AIIB: The first international financial institution of the 21st century

In 1945, a group of 43 nations led by the United States, then the world’s dominant economic power, created the International Bank for Reconstruction and Development (now part of the World Bank Group) and the International Monetary Fund – the “Bretton Woods institutions” – to promote reconstruction after World War II.

There were a number of goals. First, given the experience of the interwar period, there was a perceived need to coordinate exchange rate policy and both control and cushion the impact of cross-border capital flows. Second, there was a desire to provide technical assistance to governments lacking expertise in promoting growth and development. And finally, in places where domestic financing, private or public, was insufficient, there was a need for the resources for public infrastructure projects.

Today, infrastructure funding remains insufficient, and nations still experience sudden stops of private funding that official lending can temporarily cushion. But the global economy has evolved much faster than the operations of either the Bretton Woods institutions or some of their regional siblings like the Asian Development Bank (ADB), the African Development Bank (AfDB), the Inter-American Development Bank (IDB), and the European Bank for Reconstruction and Development (EBRD).

What happens when official international financial institutions (IFIs) fail to respond to a changing environment? The same thing that happens to firms that stop innovating. New, more competitive institutions (firms) arise that compel them to change or – like dinosaurs – become extinct.

We may be witnessing this process of creative destruction right now. Last month, a group of 57 founding nations led by China signed the articles of agreement to establish the Asian Infrastructure Investment Bank (AIIB) with an initial subscribed capital of $100 billion. While most of the G20 nations, including the big European states, Australia, and South Korea, are among the founding members, the United States, Japan, and Canada are noticeably not.

No one disputes the need for more official infrastructure funding: the World Bank projects infrastructure spending needs over the next 20 years in east and south Asia at about $500 billion per year (see figure 0.4 here). The ADB’s estimate is even higher, putting Asian infrastructure investment needs at $8 trillion in the current decade (2010 to 2020). Yet, all types of loans on the balance sheets of the ADB and the World Bank (which includes lending outside of Asia) together total only a bit over $200 billion (see here and here).

What we find the most interesting is that the AIIB founders didn’t ask member countries to approve an expansion of either the World Bank or the ADB. Instead, they opted for a new organization altogether.

Why? The problem is institutional legitimacy arising from issues of power and governance. Frustrated with the failure of the IMF and World Bank to modernize, the AIIB’s 57 founders moved to start from scratch in an attempt to do better. Critical changes include the mechanism for distributing capital shares and voting rights; the role of the organization’s board; the focus on a single critical task; and the imposition from the start of oversight mechanisms to ensure compliance with rules that limit political interference and corruption.

In effect, the AIIB, which could begin operations this year, aims to establish principles for best practice for IFI’s in the 21st century. If it meets that high standard, the traditional IFIs will either have to change or, like many firms that fail to adapt, their importance will diminish over time.

The most glaring problem with the 20th century IFI’s – the BIS, IMF, World Bank and the regional development banks – is representation. Compare, for example, the relationship between the share of IMF quotas allocated to a country (a rough proxy for that country’s voting power) and its share of global GDP. The bars in the following chart show the gap between these two measures. For example, in 2014, China’s IMF quota was nearly 4% of the total, while it accounted for closer to 16% of global GDP (measured at PPP), a gap of 12 percentage points. Other large emerging economies also show sizable negative gaps – some of which have widened significantly since 1990. By contrast, Japan, the United States and the countries of Europe show growing overrepresentation. This all reflects the failure of the United States and Europe to implement a reallocation of quotas and voting rights commensurate with economic growth.

Gap between IMF quota share and global GDP share (measured in percentage points)

Note: GDP is measured as current international U.S. dollars (adjusted for purchasing power parity). Data for 2014 show the gap between 2014 quota shares and 2013 GDP shares. Sources: IMF and World Bank.

Note: GDP is measured as current international U.S. dollars (adjusted for purchasing power parity). Data for 2014 show the gap between 2014 quota shares and 2013 GDP shares. Sources: IMF and World Bank.

You might wonder if the chart overstates the misrepresentation in the Bretton Woods organizations. If anything, the opposite is true. Since 1945, European members have always selected the IMF’s leader (known as the “Managing Director”), the United States has always selected both the leader of the World Bank (known as the “President”) and the deputy at the IMF, while Japan has always designated the head of the ADB. Other elements of IFI governance are skewed similarly. For example, despite an adjustment in recent years, advanced economies in Europe remain overrepresented on the IMF Board. (The current quota for the EU as a whole is roughly 30% of the total, twice its share of global GDP.) And, while most countries elect directors in a competition for shared slots on the Board, the United States, Japan, Germany, France, and Britain each appoint their own Board members.

Perhaps most important are the veto rights. In the case of the IMF, both the United States and (collectively) the large European members have sufficient voting shares to veto constitutional changes. As a result, the U.S. Congress’s continued failure to approve a 2010 IMF reform is the only remaining roadblock to a modest reallocation of voting shares and a shift to an all-elected IMF Board (see here for the policy options facing Congress). Finally, none of these organizations have agreed on or created a formula for future changes that would automatically reallocate voting shares as global GDP shares evolve, without triggering repeated constitutional debates.

Instead, the Bretton Woods institutions are becoming aging political fiefdoms, ruled by governments whose economies are diminishing in global importance. No wonder China – which remains the largest contributor to global economic growth – has led the charge for reform by doing an end-run around the existing IFIs.

Is the AIIB likely to do better? There are reasons to be hopeful. First, three-fourths of the voting shares will be allocated to Asia-Pacific members, boosting the representation of emerging and developing economies. Second, the Bank’s broad membership and its constitutional pledges bode well for implementing high standards for transparency. To highlight the founders’ desire for good governance, and notwithstanding U.S. absence from the organization, the AIIB has appointed a top U.S. and ex-World Bank lawyer as the Chief Counsel for the Secretariat that is preparing for the start of AIIB operations. Third, while China initially will have sufficient votes to veto constitutional changes, Chinese authorities argue that its voting rights will be diluted as others join. Fourth, unlike the Bretton Woods institutions, the AIIB’s Board will be nonresident. In an age when Board members can travel easily, a nonresident Board is less costly and avoids the sort of intrusion into daily management that comes from having an executive board in the building (as there is at the IMF). Finally, the AIIB’s focus on infrastructure lending and its stated willingness to cooperate with existing IFIs should allow more efficient specialization. Not every IFI needs a large staff (the World Bank has staff of more than 12,000).

Of course, the proof will be in the pudding. When the AIIB begins operations, observers will be watching closely whether these ideals are realized. Will AIIB loans be free of political interference and bid-rigging? Will it avoid favoring providers from nations like China that have large quotas and voting rights? Will AIIB leadership and employment be based solely on merit, rather than on nationality? Will it be able and willing to recruit top-flight staff? Will the AIIB cooperate where possible with the World Bank and the ADB to avoid duplication of effort or outright conflict? Will the rules of the game promote transparency and continued self-reform? And, as the relative economic importance of the countries changes, will voting rights adjust?

As economists, we like competition. If the AIIB meets the high standards its leaders espouse, it will heighten the pressure on the existing IFIs’ political masters to change with the times. In addition, in light of numerous potential areas of conflict between China and the United States (think cyberspace and the South China Sea for starters), wouldn’t we all benefit from having these two leading economies and governments instead focus their competitive energies on improving global infrastructure finance?

From this perspective, we see a powerful argument for the United States to do two things.  First, the U.S. Congress should belatedly approve the IMF’s 2010 Quota and Governance Reforms to signal its support for continued global economic and financial cooperation in coming decades. And second, after failing to stop the AIIB, and refusing to participate as a founding member, the United States should join the institution as soon as it can, participating actively in holding it to the highest 21st century standards.