The World Bank—a financial appraisal: II: Lending policies, creditworthiness of borrowers, project appraisal, and the role of IDA examined

This is the second of two articles on the Bank’s financial operations. It covers the Bank’s lending policies, the credit worthiness of borrowers, project appraisal, and the role of the International Development Association. The first article appeared in the September 1976 issue of Finance & Development and covered the liquidity policies, borrowing program, and capital structure of the Bank.

Abstract

This is the second of two articles on the Bank’s financial operations. It covers the Bank’s lending policies, the credit worthiness of borrowers, project appraisal, and the role of the International Development Association. The first article appeared in the September 1976 issue of Finance & Development and covered the liquidity policies, borrowing program, and capital structure of the Bank.

Eugene H. Rotberg

The financing of economic development is one of the principal purposes for which the Bank was established. The care employed in managing the Bank’s finances and borrowings is directed toward ensuring that it will be able to raise sufficient funds to finance its development program. That is its basic job. The future of the Bank ultimately depends on the policies and practices that govern the quality of its lending. To maintain the continuing support of its member governments, its loans must stimulate economic growth in the less developed countries where it lends. At the same time, it must satisfy those from whom it borrows its funds that it will meet its obligations.

The lending operations of the Bank are different from those of the private market. How are they different? Loans must be granted on a basis of sound financial and economic analysis; the projects must produce an acceptable rate of return; and, in each case, the prospect for repayment must be apparent. Bluntly put, the Bank has proven to be a tougher, harder lender than many commercial institutions. It asks questions and receives answers on issues that are relevant to the making of loans but are rarely dealt with by commercial institutions.

Over 90 per cent of the Bank’s loans are committed to the financing of specific development projects. The Bank does not lend in support of military or political objectives, or for the purpose of facilitating exports of any particular industrialized country. Of the $29 billion equivalent in loans committed by the Bank over the past three decades, including the $2.5 billion sold to third parties, a total of almost $7 billion has been repaid. Disbursed and outstanding loans held by the Bank on December 31, 1975 amounted to over $12.6 billion, and a further $9.4 billion of committed loans had not yet been disbursed.

A broad spectrum of projects is financed by the Bank. They are in such sectors as agriculture and rural development, industry, power, telecommunications, transportation, education, urban development, and water supply and sewerage. Education, for example, is essential for raising the level of competence and increasing the skills necessary for implementing economic development. Improvements in urban areas and in water supply and sewerage facilities contribute to the health and well-being of people in developing countries and, therefore, to their productive capabilities.

It is reasonable for potential lenders to the Bank to raise questions about the creditworthiness of the governments to which the Bank lends. The World Bank makes loans to borrowers who cannot obtain the funds on reasonable terms elsewhere. There is no pretense that the Bank can predict with certainty which borrowers 10, 15, or 20 years from now will be creditworthy. The discussion here centers on what the Bank’s several hundred economists and financial analysts look at in evaluating the creditworthiness of a potential borrower.

The Bank staff examines the country’s per capita income, and its potential for the future. It looks at the country’s population growth, its savings rate, and the vehicles through which savings occur. It examines the country’s foreign exchange position, its sources of borrowing, its tax base, and its terms of trade. The staff closely monitors the potential borrower’s external debt—its interest and principal requirements for the immediate and foreseeable future. It studies the country’s reliance on export commodities, whether one or several, and prepares the economic analyses required to show how the country’s exports could be affected by declines in international commodity prices. It examines the country’s imports, and whether imports could be curtailed in order to conserve the necessary foreign exchange to meet debt obligations. It examines the country’s tariff structure, its reliance on food and energy imports, its overall economic health, and the relative commitment of resources to productive and unproductive projects. The Bank insists on receiving and has the right to receive this information. There are few commercial institutions or governments which are equipped to make this kind of creditworthiness study before making a loan.

There is no incentive to do other than make the right determination as to whether or not a country will be able to service its debt to the Bank. A significant portion of the Bank staff is committed to that responsibility, and, if sufficient doubt exists, the country does not receive a Bank loan. A great deal of time, effort, energy, and intelligent thinking goes into making decisions which are for the benefit of both the borrower and the bondholder.

Project appraisal

Nor is the Bank’s interest limited only to questions of the creditworthiness of potential borrowers. The staff carefully appraises all projects for which a loan is proposed. This involves investigation of various aspects of the project: economic, technical, financial, organizational, managerial, and operational. Examination of the economic aspects includes a determination of whether or not the benefits and rate of return will be worth the cost. The technical study involves investigation of the project’s feasibility, its merits, and whether the technical solution proposed is appropriate. The project must be of high priority to the economic growth of the country. If it is not, the Bank will not finance it.

The staff also reviews with the government its long-term plans to determine whether the project, at a particular point in time, fits into the country’s economic development program—whether it comes too early, or whether it simply will not work until other fundamental changes are first made in the country’s economic or social structure. Here, too, there is no incentive other than to make the most meticulous technical analysis of the specifics of each project. The financial aspects are appraised with a view to ensuring that the financial conditions for sound implementation and efficient operation can and will be met by the borrower. In appraising the organizational, managerial, and operational aspects of a project, the Bank is particularly interested in the competence of the management to implement the project and to operate it after completion. Ultimately, the willingness of a country to want to continue to meet its obligations will depend on its evaluation of the staff’s intelligence and objectivity, and on its desire to obtain financial and technical assistance from the Bank. The Bank’s interest in its loans does not dwindle down to collection of principal and interest once the loan contract is signed. The Bank is very much involved in ascertaining that the loan proceeds are spent efficiently and economically and for the purposes intended. To ensure that borrowers obtain goods and works for Bank-assisted projects at reasonable prices and on favorable terms, the Bank requires in most cases that procurement be made through international competitive bidding (reviewed by the Bank) open to suppliers in member countries and Switzerland. The Bank is concerned that the projects it supports be soundly executed. Accordingly, it requires the borrower to submit reports on the progress of a project. Bank staff visit the project periodically to examine physical construction or operations, the borrowers’ accounts, the use and maintenance of equipment purchased with the proceeds of Bank loans, and the effectiveness of the project management. The point of all this is to be in a position to identify, at an early date, any problems that arise, and to discuss and resolve them with the borrower.

Disbursements of loan proceeds are carefully scrutinized and are made only on receipt of documentation that the goods and services being paid for are covered by the loan agreement and have been procured in accordance with its terms. The Bank controls the disbursements of the loan; it does not hand over the proceeds of the loan when the agreement is signed. A typical Bank loan takes seven years to disburse fully, during which period the Bank receives a commitment fee on the undisbursed balance. The Bank, therefore, reviews the invoices, pays them, and then notifies the borrower that disbursement has been made on the loan. Interest is payable on that portion of the loan from that point onward.

Unlike some commercial banks and bilateral lenders, the Bank seeks no political or trade commitment as the price for a loan. Admittedly, mistakes have been made. But they have stemmed from the human frailty of not knowing the optimum means to facilitate economic development, and not from a desire to control a country’s political future. Project appraisal and evaluation take considerable staff commitment, but that is what the Bank is all about. It commits 20 times more in staff time to evaluating countries and projects before, during, and after a loan is made than it does to the raising of funds or the investment of liquid resources. And that is the way it should be.

No defaults on loans

What has this commitment produced? The Bank has not had any losses on its loans. It has never had a write-off of a loan. The Bank has a firm policy against debt rescheduling, and does not tolerate late payments. In December 1975, on the occasion of the Bank’s most recent public bond issue in the United States, of the $12.6 billion in loans then disbursed and outstanding, none was over 30 days late either in interest or in principal. And while Bank financial statements include a “general reserve” (previously called “reserve against losses on loans”), that item constitutes, in fact, accumulated retained earnings. The Bank has no actuarial basis for its “reserves” simply because it has never had a bad loan. That is not to say that it never will have a “bad loan.” But the point is that borrowers have seen fit to maintain impeccable financial relationships with it.

There are substantial pragmatic reasons why borrowers do not default on World Bank loans. In the event of a default, no further disbursement would be made on that loan or on any other Bank loan that was outstanding in the country. And, no new loans would be committed until the default had been corrected. Borrowers know Bank policies in this regard, and given the substantial amount of undisbursed loans, they would be extremely reluctant to take steps to jeopardize the transfer of future resources.

A default to the Bank also carries serious consequences which would affect the credit of the country involved, both with other countries and with commercial suppliers of resources. If, for example, principal and interest payments on loans are even 30 days late, the Executive Directors of the Bank, who represent all 127 member governments, are formally notified of the delinquency.

As noted, the Bank, after 30 years of lending, has yet to experience a write-off of a loan. There have been numerous changes of government in member countries, including change by armed revolution, coup, or assassination. The successor government, however, has always honored its predecessor’s obligation to the Bank. This attitude is engendered not only by the sanctions inherent in a default to the Bank, but also by the Bank’s nonpolitical approach to the granting of loans, and by the fact that the projects financed make sense in that they contribute materially to economic stability and growth in the countries where they are located.

It would be fair to say that borrowers trust the Bank. They trust its objectivity, its fairness, and its commitment simply to do the right thing. They want to maintain a relationship with an institution which does not attach political strings to loans and which has a competent body of professionals whose role is to make decisions on strictly economic and financial grounds. For some borrowers, it is that- pool of intelligence and objectivity which is as important as the actual transfer of monetary resources. And the borrowers know that those resources will no longer be available to them should their relationships with the Bank become less than impeccable.

Nonetheless, I am asked sometimes what impact a default would have on the finances of the Bank and on its ability to meet service on its indebtedness. Let us take one exaggerated example. Assume that a sizable borrower repudiates all of its debt to the World Bank and stops payment of debt service immediately. The effect of this action might be that the Bank incurs a loss against its current income.

As far as the ability of the Bank to meet service on its debt is concerned, however, the default would have little, if any, impact. In the immediate period following the default, the Bank’s cash flow very likely would increase, since all disbursements on loans to the defaulting country would be stopped. Further, since the debt structure of the Bank consists primarily of long-term and intermediate-term obligations, the effect on the market of the Bank’s outstanding obligations would be minimal. It would be a nonevent in terms of its effect on the Bank’s bondholders. The Bank’s reserves are adequate. Its capital is huge. And, most important for the bondholder, the very real and substantial liquid position of the Bank of over $6 billion, as well as its access to worldwide markets, affords protection not available elsewhere. The uncalled capital is merely icing on the cake. All of this is available, along with the cash flow from the repayments of the pool of disbursed loans, to support the credit of the Bank and the security of those who invest in its bonds and notes.

The role of IDA

The International Development Association (IDA) was established in 1960 to assist in financing economic development in those developing countries whose ability usefully to employ externally borrowed funds exceeds their ability to service such borrowings on conventional terms, including the terms of World Bank loans.

Membership in IDA is open to all members of the World Bank, and 116 of them have elected to join. Eligible recipients of credits, however, generally are those poorer developing countries which have an annual per capita gross national product of $375 or less. The funds employed by IDA in its credit operations—they totaled $11.5 billion at the end of 1975—come mostly from the 21 industrialized and highly developed members including the United States. In addition, an aggregate of $1.02 billion has been provided by the World Bank in the form of grants to IDA. These grants have been made from the Bank’s net income in each of the fiscal years 1964-75, after prudent allocation of net income to reserves. And only that portion is available to IDA which otherwise might have been appropriate for dividend payments.

IDA is administered by the same management and staff as the World Bank. The Association has been called “the World Bank’s soft loan window.” It is true that IDA’s terms to its borrowers are-highly concessional—50 years to final maturity and a service charge of only ¾ of 1 per cent a year—but there is nothing “soft” about the credits themselves. The same rigorous standards that are applied to projects supported by Bank loans are applied to projects supported by IDA credits. The difference is that the countries receiving IDA credits are not creditworthy for a loan on the Bank’s conventional terms. It should be stressed that if funds become unavailable for IDA operations the World Bank will not lower its creditworthiness standards to make up the shortfall.

Though the same personnel administer both the World Bank and IDA, the two institutions are legally and financially separate entities. This includes separation in respect to assets, liabilities, and capitalization. The Bank’s credit is in no way involved with IDA. The Bank cannot lend to IDA. Whatever financial questions might arise in connection with IDA, it is the Association’s member governments that are at risk, not the World Bank or the investors in its securities. This means that institutions or individuals which lend to the Bank are not at risk by reason of IDA’s activities. The poorest countries are primarily recipients of IDA credits. The credits extended to them in no way jeopardize the Bank itself. On the contrary, for those countries which have outstanding Bank loans and which now are receiving IDA credits, these credits enable them to obtain the services and experience of the Bank’s staff and the planning, implementation, and financing of development projects at very low cost for 50 years.

Thus, there are substantial advantages from IDA accruing to the World Bank and its creditors, since Bank loans are reinforced by the financial and economic benefits flowing from IDA-supported projects. IDA’s funds, of course, come, for the most part, from the taxes of the richer countries; to that extent, taxpayers have a major interest in its operations. IDA does cost the taxpayers something, but in no way does it add to their risk as World Bank bondholders. On the contrary, it reduces it. Any of the poorer countries qualifying for IDA assistance which had an outstanding Bank loan would seriously hesitate before defaulting on it lest it jeopardize the interest-free 50-year development credits from IDA.

Financial environment

Some reference should be made to the financial environment in which we live, as it affects the investment climate generally and the attitude of investors toward the World Bank. Despite the financial strength of the Bank and its commitment to prudent financial policies one would be less than frank, and indeed, quite naïve, if one assumed that it was recognized by the whole investment community in, say, the United States, as the only premier credit in the marketplace. For example, the Bank does not trade in the market at the same yield as direct obligations of the U.S. Government. The Bank has neither taxing power nor the power of the printing press, nor is it a household name. Few people understand what the Bank does, and fewer still have any conception of its financial structure or financial policies. The Bank is a fairly complicated institution and portfolio managers, given a bewildering variety of potential alternatives, sometimes feel more comfortable with an investment which they can clearly categorize as “government,” or “foreign,” or “utility,” or “industrial.” It is a sad, but probably accurate, commentary that some investment managers cannot and do not explain the Bank to their Boards of Directors or their policymakers.

Further, the reaction of the financial community to exaggerated and often inaccurate public commentary about the problems of developing countries, defaults, possible debt reschedulings, expropriation of property, or political instability in some developing countries certainly does not contribute to a dispassionate evaluation of the Bank’s credit. As overblown—-possibly even irrelevant—as these matters might be to the financial strength of the Bank, the market’s reaction to such talk is a factor in the establishment of the Bank’s financial policies.

In a very real sense, these financial policies are based on the reality of the Bank’s environment. The Bank, therefore, conducts its operations and maintains financial policies which recognize that the Bank’s financial structure and strength may not be fully understood; that questions have been raised about its lending policies which may be based on inaccurate perceptions of the operations of the Bank; and indeed that there may be some hostility even toward the role of the Bank. Despite the Bank’s successes in coping with these sometimes subliminal, sometimes expressed concerns, it will not conduct itself as if the perception of investors will always be rational and based upon fact. The assumption is that both investment managers and the Bank will make mistakes. Therefore, the financial policies of the Bank are designed to permit the flexibility necessary to operate successfully in difficult environments. That is why the Bank has built the overwhelming financial strength described in this article and that is why it intends to keep it that way and maintain its standing as one of the strongest financial institutions in the world. The World Bank is not a social welfare agency committed to making transfer payments to solve the problems of misery or poverty. It is a development bank using the most sophisticated techniques available to facilitate development while providing unmatched protection and strength for creditors and shareholders.

Finance & Development, December 1976
Author: International Monetary Fund. External Relations Dept.