Promising Developments in Exceptional Finance

Image by Markus Krisetya via Unsplash

By Sean O’Connell, Edited by Daniel Balke

An Introduction to Exceptional Finance

Exceptional finance—funding that deviates from the normal policy of  multilateral lending institutions like the World Bank and IMF—is not new to the international financial community. Financial policies one might call “exceptional” have long included things like the provision of emergency loans, special tranching schemes, and policy-specific lending.  Although these practices are used infrequently, multilateral development banks (MDBs) and national development institutions tend to have regularized procedures that govern each practice when their use is deemed necessary.

Certain forms of exceptional finance have become something approaching normal practice in the MDB community. Practices geared toward macroeconomic stabilization during crises represent notable examples. The Heavily Indebted Poor Countries and  Multilateral Debt Relief Initiative (HIPC and MDRI) debt restructuring programs in the late 1990s and early 2000s sought to relieve low-income countries of massive debt burdens as a means of sparking economic growth and poverty reduction. The World Bank’s 2007 International Reconstruction Fund for Iraq (IRFFI) program offered extraordinary donor support to manage the economic effects of Iraq’s sectarian conflict following U.S. invasion, while a debt restructuring program sought to ease Haiti’s path to recovery in the aftermath of a devastating earthquake in 2010. Importantly, however, exceptional finance applications to macroeconomic problems sometimes required governments to reduce their social sector spending in service of structural stability: something the Bank has reconsidered in recent years.

To date, multilateral lenders have typically used exceptional finance to help countries deal with unusual macroeconomic economic challenges rather than as an incentive to engage in activities linked to social development. Using extraordinary finance to incentivize countries to make ex ante investments in crisis prevention, enhance support for refugees, or take meaningful steps to resolve longstanding civil wars remain underexplored aspects of exceptional finance’s potential applications.

Notwithstanding its limited use, several exploratory attempts at using exceptional finance to promote social development point to the benefits of such an approach. Chief among these benefits is the ability of exceptional finance to amplify the development impact of multilateral lending while maintaining debt sustainability: what one might call “bigger bang for your buck.” Certain exceptional financial practices—such as offering lower-than-normal interest rates or levels of investments that exceed what could typically be offered to any individual country—can effectively incentivize countries to promote social development in ways that would otherwise be inaccessible. Social development prerogatives can be defined under three umbrella categories: investment in crisis prevention and mitigation, civil war resolution, and the provision of global public goods, like hosting and caring for refugees. These priorities naturally fail to capture the challenges facing a given country, nor are they official categories used by the World Bank. They are also undoubtedly the products, at least in part, of neocolonial “open market” policies supported by the Bank and its donors between 1960 and 1990. Be that as it may, the categories cover a broad, if not comprehensive, scope of challenges facing low and middle income countries.

Before entering into discussion on exceptional finance’s opportunities, it is necessary to recognize why, to date, it has been so infrequently used. Most concerns surrounding extraordinary finance derive from the desire of multilateral lenders to retain strong credit ratings among rating agencies, a large part of which depends upon ensuring that loans made to developing country borrowers are repaid. The ability to borrow at low interest rates in international capital markets is essential to the business model of development lenders, who use the money they themselves borrow to lend back out to developing country member states. For this reason, proposed reforms to lending policy that threaten—or can be construed to threaten—the strong ratings that multilateral lenders have cultivated in international bond markets are viewed with caution by the staff of these institutions. This dynamic is exacerbated by the difficulty of implementing any new policy change (even one that does not entail new risk) in large institutions, whether development banks like the World Bank, a national ministry, or a multinational corporation.

The adoption of exceptional finance faces each of these barriers to institutional change. On one hand, its substantive premise of offering exceptional incentives to induce socially desired behavior from borrowers involves a shift from traditional, conservative lending practices to riskier ones. Charging lower interest rates means lenders will be repaid lower amounts of money than usual, while increasing exposure to particular borrowers would amplify the negative effects on the lender’s balance sheet if such a borrower were to default. On the other hand, even irrespective of changes in risk, the new lending policies it entails would require operational changes that bureaucrats may resist due to the unfamiliar nature of these practices and the added effort required to employ them.

Broader concerns about the extent to which the World Bank is influenced by the political desires of wealthy donor countries also have implications for exceptional finance. Many innovative financial tools associated with exceptional finance were introduced when the World Bank was focused on encouraging macroeconomic reforms in low-income countries during the 1980s and 1990s. Unfortunately, these large-scale “structural stability” programs were associated with neoliberal economic policies suspected of opening developing markets to provide wealthy countries access to favorable trade and investment opportunities.

The Bank has since recognized these concerns and shifted many of its development priorities, including most of those associated with exceptional finance, toward social and humanitarian goals. This new pivot towards humanitarian outcomes has also extended to exceptional finance, where the Bank’s outlook has shifted from using exceptional finance as a tool to leverage top-down reforms and towards an enticement for low-income countries—including fragile states—to embark on projects with lower economic returns but large-scale social benefits.

This does not mean, however, that extraordinary finance oriented toward social development lacks precedent or would prove impossible to scale up. To highlight the potential benefits of pairing social metrics with exceptional finance, we introduce two cases fitting the definition of innovative strategies multilateral lenders have deployed to pursue socially desirable development outcomes that they struggled to achieve through normal lending practices. These cases include the Swedish International Development Agency’s (Sida) exploration of risk transfers with regional development banks and the World Bank’s extension of special lending rates to Lebanon to help it manage the influx of Syrian refugees.

Sida Explores Risk Transfers

In 2016 Sida, coordinating with the Asian Development Bank (ADB), agreed to back 155 million USD in special loans provided to the Indian government by the ADB.  The goal of this so-called “risk transfer” guarantee was primarily to free the ADB from its national lending ceiling. Through the arrangement, if India defaulted on the loan, Sweden would cover ADB’s losses by paying it the total amount on which India had defaulted. By transferring the repayment responsibility in case of default from India’s BBB- credit rated government to Sweden’s AAA rating, the ADB mitigated lending risk while extending an exceptional loan to incentivize India to undertake specific social development activities.

The lending agreement, which was intended to augment the ADB’s capacity by 50 million USD per year through 2026, represented the first example of using risk-transfer agreements at the multinational scale. But this exceptional finance was conditioned on its being used for a specific purpose: The Swedish government required the ADB to promise to use the new funding capacity enabled by the guarantee “to increase […] access to electricity in rural areas, building roads that connect to markets, health clinics and schools and to supporting entrepreneurship,” according to a 2016 SIDA press release. Sida’s specifications on the ADB’s use of the funding illustrate one of exceptional finance’s key attributes: using targeted lending to increase the incentives countries have to promote social development activities they might not otherwise be able to prioritize under standard lending regimes.

Sida’s interest in pairing exceptional finance with social sustainability extends beyond the ADB. In a 2012 policy paper, Sida referred to its exploration of exceptional financial policy as “resilience investments in developing economies,” citing both its developing ADB risk transfer agreement as well as a nascent concessional lending program providing food aid to Kenya as examples of this “resilience investment.” The report further noted that the potential success of an ADB risk transfer would be a useful determinant of whether Sida might “possibly enable the replication of the instrument in larger transactions both at ADB and other MDBs.”

Sida’s risk transfer agreement displays two beneficial outcomes of socially driven exceptional finance. Fiscally, the abnormal use of a multilateral risk transfer essentially created new capital for the ADB without substantially increasing its insolvency risk. And from a social perspective, the ADB’s reliance on Swedish credit to guarantee India’s loan repayments allowed Sida to make the risk assumption contingent on social improvement in the form of large scale infrastructure and humanitarian projects.

The World Bank Experiments with Concessional Lending

Several months prior to Sida’s announcement of its partnership with the ADB, the World Bank made another pioneering move in the social application of exceptional finance. In March of 2016, the WBG announced it would provide 100 million USD to the Lebanese government contingent on highly specific spending parameters for educational accommodation of Syrian refugees. The program, entitled  Reaching all Children with Education in Lebanon (RACE 2), was extended to Lebanon with an attractive concessional lending rate of 0.38 percent per year. For perspective, the regular annual lending rate for Lebanon from the bank is between 0.48 and 0.65 percent for a minimum eight-year maturity loan, so the concessional lending rate was offered by the WBG to incentivize acceptance. Though the lending rate was considered exceptional, the WBG rated the program risk at a “moderately satisfactory grade, indicating the plan’s sustainability. The extension of the concessionally financed 100 million USD was augmented by an additional 120 million USD in “innovative results-based financing” provided by national grants contingent on educational improvement and increased refugee student enrollment.

The Lebanese concessional loan applied extraordinary finance in the form of reduced interest rates with the goal of increasing the WBG’s ability to direct capital towards development projects for which the recipient government might otherwise not have borrowed. Whereas in India, exceptional finance was used for infrastructure and humanitarian efforts, in the Lebanese case, it was used for refugee education and stabilization. Since the initial 2016 loan extension, the WBG has founded the Global Concessional Financing Facility (GCFF) to provide concessionally financed capital to other countries experiencing refugee influxes. The program uses donor grants in which “each dollar in donor grant unlocks approximately 4 dollars USD in concessional loans,” and the Bank closely follows the finance to ensure it is actually being used to help host countries resettle and provide for refugees by finding them jobs in existing industries and expanding government social services. Further, the financing for the GCFF comes exclusively from donor countries and is provided to middle-income countries who must file an application for financing on their own volition. Accepting these loans does not affect the country’s existing borrowing portfolio with the World Bank, and profits made off interest payments are used for future GCFF programs.

The GCFF therefore represents the successful incorporation of exceptional financial practices and social development prerogatives into existing MDB structures, and to date has catalyzed over three billion USD in concessional finance to support the social development of refugees and their host communities.

Further Exploration and Research Direction

These two examples only begin to introduce the diverse opportunities for intersection between exceptional finance and social development. However, they clearly demonstrate how multilateral lenders can effectively use financial incentives to convince borrowing governments to undertake social development activities they might not otherwise be willing or able to, given political factors and/or scarce resources. These examples further demonstrate that multilateral lenders can deploy exceptional finance even while adhering to their own requirements around financial solvency and maintaining the impeccable credit rating necessary to borrow cheaply in global capital markets.

The exploratory nature of exceptional finance makes defining its scope and parameters difficult, which points to an important avenue we intend to pursue in future research. By clarifying a set of parameters around which to identify “exceptional finance” in the context of “social development,” we aim to begin building a methodology by which to evaluate concessional finance’s place in large-scale social development policy among not only multilateral lenders such as those explored here, but also bilateral donors and even actors in the private sector, such as credit rating agencies, investment banks, and multinational corporations. The goal of our research is therefore to lay a conceptual foundation for what exceptional finance is, and to provide insight into how a variety of lenders can use it to pursue social development aspirations across the globe.

Sean O’Connell is an undergraduate student at the University of California at Berkeley studying economics. He has served as an intern with the Department of State’s Office of Development Finance, is currently an assistant editor at the Berkeley Economic Review, and is the Editor-in-Chief of the Business Review at Berkeley. Since September 2019, Sean has worked under the direction of Daniel Balke, performing research on exceptional finance’s potential for providing global public goods.

Daniel Balke is a PhD student in political science at the University of California at Berkeley and World Bank officer in South Sudan. He previously served as a Strategy and Operations Officer in the Fragility, Conflict, and Violence Group and the Middle East and North Africa Region of the World Bank Group in Washington, D.C., as well as an assistant to former World Bank Group President Jim Yong Kim, where he helped draft speeches and analytical economic briefings for the President. He holds a B.A. in international relations from the Elliott School of International Affairs at George Washington University and an M.A. in Latin American Studies from Georgetown University’s Center for Latin American Studies.

The views expressed in this article do not necessarily represent those of the Berkeley Public Policy Journal, the Goldman School of Public Policy, or UC Berkeley.