On Incentives

"Never penalize those who work for us for mistakes or reward them for being right about markets. It will go to their heads, is counterproductive and, in any event, material compensation will not correlate with their ability to predict the future next time."

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Writings & Speeches

                                                              Eugene H. Rotberg
                                                     Vice President and Treasurer
                                                                The World Bank

                                                             Borrowing Seminar
                                                              Opening Statement
                                                      Beijing, China, October 1986


It may be useful to set out what issues we expect to discuss and cover in the next few days.  But first, it is important to note what we will not comment upon.

We cannot advise China whether it is wise to borrow.  That is not a financial question; it is a political question.  You alone can decide whether you can have sufficient growth without external borrowing, i.e., whether economic growth is, in fact, a matter of overriding importance to you.  You must also decide whether growth should be limited only to what you can save and finance domestically.

If China decides to borrow, only you can decide the appropriate amount of your GNP as a percentage of your debt, or as a percentage of your exports.  Only China can decide whether and to what extent they wish to be dependent, and to what extent on the good will and savings of other countries.

Nor can the Treasurer's staff tell you where borrowed funds should be allocated, or for what purpose.  That, too, is a matter which we cannot decide or even advise you, first because there are delicate political matters involving the basic distribution of growth, wealth, power and authority, and second because borrowed resources cannot be separated or distinguished from all other sources for investment:  exports, imports, savings on whatever form it takes.  In short, borrowed money is indistinguishable from any other resources available for investment.

Finally, only China can know whether resources borrowed (which must be repaid and on which interest must be paid) can be held in liquid financial assets until utilized and until needed for the specific project or purpose intended.  Money, once borrowed, creates an obligation.  Only if the return on the project intended exceeds the cost of the funds does it make sense to borrow, and if the resources are not deployed for purposes consistent with growth, then China should not borrow.

Let us assume, however, that China wishes to borrow, that the monies borrowed will be used productively, and that the amount of borrowing will not make China financially dependent, in an unacceptable fashion, to Japanese or Western financial institutions.  Let us, therefore, work on the premise that China wishes to borrow wisely, with intelligence and sophistication, and safely, with the freedom to choose when not to borrow -- or to stop borrowing if it needs to or chooses to, without undue harm to its economy.  These matters will be the subject of the lectures and case studies over the next five days.

My role this afternoon is to put these seminars in a frame of reference and mostly Chair this session.  I have ten points I would like to make today:

Point One:  There is just as much risk in not borrowing as borrowing at any point in time.

  1. Borrow small amounts, not large.
  2. If interest rates are 8% and one does not borrow and the rate rises to 9%, not borrowing at 8% is a mistake.  It involves the same risk and cost as borrowing at 9% if rates move to 8%.
  3. Not borrowing at any time means constrained growth.
  4. Not borrowing means drawing down foreign exchange reserves.
  5. Not borrowing now means borrowing more later.
  6. Not borrowing now means less flexibility later.
  7. Not borrowing now means possible lost opportunities.

This does not mean that borrowers should always borrow as much as possible now rather than later; it simply means that not borrowing now has the same risk as borrowing.  The mistake of not borrowing is simply not so visible.

Point Two:  It is of the greatest advantage to have a maximum choice as to when to borrow, how to borrow, where to borrow, what currency to borrow.

What does one need to achieve flexibility and choice?  To choose when, where, how, and in what manner requires long-term planning and an understanding of what investors expect of an issuer.

  1. In the bond market, investors seek a "perfect" credit without risk -- always paying all that is due on time.  Rumors about late payments spread quickly.  Most bond buyers do not even want to think about credit.  Creditworthiness is assumed.  Investors take a risk on the level of interest rates -- should they invest now or later -- not the creditworthiness of the issuer.  Speculators, for a price, are prepared to take risks on the creditworthiness of the issue.
  2. Investors must think you will use the money wisely.
  3. They must think it is to their advantage to buy your bonds.  You do not need them; they need you.  That is the image you seek to develop.
  4. China must use many sources and not rely on one source of borrowings.  Fixed rates and floating rates, short term and long term, lines of credit, swaps, and direct borrowings of Deutsche marks, Yen, Swiss francs, dollars, French francs, etc.  The key word is diversification.  Buy bond issues, private placements, bank loans, syndicated loans, borrowings from governments and from the private sector, borrowings from savings banks, insurance companies, credit institutions, small investors and large ones.
  5. Borrow invisibly.  Quietly.  Borrow in ways and in a manner which others do not know about.
  6. 6.Try to borrow when you do not need to.  Borrow before you have to.  Borrow before everyone knows you have little choice.  And if you do so, you will have more choices.
  7. Do not rely on one source, one market, one currency.  Have more choices than you could possibly use at one time.  For, assuredly, the time will come when some of the choices will disappear.  You cannot take the risk of relying on so few places or markets that when one disappears or becomes hostile or too expensive you have no choices left.  And a borrower cannot broaden its choices after matters become difficult.  Borrowers cannot innovate or expand or look for new sources during a period of stress.  Then it is too late.
  8. Borrow opportunistically.  When you believe rates are low, borrow more than you need.  Build liquidity.  Hold reserves.  Do not use them for unproductive purposes.  If you believe markets are receptive -- either because of cost or because of your standing -- borrow.  And by building liquidity -- reserves -- the market will want to lend even more.  And on better terms.  Manage your reserves.

Point Three:  Mistakes will be made many times in executing a borrowing plan.

All of us make mistakes.  We borrow too soon, too late, too short term, too long term.  We borrow the wrong currency.  We cannot predict interest rates or exchange rates.  Every decision will turn out to be a mistake -- compared to what we could have done.  That's life.  It does no good to penalize mistakes.  Then we will make no decision.  Or we will learn to hide them.  Or blame others.  We will be afraid of making choices.  Admit to error, vulnerability, uncertainty.  Only by accepting error -- your Yen borrowings, for example -- will we learn about risk.  And only by admitting to risk can we learn to protect ourselves.  My colleagues will talk later about "protection."  We must consider how to protect ourselves because mistakes will always occur.

Point Four:  The best terms negotiated in a particular transaction may not be in the best interest of the borrower.

  1. It is sometimes unwise to achieve terms we do not deserve.
  2. The whole financial world knows about the excellent terms Chinese borrowers obtain in Yen.
  3. But it probably has done you more harm than good:
    1. Others will be more careful.
    2. They do not want to lose money.
    3. It is not sustainable.  It provides you low costs in small volume with a poor public image.
    4. It reduces the comfort of investors.
    5. You will soon owe them something.
    6. You will not see their newest or best ideas.
    7. When markets are difficult or investors reluctant, they will be unwilling to support your issues because of their previous losses.
    8. They will consider you as their adversaries and, having far more information than you, in the future they will deal with you to their advantage.
    9. You will discourage firms from competing for your business, for fear that if they get it, they will lose a great deal of money.  They are not in business to lose money.  The test should be fairness to all parties -- bankers, investors, borrowers.  If borrowers treat bankers as adversaries, they soon will have few choices.

Point Five:  Volume -- the capacity to borrow large amounts is more important than attaining the lowest cost for any particular transaction.

China wants economic growth at a speed and magnitude which will require substantial external borrowings.  Choice:  borrow $1 billion at 8% or borrow $2 billion at 8.1%.  Never, however, borrow at costs which gives the signal to the investor that you must borrow and are, therefore, prepared to pay anything.  At the beginning, look to markets where you are most wanted, not least preferable.  Create scarcity, then volume will follow.

China's greatest risk will not come from having paid 1/4% more over LIBOR than perhaps was required, but from not getting the $10 billion a year they should be able to borrow for infrastructure, for agriculture, power plants, highways, education, technology, communications.  The capacity to borrow large volumes gives you the flexibility not to borrow when you would prefer to wait.  Volume provides choice and respectability.

Point Six:  The external world will create great pressures which will make it very difficult at times to borrow and to sustain economic growth.  Often, these pressures will involve matters outside of China's control.

A borrowing plan to finance growth will have to cope with unpredictable, yet certain, occurrences on the way.  Many will be costly.  Not everyone will wish you well.  Our physical surroundings sometimes will create great stress and untrack careful plans:  earthquakes, the need for rebuilding roads and dams; weather wreaking havoc on a proposed agricultural expansion; high interest rates in another country's currency -- which you will have to pay; a revaluing Yen, also outside of your control, which you have borrowed; falling oil prices, rising oil prices, recession in the West.  Your exports will be constrained because of protectionism or international politics.  All of this will occur, and in an unpredictable fashion.

All plans will need to be revised:  borrowing plans, growth plans, export plans -- not because you will make mistakes, but because the outside world makes our lives difficult.  Unpredictable.  We -- you -- cannot separate ourselves from them.  Your plans will depend on what happens outside.  A financial plan is a political plan which assumes difficult times.  If expectations of open foreign financial markets are the underpinning of economic growth and a raised standard of living, then a financial plan must cope with the unexpected and the adverse -- just like foreign affairs, and just as complex, if a continuing flow of resources from other countries is to be relied on.

Point Seven:  Try to avoid credit enhancement.

Point Eight:  A default by a private (previously State) enterprise or parastatal will affect sovereign credit standing.

Point Nine:  Over time, you will have visible and invisible losses.

Point Ten:  Be modest.  Admit to uncertainty

                                                                 *          *          *


                                                              Eugene H. Rotberg
                                                     Vice President and Treasurer
                                                                The World Bank
                                                             Borrowing Seminar
                                                           Concluding Statement
                                                      Beijing, China, October 1986



Once one borrows, three principles follow:

  1. The borrower can have economic growth if the borrowed funds are used wisely and productively.
  2. The borrower places a serious burden on the next generation to repay.
  3. All economic and financial mistakes and failures will be visible since interest must be paid every six months irrespective of the uses of the funds or their ultimate real cost.

Based on the last five days of seminars, we have 13 recommendations, or suggestions, which take into consideration these three principles:

  1. Borrow and open up markets before you need to, i.e., diversify your funding base to create the flexibility not to have to borrow at any particular time.  Innovate before you have to.  A borrower cannot innovate during periods of difficulty.
  2. Maintain a high level of liquidity, i.e., create flexibility in an uncertain world.  Countries and individual borrowers should plan for adversity.
  3. Provide the financial markets with clear, unambiguous signals, i.e., the level of debt, guarantees, China's export potential, its decision-making process.  Monitor leasing, guarantees, export finance, borrowings from Hong Kong banks, if there is an obligation outstanding in another country's currency which the financial markets consider as a de facto test of China's creditstanding.
  4. Place more emphasis on volume and less on price, i.e., do not always insist on least cost.  It will create an adversarial relationship with bankers and will damage the attractiveness of your obligations with investors.  Below market terms are not sustainable in volume.
  5. The PRC should borrow in its own name.  So should designated borrowers with PRC guarantees.  The market expects the PRC to meet the obligations of entities under its control.
  6. 6.Use a diversity of borrowing techniques:
    1. Public vs. private vs. silent issues.
    2. Long and short borrowings.
    3. A diverse currency mix.
    4. Hedge currency risks.
    5. Place your obligations in different market sectors (savings banks, commercial banks, insurance companies, pension funds, cooperative and agriculture banks, etc.).
  7. Describe China.  Begin an image campaign by maintaining a dialogue with investors.  Most important, make sure all Chinese entities are meeting all obligations on time -- particularly in Hong Kong.  Rumors about payment delays spread quickly.
    1. Learn to describe China's strength and financial prudence.
    2. Describe financial plans.
    3. Present no surprises to markets.
    4. Learn what investors want and respond to their concerns, even if they are reluctant to tell you.
    5. Choose bankers you can trust and who are prepared to bring you bad news.
  8. At the PRC level, implement internal controls to allow centralized monitoring of the nation's overall external debt and how to cope with currency risk overall -- or for any particular borrower.  Set ceilings for all external debt irrespective of the form of the obligation or the identity of borrower.  If it is an obligation, even if not in the form of debt, monitor it and control it.
  9. Avoid saturation of one market:
    1. Diversify sources.
    2. Use swaps extensively instead of borrowing.
    3. Use lines of credit.
  10. China must be able to borrow quickly -- within a few hours.  Therefore, China must plan ahead.  Staff ahead.
  11. Be careful of too much reliance on bond markets.  Borrowing in the securities markets may reduce flexibility if you need to reschedule or refinance.  Loans and syndicated credits and private placements should predominate a large borrowing program.
  12. Start discussions with the Bank of England on old debt issued by the prior regime.  It need not be settled to China's disadvantage.  But discussions should begin.
  13. Assume China will face difficulties.  China should have a plan to fall back on to service its debt.  Provincial or non-PRC entities should plan ahead as if there were no China or central government to help them or reallocate foreign exchange in the event of difficulties.  But China, the central government, must act and plan as if the Provinces or other non-PRC borrowers will fall on difficult times and China will, in fact, be responsible to service that debt.

Although China's recent reforms contemplate decentralization and further responsibility given to local sectors, where an obligation is assumed in a foreign currency, it must be controlled and monitored by the State.  The State must set limits because the State is responsible for economic planning, the distribution of wealth, the burdens placed on future generations and the allocation, overall, of all resources or deficits from all sectors' borrowings, imports and exports.  A State can have administrative decentralization for purposes of execution, timing, staffing, the generation of foreign exchange or profit, but CHINA sets external limits, publicizes them, and creates the comfort externally on the ability of the nation to service debt irrespective of the identity of the borrower.

Finally, on behalf of my colleagues:

  1. We have learned a great deal.
  2. It is an exciting and challenging time for you.  You can benefit from examining the mistakes of others.
  3. You have a wonderful reputation for integrity.
  4. We are pleased to talk to you.  Call us.  We are most pleased to provide a "second opinion."