Development Finance: Enter the Private Sector

Making poverty history by 2030 will require massive increases in private investment, not just public aid, argues Brett House.
By: /
March 26, 2015

This article originally appeared in the Spring/Summer 2015 issue of Global Brief.

This year has the potential to be pivotal for international development. In 2015, the world reaches the target date for the 15-year-old Millennium Development Goals (MDGs). In September, the UN General Assembly convenes in New York to agree on their successors – a new set of ‘sustainable’ development goals (SDGs) for 2030. Just beforehand, in July, governments will gather in Addis Ababa to make financial pledges to support these SDGs.

Turning these pledges into real investment for development is a huge challenge: while the MDGs have been successful in rallying new resources for poverty reduction, they have never been fully financed. Money alone is evidently not a panacea in the fight to end poverty: good institutions, thoughtful policies, and appropriate technologies are also critically important. But adequate financing makes all of these things more likely too. This article sets out an agenda for mobilizing both the public resources and private investment needed to end global poverty by 2030.

Estimates of the extra annual financing required to reach the SDGs range from US$500 billion to US$3 trillion on top of what is already being spent on the MDGs. This range hinges critically on whether one includes in these numbers climate change-related spending and a host of big infrastructure projects. Official development assistance (ODA) from governments will never on its own cover these sums. Projected to hit about US$150 billion in 2015, or US$125 for every one of the roughly 1.2 billion people living in extreme poverty, ODA is not even in the ballpark of these cost estimates. Even if every OECD country decided to meet former Canadian prime minister Lester Pearson’s vaunted goal of raising aid to 0.7 percent of GNP (only five OECD countries are currently at this standard) and to realize other unmet commitments, annual ODA flows would still total only about US$350 billion – some US$200 billion higher than current annual disbursements. Aid from new donors – the BRICS and Persian Gulf countries – is increasing, but these flows only partially offset reductions from established donor countries. In short, there is no plausible scenario under which aid flows would be sufficiently large to finance a single year of SDG spending.

Indeed, current ODA numbers overstate the cash that actually reaches the budgets of developing countries. For instance, Development Initiatives, a UK-based NGO, notes that between 2008 and 2011 net ODA reported by Uganda was only 40 percent of that reported by donor governments. Or consider that Denmark and Italy reported US$2 billion in ODA disbursements in 2011: two-thirds of Denmark’s aid was delivered as grants, loans, project support, and technical assistance; more than two-thirds of Italy’s aid was debt relief or refugee support – none of which left Italy.

The impact of aid is further limited by the fact that too little of it reaches the countries that need it most – that is, aid is still overly concentrated in a small number of middle-income countries. The UK’s Overseas Development Institute (ODI) has found that these countries also get more money for every person living in extreme poverty than lower-income countries. This is perverse.

Sixty percent of the world’s poor live in middle-income countries, and yet these countries should not generally receive ODA dollars. Aid tends to forestall the domestic political pressure needed to address the inequalities that allow extreme poverty to persist at the national level. Some countries have recognized the need for change: the UK, for instance, will end its aid to India and South Africa this year; and the EU has cut aid to 16 upper-middle-income countries. Grants to these countries can be replaced with commercial lending and technical support – particularly to deal with climate change. Scarce ODA dollars can then be sent to poorer countries where they are needed most.

Aid also bunches in certain sectors. Medicine-based efforts to fight AIDS, tuberculosis and malaria have been well-funded; some other MDG targets, however, have been starved for cash. Moreover, aid flows tend to unevenly ebb and flow over the course of time, which further dents the effectiveness of each aid dollar: developing countries cannot spend strategically if they do not know in advance what aid to expect year over year.

Of course, donor governments should still be held to their aid commitments – commitments that are eminently achievable. The 2008 financial crisis is not an adequate excuse for failing to hit these targets: the UK has lifted aid to 0.7 percent of GNP, and set the target into law despite being rocked by the Great Recession, the Eurozone crisis, and years of austere budgets. The UAE, for its part, recently became the first ‘new’ donor to hit 0.7 percent only a few years after Dubai’s own debt crisis in 2009.

The UN has looked at what it calls ‘innovative’ sources of public financing to make aid commitments more easily achievable for donor countries. Some of the schemes considered are not particularly innovative and have not provided more than a few hundred million dollars in financing per year. Ranging from fees on financial transactions to a ‘solidarity’ levy on airline tickets, many of the schemes are simply additional taxes. Instead, pooling public money under funds for specific purposes, such as the Global Fund for AIDS, Tuberculosis and Malaria (GFATM), has proven to be much more effective for the purpose of raising additional, predictable, multi-year financing. Efforts are now underway to replicate the success of the GFATM under a G20-organized infrastructure fund.

Simply ensuring that existing tax systems in developing countries are able to collect the revenue that they are already mandated to bring in is more innovative than it sounds. The IMF and ODI think that some US$65 billion per year in additional tax revenues could be squeezed from the domestic tax bases of developing countries by improving the effectiveness of tax authorities. As these economies grow and their tax systems become more sophisticated, the potential additional yield will likely increase. Aid, both in the form of dollars and technical assistance, should play a central role in making this happen.

Global Financial Integrity, an American NGO, estimates that ending tax avoidance by international companies operating in developing countries could put an additional US$160 billion per year into government coffers. As a minimal first step toward realizing this target, every donor country and its companies should be made fully compliant under the Extractive Industries Transparency Initiative (EITI) and publicly report everything that they pay to governments and government officials.

Public money remains crucial, but it will not be sufficient to hit the SDGs. Aid could provide an additional US$200 billion per year; innovative financial levies could add US$1 billion at most; and improved tax collection and reduced tax evasion could yield up to US$225 billion in additional public financing. Pooled funds like the GFATM might mobilize further monies. And yet, at just over US$425 billion in new resources, public money would still not hit even the lower estimate of additional annual aid needed to reach the SDGs.

Poor countries have, unfortunately, returned to external borrowing to fill their development financing gaps. Aid catastrophists, such as Dambisa Moyo, have heralded the recent foreign bond issues by several developing countries as an “escape from the yoke of aid.” This critique completely misunderstands what is driving demand for this new debt. International investors have not suddenly embraced Senegal or Ghana as the next economic miracles. Instead, bondholders are simply scrambling for yield now that rich-country interest rates have been pinned near zero for several years.

Until 2006, South Africa was the only Sub-Saharan African country that had issued an external sovereign bond: since then, 12 poor Sub-Saharan African countries, all rebranded as ‘frontier’ markets, have issued some US$15 billion in bond debt. When this paper comes due in a few years, it will likely be impossible to roll it over at affordable rates.

In fact, low-income countries cannot sustain borrowing even on generous terms. After decades of long-horizon loans from public lenders at concessional rates, several developing countries saw their debt become unmanageable in the 1990s. Between 1996 and 2007, donor governments and multilateral financial institutions agreed to write off approximately US$75 billion in debt owed by 36 poor countries. Each country received a clean slate to invest in development.

Investors, donors, the multilaterals, and even poor countries themselves promptly forgot the hard-won lessons of the millennial debt relief effort: just a few years of fresh borrowing at historically low rates has already pushed low-income countries back into trouble. The IMF estimates that some 40 poor countries are in medium to severe debt distress. The next debt crisis is already brewing. Bref, poor countries cannot borrow their way to development.

It follows that policymakers, business and activists also need to focus on increasing private investment in developing countries, and on getting this capital to the places that need it most. Industrialized economies thrive on a mix of public and private actors; developing countries are no different. Donor countries themselves have always recognized the necessity of this mix. The OECD’s 2011 Busan Partnership for Effective Development Cooperation asserts that “[a]id is only part of the solution to development.” The private sector also has a “central role […] in advancing innovation, creating wealth, income and jobs, mobili[z]ing domestic resources, and in turn contributing to poverty reduction.”

Industrialized economies thrive on a mix of public and private actors; developing countries are no different

In order to get ahead, developing countries require greater domestic savings, increased tax revenues, inward foreign investment, and more aid. In 2011, Bill Gates underscored to the G20 that these are not interchangeable bargaining chips. Private money and public aid are complements, not substitutes: they finance different things that need each other to succeed. Public money is the only viable financing for goods and services whose social returns exceed the profits that they generate for individual private investors. Left to the private sector, these public goods would be underprovided, or not provided at all. Conversely, the World Bank estimates that 90 percent of all jobs in the developing world are created by the private sector. In other words, public and private development are two sides of the same poverty-reduction coin.

Jeffrey Sachs notes that there is almost US$22 trillion in private savings globally, but that it is not optimally distributed for development – that is, a large proportion sits idly on corporate balance sheets. If a fraction of this amount were devoted to the SDGs, extreme poverty could be eliminated by 2030. This is not just an altruistic concern, as the fate of the developed world is intimately tied to that of the rest: consider that some 40 percent of the S&P 500 stock index is exposed to the performance of emerging and frontier markets.

At around US$2 trillion annually, the sum of the diverse range of private capital flows to developing countries is some 13 times greater than ODA. However, like aid, most of this financing goes to a small group of middle-income countries. Only a sliver makes it to the 40 or so low-income countries that are home to approximately 850 million of the world’s extreme poor. Moreover, much of this money is focussed on sectors and activities that make little contribution – directly or indirectly – to poverty reduction efforts. There is, as such, a role for the public sector and aid money to create the enabling conditions to facilitate private poverty-reducing investments in poor countries.

Market fundamentalists argue that private capital does not flow to poor countries because the perceived risks outweigh the likely rewards. However, various studies show that colonial, cultural and linguistic ties guide capital flows to developing countries as much as economic factors. This means that familiarity moves money as much as fundamentals. As such, governments, multilaterals and NGOs can all play a role in creating the awareness needed to shift private capital to the spots where it can have the biggest impact.

Developing countries need patient capital – not hot money looking for a quick return. Even great institutions and excellent policies sometimes provide little buffer against global events and dynamics. For instance, when the US Federal Reserve began removing exceptional liquidity measures in 2014 – signalling that higher US interest rates were nigh – investors indiscriminately fled emerging markets, regardless of the quality of their economic management. Indeed, better performers tend to have the most liquid markets, and liquid markets are the easiest to exit.

Patient private capital comes in a few forms. Remittances by international migrants from developing countries are an especially stable – and strings-free – source of foreign exchange that amounted to approximately US$435 billion in 2013. The Israeli and Indian governments have tapped their migrant communities through the issuance of US$35 billion in ‘diaspora bonds’ at a ‘patriotic’ discount to market rates. ‘Impact bonds,’ which provide capital in return for demonstrated development results, mine similar affinities among non-nationals. Still, however lucrative, all of these instruments are limited by their reliance on some form of forbearance – rather than yield – for support.

The needs of poor countries dovetail with the long horizons of rich-world pension funds and insurance companies. These asset managers are saddled with trillions of dollars of future liabilities that are sustainable only if they can get better yields than Western governments currently offer. They are not used to dealing with poor countries, but public institutions can help to ease their engagement.

Public development finance institutions (DFIs) can mitigate risk and drive increasing flows of private capital. A DFI can finance the most difficult parts of deals via loans, equity, insurance, or trade credits. This is not a new idea: most OECD countries and multilaterals have DFI arms, such as the World Bank’s International Finance Corporation (IFC) and the Multilateral Investment Guarantee Agency (MIGA). Nevertheless, this is an idea that needs to be expanded massively.

A typical DFI provides financial products on a quasi-market basis to investors working in developing countries for projects that would otherwise fail to attract support on reasonable terms. DFIs operate with three goals in mind: addressing market failures; producing development gains; and earning a decent return. Nearly every DFI is profitable, and many recycle their profits into aid, more lending, or their government’s general budget.

DFIs can play a particularly critical role in stimulating foreign direct investment (FDI) – that is, investment in real or metaphorical bricks and mortar. FDI is the least volatile of capital flows and is usually accompanied by business savvy, technology transfers, and trade ties. FDI accounts for 75 percent of foreign capital in Sub-Saharan Africa, but it is concentrated in less than a third of the region’s countries. Oil exporting nations, for their part, receive twice as much, on average, as the others, even if extractive-industry investments usually have the most limited positive spinoffs for local people – which is why other forms of FDI need encouragement.

Keeping a DFI focussed on both poverty reduction and profits is – to be sure – challenging. Development impact is harder to measure than simple financial returns. The IFC, for instance, has been taken to task for failing to measure adequately the poverty impact of its projects and incentivizing its employees on deal volume rather than development gains. Other DFIs have avoided these problems through strong boards, rigorous project vetting, and incentive systems aligned with both of their twin goals.

Most DFIs are constrained by the capital at their disposal, not by the availability of attractive projects. Donor governments could simply follow the lead of KfW, whose DEG subsidiary is Germany’s DFI. KfW has the authority to issue bonds on international markets. Backed by the sovereign’s credit rating, these funds are relatively cheap compared with other sources of private financing.

DFIs should be enabled to use the full range of potential development finance instruments: loans, equity, insurance, guarantees, and trade credits. Insurance and guarantees, in particular, can expand the reach of a DFI’s balance sheet. MIGA, for instance, has provided protection on over 700 projects for US$30 billion in exposure since 1988; it has paid out claims worth a total of only US$16 million on six projects. Private-sector assessments of risk in many developing contexts have apparently tended to be overblown, making insurance on international development projects both profitable and effective in catalyzing investment.

National DFIs should also be freed from arbitrary constraints that prevent them from supporting the projects that best combine poverty reduction and profit imperatives. The Overseas Private Investment Corporation (OPIC) sends US$8 to the US Treasury for every dollar of overhead that the US federal budget provides. Still, OPIC is hampered by rules that limit its support to American companies. These rules reduce both OPIC’s development impact and its returns for US taxpayers.

The few OECD countries that lack DFIs should create them. Canada, as the only G7 country without its own DFI, can learn from the experiences of others and avoid the pitfalls that they have encountered. Canada could leverage the strengths of its immigrant communities, the health of its financial sector, and its regulatory probity to create a model DFI. Aware of all this, Canada’s International Development Minister, Christian Paradis, indicated in October of last year his interest in creating a new development finance mechanism.

Ridding the world of extreme poverty by 2030 is at once an ambitious and entirely feasible goal: ambitious because the world has never done it before; feasible because the world has the technical means to do so. Some plan to increase public financing for the SDGs will almost inevitably be brokered in Addis Ababa in July. Promises will be made to increase aid, make tax systems more efficient and effective, and find new ways to raise public funds. This is all important and essential, but it will not be enough. The world also needs to come together to increase the flow of poverty-alleviating private investment in the countries and sectors that see little of it now. Reforming, renewing, expanding, and freeing the world’s DFIs – as well as adding to their ranks – is the most immediate way to put private capital to work to achieve the SDGs. After 15 years of practice on their MDG predecessors, the world knows what to do. And this is the year to make it happen.