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BRICS Bank: The New Kid on the Block

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Pacific Money

BRICS Bank: The New Kid on the Block

Is this a new solution to an old problem?

While many Germans were busy recovering from the World Cup Final in Rio, in another part of the host country five major emerging economies were stepping into the world of international lending. The 6th BRICS summit at Fortaleza saw the creation of two important entities in the spectrum of development finance; a $100 billion New Development Bank (NDB)and an emergency $100 billion BRICS Contingent Reserve Arrangement (CRA), to tackle infrastructure deficits and halt short-term liquidity pressures.

The NDB will have an authorized capital of $100 billion, with the initial subscribed capital of $50 billion divided equally amongst the founding members. A total of $2 billion will be invested over the span of the next seven years with each founding member having an equal vote, and the remaining $50 billion will be in the form of guarantees. The bank aims to allocate resources for infrastructure and sustainable development purposes amongst the BRICS and other emerging and developing economies. The CRA, on the other hand, will have contributions based on the strength of the member economies; China will contribute $41 billion; Brazil, Russia and India will contribute $18 billion; while South Africa will contribute $5 billion. Though the finer points regarding the functioning of these entities are yet to be confirmed, many articles argue whether such an institution can legitimately substitute the World Bank in providing funds to emerging economies. There are three fundamental questions that need to be addressed before a verdict can be passed.

Capital Requirement: How much is enough?

Amar Bhattacharya, Mattia Romani and Nicholas Stern, in a paper for the Center for Climate Change Economics and Policy (CCCEP), estimated that infrastructure spending in emerging markets and developing countries (EMDC) will have to increase from the current $0.8-0.9 trillion per year to $1.8-2.3 trillion per year by 2020. The World Bank estimates an infrastructure deficit of at least $1 trillion dollars in these regions. Clearly, $100 billion will not make a significant impact on alleviating conditions in developing countries. It does however, help in providing another alternative to many of the EMDC’s in acquiring financing.  Stephany Griffith-Jones, a renowned economist, argues that the bank has to be big enough to make a significant impact. Though the initial $50 billion subscription is a good start, there is a strong case for further scaling up in order for it to actually prove sufficient. In a paper for the United Nations conference on Trade and Development, Griffith-Jones offers the solution of extending membership to smaller EMDCs to increase the capital pool of the NDB. Though this helps in achieving more lending activity, it also poses a challenge to the cost of borrowing.

Funding: At What Cost?

The cost of borrowing for the World Bank and IMF tends to be lower given the strength of the U.S. and the strong European economies that back it. In contrast, the NDB would face a much higher cost of borrowing in the international capital markets. Amongst the founding members, China has an AA-credit rating (issued by Standard & Poor’s) while the rest of the members are assigned BBB-, reflecting their risk and subsequent high cost. These borrowing costs will only increase if more EMDCs join the pool. As a result, the cost of borrowing will be a fundamental problem to address as the bank strives to balance a healthy portfolio of loans.

Is This a Better Option?

Capital accessibility and lower borrowing costs may prove to be a relevant function, while equal voting power and possibly no conditionality on lending may serve as important factors in the success of the NDB.

The NDB and CRA stem from the slow reform process of the IMF to extend more voting power to emerging countries. The disparity between a country’s contribution to global GDP and its voice in allocating resources through the IMF is surprising. For example, the BRICS consist of only 11.51 percent of voting power in the IMF, while contributing almost 25 percent of global GDP. In December 2010, the IMF agreed to wide-ranging governance reforms to reflect the increasing importance of emerging market countries. If these reforms were to be implemented, the quota share for China, Brazil, India and Russia would increase over 5 percent, making them a part of the top 10 shareholders of the fund. This summit, as a response to the delay in implementation, saw the BRICS countries express grave disappointment andpotentially negatively impacting the IMFs role in developing countries.

By providing equal votes to members in the NDB, there is already a new framework in place opposing the bureaucratic system of the IMF and World Bank. Furthermore, the World Bank has imposed conditionalities and a rigorous process when lending to developing countries, leading to an additional cost for borrowing countries. In many instances this has proven to be the reason why many developing countries have received less funds, or are not motivated to approach the World Bank/IMF for funding. Though the operational procedures for the NDB are yet to be finalized, the possibility of non-conditional loans and a less rigorous process for lending could be a potential catalyst for driving consistent growth in developing countries. Although the ease of lending should be given importance, debt repayment from recipient EMDC states will still be a challenging problem for the NDB, and securing physical assets as collateral may perhaps be a reasonable solution.

Verdict

Geopolitically, the formation of the NDB and the CRA can be seen as a first in expressing a unified voice for emerging markets to end the hegemony of stronger developed economies through the IMF and World Bank. In the long run, such a financial institution could be used to amplify the bargaining power of emerging economies in global markets. Most interestingly though, if the IMF reforms take place by January 2015, as confirmed by the board of governors, any realignment in the quotas in favor of the BRICS would give them a very powerful voice amongst EMDC nations. It remains to be seen if such a powerful voice would be used in favor of the developing countries, or if it could possibly be the beginning of a unified powerbase within these lenders. In conclusion, it is hard for supporters to prove exactly how the NDB will be able to provide a significant alternative for developing nations given the financial resources at hand and the challenges to be overcome. The deciding factor for the NDB lies with the yet to be decided operating framework, but the option of having another lending arm focused on the development of emerging economies is a significant supplement in the field of development finance.

Unmesh Rajendran has been a student researcher with Export Import Bank of India and an equity research intern with JP Morgan covering the fertilizer sector in India.