Was Lagarde wrong? How Europe can release billions for development

Machinations inside a pair of deconstructivist-style glass towers overlooking the River Main in Frankfurt, Germany, could be all that is standing between tens of billions of dollars and countries struggling to fund their economic growth, fight pandemics, and adapt to climate change. This story begins in October 2021, when European Central Bank chief Christine Lagarde declared that European national central banks were barred from rechanneling a valuable reserve asset known as Special Drawing Rights to multilateral development banks. This effectively meant that high-income European countries holding hundreds of billions of dollars worth of SDRs that they didn’t need could not put them to work to help their poorer counterparts. Many of those SDRs have laid dormant in national coffers ever since. “Euro system countries hold some $200 billion dollars worth of SDRs. It’s a very significant number,” said Stephen Paduano, a Ph.D. student at the London School of Economics who has been digging into the issue. “All of these countries now have their hands tied,” he added in an interview with Devex. Now, experts including Paduano argue that there are ways to unlock that SDR treasure trove — and they want Lagarde to revisit her stance. They have come up with two proposals. If they succeed, those billions could flow to pressing global issues such as climate change and rising inequality. Folks, if you ever wanted to be at the nexus of central bank policy, global development, and more money than you can imagine, you have come to the right place. Here’s where the SDR saga could go next. First, remind us: Where did all these SDRs come from? Most emerged in 2021 at the peak of the COVID-19 pandemic. The International Monetary Fund issued $650 billion worth of the reserve asset to help countries cope with the economic fallout. This was the largest SDR issuance in IMF history. And because SDRs are issued based on shareholder stakes in the IMF, and share size is mostly based on relative weight in the global economy, the majority went to high-income countries. Many of these are in Europe. Only $21 billion went to the lowest-income nations. The problem is that high-income countries generally did not need the SDRs, while lower-income countries required much more than they got. The hope at the time was that the wealthy would reallocate their excess SDRs through international finance institutions focused on development. The Group of 20 major economies, for example, promised to rechannel $100 billion in SDRs to vulnerable countries. Got it. And along came Lagarde. Right. The European Central Bank is not the natural institution to be the arbiter of development finance. But the stuffy institution was thrust into the SDR debate with Lagarde’s consequential words. “The direct financing of multilateral development banks by national central banks of EU Member States through SDR channelling is not compatible with the monetary financing prohibition,” Lagarde said in October 2021, referring to a European ban on central banks funding governments. And in many countries, including in Europe, central banks hold the SDRs. Lagarde has also said that rechanneling may not adequately preserve the SDRs’ reserve asset status. Her words had ramifications far beyond Europe’s borders, effectively shutting down what had been a promising pathway to fund development. European countries stopped engaging with proposals to rechannel the SDRs to vulnerable countries through the development banks. And so, Paduano and other researchers set about to find a way to undo the binds. So what are the two ideas? One is Paduano’s own proposal, co-authored with economist Brad Setser, which argues for creating an SDR-denominated bond at the World Bank. Wealthy shareholders would get the bonds in exchange for the reserve assets, which would be turned into cash through the IMF. The end result is that the shareholders swap one asset for another — SDRs for bonds — and the bank has money it could lend to countries. Devex wrote an in-depth piece on the proposal. The other proposal comes from the African Development Bank and the Inter-American Development Bank and involves treating the SDRs as hybrid capital. This term means that the shareholders would not get additional voting power in exchange for their SDRs — as equity normally works, whether at a development bank or any firm. However, as far as ratings agencies would be concerned, the SDRs would be equity that the banks could put to work on markets. This would allow the banks to turn $1 billion in hybrid capital into $3 billion in lending, given current leverage rates at the AfDB. “The real power of this proposal is the leveraging impact,” said Hassatou Diop N'Sele, the finance chief at the AfDB, which led the initiative. “This is thanks to the unique financing model of the MDBs which uses capital markets.” As Paduano and his research partner Théo Maret argue in a new paper, both proposals should satisfy Lagarde and let Europe dust off its unused SDRs for use by development banks. And they would enable the G-20 to follow through on its promise to rechannel $100 billion. Are the proposals viable? Both ideas stand a good chance of pushing Lagrarde to reconsider her position, according to Paduano and Maret, an analyst at Global Sovereign Advisory, a consultancy firm. “We concluded these proposals are perfectly viable,” Paduano said of their paper. They rely on a slew of precedents. The pair say both the bond and the hybrid capital proposals do two things: They preserve the reserve asset status of the SDRs, and they would not constitute so-called monetary financing, which is when central banks fund governments. The IMF insists on the former, and the Europeans have a rule against the latter, which was the basis for Lagarde’s objection. So what does the ECB think? The ECB declined multiple requests by Devex for an interview for this article. A spokesperson pointed Devex to existing reports from the institution which detail the monetary financing rules. Which idea is better? In Paduano’s view, the bond proposal has the best case vis-à-vis the monetary financing prohibition, as the World Bank would not hold the SDRs. The hybrid capital proposal would have a tougher hurdle to surpass if the ECB insists on a very conservative reading of its rules, as the idea still effectively keeps the SDRs at a development bank. “We think this should sail through. We just need a Eurozone country to actually request a ruling from the ECB,” Paduano said of the bond proposal. And to move that along, a development bank would need to adopt the idea. Setser, for his part, argues that the ECB’s concerns are “probably unfounded.” What is the risk of failure to act? The ONE Campaign, an anti-poverty advocacy group, is now working with outside lawyers to determine whether they could argue under ECB rules that Lagarde needs to revisit her past stance and let the SDRs go to the banks using these proposals. “We’re exploring all options — political and legislative — to see how we can ensure EU member states have the possibility to on-lend their SDRs outside of the IMF,” said Sara Harcourt, who leads policy work at the organization. “We hope that EU member states and the ECB can come up with a solution quickly.” She is concerned that the more time passes, the more political momentum could fade. “I think there is a real danger that we don’t realize the promise of $100 billion in rechanneling SDRs,” Harcourt said. That would mean the assets never end up being put to work for development. So far, even just looking at pledges, countries have only promised about $60 billion of the $100 billion to various facilities. In terms of actual donations, the promises dwarf reality. What could happen next? One venue where the ideas could get more wind in their sails is this summer in Paris. French President Emmanuel Macron is holding a summit for a “new global financial pact” which he said would look at “all the means and ways of increasing financial solidarity” with the global south. SDRs are on the agenda, though the outcome is far from certain. Mark Plant, a senior policy fellow at the Center for Global Development, reviewed an early copy of Paduano and Maret’s research by Paduano and has written in detail about the African proposal. “At the time of her announcement, Lagarde and her staff probably never envisaged such a proposal,” he said in an email. She might have been trying to shut down ideas that never stood a chance, he added. Plant recently organized a symposium that brought together Diop, Setser, Paduano, and others, to weigh next moves and to sort out legal hurdles. Why do we need two proposals? The big difference between the two ideas is that the bond would likely draw in more SDRs from more shareholders, because the assets would not sit at an MDB. However, the hybrid capital would allow each SDR handed over to be leveraged several times over. Setser argues that no single proposal should dominate discussion as domestic laws in countries differ. Some countries might be amenable to a hybrid capital model and prefer a method that allows leverage, while others would see the bond proposal as the more straightforward solution that will keep the ECB happy and that would not require U.S. Congressional approval. “There needs to be different ways to put SDRs to use,” Setser said. But he is clear about his objective, which means not only meeting the $100 billion target, but potentially recycling all of the excess SDRs. “Be bold, be big,” is the slogan Setser uses, saying it would be “disappointing” if the World Bank’s balance sheet did not double in size by the time India wraps up its presidency of the G-20 at the end of the year.