JULY/AUGUST 1996 · VOLUME 17 · NUMBERS 7 & 8

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E C O N O M I C S

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IN WHAT COULD CONSTITUTE the first decisive blow against the house of cards that make up the multilateral development bank system, Standard & Poor's, one of the world's foremost credit rating agencies, downgraded the African Development Bank's senior long-term debt on August 30, 1995. After months of deliberation and analysis, Standard & Poor's announced the "increasing politicization" of the Bank's corporate governance and management made the move necessary. The downgrade made it more expensive for the Bank to borrow money on international markets, rocking the Bank's already precarious financial foundation and threatening the Bank's very survival.

The downgrade could not have come at a worse time for the beleaguered African Development Bank (AfDB). For more than a year, with the AfDB plagued by allegations of corruption and fraud, Western donors had refused to replenish the Bank's soft loan window, the African Development Fund. Meanwhile, an internal review of the Bank's projects by former World Bank Vice President David Knox, also in 1994, warned that unless certain reforms were implemented, the institution might self-destruct.

None of the signs of potential collapse was lost on the financial press. The preeminent publication in the world of international finance, Euromoney, called the Bank an "international embarrassment," saying it was "hopelessly inefficient and shoddily managed." The Economist said the Bank was "an inefficient, corrupt and politicized shambles."

The Bank, having been party to the financial deterioration of Africa, now faces insolvency as many of its debtors sink deep into arrears and its profits plummet. The World Bank and the other development banks in Asia and Latin America are nervously watching the situation at the AfDB, fearful that its financial collapse could cause a loss of confidence in the entire multilateral development bank (MDB) system.

Institutionalized mismanagement

Created in 1963, the AfDB has 77 country members, 53 from Africa and 24 from outside of Africa, the majority of which are rich Western countries. The rich member countries provide guarantees that enable the Bank to borrow money on international bond markets at favorable interest rates, which the Bank passes on to its poor African borrowers. The Bank also makes interest-free loans to Africa's poorest countries through its soft loan window, the African Development Fund, which is financed by regular cash infusions from the rich member countries.

Until August 1995, the AfDB's triple-A credit rating, like that of its sister multilateral development banks, seemed unassailable. The Bank's credit rating is based not on assets with inherent value such as sound loans to African countries, however, but on its borrowers' promise to treat the Bank as a preferred creditor which they will pay back first, and on political commitments from the rich member countries to appropriate money should the Bank prove unable to collect from its debtors to pay its creditors. Both commitments seemed uncertain by August 1995, so Standard & Poor's downgraded the Bank a notch.

The erosion of member support for the AfDB began in 1994 when the blockbuster report on the Bank's portfolio by David Knox was released. Innocuously named "The Quest for Quality," the report revealed an institution crippled by management problems, lack of accountability and boardroom squabbles.

Knox discovered that the Bank was mismanaged, and even lacked "a comprehensive reporting system to assess the quality and status of its portfolio." The Bank's record-keeping was so careless, haphazard and unrepresentative that the taskforce could not give a realistic evaluation of the Bank's portfolio.

The report concluded that many of the Bank's projects were failing because of lack of technical supervision, problems with subcontractors and difficulties by borrowers in complying with loan conditions.

Knox painted a picture of an institution more concerned with the amount of money it disbursed than with the quality of projects it funded. This "culture of approval" forced Bank staff to approve more and more loans, while paying little attention to the environmental, social and economic viability of projects. In fact, Knox said, "too much attention is paid to the quantity of lending and too little, perhaps even none, to its quality."

In spite of the limitations of Bank data, Knox estimated that 40 percent of the Bank's projects were unsuccessful. Consider the following examples:

* In 1991 the Bank prepared a $140 million loan for a road construction project in Cameroon that would have paved the way for large-scale logging of Cameroon's tropical rainforests and threatened the livelihoods of the traditional forest dwellers, the Baka pygmies. The project was subsequently cancelled, but only after an international campaign by citizens' groups warned of the massive destruction that would follow the road's construction.

* A $200 million loan to the Ivory Coast, also for road construction, threatened that country's tropical rainforest, home to Ivory Coast's last remaining elephant populations. An environmental assessment for the project described the extent of rainforest destruction in Ivory Coast as "a vision of apocalypse." The Bank decided to go ahead with the project, nonetheless.

* In Kenya, the Bank has run into significant problems financing water supply and sewage projects. Of four projects approved before 1983, only one has been completed and many other projects approved since then have suffered delays and major cost overruns. A paper mill financed by the Bank, also in Kenya, has generated widespread air and water pollution which has led to respiratory diseases and other health problems among the local people.

* The Bank's portfolio shows no signs of improving. It is now considering a $35 million loan for a hydroelectric project on the Mono River, along the border between Benin and Togo. The Adjaralla Dam, if completed, will forcibly resettle 10,000 people and will cause untold damage to the fisheries and forests of the area.

Knox concluded that unless the quality of the Bank's lending could be strengthened, the Bank "may end up by destroying itself."

The Bank's promises to clean up its act, meanwhile, did nothing to assuage Western donors who, amid the rumors of financial mismanagement and infighting, had suspended negotiations for the seventh replenishment of the African Development Fund.

An internal pressure cooker

The various pressures within the Bank found their outlet in a storm of controversy surrounding the Bank's president, Babacar Ndiaye. In the presidency since 1985, Ndiaye was the longest serving president the Bank had ever had. But Ndiaye was facing increasing problems with a fractious board of executive directors riven by differences between African and non-African members. Non-African shareholders were becoming increasingly vocal in their criticism of Bank management. African executive directors, meanwhile, were determined to minimize the influence of non-African shareholders in an effort to maintain the "African" character of the Bank. To top it all off, the Knox report exacerbated differences between African and non-African members of the Bank by exposing an institution paralyzed by "political pressure to make loans and award contracts."

Acrimony between Ndiaye and his board of executive directors (political appointees who represent member governments) reached a fever pitch in May 1995, when Ndiaye wrote a scathing letter to the Bank's governors (usually finance ministers from the Bank's member governments) accusing the Bank's board of executive directors of "excesses, irregularities and outright misconduct" and of "turn[ing] their offices into unconstrained cost centers from where a number of them flagrantly misuse Bank resources."

But the executive directors were not the only ones to blame for deficiencies at the Bank, argued Ndiaye. In a speech, he also blamed the failure of the Bank's development efforts on corrupt African governments and wayward Bank staff. "Reports ... show that the cost-effectiveness and economic impact of certain [Bank projects] have been compromised by procurement of goods and services without transparency," he said.

In addition to the president's accusations of corruption, an independent publication, Emerging Markets, reported in May 1995 that the Bank had fired five officials and disciplined 15 others for fraud. Ndiaye levelled similar accusations of fraud at the Bank's executive directors, alleging that travel expenses, money transfers and housing allowances were used by directors to collect extra reimbursement. "I regret to inform you," he wrote the governors, that the majority of the executive directors "are not fit to continue in office." The board of executive directors, in turn, responded that they could no longer work with Ndiaye. Ndiaye left the presidency in May 1995.

The search for a new president was highly politicized and did little, if anything, to restore confidence in the Bank. Five candidates emerged at the Bank's annual meeting in May 1995, but after five rounds of voting and negotiations, the Bank still did not have a new president. It was not until an extraordinary meeting of the board of governors in August that the Bank finally elected Omar Kabbaj, the candidate from Morocco. On the night of his election, Kabbaj told a French journalist, "I should like, and I shall try, to make the Bank a bank." The international investment world was not impressed. Four days after the election, the Bank's credit rating was downgraded by Standard & Poor's.

The crash of the Ponzi scheme

The World Bank must have seen it coming. Just a month earlier, in a leaked document about the need to relieve the world's poor countries' growing multilateral debts, a World Bank task force warned that "some solution needs to be engineered to prevent [the AfDB's] marginalization. Failure to do so may hurt the multilateral system itself." The World Bank task force proposed a debt relief fund as a way to "resolv[e] the conundrum of finding a way to bail out African countries, without bailing out the African Development Bank."

To date, the AfDB, like the World Bank and the multilateral development banks in Asia and Latin America, have dealt with precarious borrowers by lending these countries more than they must repay. Because the AfDB and the other MDBs will not reschedule loans of countries with cashflow problems (to do so would imply that the banks were not preferred creditors), the banks instead finance their own repayments with new loans. Dubbed by the World Bank as "defensive lending," this stop-gap strategy does little for hapless African borrowers, who dig themselves into ever deeper debt instead of coming to grips with their need to get their financial houses in order.

Defensive lending, like its close cousin the Ponzi scheme, inevitably runs into trouble, and at the AfDB, trouble means disaster. As the cost of borrowing Bank money increases due to the loss of investor confidence in the Bank and as fresh loans are less available due to the scaling back of Fund and Bank resources, Bank borrowers find it more difficult to pay back their loans, thus further threatening the Bank's preferred creditor status and raising the specter of the Bank calling on its capital -- the guarantees of the its rich-country shareholders -- to repay bondholders. This call on capital could represent the Bank's final act before liquidation.

Bilateral agencies like the U.S. Agency for International Development and the U.S. Export-Import Bank have carefully engineered other measures to stave off financial crisis at the AfDB and its sister multilateral development banks. These bilateral agencies, which hold more than 60 percent of the total debt of the 40 poorest countries -- many of them African countries -- receive under a third of their repayments: they convert missed interest payments to principal, postpone principal repayments and forgive debts outright. By using their bilateral institutions to deliver official debt relief over the past decade, rich-country governments have protected the preferred creditor status of the multilateral banks. But these disguised attempts to rescue the MDBs in the past have not gone unnoticed. In a 1992 investigation, Canada's Auditor General recognized this taxpayer bailout was quietly operating to keep a financial crisis from the multilateral banks' doorsteps and warned that "maintaining the preferred creditor status of the regional development banks is not cost free to countries like Canada."

The AfDB brass has, for the moment, secured its next taxpayer bailout. At the Bank's annual meeting in Abidjan in May of this year, Western donors agreed to a $2.6 billion, three-year replenishment of the African Development Fund. But only part of that amount, $1.6 billion, is new money; the rest will come from loan cancellations, repayments of past loans and payment of shareholder arrears. This most recent cash infusion is smaller than the Bank had hoped for and it is also notably less than the Fund's last replenishment of $3.42 billion. The replenishment is to be paid in three installments, the second of which is conditional on the Bank drawing up an action plan to carry out reforms. The third installment is conditional on the implementation of those reforms.

Meanwhile, the Clinton administration, which promised $200 million as its share of the ADF replenishment -- significantly less than the $315 million it promised in 1994 when the Democrats controlled Congress -- still has to get the green light from a decidedly more hostile Republican Congress.

The Bank is hoping for a capital increase by the end of 1997, but "Reforming the Governance of the African Development Bank," a report written by a former vice president of the Asian Development Bank, the former Africa director at the International Monetary Fund and a former Kenyan treasury official and circulated at the annual meeting, said that "if there is no agreement on any institutional change which meets some of the concerns of the non-regional countries, funds for neither a capital increase of the Bank nor for the replenishment of the Fund may be forthcoming."

Whether the Bank's new president Omar Kabbaj can turn this ship around has yet to be seen. In his year in office following his promise to make the Bank act like a bank, Kabbaj has shed one fifth of the Bank's staff, floated a well-received bond issue and adopted a new credit policy which deems most of the Bank's former clients too poor to qualify for the near commercial loans of the Bank and forces them to borrow from the Fund only. The fact remains, however, that the Bank is not a bank but an artifact of political decisions that depends on taxpayer support for its survival.

As their own growing budget problems bear down on them, and if the AfDB's governance problems persist, the donor countries may be forced to turn off the spigots that once kept the MDBs going. The AfDB, the most vulnerable among them, may be the first to sink.