Over the next five to six years, the World Bank’s lending is expected to increase by about 10 percent a year. This will be made possible by the recently approved general capital increase (GCI) of about $75 billion, which will bring the total authorized capital of the Bank (formally, the International Bank for Reconstruction and Development) to about $170 billion (see “The World Bank General Capital Increase” by Ernest Stern in the June 1988 issue). Only 3 percent of this GCI is paid-in capital and therefore available for lending; the remainder is callable, that is, it would only be called upon to fulfill the Bank’s contractual obligations once all other sources of funds have been depleted. Therefore, as has always been the case, the funding for the increased lending will have to be obtained from the international financial markets, backed by the paid-in and callable capital and the Bank’s reputation for sound financial management.
The objectives of the Bank’s borrowing program are twofold: first, to ensure that sufficient funds are forthcoming to finance the growing lending program; second, to minimize the effective cost of the funds used in its lending operations. This article describes how the Bank has developed a funding strategy and conducts its treasury operations to fulfill these twin objectives.
How is lending funded?
In essence, the Bank has two categories of assets: loans and liquidity. At the end of calendar year 1987, loans outstanding amounted to about $90 billion and the Bank’s liquidity, held in cash and investments, totaled $21 billion. These assets were funded by three major sources: borrowings, paid-in capital, and retained earnings. The largest of these sources was borrowings, amounting to around $96 billion (86 percent of total assets). Retained earnings stood at $9 billion (8 percent), and paid-in capital available for lending made up the remaining $6 billion (5 percent) of total funding.
The dominance of borrowings in the funding of the Bank reflects its special role as an intermediary between the funding needs of the developing countries and the international financial markets. The Bank draws upon the markets in various ways—loans, bond issues, private placements—and also offers market-based investment opportunities to official institutions. Using these approaches, the Bank will attempt to raise over $75 billion from the markets for the developing countries in the next five or six years.
The Bank has maintained its credit rating at the highest ranking given by financial market analysts. This enhances its ability to access funds at favorable rates, thus benefitting developing country borrowers directly. Three fundamental sources of strength help the Bank maintain its high credit-standing in the markets, and thereby attain its funding goals:
- the strong support of its 151 member countries—periodically reaffirmed by general capital increases, and by giving it permission to raise funds in some national capital markets that are often not open to international borrowers;
- the recognition by borrowers of the importance of the Bank as a continuing source of funding (the Bank is treated as a “preferred creditor,” that is, its loans are repaid by borrowers ahead of other creditors).
- the prudent financial management of the Bank. This is the main focus of the ensuing discussion.
Interest rates. Through careful development of its financial management, the Bank has been able to avoid some of the risks that have been a source of problems for other financial institutions. The avoidance of interest rate risk is one example. When interest rates were rising over several years in the early 1980s, the Bank’s loans were made at fixed interest rates. This posed a problem for both the Bank and its member countries: the Bank’s net income was exposed to risk as the Bank was funding previously-made fixed rate loans with borrowings at higher interest rates, and new commitments to developing countries were being made at historically high interest rates. To address these problems, the Bank adopted a system of variable rate lending, resetting the lending rate every six months at one-half of a percent over its average cost of borrowed funds. While covering the Bank’s borrowing cost, this system also allowed the Bank to pass along interest rate reductions to borrowing members in the form of lower lending rates as the cost of the Bank’s borrowings was reduced. Since the variable lending rate system was adopted in 1982, not only has the Bank’s net income grown, but also borrowers have received 11 consecutive reductions in their interest rates on Bank loans, bringing the rate down to 7.72 percent in early 1988. (Should the secular reduction of the Bank’s borrowing cost since 1982 be reversed, that increase of cost would, of course, also be reflected in the lending rate.)
Currencies. The Bank’s careful financial management is also reflected in its currency management practices. The Bank avoids exchange rate risks by holding or lending the proceeds of its borrowings in the same currencies in which they were borrowed. The Bank’s borrowers owe the Bank the currencies used for disbursements. Before 1980, this rule applied on a loan-by-loan basis. Thus, one borrower’s debt to the Bank could have a different currency composition from another, yet the applicable interest rate could be the same. This was deemed inequitable, so, beginning in 1980, the currencies used for disbursements were pooled, and all borrowers now owe the Bank the currencies in the pool in the same proportions.
Liquid reserves. The Bank maintains a large liquid reserve for reasons of prudence. The annual borrowing programs are devised so that at the end of each fiscal year the Bank has a liquid portfolio of not less than 45 percent of its borrowing requirements for the next three years. At the end of calendar year 1987, with liquidity at $21 billion, the Bank had covered around one-half of its borrowing requirements for the next three years. The importance of this reserve of liquid funds is twofold. First, it provides a very strong assurance to both borrowers and bondholders that the Bank will be able to meet its contractual obligations over the next 12-18 months, regardless of its ability to borrow in different capital markets. Second, it provides the Bank’s Treasurer with the freedom to choose when and in which markets to borrow in order to do so at the lowest cost. Thus, when interest rates are low in an historical context, the Bank increases its borrowings, and slows them down as interest rates climb.
Volume of borrowing
The Bank has rapidly increased the volume of its treasury operations over the years, particularly in the 1980s, with borrowings outstanding increasing from $32 billion in fiscal year 1982 to $79 billion in fiscal year 1987. At these volumes, the Bank has maintained its position as a dominant nonresident borrower in virtually all national markets where it raises funds.
For FY 1989 (starting July 1, 1988), current projections indicate new borrowing of about $11.5 billion. This represents an increase of $500 million over the previous year’s borrowing program. Since a large portion of this new borrowing will be used to refinance old debt that is maturing, the increase in total borrowings outstanding will be only about $2.4 billion.
In the next few years, with the support of the GCI, Bank lending is expected to grow. So, too, will the borrowing requirements. The Bank’s funding strategy is developed with this task in mind. The centerpiece of the strategy is to exploit every opportunity to create flexibility for the funding program.
Flexibility has been created mainly by a gradual expansion of the number of currencies in which the Bank borrows. In the early years, the Bank borrowed exclusively in US dollars. As demand for funding grew, the currencies borrowed were diversified. The Bank now has borrowings denominated in 22 currencies. Ninety-two percent of original borrowings outstanding (before swaps, explained below) at the end of calendar year 1987 were denominated in the following major currencies: Japanese yen (27 percent), US dollars (23 percent), deutsche mark (19 percent), Swiss francs (16 percent), and Netherlands guilders (7 percent). The remaining 8 percent were distributed among other currencies worldwide. While these latter markets are tapped only occasionally at present and the Bank could manage its funding without such borrowings, they reflect the planned expansion of the Bank’s funding base to meet its increasing borrowing requirements.
These other markets often have nominal interest rates above those of the Bank’s average cost of borrowings. In order to avoid increasing the Bank’s lending rate as a result of borrowings in these currencies, the Bank makes active use of currency swaps of its liabilities. Swaps allow the Bank to trade a liability denominated in a currency with a high nominal cost for a comparable liability in a currency with a lower nominal cost. Swaps effectively separate the decision of where to borrow from the decision of what currencies to owe. This separation has allowed the Bank to borrow where it has the largest comparative advantage, thus allowing the Bank to obtain the desired currency at a lower cost than if it had borrowed the currency directly. (See “The World Bank’s currency swaps,” by Christine Wallich, Finance & Development, June 1984.) Now a common instrument for financial management, currency swaps were pioneered by the World Bank in fiscal year 1983. At present, the Bank enters into the equivalent of around $2 billion in currency swap agreements annually. The total amount of swaps outstanding as of December 31, 1987 was $8.9 billion.
The composition of currencies owed by the Bank after swaps is more concentrated than that of its currencies borrowed, with a total of 99 percent in the group of major currencies: Japanese yen (28 percent), Swiss francs (23 percent), deutsche mark (21 percent), US dollars (17 percent), and Netherlands guilders (8 percent).
The emphasis on currencies with low interest rates has paid off in the past. The Bank closely monitors the evolution of the effective cost in US dollars of its borrowings, taking into account the effects of currency exchange rate changes and the interest rates on its borrowings. During the last 10 years, the effective cost has been remarkably low. This was due to low nominal interest rates on loans in currencies that depreciated against the US dollar for a long period in the 1980s.
Recently, however, the strong depreciation of the US dollar against almost all major currencies has sharply increased the effective cost of the Bank’s borrowings in US dollar terms. Even so, after three consecutive years of depreciation of the US dollar, the effective cost of the Bank’s portfolio of borrowings in other currencies is still comparable to the cost had the same funds been raised in US dollars.
Maturity of borrowings
The Bank seeks funds for itself primarily in the medium- to long-term fixed rate markets. This was essential in the past, when the Bank lent at fixed interest rates. The practice has been continued since the Bank switched to lending at variable interest rates, partly because the medium- and long-term markets are where the advantage of its highest credit rating is greatest. Ninety-four percent of the Bank’s outstanding debt at the end of fiscal 1987 was in medium- to long-term instruments. Of this, only a handful of borrowings was contracted at variable rates.
Short-term borrowings account for $4.4 billion (close to 5 percent) of the Bank’s portfolio of borrowings. These borrowings are made through discount notes and the Bank’s Central Bank Facility. Discount notes are issued continuously in the domestic US market with an average maturity of about 50 days. Currently around $2.7 billion is outstanding on discount notes. The Central Bank Facility opens up the possibility for central banks to make year-long time deposits with the Bank. About $2 billion currently reside in this type of deposit with the Bank.
The maturities of debt issued vary with market receptivity. At the short end (40 to 50 days) is the discount note program. In the middle of the range is the Central Bank Facility with its one year maturity. In the two- to five-year spectrum lie the bond issues aimed at central banks. Public issues, private placements, and syndicated loans are seldom of a shorter maturity than five years, but can be as long as 30 years or more. During the rally in the bond markets as interest rates declined in fiscal years 1984-86, the Bank succeeded in lengthening the average maturity of its outstanding debt because investor demand for assets of very long maturity was high. The result was that the average maturity of new medium- to long-term-borrowings lengthened from 6.5 years in fiscal 1984 to 14.5 years in fiscal 1986. At the end of calendar 1987, the increase in maturity of new borrowings gave an average maturity of borrowings outstanding at 6.8 years; in comparison, the average life of loans that the Bank committed at that time was 7.9 years. This results in a fairly low level of maturity transformation risk.
Technical innovations play an important role in the Bank’s efforts to reduce the cost at which it borrows. In the last few years, the changes in the international financial markets have been very dramatic. Deregulation has invited the application of new financial techniques, improving competition and the efficiency of markets, and thereby reducing costs to issuers. New structures of securities often can capitalize on larger-than-average demand, either because they are more visible in markets, or because they better meet the specific needs of various interest groups. Some recent examples of the Bank’s application of new funding techniques are:
- The Daimyo yen public bond issued in the domestic Japanese market. A cross between a Euroyen public issue and a Samurai bond (a Japanese domestic public issue by a non-resident), the Daimyo has the advantage that it can be traded in a broader and deeper market than Samurais. The improved liquidity reduces the risks to the investor and reduces the yield required for a purchase.
- The continuously offered longer-term securities program (known as COLTS). This program offers institutional investors in the US domestic markets assets tailored to fit the specific maturities and cash flow profiles that they require. The continuous availability and flexibility of design provide the added value to investors that reduces cost to the Bank.
- Funding through loan sales by the Bank, allowing it to sell participations in its loans to other institutions. This fairly minor program allows primarily commercial banks to make efficient use of their credit lines where there is a scarcity of assets in the market.
The Bank has also become more active in managing its existing portfolio of liabilities. For instance, it has prepaid loans and public issues denominated in Japanese yen, Swiss francs, Kuwaiti dinars, and Luxembourg francs, ahead of the regularly scheduled final maturity. These borrowings were made at the higher interest rates of a few years back. Considerable savings have been locked in through refinancing some of these borrowings at current, lower interest rates. The Bank has also reversed interest rate swaps made in the past.
Thus, the Bank has a sophisticated and technically evolved funding strategy that is designed to achieve its twin objectives of adequate financing and efficient borrowing. The Bank is consciously striving to expand the investor base through diversification of instruments, currencies, and maturities, and to enhance further the usefulness of Bank securities to investors. The goal of these treasury operations is to ensure that funding is made available to fulfill the goals of the GCI: to help the Bank’s members adjust to the changing world economy and to restore sustainable growth patterns.
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