New approaches to financing development – rhetoric and reality Sam Jones*
April 2009
Abstract: Foreign aid is consistently subject to criticism. Various solutions have been suggested, including replacement of aid by private flows. This debate is polarised, often based more on rhetoric than substance. The present paper provides a balanced comparative assessment of non-traditional approaches to development financing, including private capital flows, vertical funds and risk-sharing instruments. It reviews the progress these approaches have made and assesses their strengths and weaknesses. It argues that new financing approaches are not solutions to the problems of foreign aid and should be seen as complements not substitutes. New instruments involve trade-offs that are poorly recognised and there remains weak evidence of their comparative effectiveness. This conclusion is reinforced when the impact of the present financial crisis is considered.
* PhD student, Department of Economics, University of Copenhagen. Email:
[email protected]. Correspondence address: Studiestræde 6, DK-1455 Copenhagen K.
Acknowledgements: thanks to Channing Arndt, Peter Gibbon, Stefano Ponte and Finn Tarp for helpful comments. This paper is partially based on work undertaken by the author while employed by The Danish Institute for International Studies under the auspices of a research project financed by the Danish development agency, Danida. The usual disclaimer applies.
New approaches to financing development – rhetoric and reality
Abstract: Foreign aid is consistently subject to criticism. Various solutions have been suggested, including replacement of aid by private flows. This debate is polarised, often based more on rhetoric than substance. The present paper provides a balanced comparative assessment of non-traditional approaches to development financing, including private capital flows, vertical funds and risk-sharing instruments. It reviews the progress these approaches have made and assesses their strengths and weaknesses. It argues that new financing approaches are not solutions to the problems of foreign aid and should be seen as complements not substitutes. New instruments involve trade-offs that are poorly recognised and there remains weak evidence of their comparative effectiveness. This conclusion is reinforced when the impact of the present financial crisis is considered.
1. Introduction
The role of official foreign aid is a perennial controversy. Since its emergence after the Second World War, concerns have been consistently voiced regarding its potentially inconsequential and even detrimental effects. Today this debate is at a high pitch, stimulated by the publication of a number of studies that suggest official development assistance does not have a robust impact on economic growth over either the short or longer terms (e.g., Rajan and Subramanian, 2008). Frustration over foreign aid also stems from other sources, including the high costs of aid bureaucracies and the limited capacity of donors to mobilise funds for high priority (long-term) interventions (Birdsall, 2008). At the same time, non-traditional forms of development financing have expanded rapidly.
Since 2002, private capital flows to developing countries have surged and numerous specialised funds have been established focussing on specific developmental domains. These instruments are often touted as being more effective and sustainable, or at least less prone to deleterious effects, than traditional foreign aid.
Given this context, the current study poses the simple question: what do we know about non- traditional development financing instruments? The objective is to provide a balanced review of the available empirical evidence and thus to give a comparative assessment of the strengths and weaknesses of these instruments. In doing so it will help evaluate the extent to which non-traditional instruments might constitute genuine alternatives to the traditional aid model. For clarity, the latter can be defined as multilateral and bilateral aid provided directly to developing countries as
concessional grants or loans. In the past this largely took the form of projects or balance of payments support, but today takes on a wider range of forms.
In order to motivate the focus on non-traditional development financing, Section 2 provides a brief overview of the aid debate. This is helpful because the alleged failings of traditional aid are consistently used to bolster the case for employing non-traditional instruments. Also, an understanding of the full range of criticisms of traditional development assistance is required in order to assess the extent to which other instruments avoid the same problems.
Section 3 presents and weighs the evidence for three major types of non-traditional instrument – (i) private investment capital flows (i.e., foreign direct investment and portfolio flows); (ii) specialised partnership funds (vertical funds); and (iii) risk-sharing instruments, used to stimulate greater private sector involvement in the provision of public goods and services. In each case it is shown that these instruments do go some way to addressing the problems associated with traditional aid. For example, specialised partnership funds help reduce contract-specific incentive problems by adopting ex ante conditionality and by maintaining an expertise in very specific domains. Private flows avoid the chain of aid relationships altogether and restore a feedback loop between beneficiary and recipient.
However, while some problems may be alleviated, new challenges arise and other problems remain in play. In particular, all of the non-traditional instruments surveyed are highly sector specific and fund a narrow range of goods that may not correspond to developmental needs in a given country. One of the major lines of attack against aid, that it generates political economy and macroeconomic distortions, remains unaddressed by these non-traditional instruments. Moreover, many ‘new’ instruments are almost wholly dependent on official funding and therefore may not be immune from shifts in advanced country donor sentiment. Consequently, they cannot be seen as genuine substitutes for foreign aid. This is underlined by Section 4 which considers the outlook for development financing in the wake of the ongoing global economic and financial crisis. Section 5 summarises the findings and concludes.
Before proceeding, some caveats are in order. The purpose of this study is not to give a detailed account of the weaknesses of traditional aid, its changing nature, or how it can be made more effective. The present discussion explicitly avoids the normative questions concerning how much or which financing instruments developing countries should employ. The objective also is not to give a detailed description of individual non-traditional financing mechanisms. Numerous studies of specific instruments can be found elsewhere.1 Rather, the contribution of this study is to provide a balanced, up to date and comparative review of the characteristics of different kinds of non-traditional financing instruments placed against the backdrop of the critiques of foreign aid.
1 See for example Ketkar and Ratha (2009). There are also particularly extensive treatments of the role of China and India (e.g., Kragelund, 2008), however these ‘new’ donors are not in focus here given they largely adopt traditional approaches to disbursing aid.
2. The aid problem
The importance of effective development financing is widely acknowledged. Few economists would deny that low levels of domestic savings can be a binding constraint to economic growth. The issue, therefore, is what kind of development financing is most suitable and how this can be provided in a sustainable fashion. A starting point for understanding the expansion of non-traditional forms of development financing is the alleged failures of official development assistance (ODA or traditional aid). Not only do these help identify distinctive aspects of non-traditional instruments but it is also the failings of aid that are typically emphasised in order to promote the advantages of other approaches.
The problems associated with ODA can be grouped into three broad categories.2 The first refers to weaknesses with the recipients of aid. A predominant characteristic of ODA is that it goes directly to the public sector in developing countries. Thus, if corruption is prevalent and/or bureaucracy is stifling, such resource inflows may be ineffective. Perhaps more critically, they can have damaging political economy effects in the same fashion as natural resource windfalls. By raising the rents accruing to the public sector, aid can stimulate an increase in rent seeking and corruption as well as alleviate pressures for reform. In turn these effects undermine economic growth to the extent they distort or divert attention away from productive activities and weaken the overall institutional environment. Although difficult to assess empirically, these mechanisms have substantial theoretical plausibility (Dalgaard and Olsson, 2008) and are often employed to press for the reform or dismantling of the current aid system (e.g., Brautigam and Knack, 2004). Weak economic management capacity and minimal economic diversification on the part of the recipient also can allow other negative effects to develop from aid inflows. These refer to absorptive capacity constraints, as well as overvaluation of the real exchange rate via Dutch disease effects (for discussion see Adam and Bevan, 2006).
The second set of failings refers to problems arising from the donor-recipient relationship. The new institutional economics, which emphasises the importance of information asymmetries and transaction costs, has helped clarify the various incentive problems in multilateral and bilateral aid relations (see Svensson, 2000, 2003; Ostrom et al., 2001; Martens, 2002, 2005; Azam and Laffont, 2003; Paul, 2006). In short, aid contracts are necessarily imperfect and incomplete. Thus, assuming that agents’
interests are not fully aligned, strategic behaviour or principal-agent problems may be significant. In particular, there is a broken feedback loop as beneficiaries and decision-makers are geographically and politically separate (Svensson, 2006). This inhibits information sharing and behavioural adjustments (learning) that might enable outcomes to improve over time. Thus the stage is set for
2 For a comprehensive overview of foreign aid see Riddell (2007). Tarp (2006) provides a review of the literature on aggregate aid effectiveness. The contributions in Easterly (2008) also set out some of the latest critiques.
various ex ante, interim and ex post contracting problems to arise such as those described by the Samaritan’s dilemma.
The last set of problems refers to donor behaviour. Alongside imperfect individual aid contracts, the existence of multiple aid relationships, or too many Samaritans, can generate additional difficulties.
As the literature on public administration has shown (e.g., Dixit, 2002, 2003), performance incentives can be severely undermined where agents face multiple principals and/or tasks. The strategies used by donors to improve individual aid contracts also tend to introduce costs for recipients especially when viewed on aggregate. For example, parallel project implementation units or short-term contracting can generate distortions such as policy fragmentation and weakened public sector capacity. Scholars also point to the high volatility of aid compared to domestic revenue sources (Bulir and Hamann, 2007), which in turn is perceived to be detrimental to macroeconomic stability (Hudson and Mosley, 2007), as well as to growth and welfare more generally (Arellano et al., 2005).
Empirically these concerns have been verified and appear particularly acute for the most aid dependent countries which deal with hundreds of donors, projects and their ensuing paraphernalia (Knack and Rahman, 2008). As Birdsall (2008) puts it, donors tend to treat the recipient public sector as a common pool resource with ensuing tragic effects. Of course, these problems apply whether or not recipient motives are benign. In the latter case, however, the negative effects of too many Samaritans may intensify adverse selection and moral hazard problems.
Donors are also criticised for not mobilizing enough funds. The UN Millennium Project’s (2005) action plan to achieve the MDGs, for example, states that although the international community knows how to reduce poverty, the financial means and political will to do so have been lacking. While estimates of additional financing needed to achieve the MDGs on a global basis vary, ranging from USD 50 billion per year to over USD 100 billion, a consistent theme is that at least an approximate doubling of real resource transfers are required (for discussion see Clemens et al., 2007). Thus, all forms of development financing, both public and private are needed to meet the gap.3
Traditional aid has been under attack from all angles. As might be expected, some changes have emerged in response. Addressing mainly the second and third set of failings, recent aid reforms have encouraged greater alignment with country-led poverty reduction plans, wider use of multi-year programme and budget support modalities and greater use of grant- as opposed to credit-based instruments in low income countries. Even so, the extent of reform appears limited and there remains a wide gap between formal commitments to scaling-up ODA and actual increases (Wood et al., 2008;
3 This is explicitly advocated by the United Nations in order to achieve the MDGs: “The public and the private sectors both have a role in almost every form of investment needed for the Goals. ... Public and private investments, when well designed, tend to be complementary, not rivals or substitutes. It is therefore a huge mistake to be dogmatic about public versus private investments. Both are needed.” (UN Millennium Project, 2005: 46)
OECD, 2008). Indeed, although some scaling-up of ODA has taken place since 2000, this is only modest in historical perspective. Total net official assistance to developing countries has fallen from USD 92.5 billion in 1995 to 80.4 billion in 2007 (at constant 2000 prices and including net IMF credits) – see Table 1 (Section 3.1).
Although not a full explanation, optimism surrounding the potential of non-traditional development financing instruments corresponds to the persistence and rising volume of arguments against traditional modes of foreign aid. Non-traditional instruments include (but are not limited to) private capital flows, specialist partnership funds and risk sharing instruments. For some, these tools are considerably more efficient and effective than ODA and, thus, should be considered realistic alternatives to the traditional aid model. A few examples underline this point. With respect to providing support to health, Hilts (2007) argues that ‘smart aid’, provided through vertical funds, avoid the major problems of ODA. The Global Fund itself explicitly describes itself as a vehicle which puts the Paris Principles of enhanced aid effectiveness into practice.4 With respect to other instruments, Moyo’s (2009) argument that aid should be abandoned and replaced with private flows is extreme but far from isolated.5 Even for sub-Saharan Africa, the IMF has highlighted the potential role of international private capital markets, arguing that they: “provide countries with an alternative source of financing [... and ... ] contribute to higher growth while enhancing prospects for meeting the Millennium Development Goals.” (IMF, 2008: 45). Given the number and apparent credibility of these arguments, it is critical to review what we actually really know about non-traditional financing instruments; and it is to this question I now turn.
3. Assessing non-traditional financing instruments 3.1. Private capital flows
A long line of scholarship stresses the advantages of external private investment flows as a means to stimulate economic development. As Lucas’s (1990) seminal paper identifies, in principle one should expect marginal returns to investment to be high in low income countries as physical capital is scarce.
Thus, advanced country investors should pursue opportunities in developing countries until marginal returns are equalised. From an agency framework, the appeal of private investment is that it removes intermediaries from the aid chain and restores a feedback loop through a singular, observable focus on profit. These claims are frequently made by those who advocate that development financing should be mainly comprised of private capital flows (e.g., Bauer, 2000; Ayittey, 2004; Moyo, 2009).
4 See for example: www.theglobalfund.org/en/aideffectiveness
5 For example, an opinion piece in the Wall Street Journal suggests that, instead of providing ineffective aid transfers: “America must remove trade barriers on exports from the poorest countries, regardless of trade policies in those countries. With global market access, poor countries would automatically attract private investment, despite their institutional weaknesses. These institutions would become stronger over time as businesses flourish. Private investments capitalizing on access to global markets would necessarily employ low- cost labor, thus creating jobs.” (Quadir, 2009)
Optimism about the capacity of private flows to meet development financing needs has gained credibility from the boom in private investment flows to developing countries over the period 2002- 2008. As shown in Table 1, these flows have risen faster than ODA and real income, expanding from 3.4% of GNI in 1995 to 6.3% in 2007 for all developing countries combined. Importantly, this phenomenon has not been isolated to the famous BRICs – Brazil, Russia, India, and China. Net private investment inflows to sub-Saharan Africa (SSA) have been even more impressive, rising to 8.1% of GNI in 2007 alone. A select number of SSA countries have been able to (re)gain access to private capital markets. In 2007 both Ghana and Gabon undertook debut Eurobond issues (for USD 750 million and USD 1 billion respectively). Over a billion dollars in international equity issues were raised by Nigerian firms in 2007 alongside various large syndicated loan deals. Growth in the market capitalization of selected African stock markets (especially in Nigeria, Kenya and Ghana; see Jones, 2008) has been notable, prompting some analysts to suggest these countries are moving towards serious frontier emerging market status (Nellor, 2008; IMF, 2008b).
INSERT TABLE 1 ABOUT HERE
These are positive signs. Nevertheless, some caution is required in extrapolating from these trends. At a general level, the historical behaviour of private capital flows to low income countries is discouraging. As the Lucas paradox describes, capital flows from richer to poorer countries have been much smaller than neoclassical theory predicts. More recently, Prasad et al. (2007) show that despite increasing global financial integration, this paradox has intensified and finance capital now flows uphill from poorer to richer countries on aggregate. Contrary to explanations for this puzzle based on risk-adjusted returns, developing countries with higher rates of growth have consistently been net exporters of investment capital (Gourinchas and Jeanne, 2007). Secondly, access to foreign direct investment and international capital markets remains highly uneven among low income countries.
Since at least the 1980s, over 70% of all FDI to SSA has been directed to resource-rich countries, a trend which has persisted during the recent boom.6 Moreover, for the period 1990 to 2007, approximately 99% of all non-bank portfolio flows to SSA have been absorbed by South Africa; and net flows of commercial lending to SSA excluding South Africa have been negative on average since the Asian financial crisis of 1997/98 (Jones, 2009).
A useful take on these issues comes from the new institutional economics, which emphasises that contracts do not take place in an institutional vacuum. The presumed capacity of private agents to realise mutually beneficial transactions depends inter alia on the stability and quality of the overarching contracting environment. This is particularly important for cross-border investments where foreign investors do not have a direct say in the economic governance of the recipient country.
6 For example, for the period 2005 to 2007, Nigeria absorbed 56.1% of total net FDI to the SSA region excluding South Africa (author’s estimates based on data from UNCTAD, 2008).
Therefore, contracting risks and transaction costs may be large. These effects are substantiated by findings of a positive (partial) correlation between host country institutions and capital inflows. For example, Alfaro et al. (2008) find that historical determinants of institutions have a first-order effect over policies as determinants of capital flows. Similarly, Bénassy-Quéré et al. (2007) argue that controlling for income, the quality of institutions matters for inward FDI. Consequently, the authors conclude that public efficiency is a key determinant of private investment inflows.
This suggests a broader point that private returns to investment may depend on the provision of public goods such as security, education, and socio-economic infrastructure. Public spending and institutional reforms can provide a platform for long-term growth (Moreno-Dodson, 2008), a view which finds support from numerous poverty trap theories (see Azariadis and Stachurski, 2005). More critically, the free-rider problem assures there will not be an optimal level of public goods provision by self-interested investors alone (whether domestic or foreign). Thus, some form of external support to the provision of these goods may be indispensable at low levels of economic development. This should not be taken as a rejection of the positive role external investment can play in economic development. Empirical evidence and agency theory simply suggest that private inflows are likely to have a more limited contribution, especially where core public goods and services are severely deficient. As Collier (2009) puts it, arguments that international finance can stimulate development in the poorest countries tend to exaggerate the opportunities and underestimate the difficulties involved.
Finally, in addition to its selectivity, private capital flows to developing countries are often considered to be highly volatile and thus not a reliable source of funding. To gauge the import of this critique, it is helpful to extend the analysis of Bulir and Hamann (2007) in order to compare the volatility of a range of private capital flows (versus domestic sources and foreign aid). The results from this exercise are shown in Table 2, which gives the standard deviation of annual flows of various kinds across groups of countries categorised by aid intensity status. Details of the methodology, sample and data sources are described in Appendix A. The dataset covers 89 developing countries from 1980 to 2005.
In all cases, the flow variables are stated as a percentage of GDP. Part I of the table provides simple or unadjusted standard deviations, and thus indicates the expected annual change in each variable as a ratio to GDP. As per the direction of results elsewhere, ODA is found to be considerably more volatile than domestic revenue sources, particularly in more aid intensive countries. However, perhaps, contrary to expectations, the volatility of both FDI and non-FDI private capital flows (portfolio investment and bank lending) is lower than ODA and more comparable to domestic revenue sources.
INSERT TABLE 2 ABOUT HERE
Nevertheless, and as recognised by Bulir and Hamann (2007), this latter interpretation is misleading because the absolute size of these different flows is not equal (for a given country), and in many cases, flows have not behaved in a stationary fashion over the period surveyed. Consequently, Part II
of the table normalises the underlying variables, restating them as relative deviations from five year moving averages, and then recalculates the (entire period) standard deviation. This adjustment substantially alters the findings. While the lower volatility of domestic revenue remains clear, the relative volatility of all forms of private capital flows is now much higher. This derives from the point that these latter flows have been small for many developing countries, thus generating low unadjusted standard deviation scores. Thus, when corrected to ensure comparability (and enhance stationarity), development aid appears distinctly less volatile than its possible private alternatives. In the most aid intensive countries, FDI is found to be over four times and non-FDI flows over twenty times more volatile than ODA flows. Even so, as others have noted, it remains the case that ODA is considerably more volatile than domestic revenue using this adjusted measure.
3.2. Specialised partnership funds
A striking recent trend, and one that is particularly salient for low income countries, has been the expansion and proliferation of specialized vehicles for financing the provision of basic needs. These are often referred to as vertical funds and focus on very specific developmental interventions, normally in the area of merit goods such as basic health care, clean water, sanitation, child nutrition and shelter. Table 3 provides a summary of some of the main vehicles that have emerged. Despite key differences, they share common characteristics. Firstly, they tend to operate as independent organizations, often structured as a partnership between existing public and non-government development agencies as well as private firms. In the latter cases this means their governing boards include members from a range of different organizations. Secondly, the vehicles typically perform three main functions, namely they: (a) raise and pool funds for highly specific causes; (b) disburse grants to local implementing agents (from the public and private sectors); and (c) focus explicitly on results, often via formal evaluation of outcome. Thus they typically do not operate directly in developing countries.
Thirdly, as part of a narrow focus and results-based orientation, these vehicles tend to apply explicit eligibility criteria for access to funds. For example, the Global Fund is open to all low income countries but requires lower and upper middle income countries to pass differentiated targeting and cost-sharing tests. Other vehicles, such as the Education for All Fast Track Initiative (EFA-FTI) and the Millennium Challenge Corporation (MCC), also incorporate specific selection criteria on governance and policy soundness. In many ways these vehicles appear to address some of the incentive problems associated with traditional development financing (see Section 2). Their specialism and expertise in specific developmental domains, political independence and use of ex ante conditionality point toward an enhanced capacity to make time consistent commitments and choose well-performing agents and projects over time. These features have not gone unnoticed and backed by astute campaigning, these vehicles have been able to rapidly mobilize and disburse large volumes of
funds. To cite some examples, the International Finance Facility for Immunisation has secured legally binding funding commitments from numerous advanced countries until 2026 (see Table 3). As a consequence, the GAVI Alliance reports that over the period 2000-08 it has protected a total of 213 million children with new and underused vaccines and prevented 3.4 million future deaths.7 Similarly, the Global Fund boasts funding commitments of over USD 17 billion and already has become a major player in global health, providing an estimated 20% of donor funding to HIV/AIDS, 64% for malaria, and 70% for tuberculosis (McCarthy 2007: 307). The U.S. President’s Emergency Plan for AIDS Relief (PEPFAR), also a major contributor to the Global Fund, reports that antiretroviral has increased dramatically in its focus countries and attributes gains of over three million cumulative life years to its financial support (OUSGAC, 2009: 12).
These achievements are noteworthy and there is a broad consensus that in contrast to the relatively fragmented and protracted mechanisms of traditional aid, the innovative features of these vehicles have been crucial to their success (Radelet, 2004; Lu et al., 2006; McCarthy, 2007; TERG, 2007).
Nevertheless, they are not a panacea. Firstly, they are almost wholly reliant on official financing sources leading some to question the real extent of additionality (e.g., Godal, 2005). In the case of the Global Fund, the largest of all initiatives on an annualised spending basis, 96% of projected funding derives from official grants which in turn correspond mainly to the larger DAC donors.8 Similarly, the MCC is a US government corporation with exclusive funding through Congressional appropriations. Thus, on the one hand, the expansion of specialist funds has enabled bilateral aid agencies simply to delegate tasks to what appear to be more competent and effective agents. On the other hand, however, government aid agencies have not been made redundant; their role merely has been transformed into a more passive one.
Secondly, while these vehicles address some agency problems within individual aid contracts, they do not simultaneously resolve the system-wide challenges facing recipient governments arising from multiple donor relations. Various studies indicate that new partnership funds tend to operate as separate aid channels with their own distinctive systems and processes. This not only creates inefficient duplication, but they also place additional burdens on local administrative resources via use of government systems (Godal, 2005; Dodd et al., 2007; Garrett, 2007; Oomman et al., 2007, 2008).
Referring specifically to global health partnerships, Caines (2005) argues they have exacerbated overlaps between donors and tend to be poorly aligned with country systems. Also, as suggested by Martens (2005), the emphasis on quality, selectivity and ex post conditionality appears to have increased ex ante transaction costs during programme negotiation and initiation. With respect to the MCC, for example, Herrling et al. (2009) note that start-up processes and procedures have been much slower than originally envisaged. The US Government Accountability Office (Gootnick, 2007)
7 Information based on www.gavialliance.org/performance/global_results/index.php, accessed March 2009.
8 Author’s calculations from data on pledges and contributions, see: www.theglobalfund.org/en/pledges
estimates it has taken an average of 633 days (about 21 months) for African countries to progress from being selected as eligible to signing a compact; and only 23% of disbursements took place as planned for compacts to African countries operational through to end March 2007. These problems are explained by the MCC’s highly optimistic initial assessments of partner country capacity, including availability of qualified personnel (Gootnick, 2007).
Thirdly, these challenges reinforce the notion that the long-term effectiveness and sustainability of any single aid intervention depends on broader systems and local capacities. While in many countries these remain critically weak, they have not been adequately prioritised by specialised funds (or other donors) due to the lower visibility and diffuse benefits of systemic approaches (Dodd et al., 2007;
Reich et al., 2008). Taking the example of health, some commentators suggest that access to funding is no longer a binding constraint for many developing countries. The more critical challenge is to build national health systems with adequate personnel, high quality information and competent planning processes (Sridhar and Batniji, 2008; Bertozzi et al., 2008; AbouZahr et al., 2009). In their absence, health funding can be distorted by donor concerns rather than country needs and thus is only weakly effective on aggregate. Garrett (2007) cites examples from across Africa where health system capacity indicators (e.g., doctors per capita) have stagnated or declined despite huge volumes of funding for specific diseases such as HIV/AIDS. Sridhar and Batniji (2008) show extremely large discrepancies in the allocation of funds to different diseases, as well as the excessive focus of major global health funds on treatment as opposed to prevention. Case studies of Uganda and Ethiopia, documented in Berstein et al. (2007), also suggest that where local government capacity bottlenecks exist, pressure to achieve disbursement targets has led specialised funds to push for ‘external’
solutions, such as outsourcing of key functions, as opposed to internal strengthening.
The message is that specialised funds have been highly effective in rapidly leveraging significant volumes of financing to tackle discrete and tangible challenges where the relevant technology of invention is known (e.g., vaccination). But it is doubtful they have a comparative advantage in the more complex and longer-term tasks of institution and capacity building. Of course, many such vehicles have recognised and begun to address these deficiencies – for example through the Global Fund’s diagonal’ approach (see Reich et al., 2008). However, this has also revealed tensions in their underlying objectives. A recent independent evaluation of the Global Fund identifies an unresolved conflict between retaining a strict focus on channelling funds to the most efficient/effective local agents and becoming more closely involved in implementation processes through local capacity- building (TERG, 2007). Other tensions have emerged, such as between adherence to selectivity- and performance-criteria versus building flexible long-term partnerships (TERG, 2007; Birdsall, 2008;
Herrling et al., 2009). Thus, specialised funds are not a comprehensive solution to problems in
delivering aid and it may be highly problematic to apply this model to domains which are more controversial, complex and interdependent in comparison to primary health needs.9
INSERT TABLES 3 and 4 ABOUT HERE 3.3. Risk-sharing instruments
Between the extremes of pure private and pure public provision of goods or services, a wide spectrum of relationships between the government and private sector exists. Since at least the early 1990s there has been a rapid expansion of private sector involvement in areas previously reserved for the government, such as in transportation and healthcare. This trend has been notable in advanced countries and often goes by the label of public private partnerships (PPPs). While many developing countries pursued widespread privatization during the 1980s and 1990s (Parker and Kirkpatrick, 2005), an increasing use of PPPs has been observed more recently (Pessoa, 2008). Of interest in this subsection are innovations in traditional aid which engage with this phenomenon.
Summarised in Table 4, advanced country donors have established numerous initiatives to stimulate greater private sector involvement in the provision of goods and services. These initiatives share two common features – they focus on projects with a public character and support is provided only indirectly via risk-sharing. This differs from traditional risk mitigation products, such as export credits, as the latter are often used to promote investments by companies from advanced countries.
Moreover, these donor-initiatives address project risks in distinctive ways. For example, a common impediment to infrastructure investment in developing countries is poor information regarding viable opportunities as well as high costs of pre-financing preparation. To reduce these search and design risks for private sector agents, the DevCo facility (see Table 4) and a development finance information portal have been setup.10 Other approaches tackle specific financing risks that impair access to credit for firms in developing countries. Local currency debt financing is supported under the GuarantCo and GEMLOC initiatives. Similarly, the US government’s DCA predominantly underwrites risks assumed by local financial institutions in lending to underserved sectors. Finally, the GPOBA assists in the design and financing of schemes that delegate (public) service delivery to third- parties, typically in the private sector. Here donors aim to raise the quality of projects and reduce the private sector’s demand risk by providing subsidy funds where full cost recovery through direct user fees is problematic (see Brook and Smith, 2001; GPOBA, 2005).
The anticipated benefits of these initiatives directly correspond to critiques of traditional aid (see Section 2). Private participation can leverage new (or additional) financing and may even improve the
9 Eurodad (2008) notes that recommendations to establish a global fund for agriculture have been largely dismissed by major donors for precisely these reasons. Also see Foster et al. (2001).
10 The latter refers to the Global Clearinghouse for Development Finance (www.globalclearinghouse.org), currently sponsored by the Swiss Agency for Development and Cooperation and the UNDESA.
government’s financial position through revenue-sharing or divestitures. From an agency perspective, private sector involvement also can reduce problems of adverse agent and project selection. This occurs by introducing competition among contractors and ensuring that outcomes are rewarded (by profits), thus improving efficiency and performance (Fourie and Burger, 2000). Consequently, use of specialised risk-sharing instruments to enhance private sector involvement can be conceived as a response to the incentive problems that characterise the Samaritan’s dilemma. In a similar way to the funds surveyed in Section 3.2, by establishing expert vehicles with pooled donor support, progress is made in boosting information, technical capacity and financing volumes. Also, by reducing private sector risks, some of the difficulties identified in Section 3.1 concerning the uneven and limited extent of private investment may be overcome, in turn energizing the contribution of private enterprise to development.
Risk-sharing instruments which stimulate enhanced private sector participation appear to respond to a clear gap in the development financing landscape. Estimates of the infrastructure financing needs in the poorest countries are extremely high. The World Bank’s recent Africa Country Infrastructure Diagnostic (Foster, 2008a), for example, identifies that an annual USD75 billion in additional financing is required to address the region’s critical infrastructure ‘gap’. Moreover, traditional sources of external financing such as ODA have been demonstrably insufficient. This reflects both ODA’s weak overall record (see Table 1), as well as the concern that infrastructure as a share of donors’
commitments fell during the 1990s due to concerns regarding governance and the general shift toward social spending (Briceño-Garmendia et al., 2004). At the same time, private participation in infrastructure (PPI) has been on the increase – rising from around USD 2 billion in 2000 to 11.7 billion in 2006 for the SSA region alone, surpassing ODA commitments to infrastructure investment (ICA, 2007). Importantly, PPI projects (once implemented) appear to have reasonably high success rates, even in low income countries. According to data from the World Bank only around 3% of PPIs in SSA and South Asia are cancelled or distressed, versus 7% overall (by value).11 Similarly, evaluations of private sector involvement in service delivery in poor countries have shown positive impacts, particularly with regard to expanding access (Loevinsohn and Harding, 2005; Halpern and Mumssen, 2006; Patouillard et al., 2007; Liu et al., 2008).
Despite the above, many of the instruments which enable donors to support PPP-style deals are at an early stage of development. Only a small number of transactions have been concluded (see Table 4) and there is little information regarding longer-term outcomes which are needed for comprehensive evaluation. With respect to results-based financing schemes, for example, Oxman and Fretheim (2008) conclude that most existing evaluations are not rigorous and there is almost no evidence on cost-effectiveness. They also note that unanticipated adverse effects have occurred in some instances,
11 Author’s calculations from World Bank (2009).
such as a reduction in provision of services to the severely ill, which may be associated with the specific ways in which performance is monitored. Similar concerns are encountered with respect to PPIs. Transfer of risk to the private sector is not costless and pricing estimates suggest that private sector funding is only marginally more attractive than (distortionary) tax funding, whereas ODA comes at a 70% discount (Foster, 2008a). Non-OECD donors such as China, India and the Arab states also have become particularly active in infrastructure financing in low income countries, also providing funds at substantial discounts to the private sector.
In addition, PPP deals tend to be complex and can require substantial public administrative and regulatory capacity to be effective. This has been learnt in advanced countries, prompting scholars to conclude that use of the private sector does not solve public sector agency problems but only transforms them into a new set of regulatory challenges (Grout and Stevens, 2003). The latter are particularly severe in developing countries due to low levels of competition, weak or non-existent conflict of interest legislation and inadequate technical capacities on the part of the government (Pessoa, 2008). Thus, one cannot presume that the opportunity costs of using PPPs to address public sector deficiencies are always low. Moreover, moral hazard may emerge where the private sector provider is aware of a scheme’s dependence on donor support and that the services she is providing cannot easily be severed, thereby reducing incentives to increase efficiency and ‘graduate’ to full cost recovery (Fourie and Berger, 2000). Although limited in number, case studies confirm that donor- supported PPPs are not a magic bullet. For example, PPP deals in Cambodia have been hampered by weak capacity and a number have been suspended by the World Bank due to concerns regarding corruption (Navarro and Tavares, 2008).
Finally, the experience of PPIs in low income countries indicate the private sector has a strong preference for activities where uncertainty is lowest and cost recovery most rapid – i.e., goods and services that are least rivalled and easily excludable (Hammami et al., 2006; Foster, 2008a). World Bank (2009) data shows that over 70% of PPIs in SSA have gone to the telecoms sector, versus less than 1% to water, sewerage and sanitation. The preliminary record of donor-supported schemes suggests this sectoral concentration continues. Of the twelve deals supported by the EAIF, for example, five are in the telecoms sector and one is a private mining project with highly concessional tax relief (the Moma Heavy Sands project in Mozambique). The two deals supported by GuarantCo are also in the telecoms sector. Consequently, Foster’s (2008b) argument that different sources of financing are likely to be complements rather than substitutes remains valid.
4. Current outlook
Before concluding, it is pertinent to reflect on the impact of the current global financial crisis on development financing in general and non-traditional financing mechanisms in particular. As has become evident, although the financial crisis found its origins in advanced countries, developing
countries have been extensively affected. As Smick (2008) notes, the thesis that (some) emerging markets were becoming decoupled from the vicissitudes of the US business cycle has been strongly undermined by recent events. The shortage of liquidity in advanced countries as well as the desire to reduce leverage has led to a rapid contraction of investors’ risk appetite and a flight to quality.
While it is unwise to proffer clear-cut predictions given the rapidly evolving and uncertain nature of global conditions, the preliminary evidence is that there has been a significant ‘halt’ in private capital flows to all emerging markets.12 At least for some regions, this appears to echo the sudden stop in capital inflows which occurred in response to the Asian crisis of 1997/98 (see IMF, 2009: 29). This has involved a flow of funds out of (higher risk) developing country markets and a jump in financing costs, evidenced by the decline in stock market valuations across the developing world and an increase in bond spreads. Although access to international capital markets has been historically limited, these effects have caused lower income countries to revise private financing plans. Nigeria, Ghana and Kenya have all had to postpone plans for international sovereign bond issues. Evidence of the dramatic change in financing possibilities is illustrated by the spike in the spread on emerging market bonds in general, as well as for Ghana in particular. With regard to the former, the blended spread on its sovereign Eurobond (which gives the yield difference over US Treasuries) has risen from around 370 basis points when it was launched in November 2007, to over 1000 basis points in April 2009. While this is down from a peak of 1500 basis points at end December 2008, financing costs remain around three times higher than they were before the crisis (based on monthly data from Datastream). Equally, the spread on the JP Morgan EMBI global composite index has risen from 156 basis points in July 2007 to 550 in April 2009, a level which is not dissimilar to those seen following the Asian crisis.
An additional challenge is the effect of the global economic slowdown on fiscal balances. Lower commodity prices and export volumes are expected to reduce domestic revenues in many low income countries (especially those dependent on a small number of primary exports). Naturally, this reduces prospects for raising external investment capital as repayment risks rise. Indeed, it is precisely macroeconomic stability and fiscal strength that appear critical for attracting private flows – both directly and indirectly through risk sharing instruments. Thus, prospects for expanding these kinds of instruments may be severely limited to the extent that macroeconomic and fiscal conditions deteriorate in developing countries.
12 Speaking in 2008, for example, the World Bank’s Chief Economist made the following forecast which remains pertinent: “All of the main external sources of funds for investment [in developing countries] are likely to drop off sharply ... Portfolio investment will fall, as greater risk aversion keeps capital closer to home. While FDI is historically more resilient to shocks, it too is expected to decline. ... the global slowdown will reduce demand for commodities and manufactured goods, cutting into export earnings. And as labor markets slacken, foreign workers are likely to suffer disproportionate impacts on their earnings, which will reduce remittances.”
(Lin, 2008: 10-11)
As a consequence, a critical question for many low income countries will be the response of ODA flows. If history is anything to go by, a reduction in real aid flows is highly plausible in light of the scale of domestic capital injections already approved or proposed by the major DAC donors. Table 1 indicates that in 2000, ODA had fallen to less than half its 1995 value in real terms, a phenomenon at least partly explained by the clouds of recession then accumulating over the European Union. Using a pertinent example, Roodman (2008) calculates that after the Nordic financial crisis of 1991, aid from Norway, Sweden and Finland fell by 10%, 17% and 62% respectively (measured from peak to trough and adjusted for inflation). Private charitable contributions also may decline significantly, which may have a deeper impact in specific domains such as emergency aid and targeted health interventions (e.g., HIV/AIDS). Moreover, these effects may not be distributed equally across countries due to differences in geo-political importance. Strategically less significant countries, such as some of the poorest African countries, may be relatively more exposed to alterations in aid flows than others.
5. Summary and conclusion
The principal finding of this study is that although there has been substantial hype surrounding the potential of non-traditional forms of development financing, they are not a panacea to the ‘aid problem’. Consequently, they should not be considered alternatives to more traditional forms of foreign aid. This follows from the evidence that non-traditional instruments are selective, they tend to finance a narrow range of goods and they introduce new challenges and costs. In terms of the three groups of aid problems described in Section 2, non-traditional instruments mainly appear to address certain donor failings and donor-recipient incentive problems. However, they do not address problems arising from multiple donors nor do they convincingly resolve the host of problems on the recipient side that can undermine the benefits from resource inflows (e.g., corruption, political economy and macroeconomic distortions). Many new instruments are dependent on official support and thus may not be immune from changes in donor sentiments. Moreover, the comparative effectiveness of these instruments is largely unknown. Further evidence and research needs to be amassed before more robust comparative aid effectiveness statements can be made.
These arguments are not new. For example, numerous scholars have questioned the ability of private capital to deliver on development financing, especially for the poorest countries (e.g., van de Walle, 2005). The recycling and updating of arguments is a familiar part of the cycle of debates over foreign aid. However, questioning the potential of non-traditional instruments is once again timely given the current tide of opinion. But this does not amount to a defence of the status quo. This study has not dipped its toes into the murky waters of how foreign aid can and should be reformed to enhance its effectiveness. Also, the present conclusions should not be interpreted as a rejection of the contribution that new financing instruments can make. Different instruments offer different combinations of incentives and alternative mixes of costs and benefits. A priori, expanding the financing options
available to low income countries is likely to be a good thing, especially where it encourages recipients to critically assess their financing portfolio and search for more optimal combinations of instruments. For this reason, non-traditional instruments must be seen as complements to traditional aid but we need to be realistic about what they can contribute.
Finally, recent events reinforce the view that traditional aid is not obsolete. The global financial crisis of 2008 has morphed into a major global economic slowdown. Over the medium-term, the outlook for non-traditional financing mechanisms is uncertain due to lower risk appetites among investors and mounting pressures on official aid budgets. As private flows dry-up, the important role of official assistance from the major DAC donors to the poorest countries is likely to become more visible. At the same time, there is the possibility for a silver-lining. The financial crisis may be an opportunity to reduce aid fragmentation and overlaps in aid delivery. Alternative financing mechanisms also may receive a boost where they improve the overall financing package for recipients. Thus, deepening our understanding of the compatibilities and possible conflicts between foreign aid and other financing instruments thus remains an important agenda for future research.
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Appendix A: Measurement of flow volatility
A number of papers have investigated the volatility of flows to developing countries (see Section 3.1).
Although methods vary in their specifics, the basic approach is to calculate measures of the variance of aid flows and compare these to those of domestic revenue sources, where the underlying variables are normally stated as a percentage of GDP. The same broad approach is adopted here. Part I of Table 2 presents measures of the unadjusted standard deviation of domestic revenue, ODA, FDI and non- FDI flows where the latter are the sum of bonds, equity and net bank lending. Note that the standard deviation is calculated separately for each country and only then is the median calculated across relevant country groupings.
The underlying dataset is described in Table A.1 below, showing the countries and available data points for each country-variable combination. The maximum period is 1980-2005 for all variables except domestic revenue, for which data is available from 1980-2003 only. The domestic revenue variable (as a percentage of GDP) is taken from Bulir and Hamann’s (2007) dataset, made available from their website at the IMF.13 All other variables are taken directly from the World Development Indicators (World Bank, 2008b).
For the adjusted measures of standard deviation, given in Part II of Table 2, each variable is restated as a relative deviation from its five year moving average. This addresses both scale differences between variables and deviations from stationarity within individual series. Thus, the adjusted standard deviation for a variable of interest (x) (e.g., ODA over GDP), over the entire time period available (T), for a given country (i) is given by:
1
,
where:
1
,
1 1
1 5 ∑ 5 ∑
13 See: www.imf.org/external/pubs/ft/staffp/2007/04/data/Bulir.zip
Appendix Table A.1: Description of volatility measurement dataset
Country Domestic
revenue ODA FDI Non-FDI Albania 1992-03 1988-05 1988-05 1984-05 Algeria 1980-03 1980-05 1980-05 1980-05 Angola 1980-03 1985-05 1985-05 1985-05 Armenia 1994-03 1991-05 1990-05 1990-05 Azerbaijan . - . 2000-05 2000-05 2000-05 Bangladesh 1980-03 1980-05 1980-05 1980-05 Belarus 2000-02 2000-05 2000-05 2000-05 Benin 1980-03 1980-05 1980-05 1980-05 Bhutan 1980-03 1980-05 1990-05 1980-05 Bolivia 1980-03 1980-05 1980-05 1980-05 Botswana . - . 2000-05 2000-05 2000-05 Brazil . - . 2000-05 2000-05 2000-05 Bulgaria 2000-03 2000-04 2000-05 2000-05 Burkina Faso 1980-03 1980-05 1980-05 1980-05 Burundi 1980-03 1980-05 1980-05 1980-05 Cambodia 1987-03 1987-05 1992-05 1987-05 Cameroon 1980-03 1980-05 1980-05 1980-05 Central African Republic 1980-03 1980-05 1980-05 1980-05 Chad 1980-03 1980-05 1980-05 1980-05 China 2000-01 2000-05 2000-05 2000-05 Colombia 1980-03 1980-05 1980-05 1980-05 Congo, Dem. Rep. 1980-03 1980-05 1980-05 1980-05 Congo, Rep. 1980-03 1980-05 1980-05 1980-05 Cote d'Ivoire 1980-03 1980-05 1980-05 1980-05 Djibouti 1980-03 1985-05 1992-05 1985-05 Dominican Republic 1980-03 1980-05 1980-05 1980-05 Ecuador 1980-03 1980-05 1980-05 1980-05 Egypt, Arab Rep. 1980-03 1980-05 1980-05 1980-05 El Salvador 1980-03 1980-05 1980-05 1980-05 Eritrea . - . 2000-05 2000-05 2000-05 Ethiopia 1980-03 1981-05 1981-05 1981-05 Gabon . - . 2000-05 2000-05 2000-05 Gambia, The 1980-03 1980-05 1980-05 1980-05 Georgia 2000-03 2000-05 2000-05 2000-05 Ghana 1980-03 1980-05 1980-05 1980-05 Guatemala 1980-03 1980-05 1980-05 1980-05 Guinea 1980-03 1986-05 1986-05 1986-05 Guinea-Bissau 1980-03 1980-05 1980-05 1980-05 Guyana 1980-03 1980-05 1980-05 1980-05 Haiti 1980-03 1980-05 1980-05 1980-05 Honduras 1980-03 1980-05 1980-05 1980-05 India 2000-03 2000-05 2000-05 2000-05 Indonesia 1980-03 1980-05 1980-05 1980-05 Iran, Islamic Rep. 2000-03 2000-05 2000-05 2000-05 Jamaica 1980-03 1980-05 1980-05 1980-05
