While the poorest countries face fragile economic situations, multilateral development banks, such as the World Bank, grant them loans on terms more favourable than those offered by commercial banks and financial markets.
What is their secret to avoiding losses on these operations? The answer lies in their preferred creditor status.
Low-income countries are characterised by very limited, or even non-existent, access to international capital markets in currencies such as the dollar, the euro, the pound sterling, or the yen – these markets allow states to borrow from international investors.
This near-exclusion is explained by the fragility of their public finances, but also by their high exposure to political, climate, or security shocks.
Consequently, the risk of non-repayment by lenders (or sovereign default risk) is structurally higher for these countries than for advanced or emerging economies.
The result? Private lenders such as commercial banks and markets are discouraged from providing them with financing. Conversely, they readily lend to indebted wealthy countries because they are confident—rightly or wrongly—that they will be repaid.
In this context, international financial institutions, particularly multilateral development banks – the World Bank, the African Development Bank, the Asian Development Bank, etc. – play a central role in financing poor countries. They have received a mandate from their member states as countercyclical lenders, namely to provide financing when private actors refuse to do so.
However, they suffer few losses and their credit quality, measured by the credit rating, is generally very high.
To explain this paradox, our article highlights an institutional mechanism specific to multilateral development banks (MDBs): preferred creditor status (PCS).
In practical terms, when a state experiences difficulties in repaying its debt, it prioritises loan servicing by multilateral development banks over its other creditors – commercial banks, bondholders, or bilateral lenders.
Dependence on S&P, Moody's and Fitch ratings
The question of financing poor countries in foreign currencies, such as the dollar or the euro, arises with particular urgency when access to international markets depends heavily on sovereign ratings .
Obtaining an investment-grade rating from major credit rating agencies—Standard & Poor's, Moody's, and Fitch—is a key condition for mobilizing financial resources on sustainable terms.
However, the majority of poor countries do not meet these criteria. For many of them, multilateral development banks are their primary source of funding.
Certainly, initiatives are emerging to develop a major African rating agency , in order to better reflect the continent's economic and institutional realities. To date, the three major international agencies continue to play a central role in the financial markets' assessment of these countries' sovereign risk.
Multilateral development banks
Unlike commercial banks and bond investors, multilateral development banks (MDBs) are official creditors. They are guided by objectives of public interest, not profit. They are distinguished by several other characteristics:
1) They have a mandate to finance long-term development;
2) Their shareholders are member states, some of which are not borrowers but provide support to the institution. This is the case of the United States, the main shareholder of the African Development Bank, the Asian Development Bank, and the Inter-American Development Bank; a country that does not borrow from these institutions.
3) They have privileged access to international capital markets thanks to a generally high rating – the World Bank, the African Development Bank or the Asian Development Bank are rated AAA;
4) They benefit from protection against credit risk stemming from their status as a preferred creditor.
A privileged creditor status
The status of preferred creditor is informal – or de facto – because it is not enshrined in international law. It is based on a firmly established practice relying on strong incentives for borrowing states .
For example, a poor country can obtain a long-term foreign currency loan from the World Bank at a very low interest rate – 3 or 4 per cent – whereas it would pay much more – or even be unable to – on international markets.
Thanks to the donations they mobilize, multilateral development banks grant the poorest countries loans at subsidised rates and with very long maturities – known as “concessional” loans.
Consequently, a default on a multilateral development bank loan not only incurs a high reputational cost, but also permanently jeopardises a state’s access to the cheapest financing.
Extremely low risk of default
The data we collected from the accounts of multilateral development banks confirms the soundness of this model.
Over the period 1992-2022, the annual probability of a state defaulting on its debt to multilateral development banks is 0.4 per cent. By comparison, it ranges between 6 per cent and 12 per cent for other public and private creditors, according to data compiled by the Bank of Canada and the Bank of England.
Even in the event of default by the borrowing country, the losses suffered by multilateral development banks after recovery remain very limited, in the order of 3 to 4 per cent, thanks to the beneficial effect of their status as preferred creditor, compared to nearly 50 per cent for private creditors on sovereign bonds.
This difference is explained precisely by the status of preferred creditor. This significantly reduces credit risk and allows multilateral development banks to preserve the quality of their assets.
The implicit contract between states and multilateral development banks
The business model of multilateral development banks is unique. In order to grant loans on favourable terms, they must finance themselves at low cost on international bond markets. This requires maintaining high credit ratings, made possible, in addition to their preferred creditor status, by:
1) significant capital contributions (financial resources provided by shareholders);
2) full support from Member States, taking the form of subscribed but unpaid capital, claimed in case of difficulties;
3) prudent management of credit and financial risks;
This results in a form of implicit contract between multilateral development banks and their member states. The former provide low-cost foreign currency financing over long maturities. In exchange, the states grant them preferential treatment.
On average, multilateral development banks maintain provisioning ratios of only 1.5 per cent, compared to 2.5 per cent for comparable commercial banks. Without the protections afforded to them, including their preferred creditor status, this ratio would be higher; they would increase their rates to maintain their margins and avoid losses.
Complementarity with private actors
Commercial banks and bond investors, for their part, play a limited role in sovereign debt financing for poor countries. They do not benefit from preferential creditor status or the support of member states; they are highly exposed to the risk of borrower default should the latter encounter financial difficulties. Consequently, they provide very little financing to poor countries and demand high interest rates.
Multilateral development banks are not intended to replace the private sector, but to complement it. Their role is to intervene where the market is failing, while contributing to stabilising economies and creating the conditions for a gradual return of private investors.
In a context marked by the proliferation of sovereign debt crises and increasing financing needs, the status of preferred creditor is sometimes called into question.
Eliminating it, however, would be counterproductive. It would raise the cost of resources for low-income countries and reduce the financing available when it is most needed.
Preserving this mechanism means guaranteeing sustainable access to foreign currency financing for the poorest countries and, beyond that, strengthening the effectiveness of the international financial system in serving sustainable development.
