Analysis. Artful Aid 2: Privatize the IMF!
By Martin Hutchinson, UPI Business and Economics Editor 6/13/2002

WASHINGTON, June 13 (UPI) -- The IMF, World Bank and the other international development banks have one thing in common; they are public sector institutions, with no requirement to turn a profit.

This looked sensible in 1944, when the World Bank and International Monetary Fund were formed at the Bretton Woods conference; it is much less intellectually defensible now. It's therefore worth looking at the privatization of development banking, how it might work and what benefits it might bring.

This analysis of the international aid and development business comes in three parts. In Part 1 on Wednesday, I examined the structure and policies currently followed, and provide a taxonomy of their faults. In this Part 2, I suggest an improved mechanism for capital flows to the Third World, the banking of economic development. In Part 3 on Friday, I will look at the aid business, and suggest how that too can be better managed.

As has been extensively reported, before 1914 the world economy was as open, in terms of the percentage of gross domestic product devoted to international trade, as at any time before the 1990s. Yet there was no equivalent of the World Bank or the IMF. Instead, the London merchant banks, and in the last years of the period a small but increasingly powerful group of U.S. private banks, provided capital for international development, generally by syndicating long term international bond issues in the London or New York market. Capital was provided, not only to countries in Africa and Asia that were colonized or under the protectorate of Western powers, but also to countries such as those of Latin America, or after 1912 China, that were wholly independent. The bond issues were of long term maturity, generally 25 to 30 years with only modest amortization, and carried yields well above the top quality credits of that day, but the market appetite for them was significantly greater than for, e.g., second-tier corporate bonds, even though the risk of default was substantial.

By 1944, the year of the Bretton Woods conference, all that was ancient history. Neither of the two intellectual architects of Bretton Woods, Maynard Keynes and Harry Dexter White, regarded pre-1914 experience as relevant. Keynes had made his reputation with the 1936 "General Theory," which purported to show that the stable pre-1914 system was just an accidental special case of an economy that must be carefully steered by government, while White didn't believe in capitalism at all, being an active Soviet agent. It is thus unsurprising that the private sector played little part in the Bretton Woods blueprint for the postwar world of development finance.

Since Keynes and White both believed in state-controlled monopolies, that is what we got. The IMF was to run the world's monetary system, providing only emergency finance to prevent currency devaluations, while the World Bank was to lend for economic development. Needless to say, once the institutions had been established, bureaucratic inertia caused their roles to grow. The IMF as originally constituted should have been closed down once the Bretton Woods monetary system was abandoned in 1971; instead it, too became a development lending agency, in theory focusing on short term balance of payments financing needs, to be repaid once stability had been achieved. In practice, both the IMF and the World Bank lend for development finance, with the IMF focusing on budgetary and payments gaps, while the World Bank focuses on project and social needs. The IMF has also acquired a role in imposing "conditionality," generally very stringent and complex sets of conditions, by which Washington's policy wish-list must be met before further IMF finance is disbursed. As would be expected from such unaccountable and un-transparent institutions, their efficiency level is about that of the old Soviet Gosplan.

With competition that used taxpayer-provided capital, and which acquired through international treaty the right of first debt repayment, ahead of private lenders, the private sector was frozen out of the development finance business that it had carried out successfully before 1914. If repayment of private bonds is to rank junior to billions of dollars of official debt, and private bonds are more expensive for the borrower than billions of dollars of official finance, it becomes impossible for private bonds to compete.

In time, the merchant banks and U.S. investment banks that had provided such finance moved on to other areas. With the exception of a brief and unsuccessful burst in the 1970s of "balance of payments" financing led by the New York commercial banks, which had acquired huge amounts of cheap deposits from the Middle East, the New York banks concentrated on their domestic markets, while the London merchant banks attempted to become stockbrokers and, failing, were swallowed up by larger competitors. By 1981, Goldman Sachs was announcing in a presentation I attended that international markets were not a significant part of its future (which was to be largely devoted to risk arbitrage, led by Roger Freeman, later alas to be indicted for insider trading), and in the late 1990's "emerging markets" went largely out of fashion as a business area.

Nevertheless, even in 2002 there remain a number of banks which have expertise in doing business in emerging markets, particularly in the area of privatization advice, so the capability to analyze emerging market loans and investments is not entirely confined to the development banks.

There are two difficulties in "privatizing" the World Bank and IMF. First, they are monopolies, and have right of first repayment on international debt. If privatized as they stand, they would thus become an international equivalent of Fannie Mae, wholly unaccountable, squeezing out competition through their monopoly position, and continuing to dictate the economic policy of Third World countries through lack of competition to the money they provide.

Second, they provide more than just the lending function, and justify their existence by quasi-charitable activities. Much of the World Bank's loan portfolio, in particular, is made to support projects in infrastructure, health and education that are unlikely to earn a market return, but must be repaid through the balance of payments of the borrowing country.

As Treasury Secretary Paul O'Neill has pointed out, these functions should be carried out through grants. Since the need for outside finance for infrastructure, education and health is generally greatest in the poorest countries, financing such projects through loans, which have to be repaid, and which rank ahead of other creditors, freezes these countries out of the private financial markets. Using loans instead of grants to such countries increases their dependence on the development banks by forcing them to borrow each year to make payments on loans made in previous years.

To privatize the IMF and World Bank, therefore, you have to split them up. Close down their international lending activities altogether, other than a residual role as an international debt collection agency, which will not be able to provide "new" money, and whose priority in repayment over the private sector will therefore diminish (and could, by international agreement, be eliminated). Monies repaid to the development banks, together with a portion of the world's international aid budgets, will retire their own debt, and if any is left over, be devoted to grants, as described in part 3 of this analysis.

Freed from artificial competition from the development banks, the lending business should be left to the private sector. Of course, the level of expertise in the private sector for lending and investing in emerging markets will not initially be adequate, but on the other hand there will be large numbers of former development bank employees available on the job market, who will be able to join private sector banks, or to form consultancies and sell their advisory services.

Lending to or investing in developing countries under this new regime will not be as simple as the typical cross-border bank loan or bond issue of today. Currently, such loans are typically made on the basis of very little supervision or control, because the control function is performed by the development banks on behalf of the market as a whole. With the development banks out of the picture, lending banks, and in particular managers of emerging market bond issues, will be forced to revert to a much more "hands on" approach, inserting covenants in their loans or bonds and providing detailed advisory and in some cases remedial management services to their client countries, very much as J.P. Morgan and the London merchant banks did in the nineteenth century.

Of course, these services are labor intensive, and the payment for them (presumably some kind of annual agency fee on loans and bond issues) will not support the salaries and bonuses that have come to be expected by today's lucky traders. However, while the trading desk business in investment and universal banks will of course continue, it will not be as lucrative as it was even in the 1980s let alone in the late 1990's because stock markets and bond markets are no longer in a long secular upward trend, which remunerates traders based on the capital their institutions control and devote to an asset class whose price is increasing.

Thus investment and universal banks will have to find other sources of revenue, and investment bankers (together with former development bank staffers) will be forced to find other jobs. Emerging markets specialist banks, utilizing as staff a mixture of former bankers and former development bankers, should thus rapidly form, to provide the developing world with the capital it needs.

Apart from gains in efficiency, the most important benefit of this restructuring will be the increase in flexibility that it will give, with many different development models being peddled by competing institutions. Initially, there will of course be commercial banks making loans and investment banks underwriting bond issues with no conditionality, or very little; they will quickly find that, even though the development banks are no longer present to seize priority in repayment, the likelihood of lending to unprofitable activities, or to governments with bad policies, is unacceptably great.

Once the market has settled down, investments in the Third World (with some exceptions) will require lending bankers or underwriting investment bankers to take a much more proactive role, and impose policies on the borrowing government, as well as selecting projects and companies in which they and their clients invest with great care. However, there will be one important advantage compared to the present system. Instead of a uniform " Washington model" being imposed on every borrowing country, borrowers will have a range of possible development strategies to choose from, each of which will be sponsored by a different banking group. Inevitably, some of these strategies will be more politically acceptable to borrowers, while others will be more economically successful (which will translate into better living standards for the country's inhabitants) and a third group, being more conservative, will be more acceptable to investors and hence result in lower borrowing costs.

With a broad range of development philosophies for borrowing entities and investors to choose from, and with the relative transparency of information that is promoted by modern communications (and enforced by Stock Exchange regulators) there should arise a Darwinian competition between development philosophies, so that effective new development ideas are quickly seen to work, and are hence adopted elsewhere.

If countries are able to repay loans, and their debt is not placed behind billions of dollars of development bank finance, then banks and investors will be found to lend and invest. For projects and countries which are not able to service debt, the solution, as O'Neill has proposed, is grants, not loans. The optimum system for dispensing such grant money is discussed in part 3.

Martin Hutchinson occasionally advises governments and international financial institutions on economic development and finance.

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