the focus in the primary objective: the development of infrastructure. On the other hand, the mechanism lacked the tools for forging the necessary inter-governmental agreements – that is, the natural territory of foreign relations ministries. In the end, the process went one stage further with the creation of UNASUR. To some extent the process has landed in the proper framework since physical integration is not detached from the other dimensions of the integration agenda. Nowadays, member countries do belong to an international treaty where agreements can be crafted in regional decisions. Obviously, the actual possibilities of arriving at concrete results depend not only on legal and institutional structures but also on the real content of the agreements.

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In spite of the changing institutional designed, there has been a continuity of efforts on territorial planning, project identification and sectoral studies have proved useful. IIRSA-UNASUR (COSIPLAN) has developed a well- defined portfolio of priority projects that are backed up by regional consensus. The key question is whether the existing institutional and financial architectures are strong enough in order to deliver the expected results. The remaining of this section explores this issue.

b. Planning, finance and institutional arrangements at regional level How has IIRSA-UNASUR (COSIPLAN) experience dealt with coordination and planning at regional level? As proposed in Section 1.c, the following topics deserve special attention: regional planning and project identification, the role of finance and the regional banks and, finally, institutional arrangements and decision rules. A distinctive feature of IIRSA-UNASUR (COSIPLAN) is its clear emphasis on planning at regional level coupled with responsibilities for project identification at national level. Both tasks have, in turn, specific attributes that are worth mentioning.

Regional planning and project identification Along the years of repetitive practice, planning has meant focus on the territory. The organizing principle has been the notion of “development hubs”. The concept combines two basic aspects that are familiar to the economic geography literature: concentration and transport costs. Economic activity and population tend to cluster around infrastructure facilities that reduce transport costs – roads, railway lines and rivers. At the same time, it is assumed that the development of new projects will ease access (reduce transport costs) thereby allowing to connect the hinterland and having a positive impact on local development. Transport and connectivity within the hub space are essential but there are also other policies and projects that contribute to the development of the hub’s territory. The positive side of this integrated approach to the territory is that it allows the interaction of economic, social and environmental dimensions. The other side of the coin is that the policy agenda becomes very complex to deal with. IIRSA-UNASUR (COSIPLAN) has confronted the problem. In order to come up with an effective solution to the issue National Coordinators have the dual task of representing the country’s interest in the regional body and linking with the national agencies in charge of the relevant issues concerning actions in the territory. In practice, the process is cumbersome. Not only because of bureaucratic and technical decisions in governments are fragmented but also because issues at hand usually require the intervention of local authorities. Therefore, decisions percolate to the structure according to

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the interests of the different stakeholders. Further, as will be analyzed below there are no grant mechanisms or matching funds that can help to unblock the process. Notwithstanding the analytical dimensions of the hub concept, what is relevant for the purposes of the present discussion is that development hubs run across borders and involve different countries. Domestic political jurisdictions are a mere locational reference. The actual meaning of this approach to regional planning is that the South American space is viewed as a single borderless unity – that is, the entire sub-region is equated as it was a single country.50 All countries participate in planning deliberations and decisions. The more frequent issues under analysis are location and dynamic of economic activities including environment and social dimensions, transport and connectivity, project identification and project execution. The active technical work deployed at regional level is in itself an interesting landmark in the history of the sub-region. Planning and technical exchange has been modest and when it actually took place it remained at bilateral level and with reference to border issues. Whereas planning is carried out at regional level, project identification is in the realm of country decisions. That is IIRSA-UNASUR (COSIPLAN) projects are prioritized first at the national level and presented then to the regional body for approval. In theory, the regional portfolio is a sort of “consensus portfolio” and it is the final result of a process that starts at the national level. The procedure assumes that there are national development plans in place and that they are supported by sector strategies – in particular, transport and trade strategy – and a medium-term investment plan. Thus, project selection is the outcome of an assessment made at national level and according to national priorities. There are no regional incentives to bias the choice towards integration projects. Most countries do have national agencies in charge of planning. Further, for those cases with the stronger framework the planning and budget processes are well connected. So, national plans are supported by projects – either public or private – and capital allocations are translated to national or federal budgets when necessary. In the case of infrastructure projects developed by the private sector or through ppp, there is a need not only of technical studies but they also have to be supported by the required authorizations either legal or administrative ones. However, the situation is uneven. Several countries in the region lack the institutional and technical resources for designing strategic and operational plans, and for conducting a proper assessment of complex investment projects. As a result, the regional portfolio is an addition of projects and profiles that are subject to different investment criteria – in some cases, they are aligned with national priorities whereas in other situations the link is weak. This is not a minor shortcoming. The quality of individual projects is a key ingredient for the quality of the regional portfolio. 51 Moreover, to the extent that projects are not aligned with long-term goals there is a risk of a reversal of decisions and shifting government priorities.

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Finance, project execution and the role of regional banks As indicated above, South American portfolio is an aggregation of individual projects that are located within the hub territory (belonging to countries sharing the same hub). There are, of course, some cross border projects that involve coordinated construction works in neighbor countries. Most frequently, this is not the case. Projects are financed and carried out by member countries according to the policies, legal and administrative procedures they have in place. There are no “regional projects” as such.52 Thus, the sources of finance devoted to project financing are a decision located at national level. The scheme is entirely compatible with the notion that projects are also the outcome of domestic decisions and that debt arising from them is composed of national liabilities either public or private. In this context, the incentives for developing regional infrastructure are low: project selection, construction and finance will be biased towards investment with relatively low positive externalities and those that require minimal coordination efforts. Given the elements discussed above it is easier to understand the role of regional banks. On the one hand, they are able to finance development projects at similar interest rate costs to member countries. The alternative of having a mechanism for equating the financial costs of different projects is an attractive tool if one the countries face high borrowing costs or is credit rationed. However, in order to be effective, both countries must have coincident priorities at the time of defining the project pipeline with the financial institutions. This is not usually the case since multilateral finance is also limited and there many other factors at the time of structuring a borrowing program. Even when regional financial institutions may find out that certain (integration) projects are of key importance, countries do have the final decision on where to allocate the finance that is available to them.53 However, regional banks have also an advantage on the technical front. By definition, those institutions are better equipped to conduct studies with a regional range.54 First, institutions have the mechanisms for allocating concessional funds to this end. Second, there is an advantage when the issues at hand require similar methodologies to be applied in different countries. In actual practice, the case of IIRSA-UNASUR (COSIPLAN) has conformed to the pattern presented above. The three regional financial institutions have worked closely on technical issues. The blend of concessional resources, technical assistance and the advisory role has contributed to a sustained work program and knowledge. Regarding of the lending of the bilateral program (country-institution), contents and projects were the result of a mutual agreement that accommodates national priorities and banks’ financial capabilities and operational modalities.

Institutional arrangements As explained above IIRSA-UNASUR (COSIPLAN) has described a shifting institutional design. The early years (2000–2010) pivoted around a rather informal mechanism of inter-governmental dialogue and cooperation (Carciofi, 2008). The annual Presidential Summits contributed to raise expectations on results.

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The process helped to lay the conceptual and technical grounds of the work program though it lacked the necessary rules for internalizing regional agreements at country level. The creation of UNASUR has solved this weakness. The institutional design is strictly inter-governmental adopting a model that is common currency in Latin American integration agreements. Being so, the process is rather cumbersome: decisions adopted by the regional body have to be implemented by national governments – either by administrative of legislative measures. The sequence of decisions and implementation takes time but, in principle, there are not formal loopholes that may restrain policy actions. Real obstacles lie elsewhere. As discussed in the previous pages, the development of integration infrastructure entails significant coordination inputs and the need to internalize advantages and disadvantages at regional level. Additionally, there are marked asymmetries in the institutional capabilities for planning and project design at national level. Also, Bolivia and Paraguay, the two landlocked countries of South America, encounter particular connectivity needs (and higher investment levels). It is very difficult to come up with effective solutions to those issues when there are no regional funds available that could be allocated to the production of those (regional) public goods. As explained above, the role of regional financial institutions has helped but they provide a “second best” solution: they have a wider agenda to deal with and their own governance is subject to competing demands. It should be noted that the attempts at the creation of Banco del Sur have not materialized in actual results.55 Then the question arises: if the potential availability of regional funds might help to solve many of the current challenges, why have South American countries have not decided to set up the proper mechanisms? Is it a matter of budgetary resources or is it a political disagreement? Certainly, it is not easy to arrive at substantial understandings at the time of implementing decisions concerning deep integration. On that regard the political economy involved in this matter cannot be minimized. At the same time, it should be made clear that countries have invested considerable political resources that led to the deployment of this particular initiative. So, the lack of political will does not seem a very powerful argument. There is another dimension that has to be brought into the discussion and that was mentioned in Section 1: the degree of intra-regional trade in South America is low, intra-industrial exchange is shallow and cross-border investment is not strong enough. In order to make concrete progress towards deep integration there is a need to move forward on different fronts at the same time: convergent views on the strategy, economic policies that lead to increasing intra-regional trade and physical connectivity.

3. MERCOSUR’s structural convergence fund (FOCEM)56 a. Main features MERCOSUR is a regional integration process in the Southern Cone. It was created in 1991 by Argentina, Brazil, Paraguay and Uruguay. Venezuela became a

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full member in 2012 (six years after the signature of the Protocol of Accession).57 In 2014 the region’s GDP was almost US$3.2 trillion; it had a population of 286 million people and an area of 12.8 million km 2. Intra-regional trade accounted for 14.4% total flows, but it was significantly more important for the small economies (e.g., Uruguay and Paraguay). Since its early years, MERCOSUR has been confronted to a significant challenge: huge structural (economy, population, geographic extension) and policy asymmetries among its members. In 1991–1994 Brazil accounted for 79% of the bloc’s population, 72% of its area and 68% of its GDP, followed by Argentina (17, 23 and 29%, respectively). Paraguay and Uruguay accounted jointly for less than 4% of MERCOSUR’s area and population and less than 3% of its GDP (Gayá, 2008). In contrast to other regional integration processes in the region (such as ALALC, CAN, CARICOM and MCCA), MERCOSUR did not include any special and differentiated treatment for small or less developed countries. According to IDB-INTAL (2007), the absence of compensation mechanisms was due to the assumption that Paraguay and Uruguay would be able to gain from scale economies arising from the access to the Argentine and Brazilian bigger markets and attract investments accordingly. Thus, instruments to reduce disparities among MERCOSUR members were limited to longer schedules of trade liberalization, larger lists of exceptions to common external tariff for Uruguay and Paraguay and flexibility in rules of origin in the case of the latter (Gayá, 2008). Despite the progress in the integration process, some years later Paraguay and Uruguay began to claim that asymmetries had enlarged, in part because gains from integration were unfairly distributed among MERCOSUR members. Consequently, they demanded a compensation mechanism.58 FOCEM was the regional response to those claims. It is a regional fund created in 200459 (in force since 2006) with the aim of reducing disparities among MERCOSUR countries. FOCEM’s specific purposes are to promote structural convergence, to develop competitiveness, to foster social cohesion (especially in small economies and least developed regions) and to support the operation of the institutional structure and the strengthening of the integration process. Paraguay and Uruguay are the main beneficiaries of the resources.

b. Planning, finance and institutional arrangements at regional level As FOCEM’s main purpose is to reduce disparities, its contribution to regional physical integration can only be significant if it is considered as an adequate means to reach that goal by member countries. From the fund’s creation to date, many projects have been related to physical integration, but this emphasis can change as long as member countries’ priorities and perceptions do. FOCEM deals with two issues that other regional mechanisms do not address. On the one hand, member countries make regular budgetary contributions to

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finance projects. On the other hand, financing is conditioned to matching funds by local counterpart, which provides incentives for project execution.

Regional planning and project identification Despite being conceived as a regional instrument, FOCEM is organized on an inter-government basis where projects are designed nationally and oriented mainly to reduce asymmetries among members. Thus, not all projects necessarily contribute to regional integration and some of them are purely national. Each country submits proposals that are assessed according to FOCEM’s protocol. Pluri-state projects (involving more than one country) can be proposed by two or more governments or by MERCOSUR institutions. Member countries – through the Commission of Permanent Representatives (CRPM for its Spanish acronym) – select projects to be financed taking into account their contribution to reduce regional disparities or strengthen integration. There are two ways in which infrastructure can contribute to reduce disparities among MERCOSUR members: (a) through developing facilities in least developed regions and (b) through integrating these regions to others (transport and communication infrastructure). As projects are designed nationally, each government decides on the relative weight of (a and b) goals. Therefore, it is up to a government call to promote integration projects only when they are regarded the best way to reduce disparities. FOCEM is divided into four programs shown below (Table 10.4): structural convergence, competitiveness development, social cohesion and support of the operation of the institutional structure and the strengthening of the integration process, each for one of the specific purposes of the Fund. The main goal of Program I – which includes projects related to physical integration – is to foster development and structural adjustment of small economies and least developed regions, including improvement of border integration and communications. This is the most important program of FOCEM with 21 projects (out of 45 approved) relating to transport infrastructure, electricity and water representing 88.7% of total resources (US$876 million). Four types of projects can be financed under Program I. The first category is specifically associated to physical integration. It accounts for 38.9% of total resources (US$529 million). Projects approved until 30th November 2014 are related to transport improvement. It is important to underline that MERCOSUR is not considered a single territory and projects are not aimed to develop a regional transport network. As explained above, they are supposed to reduce asymmetries and contribute directly or indirectly to increase intra-regional trade flows. Until 2014, there were no projects related to fuel exploration, transport and distribution. All the projects approved under the third category are also related to physical integration: they aim at promoting the interconnection of electric systems of MERCOSUR countries, but there are no instruments to develop

272  Ricardo Carciofi and Romina Gayá TABLE 10.4  FOCEM programs: description, goals and approved resourcesa

Program

Goal

Projects related to

I Structural convergence

To foster development and structural adjustment of small economies and least developed regions, including improvement of border integration and communications To increase competitiveness of MERCOSUR production

88.7 Transport infrastructure. Fuels. Electricity. Water and sanitation

II Competitiveness development

III Social cohesion

% of total resources

Productive adjustments, 4.6 productive integration, qualityrelated institutional improvements and research and development Health, education, 6.5 poverty alleviation and employment

To contribute to social development with emphasis in small economies and less developed regions, especially in border regions Institutional issues To improve IV Support of the MERCOSUR’s operation of institutional structure the institutional and to deepen structure and the integration strengthening of the integration process

0.1% (entirely financed by FOCEM)

Source: Authors’ elaboration with data from CRPM. Note: a Projects approved until 11/30/2014.

a regional electric market or to improve bilateral trade of electricity through interconnections already available. This component represents 56.9% of total investment with US$773 million, corresponding more than 70% to the biggest project of FOCEM.60 In the fourth category (US$57.3 million) there is a bilateral project to improve water and sanitation in Acegua, a border region of Brazil and Uruguay.

Finance, project execution and the role of regional banks In contrast to other regional initiatives, FOCEM has its own resources that come from regular and nonrefundable contributions by member countries. Its annual

Physical integration in Latin America  273

budget is US$127 million (US$100 million until Venezuela joined the fund in 2014), but member countries can make additional voluntary contributions for specific purposes. To date, only Brazil has made voluntary contributions for over US$200 million (more than one fifth of total resources since the fund was created). FOCEM cannot borrow funds from third sources. From the point of view of project financing, FOCEM is a non-reimbursable source that can adapt to other sources: national budget, private banks and multilateral financial institutions.61 As the Fund’s purpose is to reduce asymmetries, Paraguay and Uruguay are the main beneficiaries of the resources and Brazil, Argentina and Venezuela make the largest contributions (Figure 10.3). Scale is one of the most important limitations of FOCEM. Infrastructure projects require large investments and the fund’s resources are scarce: regular contributions are small and there is no leverage. In addition, considering its annual budget is a fixed amount, the fund becomes relatively less important as economies grow. In 2015, FOCEM’s budget represents only 0.02% of forecasted GPD62 (including regular and voluntary contributions and resources available from previous years) compared to 0.5% of GDP of Cohesion Policy in the EU.63 However, some differences between both policies must be considered when comparing them. First, in absence of a regional trade policy and common customs revenues, MERCOSUR does not have its own resources. EU resources,

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Regular contributions Argentina FIGURE 10.3

Brazil

Paraguay

Available funds Uruguay

Venezuela

Program IV

FOCEM: Regular contributionsa and fund availability by member country and Program IV (2015 budget).

Source: Authors’ elaboration with data from CMC Decision #40/14. Note: a Voluntary contributions not included.

274  Ricardo Carciofi and Romina Gayá TABLE 10.5 FOCEM: approved projects by beneficiary (quantity, value, participation

and share of FOCEM resources in total financing a

Beneficiary

Approved FOCEM resources projects US$ million %

Argentina 4 Brazil 5 Paraguay 17 Uruguay 12 Venezuela 0 Pluri-state projects 3 Program IV (institutional strengthening) 4 Total 45

46.8 33.8 623.8 255.6 0.0 26.7 0.7 987.3

4.7 3.4 63.2 25.9 0.0 2.7 0.1 100.0%

FOCEM/ total (%) 67.2 74.0 67.8 58.0 – 78.3 99.6 65.4%

Source: Authors’ elaboration with data from CRPM. a Projects approved until 11/30/2014.

in contrast, include members’ contributions64 as well as EU traditional own resources (customs duties on imports from outside the EU and sugar levies).65 Second, largest net contributions in the EU come from developed countries, but the main donors in FOCEM are developing countries where it is more difficult to get funds to finance development projects abroad. Third, resource allocation in FOCEM is defined on a national basis in order to reduce disparities among member countries. If EU convergence criteria were used in MERCOSUR, Uruguay would be a net contributor while least-developed regions in Brazil and Argentina will be among the main beneficiaries. Each project is financed by grants (non-repayable funds) disbursed by FOCEM and matching funds from a local counterpart (at least 15% of eligible expenses). As shown in Table 10.5, FOCEM provides almost two thirds of total approved financing. As mentioned above, the existence of matching funds by the beneficiary provide an incentive for project execution and it provides assurances that funds are allocated to the agreed target.

Institutional arrangements As mentioned earlier, FOCEM is organized on an inter-government basis. Member countries – through the Commission of Permanent Representatives (CRPM for its Spanish acronym) – select projects to be financed taking into account their contribution to reduce regional disparities or strengthen integration. FOCEM’s Technical Unit (UTF for its Spanish acronym), a regional institution depending of MERCOSUR Secretariat, is responsible for project evaluation and monitoring and it works closely to national technical units. National States are in charge of project execution, even when they delegate this function to public, private or mixed institutions. Only legal entities or natural

Physical integration in Latin America  275

persons from MERCOSUR countries can be suppliers in acquisitions financed by FOCEM resources and they should be treated equally (national treatment). Projects with a higher degree of regional content will have a 10% preference. Has FOCEM been a useful tool for reducing asymmetries? A proper answer to that question requires a thorough assessment of approved projects and this is a pending matter for future research. However, the review above suggests two features that are worth considering for an in-depth study. First, given MERCOSUR structural asymmetries, FOCEM policy rationale is justified though the volume of resources seems quite limited to the declared target. In this context, it is not easy to understand why FOCEM has not placed more emphasis on the financial leverage of its own resources. Second, given the absolute and relative importance of Program I – Structural Convergence – and its concentration of physical integration, it is not clear why MERCOSUR has not launched a more ambitious program of regional proportions.

4. Mesoamerican integration and development project (MIDP)66 a. Main features Central American countries started planning their regional integration in the second half of the 20th century. ECLAC provided key intellectual inputs that were quite functional to prevailing political impetus of the time. In 1961 Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua signed the Central American Economic Integration Treaty, aimed at creating the Central American Common Market (MCCA, for its Spanish acronym), where institutional design meant a pioneer decision in the context of those years. Although results were not as good as expected (in terms of export diversification, import substitution and symmetric distribution of trade gains), MCCA led to a strong growth of intra-regional trade. However, the conflict between El Salvador and Honduras resulted in a crisis and the latter left the bloc in 1970. Six years later, the Central American Economic Integration Subsystem (SIECA in Spanish) tried to encourage integration through an innovative project that included a social dimension. However, it did not work during the 80s because of the internal armed conflicts in El Salvador and Nicaragua and the economic crisis which increased protectionism in the region ILO, 1999). During the 90s Central American countries improved their macroeconomic fundamentals and decided to boost regional integration. They created SICA which included social, environmental and cultural dimensions. SICA members are Belize, Costa Rica, Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua and Panama. All these countries except Belize and Dominican Republic also take part of SIECA. The following decade, MCCA countries deepened trade integration through the development of the customs union (SELA, 2014). At the same time and more recently Central American countries pursued an open trade strategy including extra-regional countries: most countries signed

276  Ricardo Carciofi and Romina Gayá

RTAs with the EU and the US. In fact, the Dominican Republic-Central America free trade agreement with the US (CAFTA-DR) helped to the consolidation of regional trade advantages and access to the US market. In this context and despite the ups and downs of the integration process during the last century, some regional isolated projects encouraged physical integration in Central America, which became the region with the highest level of intra-regional trade in Latin America. 2001 meant an inflection point. Plans proposed by the Mexican government and the Grupo Consultivo de Reconstrucción y Transformación de Centroamérica resulted in the creation of the Tuxtla Mechanism in 2001. On the one hand, Mexico was interested in integration with the region despite low levels of intra-regional trade. In fact, Mexico’s motivations were mainly geopolitical: to become a nexus between Central and North America, to contain immigration from Central America and to improve social and economic conditions in southern and south-eastern less developed states,67 which have cultural similarities with the region.68 On the other hand, Central American countries could benefit from the cooperation with Mexico, a large economy with close ties with the United States, as well as from integration within the region. The Tuxtla Mechanism was subscribed by Mexico and seven Central American countries.69 It included a comprehensive regional approach to promote development and to complement SICA (the institutional framework of integration in Central America): the Plan Puebla Panamá (PPP). PPP project selection was aimed at enhancing electrical, transport and telecommunications infrastructure and thus contributing to physical integration and regional development. In 2006 Venezuela decided to abandon CAN and a crisis emerged in the Andean bloc. Hence, Colombia was forced to develop a new strategy which included deepening integration with Central America. That year Colombia started negotiating a RTA with El Salvador, Guatemala and Honduras and joined PPP (Ruiz Poveda, 2014). In 2007 member countries agreed to reinforce the process through the MIDP, which was officially launched at the 10th Tuxtla Dialogue and Agreement Mechanism summit in Tabasco, Mexico in June 2008. MIDP members are ten Mesoamerican countries: Belize, Colombia, Costa Rica, El Salvador, Honduras, Guatemala, Mexico, Nicaragua, Panama and Dominican Republic (since 2009). The region is 3.7 million km 2, it has a population of 208 million people and a GDP of US$1,900 billion. Intra-regional trade reached US$2 billion in 2014 (6% of total exports). However, trade among Central American countries and Dominican Republic (i.e., Mesoamerica excluding Mexico and Colombia) represents 22% of their total trade. MIDP is a proposal aimed at strengthening regional integration and to promote economic and social development of Mesoamerica. Thus, it boosts trade flows (complemented with new and improved RTAs) and adds social, cooperation and physical integration projects. To reach that goal, MIDP is oriented to enhance connectivity, to increase interaction and interdependence among

Physical integration in Latin America  277

member countries and to stimulate convergence of national efforts to a strategic regional vision. It also contributes to policy dialogue on regional priorities, promotes specific projects, gathers multilateral funding to finance strategic projects and encourages the development of regional public goods. Regional integration is essential in MIDP. The region is considered as a single territory and the specific purpose of this mechanism is to encourage programs, projects and activities relevant for regional interests. Some examples of the regional focus are the development of a regional electric market (see Box 10.1), the fiber-optic network and the International Network of Mesoamerican Highways (RICAM for its Spanish Acronym). Regional integration is also evident in the very many RTAs that exist among MIDP countries. Although many of these agreements were previous to PPP, negotiations in the region intensified during the last 15 years to subscribe new agreements or to harmonize the existing documents (e.g., Mexico and MCCA countries). MIDP is organized in two main working areas: a social axis (health, environment, risk management and housing) and an economic axis, which comprises physical integration projects (transport, energy and telecommunications), as well as others issues related to trade facilitation and competitiveness. Regional institutions have supported the process through the interinstitutional technical group (GTI for its Spanish acronym), conformed by IDB, CABEI, CAF, ECLAC, SICA’s General Secretariat, SIECA and Pan-American Health Organization (PAHO). GTI helps the Executive Committee of MIDP to define projects and actions. IDB, CABEI and CAF also provide financial assistance through loans and non-refundable technical cooperation.

b. Planning, finance and institutional arrangements at regional level As proposed in Section 1.c, the analysis of MIDP includes considerations on regional planning and project identification, the role of finance and the regional organizations and institutional arrangements and decision rules. MIDP has three main characteristics. First, all the projects should contribute to regional integration. Second, in order to reinforce integration, the mechanism encourages coordination and cooperation among members in project design and financing. Third, it adopted a flexible and pragmatic financing mechanism based on different modalities.

Regional planning and project identification As mentioned earlier, the regional dimension is a key feature of MIDP and the projects included in this mechanism are oriented to strengthen cooperation and to encourage regional integration, complementarity and connectivity among member countries. In fact, all MIDP projects must take into account priorities defined by governments and boost regional integration. MIDP includes projects involving at least two member countries, national projects that contribute to regional initiatives

278  Ricardo Carciofi and Romina Gayá

and projects that develop regional public goods. Coordination among member countries of MIDP is essential to harmonize projects in order to avoid duplicate efforts. Projects are divided into two categories corresponding to social and economic axis. The latter accounts for 95% of MIDP’s portfolio (transport 76.7%, energy 18%, and social axis 5%). Projects related to physical integration in Mesoamerica represent US$2.4 billion and are divided in three categories: transport, energy and telecommunications (Table 10.6). The goal of the first category – US$1.9 billion in 2013 which accounted for 76.7% of total MIDP investment – is to develop an efficient multimodal regional transport system. These projects are designed, proposed and executed by the Technical Transport Commission. One of the most important components of this category is RICAM, which aims to improve competitiveness by connecting producers and consumers with distribution and shipping centers. As shown in Figure 10.4, RICAM includes the Atlantic Corridor, the Pacific Corridor, Inter-Oceanic Logistics Corridors, the Caribbean Tourism Corridor and supplementary roads and connections. It is important to mention that RICAM goes further than connecting roads; it is a regional road network that includes common rules on speed limits, modernization of border crossing points and the implementation of the Mesoamerican Procedure for International Goods Traffic (TIM in Spanish).70 The main goal of energy projects (18.1% of total investment) is to develop a regional electric market (see Box 10.1) and the last category aims to improve telecommunications in the region. TABLE 10.6  M IDP projects related to physical integration

Transport

Energy

Telecommunications

Goal: to meet the regional Goals: universal service, lower rates, regional electricity demand and interconnection, development to develop the regional of value added-services electric market Projects Projects Projects o Mesoamerican Information o SIEPAC o Multi-modal Highway Mesoamerican Transport o Regional Electric Market System (STMM) o Electric interconnection o International Network (Mexico–Guatemala, of Mesoamerican Panama–Colombia) Highways (RICAM) o Mesoamerican Biofuels o Technical cooperation Program for road transport o Short-distance maritime o Energy efficiency transport Goal: to develop an efficient multimodal transport system

Source: SELA (2014) and MIDP.

Physical integration in Latin America  279 Tampico

Pacific Corridor Atlantic Corridor Caribbean Tourism Corridor Inter- Oceanic Logistics Corridors Supplementary roads and connections

Cancun Tuxpan

PUEBLA

Veracruz Coaizalcos

Oaxaca

XPUJIL Thenamal

Villagerman

BELMOPAN

Salima Cruz Tapachula

Tuxtila Gutiennar

La Ceiba Trujillo TEGUCIGALPA

La Mesilla Pro Queen Acajulted La Liberated

MANAGUA

La Units Carinto

Limon Colon PANAMA David

FIGURE 10.4 

International Network of Mesoamerican Highways (RICAM).

Source: MIDP.

Box 10.1 Central America: towards a regional electricity market Even when energy experts are well aware of the Central American experience in the creation of a regional electricity market, the main features of the process have largely gone unnoticed to the integration literature. With a total population of almost 43 million and six countries, Central America offers quite interesting properties for integrating national electricity systems: power generation is subject to internal economies of scale, distances among national markets are not an obstacle for electricity transport and the Central America energy matrix combines a variety of sources: Costa Rica and Panama rely on hydroelectricity whereas the other four countries (Nicaragua, Honduras, El Salvador and Guatemala) have thermal generation and are heavily dependent on oil imports. The early steps of electricity exchanges date back to the mid-1970s when a bilateral project between Nicaragua and Honduras interconnected both countries. Since then similar projects developed thereby successfully linking each of the six countries. Even when modest in relative and absolute terms, bilateral exchanges of electricity took place. National regulators and policy makers began a dialogue aimed at coordinating its different national plans and met regularly.

280  Ricardo Carciofi and Romina Gayá

The great leap forward was the creation Regional Electricity Market (MER) in 1996. Formally, MER is a plurilateral treaty composed of three elements: a regional regulatory body, a regional operator in charge of coordinating exchanges and the creation of a Network Regional Enterprise (EPR) that owns the regional transmission line. The Enterprise is owned by national electricity operators and ENDESA – the Spanish National Electricity Company. Colombia and Mexico joined EPR in 2005 and 2008, respectively. EPR is a key ingredient of the 1996 Treaty because it implies the deployment of a truly regional infrastructure: a longitudinal 1800 km 230 KV line from Panama to Guatemala furnished with 28 connecting spots. The project – so-called SIEPAC – started in 2007 and was completed in December 2014 at a cost of US$500 million. Given the co-existence of MER and the national systems, MER was conceived as the “seventh market”. The nine national partners and IDB and CAF provided the finance. ECLAC and the regional banks were heavily involved with technical assistance. The infrastructure that is now available reduces transport costs, transmission charges and eases the interconnection of the national systems. During the past two decades, the Central American electricity market has proved its viability though it is still operating below its full potential. As shown in Figure 10.5, electricity exports represent barely less than 2% of regional generation whereas 15 years ago peaked more than 5% – Guatemala exported 14% of its generation to El Salvador in 2000. There are several reasons that explain the meager use of interconnections. First,

6 5 4 3 2

FIGURE 10.5

Exports/total generation.

Source: ECLAC (2014).

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1988

1997

1996

1995

1

Physical integration in Latin America  281

there are significant differences in the economic design of the six countries. Guatemala, El Salvador, Nicaragua and Panama apply a decentralized model – generation, transport and distribution are allocated to separate private and public providers. Costa Rica and Honduras are national integrated monopolies. Thus, the pricing mechanism and the planning principles are difficult to accommodate under the same framework. Second, despite the formal creation of MER since 1996, regulatory design took a long time. The lack of firm and established rules has undermined the confidence in the ability of MER bodies to effectively run the system. Third, as a result, electricity trading has been restricted to the spot market. Firm delivery wholesale contracts have been infrequent since national regulators avoid to compromise domestic generation in forward foreign transactions. Finally, given the shortcomings of the regional market, national authorities have given priority to energy security through autonomous systems. Foreign sources and the regional market are still viewed as a full back resource that complements the domestic system. What is the likely future of Central American electricity market? Will it move forward to a fully integrated system or will it remain as a shallow spot market? Along the past 40 years, the sub-region has gradually made progress aimed at a deeper integration. SIEPAC reveals a substantial degree of political commitments, institutional resources and a significant amount of capital investment aimed at interconnecting domestic systems. Now that the SIEPAC project has been completed, MER has been able to set the different pieces together. The scene seems ready to go for the final assault. However, a key challenge is still pending: new additions to generation have to be aimed at the regional market. Therefore, MER regulators should provide clear signals and incentives compatible with that goal. At the same time, it is necessary to design mechanisms to ensure the viability of long-term firm contracts for wholesale clients. There are many obstacles to be overcome. If Central American countries converged to a similar model of sector organization, there would be more chances of speeding up the integration process.

Finance, project execution and the role of regional banks One of the main challenges of physical integration initiatives is to stimulate coherence between regional goals and national interests and priorities in order to reduce the bias towards projects that require minimal coordination. In terms of finance, the approach chosen by MIDP solves some problems faced by other initiatives related to physical integration: when regional and national objectives are not fully aligned, there is a regional mechanism to finance projects or to stimulate member countries to prioritize investments and/or to execute projects simultaneously. This mechanism includes technical cooperation

282  Ricardo Carciofi and Romina Gayá

for project design and different types of financing schemes (Dirección Ejecutiva del Proyecto Mesoamérica, 2013). Contrary to FOCEM, there are not fixed contributions from member countries but the financing mechanism is flexible and regional entities can obtain resources and thus increase available funds. The pragmatic approach adopted by MIDP includes different modalities to finance projects: • • •

Sum of national financial sources according to coordinated regional objectives (e.g., many RICAM projects). Regional financing: Projects financed by technical cooperation programs managed by regional institutions. Creation of regional entities: For example, in the case of SIEPAC, a regional firm was created by public companies of member countries and ENDESA to manage funds and non-refundable resources from multilateral financial institutions.

Regional financial institutions play a key role in MIDP. First, by participating in the GTI they help to define projects and actions. Second, they provide financial resources and contribute to obtain additional funds through the Promotion and Finance Commission (CPF for its Spanish acronym). Third, they provide technical assistance. Until 2013 they invested US$20 million in technical cooperation related to physical integration. CABEI is the main source of financing for infrastructure projects, followed by the IDB, the Brazilian Development Bank (BNDES for its Spanish acronym), CAF and the Yucatan Fund (a trust fund created by the Mexican government to finance infrastructure projects in Central America and the Caribbean). However, technical studies and institutional strengthening projects are financed mainly by the IDB and CAF (Dirección Ejecutiva del Proyecto Mesoamérica, 2013).

Institutional arrangements MIDP is organized on an inter-government basis and supported by regional bodies that have either a coordination or regulatory role. The main institution is the Presidential Summit. The Executive Committee, composed of national delegates, is responsible for planning, coordination and monitoring MIDP projects, but these projects are proposed, designed, approved and executed by Technical Commissions composed by Ministers of Finance of member countries (or their representatives) (Figure 10.6). In sum, MIDP has helped to boost physical integration in Central America. The Initiative has been able to develop a mechanism for coordinating national decisions and regional goals: project selection and financial tools are focused on connectivity infrastructure.

Physical integration in Latin America  283 Presidential Summit •Presidents / Prime Ministers of member countries. Executive Committee •Presidential Representatives. •Responsible for planning, coordination and monitoring. National Bureaus •Directors: Presidential Representatives (members of the EC) Chief Executive Office •It supports the Executive Committee CPF •IDB, CAF, CABEI and representatives of Ministry of Finance of member countries. •It helps countries to obtain financial resources. GTI •SIECA, IDB, CAF, CABEI, ECLAC, PAHO. •It helps the Executive Committee to define projects and actions. Technical Commissions •Ministers of Finance of their representatives. •They propose, design, approve and execute projects.

FIGURE 10.6

MIDP institutional design.

Source: Authors’ elaboration.

5. Concluding remarks There is a substantial amount of empirical research that underlines the importance of efficient connectivity and logistics as a platform for international trade. The proofs are quite robust and the impacts are significant. Thus, trade and integration strategies have a key influence in molding the vast array of policies and investment decisions aimed at improving connectivity – infrastructure, as this chapter has made it clear, is a key ingredient. The development of better connectivity in the framework of integration initiatives entails a substantial degree of coordination among members. It is not just a matter of “connecting to compete” but “connecting to integrate, and integrate to develop”. Since the main challenge is to make progress in the connectivity of the entire regional space, several pieces should come together: investment plans, sectoral policies, project selection and finance mechanisms, regulatory convergence, to name just a few of them. To the extent that transport costs are brought down, location of economic activities is spread out more evenly in the territory. The Latin American experience seems to fit quite well in the above-presented framework. Over the last 15 years, the region is investing an important amount of resources – financial, institutional and political capital – in order to improve physical integration. Thus, there seems to be a clear understanding of the results of analytical and empirical research. As Table 10.7 summarizes, not all the initiatives follow the same model:

284  Ricardo Carciofi and Romina Gayá TABLE 10.7 IIRSA-UNASUR (COSIPLAN), FOCEM and MIDP: main features

IIRSA-UNASUR (COSIPLAN) Creation

Main purpose

Institutional design Project design level Project selection/ evaluation level Projects related to physical integration Resources origin

FOCEM

MIDP

2000 (IIRSA) – 2004 (in force since 2010 (IIRSA – 2006) COSIPLAN) Asymmetries Integration of reduction among transport, MERCOSUR energy, and integration communications infrastructure in South America Intergovernmental Intergovernmental

2001 (Tuxtla Mechanism – PPP) – 2008 (MIDP) To strengthen regional integration and to promote economic and social development of Mesoamerica Intergovernmental

National/regional

National

National/regional

National

Regional

Regional

All

Some

95% of total investments

Each country must Regular and non-refundable get the resources contributions + needed to voluntary finance projects contributions by member countries Project financing FOCEM (grants) + member countries Role of regional CCT, project banks and finance and institutions technical cooperation

Flexible and pragmatic approach. Sum of national resources, regional financing, creation of regional entities, etc.

GTI, project finance and technical cooperation

Source: Authors’ elaboration.

The process seems to be quite deep in Central America where transport, energy and telecommunication systems are being developed with a very clear regional target in mind. Further, it is interesting to observe that Central America has enlarged its “integration space”: Mexico and Colombia have joined the process. Leaving aside historical and political reasons, physical integration – particularly in energy and road transport – is paving the way for further intraregional trade and investments. The case of South America is also remarkable though speed is slow and the depth of integration is shallower than the Central America case. Even when declared objectives and official speeches point at the need of creating a regional

Physical integration in Latin America  285

integrated space, the actual results show that South America is not quite yet on the mark. Transport, energy and telecommunication systems are far from being integrated. However, it is undeniable that current efforts are concentrated upon improving connectivity through more or less coordinated actions. There are several factors that explain why the process is running along those lines: South America integration is a relatively recent initiative, intra-regional trade is low, there are huge asymmetries among members, and, given geography, infrastructure development requires an important amount of resources. The case of MERCOSUR and FOCEM is a worth-mentioning step forward since it represents a specific tool for reducing asymmetries and improving connectivity. Shortcomings lay elsewhere: there are multiple objectives with a limited scale of resources, though it should be taken into consideration that funds come from national budgets only. On the institutional front, the three Latin American experiences seem to conform to a relatively common mold. First, as shown in Table 10.7 above, all cases pivot around an important degree of inter-governmental coordination that involves a vast number of sectoral agencies of member countries. Second, regional banks play a useful function: they are providers of financial resources and technical cooperation and contribute to policy dialogue. Third, all three initiatives call for the participation of the private sector though specific modalities are laid down by the idiosyncratic rules of member countries. The review of the Latin American experience reveals quite clearly that physical integration and connectivity confront two main challenges. On the one hand, as aggregate indicators suggest, the region faces an “infrastructure gap” that should be bridged by a higher rate of capital investment – planning capabilities, adequate project selection and a higher rate of domestic savings are all relevant factors. On the other hand, integration is not a single-handed agenda – though it has a complexity of its own. All dimensions involved in the process of integration should flow accordingly: basic political understandings, intra-regional trade and a favorable climate for cross border investments, institutional rules that provide clear signals that the process is not reversible, and clear cut decisions that infrastructure development is oriented towards better regional connectivity.

Notes 1 This paper was first presented at an UNCTAD workshop on South-South regional financial integration, held at the Palais des Nations Geneva; and updated in December 2019. The authors thank the workshop participants and the editors of this volume for their valuable comments and suggestions. The usual disclaimers apply. 2 Most of the early literature on economic integration assumes that no friction arises either from space or geography. It was Krugman (1991) who turned the attention to the spatial dimension. The new approach contributed to the regional debate in the context of European integration, see Martin (1999). For a more recent review of new economic geography with a particular focus on the effects on economic integration on spatial development, see Ascani et al. (2012).

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44

45 46

active bilateral trade with Great Britain that reinforced geographical concentration around harbors and coastal cities. Analysis below does not make specific references to any particular type of infrastructure though it applies to transport modalities more directly. Energy and telecommunications do share some similarities – all of them are operate as networks – but they also entail other issues given the specific goods that they are dealing with – oil, gas, electricity, inter-connection of telecommunication networks. For a more general discussion of the infrastructure gap in Latin America and the role of the different sources of finance, see Rozas (2010). For example, traffic congestion, pollution and high fixed costs (e.g., land). Labraga (2010) applies similar concepts to analyze the case of Uruguay and MERCOSUR. As will be quoted below, several papers have addressed the different schemes with detail and offer a good background to the analysis. The UNASUR treaty was agreed in 2008 and it took two years to be signed by the different members. In 2011 UNASUR gathered the required number of votes (nine) of congressional approval by member countries thereby giving rise to a formal plurilateral agreement. For a discussion of the South American case, see Bouzas et al. (2008). Brazil has common borders with 10 out of 12 South American countries. The Asunción Treaty was signed in 1991 and marks the creation of MERCOSUR. There have been initial contacts with Ecuador but no progress has yet been made. ECLAC’s estimates suggest that Latin America would need to double the amount of total infrastructure investment in order diminish the gap with other emerging regions. See Rozas (2010, p. 74). Initially, the energy and telecommunications sectors were also included in the agenda. However, since 2010 onwards, energy projects and planning were located under the mandates of the Energy Council of UNASUR. The telecom sector has concentrated the tasks in developing a broad band regional understanding which has not been approved yet. It should be noted that in year 2000 Brazil was implementing a medium-term development plan called “Eixos de Integracao” lead by the Federal Planning Ministry. There are strong similarities in the conceptual framework of the Brazilian development and the IIRSA approach adopted in its early years. For an overview of IIRSA during its first ten years, see IDB-INTAL (2011). Between 2000 and 2010, IIRSA was the only (informal) body of sub-regional coordination that acted on a regular basis in South America. IIRSA process was backed up and validated by Presidential Summits held annually. From 2011 onwards IIRSA was redefined as the technical body of the Planning and Infrastructure Council of UNASUR. There were official attempts of promoting a convergence process between CAN and MERCOSUR. See www.iirsa.org. See www.iirsa.org. According to IIRSA’s documents Development hub is a more comprehensive notion than transport corridors (CCT, 2003). The former looks at the economic activities, social aspects as well as environmental concerns associated with existing and new infrastructure. It is interesting to add that the technical nature of the work has been quite demanding. National agencies concerned with infrastructure planning allocated staff to meet the requirements. The recurrent work has given rise to a fluid dialogue among government members. See http://www.iirsa.org/Document?menuItemId=5 for organizational and institutional details. Available data for the last three years indicate that multilaterals invest an annual average of US$30 million in non-reimbursable funds (COSIPLAN, 2014a).

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66 See http://www.proyectomesoamerica.org/. 67 Guerrero, Oaxaca, Chiapas, Tabasco, Veracruz, Yucatán, Campeche and Quintana Roo. 68 See Rocha (2006) and Villafuerte Solís and Leyva Solano (2006). 69 Belize, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama. 70 Some features related to physical integration were developed many years before the creation of MIDP. For example, in 1958 Costa Rica, El Salvador, Guatemala, Honduras and Nicaragua decided to adopt a common road sign system.

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INDEX

Note: Bold page numbers refer to tables; Italic page numbers refer to figures and page numbers followed by “n” denote endnotes. Addis Ababa Action Agenda 153–158, 174n2 Africa: Africa 50 161, 175n13; alternative infrastructure financing sources 89–94; China financing in 8–9; importance of national and sub-regional financial institutions 36; infrastructure deficit and MDB response 86–88; infrastructure finance in 8–9; multilateral development banks role in 85–86; Programme for Infrastructure Development in 8 Africa Growing Together Fund (AGTF) 130, 176n35 Africa Infrastructure Desk (Afri-ID) 90 African Development Bank (AfDB) 8, 24, 45n6, 87, 91–93, 105, 131, 156, 157, 161, 163, 164, 165, 174n5, 175n15, 175n17 African Union’s (AU) Programme for Infrastructure Development (PIDA) 86 Agriculture Refinance Corporation 110 Akyuz,Yilmaz 214 alternative models towards bridging financing gap 158–163 Andean Community (CAN, Comunidad Andina) 238, 253, 256, 262, 264, 270, 276, 287n40 Andean Development Corporation (Corporación Andina de Fomento) (CAF) 35–36; interest rates 143 Andean Group 183

Arab Financing Facility for Infrastructure 193 Arab Infrastructure Investment Vehicle 193 Arezki, R. 162 ASEAN: ASEAN+3 Bond Market Forum (ABMF) 210; ASEAN+3 Finance Ministers Meeting 12; ASEAN+3FM 210; ASEAN+3 Macroeconomic Research Organization (AMRO) 209, 220 Asian Bond Fund (ABF1) 210 Asian Bond Markets Initiative (ABMI) 12, 210–211 Asian Development Bank (ADB) 32–33, 121, 131, 156, 175n17, 193, 200, 210–214, 217; Board of Governors 160; disbursements and private co-financing 157; Leading Asia’s Private Sector Infrastructure Fund (LEAP) 161; loan levels and gearing ratios 165, 165; loanto-equity ratios 164; selected financial indicators of 218; as shareholder in Asia Credit 221n4 Asian Development Fund (ADF) 160 Asian Financial Crisis (AFC) of 1997/1998 206, 220, 221n3, 221n4; and emergence of RFA 206–209 Asian Infrastructure Investment Bank (AIIB) 9–10, 12, 16, 25–26, 86, 121, 130–131, 154, 162–163, 175n17,

294 Index

181–182, 218; articles of agreement (AoA) 167; board of directors 71; China and 173–174; current loan-tocapital ratios 40; establishment of 29, 69; financial statements of 167–168; funding mechanism 32; investments across the world 69; lending practices of 164–165; special funds, role of 167–172 Asian Monetary Fund 12, 208, 218 Asian regional financial architecture (RFA): Asian bond market initiatives 210–211; Asian Financial Crisis and emergence of 206–209; Asian initiatives (defensive and developmental) in 209; critical assessment of bond market 213; developmental pillar of 209–210; liquidity-stability trade-off 213–215; new business model 218–220; performance of bond markets 211–213; regional development bank 216–218; traditional international financial architecture 205–206 Asunción Treaty 263, 287n33 Balassa, B. 251 Banco del Sur 58, 75–76, 240–241 bank lending: capital markets and 216; for infrastructure 194–201 Bank of North Dakota (BND) 217 Bank of South see Banco del Sur banks: and credit creation 3; importance of 3; Southern-led 4–6; see also specific banks and banking systems BANOBRAS (National Bank of Constructions and Public Service) 63–64, 78n20 Basel III rules 156 beggar-thy-neighbour policies 239 Belt and Road Forum 171 Belt and Road Initiative 10, 34, 128, 169, 171–173 Bernanke, Ben 221n11 Bhattacharya, Biswa Nath 213 “blended finance” 159 Bolivarian Alliance for the People of Our America (ALBA-TCP) 253, 254 bond market: Asian Bonds Online Website 210; corporate debt 114–115, 115–116; critical assessment of 213; India 114–115, 115–116; performance of 211–213 Bordo, Michael D. 217 Brazil: Chinese development finance in 134; long-term financing in 60; national banks and southern investments 23; PAC in 79n25

Brazilian Development Bank (BNDES) 23, 34, 35, 59–60, 65–68, 74, 165, 169, 217, 240, 282, 288n54; challenges of 67; financial performance of 65; importance for country 65; loans, costs of 68; sources of funding to 65–66; use of TJLP 66–68 Brazilian Economic and Social Development Bank (BNDES) see Brazilian Development Bank (BNDES) Brazil National Development Bank (Banco Nacional de Desenvolvimento Econômico e Social – BNDES) see Brazilian Development Bank (BNDES) Brazil’s State-owned Federal Savings Bank (Caixa Economica Federal) 169 Bretton Woods agreement 11, 25, 29, 205–206 BRICS 88, 94, 99, 173–174, 176n27 BRICS New Development Bank (NDB) 16, 25, 32 CAF Asset Management Corporation (CAF-AM) 191 capital-market based financial structure 53 Cardoso, Fernando Henrique 259 Caribbean Community (CARICOM) 253, 254, 256, 270 Caribbean Development Bank 35, 124 Castillo, Martha 201 Castro, L. 51 CELAC-China Investment Fund 130 Central African States Development Bank 36 Central America: Logistics performance index (LPI) 252; regional electricity market 279–281 Central American: Central American Bank for Economic Integration (CABEI) 35, 124, 250, 277, 282; Central American Common Market (MCCA) 270, 275; Central American Economic Integration Subsystem (SIECA) 275, 277; Central American Economic Integration Treaty 275; Central American Electrical Interconnection System (SIEPAC) 250, 256, 280–282; Central American Integration System (SICA) 253, 275–276 central banks: and national development banks 31 Chatusripitak, N. 213 Chavez, Hugo 76 Chen Yuan 126–127, 145 Chiang Mai Initiative 11–12, 209 Chiang Mai Initiative Multilateral Arrangement (CMIM)/Chiang Mai

Index  295

Initiative Multi-lateralization (CMIM) fund 209, 220 Chile 61–62; concession system 62; currency risk management program 62; infrastructure financing architecture 62–63 China: and African infrastructure 91–92; Belt and Road initiative 169, 171–173; development finance in LAC 131–149, 133; development finance institutions in LAC 125–131; global funds 129; and MDBs 131; multilaterals 130–131; national banks and southern investments 23; oil-backed finance in LAC 141; State Council 166 China-Africa Development Fund (CADF)/ China–Africa Industrial Capacity Cooperation Fund Company Limited (CAICCF) 40, 129, 171 China–ASEAN Investment Cooperation Fund 169, 170 China-backed investment funds 154, 168–172 China–Brazil Investment Fund/China– Brazil Production Capacity Cooperation Fund 130, 169 China–Central and Eastern European (China-CEE) Fund/China–Central and Eastern Europe Investment Cooperation Fund 128, 169, 170 China Co-Financing Fund for Latin America and Caribbean Region 171 China Development Bank (CDB) 6, 23, 33–34, 36, 124–125, 165; CADF as a subsidiary of 171; consortia approach 126, 127; created in 166; flow of finance to LAC 132–136, 134; interest rates 143; loan levels and gearing ratios 165, 168; policy banks 125–128; reasons for providing development finance 136–141, 139, 140; as world’s largest NDB (by assets) 166 China EXIM 169, 171 China Investment Corporation (CIC) 128, 171–172 China–Kazakhstan Production Capacity Cooperation Fund 169 China–LAC Cooperation Fund/China– LAC Industrial Cooperation Fund 130, 171 China–Latin American Industrial Cooperation Investment Fund (CLAIFUND) 169, 170 China–Russia Regional Development Investment Fund 169, 171

Chinese National Petroleum Corporation 142 collateralised loan obligations (CLOs) 162 commercial banks: vs. development banks 7 Commission of Permanent Representatives (CRPM) 271–272, 274 commodity-backed finance, to LAC/ commodity-backed loans 34, 141–142 Community of Latin American and Caribbean States (CELAC) 150, 253, 262 concessional lending 38 concession system, Chile 62 Conference of Finance Ministers of the Muslim Countries in Jeddah, Saudi Arabia 185 “consortia” approach 2, 13, 45n8, 126, 127 Contingent Reserve Arrangement (CRA) 37–38, 94–95; Chinese 98; international 105 Corporacion Andina de Desarollo (CAF) 59, 60 corporate debt 114–115, 115–116 Covid-19/coronavirus i, 1, 2 credit-creating banks 52 credit growth: India 118; Mexico 64 Credit Guarantee and Investment Facility (CGIF) 211 credit ratings: international development banks 37; of member countries 190–194 currency swap 78n17 current loan-to-capital ratios 40 developmental pillar of RFA 209–210 Development Bank of Latin America (CAF) 124, 150, 181, 183–185, 240; bank lending for infrastructure 194–201; as borrower-led development bank 181–182, 188; country representation in governance 184; credit ratings of member countries 190–194; creditreceiving countries 185; founded by 183; Green Environment Facility (GEF) 202; infrastructure finance as a share of total approvals 195; loan levels and gearing ratios 165, 165; loan-to-equity ratios 164; project cost overruns 201; sector distribution of lending 197; selected balance sheet items 190; “sense of ownership” of 240; shareholders of 183; social and environmental risks 201–202; sustainable infrastructure finance as share of approvals 195; technical cooperation of 264–265

296 Index

Development Bank of Southern Africa (DBSA) 8–9, 26, 36, 92–93, 103, 165; loan levels and gearing ratios 165 development banks/banking 154–158; vs. commercial banks 7; described 31; and financial conditions 52–55; and functionality 52–55; growth and transformation 50–55; and India 6–7; infrastructure in India 110–111; in Latin America 59–68; main features of 43–44; need for 3–4; neoliberal transformation of 109–121; role of 55; from south 4–6; South-South 25–26; see also multilateral development banks (MDBs) Development Capital Certificates (CKDs) 64, 79n23 development finance (DF): described 138; in LAC by China 131–149, 133; social and environmental policies 146–149 development finance institutions (DFIs) 88; and African infrastructure 92–93; decline in India 111–114; loans in India 111 Dewan Housing Finance Limited (DHFL) 121 Downs, E. 128 East African Development Bank (EADB) 36 Economic Survey 2016–2017 120 ENDESA 280, 282 environment and social safeguards (ESS) 146–149, 148 European Bank for Reconstruction and Development (EBRD) 32, 102, 131, 174n5, 175n17 European Bank for Reconstruction and Development Equity Participation Fund 161 European Central Bank 166 European Investment Bank (EIB) 9, 102, 131, 157, 175n17, 217; loan levels and gearing ratios 165, 165–166; loan-toequity ratios 164, 164; selected financial indicators of 218; total disbursements and private co-financing 157 European Union 159, 164, 255 EVA (economic value added) business model 218–219 EXIM Bank 110 Export and Import Bank of China (China EXIM) 6, 23, 34, 36, 38, 124–125; flow of finance to LAC 132–136, 134; policy banks 125–128; reasons for providing development finance 136–141, 139, 140; subsidies on small loans 143

Export–Import Bank of India (India EXIM) 165 Federal Savings Bank (Caixa Economica Federal) 169 Fei Yuan 135, 147 Financial Fund for the Development of the River Plate Basin (FONPLATA) 250, 264 financial institutions 50; state-owned 51; see also specific types financial integration in South America 238–244; FDI flows and stocks 241–244; and sharing of portfolio wealth 238–241; short-and long-term financing 238–241 “financial repression hypothesis” 55 financial system, defined 77n7 financing: long-term 238–241; short-term 238–241 financing architectures 55 financing infrastructure 61, 85, 95, 110, 157, 158, 188–194 Fitch 37 FONADIN 63–64, 78n22 foreign direct investment (FDI) 242; flows and stocks 241–244; flows by region 243; Ratio of FDI to GFCF in UNASUR, developing economies and the world 244 Free Trade Area of the Americas (FTAA) 225, 263 G-20 process 55 Gallagher, K. P. 127, 135, 136, 142–145, 147 General Council for Islamic Banks and Financial Institutions (CIBAFI) 194 global financial crises (GFC) (2007-2009) 94, 205, 214 Great Depression 205, 219 Green Climate Fund 193, 202 green investments 33–35 Green New Deal 15 Griffith-Jones, S. 167 Gross Fixed Capital Formation (GFCF) 111 Group of 20-IFA Working Group 163 ‘Growing Africa Together Fund’ 92 Grupo Consultivo de Reconstrucción y Transformación de Centroamérica 276 Hakansson, N. 213 Herring, R. 213 heterogeneity and regression: South America 229–233 Highly Indebted Poor Country (HIPC) initiative 93

Index  297

Ho Kwon Ping 219 Housing and Urban Development Corporation (HUDCO) 110 Humphrey, C. 160, 164 hydropower 203n3, 203n4 IDBI 110–111, 113–114 IDB-INTAL 270 IIRSA-UNASUR (COSIPLAN) 266, 286n4, 288n49, 288n51, 288n52; finance, project execution and role of regional banks 268; institutional arrangements 268–269; main features 262–266, 284; planning, finance and institutional arrangements at regional level 266– 269; regional planning and project identification 266–267 India 6–7; bond market 114–115, 115– 116; credit growth 118; development banking in 6–7; development banking infrastructure in 110–111; development finance institutions decline in 111–114; foreign capital flows in 120–121; Gross Fixed Capital Formation (GFCF) 111; infrastructural lending 119; instability in financial structure in 117–121; longterm investment finance 116–117 India Infrastructure Finance Company Limited 116 Indian Railway Finance Corporation 110 Indian Renewable Energy Development Agency 110 Industrial Credit and Investment Corporation of India (ICICI) 110, 113 Industrial Development Corporation of South Africa Limited (IDC) 9, 36, 104, 165, 165 Industrial Finance Corporation (IFCI) 110, 121n1 Industrial Finance Department (IFD) 110 Industrial Investment Bank of India (IIBI) 113 industrial production and structure: South America 229–233 Infrascope 77n10 infrastructure: bank lending for 194–201; financing infrastructure 61, 85, 95, 110, 157, 158, 188–194; infrastructure deficits 56; risk management 201–202 Infrastructure Consortium for Africa (ICA) 89–90 Infrastructure Development Finance Company (IDFC) 116 infrastructure investments: in developing and developed countries 56; ECLAC

and 287n35; IIRSA and 246; in Latin America 56, 59; levels across LAC 57, 57; Mexico 63–65; as percent GDP 56; and physical integration 244–248; public private partnerships (PPPs) in 57 Infrastructure Leasing and Financial Services (IL&FS) 116, 121 Initiative for the Integration of the Regional Infrastructure of South America (IIRSA) 13, 246, 250, 263–264, 287n39, 288n50 institutional investors 154–158, 156 Inter-agency Task Force on Financing for Development 2017 155, 158 Inter-American Development Bank (IADB) 10, 59, 60, 123–124, 130, 131, 156, 174n5, 175n15, 175n17, 176n35, 181, 240–241, 247, 258, 264, 277, 280, 282, 288n53; Corporate Procurement Committee 202; country representation in governance 184; credit-receiving countries 185; Fund for Special Operations 160; Independent Consultation and Investigation Mechanism 202; infrastructure finance as a share of total approvals 195; Infrastructure Fund (InfraFund) 161; Regional Infrastructure Integration Fund 161; sector distribution of IADB lending 197; selected balance sheet items 190; sustainable infrastructure finance as share of approvals 195; total disbursements and private co-financing 157 International Bank for Reconstruction and Development (IBRD) 164, 165, 187–188, 188, 189, 194; interest rates 143 international development banks: advantages of 31; credit ratings 37; disadvantages of 31; funding structures 31 International Finance Corporation (IFC) 193 International Monetary Fund (IMF) 29, 123, 181, 206 International Network of Mesoamerican Highways (RICAM) 277–278, 279 investment funding 53 investment funds: China-backed 168–172 Irwin, Amos 127, 142–145 IsDB-ADB Infrastructure Fund 193 Islamic Bond Market 189 Islamic Development Bank (IsDB) 10, 32, 36, 181, 185–188 Islamic Financial Services Board 194

298 Index

Japan Bank for International Cooperation (JBIC) 165, 165 Japanese Development Bank 216 Japan International Cooperation Agency 175n12 Jiang Zemin 128 Jin Liqun 69, 79n29 Jin Qi 171 Kazakhstan’s National Export and Investment Agency (Kaznex Invest) 169 “kereitsu” system 216 Keynes, John M. 52–53, 215 Kong, Bo 136 Korea Development Bank (KDB) 165–166 Krugman, P. 285n2, 286n10 Latin America: analytical matrix for reviewing physical integration 261–262; FOCEM 269–275; IIRSA-UNASUR (COSIPLAN) and 262–269; improving connectivity 257–261; infrastructure development, challenge of 257–261; integration and trade strategies 253–257; issues relevant for analyzing Latin American case 251–262; MIDP 275–283; overview 249–250; physical integration 251–262 Latin America and the Caribbean (LAC): and AIIB 4; Bank of the South (Banco del Sur) 29; CAF 26; China’s development finance institutions 125–131; Chinese development finance in 131–149; and climate change 124; commodity-backed finance to 141–142; development banking in 4, 59–68; green financing 135, 135–136; infrastructure investments in 56, 59; investments for growth in 49; and NDB 4; need for development finance in 123–125; poverty line 124; public private partnerships (PPPs) in 57, 58; social and environmental policies 146–149 Latin American Association of Development Financing Institutions (ALIDE) 60 “Latin American bonanza” 227 Latin American Free Trade Association (ALALC) 270, 286n12 Latin American integration and trade strategies Latin American Integration Association (ALADI) 253, 286n14, 286n17 Latin American Integration Association (LAIA) 239

Latin American Reserve Fund (Fondo Latinoamericano de Reservas-FLAR) 239 Lehman Brothers 214 Limao, N. 286n12 Lin, J.Y. 169 liquidity-stability trade-off 213–215 Local Currency Payments System (Sistema de Pagos en Moneda Local – SML) 239 local development finance institutions: and African infrastructure 92–93 Logistics Investment Program (PIL) 79n25 Logistics Performance Index (LPI) 251, 252, 286n8 long-term financing 238–241 Marshall, A. 286n10 McKinsey report 89–90 Medium Term Note (MTN) Program 189 “mega-projects” 201 MERCOSUR 238, 250, 253, 254, 256, 262, 287n28, 287n33, 287n40; Bolivia signed the Protocol of Accession to 288n57; challenges 270; created in 269–270; internal agenda of 263 MERCOSUR Structural Convergence Fund (FOCEM) 13, 269–275, 271–272; finance, project execution and role of regional banks 272–274; institutional arrangements 274–275; main features 269–270; planning, finance and institutional arrangements at regional level 270–275; regional planning and project identification 271–272 Mesoamerican Integration and Development Project (MIDP) 13, 250, 275–283; finance, project execution and role of regional banks 281–282; institutional arrangements 282–283; main features 275–277; planning, finance and institutional arrangements at regional level 277–283; regional planning and project identification 277–281 Mesoamerican Procedure for International Goods Traffic (TIM) 278 Mexico 63–65; BANOBRAS 63–64; FONADIN 63–64; infrastructure investment 63–65 Middle East and North Africa (MENA) 186, 197, 203n2 Monterrey Consensus 155 Montes, M. 174n2 Moody’s 37, 175n22 Moringa Fund 193, 202 multi-bi aid 159

Index  299

multilateral development banks (MDBs) 10, 15, 55, 69–73, 175n15, 175n17, 175n18; and Africa infrastructure deficit 86–88; African infrastructure 93–94; bank lending for infrastructure 194–201; bank origins and governance 183–188; bridging infrastructure gap 156–158; CAF 183–185; comparison between new and existing 70; credit ratings of member countries 190–194; financing infrastructure 188–194; future prospects and lessons for new 202–203; gearing ratios of 163–167; infrastructure 201–202; Islamic Development Bank (IsDB) 185–188; loan levels and gearing ratios 165; loan-to-equity ratios 164, 164; multilateral institutions 22; overview 181–182; paid-in capital 189–190; risk management 201–202; role in Africa 85–86; see also development banks/ banking NAF-INSA 63 National Bank for Agriculture and Rural Development (NABARD) 110 National Development and Reform Commission (NDRC) 137 national development banks (NDBs) 163; advantages of 31; and BRICS Summit 73; and central banks 31; disadvantages of 31; funding structures 31; gearing ratios of 163–167, 165; in LAC 61; Latin American 60–65; overall and corporate governance 72; in well-developed economies 51–52 National Development Finance Institute (NDFIs) 92–93 National Industrial Credit (Long-Term Operations) Fund 110 National Infrastructure Program (Mexico) 64 national public lenders and investors: and Brazil 23; and China 23; and Southernled landscape 22–25, 23, 24 NEPAD Business Foundation (NBF) 90 new business model 218–220 New Development Bank (NDB) 4, 8–9, 25, 26, 29, 32, 34, 37, 40, 50, 86, 88, 121, 130, 167, 181; establishment of 29; executive positions 97; vs. financial sources 103–104; impact on infrastructure financing 103–105; initial capital position of 108n30; origins of 94–95; projects 100–103, 101; structure, capital and membership 96–100, 98

New Partnership for Africa’s Development (NEPAD) 8, 87; Infrastructure Project Preparation Facility (NEPAD-IPPF) 40, 161–162 “The New Role and Functions for the UN and the Bretton Woods Institutions” project 189 Nigeria 36–37, 93, 93–94 non-bank finance companies (NBFCs) 113, 116–117, 121 North American Free Trade Agreement (NAFTA) 253, 286n15 North Atlantic financial crisis (2008-2009) 55 Northern-led development banks 28 Ocampo, J.A. 227 Official Development Assistance (ODA): and African infrastructure 91 One Belt One Road (OBOR) policy 71 Organization of American States (OAS) 253, 262 Organization of Islamic Cooperation (OIC) 185 PAC 79n25 PAC-2 79n25 Pacific Alliance (AP) 253, 254, 256 paid-in capital, and MDBs 189–190 Pan-American Health Organization (PAHO) 277 Park, Daekeun 213 Park,Yung-Chul 213 People’s Bank of China 168, 172, 176n35 Perrotti, D.L. 245 PetroChina 142 physical integration: infrastructure investment and 244–248; key issues relevant for analyzing Latin American case 251–262 PIDA Priority Action Plan (PIDA-PAP) 87–88 Plan Puebla Panamá (PPP) 276 portfolio wealth 238–241 Power Finance Corporation 110 Preferential Trade Area Bank 36 “prior-saving approach” 50, 51 private funding: in African electricity 89–90; and African infrastructure 89–90 Programme for Infrastructure Development in Africa (PIDA) 33 Public Law 480 121n2 Public Private Partnership model 33 public private partnerships (PPPs): in Latin America 57, 58

300 Index

Ramos, L. 54 Recine, Antonio 189 regional development banks 14, 216–218, 238, 240 regional imbalances: and Southern-led institutions 35–37 regional integration, need for 3–4 regional trade agreements (RTAs) 256 Report of the Committee on Banking Sector Reform 112 Report of the Committee on the Financial System 112 Reserve Bank of India (RBI) 7, 110, 112 resource-secured loans 34 Restricted Mudaraba Agreement 193 Rio+20 United Nations Conference on Sustainable Development 199 risk management 201–202 Rural Electrification Corporation Ltd. 110 Russia-China Investment Fund (RCIF) 128 Russian Direct Investment Fund 128 Sánchez, R.J. 245 Santander, Torres 68 Saran, Samir 94 Scale and scope, of Southern-led banks 22–25 Schumpeter, Joseph 52 Second World War 55 SELIC (liquid bonds) 66 Sharan,Vivan 94 Shipping Credit and Investment Company of India 110 short-term financing 238–241 “shovel ready projects” 2 Silk Road Fund (SRF) 128, 168 Singapore Management University 219 small-and medium-sized enterprises (SMEs) 218 Small Industries Development Bank of India (SIDBI) 110 social infrastructure 56 South Africa 36; Industrial Development Corporation (IDC) 104; New Development Bank Special Appropriation Bill 96 South America: FDI flows and stocks 241–244; financial integration in 238–244; and global economy 226–229; growing challenges 226–229; heterogeneity and regression 229–233; hidden opportunities 244–248; IIRSAUNASUR (COSIPLAN) 262–269; industrial production and structure 229–233; infrastructure investment and physical integration 244–248; overview

225–226; and sharing of portfolio wealth 238–241; short- and long-term financing 238–241; weak and decreasing extra- and intraregional trade 233–238 South American Council of Infrastructure and Planning (COSIPLAN) 58–59, 246, 250; portfolio of projects 246; portfolio of projects by subsector 247 Southern-led banks 4–6; as borrowerled 10–11; financial firepower 15–16; governance 16; international loans by 24; leadership 17 Southern-led institutions: and concessional lending 38; CRAs 37–38; forming partnerships with private sector 32–33; initiatives 42; loan portfolios 33–35; macroeconomic coherence 35; mandate, ownership and governance 28–32; regional imbalances concerns 35–37 Southern-led landscape 22–27; multinational or multilateral initiatives 25–26; national public lenders and investors 22–25, 23, 24 South–South Climate Cooperation Fund 130 South–South development banks 25–26 South-South development financing initiatives 2 South-South financial cooperation 1–2 Sovereign Wealth Funds (SWF) 24–25, 28, 35, 39 Standard and Poor’s 37, 166, 211 State Administration of Foreign Exchange (SAFE) 171 State Financial Corporations (SFCs) 110 state-owned financial institutions (SOFI) 51 Studart, R. 54 submarine fibre optic cables 107n7 sub-regional development banks 31 Sukuk (Trust Certificates) 189, 221n6 Sustainable Development Goals (SDGs) 124, 153; Addis Ababa Action Agenda 154–158; alternative models towards bridging financing gap 158–163; Chinabacked investment funds 168–172; development banks and 154–158; gearing ratios of MDBs and NDBs 163– 167; institutional investors and 154–158; MDBs 156–158; overview 153–154; role of AIIB special funds 167–172; scaling up finance for 153–174; and Southernfinancial institutions 21–22 Sustainable Transport Appraisal Rating (STAR) system 200 “syndicated lending” 192

Index  301

Tett, Gillian 213 Third Forum on China–Africa Cooperation 171 Third International Conference on Financing for Development 153 Tissot, Roger 146 TJLP 66–68 Tourism Finance Corporation of India 110 trade, extra- and intraregional: South America 233–238; weak and decreasing 233–238 traditional international financial architecture 205–206 TransAnatolian gas pipeline (TANAP) 71 Trump, Donald 85 trust funds 159, 168 Tuxtla Mechanism 276 2030 Agenda for Sustainable Development 153 UNCTAD 157, 227, 238, 285n1 UNFCCC 193; Clean Development Mechanism 11, 182, 195, 203n3, 203n4 Union of South American Nations (UNASUR) 13, 14, 58, 225, 242–243, 243, 244, 246, 250, 253, 269, 286n4, 286n5, 287n30, 288n55 United Nations Economic and Social Council 174n2 United Nations Economic Commission for Africa (UNECA) 8, 87 United Nations Economic Commission for Latin America and the Caribbean (ECLAC) 56, 124, 150, 250 United Nations General Assembly 153

United Nations organisations 159 United-States Free Trade Area of the Americas 14 Unit Trust of India (UTI) 110 USMCA 286n15 Venables, A. 259, 286n11, 286n12 Von Tunen, J. 286n10 Wang,Y. 169 West African Development Bank 36 World Bank 8, 10, 15, 23, 29, 32–33, 55, 121, 156, 165, 174n5, 181, 187, 193–194, 199, 217, 258; on African infrastructure investment 86; Global Infrastructure Facility (GIF) 161; governance 16; on importance of infrastructure spending in LAC 123; index of connectivity 286n8; infrastructure sector shares 200; interest rates 143; International Development Association (IDA) 160; leadership 17; loan conditions 5; loan-to-equity ratios 164 World Bank Private Participation in Infrastructure 33 World Economic Outlook 181 World War II 216 World Wildlife Fund 124 Xi Jinping 69 Yucatan Fund 282 Zedillo Commission 16 Zhou Xiaochuan 168–169, 172