The BRICS Bank: now for the hard part

Arguing the case for the BRICS Bank was the easier part; China, though soon to be the world’s largest economy, has a shareholding at the IMF smaller than the Benelux countries. Brazil, with an economy almost three times the size of Belgium’s and a population about 18 times bigger, also has a smaller IMF shareholding.

As a group, the BRICS countries account for about 42% of the world’s population and about a fifth of the global GDP, yet just over a tenth of the shareholdings in the IMF. It is true that reforms are under way to give developing countries a slightly greater voice, particularly the BRICS countries, but the pace has been  slow and rather hesitant.

No wonder then that the BRICS countries keenly desire a new international financial institution where they will have a strong say in keeping with their growing economic weight. There is also the issue of huge and largely unmet needs for the financing of infrastructure projects in the developing world, to the tune of almost a trillion dollars a year in Asia alone. The new BRICS institution could help to supplement the resources already being provided by international financing institutions like the World Bank and the regional development banks.

It wasn’t an easy or straightforward road that led to the clasping of hands of the five BRICS leaders at the Fortaleza Summit in Brazil in mid-2014, when they announced the creation of two institutions, first, the BRICS Bank itself, formerly named the New Development Bank, or NDB, with an initial capital base of $50bn, and second, the $100bn Contingency Reserve Arrangement (CRA).

A number of potentially very disruptive issues had first to be dealt with. China had initially suggested an ownership structure in proportion to each of the five countries’ economic size but  this would have created a very lop-sided institution as China’s GDP is greater than the combines economies of the other four countries. After a drawn-out and difficult bargaining process, an equal shareholding arrangement was agreed on. In return, China would host the institution in Shanghai. The others were not left empty-handed as it was agreed that an Indian would head the institution for the first six years, a Brazilian would chair the Board of Directors, a Russian the Board of Governors and South Africa would host a Regional Office of the NDB.

Now comes the hard part: implementation. As well as the usual challenges that any newly-created institution faces, there are some critical issues the NDB still has to contend with. First, diversity. There is no denying that the five BRICS countries have more that differentiates them than they have in common. China’s economy is about 16 times that of South Africa; per capita GDP in Russia is about six times that of India. Two of the BRICS are permanent members of the UN Security Council, and have been every bit as reluctant as the U.S., the UK and France to admit others to permanent membership. Three BRICS countries are vibrant and often chaotic democracies, and have to contend with very different and demanding processes of consensus building.

In light of their diversity, it’s still far from clear how the NDB will formulate operational policies. Nor is it clear who the NDB will lend to and what its priorities will be. Will it be only to the BRICS countries themselves or will other developing nations be eligible to borrow? If the latter, how will those countries be selected? And within the BRICS, what will be the banks’ criteria for lending?

On top of that, there’s the thorny question of the cost of borrowing from the NDB. International financial institutions like the World Bank or the Asian Development Bank (ADB) operate on a very simple financial model; backed by the collective economic strength of their members, which include most of the advanced economies, these institutions enjoy AAA prime credit ratings – often better than the terms enjoyed by individual member countries. They therefore borrow on international capital markets at highly competitive terms, add a small margin and on lend those funds at rates lower and for longer maturities than national borrowers could have  mustered on their own. With the NDB currently owned by only five countries, it is not clear what credit rating it will enjoy and thus both the volume and price of the debt funds it will be able to raise in the international capital markets remain uncertain.

There is also the matter of credibility. An important factor influencing the cost of borrowing is the NDB’s credibility. Its track record as a lender that upholds the highest standards in its lending operations has yet to be established; so nothing is still known of its governance methods or its respect for social and environmental safeguards. The new bank also has to establish its credibility as a borrower that repays its debt and enjoys sound financial health.

The demand for funds, particularly to finance infrastructure projects, is enormous in all five BRICS countries and throughout the developing world. The NDB will need to lend at a meaningful level each year, but its relatively limited initial equity base of only $50bn means its lending volume will be determined by the level of debt funds it is able to mobilize. That in turn will depend on the credit rating it can command.

The need will be for great attention by the NDB for its due diligence processes regarding projects, including on social and environmental safeguards. The long-term viability of NDB as an institution will depend on the viability of the projects it finances; so these will need to be technically and economically viable while upholding best practices in social and environmental safeguards. The financial viability of projects will need to be assured either by the direct beneficiaries or by the borrowing government. Any compromises on the project quality at entry and during implementation would over time compromise the NDB’s own integrity and its financial health.

How well the BRICS’ new institution builds a pipeline of bankable projects will determine the credibility of the NDB, and there should be no illusions that doing so will need painstaking efforts and time-consuming development of staff skills and operational policies. The new institution will need to guard against any relaxation of its the standards of due diligence, or in the design and preparation of projects out of a desire to respond to borrowing countries’ needs.

The rationale for the NDB is strong, and it should start to take shape in the coming months so as to be ready for business in 2016. But the rationale for the Contingency Reserve Arrangement is not so strong and still needs careful review. The idea is that the $100bn CRA’s pooling of the five countries’ foreign exchange reserves will be available for BRICS members to draw on in a crisis. The two major challenges are that, first, in a genuine crisis a fund as small as $100bn will be insignificant even for the smallest of the giant BRICS countries. Second, any doubts about the repayment capacity of a borrower would mean that the other BRICS countries might well be unwilling to lend without imposing tough conditions. This would be politically very difficult between sovereign states of a club whose members are deemed to be equal partners. Conditionalities and the monitoring of compliance would exacerbate the tensions of a partnership whose diverse interests risk making their working harmoniously together difficult under the best of circumstances.

An instructive footnote could be that the similar Asian arrangement of swap lines and credit was established with the Chiang Mai Initiative following the 1997 Asian financial crisis, but was never used, even during the 2008 global financial crisis. There is no reason to believe that the CRA will be any more successful. The architects of the arrangement themselves recognised the CRA’s potential pitfalls by including in its design a provision that any country drawing more than 30% of their swaps will also need to negotiate an IMF programme. In short, it may be better for the BRICS to focus their attention on the NDB rather than pursue the CRA too.