Twin upstarts from Fortazela – A sign of the times to come?

“International governance structures designed within a different power configuration show increasingly evident signs of losing legitimacy and effectiveness”

– Official statement signed by the BRICS leaders

On July 15, 2014, the BRIC countries announced the formation of twin financial institutions at the Fortaleza summit – the New Development Bank (NDB) and the Contingent Reserve Arrangement (CRA). The announcement has been variously received with gushing optimism about the changing world order to cautious questioning of the feasibility of the bank. Considering the wide disparity in reactions, it is instructive to understand the structure, the motivation for setting up and the implications of this newly minted multilateral institution which is being hailed by many as the sign of the times to come.

The “What”

The New Development Bank adds on to the burgeoning list of development banks internationally – a 2009 study from the Association of Development Financing Institutions in Asia and the Pacific estimated that there were 550 development banks in the world. The NDB (having a $50Bn paid-in capital) aims to fund infrastructure and sustainable development projects while the CRA is $100bn swap line that gives each country an access to emergency supply of paid-in capital. While the initial capital for NDB is being contributed equally by each of founder member countries ($10Bn each), the CRA will have a different set of contributions from each country.

Figure 1

Fig: Initial contributions, Source: Reuters, Government of Brazil

Though the NDB in a section of commentary has been hailed as a possible alternative to the Bretton Woods institutions (World Bank and IMF), its initial capital base is lower than many of the existing multilateral banks.

Figure 2

Source: Market Realist

The bank has been structured to be open to new membership with a caveat that the founding members will hold a minimum of 55% of the voting power all the time. After much last wrangling, the BRICS decided that the bank be based out of Shanghai and while India will preside over the operations for the first five years, followed by Brazil and then Russia.

Why was it set up?

The setting up of NDB has been read as a first step towards the assertion of greater power by the developing countries and towards the breaking of dollar dominance. The NDB is the result of dissatisfaction with the current west-dominated international financial system which has not reflected the rise of the developing countries. For instance, the voting rights in the IMF for the BRICS countries are completely incongruent to the economic heft and the population of these countries.

Figure 3

Source: Financial Times

There also has been particular frustration in the style of operation of the global multilateral institutions such as the World Bank and IMF which attach sometimes unsuited and unreasonable requirements to the loans and assistance they offer. More often than not, privatization of resources is insisted which results in lucrative contracts for private companies, which are mostly based out of the west. Additionally, the perceived hypocrisy of these institutions while imposing harsh austerity measures on Asian countries after the Asian currency crisis and the acceptance of the lax stance of the European countries after the global financial crisis, served to heighten the antagonism among the developing countries towards these institutions. A more immediate trigger came in the form of rapid exodus of capital from emerging markets triggered in 2013 due to scaling back of the expansionary monetary policy in the US which highlighted the perils of over-dependence on the dollar and monetary policy of the US Fed.

Why does it matter?

The coming together of the BRICS countries to negotiate as significant multilateral institution points to the growing maturity of the bloc. This can be heralded as the v2.0 of the BRICS grouping – a shift from the being a convenient grouping of countries for investors towards tangible institution development. The impact of such a bank can be analysed with respect to 2 dimensions:

  • Global power shifts – The development of a NDB and CRA signals the viability of cooperation among the BRICS countries to come up alternatives if their demands for greater share of authority are not met. As an example, the draft IMF reforms for increasing the vote share of the BRICS countries agreed upon in 2010 is stuck in the US congressional process with no signs of any breakthrough. Furthermore, the CRA mechanism is designed to help the BRICS countries to lessen their dependence on the US Fed and the dollar.
  • Funding for developing countries – According to the World Bank, there exists a $1 Trillion funding gap for infrastructure in developing countries. In this context the NDB will provide an attractive alternative for other developing countries to acquire funds from other than western dominated multilateral institutions. The fact that a BRICS bank aims to make electricity, transport, telecommunications, and water/sewage a priority is important; the demand for infrastructure is expected to grow sharply as more countries transition out of low-income status. In terms of scale, after a couple of decades, if the membership expands along with mobilization of government financing and private funds—the BRICS Bank loans could dwarf World Bank loans. This type of success has been seen with the CAF, which now funds more infrastructure in Latin America than the World Bank and the Inter-American Development Bank combined. Over the long run, this might result in a reduced loan portfolio and consequently lower policy influence of current dominant institutions such as the World Bank. However, for the foreseeable future, given the huge demand-supply gap for financing, NDB will play a complementary role rather than supplementary one. This realization is reflected even in the official responses of the World Bank and IMF, which have welcomed the creation of NDB and CRA.

There are however several potential pitfalls for the success of NDB and CRA. The fairly heterogeneous composition of the BRICS setup – varying from quasi-dictatorial style of functioning of raucous democracy – will impose challenges in reconciling the negotiations to a common set of outcomes acceptable to all. This was already exhibited in the way the first set of decisions on headquarter location and the presidency were taken – at the last moment. Furthermore the range of scale of economies – China’s economy is almost 24 times the size of South Africa’s economy will put strain on the “democratic” nature of the institutions with China naturally wanting to impose itself. China needs to resist overwhelming the institutions for its own advantage, in order to secure support from players such as India and Brazil.

The institutions born at Fortazela, have the potential to be harbingers of the needed change in the western dominated world of international finance. However, it will take patience and extraordinary maturity on the part of the BRICS nations for these institutions to fulfil their potential.