As established in the Addis Ababa Action Agenda (2015), Multilateral Development Banks (MDBs) are expected to provide lending in the event of financial or economic shocks. Economists call this countercyclical lending. However, a recent study shows that while the MDB system as a whole acts countercyclically, in other words, lends less to a country during its booms and more during its downturns, the evidence of this behavior for Regional Development Banks (RDBs) is weaker.
In the case of the countries in Latin America and the Caribbean, the evidence of countercyclicality by RDBs is stronger. However, research shows that MDB countercyclicality has been fading over time. A decade ago MDBs were strongly countercyclical; currently they are significantly less so, particularly RDBs. There are several reasons that explain this. On the one hand, and most crucially, capital adequacy models used by credit-rating agencies limit the potential countercyclical role of MDBs; on the other, public expenditure in some borrowing member countries is increasing its procyclicality, dragging MDB financing.
Regarding the former, the challenge faced by MDBs is that capital adequacy weights are tied to a borrowing country’s credit rating. By their very nature credit ratings are procyclical, as shown by several studies [See Auh. (2015); Cavallo, Powell, and Rigobón, R. (2012); or Ferri., Liu, and Stiglitz, J. (1999)]. For instance, a country experiencing an economic downturn will likely face rating pressure, either through a change in outlook, or an actual lowering of its credit rating. Once the credit rating of that country has been lowered, loans to that country become more expensive in terms of capital consumption for an MDB, making it more difficult for that MDB to act countercyclically in individual countries.
In the case of a systemic downturn in the region or sub-region served by the MDB, the rise in capital costs could lead to a contraction in the overall lending of the MDB to the region or sub-region.
The other aspect limiting MDB countercyclicality is the behavior of public finances with respect to the country’s business cycle. Government expenditure has historically tended to be procyclical in most developing countries, amplifying economic fluctuations and worsening recessions. There seemed to be some progress during the 2008-09 global financial crisis when some countries were able to increase expenditure thanks in part to the fiscal space built during the 2002-08 boom. However, evidence suggests that afterwards, countries have switched back to procyclical fiscal policy.
In Latin America and the Caribbean, a few countries have been able to reduce the procyclical bias in fiscal policy. This has been possible, only in cases where a strong structural balance budget rule complemented with a strong institutional framework prevail. As a result, fiscal policy has been able to remain countercyclical and has avoided any forecasting over optimism in key macroeconomic variables that could have later derailed the performance of its fiscal rule.
Procyclical fiscal policy is an impediment for MDBs to act countercyclically. If in a country the degree of fiscal policy procyclicality is high and if MDBs are aiming for positive engagement through a disbursement program that is correlated with aggregate government expenditure, it is very likely that MDBs end up being procyclical. Since reducing the engagement with the country is not a viable policy option to reverse this situation, MDBs control their cyclicality up to the extent that they can manage the composition of their countries’ programs.