# **1. Introduction**

With the launch of the Human Capital Project (HCP), the World Bank has called on countries to accelerate progress in the human capital of their populations (World Bank, 2018). There are many reasons why human capital outcomes might fall short of expectations. For example, countries may underinvest in the skills, health, and resilience of their citizens because the returns on these investments can take a long time to materialize. In comparison, investments in physical capital – bridges and roads – could materialize more quickly. Moreover, differently from investment in human capital, they often generate financial returns (for example, tolls). These arguments led development practitioners to conjecture that countries borrow less for human development interventions in the face of increased borrowing costs. For instance, when countries graduate from IDA (International Development Association) status to IBRD (International Bank for Reconstruction and Development)<sup>3</sup> status in their engagement with the World Bank, they also face an increase in borrowing costs. Countries with per capita income below $1,215 have access to IDA funds at concessional terms, while richer countries have access to IBRD funds (which typically charge LIBOR plus a fixed spread).

The discrete change in financing terms when countries graduate from IDA to IBRD could discourage countries from borrowing for “soft sectors” like Education, Health and Social Protection (together grouped as the Human Development group in the World Bank) in favor of sectors where investments have more immediate and tangible returns. However, other mechanisms might be at play. Take total Bank borrowing for example. On one hand, as interest rates go up when countries graduate IDA, the demand for Bank loans should decline. In addition, IDA graduation also operates as a signal of creditworthiness for other lenders (bilateral lenders as well as the market), thereby permitting crowding in other lenders, which could further lower borrowing from the Bank. On the other hand, IDA graduation alleviates borrowing limits imposed on the IDA pool and countries face fewer restrictions on how much they can borrow. Finally, the creditworthiness signal could work in the opposite direction as well – observing the signal, bilateral donors may reduce aid amounts, thus increasing governments’ demand for Bank loans.<sup>4</sup> What is even less clear theoretically is how HD lending would respond to graduation vis-à-vis total lending.

In this work, we use the Bank’s portfolio data to understand and describe the patterns of total and HD lending at the World Bank. First, we describe the patterns of lending in IDA and IBRD countries. We then examine how total Bank lending and lending for HD sectors respond to countries’ transition from IDA to IBRD. To do this, we combine the Bank’s portfolio data with countries’ borrower status and analyze the effect of IDA graduation in a regression framework. Although, in principle, countries graduate from IDA status exogenously when they cross a prespecified income threshold, in practice, there are exceptions and additional factors that affect graduation eligibility, which makes it impossible to treat graduation as an exogenous event. As a second-best approach, we use fixed-effects regressions (country and year) to isolate the effect of graduation. Year fixed effects capture economic climate and

> 3 Interest rates for IBRD flexible loans with a variable spread were LIBOR + 0.99% as of October 1, 2018 (Group A countries, >18-20 years maturity). The USD LIBOR – 6 months average for 2018 was 2.487%. The interest rate on regular IDA loans was 3.125% with 38 years maturity, and 6 years grade period.

> 4 See Knack et al. (2014) for further discussion. The authors study how IDA graduation affects other donors’ allocation of aid, thereby generating direct evidence on the signaling effect.

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