A Financial House of Cards

by Patricia Adams

IN JUNE 1993, just three months after it dramatically ended its disbursements to the controversial Sardar Sarovar dam in India, the World Bank assembled a massive loan package for the Indian government. Worth $2.3 billion, the loans had all the markings of a political payoff.

The Sardar Sarovar dam had become an albatross around the World Bank's neck: an independent review of the project revealed the dam would perform poorly and impoverish some 240,000 people who would be moved to accommodate it. Public outrage in India over the World Bank's support for the megaproject led to a "Quit India" campaign - a revival of Gandhi's campaign against British colonial rule - to expel the World Bank. International outrage, meanwhile, was beginning to threaten the World Bank's bid for an $18 billion capital fix from the Western countries which periodically refill its coffers. Both Finland and Canada cut their contributions to the Bank, and the U.S. Congress - the World Bank's biggest benefactor - was threatening to withhold its hefty 20 percent share of the World Bank's budget.

But the Bank could not walk away from the project without offending the Indian government. Wounded by a balance of payments crisis and public opposition to its economic reform package, the Indian government was also furious over what it perceived as meddling in its sovereign affairs by foreign environmentalists and the World Bank over Sardar Sarovar. In a daring game of financial brinkmanship, the Indian government threatened to default on its World Bank debts if the Bank withdrew its support for the dam. As the World Bank's biggest borrower, the Indian government had the Bank over a barrel. An Indian default on its World Bank debts would put 15 percent of the Bank's entire portfolio in the limbo of nonaccrual status, threatening the Bank with its first annual loss.

The World Bank capitulated. To appease its critics, it cancelled the remaining $170 million in disbursements for Sardar Sarovar; to please its client state, it offered more than 10 times as much, not allocated to specific projects with their potential for embarrassment, but to be spent at the discretion of the Indian government.

Indulgent benefactors

 Buckling under international pressure seems uncharacteristic for the Bank, viewed by many as the world's most unflappable financier. With a reputation for imposing discipline on its borrowers, and for cool- headed, unsentimental economic analysis and an unshakable triple-A credit rating, the World Bank has always seemed the most prudent of financial institutions.

It is a reputation that the World Bank carefully cultivates. In its Information Statement (a prospectus for potential purchasers of its bonds), the World Bank reassures investors that it "does not make loans which, in its opinion, cannot be justified on economic grounds." It boasts that it "has never written off any of its outstanding loans," nor will it reschedule its loans the way other, by implication less adroit, financiers do. The World Bank also regularly points out that because of its "preferred creditor status" it always gets paid back first, before all other creditors.

All these factors contribute to the Bank's blue-chip status. But no factor matches the pledges by rich country members to repay bondholders should the Bank's Third World borrowers default. It is because of these pledges that even failed World Bank loans do not tarnish the Bank's credit rating.

Money-losing loans, as it turns out, have been the order of the day.

The first outside, independent assessment of a World Bank project ever done - which was for India's Sardar Sarovar dam - documented institutionalized deception, incompetence and negligence. Engineering studies to determine the dam's viability were never completed, the review found. The review team also rejected the argument that Sardar Sarovar might be an isolated example, stating that "the problems besetting the Sardar Sarovar Projects are more the rule than the exception to resettlement operations supported by the Bank in India."

India's problem projects were, in turn, only a hint of even bigger problems. Just months after the release of the damning Sardar Sarovar report, an internal report commissioned by Bank President Lewis Preston to investigate project quality was leaked to the public. It revealed that the problems plaguing the Sardar Sarovar project were Bank-wide.

Prepared by high-ranking World Bank official Willi Wapenhans, this report found that more than one-third of the Bank's $140 billion in projects were failing. Worse still, deterioration of the Bank's loan portfolio was "steady and pervasive."

"There is reason to be concerned!" declared Mr. Wapenhans in a June 1992 presentation to members of the Bank's Board of Executive Directors. "The portfolio is under pressure," and "this pressure is not temporary; it is attributable to deep-rooted problems," he explained in his report.

Among them, Wapenhans found the World Bank staff to have a "systematic and growing bias in favor of optimistic rate of return expectations at appraisal." He found that the Bank operated as an "approval culture" in which "staff perceive appraisals as marketing devices for securing loan approval (and achieving personal recognition)." "Appraisal," observed Wapenhans with dismay, "becomes advocacy."

What critics had long suspected was now confirmed at the Bank's most senior level - the World Bank's books had been cooked to make unsustainable projects appear viable. Contrary to its claims, instead of detached economics calling the shots, bureaucrats and borrowers out to build empires viewed all Bank projects through rose-colored glasses.

Moreover, the Bank seemed no better at implementing projects than appraising them: Wapenhans discovered borrowers' non-compliance with legal loan covenants, especially financial covenants, to be "gross" and "overwhelming." Of the water-supply projects financed by the Bank between 1967 and 1989, for example, only 25 percent of the borrowers complied with their financial covenants.

Guaranteeing bad loans

 Despite this rash of bad news about its mismanaged projects, the World Bank's triple-A credit rating remains unscathed. The Bank claims the credit rating agencies are satisfied that the Bank will do better in future. "The shift in the Bank's procedures [in response to the Wapenhans Report] has been thoroughly discussed with the ratings agencies and was well received by them as evidence of the Bank's efforts to improve the quality of its services on an on-going basis," says Ellen Tillier, a World Bank spokesperson.

 But any other bank with such a disastrous portfolio would see its credit rating slashed and its investors flee. The World Bank is unlike any other bank, however. Rather than being governed by market discipline and exercising investment prowess, the World Bank is propped up by state guarantees and disguised government bailouts.

Because all Bank loans are guaranteed by borrowing governments which pay them back out of general government revenues (instead of from project profits), the World Bank need not ensure that its loans are invested in economically viable endeavors. "With such a setup," says longtime Bank critic Bruce Rich in his recent book Mortgaging the Earth, "it makes no difference whether the projects the Bank lends for are well managed or mismanaged, or whether some or all of the money disappears." Hapless Third World taxpayers are the first ones to take the hit for disastrous investments.

Meanwhile, tax revenues from rich countries are routinely used to disguise the fact that the World Bank, with the riskiest loan portfolio in the world, is a financial house of cards that could crumble at the slightest tremor. A 1992 investigation of the Bank by the Canadian Auditor General (a parliamentary watchdog over government expenditures) debunked the Bank's claim that it never reschedules debt and that its Triple-A credit status is the result of some inherent financial integrity in the Bank.

Maintaining the preferred creditor status of the multilateral development banks - the linchpin in their triple-A credit ratings - "is not cost free to countries like Canada," explained the Auditor General. Nor is it "based on a formal or legal subordination of the debts owed other creditors to the debts owed to the banks." Rather, the Auditor explained, it is based "on informal factors, like the willingness of the development banks to maintain a positive cash flow to their borrowing countries."

Without a "positive cash flow" - to allow Third World debtors to receive more in new loans than they must pay back - many Third World countries would be unable to repay the World Bank. To ensure the Third World gets enough new money to make these debt payments, the World Bank provides structural-adjustment loans - immediate loans for unspecified expenditures, made to help a borrowing country reform its economy. Reform through these loans generally results in export-oriented growth strategies at the expense of poor and working people and the environment. Through these round-trip loans, Third World borrowers get deeper into debt and the Bank becomes increasingly vulnerable to its high-risk debtors.

A 1992 confidential report to the Bank's Board of Executive Directors recognized the problem. "The quality of the portfolio has deteriorated significantly," it warned. "Almost half of the projected increase in Bank exposure is to countries that are currently considered to be high risk," and "it is possible that a few of today's high risk countries could slide into nonaccrual over the next few years." The Bank admits the problem has not gone away. "Development lending is risky, and there is the chance that the Bank's borrowers will face payment difficulties," Tillier says. Should this occur, she adds, the Bank could manage the risk by maintaining a high level of reserves and suspending its present practice of waiving some of its loan charges to certain countries.

 However, it would only take one large debtor, like India, or a handful of smaller debtors to default on their loan repayments for the unthinkable to happen: the Bank would have to start calling on its reserves (funds authorized by member countries) to meet its obligations to its bondholders. But that might set off a chain reaction, undermining the Bank's shaky foundation. Member countries would likely be called upon for additional funds. But taxpayers in member countries might well resist bailing out boondoggles, dragging down the Bank's credit rating. The cost to the Bank of borrowing money would increase, and its Third World borrowers would begin to question the wisdom of more borrowing - and the wisdom of repaying their Bank loans. The Bank's entire financial stability would be put at risk.

Bailing out the Bank

 The Canadian Auditor General observed that donor countries have been maintaining the Bank's preferred creditor status by offering debt relief "indirectly" through the Paris Club.

The Paris Club is a regular meeting of lending and borrowing nations, hosted by the French finance ministry, to renegotiate Third World debts to government lenders. While the Bank does not participate in those negotiations, its rich country members protect the Bank by directing their own lending institutions (aid agencies such as the U.S. Agency for International Development and export credit agencies such as the U.S. Export-Import Bank) to reschedule or forgive their Third World debts first. The Paris Club reschedulings have thus become an important safety valve protecting the World Bank.

Sometimes the Bank requires a more overt rescue to avoid a downward spiral triggered by one large borrower defaulting. Since the World Bank's financial facade does not admit to the existence of round-trip loans to get chronic debtors out of arrears, the Bank's rich members do the job instead. In 1990, a "support group" of creditor countries, worried that the mounting arrears of various small borrowers would weaken the credibility of the World Bank and the International Monetary Fund (IMF), pooled millions of dollars to pay off Guyana's arrears to the World Bank and IMF, thus restoring Guyana's good standing with the two institutions through a package of loans, grants and debt rescheduling. Similar packages have been marshaled since: France recently gave a grant to cover Cameroon's debt service arrears to the World Bank while last year the United States and Japan gave a bridging loan to Peru to clear its World Bank arrears.

Third World debtors have "often been supported through bilateral and multilateral programs to enable them to service their debts with the World Bank," said Canada's Auditor General, suggesting that a taxpayer bailout has been quietly operating to keep a financial crisis from the World Bank's doorstep. But, he added, "One must ask whether these flows can be maintained indefinitely."

For now, the Bank's priority is to keep money flowing to its Third World debtors at higher volumes than the debt repayments it receives, thereby providing debtors with the wherewithal to repay old World Bank debts.

But maintaining a positive net flow of funds requires ever more funds from increasingly reluctant rich countries, especially given that they are still on call to pay back some $100 billion to Bank bondholders should Third World countries default.

The risk of a World Bank bailout led Canada's Auditor General to urge the G-7 countries, which are collectively liable for $70 billion of the World Bank's $100 billion debts, to conduct an independent review of the World Bank's financial situation. Such a review would likely reveal the fragility of the Bank's finances. When wealthy countries tire of endlessly pledging more money to the Bank's Third World debtors to induce payment of old debts, the Bank's preferred creditor status will collapse like a house of cards, threatening its triple-A credit rating and exposing its operations as a kind of global Ponzi scheme dependent on uninformed taxpayers to keep it going.


True Confessions of the World Bank

MORE THAN ONE-THIRD OF WORLD BANK PROJECTS completed in 1991 were judged failures by the Bank's own staff, a dramatic 150 percent rise in failures over the last 10 years, according to an internal review by Willi Wapenhans, a former vice president of the Bank.

A follow-up survey, which has yet to be published, shows that more than 60 percent of the audits of all Bank projects are not received on time, making them "inconsequential for project management purposes." One-fifth of these audits have qualified, adverse or disclaimers of opinion, meaning the auditors believe that either additional information is required before the audit can be signed, the audit is misleading or there is insufficient information for the auditor to judge the audit, respectively.

The Bank's four affiliates lend out $23 billion a year to developing countries in Asia, Africa and Latin America, as well as the countries of the former Soviet bloc, making it the world's largest funder of development projects.

Wapenhans submitted his draft recommendations in late 1992, after reviewing approximately 1,800 Bank projects in 113 countries representing Bank loans of $138 billion.

Wapenhans noted that 37.5 percent of the projects completed in 1991 were deemed failures, up from 15 percent in 1981 and 30.5 percent in 1989. Bank staff also said that 30 percent of projects in their fourth or fifth year of implementation in 1991 had major problems. The worst affected sectors were water supply and sanitation, where 43 percent of the projects were said to have major problems, and the agriculture sector, where 42 percent were reported to have problems.

Geographically, the African region had the most problems, with some countries having success rates as low as 17.2 percent. The Wapenhans report says that, far from being isolated phenomona, such problems were spreading. "Traditionally strong performing sectors are now affected too: in 1991, telecommunications ([with a failure rate of] 18 percent), power (22 percent), industry (17 percent) and technical assistance (27 percent). New areas of lending also encountered major problems: poverty (28 percent), environment (30 percent) and private and public sector reform (23 percent)."

The report concludes, "The portfolio is under pressure. This pressure is not temporary; it is attributable to deep rooted problems which must be diagnosed and resolved. The cost of tolerating continued poor performance is highest not for the Bank, but for its borrowers." In a candid evalution of the Bank's lending procedures, Wapenhans said that many of these problems stemmed from the fact that the Bank did "little to ascertain actual flow of benefits or to evaluate the sustainability of the projects during their operational phase." Project completion reports tended to be written shortly after the last loan disbursement, before there was an opportunity to assess the actual results of the project.

The borrower's revolt

 A meeting with representatives from half of the borrowing countries in May 1992 provided some startling comments on the Bank. Wapenhans recorded over 400 pages of anonymous testimony which slammed the Bank for ignoring local views in favor of policy mandated from Bank headquarters. One borrower said that Bank staff insisted on as many conditions as possible, some of which reflected insensitivity about the political realities of the country and sometimes even conflicted with fiscal policy set by the structural adjustment policy changes required by the Bank and its sister organization, the International Monetary Fund.

The borrowers accused the Bank staff of being high-handed and insensitive, insisting on designing projects according to its policies at the time instead of consulting with the borrowers and local people. One borrower said that Bank staff "take a negotiating position, not a consulting position - they know what they want from the outset and aren't open to hearing what the country has to say." Another representative said that they felt "psychologically pressured" to take or leave the Bank's loan offer, leaving the country to choose between no money or agreeing to conditions that it could not honor. Another complained that the Bank "changes its wisdom with the passage of time. We saw the Bank talking about import substitution in the sixties, then export substitution, then social problems and then the environment."

One borrower asserted that the high rate of Bank failure was due to the increased complexity of meeting Bank requirements. "There is a consultant who has prepared it, a mission which has appraised it, a Board which has sanctioned it, and there are supervision missions which are watching its progress. [But] unless the borrower is committed, the project will not be implemented."

The borrowers agreed that the Bank staff appeared driven more by pressure to lend than a desire for successful project implementation.

Bank staff often insist on using international consultants to prepare projects, the borrowers charged, resulting in poor quality suggestions because the consultants "from New York or London" have no experience in the project countries. The borrowers said that the Bank often rejects local consultants and local suppliers because the terms of its open competitive bidding give the advantage to big international corporations. The reliance on foreign contractors, they said, slows project implementation and then results in the proliferation of infrastructure and technologies that are not easily repaired or supported locally.

Responding to failure

 The Wapenhans review triggered alarms at all levels of the Bank. It provoked especially sharp reactions from the Bank directors, including the Netherlands' Evelyn Herfkens, Scandinavia's Jorunn Maehlum, the Patrick Coady from the United States and Germany's Fritz Fischer. A series of high-level meetings were convened by the directors with the Bank's management in November and December of 1992, where several directors floated the idea of an independent unit to monitor Bank projects and stem the failures.

One follow-up review was conducted by the Financial Reporting and Auditing Task (FRAT) Force, headed by George Russell, a financial adviser in the Bank's central and operational accounting division, to find out what happens to Bank funds once they are doled out.

Russell discovered that more than 60 percent of Bank project audits are not received within the grace period of four to nine months after the end of each fiscal year of the projects to be audited. More than 90 percent of the reports are received within two years but 7 percent of them are not received at all. Russell's report blames poor accounting standards in the borrowing countries, lack of experienced staff and "unduly burdensome" reporting requirements.

In addition, Russell's team reported that "the format of the [financial] information received often does not allow for (i) comparison with staff appraisal reports (ii) linkage of physical achievements with project expenditures and (iii) reconciliation with Bank disbursement records."

FRAT points out that the Bank also needs to upgrade its own technical staff. "Financial statements frequently are not reviewed or are reviewed by staff without the necessary skills to identify significant problems and to take appropriate action," says the report. Interviews with members of the team also revealed that in many countries, particularly in Africa, government auditors who have to review the projects have little or no training on how to prepare proper financial statements.

"Nobody was reading the auditing requirements because they were too complex," says Bank President Lewis Preston. "Our accounting and legal departments are now working together to try and simplify them."

The task force report also cited several other factors that have affected performance. It noted that problems increased with the number of co-financiers, such as private banks and bilateral aid (the Bank's total portfolio of 1,800 projects is collectively worth $360 billion, of which it provides $138 billion). Swings in the world economic environment such as declining terms of trade for borrowing countries, rising international and inflation rates, declining capital inflows and volatility of petroleum prices closely correlated with the failure rate of projects, as did problems within the project country.

In an analysis of the success rate for major country portfolios, a number of countries had a success rate of less than two-thirds for completed projects - Bangladesh (66 percent), Philippines (65.8 percent), Algeria (58.3 percent), Mexico (56 percent), Brazil (55.9 percent), Kenya (48.2 percent), Tanzania (34.8 percent), Nigeria (26.3 percent) and Uganda (17.2 percent).

The task force recommended that the Bank place greater emphasis on managing projects at a country-by-country level, as opposed to the current system of global sector management which ignores the reality of local factors and the impact of other local Bank projects. It said that local "ownership" of projects should be stressed, and the emphasis should be shifted from loan approval to performance and the impact of the project.

Another immediate action by the Bank was to prepare a suitable response to the Wapenhans report. In July 1993, Acting President Ernest Stern issued a new plan entitled "Getting Results: The World Bank's Agenda for Development Effectiveness," which he said switched the focus of the Bank to the implementation and monitoring of development projects, as opposed to the past emphasis on the granting of credits, with little or no follow-up. "It is a recognition that we know we can do better and that we are determined to do so," Stern told reporters at a press conference.

The new plan took up the Wapenhans recommendation to change the administrative dynamic of the Bank, allowing the Bank to oversee all of its operations in a given country as a whole, instead of isolating each individual project. The Bank also promised to pay more attention to the quality and viability of new projects, ensuring they are consistent with the needs and abilities of the target communities, while encouraging increased participation of local entities, including non-governmental organizations.

"These actions will help to accelerate a cultural change within the Bank, a shift from treating new lending per se as the overriding priority, to an increased focus on the impact of the entirety of our operations. [But] we should all recognize that development is a risky business. No one achieves a 100 percent success rate. No one should realistically expect one," Stern said.

But while the plan did seek to improve the loan management system of the Bank, it paid only lip service to other Wapenhans recommendations such as the need to consult with local people about their needs. While it defined development as "reducing poverty and improving people's lives," the new plans to include the poor in its work amounted to a single paragraph in the 23-page report which simply said that the World Bank was carrying out new experiments that aimed to strengthen staff training programs to involve the poor.

-Pratap Chatterjee