President George Bush recently proposed that the World Bank's International Development Association (IDA) begin extending performance-based grants to poor countries instead of loans that they have little chance of repaying.¹ A similar proposal was made by the congressionally appointed International Financial Institution Advisory Commission (the Meltzer Commission) in March 2000.²

Rather than welcoming this proposal as a show of support for poor nations, some representatives of the World Bank have criticized it. Jeff Lamb of the World Bank, for example, claims the idea does not "resonate with conservative economics."³ Beverly Warmington, spokeswoman for the British government's Department for International Development, also dismissed the proposal noting that "The World Bank is actually a bank and there are development agencies to give grants. It's important that the World Bank work alongside them instead of competing with them."⁴

Yet the World Bank has shown little commitment to applying "conservative economics" to its lending policies. On the contrary, poor countries that receive World Bank loans are likely to remain poor despite repeated World Bank loans, and many are so burdened by the development loans that debt forgiveness has become a common topic at the Bank's regular meetings. Moreover, there is no shortage of projects that need funding, poor who need medicine, or children who need education; and the notion of organizations fighting for an opportunity to provide funding for these purposes would be welcomed by developing countries.

In truth, the President's proposal is about increasing the effectiveness and accountability of World Bank assistance to poor nations. The Administration will need leverage to overcome opposition to the plan at the World Bank. The means to do so is available: the appropriation of $803.4 million for the IDA in the Foreign Operations, Export Financing, and Related Programs Appropriations Act for 2002 (H.R. 2506), which the House passed on July 26. The Administration should work with Congress to ensure that future IDA appropriations are tied to that organization's adoption and implementation of the President's grant proposal.

Improving the Effectiveness of Foreign Aid

A common misperception is that foreign aid primarily involves large gifts of money to nations in need. In reality, most aid involves providing funds at a subsidized rate and, therefore, cheaper than rates available in international financial markets. The World Bank does so by extending subsidized loans. Its International Development Association, for example, offers virtually interest-free loans with a delayed repayment schedule to extremely poor nations.

After studying the operations and effectiveness of the key international financial institutions, the Meltzer Commission proposed that the World Bank replace subsidized loans for development with performance-based grants on a sliding scale, according to a country's wealth. In other words, the poorer the country, the greater the portion of grant financing from the Bank. Many experts had testified to the ineffectiveness of the current lending system, particularly with respect to spurring economic growth in poor nations.

Specifically, the Meltzer Commission found that

neither the World Bank nor the regional development banks are pursuing the set of activities that could best help the world move rapidly toward [the Bank's stated goal of "a world without poverty"] or even the lesser, but more fully achievable, goal of raising living standards and the quality of life, particularly for people in the poorest nations of the world.⁵

The economic performance of IDA recipients--the world's poorest countries that are most in need of economic growth--over the past two decades clearly supports the Commission's conclusion. As Table 1 shows, IDA loan recipients between 1980 and 1999:⁶

• Experienced little or no economic improvement. Of the 85 countries receiving IDA loans between 1980 and 1999, 33 experienced negative compound growth in inflation-adjusted per capita GDP (their people became poorer); 20 countries experienced between zero and 1.5 percent growth (their people experienced marginal increases in wealth); and 28 countries experienced growth greater than 1.5 percent.⁷ The data clearly show that nearly two-thirds of IDA borrowers in the past 20 years derived little or no benefit in terms of per capita wealth. In fact, recipients are more likely to be worse off after the loans than they are to experience significant economic growth.
• Became increasingly indebted to multilateral lending organizations like the IDA. Of the 85 countries listed in Table 1, 65 received IDA disbursements at least 10 of the 20 years between 1980 and 1999.⁸ Many developing countries owe most of their debt to international financial institutions (IFIs) like the World Bank.⁹ Moreover, Table 1 shows that 35 percent of the countries receiving IDA loans in the past 20 years owe at least one-fourth of their debt to the IDA and are becoming increasingly indebted to that organization. Only 11 countries reduced their debt-to-GNP ratio from 1980 to 1999, and all but 17 became increasingly indebted (as a percentage of total debt) to the IDA. The reason: Repayment of IDA loans is a fiction. Recipients are on a debt merry-go-round, with new loans being used to pay off old loans. Only 36 of the 85 borrowers of IDA assistance had even a single year out of 20 in which total repayment of their IDA loans exceeded the amount they received in new disbursements. Only 14 of those countries made net payments to the IDA at least 50 percent of the time. Moreover, 69 of the 85 countries were in arrears (interest plus principal) on their long-term debt in 1999.

The Meltzer Commission Proposal

During deliberations on how to address the failures of the current development lending system, the Meltzer Commission proposed an ingenious idea to capitalize on the dramatic growth in capital markets worldwide in order to finance development in poor countries, increase accountability to improve results, and eliminate the possibility of Bank loans contributing to unsustainable debt burdens. Specifically, the Commission advocated focusing World Bank assistance on the poorest nations through a system of grants. This would be a dramatic departure from current Bank practices in which the world's 90 poorest countries receive only 40 percent of its funds.¹⁰

Under the Commission's proposed system, the Bank would award grants on a sliding scale depending on the recipient's per capita wealth and ability to attract private sector resources. Countries with access to capital markets (those with investment grade bond ratings) or a per capita income greater than $4,000 would not be eligible.¹¹ Eligible countries would receive grants for up to 90 percent of the cost for delivering services. The grant portion would decline to 10 percent for the wealthiest eligible countries. Recipient countries would be responsible for paying the remaining portion of the projects, from a minimum of 10 percent to a maximum of 90 percent.

A contract to deliver services would be submitted to open, competitive bidding. The government agency, non-governmental organization (NGO), charity, or private sector business that submitted the cheapest bid would win the contract, thereby ensuring that each dollar awarded would have the greatest effect.

The Commission recommended an important change to the current system--recipients and the Bank would not pay for the approved projects up front, but rather would pay as results were delivered through service contracts. The agent implementing the project would borrow the stipulated funds from capital markets at interest rates that are cheaper than would otherwise be available by using the Bank service contract (backed by the elite credit ratings of Bank donors) and the recipient country's service contract as collateral. Payments would be made only after an independent auditor had verified results. No results, no payment.

The Benefits of Performance-Based Grants. Critics dismiss this proposal as a backdoor attempt to reduce the amount of assistance available to poor countries. Nothing could be further from the truth. Replacing loans with performance-based grants is superior to the current system in that it would:

• Increase resources for development. The Meltzer Commission grant proposal, which merges the balance sheets of the IDA and International Bank for Reconstruction and Development (IBRD), would provide more assistance per dollar of resources than the recipients can obtain from the existing World Bank loan system. A $100 million project requires $100 million in Bank loans under the current system but would require much less in grants. This is because the only benefit of IDA loans to poor nations comes through the interest rate subsidy, the grace period, and the extended repayment schedule. The subsidy can be provided directly by a grant without tying up $100 million in IDA resources. According to Adam Lerrick, Senior Advisor to the Meltzer Commission, "every dollar of annual grants [as outlined in the Meltzer Commission] replaces seventeen dollars of loans for the nations that need it most"; thus an annual grant of only $6.5 million would leverage the same amount of funds as a $100 million Bank loan, on average.¹² By switching to grants, the current Bank resources could support significantly higher levels of assistance for poor countries.
• Create a self-sustaining source of funding. Under the Commission's proposal, the World Bank would invest its $138 billion in paid-in equity (the combined balance sheets of the IDA and the IBRD) in market instruments. Assuming a conservative return of 8 percent on this investment, the invested equity would provide $11.04 billion annually for grant funding ($9.64 billion after deducting the $1.4 billion for annual administrative expenses). Because only the earnings would be used for grants and the invested equity "endowment" would remain untouched, the plan would result in a self-sustaining source of funds.¹³
• Establish greater accountability. Past loans all too often have funded ineffective projects or were diverted by unscrupulous government officials to their personal benefit. According to the Bank's own evaluation, less than a third of World Bank projects in poor countries yield "satisfactory and sustainable results."¹⁴ Poor performance is less likely under the Commission's proposal because it would require independent audits to verify results before the grants would be disbursed. The auditing is the most important aspect of the proposal and probably the source of the World Bank's opposition to the plan.
• Lessen the chance that poor nations will build unsustainable debt burdens. Many poor countries are paying today for failed Bank projects financed by loans borrowed decades ago. A system of performance-based grants would alleviate this predicament, most notably by the fact that the Bank portion of the grant would not have to be paid back. Thus, the grant system would lessen the likelihood that countries would assume an unsustainable debt burden.

The Bush Administration Proposal

In all respects, the grant system proposed by the Meltzer Commission would be superior to the current World Bank lending system. The Bush Administration recognizes this fact, and on July 17 proposed that "the World Bank and other development banks dramatically increase the share of their funding provided as grants rather than loans to the poorest countries."¹⁵ This proposal, a variation of the Meltzer Commission proposal, reportedly would dedicate a portion of annual International Development Association assistance to grants for low-income countries.

If the Administration's plan is financed in a manner similar to the Meltzer proposal, one-third of the IDA's 12th replenishment ($3.63 billion) invested in market instruments would provide $290 million annually for grants, assuming a conservative return of 8 percent. If every grant dollar replaces 17 loan dollars, the $3.63 billion endowment would support $4.9 billion in programs for poor countries.¹⁶ Even if the average grant financing of IDA projects is 75 percent (the equivalent to the gift component of current IDA credits), implementing the grant proposal would provide resources equivalent to the original $3.63 billion with one critical difference--the funds would be self-sustaining, without relying on the recipient country's ability to repay.¹⁷ Moreover, the assistance would be more effective because accountability and transparency would be enhanced through ongoing independent audits.

If all IDA funds were invested to provide earnings for grants, IDA resources would, at worst, be equivalent to current levels. After a transition period allowing the repayment of existing loans,¹⁸ the IDA would provide $108.1 billion for an endowment (paid-in capital and retained earnings) in market instruments, which would yield annual income of slightly less than $8 billion for grants with a conservative 8 percent return.¹⁹ This would support at least as much as the current maximum $108 million in lending programs. Additional benefits include reducing the risk of debt accumulation by poor countries and self-sustaining aid resources without risk of loss.

Changing to a System of Grants

Clearly, the time has come for the World Bank to implement performance-based grants. In order to move its proposal forward, the Administration will need to pursue a two-track authorization strategy. The first step should be to make sure that new IDA funding is used for the grant proposal. Second, the Administration should seek support among fellow IDA members to use existing IDA resources for the grant proposal as they are repaid. Specifically, the Administration should:

• Work with Congress to condition IDA funding on implementation of the grant proposal. The House overwhelmingly (381-46) passed the Foreign Operations, Export Financing, and Related Programs Appropriations Act for 2002, which includes an $803.4 million appropriation for the IDA. The legislation mandates the Secretary of the Treasury to "accord high priority to providing the International Development Association with the policy flexibility to provide new grant assistance to countries eligible for debt reduction under the enhanced HIPC [Heavily Indebted Poor Country] Initiative."²⁰ This is a solid first step.

Ideally, however, the legislation also should prohibit funding until the IDA implements the grant proposal. Moreover, it should stipulate that the IDA adopt independent performance audits and greater transparency. The Administration should work with the Senate to ensure that the current language remains or is strengthened during deliberations.

Authorization for the IDA to implement the grant proposal requires the approval of a two-thirds majority of IDA voting stock. The United States, which controls 14.86 percent of the voting stock, must gain support from an additional 51.14 percent of the voting stock. If the Administration gains support from the next largest contributors (Japan, Germany, the United Kingdom, and France), it still must gain support from at least six other voting groups.²¹ While gaining the support of IDA recipients is important (and easy, as most recipients are in favor of grants), the key players are the major IDA donors (only 39 of the 161 member countries are donor countries). A coalition of European countries and Japan could block the grant proposal. However, if the countries that provide IDA funding support the grant proposal, the recipients will go along.²² Because the U.S. cannot unilaterally implement the grant proposal, the Administration must:

• Build support for using the 13th replenishment as core funding for the grant proposal. IDA donors have approved 12 replenishments since 1960. Negotiations for the 13th replenishment of funding for 2003-2005 (which actually begins on July 1, 2002) will continue at upcoming IDA meetings in October and December. The Administration should use these meetings to gain support for its plan to use the 13th replenishment for grants.²³ If the 13th replenishment is as large as the 12th ($10.92 billion),²⁴ and assuming an 8 percent return on investments, then using only those resources for grants would mean that $873 million would be available annually.
• Build support among donors for converting existing IDA resources into performance-based grants. The Secretary of the U.S. Treasury should instruct U.S. representatives at the World Bank to press for the conversion of the remaining IDA resources to investments in market instruments in support of additional grant funding.²⁵ Once past loans are repaid, all IDA resources would be invested and earnings used for grants.

The 11th and 12th replenishments offer precedent for using donor funds for grants, and the Administration should use this authority as a model. IDA members have already authorized the use of 11th and 12th Replenishment donor funds to finance IDA development grants in the context of the Heavily Indebted Poor Country Debt Initiative. The net income transfers from IBRD for fiscal years 1997, 1998, and 1999 also authorizes the use of such funds for IDA development grants.²⁶

Bank staff are certain to mount stiff resistance, and the Administration must be prepared to counter their arguments. For instance, the Bank rejected the idea of grants on the basis that the IDA is a bank and its members expect it to act like one. This defense is a smokescreen; in reality, the IDA is an aid agency in all but name. A bank is a middleman between suppliers and users of funds, which pays interest to suppliers and charges interest to users based on risk (the higher the risk, the higher the interest rate). By contrast, IDA charges no interest on its "loans" to the world's least creditworthy clients.²⁷ Instead, it assesses a tiny service charge of 0.75 percent on 35- or 40-year loans that have a 10-year grace period. IDA loans already have an overwhelming grant aspect in the difference between the 0.75 percent service charge and a market interest rate, and in the 10-year grace period, which lowers the net present value of the loan. Of course, this assumes that IDA recipients actually repay their loans, an assumption disputed by Bank data showing IDA recipients becoming ever more indebted to the organization. (See Table 1.)

The real concern for opponents is the increased transparency and accountability at the heart of the President's proposal. The World Bank and corrupt governments fear increased transparency and accountability, albeit for different reasons, while liberal groups are suspicious of the proposal's reliance on free markets. If forced to compromise, the Administration should yield on the issue of the substitution of grants for loans before yielding on its demands for truly independent performance audits and halting disbursements if results are not verified. Taxpayers in donor and recipient nations deserve to know how their money is being used, and greater transparency and accountability would alleviate, if not end, some of the debt issues by lessening the likelihood that IDA loans could be wasted.

Conclusion

The World Bank has not been successful in catalyzing economic development, especially in the world's poorest nations. President Bush's proposal to replace International Development Association loans with performance-based grants is a reasonable recommendation, which addresses the failures of the current system. His plan would create a self-sustaining source of funds for grants that would not add to the debt burden of poor countries, but that would impose more stringent accountability on the system to protect U.S. taxpayer dollars and ensure that boondoggles are not funded endlessly.

The Administration should work with Congress to tie future IDA appropriations to implementation of the President's grant proposal. At the same time, the President should direct the Secretary of the U.S. Treasury to work with other countries to change policy at the World Bank.

President Bush's grant plan would benefit the people in poor nations at the expense of unscrupulous government officials who could no longer use international assistance for their personal benefit and World Bank bureaucrats who would be forced to provide results instead of platitudes. Neither of these constituencies should stand in the way of reform that would transform the World Bank from a development hindrance to a contributing component of assistance to the poorest of nations.

Brett D. Schaefer is Jay Kingham Fellow in International Regulatory Affairs in the Center for International Trade and Economics at The Heritage Foundation.