A Better Way To Lend A Hand.

The World Bank should convert its lending program for the poorest countries to outright grants.

The sight of a starving child anywhere in the world causes discomfort at the dinner tables of the well fed that no amount of antacid can alleviate. In the electronic world of the global village, as Marshall McLuhan predicted in the 1950's, "the living room has become the voting booth." Television, which intimately connects with suffering and despair, has moved the debate on development aid away from the conference tables of finance ministries and multilateral institutions up to the pulpit, onto the streets, and into the public conscience.

Not to give to needy nations is no longer an option. To give more is on every list. How to give wisely, cost-effectively, and directly for the benefit of the poor is the elusive goal.

Some ninety countries comprise the world's poorest economies without access to private sector resources. Their collective 1.3 billion citizens subsist on a per capita income of less than $2,500, yet are accorded just 40 percent of World Bank attention and funds.

It was for these stepchildren of the system that the Meltzer Commission proposed a major change in the format of development aid. End traditional loans to impoverished nations that cannot repay. Instead, provide outright grants for the basic improvements in living standards and infrastructure that are the foundation for the climb from poverty to productivity.

Grants are not new, but these were redesigned to succeed. Project-centered on tasks that are easily quantified, such as vaccinations, literacy, water treatment, and electricity. Executed under competitive bid, with a strong reliance on the specialized skills of increasingly mobile private sector providers and charitable organizations. Costs shared by the donor and the beneficiary on a sliding scale according to need. Payment made only for performance, as measured by independent audit. No results: no funds expended.

Loud voices from high places rose in protest. U.S. Treasury Secretary Lawrence Summers wrote in the Financial Times: "This would dramatically reduce the total amount of resources that can be brought to bear in these (developing) economies and require an unworkable system for delivering such assistance." World Bank President James Wolfensohn, in a letter to Commission Chairman Allan Meltzer, deemed grants "unrealistic," and went on to write: "In a time of severely constrained foreign aid budgets, it is highly doubtful that donors would be able to provide and to sustain the needed level of funding." The formal Treasury response made it official: Grants "would limit the overall availability of financial assistance to the poorest" and "moving to an all grant system would have negative long-term financial implications for the institutions and their shareholders."

Perhaps the calculators were mislaid in the counting rooms of the Treasury and the pencils unsharpened in the vaults of the Bank. Grants of $100 million are not required to accomplish the same ends as $100 million in World Bank loans. Just an annual grant of $6.5 million will on average suffice. Every dollar of annual grants replaces seventeen dollars of loans for the nations that need it most. Nor will the agency be humbled to go forth each year, alms bowl in hand, to beg funding from national treasuries. There is money for a significant increase in aid fight now on the Bank's balance sheet. The effective use of the $138 billion in paid-in equity will generate an annual income stream of $10.4 billion and support $181 billion in aid programs or 68 percent more than is currently provided to the poorest nations. Later, each new appropriation will yield 140 percent of its dollar value.

Leverage is what grants bring to the aid process, expanding the influence of every dollar of scarce official resources by drawing upon the capacity and skills of the private sector. Even a decade ago, the capital markets did not imagine what they offer routinely today--sheer size, sophistication in instruments, and the willingness to tolerate the risk which once deterred projects in the developing world.

But grants are not just about money. Grants have debt-forgiveness built right into the structure. Because they are an outright gift, citizens of impoverished nations will no longer be forced to service and repay often ill-considered borrowing agendas. Grants will sidestep the classic pitfalls of corruption, wanton waste, and incompetence because funds will be paid directly to service providers and only upon independently audited proof of results. No results: no money expended. Loans may default but with grants there can be no losses for donor taxpayers; the pool Of resources for future aid remains intact, independent of the financial fortunes of the recipients. And grants increase discipline by demanding a current co-payment, no matter how small, rather than a repayment obligation twenty to fifty years away.

The logical path ahead leads toward merging the balance sheets of the International Bank for Reconstruction and Development (IBRD) and its concessional arm, the International Development Association (IDA). This will modernize the structure of the Bank that was devised in what is now financial pre-history. The strength of the combined entity would be greater than the sum of its parts, with a heightened AAA debt capacity to the benefit of existing IBRD bondholders. Total assets would reach $304 billion while total Bank borrowing of $166 billion would be secured by $138 billion of investment securities, $103 billion of industrialized member callable capital, and $166 billion of developing country loans. Seventy percent of the lending pool would be traditional IBRD loans.

This begins the transformation of the Bank into the World Development Agency. It creates a foundation that focuses on the poorest nations without access to alternative resources, adapts its methods of intervention and structure to a global economy dominated by private capital, and improves dramatically the effectiveness of its programs. It is this institution that is now needed in the matrix of aid finance.

Grant financing: step by step. The only true aid component of development assistance, and the only cash requirement of the new grant format in a world of sophisticated financial markets, is the subsidy that fills the gap between what impoverished recipients can afford to pay and the real cost of supplying the service. This would range from 90 percent to 10 percent, depending upon the nation's per capita income and ability to attract private capital.

Under the traditional system, a $100 million twenty-year project, when financed through a World Bank twenty-year subsidized credit, requires $100 million of aid resources. Instead, the identical project would be provisioned through annual payments of $13 million upon certified delivery of results. If the income level and capital market access of the recipient qualify for 50 percent grant aid, the World Bank would enter into a direct contract to pay the provider $6.5 million per annum. The recipient government would enter into a similar contract to pay the remaining $6.5 million per year. Together, the two contracts will constitute the security needed by the service provider to obtain private sector funding. In the capital markets, the financeable value of the direct World Bank revenue stream at a 9 percent yield is $59.3 million. The financeable value of the recipient country obligation at a 15 percent yield is $40.7 million. Thus, a $6.5 million per annum commitment by the World Bank would be leveraged by private sector lenders to supply the requisite $100 million in funding. Additional resources mobilized from donor and host governments will be equally forthcoming under the grant format.

The markets make the difference. The low credit-worthiness of most truly poor countries and the lack of profit potential in projects of social value have long been advanced as obstacles to private sector funding of development. The direct World Bank contract removes these impediments. For very poor countries with no access to the capital markets, the direct payment obligation of the World Bank will equal 90 percent of total cost, eliminating 90 percent of the political/credit risk for the provider and hence its banker. The risk for the capital markets is therefore that of the contractor -- major international firms and non-governmental organizations -- not that of the host country. Investors bear the recipient's credit only on its 10 percent share. As the income level or capital market access of the beneficiary increases, the share of the World Bank payment in total cost declines, to as little as 10 percent, but the ability of the economy to generate domestic resources and attract private lenders rises.

The development bank as foundation. Existing resources in the Bank can generate an annual stream of $10.4 billion in perpetuity, while maintaining the Bank's capital intact. The World Bank has $138 billion in paid-in equity resources. Paid-in capital and retained earnings on the IBRD balance sheet amount to $30 billion. IDA holds $108 billion. If this $138 billion endowment is invested in market instruments at a conservative 8 percent return, it earns gross annual income of $11.1 billion. Net income will reach $10.4 billion after deducting $700 million, or one-half of the World Bank's $1.4 billion annual administrative expense. The remainder is assigned to IBRD classic lending activities.

In serving its poorest members, the Bank would allocate the annual income between interest subsidies on loans to promote institutional reform and grants covering a portion of user fees on infrastructure and social service projects. Both subsidies would vary between 10 percent and 90 percent based upon the income level and capital market access of the beneficiary. The reform loans themselves would be funded by the issuance of debt secured by the institution's capital structure. In time, these would enable local agents, both public and private, to develop as providers of services and to enter the project-bidding process.

The $10.4 billion income stream would be divided into interest subsidies of $1.6 billion on $46 billion of institutional reform loans and $8.8 billion of user fee grants for $135 billion of infrastructure and social service projects. This follows the Bank's traditional 25 percent allocation to reform operations. Existing resources would therefore support $181 billion in aid programs for the world's poorest countries. This compares to the current $108 billion maximum under IDA's prevailing system of concessional lending. The proposed structure reduces the Bank's capital at risk to the poorest countries by 58 percent because the endowment and income stream are unaffected by the financial condition of the recipients. IBRD non-aid lending can be maintained at current levels, financed by conventional capital market borrowing.

The grant program endowment would start using the $34 billion now available in IBRD paid-in equity capital and IDA undisbursed, uncommitted funds. As borrowers repay past IDA credits, these resources would be added to the endowment. Each $100 increment would produce $8 in additional investment income, providing $6.8 in grants for $105 of social projects and $1.2 in interest subsidies for $35 of reform loans, or a total of $140 in new programs. At every moment during the transition period, a larger volume of development programs would be supported under the grant structure than under the traditional loan delivery system. From an initial gain of 37 percent, an overall increase of 68 percent will gradually be achieved once the transformation is completed and the endowment reaches $138 billion. Future appropriations, when added to the endowment, will increase total aid programs by a multiple of 140 percent.

Financing with Grants A Pro Forma World Bank Balance Sheet

($ billions)

Assets

IBRD traditional loans                $120
Poor country institutional
  reform loans                          46
Investment securities                  138

Total assets                          $304

Liabilities

Borrowing for IBRD loans              $120
Borrowing for poor country
  institutional reform loans            46

Total liabilities                     $166

Equity                                $138
  Additional callable capital
  of industrialized members       103

Total liabilities and equity          $304

Source: World Bank

More Aid Per Dollar From World Bank Resources

($ amounts in billions)

                                      IDA Existing      Proposed
                                      System of Loans   Grant System

Total World Bank                      $138              $138
  paid-in capital
IBRD traditional loans                $120              $120
Return on capital endowment           n.a.              8%
Annual income                         n.a.              $11.1
One-half of World Bank                n.a.              $0.7
  administrative expense
Net income                            n.a.              $10.4
  Interest subsidies                  n.a.              $1.6
  User fee grants                     n.a.              $8.8
Capital at risk in poor countries     $108              $46
Institutional reform                  $27 (25%)         $46 (25%)
  resources
Project resources                     $81 (75%)         $135 (75%)
Total aid resources                   $108              $181

Notes:

(1) Private sector financing cost: World Bank direct payment: 9% Recipient payment: 15%

(2) World Bank cost of borrowing: 7%

(3) Internal World Bank amortization schedule of grants: 20-year level total payment

(4) Average subsidy element: 50% of user fee/interest cost

Adam Lerrick served as Senior Advisor to the chairman of the International Financial Institution Advisory ("Meltzer") Commission of the U.S. government.