Foreign Relations of the United States, 1981–1988, Volume XXXVIII, International Economic Development; International Debt; Foreign Assistance

350. Memorandum From the Administrator of the United States Agency for International Development (McPherson) to the Deputy Secretary of State (Whitehead)¹

Washington, December 23, 1985

SUBJECT

• The World Bank

The World Bank has often, in effect, encouraged public sector growth. An important reason for this is that the Bank requires government guarantees for all of their loans. The result of this requirement is that most loans go to public enterprises.

Attached is a description of the problem and a proposal that the Bank make at least some loans without the government guarantee.

Attachment

Paper Prepared in the United States Agency for International Development²

Washington, undated

THE WORLD BANK AND THE PRIVATE SECTOR: THE NEED FOR FLEXIBILITY CONCERNING GOVERNMENT GUARANTEES

Problems Caused by Government Guarantee Requirement

Of the $14.5 billion lent by IBRD/IDA in FY 1985, the overwhelming majority of resources went to LDC governments or other public sector entities. Although some of these funds were later on lent to the private sector, they were first channelled through a government entity which made the major decisions about their allocation and use. A major reason almost all IBRD/IDA funds went to public borrowers was the Bank’s requirement that all of its loans carry a government guarantee.

It was this concern that led the Asian Development Bank to decide a few weeks ago to adopt an experimental program of limited lending without a government guarantee. It is now the time for the World Bank to show similar flexibility. (The Inter-American Development Bank and the African Development Bank have similar guarantee requirements which should also be reviewed.)

For many years the standard answer on this issue has been that the World Bank’s affiliate, the International Finance Corporation (IFC), could finance those projects for which a government guarantee was not feasible or desirable. However, the IFC is by far the junior member of the Bank Group (total lending and equity investments in FY 1985 of under $1 billion), and is heavily focused on relatively small (the average IFC investment is $7 million), highly leveraged projects. Therefore, the IFC is often not an appropriate source of financing for several kinds of projects which receive large amounts of World Bank funding. Unfortunately, these projects are frequently the very ones for which government ownership is not appropriate.

These projects often include:

— Financial intermediaries which supply capital for medium and long-term lending to private firms.

— Firms supplying social services such as health care, family planning services, and training.

— Utilities such as electric companies, telephone companies, gas pipelines, and transportation entities (railroads, urban transit).

As long as large amounts of IBRD/IDA resources are available for loans for such publicly owned entities, but not for their privately owned counterparts, the World Bank will continue to be a force that encourages public ownership. This is true even though the record is now clear that public ownership, perhaps especially in LDCs, is often uneconomical.

For those countries eligible for IDA, IDA’s very concessional loans are usually the most attractive foreign financing available. In other words some small and poor countries may now be in the position of expanding their public or publicly supported sectors more than they would otherwise choose in order to receive the very attractive IDA financing.

The reasons the IBRD/IDA has always required a government guarantee for loans are fairly simple. (This requirement is stipulated by the World Bank’s charter but not that of IDA, although as a matter of policy IDA has always required such a guarantee as well.) The requirement for a government guarantee does the following:

(1) Facilitates and simplifies Bank lending. The Bank reduces its risks and is therefore able to lend for more innovative projects. It also makes project appraisal work easier and certainly requires less intensive post-project completion monitoring.

(2) Reassures financial markets and hence facilitates Bank borrowing. For the Bank’s hard window the government guarantee provision increases the value of the Bank’s portfolio in the eyes of bond rating agencies and potential bond buyers. This, of course, contributes to the financial markets’ overall perception of the financial quality of World Bank bonds.

Could the Government Guarantee Requirement Be Eliminated For Some or All of These Loans?

The legal or financial obstacles are surmountable.

In the case of IBRD (but not IDA) a change in the charter would be required. This would require a favorable vote of 80% of the voting shares and would need to be carefully orchestrated to avoid requests for other charter changes. However, based on the ADB precedent, it appears reasonably likely that a well designed and probably limited size program of lending without government guarantees could gain the support of most members.

It should first be noted that IBRD’s current outstanding portfolio is now $41 billion. Therefore, if the amount of IBRD lending without a government guarantee initially is kept to a limited size, there should be minimal effect on financial market perceptions of portfolio soundness.

As to IDA, there should be relatively few problems with eliminating the government guarantee requirement for IDA lending since it is based on donor contributions rather than capital market borrowings.

As is to be done at the Asian Development Fund, private borrowers could receive IDA funding on near commercial terms, unless the innovative nature of the project or some other reason justified subsidized financing for the private borrower. The Bank’s staff, of course, will need to conduct particularly careful feasibility and risk assessments of projects to avoid embarrassing defaults.

For both IBRD and IDA, there are a number of measures which could be taken to greatly reduce the risk of loss. Guarantees could be provided by other private entities such as local or foreign commercial banks. Various other forms of security (e.g., mortgages on property) could be obtained, and the Bank could set aside a special reserve fund for losses under this program. This fund could be financed by special charges for unguaranteed loans or by existing Bank net income.

In formulating a new program of lending to the private sector without government guarantees precautions would also need to be taken to assure that loans were not being substituted for otherwise appropriate commercial financing.

1. Source: Department of State, Executive Secretariat, S/S–I Records, The Executive Secretariat’s Special Caption Documents, Lot 92D630: No folder title. No classification marking. Not for the system. Whitehead wrote in the top right-hand corner of the memorandum: “PMcP, I agree with this approach. Some kind of dividing line needs to be established between the IBRD and IFC private sector loans though. What should we do to propose it? Should we talk to Baker or Clausen? J.”
2. No classification marking. No drafting information appears on the paper.