Going Private

The IDB plans to promote the private sector to tap its entrepreneurial energy to revive growth. Critics call it trickle-down economics.

By Lucy Conger
March 2002
Institutional Investor Magazine

Although a number of Latin American leaders and not a few U.S. economists are inclined to believe otherwise, "free" markets don't come without a cost. After more than a decade of reducing trade barriers, privatizing state enterprises, imposing fiscal discipline and carrying out other classic neoliberal free-market reforms, Latin America appears to be worse off than before by several key economic measures.

Alarmed at the lack of progress, Inter-American Development Bank president Enrique Iglesias last year commissioned a study of IDB member countries' global competitiveness that amply confirmed his fears. Released in October, the analysis found that over the past decade, most of the 26 nations in the bank's Latin American and Caribbean domain had backtracked in productivity; seen slower gains in education; made no headway against the poverty that afflicts one out three of the region's residents, even as the gap between rich and poor widened; and managed as a group to grow at a lackluster 3.3 percent a year, compared with 5.2 percent for Asian developing nations. Only Africa ranks behind Latin America and the Caribbean in competitiveness, the report said. Its unflinching conclusion: "Most countries in Latin America and the Caribbean lack the foundation to substantially improve growth in productivity and incomes." Latin America's infrastructure needs are put at $500 billion over the next decade.

What's the solution? The cure for the deficiencies of capitalism may be more capitalism, the IDB has been told. In recommendations to be presented at the bank's annual meeting this month in Fortaleza, Brazil, a blue-ribbon panel appointed by Iglesias and headed by former Mexican Finance minister Angel Gurría will lay out the case for creating an IDB affiliate comparable to the World Bank's International Finance Corp. to promote the private sector by making loans directly to companies.

This new entity would use partial loan guarantees and other forms of insurance and reinsurance products in a bid to lure wary investors back to Latin America and the Caribbean. The affiliate would be "more creative and modern, design new products and projects and use capital to a greater extent to deal with the private sector," says Gurría.

"The scenario in which Latin America carried out the reforms in the 1990s no longer holds," Iglesias told Institutional Investor. "We have to rethink things. The fronts where we must work to be more competitive include credit, institutions, technology and information systems. And our actions must go in tandem with a comprehensive social program."

The panel has urged the bank to engage member governments in a dialogue to identify the "next big thing" that would allow their countries to prosper in the global economy. Each country would draft a national competitiveness program revolving around legal and bureaucratic reforms; easier access to capital; and educational, infrastructure and trade improvements.

At issue are so-called second-generation structural reforms that are more complex and often more prickly than first-generation measures such as taming inflation, trimming public spending and privatizing state enterprises. Countries need to provide fuller disclosure and establish accountability at major institutions, upgrade administration, combat corruption, enforce the law and ensure continuity in regulation. This is in addition to maintaining fiscal discipline and pushing through difficult labor and tax reforms.

Under the Gurría panel's proposals, the IDB would press for and help underwrite establishment of reasonable and predictable rules, solid enforcement mechanisms and greater transparency. Poor creditor rights and slipshod corporate governance are "big issues preventing greater capital flows" to emerging markets, points out Abigail McKenna, managing director of Morgan Stanley Asset Management.

The panel's recommendations, which must be vetted by the IDB's full membership, are bound to be contentious because they involve a significant shift in the bank's resources from the public sector to the private. In January the IDB doubled its existing cap on private sector lending to 10 percent of its portfolio. The panel has not proposed a funding level for the affiliate.

Its recommendations would appear to derive from a certain logic. "It's a simple equation," explains Gurría. "The savings rate in Latin America is insufficient to fund the necessary investment for economies in the region to grow at their cruising speed, to absorb new labor entrants and pick up the lag. You have to give people education, health and jobs to cover the lag, and the only way to do this is to increase investment and growth." Another panel member, Marcílio Marques Moreira, a former Brazilian minister of Economics, Finance and Planning and now senior international adviser to Merrill Lynch & Co. in Rio de Janeiro, says of the proposed private sector arm: "You need to have a more dynamic unit at the IDB to deal with the private sector and capital markets. It's a very different story from sovereign governments and the public sector."

Still, the IDB's prospective free-market thrust comes at a time of growing doubts in Latin America and elsewhere about the extent of the benefits of capital markets liberalization and export-led growth (see related story, page 89). The development bank is already under fire for supposedly neglecting the plight of the poor. "It is difficult to have sustainable economic growth without more equitable sharing in the wealth it has generated," contends Peter Bell, president of Care. "There has been a growing appreciation at the bank for issues of poverty and the social side of development, including the building of civil society. But the capacity to follow through on that, and turn it into effective policies, programs and loans, lags."

The panel's development experts, in championing private enterprise rather than the state as the engine of growth, argue that only such an emphasis can significantly raise productivity and output, which ultimately improves living standards for the poor as well as the middle class.

But to some skeptics this harks back to the discredited "trickle down" economics of the 1980s. "They should consider that a rising tide doesn't lift all boats," says Randall Dodd, director of the Derivatives Studies Center, a Washington, D.C., research and policy group specializing in financial market regulation. "It has done so with full employment in developed countries, but developing countries that are far from full employment need policies that address income distribution and create demand." Nora Lustig, an economist on leave from the IDB to serve as rector of the Universidad de las Américas in Puebla, Mexico, observes that "things that can imply investing in the poor are also good for growth: Human capital investments in education, health and nutrition improve the living conditions of the poor and make them more productive."

But as Nancy Birdsall, president of the Center for Global Development and a former executive vice president of the IDB, points out: "It would be a false hope to think the Bank's projects, which represent 2 to 5 percent of public spending, will be in and of themselves a big factor in reducing poverty, so you can't get away from the overall policy framework."

Others fault the panel's loan guarantees and kindred proposals on technical grounds. "There should not be a blanket application of credit enhancements and guarantees,"says Mohamed El-Erian, emerging-markets director at Pacific Investment Management Co. in Newport Beach, California. "They obfuscate market signals, subordinate unsecured creditors and do not result in a net addition of resources." Gurría, however, counters: "Markets don't have complete information and tend to move in procyclical swings. So the IDB - with its knowledge of the region - can mitigate risk with partial guarantees, reinsurance and risk-sharing."

The Gurría panel is more than familiar with the many permutations of the development debate. A powerhouse team combining expertise in regional issues with savvy about the capital markets, the 15-strong External Advisory Group is laden with former finance ministers and central bankers as well as academics and prominent commercial and investment bankers. Roughly half the members are former Finance or Economy ministers from Latin America and the Caribbean: Argentina's José Luis Machinea, Brazil's Marques Moreira, Chile's Manuel Marfán, Colombia's José Antonio Ocampo, El Salvador's Manuel Hinds, Mexico's Gurría and Wendell Mottley of Trinidad and Tobago. The other eight represent the IDB's nonborrowing member countries: Canada's Sylvia Ostry, a University of Toronto economics professor and a former deputy Trade minister; Germany's Albrecht Raedecke, an advisory board member of Deutsch-Südamerikanische Bank; Israel's Jacob Frenkel, chairman of Merrill Lynch Sovereign Advisory Group and a former Bank of Israel governor; Japan's Makoto Utsumi, a former vice minister of Finance and now a business professor at Keio University; Spain's Guillermo de la Dehesa, president of Plus Ultra Insurance and a former Finance minister; the U.K.'s Nicholas Baring, a member of the Baring Foundation's management council; Darby Overseas Investments chairman and former U.S. Treasury secretary Nicholas Brady; and David Hale, global chief economist of the Zurich Group, also of the U.S.

The panel's stress on private sector solutions stems as much from practical considerations as ideology. Great shifts have occurred in Latin American and Caribbean economies over the past decade. Privatization campaigns have transformed once state-run utilities, telecommunications companies and highways. Governments have restrained their hitherto dominant economic role and cut back spending and borrowing accordingly, while encouraging private investment.

Foreign investors have responded enthusiastically, albeit with intermittent panic attacks; private capital flows into the major Latin economies now eclipse lending by the IDB.

Yet, as has so often been seen in Latin America - in the 1995 "tequila" panic, the 1997 Asia crisis, Russia's 1998 default and again with Argentina's collapse in recent months - private capital flows can dry up suddenly. "The lesson of Argentina is that, with the private sector, it's feast or famine," says Pimco's El-Erian.

What can the IDB do to help tie down this foreign money? Possessed of $101 billion in capital, the bank is well positioned to play a greater role alongside private investors in supporting infrastructure and other growth-generating projects. The bank's private sector affiliate might, the panel suggests, develop and invest in regional, subregional, national and sector funds to promote private investment through private equity and mezzanine funds. The private sector arm might also enter into partnerships with investors and regional development banks to underwrite private sector ventures.

It would also develop innovative financial products to make investing in the region more alluring. The panel envisions credit-enhancement and risk-mitigation tools, partial guarantees, the leadership of syndications for national and regional projects, credit guarantees and insurance. The affiliate should also embrace a completely new financial mechanism, says Gurría: partial guarantees on contracts. Backed by the affiliate, these would cover arbitrary changes in regulations or in the legal climate. Another recommendation is to make greater use of insurance to entice Latin America's growing pension funds to make direct investments that they'd otherwise deem too risky.

"What is often lacking in development is private sector financiers willing to invest in infrastructure projects because they are concerned the government will back away from its undertaking," says a close associate of the panel, Robert Graffam, managing director of Darby Overseas Investments in Washington, D.C., and former head of risk management for the IFC.

The idea of the various guarantees, says Gurría, "is to seek structures in which every peso or dollar that the IDB lends can mobilize six or seven." Graffam illustrates the concept this way: If the IDB lent $1 to Colombia to build a power plant, it wouldn't get nearly as much bang for the buck as if it instead backed a partial guarantee covering 20 percent of the risk in the plant on behalf of private investors.

Funding for the private sector arm would come either from a direct equity investment by the IDB or from a capital increase by shareholders. But the key is that the affiliate would be launched as a financially distinct entity so that it could leverage its capital by borrowing. Although the IDB would retain a controlling interest, the affiliate would have a separate balance sheet to protect the bank's cherished triple-A rating, explains Gurría. As for the affiliate, it would be expected to achieve and maintain an investment-grade rating.

Some market players are skeptical about the panel's rough sketches for products (the blueprint stage is still a ways off). Political-risk guarantees tend to be hard to understand because of all the qualifiers and exclusions, they say, suggesting that the contractual-risk notion would require elaborate explanations that might intimidate investors. Some market analysts argue that it's not efficient to use the IDB's triple-A balance sheet in the guise of a partial guarantee to back a private investor's double-B risk and come up with something in between. Darby Overseas' Graffam, however, points out that the panel emphasizes partial guarantees and risk reducers precisely because these would allow the affiliate to use up as little of the IDB's own risk as possible backing other credits. In addition, panel members say, the use of such sophisticated instruments would accelerate the transfer of financial technology to Latin America.

Others critics, like Pimco's El-Erian, question cushions for credits because they can distort the market. Instead, he proposes that the IDB affiliate apply enhancements and guarantees only to companies that have no access to the markets. "Certainly, there is a market failure in financing small, medium and local enterprises in Latin America," he says. "The way to do it is through equity participation and allowing entrepreneurs to graduate" by being bought out or going public.

In a sensitive proposal that does not involve the private sector affiliate, the panel urges the IDB to launch a pilot program of direct lending to provincial and municipal governments and regional utilities without the usual sovereign guarantees. The rationale is that decentralization over the past decade has left provincial governments in charge of many health and education programs and some antipoverty initiatives, making them much more critical players in development. "If you want to reform education and health, you have to work at the level of provinces because that's where the decisions are made," says panel member Machinea, former Argentinean Economy minister.

This form of lending nevertheless demands strict supervision to prevent provincial and city governments from taking on too much debt. Claudio Loser, director of the Western Hemisphere department of the International Monetary Fund, sounds a note of caution: "Our position has always been one of concern about the foreign indebtedness of subnational governments. We have always asked for great prudence and strict coordination with subnational governments."

Perhaps the most controversial of all the panel's proposals, though, is that the IDB consider calling for a ninth capital replenishment. The last time that the bank was recapitalized by its members, with an injection of $40 billion in 1994, its lending capacity grew substantially. But a "zero growth" constraint was imposed that mandated that the bank's lending be "sustainable"; in practice, this meant it had to cap new loans at the amount of loan repayments.

That cap now feels snug. The panel also recommends that other means be explored to expand the IDB's capital, such as increasing leverage. But now that the subject of a major new capital infusion has been broached, it is sure to be debated animatedly at the IDB meeting. The U.S., for instance, is understood to back funding for the private sector initiative.

Machinea says of the IDB's need for fresh funds, "Emergency situations arise in the countries, and the bank has to be prepared to lend in them." And, as an Argentinean, he can say that with particular conviction.