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New World Bank financing instruments

Who bears the risk?

4 December 2007

With pressure on president Robert Zoellick to maintain the World Bank’s relevance and stamp his mark on the institution, there was interest in his comments before the annual meetings about the Bank learning from Wall Street “concepts and tools” (see Update 57). Two areas that Zoellick’s Bank is likely to focus on are the promotion of risk management instruments, and the development of local currency bond markets.

The UN Department of Economic and Social Affairs (DESA) has for years called on the Bank to help “develop counter-cyclical instruments, both public and market-based, that would help smooth private capital flows so they can better support – and not undermine – development”.

Shortly after the Asian financial crisis in the late 90s, the Bank developed risk management tools that countries could apply to their entire debt portfolio – whether owed to the Bank or other creditors. Managed by the staff of the Bank’s treasury, these tools include currency, interest rate and commodity swaps, and technical assistance with the legal and accounting systems needed to effectively use them.

Currency swaps allow countries to reduce their exposure to fluctuations in the value of a currency in which they have borrowed. Interest rate swaps allow borrowers to exchange a floating interest rate to a fixed rate or vice versa, insuring themselves against an unexpected rise in interest rates. Commodity swaps might, for example, allow a country which is a raw material exporter to link its debt service to the price of that raw material, paying less when prices are low, and vice versa.

The chief advantages for developing countries in going to the World Bank rather than private banks are access and cost. The Bank uses its top-notch credit rating to access larger volumes, longer maturities, and lower costs than countries could get on their own. Over 40 largely middle-income countries have set up currency and interest rate swaps on their Bank debt. Only five countries have signed agreements with the Bank to manage risks on both their Bank and non-Bank debt portfolio.

Commodity swaps have not been taken up, partly due to the technical complexity in modelling the impact of commodity price changes on a country’s economy. Officials may fear being blamed for signing up to costly agreements which will limit their country’s profits when commodity prices are high, since conversely, low prices can be blamed on the international marketplace. A longer-term structural question is whether or not increased investment in market-based risk management will deter interest in other measures to address commodity market instability such as the creation of buffer stocks, management of commodity prices, compensatory financing or economic diversification.

In October, the Bank launched the $5 billion Global Emerging Markets Local Currency Bond Fund (Gemloc). While about 70 per cent of emerging market debt is denominated in local currencies, institutional investors hold only around 10 per cent of their emerging market debt investments in local currencies. Gemloc aims to increase this investment, providing money for countries to fund long-term investments such as infrastructure. It is an IBRD-IFC initiative which will use a private fund manager to solicit investments from institutional investors, sovereign wealth funds and central banks.

The initiative has the potential to decrease developing country dependency on multilateral bank finance in the long run, and has been a key ask from developing countries. At their November meeting in South Africa, the G-20 encouraged the Bank’s “role in fostering lending in local currency as a means to develop domestic capital markets which will enhance better liability management.”

The development of local currency bond markets is not without risk. The pace and sustainability of the expansion of the markets will be key. A rapid increase in domestic debt must be matched by productive investment if it is not to lead to renewed debt sustainability problems. An increase in the volume of local currency denominated domestic bonds held by foreign investors raises the spectre of sudden reverse flows if the value of the currency falls in the absence of capital controls (see Update 58). In the 1994 Mexican ‘tequila crisis’ local currency bonds were dumped by domestic residents and foreign investors alike.

Another obstacle which the Bank may face in developing local currency markets is the IMF. Fixated as it is on macro-economic stability, the IMF may look unfavourably on countries’ taking on additional debt, no matter what currency it is denominated in.

Unclear are the policy implications of the second part of the Gemloc initiative – the launch of a new Global Emerging Markets Bond Index. The IFC-led index will list local currency bonds and provide a statistic reflecting their value weighted not just by size of market, “but by ‘investability’ as well, the latter adjusting for such variables as regulatory and tax regimes and market access rules”. Zoellick said: “The aim of this local currency bond fund is to establish a clear link between policy reform and investment”.

Gemloc will initially invest in 15-20 largely middle-income economies, but is expected to spread to 40 countries within five years. The expansion of the initiative to low-income countries requires caution since it raises the possibility of crowding out private credit. Many low-income countries already suffer from banks’ preference to invest in the guaranteed return of treasury bonds rather than the productive sector.

Another instrument which could play a counter-cyclical role and apply to both middle- and low-income borrowers would be the creation of a market for GDP-linked bonds. This would allow borrowers to pay more interest when their economies are healthy and less when they are not. Economist Stephany Griffith-Jones and then-head of UN DESA José Antonio Ocampo, in a paper for the G24 group of developing countries, called on the Bank to “play the role of ‘market makers’ for GDP-linked bonds”. For the time being there are no plans for their development at the Bank, with treasury staff saying that they “can not work on products with no uptake”.